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Imperfect Competition Imperfect Competition Topics in Public Economics Fall 2017 Outline Competitive Markets and Efficiency Imperfect Competition Concepts of Competition Market Structure Welfare Competitive Markets, Allocation and Efficiency Efficiency: Price mechanism as a means of allocating resources. I When agents are price takers, prices reveal true economic values and act as signals that guide agents to mutually consistent decisions ! Pareto Efficiency I First Fundamental Theorem of Welfare Economics: The competitive equilibrium, where supply equals demand, maximizes social efficiency. First Theorem I Second Fundamental Theorem of Welfare Economics : Society can attain any efficient outcome by suitably redistributing resources among individuals and then allowing them to freely trade. Second Theorem back back Prices and Efficiency I Imperfect competition arises whenever an economic agent has the ability to influence prices. I To be able to do so requires that the agent must be large relative to the size of the market in which they operate. I It follows from the usual application of economic rationality that those agents who can affect prices will aim to do so to their own advantage. I This must be detrimental to other agents and to the economy as a whole ! room for economic policy Outline Competitive Markets and Efficiency Imperfect Competition Concepts of Competition Market Structure Welfare Market Power and Prices I Firms with market power can push prices above competitive level which will hinder efficiency. I It then becomes possible that policy intervention can improve on the unregulated outcome. Outline Competitive Markets and Efficiency Imperfect Competition Concepts of Competition Market Structure Welfare Concepts of Competition I Imperfect competition arises whenever an economic agent exploits the fact that they have the ability to influence the price of a commodity. I If the influence on price can be exercised by the sellers of a product, then there is monopoly power. If it is exercised by the buyers, then there is monopsony power, and if by both buyers and sellers, there is bilateral monopoly. I A single seller is a monopolist and a single buyer a monopsonist. I Oligopoly arises with two or more sellers who have market power, with duopoly being the special case of two sellers. Price or Quantity I An agent with market power can set either the price at which they sell, with the market choosing quantity, or can set the quantity they supply, with the market determining price. I Choice variable does not matter for monopoly or monopsony I Oligopoly ! Cournot or Bertrand Competition I Homogenous products ! single price I Product differentiation ! variable prices I Monopolistic competition: Competition among many differentiated sellers who can enjoy some limited monopoly power tahnks to heterogenous tastes of consumers Outline Competitive Markets and Efficiency Imperfect Competition Concepts of Competition Market Structure Welfare I The structure of the market describes the number and size of firms that compete within it and the intensity of this competition. I How do we define the market? I Close substitutes: own price elasticity vs cross price elasticity I Industry classification: not always I Geographic areas: where to locate? Measuring Competition What does it mean to say that there is ??more?? or ??less competition?? in a market? I Three distinct dimensions I Contestability : entry barriers and potential competition I Concentration : the number and distribution of rivals P 2 1 Herfindahl index: H = i si ! n for n equally sized firms I Collusiveness : degree of independence of firms’ strategies and capacity to determine prices in unison Explicit or tacit collusion Outline Competitive Markets and Efficiency Imperfect Competition Concepts of Competition Market Structure Welfare Inefficiency Imperfect competition ! market failure ! inefficiency ! public intervention? I Cournot behavior (quantity is the strategic variable) and homogeneous product I Competitive markets ! price equals marginal cost p = c I Compare with a monopolist with constant MC Monopoly Pricing dp π = [p(y) − c] y ! p + y − c = 0 ! p > c dy dy p " = < 0 profit maximization condition gives dp y p−c 1 p = j"j which is known as Lerner Index. This is equivalent to 1 p = µc with µ = 1−(1=j"j) and µ is monopoly mark-up. For mark-up to be positive j"j > 1 i.e., monopolist locates on the p−c 1 elastic part of the demand. This implies p = j"j 2 (0; 1). How can the market power of a monopolist can be lower than 1? Oligopoly Pricing The relation of the monopoly markup to the elasticity of demand can be extended from monopoly to oligopoly: I Assume there are m firms. Firm j produce yj . Total output Pm y = j=1 yj dp I π = [p(y) − c] y and p + y − c = 0 j j j dy y I Assume identical firms each producing m p−c 1 1 I Lerner Index will then be = p m j"j o o m I p = µ c with oligopoloy mark-up µ = > 1 m − (1=j"j) Welfare Loss I Equilibrium of an imperfectly competitive market is not Pareto-efficient, except in the special case of perfect price discrimination. I What is the degree of welfare loss? I Assume MC is constant and there is no fixed cost. I Compare the competitive equilibrium consumer surplus with monopoly rent + consumer surplus in a monopolistic market Deadweight Loss with Monopoly Deadweight Loss and Demand Elasticity I DWL is equal to the area BED which is equal to the half of the monopoly profit (why?) m m 1 m m I Monopoly profit: [p − c] y ) BED = [p − c] y 2 m 1 m I From FOC of monopoly output p − c = − p " pmy m Rm I DWL = − 2" = − 2" I For instance, if " = −2 then the welfare loss is 25% of sales revenue DWL or defending costs? Dynamic aspects Tax Incidence in Competitive Market Legal and economic incidence are different Economic incidence depends on elasticities of demand and supply Tax Incidence Imperfect Competition Differs from competitive market for two reasons: I p 6= c I π 6= 0 Regulation of Monopoly I Big or small, it is still beneficial to reduce the loss as far as possible I What can be policies that are available to reduce the adverse effects of monopoly. I The most natural policy response is to try to encourage an enhanced degree of competition. I Antitrust legislation I Aids to competition. I Nature of policy depends on the reason of entry barrier: legal, technological, entry deterrence... Natural Monopoly The enhancement of competition only works if it is possible for competitors to be viable Regulating Natural Monopoly I The two policy responses to natural monopoly most widely employed have been public ownership and private ownership with a regulatory body controlling behavior. I Ramsey Price p = MC or p = AC I Various forms of regulation in private ownership I Asymmetric Information and incentive design Regulation of Oligopoly I Detecting collusion I Merger Policy I The key article in the new ECMR says that ??a concentration which would significantly impede effective competition, in the common market or in a substantial part of it, in particular as a result of the creation or strengthening of a dominant position, shall be declared incompatible with the common market?? (Article 2) Merger.
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