Microeconomics S2

What is market structure?

market structure is the characteristics of a market that may influence behaviour and performance (their output and price)

Characteristics of a market

• the number and size of sellers

• barriers to entry

• extent of product differentiation

• number and size of buyers

2 rules for profit maximisation

1. SHUTDOWN RULE: The firm should shut down if price is less than Average variable cost (in short-run) or LRAC (long-run average costs where all factors are variable)

2. MARGINAL OUTPUT RULE: If the firm doesn’t shut down it should produce at the level where MR = MC

Assumptions of perfect competition

• buyers are price takers (can buy as much as they want without affecting price)

• sellers and buyers have complete information

• sellers are price takers (sellers output choice won’t impact price as wont trigger reaction from rivals due to low competitive behaviour → firms don’t actively compete with each other)

• entry is free AKA no barrier to entry and exit

Perfect competition market structure characteristics

• Many small number of sellers

• low barriers to entry and exit

• undifferentiated identical/ homogenous products (very unrealistic but closest to agricultural goods and primary commodities)

Perfect competition short-run equilibrium

when sellers produce as much as buyers want to purchase and buyers purchase as much as sellers choose to produce (

market price determined by where market supply and demand intersect (graph on left)

a sellers output is determined by seller-specific supply and demand (which is the specific MC and AVC on the right and output is when MC=MR) → profit max, may make supernormal profits, losses or break-even in short-run

supply falls off at min AVC as under this firms would shut down

Long-run equilibrium perfect competition

equilibrium changes in long-run because:

• all factors are variable which impacts seller’s costs (LRAC is a flatter curve)

• sellers can freely enter and exit market (e.g. if making profits this attracts new sellers which increases market supply and reduces price)

= sellers make normal (zero) profit in the long-run where sellers in market are incentivised to stay and none are incentivised to enter (under assumption firms are profit seeking)

declining industries

low revenues mean firm is unable to afford replacing old equipment with new ones so equipment begins wearing out.

HOWEVER people tend to blame an industry’s decline on this old equipment

so old equipment is often AN EFFECT rather than a cause of an industry’s decline

Long-run industry supply prices

in the long-run the industry supply curve ( may be:

• horizontal = constant cost industry occurs when input prices don’t change when output expands or falls

• rising/upwards sloping = when as as industry expands its output it needs more inputs and the increased demand for inputs raises their prices, as suppliers costs rises they raise their prices to cover their costs

• negatively sloped = when industries supplying their inputs have increasing returns to scale which reduce their prices = suppliers costs fall and may reduce their prices

Allocative efficiency of perfect compeitition

consumer and producer surplus is maximised so perfectly competitive markets allocate resoruces efficiently

monopoly

one dominant seller of a particular good or service, no competition

only producer in an industry so set market prices as firm = market

Monopoly assumptions

• the monopolist is a price maker (influences price by changing output → means demand curve is downwards sloping + no competition as large market power to change price)

• high barriers to entry (even in long-run potential sellers aren’t free to enter market → barriers may be legal requiring specific qualifications, structural e.g. by lowering AC by producing more so new firms who start by producing more can’t reap same profits, strategic behaviour to deter rivals

Monopoly market structure

One large seller

high barriers to entry

differentiated unique product

Monopoly equilibrium

determined by profit maximisation so where MR=MC

trace up to find cost on AC curve and price on AR curve

marginal revenue lies under AR

profits are sustained in the long-run and give incentive for research and development and finding new technologies

consumer and producer surplus

consumer surplus: the difference between the amount consumers are willing to pay and what they actually pay (difference between demand curve and price)

producer surplus: the difference between the price of a good and the minimum price producers are willing to supply it (difference between supply curve and price)

Comparing monopoly to perfect competition

total welfare (consumer + producer surplus) is greater under perfect competition than under monopoly

monopoly has welfare loss → creates rational case for government intervention to prevent formation of monopolies or control their behaviour

Revenue curves and elasticity

when marginal revenue = 0, elasticity of AR is 1 and TR is maximised → will always produce on elastic part of demand curve as want high revenue to maximise profits

when MR is positive, TR rises by more, so elasticity of AR is larger than 1

When MR is negative, TR falls so elasticity of AR is inelastic (between 0 and 1)

price discrimination

when a seller charges different prices for different units of the SAME product or service for reasons not associated with differences in cost

e.g. cinema tickets for children, students and adults, airline tickets on different dates

the ability to charge multiple prices (such as charging higher prices to those willing to pay more) gives the seller the ability to increase consumer surplus and decrease welfare loss

price discrimination allows firms to sell more without decreasing market price

cartels

when firms in an industry agree to cooperate with one another and behave as a singe seller/monopoly to maximise joint profits by eliminating competition

e.g. agree to set quota on output so produce at Q1 instead of Q0 equilibrium, which maximises profits

problems cartels face

• ensuring all members follow behaviour that will maximise the industry’s joint profits (rather than succumbing to self interest)

• preventing the profits being eroded by the entry of new firms

price discrimination vs single price

price discrimination is more profitable and has no welfare loss

conditions necessary for profitable price discrimination?

1. sellers must be price makers → in order to set the different prices

2. buyers must differ and sellers must be able to identify the different buyers in order to discriminate prices

3. consumers must not be able to participate in arbitrage (when buyers charged a low price purchase the good and resell it e.g. students cant resell to non-students due to proof of student status needed)

Assumptions of price discrimination

• the seller is a pure monopolist (price discrimination can occur in markets with more than one seller but assume its a monopolist to understand problem without complications)

• entry is blocked even in long-run so analysis doesn’t change between short-run and long-run

Types of price discrimination and definitions

1. First degree price discrimination: when sellers charge each individual buyer the maximum price the buyer is willing pay

2. second degree price discrimination: a seller can use a menu of ‘non-linear tariffs’ (non-linear when average price changes) to get buyers to reveal their preferences when they select a tariff e.g. £10 per month vs 5p per minute for calls

3. third degree price discrimination: when a seller can identify groups of buyer and charge different prices to each group (can be grouped by characteristics such as students, or by location e.g. affluent areas charged more)

first degree price discrimination and diagram

Marginal revenue is equal to Average revenue (= price)

therefore there is no deadweight loss

produces same output as a perfectly competitive seller = more than what it would without price discrimination → more profitable

since every consumer is paying maximum there is no consumer surplus (no difference between what they pay and what they are willing to) so maximum welfare is fully producer surplus

third degree price discrimination and diagram

different markets/groups have different elasticities

groups willing to pay more will have inelastic demand (market X) → benefit without price discrimination as offered lower prices to accommodate for elastic demand

groups not willing to pay as much will have elastic demand (market Y)

total market will add the market curves together horizontally so MC =MR on total market aligns with a point on MRy and MRx

produces same output as without price discrimination, deadweight loss as AR (D) is above MR

price charged in single price monopolist lies between the prices charged to the two groups

linear vs non-linear tariff

low users will prefer linear tariff

high-users will prefer non-linear tariff

forms of imperfect competition

monopolistic competition

oligopoly

2 ways products can be differentiated

• horizontal differentiation: same quality (so similar/same price) but choices depend on peoples tastes and preferences

• vertical differentiation: quality (and also price) clearly differs

Assumptions regarding monopolistic competition

• buyers are price takers

• buyers and sellers have complete information

• sellers are price MAKERS (so seller sells more when price is lower and their output choice isn’t reacted to by rivals)

• entry is free so potential sellers can enter market in the LONG run

Monopolistic competition market structure

• many small sellers

• low barriers to entry

• differentiated products either horizontal or vertical

Short run equilibrium monopolistic competition

price maker so downward sloping demand curve

long run equilibrium monopolistic competition

in long run other sellers can freely enter the market and all factors are variable which impacts sellers costs

long-run costs curves LRAC and LRMC are flatter

make normal profit in long run as when firms enter the market (more sellers) this leads to lower demand for an individual seller as there are the same amount of buyers between a larger amount of sellers

differences between monopolistic competition and perfect competition

1. price-cost margin: in perfect competition price is always equal to marginal cost but in monopolistic competition price is above marginal cost

2. capacity: perfectly competitive sellers operate at FULL CAPACITY as they produce at the minimum efficient scale (lowest possible cost) no matter how much they produce whilst monopolistically competitive sellers have EXCESS CAPACITY as firms can produce more to lower their costs

game theory and terms definitions

used to highlight strategies to maximise gains/minimise losses

helps make predictions about how economic agents will behave in certain situations

players → decision makers aka sellers

strategies → pricing decisions

payoffs → how well players do e.g. profits

representation of games

1. extensive form = sequential move games where player A moves first then player B moves, game represented as a tree diagram

2. normal form = players move simultaneously, game represented by matric (more strategies (aka choices) = larger matrix 2×2, 3×3 etc.

dominant strategy

a strategy is dominant if it provides a player with the highest payoffs regardless of a opponents strategy

can have dominant strategy equilibrium if both players dominant strategy (highest payoff) is at same point (here would be up left)

nash equilibrium

when no player can do better than their chosen strategy given their beliefs of how other players will play

two requirements:

1. each player must be playing a best response against their belief of how other players will play

2. these beliefs must be correct

(in image nash equilibrium where both are underlined as both players playing best response to others strategy)

subgame perfection

refinement of nash equilibrium for sequential move games

split tree map into subgames (e.g. what B does if A chooses up)

use backwards induction in each subgames where you start at end of game to solve for best responses

put extra arrows at best choice, nash equilibrium when arrow goes from both A and B

models of oligopolies

quantity setting (Cournot)

price setting (Bertrand)

Assumptions of oligopolies

• buyers are price takers

• buyers and sellers have complete information

• sellers are price makers → output choice triggers reactions from rivals + demand curve downwards sloping

• entry is blocked even in long run

oligopolies market structure

• few large sellers (each seller must be large enough to affect price and have rivals large enough to respond)

• high barriers to entry

• products can be identical or differentiated

Assumptions for Cournot’s model of oligopoly

• assumes only 2 sellers in market who compete in quantities and make their output decisions simultaneously

• further entry into market is completely blocked

• firms produce homogenous products (simplifies model)

• the markets demand is P = a - Q (where Q = Qa + Qb → from firm A and B)

Cournot Nash equilibrium

when no firm wants to change its output level holding both output levels constant

equilibrium is at the intersection of both firms best response functions on a diagram

(made up of tracing the different output levels using the marginal output rule MC=MR and the differing demand curves based on what the the other firm produces)

residual demand curve

a firms demand curve given the output of its rivals

the more firms B produces the closer firm A’s residual demand curve is to the origin

constructing Cournot best response functions

made up of tracing the different output levels using the marginal output rule MC=MR and the differing demand curves (original demand versus different residual demand curves) based on what the other firm produces

if firm B doesnt produce anything firm A produces at monopoly output Qm with normal demand curve, if firm B produces Qb1 output is at residual demand curve so firm A produces Qa1 which is lower than Qm.

profit increases as output tends towards the monopoly level

comparing Cournots oligopoly to monopoly and perfect competition

• the duopolists ( 2 firms) together produce more than 1 monopolists would produce

• the market price is lower than for a monopoly but higher than perfect competition = profit making

Bertrand’s oligopoly model assumptions

• there are only 2 firms in the market (duopolists), they choose level of price (compete in prices) and make their pricing decisions simultaneously

• further entry into the market is completely blocked

• firms have the same constant marginal costs and no fixed costs (which means Total costs = variable costs, and average costs = marginal costs)

• firms produce identical products (so buyers purchase from cheapest seller)

• market demand: Q = a - P (subtract firm A’s price when its below firm B’s and subtract firms B’s price when PA is above PB)

constant marginal costs

bertrand nash equilibrium

when no firm wants to change its price

equilibrium consists of price pA and pB such that given fir bm B charges pB, firm a profit max price is pA, and given firm A charges pA, firm B’s rpfoit max is pB

the intersection of firm A and B best response functions

Betrand firm specific demand curve and pmax position

if firm believes firm B will set a certain price, under the assumption that their products are identical, consumers will not buy from firm A if their price exceeds that of firm B, so demand curve cuts off at firm B price and is 0 (as firm A sells nothing)

bertrand best response function points explained

Bertrands model compared to monopoly and perfect competition

• set a lower price than the monopoly level

• market produces more output from the duopoly than under a monopoly

• set same price as in perfect competition (no deadweight loss)

• bertrands total welfare is consumer surplus

what is the bertrands paradox?

• the model claims that by adding only one firm we go from the extreme of monopoly to the other extreme of perfect competition

• this is not seen in reality

ways to break the Bertrand paradox

1) if we account for PRODUCT DIFFERENTIATION a seller won’t lose all their customers when their rival has a higher price

2) consider CAPACITY CONSTRAINTS as even if all buyers go to the firm with the cheaper price, the firm may not have the ability to supply the whole market

3) acknowledge there is INCOMPLETE INFORMATION about prices and costs so even if a firm has a lower price, consumers may not know so wont all flock to the cheaper firm

4) firms may not compete as intensely as the Bertrand model predicts if they INTERACT REPEATEDLY as they may recognise their ability to charge higher prices if they compete less

what is the prisoners dilemma? solution?

the prisoners dilemma is where the dominant strategy for both players is to act with self interest, but this leads to a nash equilibrium with a less than optimal payoff

to solve this dilemma, players can cooperate to both get a better payofff

however when firms agree to cooperate there are short term incentives to deviate from the agreement to gain an even higher payoff

oligopolies methods of collusion in cournot and bertrand models

• for Cournot (quantity setting model) if the firms cooperate they can both produce half of the markets monopoly profit max quantity

• for Bertrand (price setting model), both firms can produce at monopoly price

• for both there is a short term incentive to produce more than their share of the monopoly quantity to increase profits, or to just undercut the monopoly price by a small amount to encourage more consumers

conditions necessary for oligopolists to collude

1- sellers must interact repeatedly → this means the incentive to deviate from the cooperation agreement will be counteracted by a long-term punishment such as price wars (with price wars the profits from deviating in the long run decrease)

2- sellers must be aware of each others strategies → so will be aware of deviation and bale to punish it, firms may form cartels to monitor firms and make sure they’re each conforming to the agreement

grim trigger strategy

if both firms have decided to cooperate, as soon as one player deviates the firms revert to playing the one-shot nash equilibrium deviate, deviate forever (As trust is lost between the firms so will no longer agree to cooperate)

infinitely repeated prisoners dilemma nash equilbrium

cooperate, cooperate is the forever nash equilibrium if the short term benefit from deviating is less than the long term punishment

short term benefit: difference in payoff between cooperate, cooperate and deviate, cooperate (what they gain by breaking the agreement)

long-term punishment: the difference between a firms payoff from cooperate, cooperate / interest rate (dividing by interest rate helps put future payoffs as present values to represent long-term) and a firms payoff from deviate, deviate / interest rate

finitely repeated prisoners dilemma

can use backwards induction to find a nash equilibrium in each subgame

Supply of labour by an individual worker

supply is upwards sloping (usually) or backwards bending (rarely) depending on which effect dominates:

• substitution effect: at higher wages a person will work more as leisure has a greater opportunity cost (losing out on more income with same leisure time)

• income effect: higher wages imply worker can afford more leisure time (if dominates = backward bending)

supply of labour to an employer

an employers labour supply depends on whether employer is a wage taker (curve will be perfectly elastic) or a wage maker (upwards sloping)

shifts in supply curves due to:

• changes in number of qualified people

• non wage benefits attracting employees

changes in slope (responsiveness of supply to wage changes) depends on:

• the difficulty of changing jobs

• short-run vs long-run