Chapter 13 MONOPOLISTIC COMPETITION AND OLIGOPOLY
QUESTIONS AND ANSWERS Q13.1
Describe Describe the monop monopolist olisticall icallyy competi competitive tive marke markett structure structure and give give some some examp examples. les.
Q13.1
ANSWER
Monopolistic competition is a market structure quite similar to perfect competition in that vigorous price competition among a large number of firms and individuals is present. present. The major major difference difference between between these these two market market structures structures is is that at least least some some degree of product differentiation is present in monopolistically competitive markets. As a result result,, firms firms have at least some discre discretio tion n in setting setting prices prices.. Howeve However, r, the presence presence of many close substitutes substitutes limits the price-setting price-setting ability of individual individual firms, firms, and drives profits profits down to a normal rate of return return in the long-run. As in the case of perfect competition, competition, above-normal above-normal profits are only possible possible in the short-run short-run before rivals are able to take effective counter measures. Examples Examples of mon monopol opolist istical ically ly competi competitive tive market market structu structures res include include a broad broad range range of industr industries ies produci producing ng clothin clothing, g, consume consumerr financi financial al service services, s, profess professiona ionall services, restaurants, and so on. Q13.2
Describe Describe the oligop oligopoly oly marke markett structure structure and give give some some examples examples..
Q13.2
ANSWER
Oligopoly is a market structure where only a few large rivals are responsible for the bulk, if not all, all, industry output. output. As in the case of monopoly, monopoly, high to to very high barriers barriers to entry entry are are typic typical al.. Unde Underr oligo oligopol poly, y, the price/ price/out output put decisi decisions ons of firm firmss are are interrelated in the sense that that direct reactions from leading rivals can be expected. expected. As a result, result, the decision making of individual firms is based, in part, on the likely response of competitors. This "competition among the few” few” involves a wide variety of price and nonprice methods of interfirm rivalry, as determined by the institutional characteristics of a particular market market setting. setting. Although Although fewness in the number of competitors competitors gives rise rise to a potent potentia iall for exces excesss prof profit its, s, above above-no -norm rmal al rate ratess of retu return rn are are far far from from guaranteed. Competition among the few can sometimes be vigorous. vigorous. Examples Examples of the oligopoly market structure structure include such industries industries as: bottled bottled and canne canned d soft soft drink drinks, s, broke brokera rage ge serv servic ices es,, inves investm tment ent bankin banking, g, long long dista distance nce telephone service, pharmaceuticals, ready-to-eat cereals, tobacco, and so on.
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Q13.3
Explain Explain the process process by which which economic economic profits profits are eliminate eliminated d in a monopoli monopolistica stically lly competitive market as compared to a perfectly competitive market.
Q13.3
ANSWER
In a monopolistically competitive industry, excess profits are eliminated in the longrun through imperfect emulation of successful product design, production systems, and market marketing ing efforts efforts by both both establi established shed and new competi competitor tors. s. Excess Excess profits profits are eliminated in a perfectly competitive industry through expansion by established firms and entry entry of new new firm firms, s, both both of whom whom offe offerr ident identica icall produ product ctss that that are are perfe perfect ct substitutes. Q13.4
Would you expect the demand curve for a firm in a monopolistically competitive industry to be more or less elastic in the long run after competitor entry has eliminated economic profits?
Q13.4
ANSWER
In most most instance instances, s, demand demand will will be more more elastic elastic in mono monopoli polisti sticall cally y compet competiti itive ve indus industr trie iess after after exce excess ss profi profits ts have have been been elim elimina inate ted. d. Th Thee effe effect ct of incre increase ased d competition will typically be to make firm demand curves more elastic given the greate greaterr availab availabilit ility y of close close substi substitute tutes. s. Howeve However, r, it is conceiv conceivabl ablee that increased increased competition would simply involve a parallel leftward shift in the firm demand curve. As discussed in the chapter, monopolistically competitive equilibrium will typically involve a price-output combination between the high price-low output equilibrium reached following a parallel leftward shift in demand, and the low price-high output (perfectly competitive) equilibrium reached when the firm demand curve becomes perfectly perfectly elastic. elastic. Q13.5
“One might expect expect firms firms in a monopol monopolistica istically lly competit competitive ive market market to experien experience ce greater greater swings in the price of their products products over the business business cycle than those those in an oligopoly market. market. However, However, fluctuations in profits do not necessarily necessarily follow the same pattern.” pattern.” Discuss Discuss this this statem statement. ent.
Q13.5
ANSWER
Oligopoly prices are expected to be more stable than those in a monopolistically competitive industry. To see this, simply recall the the discussion of the kinked oligopoly demand curve and the fact that marginal cost changes within limits will not affect prices, prices, whereas whereas similar similar cost changes would affect prices in a monopolistical monopolistically ly comp compet etit itiv ivee indu indust stry ry.. But But woul would d the the mo more re stab stable le pric pricee patt patter ern n for for firm firmss in monopolistically competitive industries produce a correspondingly more stable pattern for profits? This is not entirely clear. This depends on a great many many factors, including the speed of entry and exit in response to profit changes, the level of fixed versus
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variable variable costs, and so on. For example, example, if entry conditions conditions in the monopolisti monopolistically cally competitive industry allowed instantaneous entry, profits for individual firms might closel closely y reflec reflectt require required d rates rates of return return and be quite stable. stable. In general, general, the quicker quicker (slower) the return to equilibrium, the less (more) variable will be firm profits in monopolistically competitive industries. In oligopoly markets, price tends to fluctuate less than costs, and profits can be quite variable (e.g., ready-to-eat cereal and tobacco industries). Q13.6
What is the essential difference between the Cournot and Stackelberg models?
Q13.6
ANSWER
In the Cournot model, model, oligopoly firms make output output decisions simultaneo simultaneously. usly. In the Stackelberg model, oligopoly firms make output decisions sequentially rather than simultaneousl simultaneously. y. In the Stackelberg Stackelberg model, a dominant dominant firm is the first to set output, output, and the remaining competitors follow that lead and make their own output decisions given the output decision of the dominant first mover. Q13.7
Which oligopoly model(s) result in long-run oligopoly market equilibrium that is identical to a competitive market price/output solution?
Q13.7
ANSWER
In markets where competitors produce identical products, the Bertrand model and conte contesta stable ble mark market etss theo theory ry resu result lt in a longlong-ru run n olig oligopo opoly ly marke markett equil equilibr ibrium ium price/output price/output solution solution that is identical identical to that achieved achieved in a competitive competitive market. market. According to Bertrand, when products and production costs are identical all customers will purchase from the firm selling at the lowest possible price. For example, consider a duopoly where each each firm has the same marginal marginal costs of production. production. By slightly slightly undercutting undercutting the price charged by a rival, the competing firm would capture the entire market. In response, the competing firm can be expected to slightly undercut the rival price, thus recapturing recapturing the entire market. Such a price war would only end when the price charged by each competitor competitor converged converged on their identical identical marginal marginal cost of production, production, P A = P B = MC, and economic economic profits of zero zero would result. result. While critics critics regard as implausible Bertrand’s prediction of a competitive-market equilibrium in oligopo oligopoly ly market marketss that that offer offer homo homogen genous ous product products, s, contest contestabl ablee market marketss theory theory provides provides some additional useful perspective. Oligopoly Oligopoly firms firms will sometimes sometimes behave much like perfectly competitive firms if potential entrants pose a credible threat and entry costs are largely fungible rather than sunk. Q13.8
Why is the four-firm concentration ratio only an imperfect measure of market power?
Q13.8
ANSWER
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Chapter 13
The four firm concentration ratio measures the share of domestic output produced by the top four firms in an industry. As such, it is only an imperfect measure of monopoly power. First, First, concentration ratios ignore the magnitude of foreign foreign competition. competition. Such competition limits the market power of industry leaders in automobile manufacturing, elec electr tron onic ics, s, tele televi visi sion on equi equipm pmen entt and and many many othe otherr indu indust stri ries es.. And And seco second nd,, concentration ratios compiled using national data fail to recognize regional market power due to the local character character of markets markets such as those for the newspapers, newspapers, dairy products, products, waste disposal, disposal, and so on. Thus, although although foreign foreign competition competition can sometimes cause concentration ratios to overstate true market power by ignoring the regiona regionall charact characteri eristi stics cs of many many market markets, s, concent concentrat ration ion ratios ratios can also also underst understate ate monopoly power in some instances. Q13.9
The statement “You get what you pay for” reflects the common perception that high prices prices indicate indicate high product product quality and low prices prices indicate indicate low quality. quality. Irrespect Irrespective ive of market structure considerations, is this statement always correct?
Q13.9
ANSWER
No, not necessarily. necessarily. In both perfectly perfectly competitive competitive and monopolistical monopolistically ly competitive competitive markets P = AC in long run equilibrium. equilibrium. Given efficient efficient methods of production, production, it is reasonable to infer a close relation between prices and the costs of production, and hence product quality, quality, in such markets. markets. However, However, in both monopoly and oligopoly oligopoly markets P > AC in long-run equilibrium. Therefore, there may only be a weak relation between between prices and the costs of production production (product (product quality) in these markets. Thus, the statement “You get what you pay for” may be quite descriptive of vigorously competitive markets, but is less true in instances of imperfectly competitive markets. Q13.10
“Economic profits result whenever only a few large competitors are active in a given market.” Discuss this this statement. statement.
Q13.1 3.10
ANSW NSWER
This statement is not true, and reflects a simplistic view of the link between the number of compe competi titor torss and and the the vigor vigor of compet competit itio ion. n. Hold Holding ing buye buyerr power power const constant ant,, compe competi titi tion on can can somet sometim imes es be fierc fiercee in mark market etss that that invol involve ve only only a handf handful ul of competitors. competitors. Similarly, Similarly, markets involving involving several “competitors” “competitors” may have little or no effect effective ive competit competition. ion. For example example,, despite despite the fact that there there are relative relatively ly few providers providers of general general aviation aviation equipment, equipment, competition competition for new plane orders is often fierce and suppliers suppliers seldom earn earn above-normal profits. profits. On the other hand, textile textile and agricultural markets involve thousands of competitors that are sometimes sheltered from import competition by trade barriers and government price support support programs. To accurately assess the vigor of competition in any given market, one must carefully analyze market structure (including the number and size distribution of competitors), competitor behavior and industry performance.
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155
SELF-TEST PROBLEMS AND SOLUTIONS ST13.1
Price Leadership. Over the last century, The Boeing Co. has become the largest aerospace company company in the world. world. Boeing’s principal principal global competitor competitor is Airbus, a company that has its roots in a European consortium of French, German and later, Spanish and U.K companies. Though dominated by Boeing and Airbus, smaller firms have have recently entered entered the commercia commerciall aircraft aircraft industry. industry. Notable Notable among among these is Embraer, Embraer, a Brazilian Brazilian aircraft aircraft manufac manufacturer turer.. Embraer Embraer makes makes smaller smaller commerc commercial ial aircraft that offer excellent reliability and cost effectiveness. To illustrate the price leadership concept, assume that total and marginal cost functions functions for Airbus Airbus (A) and and Embraer Embraer (E) aircra aircraft ft are as follow follows: s: TC A MC A TC E MC E
= $10,00 $10,000,0 0,000 00 + $35,0 $35,000, 00,000 000Q Q A + $250,000Q A2 = $35,00 $35,000,0 0,000 00 + $500, $500,000 000Q Q A = $200,0 $200,000, 00,000 000 + $20, $20,000 000,00 ,000Q 0Q E + $500,000Q E 2 = $20,00 $20,000,0 0,000 00 + $1,0 $1,000, 00,000 000Q Q E
Boeing’s Boeing’s total and margin marginal al cost cost relation relationss are as follows follows:: TC B MC B
= $4,000 $4,000,00 ,000,0 0,000 00 + $5,000, $5,000,000 000Q Q B + $62,500Q B2 = ∂ TC B / ∂ Q B = $5,000,000 + $125,000Q B
The industry demand curve for this type of jet aircraft is Q
= 910 - 0.000017P
For simplicity simplicity,, assume assume that Airbus Airbus and Embraer Embraer aircraft aircraft are perfect perfect substitute substitutess for Boeing Boeing aircraft, aircraft, and that that each total total cost function function includes includes a risk-adjus risk-adjusted ted normal normal rate of return on investment. A.
Determin Determinee the supply supply curves curves for Airbus Airbus and Embra Embraer er aircraft, aircraft, assumin assuming g that the firms operate operate as as price price takers. takers.
B.
What is the demand curve faced by Boeing?
C.
Calculate Boeing’s profit-maximizing profit-maximizing price price and and output output levels. levels. (Hint: Boeing’s total and marginal revenue relations are TR B = $50,000,000Q B - $50,000Q B2 , and MR B =ΔTR B /ΔQ B = $50,000,000 - $100,000Q B.)
D.
Calculate profit-maximizing profit-maximizing output levels for the Airbus and Embraer aircraft.
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E.
Is the market market for aircraft aircraft from these these three three firms firms in short-run short-run and in long-run long-run equilibrium?
ST13.1
SOLUTION
A.
Because price followers take prices as given, they operate where individual marginal cost equals price. Therefore, the supply curves for Airbus and Embraer aircraft are: Airbus PA
= MCA = $35,000,000 + $500,000QA
500,000QA
= -35, -35,00 000, 0,00 000 0 + PA
QA
= -70 -70 + 0.00 0.0000 0002 02P PA Embraer
PE
B.
= MCE = $20,000,000 + $1,000,000QE
1,000,000QE
= -20, -20,00 000, 0,00 000 0 + PE
QE
= -20 -20 + 0.0 0.000 0000 001P 1PE
As the the indus industr try y price price leade leader, r, Boei Boeing’ ng’ss dema demand nd equal equalss indust industry ry dema demand nd minus minus following following firm firm supply. supply. Remember Remember that P = PB = PM = PE because Boeing is a price leader for the industry: QB = Q - QA - QE = 910 910 - 0.0000 0.000017P 17P + 70 70 - $0.0 $0.0000 00002P 02P + 20 - $0.000001P = 1,00 1,000 0 - 0.0 0.000 0002 02P PB PB = $50 $50,00 ,000,0 0,000 00 - $50 $50,00 ,000Q 0QB
C.
To find Boeing’s profit maximizing price and output level, set MR B = MCB and solve for Q: MR B
= MCB
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$50,000,000 - $100,000QB 45,000,000
= $5,00 $5,000,0 0,000 00 + $125, $125,00 000Q 0QB = 225,000QB
QB
= 200 units
PB
= $50 $50,00 ,000,0 0,000 00 - $50,000 $50,000(20 (200) 0) = $40 $40,000 ,000,0 ,000 00
D.
Because Boeing is a price leader for the industry, P = PB = PA = PE = $40,000,000 Optimal supply for Airbus and Embraer aircraft are: QA = -70 -70 + 0.00 0.0000 0002 02P PA = -70 + 0.000 0.00000 002(4 2(40,0 0,000 00,00 ,000) 0) = 10 QE = -20 -20 + 0.00 0.0000 0001 01P PE = -20 + 0.000 0.00000 001(4 1(40, 0,000 000,00 ,000) 0) = 20
E.
Yes. The industry is in short-run equilibrium if the total quantity demanded is equal to total supply. The total industry demand at a price of $40 million is: QD
= 910 910 - 0.000 .0000 017P 17P = 910 910 - 0.0000 0.000017( 17(40 40,00 ,000,0 0,000 00)) = 230 units
The total industry supply is: QS = QB + QA + QE = 200 + 10 + 20 = 230 units
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Chapter 13
Thus, Thus, the industr industry y is in shortshort-run run equilibr equilibrium. ium. The industr industry y is also in long-ru long-run n equilibrium equilibrium provided that each manufacturer manufacturer is making at least a risk-adjuste risk-adjusted d normal rate of return on investment. To check profit levels for each manufacturer, note that: πA = TR A - TCA = $40,000 $40,000,000 ,000(10) (10) -$10,000 -$10,000,000 ,000 -$35,00 -$35,000,00 0,000(10 0(10)) - $250,000(102) = $15, $15,0 000,00 ,000 πE = TR E - TCE = $40,000 $40,000,000 ,000(20) (20) -$200,00 -$200,000,00 0,000 0 -$20,00 -$20,000,00 0,000(20 0(20)) - $500,000(202) = $0 πB = TR B - TCB = $40,000 $40,000,000 ,000(200 (200)) -$4,000 -$4,000,000 ,000,000 ,000 - $5,000,0 $5,000,000( 00(200) 200) - $62,500(2002) = $50 $500,00 ,000,000 ,000 Boeing and Airbus are both earning economic profits, whereas Embraer, the marginal marginal entrant, is earning just a risk-adjust risk-adjusted ed normal rate of return. As such, the industry is in long-rum equilibrium and there is no incentive to change. STP13.2
Soft Lens, Lens, Inc., Inc., has has enjoy enjoyed ed rapid rapid Monopolistically Competitive Equilibrium. Soft growth growth in sales sales and and high high operat operating ing profits profits on on its innova innovative tive extend extended-w ed-wear ear soft soft contact contact lenses. However, However, the company faces potentially fierce fierce competition from a host host of new competitors as some some important basic basic patents expire during the coming year. year. Unless the company is able to thwart such competition, severe downward pressure on prices and profit margins is anticipated. A.
Use Soft Lens’s current price, output, and total cost data to complete the table:
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159
Monthly
Total
Marginal
Total
Marginal
Average
Total
Price
Output
Revenue
Revenue
Cost
Cost
Cost
Profit
($)
(million)
($million)
($million)
($million)
($million)
($million)
($million)
$20
0
$0
19
1
12
18
2
27
17
3
42
16
4
58
15
5
75
14
6
84
13
7
92
12
8
96
11
9
99
10
10
105
(Note: Total costs include a risk-adjusted normal rate of return.)
STP13.2
B.
If cost cost condition conditionss remain remain constant, constant, what is the monopol monopolistic istically ally competitiv competitivee high-price/low-output high-price/low-output long-run equilibrium equilibrium in this industry? What are industry industry profits? profits?
C.
Under these same cost conditions, what is the monopolistically competitive low price/high price/high-out -output put equilib equilibrium rium in this this industry industry? ? What are industr industryy profits? profits?
D.
Now assume assume that Soft Soft Lens is able to enter into restrictive restrictive licensing licensing agreeme agreements nts with potential potential competit competitors ors and create create an effective effective cartel cartel in the industry. industry. If demand and cost conditions remain constant, what is the cartel price/output and profit profit equilibr equilibrium? ium?
SOLUTION
A. Monthly
Total
Marginal
Total
Marginal
Average
Total
Price
Output
Revenue
Revenue
Cost
Cost
Cost
Profit
($)
(million)
($million)
($million)
($million)
($million)
($million)
($million)
$20
0
$0
---
$0
---
---
$0
19
1
19
$19
12
$12
$12.00
7
18
2
36
17
27
15
13.50
9
17
3
51
15
42
15
14.00
9
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Chapter 13
Monthly
Total
Marginal
Total
Marginal
Average
Total
Price
Output
Revenue
Revenue
Cost
Cost
Cost
Profit
($) 16
(million) 4
($million) 64
($million) 13
($million) 58
($million) 16
($million) 14.50
($million) 6
15
5
75
11
75
17
15.00
0
14
6
84
9
84
9
14.00
0
13
7
91
7
92
8
13.14
-1
12
8
96
5
96
4
12.00
0
11
9
99
3
99
3
11.00
0
10
10
100
1
105
6
10.50
-5
B.
The monopolistically competitive high-price/low-output equilibrium is P = AC = $14, Q = 6(000,000), 6(000,000), and π = TR - TC = $0. Only a risk-adjuste risk-adjusted d normal rate of return return is being earned earned in the industry, and excess profits profits equal zero. Because π = $0 and MR = MC = $9, $9, there there is no incent incentive ive for either either expans expansion ion or contra contract ction ion.. Such Such an equilibrium is typical of monopolistically competitive industries where each individual firm retains some pricing discretion in long-run equilibrium.
C.
The monopolistically competitive low-price/high-output equilibrium is P = AC = $11, Q = 9(000,000), 9(000,000), and π = TR - TC = $0. Again, only only a risk-adjusted risk-adjusted normal rate rate of return return is being earned in the industry, industry, and excess excess profits equal equal zero. Because π = $0 and MR = MC = $3, there there is no incentive for either either expansion expansion or contraction. contraction. This price/output price/output combination combination is identical identical to the perfectly perfectly competitive competitive equilibrium. equilibrium. (Note that average cost is rising and profits are falling for Q > 9.)
D.
A monopoly price/output equilibrium results if Soft Lens is able to enter into restrictive licensing agreements with potential competitors and create an effective cartel in the industry. industry. If demand and cost conditions conditions remain remain constant, constant, the cartel price/output price/output and profit equilibrium is at P = $17, Q = 3(000,000), 3(000,000), and π = $9(000,000). $9(000,000). There is no incentive incentive for the cartel to expand or contract production at this level of output because MR = MC = $15.
PROBLEMS AND SOLUTIONS P13.1
Indicate wheth whether er each each of the the followin following g stateme statements nts is true true Market Structure Concepts. Indicate or false and explain why. A.
Equilibri Equilibrium um in monopoli monopolistica stically lly competi competitive tive markets markets requires requires that firms be operating at the minimum point on the long-run average cost curve.
B.
A high ratio of distributi distribution on cost to total cost tends tends to increase increase competit competition ion by widening the geographic area over which any individual producer can compete.
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
161
C.
The price price elasti elasticit cityy of demand demand tends tends to fall fall as new new compet competito itors rs introd introduce uce substitute substitute products. products.
D.
An efficie efficiently ntly func functionin tioning g cartel cartel achiev achieves es a monop monopoly oly price price/outp /output ut combin combination ation..
E.
An increas increasee in product product differe differentiat ntiation ion tends tends to increa increase se the slope slope of of firm deman demand d curves.
P13.1
SOLUTION
A.
False. Stable equilibrium equilibrium in perfectly perfectly competitive competitive markets requires requires that firms must operate at the minimum point on the long-run average cost curve. In monopolistically competitive competitive markets, however, equilibrium equilibrium is achieved at a point of tangency between firm demand demand and average cost cost curves. This tangency tangency typically typically occurs at an output level below the point of minimum long-run average costs.
B.
False. A low ratio of distribution distribution cost cost to total cost tends to increase increase competition competition by widening the geographic area over which any individual producer can compete.
C.
False. False. The price price elastic elasticity ity of demand tends to rise as new competi competitor torss introdu introduce ce substitute products.
D.
True. A perfectly functioning cartel achieves the monopoly monopoly price-output combination.
E.
True. An increase increase in product differentiation differentiation tends to increase increase the slope of individual individual firm demand curves.
P13.2
Monopolistically Competitive Demand. Would the following factors increase or decrea decrease se the abili ability ty of domes domestic tic auto auto manu manufac factur turers ers to raise raise price pricess and and profit profit margins? Why?
P13.2
A.
Decrease Decreased d import import quota quotass
B.
Eliminati Elimination on of uniform uniform emiss emission ion standa standards rds
C.
Increased Increased automob automobile ile price price adverti advertising sing
D.
Increased Increased import import tariffs tariffs (taxes) (taxes)
E.
A rising rising value value of of the dollar dollar,, which which has the effect effect of lowerin lowering g import import car car prices prices
SOLUTION
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Chapter 13
A.
Increase. As import quotas are decreased, fewer substitutes substitutes for domestic automobiles become available. available. This will will decrease competition competition in the the industry, industry, and ease pressure pressure on profit margins. margins.
B.
Increase. An elimination of uniform emission standards reduces product homogeneity. As product differentiation rises, some increase in the pricing discretion of firms will result.
C.
Decrease. Decrease. An increase in automobil automobilee price advertising increases increases price competition competition in the industry industry and thereb thereby y decreas decreases es the ability ability of firms firms to raise raise prices prices and profit profit margins.
D.
Increase. Increase. An increase in import tariffs tariffs (taxes) increases increases the price of import cars, thus making imports imports less attractive attractive to car buyers. This will reduce reduce the price pressure pressure on domestic manufacturers, and make it easier for them to increase profit margins.
E.
Decrease. A rising value of the dollar that has the effect of lowering import car prices puts downward downward pressure pressure on on the profit profit margins margins of domestic domestic manufacturer manufacturers. s.
P13.3
Competitive Markets v. Cartels. Suppose the City of Columbus, Ohio, is considering two proposals proposals to privatize municipal municipal garbage collection. collection. First, a handful of leading leading waste disposal firms have offered to purchase the city's plant and equipment at an attractive price in return for exclusive franchises on residential service in various parts parts of the city. city. A second second proposa proposall would would allow allow several several individu individual al workers workers and small small compan companies ies to enter enter the busine business ss witho without ut any any exclus exclusive ive franc franchis hisee agreem agreemen ents ts or competitive restrictions. restrictions. Under this plan, individual individual companies would bid for the right right to provide service in a given residential residential area. The City would then allocate allocate business to the lowest bidder. The City has conducted a survey of Columbus residents to estimate the amount that they would be willing to pay pay for various frequencies frequencies of service. The City has also estimated the total cost cost of service per resident. resident. Service costs are expected expected to be the same same whether whether or not not an exclus exclusive ive franch franchise ise is granted. granted. A.
Complete the following table.
Trash Pickups per Month
Price per Pickup
Total Revenue
Marginal Revenue
Total Cost
0
$5.00
$0.00
1
4.80
3.75
2
4.60
7.45
3
4.40
11.10
Marginal Cost
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
P13.3
163
Trash Pickups per Month 4
Price per Pickup 4.20
Total Revenue
Marginal Revenue
Total Cost 14.70
5
4.00
18.00
6
3.80
20.90
7
3.60
23.80
8
3.40
27.20
9
3.20
30.70
10
3.00
35.00
Marginal Cost
B.
Determine Determine price price and service service level if competit competitive ive bidding bidding results results in a perfectly perfectly competitiv competitivee price/ou price/output tput comb combinati ination. on.
C.
Determine Determine price and the level level of service service if local local regulatio regulation n results results in a cartel.
SOLUTION
A.
B.
Trash Pickups per Month
Price per Pickup
Total Revenue
Marginal Revenue
Total Cost
Marginal Cost
0
$5.00
$0.00
--
$0.00
--
1
4.80
4.80
$4.80
3.75
$3.75
2
4.60
9.20
4.40
7.45
3.70
3
4.40
13.20
4.00
11.10
3.65
4
4.20
16.80
3.60
14.70
3.60
5
4.00
20.00
3.20
18.00
3.30
6
3.80
22.80
2.80
20.90
2.90
7
3.60
25.20
2.40
23.80
2.90
8
3.40
27.20
2.00
27.20
3.40
9
3.20
28.80
1.60
30.70
3.50
10
3.00
30.00
1.20
35.00
4.30
In a perfectly competitive industry, P = MR, so the optimal activity level occurs where P = MC. Here, P = MC = $3.40 at Q = 8 pickups per month.
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Chapter 13
C.
A monopoly cartel maximizes profits by setting MR = MC. Here, MR = MC = $3.60 at Q = 4 pickups per month and P = $4.20 per pickup.
P13.4
Gray Comp Compute uter, r, Inc., Inc., locate located d in Color Colorado ado Spring Springs, s, Monopolistic Competition. Gray Color Colorado ado,, is a privat privately ely held held produc producer er of high-s high-spe peed ed electr electroni onicc comp compute uters rs with with immense immense storage storage capacity capacity and computing computing capability capability.. Although Although Gray’s Gray’s market is restricted to industrial users and a few large government government agencies (e.g., Department of Health, Health, NASA, National National Weather Service, Service, etc.), etc.), the company company has profitably profitably exploited exploited its market niche. Suppose a potential entrant into the market for supercomputers has asked you to evaluate the short- and long-run potential of this market. The following market demand and cost information has been developed: P
= $54 - $1.5Q, $1.5Q,
MR
= ΔTR/ΔQ ΔTR/ΔQ = $54 $54 - $3Q, $3Q,
TC
= $200 + $6Q + $0.5Q2 ,
MC
= ΔTC/ΔQ ΔTC/ΔQ = $6 + $1Q, $1Q,
where P is price, Q is units measured by the number of supercomputers, MR is marginal revenue, TC is total costs including a normal rate of return, MC is marginal cost, and all figures are in millions of dollars. A.
Assume Assume that these demand demand and cost data are descripti descriptive ve of Gray’s Gray’s historical historical experienc experience. e. Calculate Calculate output, output, price, price, and economic economic profits profits earned by Gray Computer Computer as a monopolist. monopolist. What is the point point price elasticity of of demand at this output level?
B.
Calc Calcul ulat atee the the rang rangee with within in whic which h a long long-r -run un equi equili libr briu ium m pric price/ e/ou outp tput ut combina combination tion would be found found for individua individuall firms firms if entry eliminated eliminated Gray’s economic profits. (Note: Assume that the cost function function is unchanged unchanged and that the high-price/low-output solution results from a parallel shift in the demand curve curve while while the low-pr low-price ice/hi /highgh-ou outpu tputt soluti solution on result resultss from from a compet competiti itive ve equilibrium.)
C.
Assume Assume that the point price elasticity elasticity of demand calculated calculated in Part Part A is a good estimate of the relevan relevantt arc price elasticity. What is the potential overall overall market size for superc supercomp omputer uters? s?
D.
If no other other near-term near-term entrants entrants are anticipa anticipated, ted, should should your company enter enter the market for supercomputers? supercompute rs? Why or why not?
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
P13.4
SOLUTION
A.
Set MR = MC to determine the profit-maximizing activity level. MR $54 - $3Q
165
= MC = $6 + $1Q
4Q
= 48
Q
= 12
and P = $54 - $1.5Q = $54 $54 - $1 $1.5(1 5(12) = $36 $36 million ion π = -$2(122) + $48(12) - $200 = $88 $88 million From the demand curve note that: Q = 36 - 0.67P, which, at the profit-maximizing activity level, implies a point price elasticity of εP
= ΔQ/ΔP × P/Q = -0.67 Η 36/12 = -2
Note: Profits are declining for Q > 12.) ( Note B.
The high-price/low-output equilibrium point is identified by the point of tangency between between the firm’s firm’s demand and average cost curves which occur after a parallel parallel leftward leftward shift in demand due to competitor competitor entry. Therefore, Therefore, in equilibrium equilibrium the new firm demand and average cost curves have the same slope. To determine the slope of the average cost curve note that:
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Chapter 13
AC = TC/Q =
$200 + $6 Q + $0.5 Q2 Q
= $200Q-1 + $6 + $0.5Q Slope of average cost curve Slope of new demand curve
= ΔAC/ ΔAC/ΔQ ΔQ = -200 -200Q Q-2 + 0.5
= -1.5 -1.5 (Same (Same as for orig original inal dema demand nd curve) curve)
And in equilibrium, Slope of average cost curve -200Q-2 + 0.5
=
Slope of new demand curve
= -1.5
Q-2
= 2/200
Q2
= 100
Q
= 10
and P
= AC = $200(10-1) + $6 + $0.5(10) = $31 $31 million ion
π
= P × Q - TC = $31(10) $31(10) - $200 $200 - $6(10) $6(10) - $0.5(1 $0.5(10 02) = $0
The low-price/high-output equilibrium point occurs where P = AC and average costs are minimized (this is also the perfectly competitive equilibrium). Set MC = AC to determine the point of minimum average costs, and solve for Q: MC = AC $6 + $1Q = $200Q-1 + $6 + $0.5Q
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
167
200Q-1 = 0.5Q 200Q-2 = 0.5 Q2 = 200/0.5 = 400 Q =
400
= 20 and P = AC
= $200(20-1) + $6 + $0.5(20) = $26 $26 million ion
π
= P Η Q - TC = $26(20) $26(20) - $200 $200 - $6(20 $6(20)) - $0.5(20 $0.5(202) = $0
C.
If the high-price/low-output equilibrium is achieved in the long run, total industry output rises to 16.2 supercomputers because: EP
=
-2
=
-2
=
Q 2 - Q1
×
P 2 - P1 Q 2 - 12 31 - 36
×
P 2 + P1 Q 2 + Q1 31 + 36 Q2 + 12
67(Q2 - 12) - 5(Q2 + 12)
10(Q2 + 12)
= 67(Q2 - 12)
10Q2 + 120
= 67Q2 - 804
57Q2
= 924
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Chapter 13
Q2
= 16.2
Conversely, Conversely, if the low-price/high-outpu low-price/high-outputt equilibrium equilibrium is achieved, achieved, total industry output rises to 23.4 supercomputers because: EP
=
-2
=
-2
=
Q 2 - Q1
×
P 2 - P1 Q2 - 12
×
26 - 36
P 2 + P1 Q2 + Q1 26 + 36 Q2 + 12
62(Q2 - 12) - 10(Q2 + 12)
20(Q2 + 12)
= 62(Q2 - 12)
20Q2 + 240
= 62Q2 - 744
42Q2
= 984
Q2
= 23.4
D.
No. Entry into this industry industry is unwise. unwise. Gray currently currently sells 12 supercomputer supercomputerss per year, a substantial share of the projected long-run potential of between 16.2 and 23.4 for total industry output. Moreover, the industry does not have the potential to su support pport more than one firm of Q = 20 size class, the minimum optimal firm size. Therefore, by virtue of its role as an industry leader of dominant proportions, Gray would have the capability to continuously undercut new rivals and make profitable entry very difficult, if not imposs impossible ible.. ( Note Fractional onal output output can be comple completed ted during during subseque subsequent nt Note: Fracti periods). periods).
P13.5
Assume the Hand Hand Tool Manufactu Manufacturing ring Industry Industry Trade Trade Cartel Equilibrium. Assume Associat Association ion recently recently publis published hed the followi following ng estimate estimatess of demand demand and supply supply relatio relations ns for hamm hammers: ers: Q D
= 60,000 - 10,000P
(Demand),
QS = 20,000P A.
Calc Calcul ulat atee the the combination.
perf perfec ectly tly
(Supply). comp compet etit itiv ivee
indu indust stry ry
equi equili libr briu ium m
pric price/ e/ou outp tput ut
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
169
B.
Now assume that the industry industry output is organized organized into a cartel. cartel. Calculate Calculate the industry price/output combination that will maximize profits for cartel members. (Hint: As a cartel, industry industry MR = $6 $6 - $0.0002Q.)
C.
Compare your your answers to parts parts A and B. Calculate the price/output price/output effects of the cartel.
P13.5
SOLUTION
A.
The industry equilibrium price is determined by setting: QD 60,00 ,000 - 10,000P P
= QS = 20,000P = $2
At P = $2, the equilibrium output is 40,000 because:
B.
QD
?
=
QS
60,000 - 10,000(2)
?
=
20,000(2)
40,000
=
40,000
The profit-maximizing activity level is found where MR = MC. Here it is important to recognize recognize that the industry supply curve represents represents the horizontal horizontal sum of the marginal cost curves for individual individual producers. producers. Therefore, Therefore, when the industry is organized organized into a cartel and acts like a monopolist, the industry supply curve represents the relevant marginal cost curve: QS MC = P
= 20,000P
(Supply)
= $0.00005Q
From the demand curve: QD P TR
= 60,000 - 10,000P = $6 - $0.0001Q = P×Q
(Demand)
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Chapter 13
= ($6 ($6 - $0. $0.00 0001 01Q) Q)Q Q = $6Q $6Q - $0.0 $0.000 001Q 1Q2 MR
= ΔTR/ΔQ = $6 - $0.0002Q
And the profit-maximizing activity level is found by setting MR = MC and solving for Q: MR $6 - $0.0002Q 0.00025Q
= MC = $0.00005Q = 6
Q
= 24,000
P
= $6 - $0.0001(24,000) = $3.60
C.
With a cartel, the level of industry output falls from 40,000 to 24,000 units and price rises rises from from $2 to $3.60, $3.60, when when compare compared d with with the perfect perfectly ly compet competitiv itivee industr industry. y. Generally speaking, monopolists offer consumers too little output at too high a price.
P13.6
Cournot Equilibrium. VisiC VisiCalc alc,, the first first compu computer ter spread spreadshe sheet et progra program, m, was was released released to the public in 1979. 1979. A year later, introduct introduction ion of the DIF format made made spreadsh spreadsheets eets much much more more popular popular because because they could now be imported imported into word processin processing g and other other software software programs programs.. By 1983, 1983, Mitch Kapor used his previous previous program programming ming experie experience nce with VisiCalc VisiCalc to found found Lotus Corp. Corp. and introduce introduce the wildly wildly popular popular Lotus Lotus 1-2-3 spread spreadshee sheett program. program. Despite Despite enormous enormous initial initial success, success, Lotus Lotus 12-3 stumbled when Microsoft Corp. introduced Excel with a much more user-friendly graphica graphicall interface interface in 1987. 1987. Today, Today, Excel Excel dominate dominatess the market market for spreadsh spreadsheet eet applications software. To illustrate the competitive process in markets dominated by few firms, assume that a two-firm duopoly dominates the market for spreadsheet application software, and that the firms face a linear market demand curve P
= $1,250 $1,250 - Q
where P is price and Q is total output output in the market (in thousands) . Thus Q = Q A + Q B. For simplicity, also assume assume that both firms produce an identical product, product, have no
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
171
fixed fixed costs and marginal marginal cost MC A = MC B = $50. In this circumstance, circumstance, total revenue revenue for Firm Firm A is TR A
= $1,250Q A - Q A2 - Q AQ B
Marginal Marginal reven revenue ue for for Firm Firm A is is MR A = ΔTR A /ΔQ A
= $1,2 $1,250 50 - $2Q $2Q A - Q B
Similar total revenue and marginal revenue curves hold for Firm B. A.
Derive Derive the output output reactio reaction n curves curves for for Firms Firms A and B.
B.
Calculate the Courtnot market equilibrium price-output solutions.
P13.6
SOLUTION
A.
Because MCA = 0, Firm A’s profit-maximizing output level is found by setting MR A = MCA = 0:
MR A $1,250 - $2QA - QB
= MCA = 50
$2QA
= $1,200 - QB
QA
= 600 - 0.5QB
Notice that that the profit-maximizi profit-maximizing ng level of output for Firm Firm A depends upon upon the level of output produced by itself and Firm B. Similarly, the profit-maximizing level of output for Firm B depends depends upon the level of output produced produced by itself itself and Firm A. These relationships are each competitor’s output-reaction curve
B.
Firm A output-reaction cu curve:
QA = 600 - 0.5QB
Firm B output-reaction curve:
QB = 600 - 0.5QA
The Cournot market equilibrium level of output is found by simultaneously solving the output-reaction curves for both competitors. To find the the amount of output produced by Firm A, simply insert the amount of output produced by competitor Firm B into Firm A’s output-reaction curve and solve for QA. To find the amount of of output produced by Firm B, simply insert the amount of output produced by competitor Firm A into Firm
172
Chapter 13
B’s output-reaction curve and solve for QB. For example example,, from the Firm Firm A outputoutputreaction curve QA
= 600 - 0.5QB
QA
= 600 600 - 0.5 0.5(6 (600 00 - 0.5 0.5Q QA)
QA
= 600 600 - 300 300 + 0.25 0.25Q QA
0.75QA QA
= 300 = 400 400 (00 (000) 0) unit unitss
Similarly, from the Firm B output-reaction curve, the profit-maximizing level of output for Firm B is QB = 400. With just two two competitors, competitors, the market equilibrium equilibrium level level of output is Courno urnott eq equil uilibriu brium m out outpu putt
= QA + QB = 400 + 400 = 800 800 (00 (000) 0) unit unitss
The Cournot market equilibrium price is Cour Courno nott equ equil ilib ibrrium ium pr price ice
= $1,2 $1,250 50 - Q = $1,2 $1,250 50 - $1( $1(80 800) 0) = $450
P13.7
Imaginee that that a two-fi two-firm rm duopol duopolyy domina dominates tes the marke markett for Stackelberg Model. Imagin spreadsh spreadsheet eet application application software software for personal personal computer computers. s. Also assume assume that the firms face a linear linear marke markett demand demand curve curve P
= $1,250 $1,250 - Q
where P is price and Q is total output output in the market (in thousands) . Thus Q = Q A + Q B. For simplicity, also assume assume that both firms produce an identical product, product, have no fixed fixed costs and marginal marginal cost MC A = MC B = $50. In this circumstance, circumstance, total revenue revenue for Firm Firm A is TR A
= $1,250Q A - Q A2 - Q AQ B
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
173
Marginal Marginal reven revenue ue for for Firm Firm A is is MR A = ΔTR A /ΔQ A
= $1,2 $1,250 50 - $2Q $2Q A - Q B
Similar total revenue and marginal revenue curves hold for Firm B. A.
Calculate the Stackelberg market equilibrium price-output solutions.
B.
How do the Stackelbe Stackelberg rg equilibri equilibrium um price-outp price-output ut solutions solutions differ differ from those those suggested suggested by by the Cournot Cournot model? model? Why?
P13.7
SOLUTION
A.
To illustrate Stackelberg first-mover advantages, reconsider the Cournot model but now assume that Firm A, as a leading firm, correctly anticipates anticipates the output reaction of Firm B, the following following firm. With prior prior knowledge knowledge of Firm B’s output-reacti output-reaction on curve, Q B = 600 - 0.5Q A, Firm A’s total revenue curve becomes TR A
= $1,250Q A - Q A2 - Q AQ B = $1,250Q A - Q A2 - Q A(600 - 0.5Q A) = $650Q A - 0.5Q A2
With prior knowledge of Firm B’s output-reaction curve, marginal revenue for Firm A is MR A = ΔTR A /ΔQ A
= $650 - $1Q A
Because MC A = $50, Firm A’s profit-maximizing output level with prior knowledge of Firm B’s output-reaction curve is found by setting MR A = MC A = $50: MR A
= MC A
$650 - $1Q A
= $50
Q A
= 600
After Firm A has determined its level of output, the amount produced by Firm B is calculated from Firm B’s output-reaction curve Q B
= 600 - 0.5Q A = 600 600 - 0.5 0.5(6 (600 00))
174
Chapter 13
= 300 With just two competitors, the Stackelberg market equilibrium level of output is Stack Stackel elber berg g equil equilib ibriu rium m output output
= Q A + Q B = 600 + 300 = 900 900 (00 (000) 0) unit unitss
The Stackelberg market equilibrium price is Stac Stacke kelb lber erg g equ equil ilib ibri rium um pric pricee
= $1,2 $1,250 50 - Q = $1,2 $1,250 50 - $1( $1(90 900) 0) = $350
B.
Notice that market output is greater greater in Stackelberg Stackelberg equilibrium equilibrium than in Cournot equilibrium because the first mover, Firm A, produces more output while the follower, Firm B, produces less less output. Stackelberg Stackelberg equilibrium equilibrium also results results in a lower market market price than that observed observed in Cournot equilibrium. equilibrium. In this example, example, Firm A enjoys a significant first-mover advantage. Firm A will will produce twice as much output and earn twice as much profit as Firm B so long as Firm B accepts the output decisions of Firm A as given and does does not initiate initiate a price war. If Firm A and Firm Firm B cannot agree agree on which firm is the leader and which firm is the follower, a price war can break out with the potential to severely undermine the profitability of both leading and following firms. firms. If neither duopoly duopoly firm is willing to allow its competitor competitor to exercise exercise a market leadership leadership position, vigorous price competition competition and a competitive competitive market price/output price/output solu soluti tion on can can resu result lt.. Obvi Obvious ously ly,, parti partici cipan pants ts in olig oligopo opoly ly mark market etss have have stro strong ng incentives to resolve the uncertainty surrounding the likely competitor response to leading-firm output decisions.
P13.8
Coke and Pepsi Pepsi domin dominate ate the U. S softsoft-dri drink nk marke market. t. Bertrand Equilibrium. Coke Together, they account for about 75% of industry sales. Suppose the quantity of Coke demanded depends upon the price of Coke (P C ) and the price price of Pepsi Pepsi (P P ) QC = 15 - 2. 2.5P C C + 1.25P P where output (Q) is measured in millions of 24-packs per month, and price is the wholesale price of a 24-pack. 24-pack. For simplicity, assume average average costs are constant constant and AC = MC = X dollars dollars per unit. unit. In that case, case, the total total profit and and change change in profit with with respect to own price functions for Coke are
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
175
π C = TRC - TC C C C = P C C QC - XQC = (P C C - X) QC Δπ C = 15 - 5P C + 1.25P P + 2.5X C /ΔP C C A.
Set Δ π C Coke’s optimal price-response price-response curve. Interpret your C /ΔP C C = 0 to derive Coke’s answer.
B.
Calculate Coke’s optimal price-output combination if Pepsi charges $5 and marginal costs are $2 per 24-pack.
P13.8
SOLUTION
A.
To derive Coke’s optimal price-response curve, set Δπ C = 0 C /ΔP C C
15 - 5PC + 1.25PP +2.5X 5PC PC
= 0 = 15 + 1.25PP + 2.5X = $3 + $0.25 .25PP + $0.5X
Coke’s optimal price-response curve shows that Coke should increase its own price by 25¢ with each $1 increase in the price of Pepsi, and increase its own price by 50¢ with every $1 increase in the marginal cost of production. B.
If Pepsi charges $5 and marginal costs are $2 per 24-pack, Coke’s optimal priceresponse curve shows that Coke should charge $5.25 per 24-pack: PC
= $3 + $0.25 .25PP + $0.5X = $3 + $0.2 $0.25( 5($5 $5)) + $0.5( $0.5($2) $2) = $5.25
P13.9
Kinked Demand Curves. Assume Safety Service Products (SSP) faces the following segmented segmented demand demand and and margi marginal nal revenu revenuee curves curves for its its new infant infant safety safety seat: seat: 1. Over the range range from 0 to 10,000 units of output, output, P 1 MR1
= $60 - Q, = ΔTR1 /ΔQ /ΔQ = $60 $60 - $2Q.
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Chapter 13
2. When output output exceeds 10,000 units, units, P 2 MR2
= $80 - $3Q, = ΔTR2 /ΔQ /ΔQ = $80 $80 - $6Q.
The company’s total and marginal cost functions are as follows: TC
= $100 + $20Q + $0.5Q2 ,
MC
= ΔTC/ΔQ ΔTC/ΔQ = $20 $20 + $1Q, $1Q,
where P is price (in dollars); Q is output (in thousands); MR is marginal revenue; TC is total cost; and MC is marginal cost, all in thousands of dollars. A.
Graph the demand, marginal revenue, and marginal cost curves.
B.
How would would you describe describe the market market structure structure of the industry industry in which which SSP operates? Explain why the demand demand curve takes the shape indicated previously. previously.
C.
Calculate price, output, and profits at the t he profit-maximizing activity level.
D.
How much could marginal marginal costs costs rise before the optimal optimal price price would would increase increase? ? How much much could could they they fall fall before before the the optima optimall price price would would decre decrease? ase?
P13.9
SOLUTION
A.
Note that: that: MR 1
= ΔTR1 /ΔQ = $60 - $2Q
MR 2
= ΔTR2 /ΔQ = $80 - $6Q
MC
= ΔTC/ΔQ = $20 + Q
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
177
S a fe f e t y S e r v icic e P r o d u c K in k e d D e m a n d C u rv rv
D o l la la r s ( $
$90 $80 $70 P1 = $ 6 0 - $ 1 Q $60 (10, 5
$50 M R 1 = $60 - $2
$40
(10, 4
$30 $20
(10, 2
P2 = $ 8 0 - $ 3 Q
M C = $20 + $
$10
M R 2 = $ 8 0 - $ 6
$0 0
5
10
15
20
O utput (
B.
The firm is in an oligopoly oligopoly market. market. It faces a kinked demand demand curve, indicating indicating that competitors will react to price reductions by cutting their own prices and causing the segment of the demand demand curve below the kink to be relatively inelastic. Price increases are not followed, causing the portion of the demand curve above the kink to be relatively elastic.
C.
An examination of the graph indicates that the marginal cost curve passes through the gap in the marginal marginal revenue curve. Graphically, this indicates optimal P = $50 and Q = 10(000). Analytically, MR 1 = $ $6 60 - $2Q
Q
≤ 10,000
MR 2 = $ $8 80 - $6Q
Q
> 10,000
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Chapter 13
MC = $20 + $Q MR 1 > MC over the range Q ≤ 10(000), and MR 2 < MC for the range Q > 10(000). Therefore, SSP will produce 10(000) units of output and market them at a price P1 = $60 - Q = $60 - $(10) = $50. Alternatively, P2 = $80 - $3Q = $80 - $3(10) = $50. At P = $50 and Q = 10: π
= TR - TC = $50 $50(10 (10)) - $100 - $20(1 $20(10) 0) - $0.5(10 $0.5(102) = $150 $150(00 (000) 0) or $150 $150,00 ,000 0
D.
At Q = 10(000), MR 1
= $6 $60 - $2Q
MR2 = $80 - $6Q
= $60 - $2(10)
= $80 - $6(10)
= $4 0
= $20
This implies that if marginal costs at Q = 10(000) exceed $40, the optimal price would increase. increase. Conversely, Conversely, if marginal marginal costs at Q = 10(000) fall fall below $20, the optimal price would would decrease. decrease. So long as marginal marginal cost at Q = 10(000) 10(000) is in the range range of $20 to $40, SSP will have no incentive to change in price. P13.10
2005, Federate Federated d Departme Department nt Stores, Stores, Inc. Market Structure Measurement. In 2005, proposed proposed to acquire acquire The May Departme Department nt Stores Stores Co., thereby thereby combining combining the two largest largest chains chains in the United States of so-called so-called “traditional “traditional” ” or “conventi “conventional onal” ” depart departme ment nt stores stores.. Conv Convent ention ional al depart departme ment nt stores stores typica typically lly anchor anchor enclos enclosed ed shopping shopping malls, malls, feature feature products products in in the mid-ra mid-range nge of of price price and quality quality,, and sell sell a wide wide range of products. The proposed transaction would create high levels of concentration among among conventio conventional nal departme department nt stores stores in many metropolita metropolitan n areas areas of the United United States, and the merged firm would become the only conventional department store at certain of the 1,200 malls in the United States. cross-elastici sticity ty concept concept used to empirica empirically lly define define economic economic A. How is the cross-ela markets? B.
Explain Explain how the governme government’s nt’s finding finding that conventio conventional nal departmen departmentt stores stores compete against specialty stores led them t hem to approve the proposed merger.
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
179
P13.10
SOLUTION
A.
An economic market consists of all individuals and firms willing and able to buy or sell sell compet competing ing products products during during a given given period. period. The key criterion criterion in identifyi identifying ng competing competing products is similarity similarity in use. Precise Precise determination determination of whether a specific good is a distinct economic product involves an evaluation of cross-price elasticity for broad classes classes of goods. When cross-price cross-price elasticity is large and positive, positive, goods are substitutes for each other and can be thought of as competing products in a single market. market. Conversely, Conversely, large negative cross-price cross-price elasticity elasticity indicates indicates complementary complementary products. products. Complementar Complementary y products produced by a single firm must be evaluated as a single product line serving serving the same market. If complementary products are produced by other companies, companies, evaluating evaluating the potential potential of a given product line involves involves incorpo incorporat rating ing exogenou exogenouss influenc influences es beyond beyond the firm's control. control. When When cross-p cross-pric ricee elasticity is near zero, goods are in separate economic markets and can be separately analyzed as serving distinct consumer needs.
B.
In examinin examining g the Federat Federated ed propos proposal al to acquire acquire May Depart Departmen mentt Stores Stores,, the key question is the extent to which conventional department stores represent a distinct economic market. If traditional department stores compete against specialty stores and discount department stores, then it becomes appropriate to consider the relative size of these two competitors in a broader characterization of the market that includes all relevan relevantt compet competitor itors. s. If the relevan relevantt product product market market include included d only only conventi conventional onal department stores, then before the merger Federated had a market share greater than 90% in the New York–New Jersey metropolitan area. If the relevant product market also included, for example, specialty stores, stores, then Federated’s Federated’s share in that geographic area was much smaller. The evidence that Commission staff obtained indicated that the relevant product market was broader than conventional department stores. In the New York–New York–New Jersey Jersey metropolitan metropolitan area, Federated Federated charged consumers consumers the same prices that it charged charged throughout throughout much of the eastern eastern region of the United United States, States, including where Federated faced larger numbers of traditional department store rivals. May and other department store chains, like Federated, also set prices to consumers that were uniform over very broad geographic areas and did not appear to vary local prices based on the number or identity identity of conventional conventional department stores in malls or metropolitan areas. This evidence provided support for the conclusion that the acquisition likely would not creat createe antico anticompe mpeti titi tive ve effe effect cts. s. Staff Staff also also found found no evide evidence nce that that compe competi titi tive ve constraints, e.g., rivalry from retailers other than department stores, in New York– New Jersey were not representativ representativee of other markets markets in which Federated Federated and May competed. Further, evidence pertaining both to which firms the parties monitored for pricing and to consumer consumer purchasing purchasing behavior also supported supported the conclusion conclusion that the rele relevan vantt mark market et was was suffi sufficie cientl ntly y broad broad that that the merg merger er was was not like likely ly to cause cause anticompetitive effects.
180
Chapter 13
CASE STUDY FOR CHAPTER 13 Market Structure Analysis Analysis at Columbia Drugstores, Inc. Demonstr Demonstrating ating the tools and technique techniquess of market structure structure analysis analysis is made difficult difficult by the fact that firm competitive competitive strategy strategy is largely based upon proprieta proprietary ry data. Firms Firms jealously guard guard price, price, market share share and profit informati information on for individual individual markets. markets. Nobody Nobody should expect expect Target, Target, for example, example, to disclose disclose profit and loss statements statements for various various regional regional markets markets or on a store-bystore-by store basis. basis. Competit Competitors ors like Wal-Mart Wal-Mart would would love to have such information information available; available; it would would provide provide a ready ready guide guide for for their their own own profitab profitable le market market entry entry and store expansio expansion n decision decisions. s. To see the process that might be undertaken to develop a better understanding of product demand conditions, consider the hypothetical example of Columbia Drugstores, Inc., based in Seattl Seattle, e, Washi Washingt ngton. on. Assum Assumee Colum Columbia bia operate operatess a chain chain of 30 drugstor drugstores es in the Pacific Pacific Northwe Northwest. st. During During recent recent years, years, the company company has become become increasin increasingly gly concerne concerned d with the long-run implications of competition from a new type of competitor, the so-called superstore. To measure the effects of superstore competition on current profitability, Columbia asked manag managem emen entt consul consultan tantt Peter Peter Parke Parkerr to conduc conductt a statis statistic tical al analy analysis sis of the compan company’s y’s profitabi profitability lity in its various various markets. markets. To net out size-related influenc influences, es, profitabil profitability ity was measure measured d by Colum Columbia bia’s ’s gross gross profit profit margi margin, n, or earni earnings ngs befor beforee intere interest st and and taxes taxes divide divided d by sales. sales. Columbia provided proprietary company profit, advertising, and sales data covering the last year for all 30 outlets, outlets, along along with public public trade associati association on and Census Census Bureau Bureau data concerni concerning ng the number number and relati relative ve size size distri distribut bution ion of comp competi etitor torss in each each marke market, t, among among other other market market characteristics. As a first step in the study, study, Parker Parker decided to conduct a regressio regressionn-base based d analysis of the various factors thought thought to affect Columbia’s Columbia’s profitability. The first is the relative size of leading leading competit competitors ors in the relevant market, measured measured at the Standard Standard Metropolitan Metropolitan Statistical Statistical Area (SMSA) level. Given the pricing, pricing, marketing, and averageaverage- cost advantages advantages that accompany large relative size, Columbia’s market share, MS, in each area is expected to have a positive effect on profitabi profitability. lity. The market market concentra concentration tion ratio, ratio, CR, measured measured as the combined combined market market share share of the four largest largest competito competitors rs in any given market, market, is expected expected to have a negative negative effect effect on Columbia’s Columbia’s profitabi profitability lity given the stiff competitio competition n from large, large, wellwell- financed financed rivals. rivals. Of course, the expected expected negati negative ve effect effect of high high concen concentra tratio tion n on Colum Columbia bia profita profitabil bility ity contra contrasts sts with with the posit positive ive influence of high concentration on industry profits that is sometimes observed. observed. Both capital capital intensity, intensity, K/S, measure measured d by the ratio of the book value of assets assets to sales, and advert advertisi ising ng intens intensity ity,, A/S, A/S, me measu asured red by the advert advertisi ising-to-sale ng-to-saless ratio, ratio, are expec expected ted to exert exert positive positive influence influencess on profitabi profitability. lity. Given Given that profitabili profitability ty is measure measured d by Columbi Columbia’s a’s gross gross profit profit margin, margin, the coefficie coefficient nt on capital capital intensity intensity measured measured Columbia Columbia’s ’s return return on tangible tangible investme investment. nt. Similarly Similarly,, the coefficient coefficient on the advertising advertising variable variable measures measures the profit profit effects effects of advertisin advertising. g. Growth, Growth, GR, measured measured by the geometri geometricc mean rate of change change in total disposable disposable income in each market, is expected to have a positive influence on Columbia’s profitability, because some disequilibrium in industry demand and supply conditions is often observed in rapidly growing areas. areas. Columbia’s proprietary proprietary information is shown in Table 13.3 Finally, Finally, to gauge gauge the profit profit implicati implications ons of superstor superstoree competit competition, ion, Parker Parker used a “dummy” (or binary) variable where S = 1 in each market in which Columbia faced superstore
Monopoli Monopolistic stic Compe Competition tition and Oligop Oligopoly oly
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competition and S = 0 otherwise. otherwise. The coefficient on this variable measures measures the average profit rate effect effect of superstore superstore competition competition.. Given Given the vigorous vigorous nature nature of superstore superstore price competitio competition, n, Parker Parker expects expects the superstor superstoree coefficie coefficient nt to be both negative negative and statistical statistically ly significan significant, t, indicating a profitprofit-limiting limiting influence. influence. The Columbia Columbia profit-margin data and related information used in Parker’s statistical analysis analysis are given in the preceding table. table. Regression model model estimates for the the determin determinants ants of Colum Columbia’s bia’s profitabi profitability lity are are shown shown in Table Table 13.4. 13.4. A.
Describe Describe the overall overall explanato explanatory ry power power of this regressio regression n model, model, as well as the relative importance of each continuous variable.
B.
Based Based on the importanc importancee of the binary binary or dummy dummy variable variable that indicates indicates superstor superstoree competition, do superstores pose a serious threat to Columbia’s profitability?
C.
What factors might Columbia consider in developing an effective competitive strategy to combat the superstore influence?
CASE STUDY SOLUTION A.
The coefficient of determination R 2 = 77.7% means that 77.7% of the total variation in Columb Columbia’s ia’s profit profit-ma -margi rgins ns can be explained explained by the regress regression ion model. model. This is a relatively high level of statistically significant explanation (F = 13.38) for a crosssection study such as this, suggesting that the model provides useful insight concerning the the dete determ rmina inant ntss of prof profit itabi abili lity. ty. The standar standard d erro errorr of the esti estimat matee (S.E. (S.E.E. E. = 2.1931%) means that there is roughly a 95% chance that the actual profit margins for a given store will lie within the range of the estimated or fitted value ± 2 × S.E.E., or ± 2 × 2.1931%. The intercept coefficient of 6.155 has no economic meaning because it lies far outside the relevant range range of observed data. The 0.189 coefficient for the market-share variable means that, on average, a 1% (unit) rise in Columbia’s market share leads to a 0.189% (unit) (unit) rise in Columbia’s profit profit margin. margin. Similarly, Similarly, as expected, Columbia’s Columbia’s profit margin margin is positive positively ly related related to capital intensity, intensity, advertising advertising intensit intensity, y, and the rate of growth in the market area. Conversely, high concentration has the expected limiting influenc influence. e. Because Because of the effects effects of leadingleading-fir firm m rivalry, rivalry, a 1% rise in industry industry concentration will lead to a 0.156% decrease in Columbia’s profit margin. This means that relatively large firms compete effectively with Columbia.
B.
Yes, the regression model indicates that superstore competition in one of Columbia’s market areas areas reduces Columbia’s Columbia’s profit profit margin margin on average by 2.102%. Given that Colu Columb mbia ia’s ’s rate rate of retu return rn on sale saless rout routine inely ly fall fallss in the the 10% 10% to 15% 15% range range,, the the profit-limit profit-limiting ing effect of superstore superstore competition competition is substantial substantial.. Looking more more closely at the data, it appears that Columbia faces superstore competition in only one of the seven lucrative markets in which the company earns a 20% to 25% rate of return on sales. Both observations suggest that current and potential superstore competition constitutes
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a considerable threat to the company and one that must be addressed in an effective competitive strategy. C.
Devel Developm opment ent of an effe effecti ctive ve compet competit itive ive stra strate tegy gy to combat combat the influe influence nce of superstores involves the careful consideration of a wide range of factors related to Columbia’s Columbia’s business. business. It might prove fruitful fruitful to begin this analysis analysis by more carefully considering market characteristics for Store No. 6, the one Columbia outlet able to earn a substantial substantial 20% profit margin margin despite despite superstore superstore competition. competition. For example, example, this analysis might suggest that Columbia, like Store No. 6, should specialize in service (e.g., prescription prescription drug delivery) delivery) or in a slightly different different mix of merchandise. merchandise. On the other hand, perhaps Columbia should follow the example set by Wal-Mart in its early development development and focus its plans for expansion expansion on small to medium-size medium-size markets. markets. In the meantime, Columbia’s still-profitable stores in major metropolitan areas could help fund future growth. Although obviously only a first step, a regression-based study of market structure such as that described here can provide a very useful beginning to the development of an effective competitive strategy.
