AAEC 2305 Fundamentals of Ag Economics Chapter 7 - continued.

AAEC 2305AAEC 2305Fundamentals of Ag Fundamentals of Ag

EconomicsEconomics

Chapter 7 - continuedChapter 7 - continued

Firms in an Imperfect Firms in an Imperfect MarketMarket

Consider the following hypothetical case Consider the following hypothetical case of a tractor division of a farm machinery of a tractor division of a farm machinery manufacturer operating in an manufacturer operating in an imperfectly competitive environment.imperfectly competitive environment.• Assumptions of this example:Assumptions of this example:

– There are no competitorsThere are no competitors– The firm manufactures & sells 7100 to The firm manufactures & sells 7100 to

9000 tractors per year at $44,000 to 9000 tractors per year at $44,000 to $52,000 per tractor$52,000 per tractor

(continue)(continue)

Price Charged (Py)

Tractors Sold (Y)

$52,000 7100

$50,000 7800

$48,000 8500

$46,000 9200

$44,000 9900

(continued)(continued)

Py Tractors Sold

TR (millions)

Add Tractors

Sold

AR (millions)

MR ($)

52000 7100 369.2

50000 7800 390.0 700 20.8 29,714

48000 8500 408.0 700 18.0 25,714

46000 9200 423.2 700 15.2 21,714

44000 9900 435.6 700 12.4 17,714


The equilibrium price per tractor is the The equilibrium price per tractor is the price where MR and MC curves intersect price where MR and MC curves intersect (MR=MC)(MR=MC)

Under perfect competition, the MR and AR Under perfect competition, the MR and AR curves where equal and represented by a curves where equal and represented by a horizontal line, which also depicted the horizontal line, which also depicted the price line price line

In Imperfect Competition, however, the MR In Imperfect Competition, however, the MR and AR curves are two distinct curves (MR and AR curves are two distinct curves (MR does not equal AR)does not equal AR)


Under Imperfect Competition, the AR Under Imperfect Competition, the AR curve depicts the demand curve. curve depicts the demand curve. Additionally, the MR curve has a slope Additionally, the MR curve has a slope exactly twice the AR and Demand curves.exactly twice the AR and Demand curves.

Furthermore, the MR curve intersects the Furthermore, the MR curve intersects the horizonatl axis at exactly the same point horizonatl axis at exactly the same point as the AR curve. However, the MR curve as the AR curve. However, the MR curve intersects the horizontal axis at exactly intersects the horizontal axis at exactly the halfway point of the AR curve.the halfway point of the AR curve.

Determination of OutputDetermination of Output

As in perfect competition, the output of As in perfect competition, the output of the imperfectly competitive firm is the imperfectly competitive firm is determined at the point where MR = determined at the point where MR = MCMC

The price that the imperfectly The price that the imperfectly competitive firm will charge, however, competitive firm will charge, however, will be the price associated with the will be the price associated with the market demand curve for the profit market demand curve for the profit maximizing quantity.maximizing quantity.


To determine profitability, the firm To determine profitability, the firm will need to compare TR and TC or will need to compare TR and TC or AR and ATC.AR and ATC.

Imperfect Competition Imperfect Competition Among SellersAmong Sellers

There are 3 categories of imperfect There are 3 categories of imperfect competition among sellers (refer to competition among sellers (refer to Table 7.1, page 161.Table 7.1, page 161.• 1) Monopolistic Competition1) Monopolistic Competition• 2) Oligopoly2) Oligopoly• 3) Monopoly3) Monopoly

Remember we are going to use Perfect Remember we are going to use Perfect Competition as the baseline for Competition as the baseline for comparisons.comparisons.

Monopolistic CompetitionMonopolistic Competition

Monopolistic Competition differs from Monopolistic Competition differs from Perfect Competition in the following ways:Perfect Competition in the following ways:• 1) Differentiated Products (main 1) Differentiated Products (main

difference from pure competition.difference from pure competition.– Real differences in productsReal differences in products– Perception of differences in Consumers Perception of differences in Consumers

MindsMinds– Competition among firms exist on Competition among firms exist on

attributes other than pricesattributes other than prices


2) Many firms, but fewer than 2) Many firms, but fewer than under perfect competitionunder perfect competition• Food processing & marketing firmsFood processing & marketing firms

3) Limited control over prices3) Limited control over prices• A firm cannot increase prices A firm cannot increase prices

significantly without losing customers significantly without losing customers to competitors.to competitors.


4) Limited or restricted entry4) Limited or restricted entry• Entry is more difficult than in a Entry is more difficult than in a

perfectly competitive marketperfectly competitive market• Firms are fairly large, and capital Firms are fairly large, and capital

requirements are substantialrequirements are substantial• Advertising dollars alone can create a Advertising dollars alone can create a

barrier to entrybarrier to entry• Emphasis on brand names associated Emphasis on brand names associated

with higher qualitywith higher quality

OligopoliesOligopolies

Oligopoly means “few sellers”Oligopoly means “few sellers” The most distinguishing characteristic The most distinguishing characteristic

is their interdependence in pricing is their interdependence in pricing and marketing policies.and marketing policies.

Among oligopolistic industries are:Among oligopolistic industries are:• Major farm machinery companiesMajor farm machinery companies• Farm chemical companiesFarm chemical companies• Major meat packersMajor meat packers


Oligopolistic industries can result Oligopolistic industries can result from:from:• More extreme product differentiationMore extreme product differentiation• Higher entry costsHigher entry costs• Greater dependence on costly & long-Greater dependence on costly & long-

term research & development effortsterm research & development efforts• Easier access to major financial marketsEasier access to major financial markets• Aggressive merger & acquisition Aggressive merger & acquisition

strategiesstrategies


Characteristics of Oligopolies are:Characteristics of Oligopolies are: 1) Few Sellers - (ex. auto manufactures, oil 1) Few Sellers - (ex. auto manufactures, oil

industries, etc.)industries, etc.) 2) Some control over prices2) Some control over prices

• Control over prices is limited due to Control over prices is limited due to interdependence with other firmsinterdependence with other firms

• Have sticky prices to try to avoid price warsHave sticky prices to try to avoid price wars– Farmers complain that prices for their Farmers complain that prices for their

crops do not increase even when crops do not increase even when consumer prices rise.consumer prices rise.


– Farmer complain that prices for machinery Farmer complain that prices for machinery and farm chemicals are inflexibleand farm chemicals are inflexible

– Consumers complain that retail prices Consumers complain that retail prices remain high even when farm prices fallremain high even when farm prices fall

• Oligopolies provide benefits that perfectly Oligopolies provide benefits that perfectly competitive markets do not:competitive markets do not:– International competitiveness International competitiveness – Access to funds for research and Access to funds for research and

developmentdevelopment– High barriers to entryHigh barriers to entry

Pricing behavior in Pricing behavior in OligopolyOligopoly

Mutual interdependence in oligopoly Mutual interdependence in oligopoly requires strategic behavior & requires strategic behavior & interactionsinteractions

Strategic behavior is actions by firms Strategic behavior is actions by firms trying to plan for and react to the trying to plan for and react to the actions of other firmsactions of other firms

Strategic decision-making is called Strategic decision-making is called Game Theory.Game Theory.• Example - Prisoners Dilemma:Example - Prisoners Dilemma:

Prisoners DilemmaPrisoners Dilemma

A crime is committed, and two suspects A crime is committed, and two suspects are apprehended and questioned by the are apprehended and questioned by the policepolice

The police do not have enough evidence The police do not have enough evidence to convict the suspects of a major to convict the suspects of a major crime, unless one of them confesses.crime, unless one of them confesses.

The police separate the suspects and The police separate the suspects and make each one an offer that each one is make each one an offer that each one is aware of.aware of.


The offer is:The offer is:• If one suspect confesses to the crime and If one suspect confesses to the crime and

turns state’s witness, the one who turns state’s witness, the one who confesses receives only a 2-year confesses receives only a 2-year sentence, while the other who does not sentence, while the other who does not confess will get 12 years.confess will get 12 years.

• If both prisoners confess, each receives a If both prisoners confess, each receives a 6-year sentence.6-year sentence.

• If neither confesses, both will receive a 1-If neither confesses, both will receive a 1-year sentence.year sentence.


Refer to class discussions on the possible Refer to class discussions on the possible outcomes.outcomes.

This process is called the minimax This process is called the minimax strategy, meaning the players want to strategy, meaning the players want to minimize their maximum lossesminimize their maximum losses

If both suspects had not confessed, each If both suspects had not confessed, each would have been sentenced to 1 year, would have been sentenced to 1 year, but the temptation is too high.but the temptation is too high.


This same scenario exists for This same scenario exists for oligopolistic firms.oligopolistic firms.


Now consider the following Now consider the following example for two hypothetical meat example for two hypothetical meat packing firms.packing firms.

The two firms are trying to set The two firms are trying to set prices, but realize their decisions prices, but realize their decisions along with the decision of their along with the decision of their competitor affects their competitor affects their profitability.profitability.


The choice is:The choice is:• If one firm charges a lower price and the If one firm charges a lower price and the

other firm charges a higher price, the firm other firm charges a higher price, the firm that charges the lower price will that charges the lower price will receive$125,000 profit and the firm charging receive$125,000 profit and the firm charging the higher price will receive $25,000.the higher price will receive $25,000.

• If both charge a high price, both receive If both charge a high price, both receive $100,000 profit.$100,000 profit.

• If both charge a low price, both receive If both charge a low price, both receive $50,000 profit.$50,000 profit.


Clearly, the choices of each firm Clearly, the choices of each firm make a significant difference.make a significant difference.

The point of the example is that The point of the example is that the firms must anticipate the the firms must anticipate the reaction of other firms in their reaction of other firms in their industry to their pricing strategies.industry to their pricing strategies.


If one firm raises the price of its If one firm raises the price of its product, other firms may not raise product, other firms may not raise prices to the same extent.prices to the same extent.

As a result the firm raising its prices As a result the firm raising its prices may lose market share.may lose market share.

But if the firm lowers its price, other But if the firm lowers its price, other firms may likely lower their prices as firms may likely lower their prices as well to avoid losing market share.well to avoid losing market share.

Kinked Demand CurveKinked Demand Curve

The result is that each firm in an The result is that each firm in an oligopolistic industry faces a kinked oligopolistic industry faces a kinked demand curve.demand curve.

The kink in the demand curve is at the The kink in the demand curve is at the current price and quantity.current price and quantity.

Above the kink, the demand curve Above the kink, the demand curve tends to be more elastic.tends to be more elastic.

Below the kink, the demand curve Below the kink, the demand curve tends to be more inelastic.tends to be more inelastic.

4 Types of Pricing 4 Types of Pricing Behaviors in Oligopolistic Behaviors in Oligopolistic

MarketsMarkets

1) Noncollusive Oligopoly 1) Noncollusive Oligopoly • A firm may increase prices if it determines A firm may increase prices if it determines

that its product is good enough, or the that its product is good enough, or the loyalty of the customers is strong enough, loyalty of the customers is strong enough, for it to do so without losing market share.for it to do so without losing market share.

• Alternatively, a firm may cut prices in an Alternatively, a firm may cut prices in an attempt to drive rivals out of the market or attempt to drive rivals out of the market or to weaken them enough to make them good to weaken them enough to make them good targets for takeover.targets for takeover.

• Ex. Airlines, farm machinery, pesticides, etc.Ex. Airlines, farm machinery, pesticides, etc.


2) Collusive Oligopoly-2) Collusive Oligopoly-• If all firms in an industry reach an explicit If all firms in an industry reach an explicit

or tacit agreement to fix prices.or tacit agreement to fix prices.• Firms then compete on the basis of non-Firms then compete on the basis of non-

price factors such as service or advertising.price factors such as service or advertising.• Thus, as in our packer example, there is a Thus, as in our packer example, there is a

significant incentive to collude & raise significant incentive to collude & raise prices.prices.

• Problems - incentive to cheat on the Problems - incentive to cheat on the agreement.agreement.

(continued)(continued) 3) Price Leadership -3) Price Leadership -

• In some industries, there is a recognized price In some industries, there is a recognized price leader.leader.

• Additionally, in some cases, there may be little Additionally, in some cases, there may be little explanation why a firm is the price leader.explanation why a firm is the price leader.

4) Cost-Plus Pricing-4) Cost-Plus Pricing-• It is common practice in some industries, It is common practice in some industries,

especially selling unique products to the especially selling unique products to the government, to sell products at cost plus a government, to sell products at cost plus a given percentage mark-upgiven percentage mark-up

MonopolyMonopoly

Strictly speaking, a pure monopoly - a Strictly speaking, a pure monopoly - a one firm industry - is rare.one firm industry - is rare.

Monopolies may arise because Monopolies may arise because sometimes because it is the most sometimes because it is the most efficient way to organize production efficient way to organize production and marketing activities.and marketing activities.

However, instead of breaking up However, instead of breaking up monopolies in the US, it has been monopolies in the US, it has been common policy to regulate them.common policy to regulate them.

Basic Characteristics Basic Characteristics of Monopoliesof Monopolies

1) Single seller1) Single seller 2) Unique Product 2) Unique Product

• i.e. there are no close substitutesi.e. there are no close substitutes 3) Ability to Set Prices3) Ability to Set Prices

• Monopolist is a price maker, although in Monopolist is a price maker, although in some cases they may be regulated by the some cases they may be regulated by the gov’t.gov’t.

• Discriminating monopolists charge different Discriminating monopolists charge different prices to different classes of consumersprices to different classes of consumers


4) Barriers to Entry4) Barriers to Entry• A monopoly must have an economic, legal or A monopoly must have an economic, legal or

technical barrier to entry to other firms.technical barrier to entry to other firms.

The gov’t has established many agencies The gov’t has established many agencies to protect consumers from the adverse to protect consumers from the adverse consequences of oligopolies & monopoliesconsequences of oligopolies & monopolies• Interstate Commerce Commission - regulates Interstate Commerce Commission - regulates

transportationtransportation


Federal Communication Commission - Federal Communication Commission - regulates telephone rates, tv, radio, etc.regulates telephone rates, tv, radio, etc.

State & Local Power Commissions - State & Local Power Commissions - regulate local utilitiesregulate local utilities

U.S. Sherman (antitrust) Act of 1890 U.S. Sherman (antitrust) Act of 1890 and Clayton Act of 1914and Clayton Act of 1914• First of several acts with goal of preventing First of several acts with goal of preventing

collusive pricing and restrictive trade collusive pricing and restrictive trade practices of oligopolies practices of oligopolies


However, these laws and more However, these laws and more recent laws have been enforced to recent laws have been enforced to a varying extent by successive a varying extent by successive presidential administrations - presidential administrations - depending on the philosophy of depending on the philosophy of each administration.each administration.

AAEC 2305 Fundamentals of Ag Economics Chapter 7 - continued.

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