2013 request for proposals (rfp) connecting for success - hawaii

Lecture 2: Market Structure Part I (Perfect Competitionand Monopoly)

EC 105. Industrial Organization

Matt ShumHSS, California Institute of Technology

EC 105. Industrial Organization ( Matt Shum HSS, California Institute of Technology)Lecture 2: Market Structure Part I (Perfect Competition and Monopoly) 1 / 23

Perfect competition

Market structure 1: Perfect Competition

Consider market for a single good.

The perfectly competitive firm is a price taker: it cannot influencethe price that is paid for its product.

This arises due to consumers’ indifference between the products ofcompeting firms =⇒ for example, buy from store with lowest price.Consumers’ indifference arises from:

Product homogeneityConsumers have perfect informationNo transactions costMany firms

PC firm faces horizontal demand curve at market price p


Perfect competition

PC firm’s profit maximization problem

maxq π(p) = pq − C (q)

First-order condition: p = C ′(q) = MC (q)

Second-order condition: C ′′(q) > 0, satisfied if MC (q) is anincreasing function

If p ↑, production rises along MC (q) curve: MC (q) is the “supplycurve” of the firm.


Perfect competition

PC firm’s shutdown decisions

A firm produces only when its profits from producing exceed the costsit would avoid by not producing

In short-run: avoidable costs do not include sunk costs. Shut downwhen revenues fall short of avoidable costs⇐⇒ pq < Avoidable costs(q).Consider two cases:

1 All fixed costs are sunk. Avoidable costs = VC (q): shut down oncep < AVC (q) (< AC (q)).

2 Proportion α of fixed costs not sunk. Avoidable costs = VC (q) + αF :shut down once p < AVC (q) + αF

q

In long-run: avoidable costs include sunk cost. Shut down whenpq < C (q) =⇒ p < AC (q)

Short-run supply curve? Long-run supply curve? Graph.


Perfect competition

The perfectly-competitive industry: Short run

In the short run:

Number of firms fixed

Industry supply curve: sum of individual firms’ short-run supplycurves. Zero supply at prices below shutdown point. Graph.

Industry demand curve: downward sloping. Graph.

Price determined by intersection of industry demand and supplycurves. Graph.

In short-run equilibrium: positive profits for each firm as long asp > AC (q).


Perfect competition

The perfectly competitive industry: Long-run

Number of firms can vary

Free entry and exit:Any short-run profits soaked up by new firms in long-run =⇒ Price isdriven down to the minimum of the AC curve

Long-run industry supply curve: horizontal at minimum of theaverage cost curveLR supply curve may be upward-sloping if min AC is rising in marketdemand Q (due, for example, to resource scarcity)


Perfect competition

Toughness of competition

In PC market, inelastic industry demand (low |ε|) consistent with elastic residualdemand curve (high |εi |): competition too “tough”

(Caviar, pearls, petroleum ...)

Price elasticity of demand:

ε ≡ ∆q(p)

∆p

p

q=∂ log q(p)

∂ log p=∂q(p)

∂p

p

q(p)

Steep demand curves are inelastic; flat are elastic

Residual demand: Dr (p) = D(p)− So(p).

At competitive equilibrium, firm i ’s residual demand elasticity is:εi = εn − ηo(n − 1) where η0 is the “residual supply” elasticity:

η0 =∂S0(p)

∂p

p

S0(p)

Example

market demand Q = 100− p50 firms, each with supply curve q = pEquilibrium: p = 100/51;Q = 5000/51Market demand elasticity ε = −1

50 ; firm εi = −50; η0 = 1EC 105. Industrial Organization ( Matt Shum HSS, California Institute of Technology)Lecture 2: Market Structure Part I (Perfect Competition and Monopoly) 7 / 23

Perfect competition

Desirability of PC outcome

p = MC(q) = minqAC(q)

Production at p = MC (q): firm produces an additional unit only if itcan cover the production costs. Producer surplus is maximized.

Value placed on marginal unit of the good p exactly equals the costof producing that marginal unit (consumption efficiency).Consumer surplus is maximized.

Production at minimum average cost: no better alternative use ofresources is possible (production efficiency). In other words, eachfirm operating at minimum efficient scale.


Perfect competition

General equilibrium

Consider the general case with multiple goods, and heterogeneousfirms and agents.

All agents are price takers.

Given prices, consumers choose how much of each good to buy inorder to maximize their welfare, given that their expenditures mustnot exceed their income. This gives rise to demand functions.

Given prices, producers choose production plans to maximize profitsgiven their technological possibilities, giving rise to supply functions.

A competitive equilibrium is a set of prices, with associated demandsand supplies, such that all the markets clear


Perfect competition

Welfare Theorems

Weak assumptions about preferences and technological possibilitiesyield general results on competitive equilibrium.

1st Welfare Theorem: A competitive equilibrium is Pareto Optimal. Abenevolent social planner can’t improve on the competitive allocation.

2nd Welfare Theorem: Any Pareto-optimal allocation can bedescentralized by a choice of the right prices and an appropriateredistribution of income among consumers.

Requires convexity assumptions that rule out increasing returns to scale.

Key property of competitive equilibrium: each good is sold atmarginal cost. Prices induce consumers to internalize the (social) costof producing an additional unit of the good.


Perfect competition

Barriers to Entry

Nice outcome in perfect competitive world depends crucially on free-entryassumption. Fixed costs of entry are present in many markets: are they abarrier to entry??

Fixed costs borne equally by all firms: accommodated by free entryassumptionExample: salt factory, advertising?

Fixed costs which affect entrant firms disproportionately: barriers toentry“First mover advantage”: incumbent muddies waters to makesubsequent entry difficult.Ex: C1(q) = F + VC (q),C2(q) = 2F + VC (q)Microsoft: computer operating systems?Apple: iPad?

Next focus on extreme case where entry ruled out: monopoly


Perfect competition

Market structure 2: Monopoly

Industry has one firm, who faces downward-sloping industry demandcurve

Market power: ability of a firm to dictate market prices in anindustry. Depends on the slope of the residual demand curve.

Market power is “opposite” of price-taking behavior


Perfect competition

Monopoly and profit maximization

Two equivalent formulations:First, monopolist chooses quantity to maximize profits

maxq p(q)q − C (q) = Revenue(q)− C (q)

Graph. Quantity can be increased only if price is lower. Tradeoffbetween increased demand versus revenue lost on consumers whowould have bought even under the higher price

FOC: R ′(q)) = p(q) + p′(q)q = C ′(q)↔ MR(q) = MC (q). Graph.


Perfect competition

Monopoly and profit maximization

Alternatively, monopolist chooses price to maximize profits

maxp pq(p)− C (q(p)), where q(p) is demand curve.

FOC: q(p) + pq′(p) = C ′(q(p))q′(p)

At optimal price p∗, Inverse Elasticity Property holds:(p∗ −MC (q(p∗))) = − q(p∗)

q′(p∗) or p∗−mc(q(p∗))p∗ = − 1

ε(p∗) , where ε(p∗)

is q′(p∗) p∗

q(p∗) .

Across monopolistic markets, should observe negative relationshipbetween price and demand elasticity

If ε → +∞: p = MC (q)


Perfect competition

Inverse elasticity property

Firm’s market power is inversely related to the elasticity of demand

with inelastic demand, firm sets prices higherwith elastic demand, firm sets prices lower

Interpretation:

elasticity: primarily related to availability of close substituteswhen few substitutes available, a firm can set high prices without losingcustomerswhen many substitutes available, a firm which sets prices too high willlose many customers

Examples:

Ride-sharing (Uber’s surge pricing): weekends vs. weekdaysPrices of iPhone 6 once iPhone 8 released.Movies: daytime vs. evening


Perfect competition

A puzzle, or cautionary tale

p∗ −mc(q(p∗))

p∗= − 1

ε(p∗)

Reasonable interpretation: “low elasticities are good for monopolist”

What if −1 < ε(p∗) < 0? Implies p∗ < mc , which is nonsensical.Unpack marginal revenue expression:

MR(q) =∂R(q)

∂q= p′(q)q + p(q)

=q(p)

q′(p)+ p =

p

p

q(p)

q′(p)+ p = p

(1

q′(p)

q(p)

p+ 1

)= p(

1

ε(p)+ 1)

which is negative for prices where −1 < ε(p) < 0. (p′(q) = 1q′(p)).

More intuitive: monopolist never chooses a p (or equivalently q(p))where its marginal revenue would be negative.

Lesson: demand elasticity not free variable independent of price. Itdepends on price.


Perfect competition

Dead-Weight Loss

Markup provides a quantification of price distortion, and is useful forpolicy purposes (later). This is not, however, an appropriate measureof distortion from a normative viewpoint. Instead, the appropriatemeasure is the loss of social welfare.

To measure the later we compare the total surplus (consumer andproducer surplus, or profit) at the monopoly price with that at thecompetitive (marginal cost) price.


Perfect competition

Dead-Weight Loss


Perfect competition

Dead-Weight Loss

The welfare loss does not necessarily decrease with the elasticity ofdemand, even though the relative markup does.

Strong price distortions correspond to low demand elasticities

consumers decrease their quantity demanded only slightly in responseto a unit price increase.

In precisely these situations, price changes do not affect quantityconsumed very much; rather, they elicit a large transfer fromconsumers to the firm.


Perfect competition

How monopolies arise

Crucial aspect of monopoly: price-setting ability (relatively inelasticdemand curve)

Product differentiation: Apple vs. Samsung vs. RIM

Government-granted monopolies (patents): reward for firm’sinnovation efforts

Superior production technology (Demsetz critique). Monopoly“deserves” its dominant position

Natural monopoly: industry characterized by increasing returns toscale. MES is +∞, efficient to have just 1 firm.

Energy utilities (water, electricity, gas) typically natural monopoly.Governments may need to regulate to keep prices low.

Checks on a monopolist’s market power: threat of entry keeps pricearound average cost


Perfect competition

How monopolies disappear

A firm with market power makes profits, which encourages other firmsto enter

Additional entry reduces market power of firms: if price at one firm istoo high, consumers will buy at other firms.

Demand for each firm becomes more and more elastic

As more firms enter market, price is driven down to costs. Firmsmake zero profit.

Industry life cycle: firms must keep innovating to survive.

Schumpeter: monopoly profits provide an incentive for innovation andtechnological change (“process of creative destruction”)Pharmaceuticals, gaming, apps.


Perfect competition

Measuring Market Power

Recall definition of market power: ability to profitably charge a price aboveperfectly competitive levels. How to measure?

Market share. Small firms can’t have any market power. Not true:makers of “niche products” (ie. Apple Mac) may have a lot of marketpower!

Availability of substitutes to monopolist’s product: but perhaps(possibly cost-inefficient) substitutes only available when monopolistcharges p > MC . Cellophane fallacy −→ availability of substitutesis sign of market power!

“monopoly umbrella”

Direct measure of market power is given by estimates of demandelasticities, which are inversely related to profit-maximizing price-costmargin.

Estimate demand elasticities from market data: importance ofeconometrics, statistics, machine learning


Perfect competition

Summary

1 Perfect competition

Individual firm takes prices as given in making output decisionsShutdown decisions: long run vs. short runIndustry equilibrium: in long-run p = MC (q) = minqAC (q)

2 Monopoly

Firm has power to set both quantity and priceTradeoff between higher demand but lower per-unit pricesMR(q∗) = MC (q∗); inverse-elasticity pricing property


2013 request for proposals (rfp) connecting for success - hawaii

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