Topic 5 – Market Structure

11.a Introduction to Imperfect Competition

11.b Monopolistic Competition

11.c Oligopoly and Game Theory

12.a History of Oligopoly Control

12.b Canadian Competition Policy

11a Introduction To Market Structure

Market structure depends upon two variables:

1)Number of Firms

2) Product Differentiation

Product Differentiation

• Definition: Product Differentiation between two or more products exists when the products possess attributes that, in the minds of consumers, set the products apart from one another and make them less than perfect substitutes.

• Examples: Pepsi is sweeter than Coke, Brand Name batteries last longer than "generic" batteries.

Market Structure Spectrum

A) Monopolistic Competition

1) Many Firms

2) Differentiated Products

Examples: dry cleaning, socks, burgers

Approximately 2/3rds of Canada’s output comes from industries made up of small firms

Some can be explained by Perfect Competition

Those with differentiated products and price setting are explained through Monopolistic Competition

B) Oligopoly

1) Few Firms (2 Firms = Duopoly)

2) Homogeneous or Differentiated Products

Examples: Apples, Cola, Breakfast Cereals

Approximately 1/3rd of Canada’s output comes from industries with few large firms

Industries with one firm are rare, and analyzed using Monopoly

Industries with more firms are more common, and are analyzed using Oligopoly and Game Theory

Four-firm Concentration Ratio (4CR)

-Sum of the top 4 sales revenue (in percentage terms) in an industry

ie1) Internet: Shaw (50%) and Telus (50%)

4CR = 50%+50%=100%

ie2) French Fries: New York (10%), McDonalds (7%), Wendy’s (4%), Red Robin (3%)

4CR = 10%+7%+4%+3%=24%*Note: Values are assumptions

Fig. 11-1 Concentration Ratios in Selected Canadian Industries

8 Copyright © 2014 Pearson Canada Inc.

Chapter 11, Slide

Measuring Market Structure-Industries closer to perfect competition have

lowest 4CR’s

-monopolistic competition has next lowest 4CR’s

-Oligopolies have intermediate 4CR’s

-Industries closer to monopolies have high 4CR’s

-This is a GENERALIZATION (there are deviations)

-Different geographical scopes can change a firm’s market power and the model used

-the internet and globalization causes large Canadian firms to be small on the world stage

Example: Mission Fun and Games Board Game Store in St. Albert Market Estimates: 90% of St. Albert board game market 25% of Edmonton Area board game market 33% of Western Canada online board game

sales 10% of Canadian online board game sales 0.1% of North American board game sales

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11.b Monopolistic Competition

Assumptions:

Firms set priceDifferentiated productsMany buyers and sellersFree entry and exit

Products are ASSUMED to be imperfect substitutes for each other.Due to differentiated products, each firm has its own residual demand curve and optimizes like a monopoly:

•In the short run it is possible for the firms to make positive profits, break even, or even to make losses. 12

Short Run Mon. Competition

Chapter 11, Slide

In the short run, a monopolistically competitive firm faces a downward sloping demand curve and maximizes profits by equating MR and MC – IDENTIAL TO A MONOPOLIST

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Long-Run Monopolistic CompetitionIn the short run, profit is availableThere is free entry and exit

THEREFOREFirms will enter, decreasing individual residual demand until:

P=AC (profits=0)

Definition: In long-run equilibrium in monopolistic competition, goods are produced at a point where average total costs are not at their minimum

Qc-QL represents the excess capacity

Monopolistic Competition is inefficient BUT consumers benefit from a wide variety of choice

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Excess Capacity Theorem

Chapter 11, Slide

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11.c Oligopoly

Assumptions:

Few FirmsFirms engage in STRATEGIC BEHAVIOR

Definition: Behavior designed to take account of the reactions of one’s rivals to one’s own behaviorFirm A’s profits depend on its decisions and the decisions of Firm B.

Strategic Behavior is analyzed through GAME THEORY

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Game Theory and LifeYou are on a first date with the love of

your dreams. You can propose 2 activities:

1)Safe activity (Coffee)2)Exciting Activity (Waterpark)

Your date could either want a safe activity or an exciting activity. There are different results if your ideas match up or clash:

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Mr/MissRightMr/MissRight

YouYou

First Date Game – Payoff MatrixWhat is the outcome of this game?Payoff format is (Left, Top)

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Game Theory ComponentsPlayers: agents participating in the game (You and Your Date

Strategies: Actions that each player may take under any possible circumstance (Coffee, Waterpark)

Outcomes: The various possible results of the game (four, each represented by one cell of the payoff matrix)

Payoffs: The benefit that each player gets from each possible outcome of the game (the profits entered in each cell of the payoff matrix)

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Best ResponsesIn all game theory games, players choose

strategies without knowing with certainty what the opposing player will do.

Players construct BEST RESPONSES

-optimal actions given all possible actions of other players

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Mr/MissRightMr/MissRight

YouYou

Chapter Fourteen

First Date Game Best ResponsesIf you know your date will pick coffee, you should pick coffee, since 10 > -5If you know your date will pick waterpark, you should pick waterpark, since 20 > 0

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Mr/MissRightMr/MissRight

YouYou

Chapter Fourteen

First Date Game Best ResponsesIf your date knows you will pick coffee, they should pick coffee, since 10 > -5If your date knows you will pick waterpark, they should pick waterpark, since 20 > 0

Note that this game is SYMMETRICAL

22Chapter Fourteen

Nash Equilibrium

Definition: A Nash Equilibrium occurs when each player chooses a strategy that gives him/her the highest payoff, given the strategy chosen by the other player(s) in the game. ("rational self-interest")

Nash Equilibria occur when best responses line up

The Date Game:

Nash equilibria: Each proposes coffee or each proposes waterpark.

Definition: A Nash Equilibrium occurs when each player chooses a strategy that gives him/her the highest payoff, given the strategy chosen by the other player(s) in the game. ("rational self-interest")

Nash Equilibria occur when best responses line up

The Date Game:

Nash equilibria: Each proposes coffee or each proposes waterpark.

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StudentStudent

Nash Equilibrium Example 2

ProfessorProfessor

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BarneyBarney

No Nash Equilibrium Example

FredFred

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Prisoner’s Dilemma

• A classic game example is the prisoner’s dilemma– There is a Nash Equilibrium. – The Nash Equilibrium results in the worst case

scenario for the players– It is hard to cooperate even when it would be

beneficial for both players to do so– Cooperation between players is difficult to maintain

because cooperation is individually irrational.

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Classic Prisoners’ DilemmaRocky’s strategies

ConfessDeny

Ginger’sstrategies

Confess

5 yearsPrison

5 yearsPrison

7 yearsPrison

Go free

1 yearPrison

1 yearPrison

7 yearsPrison

Go freeDenyBest Response: confess, even though they would both be better off if they both kept their mouths shut.

Car Firm Prisoner Dilemma

Toyota and Honda could increase profits it they cooperated or colluded

HondaHonda

ToyotaToyota

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Types of Cooperation/CollusionCollusion: An agreement among sellers to act jointly in their common interest.

Explicit Collusion: Firms agree to joint profit-maximizing outputs (illegal in Canada)Examples: DeBeers Diamonds, OPEC oilIf a single firm cheats, it increases its profits. If cheating grows, the collusion fails

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Types of Cooperation/CollusionTacit Collusion: Firms realize that working together increases profits, and therefore make similar decisions without an explicit agreementExamples: steel company price changes, Bank Mortgage rates

Discussion: Edmonton Internet Rates 2013:3-15 MBPS 5-25 MBPS 20-50MBPS

Telus $50-$55 $60-$65 $75-$80

Shaw $55 $60 $80

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Other forms of cheatingEven firms don’t cheat by overproducing, the can cheat in other ways:

1)Competition for Market ShareFirms compete for a bigger share of the market (and more profits) through advertising, quality competition, and secret rebates and secret discounts

2) Innovation Firms that can keep ahead of their rivals grab a larger market share (ie: Apple and Iphone vs. Rim and Blackberry)Common practice among oligopolies

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Entry BarriersIf profits exist, firms want to enter, causing zero long-run profits (ie: Monopolistic Competition)Monopolies and Oligopolies work hard to maintain ENTRY BARRIERS to prevent this from happening:

1)Brand ProliferationCurrent firms produce many differentiated brands to shrink (or eliminate) the market share available to a new entrantIe: Pepsi produces (Diet) Pepsi, Pepsi, (Diet) Mountain Dew, Gatorade, Tropicana, 7up, Mirinda, Lipton, Aquafina, Pepsi Max, Brisk, Sierra Mist plus different flavours of the above and various Starbucks “ready to drink” beverages

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Entry Barriers2) Advertising/Brand LoyaltyA firm advertises to boost its brand loyalty and require a new entrant to pay high advertising costs to compete

3) Predatory PricingA firm cuts its prices to cause loses to itself (in the short run) and competition, forcing competition to leaveThis causes the firm to develop a Predatory Reputation, scaring other potential firms enough to stay out of the marketThis is illegal in Canada

4) Natural BarriersSome industries have large minimum efficient scales and can only support a few large firms

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Oligopoly Results1) Profits Oligopoly profits are higher with more co-operation and

less competition/cheating These profits will cause entry unless barriers to entry are

kept strong2) Innovation Since innovation leads to profits, Oligopolies tend to

favour innovation, which benefits society

The government’s challenge is to encourage Oligopolies to compete and innovate and discourage Oligopolies from colluding and maintaining barriers to entry.

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12.a History of Oligopoly Control

Historically, government have tried to control oligopoly prices and firm entry through two key methods:

a) Nationalization – the government takes over the industry (common in England and Canada ie: Canada National Railway prior to 1995)

b) Regulation – the government sets prices and regulates entry (common in the US and Canada ie: Canada Pacific Railway)

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History of Oligopoly Control

These methods of control had issues:a) Nationalized industries didn’t innovate as well as

true oligopoliesb) Regulators often employed industry experts who

made things better for the industry

Due to this, the 1980’s saw a period of deregulation and privatization

The 2008 economic crisis saw the emergence of government bailouts as the government again became involved in large oligopolies

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12.b Canadian Competition Policy

A government alternative to controlling prices and entry is intervention designed to promote competition.

Competition Policy – Policy designed to prohibit the acquisition and exercise of monopoly power by business firms.

Canadian Competition policy began in the 1890’s, and gained strength through the Competition Act of 1986

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12.b Canadian Competition Bureau History

The Canadian Competition Bureau seeks to prevent mergers and other actions that prevent competition.

Example 1: SafewayIn the 1980’s, Safeway was flooding the market with

stores, opening up so many neighbourhood stores that no other competition could open up a good location.

The competition bureau ruled that Safeway had to close existing stores in order to open new ones.

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12.b Competition Bureau History

Example 2: Canadian Banks:In the 1990’s, Canada’s 6 big banks tried to merge

into 3 super banks. After the Competition Bureau reviewed the data and concluded that competition would suffer, the government banned the merger.

Example 3: Cineplex Odeon and Famous Players:In 2004, Cineplex Odeon’s purchase of Famous

Players Theatres was approved, as Cineplex argued both companies could not survive alone. It was, however required to sell 35 theatres to maintain competition.

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12.b Competition Act Future

The Canadian Competition Act was significantly amended in 2009 to encompass more practices that restrict competition.

The Competition Act will need to continue to evolve as globalization increases:

a) Firms may relocate out of Canada to avoid competition act censure

b) There is ongoing pressure to harmonize competition acts across countries.

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Topic 5 Summary In Monopolistic Competition, many firms compete

with differentiated products Each firm has its own demand, and optimizes as

a monopolist would, possibly earning profits In the LR, profits attract more firms, reducing

profits to zero In Oligopolies, the competition between a few

firms is analyzed using Game Theory A Nash Equilibrium occurs when each firm has a

best response to the other firm’s actions

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Topic 5 Summary Under Oligopoly, firms can often increase profits

by working together (colluding) and decreasing outputs

A single firm who cheats and increases production increases their profit, but if all firms cheat everyone is worse off

Oligopolies compete for market power, and are a large source of innovation

Oligopolies are interested in maintaining barriers to entry to protect their profits

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Topic 5 Summary Historical government control of Oligopolies has

had unfortunate side effects Canada’s current approach to Oligopolies comes

from the 1986 Competition Act, which aims to prevent actions that limit competition

The Canadian Competition Bureau has had to evolve over the years, and will continue to evolve as globalization increases