Chpater 07 - Competition

8/9/2019 Chpater 07 - Competition

1/24


2/24

First Degree Price Discrimination:

Monopolist charges different price for eachunit of good.

Highest price for the first unit and reductionin price for every successive unit.

Guided by Law of Diminishing MarginalUtility unless a consumer is offeredsuccessive units at falling prices, he wouldnot purchase the additional unit of a good.

Monopolist exploits the consumers to themaximum possible extent.

Second Degree Price Discrimination:Monopolist sets block prices.Price is the highest for the first block of

quantity bought and it is reduced for everysuccessive block of quantity bought.

Third Degree P rice Discrimination:Different prices are charged for the same

homogeneous good from different

customers.Customers are differentiated on the basis of

geographical location, product use,purchase time, age, sex etc.


3/24


4/24

Total output of the Monopolist Q = Q1 + Q2.

Total Revenue R = R1 + R2 .

Total cost function = C (Q) = C (Q1 + Q2).

Profit = = R1 + R2 C.

To maximize profit the first order conditionrequires that d/ dQ1 = 0 and d/ dQ2 = 0.

That is d/ dQ1 = dR1/ dQ1- dC/ dQ1= 0

dR1/ dQ1 = dC/ dQ1 or MR1 = MC1Again d/ dQ2 = dR2/ dQ2 - dC/ dQ2 = 0

dR2/ dQ2 = dC/ dQ2 or MR2 = MC2

Hence the condition of profitable pricediscrimination is MR1 = MR2 = MC.

To maximize profit the Monopolist willdistribute output in two markets in such away that MR is the same in both themarkets and is equal to MC.

So long as MR1 > MR2, it will be profitablefor the Monopolist to shift one unit ofoutput from the second market to the first.

Shifting will continue so long as MR1 ishigher than MR2 and the opposite happenswhen MR2 > MR1.


5/24

E

MR

MC

0

Q10 Q

2 0 Q

AR1,MR1AR2,MR2 MR

MC

P2P1

MR1

AR1 AR2MR2

MC curve intersects MR curve at point Ewhere the equilibrium level of output is OQ.

OQ1 and OQ2 output is sold in the first andsecond market respectively to equalize MR.

OP1 and OP2 Prices are determined formarket 1 and 2 respectively.

As the elasticity of demand in the firstmarket is less than that of the secondmarket, the price in the first market ishigher than that of the second market.

By differentiating the price from one to theother market, the monopolist maximizesprofits.


6/24

Class Assignment: 1

A garment manufacturing firm has the total

demand function for its product P = 100 4Q. However, the demand function forselling garments in the domestic market andforeign countries are P1 = 80 5Q1 and P2 =180 20Q2 respectively. The total costfunction of the firm TC = 50 + 20Q.Determine the following:

The price that will be charged by the firm tomaximize profit in absence of price

discrimination.

The price that will be charged by the firm tomaximize profit when the domestic price isdiscriminated from the international price.

The difference in the profit of the firmbetween discrimination and non-discrimination.


7/24

Monopolistic Competition

It is a blending of competition andmonopoly. Refers to competition among themonopolists.

Many sellers, each having an insignificantshare in the total supply of the product inthe market.

Product differentiation, products of variousfirms are similar but not perfect substitutes.

Easy entry and easy exit.Existence of non-price competition.

The demand curve for a monopolisticallycompetitive firm is downward slopingbecause of product differentiation.

It is highly elastic though not perfectlyelastic as there are close but not perfectsubstitutes for its product.

The MR for any quantity will be less than thecorresponding price as the demand curve is

downward sloping.

The firm can sell a larger quantity only bylowering the price, i.e., each additional unitadds a smaller amount to TR.


8/24

D=AR

MR

Quantity

Price,

Revenue

Demand and marginal revenue curvesfor a firm in monopolistic competition

SR Equilibrium of a Monopolistic FirmA firms equilibrium is determined at the level

of output which satisfies the two conditions:

MC = MR

MC curve cuts MR curve from below.

A monopolistic competitive firm may faceeither of the three possibilities in the SR:

At the equilibrium output it may earnabnormal profits.

At the equilibrium output it may incur losses.

At the equilibrium output it may break-even.


9/24

Y

MC

AC

AR

MR

E

K

P

S

0

Q

T

X

Abnormal profits or Economic profits

Equilibrium Point : EEquilibrium Output : OQEquilibrium Price : OP = QTAt Equilibrium AR : QTAt Equilibrium AC : QKProfit per unit : QT QK = KTTotal profits : KT OQ = PTKS

Y

MC

AC

AR

MR

E

T

P

S

0

Q

K

X

Loss Making Firm

Equilibrium Point : E

Equilibrium Output : OQ

Equilibrium Price : OP = QTAt Equilibrium AR : QT

At Equilibrium AC : QKLoss per unit : QK - QT = KT

Total Loss : KT OQ = PTKS


10/24

Y

MC

AC

AR

MR

E

T

P

0

Q

X

Normal Profits

Equilibrium Point : EEquilibrium output : OQ

Equilibrium Price : OP= QT

At equilibrium AR : QTAt equilibrium AC : QT

As AR equals AC the firm

breaks even, i.e., it earns

normal profit.

In the SR, a firm will continue to be inproduction as long as at any level of outputits ARAVC.

LR Equilibrium of a Monopolistic Firm

In SR, if existing firms in the industry earnexcess profits, new firms would enter theindustry in the LR.

Each firms share of the total industrydemand falls and demand curve for eachfirm will shift to the left.

If the firm was running into losses, it wouldleave industry in the LR to avoid losses.


11/24

In LR, all firms break-even and produce onthe negatively sloped portion of their LACcurve.

Due to normal profit (P = AC), the entryand exit of firms will not take place.

Two conditions of LR equilibrium of a firmare:

MC = MR

P or AR = AC

When all firms reach their respective break-even points, the Group Equilibrium isattained.

AC

MC

AR

MR

0Q2 Q3

P2


12/24

The equilibrium level of output would fallshort of the optimal level of output, i.e.,

Q2Q3.OQ2 is the LR equilibrium output and OQ3 is

the output at which AC is the least.

Full capacity output is the one at which AC isthe minimum (OQ3).

Since OQ2 denotes equilibrium output, Q2Q3measures the excess capacity.

A firm under monopolistic competition never

operates at its minimum AC or always hasan excess capacity.

MC

D= ARMC

D = ARPC = MRPC

ATC

BL

Q PCQ MCQuantity

MRMC0

PmC

PPC

Excess capacity


13/24

Perfectly Competitive firm operates at theminimum point of the LAC curve.

Since P > MR and MR = MC for a firm undermonopolistic competition, it operates whenP > MC.

Both types of firm earn only normal profit inLR, means D = AR must be tangent to ACcurve.

D = AR for a perfectly competitive firm is a

horizontal straight line and it is tangent to AConly at the minimum point of AC.

D = AR for a monopolistically competitivefirm is negatively sloped and is tangent to

AC to the left of its minimum point.

The firm in monopolistic competition is awasteful as it does not produce at theminimum cost per unit as the purelycompetitive firm does.

Implies that the firm has excess orunderutilized capacity.

The firm in monopolistic competitionproduces socially sub-optimal output as P >MC.


14/24

Purely competitive firm produces a largervolume of output Qpc than themonopolistically competitive firm does(Qmc).

Price charged by the monopolisticallycompetitive firm Pmc is higher than thepurely competitive price Ppc.

Under pure competition, the consumer paysa lower price but no choice of product.

In monopolistically competitive industry, theconsumer can have wider choice.

Class Assignment: 2

A firm is operating in monopolisticcompetition with the following demand andcost functions:

P = 11,100 30Q

TC = 400,000 + 300Q 30Q2 + Q3

What is the short run equilibrium output,price and profit for the firm?


15/24

OligopolyConsists of only a few firms.

Each produces a relatively large share of thetotal output of the industry.

Firms in oligopolistic market structure areaware of their mutual interdependence.

Firms are quite interdependent in pricingdecisions, i.e., actions taken by one firmhave a large effect on other firms.

Barriers but possible entry and exit.

Firms produce identical or differentiatedproducts.

Sources of OligopolyEconomies of scale may operate over a

large range of output.

Huge capital investments and specializedinputs.

Patent right for exclusive production or touse a process.

Loyal customers base on product quality.Government may give franchise to only few

firms to operate.

Presence of Mergers and Acquisitions.


16/24

Oligopoly Equilibrium

A number of theories known as models havebeen proposed to explain OligopolyEquilibrium.

Models which recognize the existence ofinterdependence are:

Cartelization and Formal Collusion

Kinked Demand Curve Models

Price Leadership Models

Collusion Model All the firms recognize their

interdependence.

Decide to collaborate in the form of a cartelin the matter of Pricing.

One market demand function (AR and MR)and as many cost functions (AC and MC) asthe firms.

Profit-maximizing output for the industrygiven by intersection of CMC and MR curve.

Given the equilibrium output, the AR curvegive the equilibrium price.


17/24

Distribution of output among firms isobtained by equating MR to each of the MC.

Industry output OQ is divided among thethree firms oq1 to firm 1, oq2 to firm 2 andoq3 to firm 3.

All firms sell at an uniform price OP.

All firms have different levels of output andprofits due to differences in costs.

Efficient firms earn more profits and othersmay loose.

Perfect collusion avoids price wars amongrivals.

MC1

AC1

MC2

AC

2

AC3

MC3

(a) Firm I (b) Firm II (c) Firm III (d) Industry

AR

CMC

MR

0q1 0 00q2 q3 Q

Quantity

Price

P


18/24

Consumers are adversely affected by highprices and restricted quantities.

Chances of arriving at a commonunderstanding would be difficult in casenumber of firms are large.

Cartels are more difficult in case ofdifferentiated oligopoly.

Tendencies to break the cartel exist.

Cartels imply direct agreement among theoligopolists for reducing uncertainty.

Aim of the cartel is the maximization of theindustry profit.

Price LeadershipOne firm sets the price and other firms

follow, to avoid uncertainty.

Can be worked easily in case of identicalproducts.

Price Leader sets his price by equatingMR= MC for maximizing profit.

Followers considering the same price maynot maximize profits, if, may be by accidentrather than by their independent decisions.


19/24

Q

P2*

P1 = P2

0

Q2* Q1 = Q2

MR1 = MR2

AR1 = AR2

D

E

E1

MC1MC2

E2

Assumed that the two sellers have equalmarkets and have the same AR and MRcurves.

Assumed that the first firm has lower coststhan the firm 2, MC1 lying below MC2.

Low cost firm will charge the price P1 andthis will be followed by the high-cost firm.

Firms 1 MR = MC at point E1 , the output isOQ1 and the price is OP1.

Firm 2 charges the same price P1 and by thatnot maximizing the profit.


20/24

Kinked Demand Curve

Developed by Paul Sweezy, explained

observed rigidity of price in oligopolymarket.

Assumptions:

Many firms in Oligopolistic industry.

Each produces a product which is a closesubstitute for that of the others.

Each oligopolist believes that (a) if helowers the price, rivals will also lower the

prices and (b) if he raises, others willmaintain the prices at the existing levels.

Demand curve faced by the firm has a kinkat the initial price-output combination.

Based on - rivals react differently to a rise inprice or to a fall in price.

Demand curve is relatively elastic for a risein price.

Demand curve is relatively inelastic for a fallin price.

A rise in price by one seller will not befollowed by a rise in price of other sellers,while a fall in price of one seller will befollowed by corresponding fall in price byothers.


21/24

dd is drawn on the basis that when oneseller changes his price, others do not

change their prices.DD is drawn on the basis that when one

seller changes his price, others also changein the same direction.

Demand curves DD and dd intersect at pointP.

Demand curve is dPD which has a kink atpoint P.

As the demand curve is kinked, the MRcurve will be discontinuous.

QdD0

d

D

P

P


22/24

dA portion of the MR curve corresponds tothe dP portion of the demand curve.

BC portion of the MR curve corresponds tothe PD portion of the demand curve.

Length of discontinuity is equal to AB.

Point P on the demand curve has twoelasticities of demand.

If P is a point on dd, there is one elasticity ofdemand and if P is a point on DD anotherelasticity of demand.

MC curve passes through discontinuousrange of the MR curve.

MC

MR D

A

P

MC

MC

d

P

Q0

B


23/24

Equality of MR and MC is not possible.

MR can not be less than MC.

Price and quantity remain the same at thekink point.

Even if MC curve shifts but passes throughthe discontinuous range AB, the Price-Qcombination will remain constant.

Price rise or fall is not profitable for a singleseller.

Equilibrium of the firm is defined at thepoint of the kink.

Any output level < OM, MC is below MR andany output level > OM, MC is greater thanMR.

Total profit is maximized at kink thoughprofit maximizing condition MR = MC is notfulfilled at the kink point.

Not an analytical sound analysis for price-output determination.

Accepted as a reasonable explanation forthe rigidity of price and output in theoligopolistic markets.


24/24

Thank You for going through thematerial

Prof. (Dr.) T.R. Dash

Director, Post Graduate Studies, BBU

&

Director, Institute of Mobilizing Knowledgefor Economic Development and Peace, BBU

Documents

Chpater 07 - Competition