Once more: The ideal market ("Perfect
competition")
Assumptions:
• Very large numbers of buyers and sellers: Nobody
has a notable influence on supply, demand or
price→ demand curve is horizontal (firms are
'price-takers': they can sell any quantity if only
they accept the price)
• Homogeneous products
• Free entry to and exit from markets
• Everybody has adequate knowledge of prices and
technology
• Technology is given exogenously
The other extreme: Perfect Monopoly
•
•
•
•
A single firm (firm's demand = market demand)
Producing a unique product (no close substitutes)
Strong barriers to entry
Monopoly power allows to keep output low, raise
prices above competitive levels and make abovenormal profits
Examples of (past) monopolies: network industries
such as railways, electricity, gas, water or telecom
Monopoly: Marginal revenues decline much faster
than prices, as the firm has to give each client the
same price
10
8
6
5
4
3
Q
P
TR
AR
MR
0
10
0
-
-
1
8
8
8
8
2
6
12
6
4
3
4
12
4
0
4
2
8
2
-4
5
0
0
0
-8
D=AR=P
Q = Quantity
P = Price
TR = Total Revenue
AR = Average Revenue
MR = Marginal Revenue
1
0
1
2
MR
3
5
4
Quantity
A monopolist maximizes profit, choosing
Quantity Qm, where MC = MR (the golden
rule of MC = MR still applies!)
Monopoly
profit
MC
AC
Pm = AR
AC
D=AR=P
MR
0
Qm
Quantity
D = Demand
P = Price
AR = Average Revenue
MR = Marginal Revenue
MC = Marginal costs
AC= Average costs
Deadweight loss through monopoly: It is not the fact
that a monopolist produces less output; it is because
the monopolist produces less consumer and less
producer surplus!
Perfect competition and perfect monopoly are
extreme forms and occur seldom in reality.
Intermediate forms of imperfect competition:
• Monopolistic competition
• Oligopoly (collusive or non-collusive oligopoly)
• Cartels
→One common thing under all forms of imperfect
competition: There is some degree of market power =
influence on price through a declining demand curve
(to varying degrees)
Monopolistic competition:
• Large numbers of firms
• Free entry and exit
• Perfect knowledge
Same as
under perfect
competition!
• Identical cost curves
• However, other than under perfect competition:
"product differentiation" acts as a source of market
power
Some examples of "product differentiation"
• There is fierce competition among lots of music
groups, but there is only one band called U2! This
brand name (thanks to advertising, reputation etc.)
gives some market power to U2
• Only Volkswagen can sell a "Golf", but lots of other
producers offer cars in the "Golf class"
• There are lots of producers of sweet drinks, but only
one can put the name "Coca Cola" on the bottle
• Among many restaurants, some succeed to
establish a reputation for unique quality
→ All this leads to some price-setting power!
Market power:
• A perfect monopolist would typically have a steep
(inelastic) demand curve as entry of competitors is
blocked and there are no close substitutes
• Under monopolistic competition, the demand curve
tends to be more elastic. Market power exists but is
more limited, due to (close) substitutes: you could
for example still choose Pepsi instead of Cola
• Under monopolistic competition, the elasticity of the
demand curve (i.e. market power) depends on how
unique the product can be made (in the perception of
the clients)
• If uniqueness is small, monopolistic competition
comes close to perfect competition
Oligopoly
• A few (often 2-3) dominant suppliers
• Often strong brand names (due to extensive
advertising) act as an entry barrier to their market
• Oligopolists can produce homogeneous products
(steel, paper, cement, aluminium) or differentiated
products (Pampers, Guinness, Tempo)
• Oligopoly behaviour (price setting, choice of output)
is hard to predict
An oligopoly as a prisoner's dilemma
A dominant strategy game: Profits (million Euro) for two
firms (X and Y) at different prices
Firm X's price:
2 euro
Firm Y's
price:
2 euro
A
Profit:
B
Profit:
10 each
1.80 euro
1.80 euro
C
Profit:
5 for Y
12 for X
D
Profit:
12 for Y
5 for X
8 each
The kinked demand curve under oligopoly
Price
Our price increases will not be
followed by our competitors and
therefore we loose sales
Typical for
oligopoly: price
stability
D
Our price cuts will be
followed by price cuts
of our competitors and
therefore we gain only
little extra sales
D
Quantity
Concern for anti-trust authorities:
• Strong interdependence: Each oligopolist's decision
will affect the behaviour of the others. Oligopolists
observe each other very carefully!
• Strategic behaviour: what are the most likely
reactions of my rivals? How do they expect me to
react to their actions?
• Collusion: Either explicit or "tacit" agreement to limit
competition (e.g. set output quotas; fix prices; limit
product promotion)
• Cartels: setting quotas, fixing prices
• Price leadership: All other firms choose the same
price as the market leader (usually the largest firm)
Behind any imperfect market → Various
types of barriers to entry (1):
• Economies of scale: If fixed costs take a high share
of total costs (e.g. in network industries), one firm
serving the whole market can produce at lowest
costs! ("natural monopoly")
Average total costs
A "natural monopoly": Average total costs decline monotonically
If a firm has reached this position:
how could a new entrant survive?
30%
70%
% of market share
Behind any imperfect market → Various
types of barriers to entry (2):
• Economies of scope: Producing a "family" of related
products allows to make use of shared (overlapping)
R&D, marketing, storage, transport facilities or
advertising → synergies lead to cost-reduction
Example:
• An automobile producer will typically offer a whole
range of cars and lorries; knowledge developed for
one type of car can often be applied to others; the
same holds for brand reputation, joint advertising,
service networks etc.
Behind any imperfect market → Various
types of barriers to entry (3):
• Product differentiation and brand loyalty: Strong
association between a product / service and a brand.
Examples:
• "let me xerox this paper …"
• "let me google …"
• "We pamper our clients …"
Behind any imperfect market → Various
types of barriers to entry (4):
• Learning-by-doing: As a firm produces more of
something, people become more efficient in
handling machines, systems etc.
• Accumulated (tacit) knowledge: Personnel will
accumulate ("tacit") knowledge from experience for
improvements of products, services or procedures,
will know the cheapest and most reliable suppliers,
etc.
• Both points give a firm a first mover advantage!
Behind any imperfect market → Various
types of barriers to entry (5):
• Ownership/control of key inputs or of distribution
channels
Examples:
 A beer producer could deliver free equipment for a
bar if the bar exclusively sells his beer;
 Diamond producer De Beers controls a World wide
network for selling diamonds;
 Somebody happens to sit on an oil well.
Behind any imperfect market → Various
types of barriers to entry (6):
• Legal protection: Patents, copyrights, trade marks,
licences, or trade restrictions
• Mergers and takeovers: A monopolist could take
over any new entrant.
Finally:
Do firms really maximize profits?
Problems in real life:
• It is very hard to know exactly: What are the firm's
costs? (see management accounting course later
this year) and, even harder:
• What are the firm's demand curves? Determination
of demand curves through statistical observation is
very difficult!
Another problem: Principals versus agents
→Principals hire agents in order to serve the principals'
interests, but the agents have their own interests …
Examples:
• Shareholders versus managers
• Supporting services in large conglomerates
• Suppliers and buyers of intermediate products
The principal-agent problem:
Painstaking questions by the principal:
• Are my agents doing their best?
• Are they producing at lowest possible costs?
• Do they deliver the best possible quality?
General difficulty:
• Agents may take advantage from the limited
observability of their work; they tend to know more
about their work than do their principals; they can
selectively inform the principals
Solution → Incentive contracts? (perverse effects!)
Problem: For the principals, it can be
rational being badly informed – why?
• A manager works full-time in a company; her
principals (shareholders) will dedicate much less
time to the company → information asymmetry!
• Information asymmetry is worst if ownership is
dispersed among many small shareholders: Their
marginal revenues of control are small compared to
their marginal costs!
• An improvement: large block-holders (e.g. rich
families, pension funds, life insurance companies or
the "house bank" in Japan and Germany): higher
control efforts → benefits of control are higher if you
hold large blocks of shares!
Under dispersed ownership, there is still one
disciplining mechanism left: Bad management → stock
market value down → greater threat of an unfriendly
takeover (risky for managers!)
Why is there more chance of a take-over?
Tobin's Q = A firm's stock market value, divided by the
accounting value of a firm's assets: If Q is much
smaller than 1, you are an interesting candidate for a
take-over! (A take-over is cheaper than founding a firm)
Note: This works with long delays and after a long
period of really bad management!
There is room left for management to pursue
Empirical evidence: Manager-controlled firms in US
own interests:
and UK are less profitable than family firms!
Shareholders:
Maximum
profit!
Control ?
Managers: growth & prestige; high
salaries; a large Royal Court of assisting
personnel; luxurious business trips and
office rooms; favourable contracts for
my best friends;
discretionary
investments ...
These bastards do
not know all I know!
Are my marginal
revenues of control
worth my marginal
costs!?
Diffuse data on
costs, demand,
etc. (can be
manipulated
within certain
limits)
Baumol's model: Set output at MR=0!
Note:
• A profit-maximizer sets output at MR=MC (leading to Qpm and
Ppm)
• The output maximizer arrives at Psrm and Qsrm
Stock market valuation
Stock market valuation
Growth maximization: At some point, stock market
valuation will decline as you may push growth by
selecting poorer investment projects … and by
extensive advertising
Firm growth
What are the limits of striving for
growth? You must keep your
shareholders happy, otherwise they
sell their shares
→ danger of take-over!
Staffing
Nonetheless,
management has some
freedom: there is only a
weak correlation between
growth of assets and
profitability!