Advanced Monopoly Topics

Contestable Marketsand Strategies to Deter Entry

• A monopoly firm may not set profit maximizing prices because they want to keep the price low enough to keep other firms out.

• A market in which the possibility of market entry tempers the behaviors of monopolists is called a contestable market. – A pricing strategy to prevent entry is called limit

pricing.

• Firms may also use other strategies to deter entry which are less beneficial than lowering prices and increasing production.

Strategies of Entry Deterrence

• A firm may deter entry by competitors by threatening them with :– Engaging in predatory pricing.

• Price below marginal cost to drive another firm out of the market.

– Building excess capacity (promise predatory pricing)

Oligopoly

• Many industries are dominated by a small number of firms: Airlines, airplane manufacturing, supermarkets, drugstores.

• In theory, even a small number of firms may compete, driving down prices to the level of costs.– Airplane manufacturing: Boeing vs. Airbus

• Oligopolists may also collude!– OPEC– Sotheby’s and Christie’s

Concentration Ratios are often used to measure market competition

Concentration RatiosScheduled passenger air transportation Trucking Industry

Share orTop 4 Firms 33.7 7.6Top 8 Firms 50.8 12.6Top 20 Firms 73.1 21.2Top 50 Firms 89.9 28.9

Conditions of Cartel

• Small number of firms• Barriers to Entry• Ineffective or Non-existent government

regulation.

• Way to Stop Cheating–Enforcer–Capacity Constraints (California

Electricity Market)

Duopolists• Two companies can agree on a price at which they could

make profits. • If the other firm keeps its word, you can win whole

market by undercutting their price.• If the other firm doesn’t keep its word, you must undercut

the agreed upon price or lose everything.• Either way, best strategy is to cheat on agreement.

Example: Two Firms

Q P Revenue MR Cost ATC MC Profit Split Cheat50 550 27500 18750 375 8750 4375 11250

475 37575 525 39375 28125 375 11250 5625 12500

425 375100 500 50000 37500 375 12500 6250 12500

375 375125 475 59375 46875 375 12500 6250 11250

325 375150 450 67500 56250 375 11250 5625 8750

275 375175 425 74375 65625 375 8750 4375 5000

225 375200 400 80000 75000 375 5000 2500 0

175 375225 375 84375 84375 375 0

Payoff Matrix

• Two firms • Each one could choose to

collude and charge a price of 475.

• Or each could decide to cheat, steal the market for themselves and charge a price of 450

• The matrix describes the payoff of each firm given the strategies of another.

Red Firm 1

Blue

Firm

2

Collude Cheat

Collude 6250,

6250

0,

11,250

Cheat 11,250,

0

5625

5625

Game Theory & Beautiful Mind

• Game Theory is a branch of math that describes strategic interactions.

• Nash describes a game that is in equilibrium as one in which no player has an incentive to change their strategy given the strategy of the other player.

• Nash equilibrium in the above game is for both to cheat even though they both players would be better off if they could collude.

California, 2000

• In 1998, utilities in California’s deregulated wholesale power market were paying between $30 and $40 per MWH. By summer and fall of 2000, prices skyrocketed to $140.

• Five firms producing wholesale electricity (Enron, Dynegy,…). When there is excess capacity, five firm market behaved relatively competitively.

• When capacity constraints hit, firms could exercise significant pricing power and raise prices above marginal cost.

Sotheby’s and ChristiesPrior to 1995, Sotheby's and Christie's, the world's largest auction houses, were in fierce competition for consignments from sellers. ,… . In March 1995, this competition abruptly ended. Christie's … would charge sellers a fixed, non-negotiable commission … and a month later Sotheby's announced the same policies. Detailed documents kept by …, Christie's former chief executive, show that the abrupt change was due to a price-fixing conspiracy.

Anatomy of the Rise and Fall of a Price-Fixing Conspiracy: Auctions at Sotheby's and Christie's Orley Ashenfelter and Kathryn Graddy 

Why were these firms able to successfully form a cartel?

Firms may compare future profits from staying in cartel relative to current profits from cheating. In lean markets, the benefits from cheating may be less than the future benefits from staying in a cartel.

Boeing vs. Airbus.

• Why might it be difficult for two airlines to collude.

• There is a large stock of existing aircraft available for sale in used market.

• Durable goods producers have to compete with their own past.

• Some economists claim that Alcoa did not have a monopoly because the broad supply of recycled Aluminum.

Price Discrimination

• What if you don’t have to charge the same price to everyone?

• If you have perfect knowledge of the valuation applied to your product by each customer, you might tailor your price for each one.

• Since lowering your price for each customer doesn’t affect the price obtained from higher value customers, you gain by selling at a price above marginal cost.

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Total profit earned by firmP1

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Perfect Price Discrimination will generate same output as perfect competion, but monopolist will take all surplus as profit.

Learning Outcomes

Students should be able to: • Describe the conditions that characterize markets with

monopoly, oligopoly, and monopolistic competition.• Differentiate perfect competition, monopolistic

competition, and regulated and unregulated monopoly in terms of output and price relative marginal cost and or total costs.

• Discuss types of barriers of entry, entry deterrence strategies and the consequences of uncontested markets.

• Define price discrimination and discuss the costs and benefits to the firm and society.

• Evaluate the difficulties of maintaining collusion

Surplus• The demand curve represents how much consumers

are willing to pay for one more unit of a good, if they have already bought a certain number of goods.

• There are diminishing returns to any given product. As people consume more of that product, the benefit they get from consuming another one declines, and they are only willing to pay a lower price.

• Difference between the price people are willing to pay for a good (i.e. the position of the price schedule) and the actual price is the consumer surplus (net benefit to the consumer) generated by that purchase.

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Surplus generated by buying first good = 6

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Surplus generated by buying second good = 5

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Total consumer surplus is the sum of surplus of each good

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When goods adjust continuously, total consumer surplus is a triangle created by price line and demand curve

Producer Surplus

• Producers achieve profits whenever they sell an extra goods at a price above the cost of producing the extra good.

• Sum of profits for each good is the total producer surplus, the area in the triangle below the price line and above the supply curve.

Supply and Demand

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Competitive Market

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SProducer Surplus

Competitive Equilibrium is Efficient

• Economic efficiency means that there are no gains to be had at the level of society from additional trades.

• If the price is higher or lower, the sum of the areas of the consumer & producer surplus triangles will be less than at the equilibrium price.

• Economic efficiency does not guarantee that the split of the surplus will coincide with any notion of fairness.

Efficient Equilibrium Market

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Monopoly Price

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Ceiling

SD

Total Societal Surplus is lower under monopoly

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Deadweight Loss S

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