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Introduction
to Economics ECO401
VU
Lesson
6.4
MARKET
STRUCTURES
(CONTINUED...........)
OLIGOPOLY
Similar
to monopoly in the sense
that there are a small
number of firms (about 2-20)
in the
market
and, as such, barriers to
entry exist.
Similarity
of Oligopoly with other
Market Structures:
It
is similar to perfect competition in
the sense that firms
compete with each other,
often
feverishly,
which may result in prices
very similar to those that
would obtain under
perfect
competition.
It
is similar to monopolistic competition
since there is a possibility of
having differentiated
products.
Strategic
interaction:
It
differs from other forms of
competition in that the
strategy of each oligopolistic
firm depends
on
the action/reaction of other
firms in the
industry.
It
also differs from all
other forms in that it is
not possible to identify a
single equilibrium.
Collusion:
Collusion
occurs when two or more
firms decide to cooperate
with each other in the
setting of
prices
and/or quantities.
Firms
collude in order to maximize
the profits of the industry
as a whole by behaving like
a
single
firm. In doing so, they
try to increase their
individual profits. Often
there is a tension
between
these two goals ad this
can lead to collusion to
break down.
A
collusive oligopoly (or
cartel) can be formed by
deciding upon market shares,
advertising
expenses,
prices to be charged (identical or
different) or production
quotas.
Cartel:
A
cartel is most likely to
survive when the number of
firms is small, there is
openness among
firms
regarding their production
processes; the product is
homogeneous; there is a large
firm
which
acts as price leader;
industry is stable; government's
strictness in implementing
anti-
trust
(or anti-collusion)
laws.
Govt.
regulations are helpless
against internationally operational
cartels or when collusion
is
tacit
(or hidden) not
explicit.
Break
down of Collusive
Oligopoly:
A
collusive oligopoly (say
based on production quotas) is
likely to break down when
the
incentive
to cheat is very high. This
can arise, for instance, in
a situation where there is a
lure
of
very high profits so that
individual firms cheat on
their quota and try to
increase output and
profits.
But this causes everyone
else to do the same and
therefore supply soars and
prices
tumble
producing in effect a non-collusive
oligopoly.
The
incentive to collude becomes
strong for members of a
non-collusive oligopoly when
firms
are
not making good profits.
Thus oligopolies usually
oscillate between collusive
and non-
collusive
equilibria.
Prisoner's
Dilemma Situation:
A
prisoner's dilemma situation
for oligopolistic firms
arises when 2 or more firms
by attempting
independently
to choose the best strategy
anticipation of whatever the
others are likely to
do,
all
end up in a worse position
than if they had cooperated
in the first place.
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Maximin
and Maximax
strategies:
Maximin
strategy is a cautious (pessimistic)
approach in which firms try
to maximize the worst
payoff
they can make. A maximax
strategy involves choosing
the strategy which
maximizes
the
maximum payoff
(optimistic).
Kinked
Demand Curve:
A
kinked demand curve explains
the "stickiness" of the
prices in oligopolistic markets.
The
main
insight is that if one firm
raises prices, no one else
will and so the firm
will face declining
revenues
(elastic demand). However if
one firm lowered its
price, everyone else would
lower
their
prices as well and
everyone's revenues, including
the first firm's revenues
would fall
(inelastic
demand).
Non
Price Competition:
Non
price competition means
competition amongst the
firms based on factors other
than price,
e.g.
advertising expenditures.
60
Introduction
to Economics ECO401
VU
END
OF UNIT 6 - EXERCISES
Give
two examples of markets
which fall into each of
the following
categories.
Perfect
competition: grains; foreign
exchange.
Monopolistic
competition: taxis; van
hire, restaurants.
Oligopoly:
(homogeneous) white sugar;
(differentiated) soap;
banks.
Monopoly:
WAPDA (electricity transmission);
local bus company on
specific routes.
Would
you expect general building
contractors and restaurant
owners to have the
same
degree
of control over
price?
Other
things being equal,
restaurant owners are likely
to produce a more
differentiated
product/service
than general builders (as
opposed to specialist builders),
and are thus likely
to
face
a less elastic demand. This
gives them more control
over price. Note, however,
that the
control
over price depends on the
degree of competition a firm
faces. If, therefore, there
were
only
a few builders in a given
town, but many restaurants,
the above arguments may
not hold.
It
is sometimes claimed that
the market for the
stocks/ shares of a company is
perfectly
competitive,
or nearly so. Go through the
four main perfect
competition assumptions
you
have been taught about
(large no. of price taking
firms, no entry
barriers,
homogenous
product, and perfect
information) and see if they
apply to HUBCO
shares.
a.
Most aspects of the four
assumptions of perfect competition
apply.
b.
There is a very large number
of shareholders (although there
are some large
institutional
shareholders.)
c.
People are free to buy
HUBCO shares (though, in
reality, this depends on how
liquid, i.e.
accessible/available
for sale the HUBCO
shares are).
d.
All HUBCO shares are
the same.
e.
Buyers and sellers know
the current HUBCO share
price, but they have
imperfect
knowledge
of future share
prices.
Is
the market for gold
perfectly competitive?
It
is almost similar to the
market for HUBCO shares.
There are many buyers
and sellers of gold,
who
are thus price takers,
but who have imperfect
knowledge of future gold
prices. Also,
countries
with large gold stocks
(e.g. the USA) could
influence the price by
large-scale selling
(or
buying).
[Note also that the
`price' would have to refer
to a weighted average of the
price in all
major
currencies to take account of
exchange rate
fluctuations.]
What
are the advantages and
disadvantages of using a 5-firm
"concentration ratio"
rather
than
a 10-firm, 3-firm or even a
1-firm ratio?
The
fewer the number of firms
used in the ratio, the
more useful it is for seeing
just how powerful
the
largest firms are. The
problem with only including
one or two firms in the
ratio, however, is
that
it will not pick up the
significance of the medium-to-large
firms. For example, if we
look at
the
3-firm ratio for two
industries, and if in both
cases the three largest
firms have a 50 per
cent
market
share, but in one industry
the next largest three
firms have 45 per cent of
the market (a
highly
concentrated industry), but in
the other industry the
next three largest firms
have only 5
per
cent of the market (an
industry with many competing
firms), the 3-firm ratio
will not pick up
this
difference. Clearly, this
problem is more acute when
using a 2-firm or a 1-firm
ratio.
The
more the firms used in
the ratio, the more
useful it is for seeing
whether the industry
is
moderately
competitive or very competitive. It
will not, however, show
whether the industry
is
dominated
by just one or two firms.
For example, the 10-firm
ratio for two industries
may be 90
per
cent. But if in one case
there are 10 firms of
roughly equal size, all
with a market share
of
approximately
9 per cent, then this
will be a much more
competitive industry than
the other one,
if
that other one is dominated
by one large firm which
has an 85 per cent market
share.
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A
more complete picture would
be given of an industry if more
than one ratio were
used:
perhaps
a 1-firm, a 2-firm, a 5-firm
and a 10-firm ratio.
Why
do economists treat normal
profit as a cost of
production?
Because
it is part of the opportunity
cost of production. It is the
profit sacrificed by not
using the
capital
in some alternative
use.
What
determines (a) the level
and (b) the rate of
normal profit for a
particular firm?
It
is easier to answer this in
the reverse order.
a.
The level of normal profit
depends on the total amount
of capital employed.
b.
The rate of normal profit is
the rate of profit on
capital that could be earned
by the owner
in
some alternative industry
(involving the same level of
risks).
Will
the industry supply be zero
when the price of a firm A
falls below P1 , where P1
<
AVC
for the firm?
Once
the price dips below a
firm's AVC curve, it will
stop production. But only if
"all" firms have
the
same AVC curve will the
"entire industry" stop
production. If some firms
have a lower AVC
curve
than firm A, then industry
supply will not be zero at
P1.
Why
is perfect competition so
rare?
·
Information
on revenue and costs,
especially future revenue
and costs, is
imperfect.
·
Producers
usually produce differentiated
products.
·
There
are frequently barriers to
entry for new
firms.
Why
does the market for
fresh vegetables approximate to
perfect competition,
whereas
that
for aircraft does
not?
There
are limited economies of
scale in the production of
fresh vegetables and
therefore there
are
many producers. There are
such substantial economies of
scale in aircraft
production,
however,
that the market is only
large enough for a very
limited number of producers,
each of
which,
therefore, will have
considerable market
power.
What
advantages might a large
established retailer have
over a new e-commerce rival
to
suggest
that the new e-commerce
business will face
difficulties establishing a market
for
internet
shopping?
·
Customers
are familiar with the
retailer's products and
services and may trust
their
quality.
·
Consumers
may prefer to be able to ask
advice from a sales
assistant, something
they
can't
do when buying over the
internet.
·
The
retailer may have sufficient
market strength to match any
lower prices offered by
the
e-commerce
firm.
·
The
retailer may have sufficient
market strength to force
down prices from its
suppliers.
·
Consumers
may prefer to see and/or
touch the products on
display to assess
their
quality.
·
Consumers
may prefer the `retail
experience' of going
shopping.
As
an illustration of the difficulty in
identifying monopolies, try to
decide which of
the
following
are monopolies: Pakistan
Telecommunications Corporation Limited
PTCL);
your
local morning newspaper; the
village post office; ice
cream seller inside the
cinema
hall;
food sold in a university
cafeteria; the board game
`Monopoly'.
In
some cases there is more
obvious competition than in
others. For example, with
the growth of
mobile
phones supplying phone
services too, PTCL has
lost some of its monopoly
status for a
section
of the population. In other
cases, such as ice creams in
the cinema, village post
offices
and
university cafeterias, there is
likely to be a local monopoly. In
all cases, the closeness
of
substitutes
will very much depend on
consumers' perceptions.
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A
monopoly would be expected to
face an inelastic demand. And
yet, if it produces
where
MR = MC, MR must be positive,
demand must therefore be
elastic. Therefore
the
monopolist
must face an elastic demand!
Can you solve this
puzzle?
Demand
is elastic at the point
where MR = MC. The reason is
that MC must be positive
and
therefore
MR must also be positive.
But if MR is positive, demand
must be elastic.
Nevertheless,
at any given price a
monopoly will face a less
elastic demand curve than a
firm
producing
the same good under
monopolistic competition or oligopoly.
This enables it to
raise
price
further before demand
becomes elastic (and before
the point is reached where
MR = MC).
If
the shares in a monopoly
(such as a water supply
company in a European
country)
were
very widely distributed
among the population, would
the shareholders
necessarily
want
the firm to use its
monopoly power to make
larger profits?
If
the water company raised
its charges and thereby
made a larger profit,
shareholders would
gain
from larger dividends, but
as consumers of water would
lose from having to pay
the higher
charges.
Except in the case of
shareholders with only a few
water shares, however, the
gain is
likely
to outweigh the loss.
Nevertheless, with shares
very widely distributed, the
average net
gain
would be only very small,
and the wider the
distribution, the more
shareholders there
would
be
who would suffer a net
loss from the higher
charges.
In
what respects might the
behaviour of Microsoft, increasingly
becoming a monopoly in
the
software and operating
systems market, be deemed to
be: (a) against the
public
interest;
(b) in the public
interest?
a)
Prices are likely to be
higher, given the lack of
competition; there may be
less product
development,
because potential competitors
fear Microsoft's power to
block their entry to
the
market, or drive them from
it if they do succeed in entering;
less choice for
consumers.
b)
By developing products that
are in general use round
the world, it is more
convenient for
businesses
and their employees, who do
not have to learn different
sets of programmes
or
have problems with
incompatibility of programmes and
operating systems;
monopoly
profits
can lead to high levels of
investment and product
development, which can help
to
reduce
prices over the longer
term.
In
which of the following
industries are exit costs
likely to be low: (a) steel
production;
(b)
market gardening; (c)
nuclear power generation;
(d) specialist financial
advisory
services;
(e) production of a new
medicine. Are these exit
costs dependent on
how
narrowly
the industry is
defined?
a)
High. The plant cannot be
used for other
purposes.
b)
Relatively low. The industry
is not very capital
intensive, and the various
tools and
equipment
could be sold or transferred to
producing other
crops.
c)
Very high. The plant
cannot be used for other
purposes and decommissioning
costs are
very
high.
d)
Low. The capital costs
are low and offices
can be sold.
e)
Low to moderate. It is likely
that a pharmaceutical company
can relatively easily
switch
to
producing alternative drugs.
Substantial exit costs
are only likely to arise if
the
company
is committed to a long-term research
and development programme or
if
equipment
is not transferable to producing
alternative drugs.
Give
some other examples of
monopolistic competition.
Examples
include: taxis, car hire,
hotels and restaurants,
insurance agents, estate
agents, office
equipment
suppliers, antique dealers,
computer systems.
Why
may a food shop charge
higher prices than wholesale
markets (or supermarkets)
for
`essential
items' and yet very
similar prices for
"delicacy" items?
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Because
the demand for such
essential items from a local
food shop is likely to be
less price-
elastic
than the demand for
the delicacy items: if
people run out of basic
items, they will want
to
obtain
them straight away from
the nearest shop rather
than waiting until they
visit the
supermarket.
Also the supermarkets may
obtain bulk discount from
their suppliers on
basic
items,
but not on delicacy items,
where the sales turnover is
much lower.
Which
of these two items is a PSO
or Shell petrol station more
likely to sell at a
discount:
(a)
petrol; (b) sweets?
Why?
Petrol.
The reason is that demand is
more price elastic. People
will be tempted to buy
now,
rather
than waiting, if they see a
reasonable discount. In the
case of sweets, these are
often an
impulse
buy and the price is
very low anyway relative to
the amount already spent on
petrol. A
penny
or two price reductions will
probably make very little
difference to sales.
In
monopolistic competition, why does
the LRMC curve cross
the MRL curve
directly
below
the tangency point of the
LRAC and ARL
curves?
One
way of answering the
question is to note that
long-run profits are
maximized where
long-run
MR
equals long-run MC (let's
call it QL). But at QL,
long-run AR equals long-run
AC, whilst at
any
other output long-run AR is
below long-run AC. Thus
profits must be maximized at
QL.
Assuming
that supernormal profits can
be made in the short run in
a monopolistically
competitive
industry; will there be any
difference in the long-run
and short-run
elasticity
of
demand? Explain.
Yes.
The entry of new
firms, attracted by the
supernormal profits, will
make the long-run
demand
for the firm more
elastic: there are now
more alternatives for
consumers to choose
from.
Why
would you expect additional
advertising dollars spent by a
firm to cause smaller
and
smaller
increases in sales? In other
words why should advertising
suffer from
"diminishing
returns"?
Because
fewer and fewer additional
people will see each
extra advertisement (i.e.
many of the
people
will have seen the
adverts already and thus
there will be little
additional effect on
their
demand).
Which
would you rather have:
five restaurants to choose
from, each with very
different
menus
and each having spare
tables so that you could
always guarantee getting
one; or
just
two restaurants, charging a
bit less but with
less choice and where
you have to book
quite
a long time in
advance?
Many
people would choose the
first, but clearly it is a
question of personal
preference.
How
will advertising affect a
cartel's MC and AR curves?
How will this affect
the profit-
maximizing
output?
If
advertising increases total
cartel sales, the cartel's
AR curve will shift to the
right and possibly
become
less elastic. The MC curve
will only shift if the
advertising varies with
output. Given that
the
amount that member firms
will advertise might not be
known and, even if it were,
the exact
effects
of any amount of advertising on AR
are impossible to identify
and compute, it would
become
difficult for the cartel to
identify the profit-maximizing
price with any degree of
precision.
You
have been taught about
the conditions that
facilitate the formation of a
cartel?
Which
of these conditions were to
found in the oil market in
(a) the early 1970s;
(b) the
mid-1980s;
(c) 2000?
·
There
are relatively few oil
producing countries (but
more in the 1980s than in
the
1970s).
·
The
OPEC members meet openly to
discuss pricing and quotas
(in all three
periods)
·
Production
methods are relatively
similar, although costs vary
according to the
accessibility
of the oil.
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·
The
(final) product is very
similar and there is an
international price for each
type of
crude.
·
Saudi
Arabia is the dominant
member of OPEC: its
dominance over the world
market,
however,
waned from the mid-1980s as
non-OPEC production increased
and there was
a
world glut of oil. With a
growing world economy in the
late 1990s, Saudi
Arabia's
influence
grew again.
·
Entry
barriers, however, have
"not" been significant. This
has allowed several
non-
OPEC
members (e.g. Mexico, Norway
and the UK) to break
into the market.
·
The
market is relatively stable in
the short run (given
the price and income
inelasticity of
demand).
There has been a problem,
however, of a decline in demand
over the longer
term.
·
Governments
round the world have
been relatively powerless to
curb OPEC's
collusion,
although
from time to time (e.g.
during the Gulf War)
the USA has released oil
from its
huge
stock piles to prevent
excessive price
increases.
Could
OPEC have done anything to
prevent the long-term
decline in real oil prices
since
1981?
Very
little, given that the
supply of substitutes (both
oil and non-oil) for
OPEC oil has
increased
substantially.
Perhaps, with hindsight, if
OPEC had not raised
prices so much in 1973/74
and
1979
there would have been
less incentive to develop
substitutes and to break the
power of the
cartel.
Many
oil analysts are predicting
a rapid decline in world oil
output in 10 to 20 years as
world
reserves are depleted. What
effect is this likely to
have on OPEC's
behaviour?
The
fall in output will drive up
prices. Provided that OPEC
can prevent its members
from
pumping
oil more rapidly to take
advantage of the rising
price, OPEC's power could
increase. It
could
demonstrate to its members
the rising trend in oil
prices and attempt to
persuade them of
the
benefit of reducing production
even further. It could
`sell' this policy to the
world as one of
being
prudent with dwindling oil
stocks.
In
which of the following
industries is collusion likely to
occur: bricks,
margarine,
cement,
crisps, washing powder,
blank audio or video
cassettes, and
carpets?
In
all cases collusion is quite
likely: check out the
factors favouring collusion
discussed in the
lecture
and also above. In some
cases it is more likely than
others: for example, in the
case of
cement,
where there is little
product differentiation and a
limited number of producers,
collusion
is
more likely than in the
case of carpets, where there
is much more product
differentiation.
Assume
that there are two
major oil companies
operating filling stations in an
area. The
first
promises to match the
other's prices. The other
promises that it will always
sell at
Re.1
per liter cheaper than
the first. Describe the
likely sequence of events in
this `game'
and
the likely eventual outcome.
Could the promise of the
second company be seen
as
credible
(i.e. you will
believe)?
Prices
would be driven down, and
hence profits reduced, until
one of the companies could
no
longer
stick to its promise
either the first accepting
that its price will be
Re. 1 above the
second,
or the second accepting the
same price as the first.
Alternatively both
companies
simultaneously
may decide to abandon their
policy and collude to raise
prices. This may
involve
a
secret meeting between them,
or simply `letting it be known'
that they would be willing
to raise
prices,
providing that the other
company did the
same.
The
promise of the second
company could be seen as
credible if it had lower
costs or greater
financial
backing than the first
company. In such circumstances,
the first company may be
forced
to
give up its policy first. If
they have similar costs
and financial strength, then
the threat is not
credible.
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Consider
a train company which
charges different prices for
first and standard class,
for
traveling
on different days in the
week or different times in
the day etc. Are
these
examples
of price discrimination?
Price
discrimination occurs when
the same product or service
(with the same marginal
cost) is
sold
at different prices to different
customers. Thus, strictly
speaking, charging a different
price
for
first and standard class,
for travel on different
times of day, or on different
days of the week,
or
at different times of the
year are not the
purest examples of price
discrimination, since (a)
the
service
is different and (b) the
marginal cost is not the
same. On the other hand,
charging a
different
price for children,
students, old people, people
traveling on single rather
than return
tickets
etc. are examples of price
discrimination since they
allow travel on the same
seat on the
same
train to different classes of
people.
Are
these various forms of price
discrimination in the traveler's
interest?
If
the lower-price fares are
making travel possible for
people who could otherwise
not afford it,
then
clearly they are benefiting.
For the people paying
the higher-priced fares,
then there are
advantages
and disadvantages. Clearly,
they will not like
paying more than they
would in the
absence
of price discrimination, but
given that at peak times
some lines are operating to
full
capacity,
the higher price may be
necessary to prevent queuing or
grossly overcrowded
trains
(though
note, as explained in the
answer to the last question,
charging higher prices at
peak
times
to everyone is strictly speaking
not a form of price
discrimination).
If,
over time, consumers are
encouraged to switch their
use of dial-up
internet
connections
to off-peak periods, what
will happen to peak and
off-peak prices?
The
difference between the
prices will narrow.
To
what extent is peak-load
pricing (i.e. charging the
highest price for a
product/service
when
the loan of demand for it is
highest; e.g. charging a
high rate for dial-up
internet
connection
in the day rather than after
midnight) in the interests of
consumers?
It
may help to keep the
average price down, if it
spreads the use of fixed
factors (like
bandwidth
or
telephone lines) more
evenly. It may also help to
ease congestion (e.g. on
trains) at peak
times
for those who have no
alternative but to use the
service at that time. Peak
users may
prefer
a higher priced journey to a
more congested journey or
having to queue, and
possibly
running
the risk of not getting
the service (e.g. not
getting on the train or bus
because it is full).
Is
total consumption likely to be
higher or lower with a
system of peak and
off-peak
prices
as opposed to a uniform price at
all times?
Higher,
since some people would
only be prepared to buy the
product at off-peak
prices.
Which
type of price discrimination do
cinemas pursue when they
charge different
prices
for
adults and children? First,
second or third degree?
Would it be possible for
the
cinema
to pursue either of the
other two types?
It
is third-degree price discrimination. It
groups cinema goers into
two types: adults and
children.
It
could not practice
first-degree discrimination: it would
not be possible to negotiate a
separate
ticket
price with each customer!
It could possibly practice a
form of second-degree
price
discrimination,
however, if it gave tokens to
people each time they
purchased a ticket and
then
sold
tickets at reduced prices to
people with tokens.
If
all cinema seats could be
sold to adults in the
evenings at the end of the
week, but only
a
few on Mondays and Tuesdays,
what price discrimination
policy would you
recommend
to
the cinema in order for it
to maximize its weekly
revenue?
Offer
reduced-price tickets to children in
the evenings as well as in
the afternoon for the
first part
of
the week, but not
for the end of the
week.
66
Introduction
to Economics ECO401
VU
Would
the cinema make more
profit if it could charge
adults a different price in
the
afternoon
and the evenings?
Possibly.
The danger for the
cinema, however, is that
adults who would have
gone to the
cinema
anyway may now choose to go
in the afternoon, thereby
losing the cinema
revenue.
Ideally
the cinema would like to
discriminate in such a way as to
encourage people to go in
the
afternoon
at a reduced price who would
not have gone at all
(whether in the afternoon or
the
evening),
like old people for
e.g., if they had to pay
the higher price.
Why
is the Prisoners' Dilemma
game discussed in the
lecture a dominant
strategy
`game'?
Because,
whatever assumption is made
about the other's behaviour,
each prisoner is likely
to
confess.
How
would each prisoner's
strategy change if there
were five prisoners (who
committed
the
joint crime) and not
two, and if all five
all of them had been
caught?
The
more people there were
involved in the crime, the
greater would be the
likelihood of one of
them
confessing and therefore the
greater the temptation for
any individual prisoner to
confess.
Can
you think of any other
non-economic examples of the
prisoners' dilemma?
Children
in a class agreeing not to do
homework, but parents
keeping them apart after
school so
that
they can persuade their
children to do their homework,
telling them, `The other
children will
also
be doing theirs and you
will not want to show up by
doing badly compared with
them.' What
should
the children do? Do their
homework in the fear that
everybody else would do
the
homework
(the equivalent of "confessing" in
the fear of the other
prisoners confessing) or not
do
the
homework hoping that the
others won't do it as well
(the equivalent of "not
confessing" in the
hope
that the others won't do it
either).
67
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