Two weeks ago we studied competition. Last week we examined monopolies. If you own a business, which would you prefer? Don’t be too hasty in answering.
You would want perfect competition in the markets from which you buy your inputs, including your supply materials and your labor. That way you could keep your costs down. You would want a monopoly for your company in the market in which you sell your good or service. That way you could charge more and make higher profits.
In our example of a homeschool dinner, you would want several highly competitive caterers to choose from. The competition would drive down our cost for the dinner. But in selling tickets, we would want to be the only show in town. We would not want to have to compete against any other dinners or events. We wouldn’t want anyone else reducing our attendance or causing us to decrease our ticket prices.
In reality, there is almost never perfect competition. Complete monopolies are also rare. The business world is typically somewhere between perfect competition and a monopoly, depending on the market. Some markets are more competitive than others. Some companies enjoy more of a monopoly than others.
This lecture is devoted to all those situations in between perfect competition and true monopoly. The spectrum looks like this:
- Monopoly (MC=MR is how the price is determined)
- Monopolistic Competition
- Perfectly Contestable Markets
- Perfect Competition (P=ATC, average total cost, is how price is determined)
As a seller, you make more money the higher you are on the list. As a buyer, you save more money the lower you are the list. Let’s introduce each term:
Monopoly – A single seller of a product having no competition or close substitutes. The seller comprises the entire industry.
Cartel – A group of producers that band together to raise prices, restrict output, or allocate market share. OPEC, a group of mostly Arab oil producers attempting to keep profits high, is the most famous cartel.
Oligopoly – A few producers that dominate a market without fixing prices or output. If the good is identical among the companies, then it is a perfect or pure oligopoly. Examples include the steel and cement industries. Cement is cement, period. If the good is not identical, then it is an imperfect oligopoly. Examples are the car or soap industries. Cars are not identical to each other, but the auto industry is an oligopoly.
Monopolistic Competition – This has more sellers than an oligopoly and more competition too. But companies are able to increase their prices without losing all their customers. Why? Because in monopolistic competition there are differentiated products. An example is the haircutting or hairdressing industry. Cutting hair is a service that is not a perfect substitute for other haircutting services. One with a loyal customer base can increase her prices without losing her business.
Perfectly Contestable Markets – This is where there is no barrier to entry into the market and no start-up costs. There are only a few sellers, or maybe only one seller, but competition is always threatened. A newspaper vendor in a shopping mall is an example. He may be the only one, but it is so easy for another competitor to start selling newspapers that he always keeps his prices as low as he can.
Perfect Competition – A large number of sellers and buyers have full knowledge and perfect mobility of resources. The good or service is homogeneous. Competition is ruthless in keeping prices down. Price (P) equals Marginal Cost (MC) equals Average Total Cost (ATC). This is what happens when Wal-Mart moves in next door!
There are other terms worth knowing in this area. Monopsony is a buyer’s monopoly. It consists of a single buyer of a good or service. In a one-company isolated town, where one company employs most of the people, the company is nearly a monopsony with respect to labor in that town. Note that the more it hires, the greater its wage costs will become. But perfect monopsonies are difficult to imagine. Can you think of another one?
Understand all the above concepts? We’ll review the most important ones now in greater detail.
There are only a few firms in oligopoly. There are also high barriers to entry so that new companies cannot enter the industry and compete with existing firms. Each firm produces similar products.
Memorize the conditions: (1) few companies, (2) high barriers to entry, and (3) similar goods.
The car industry is a good example. General Motors, Ford, Toyota, Daimler-Chrysler, and so on. All the car companies in the world could be listed on one sheet of paper. There are only two American-owned car companies: GM and Ford. So this satisfies the first condition: few companies.
Is there a high barrier to entry? Yes. It is not easy or cheap to start a new car company. I have not heard of new American car company being started in the last ten or fifteen years. John DeLorean was the last one to try, and his effort went bankrupt. So condition two is satisfied.
Are cars similar goods? Yes again. There are differences, of course, but they all have four wheels, an engine, and run on gas. They take you from point A to point B. When you need to drive somewhere, you usually do not care what type of car is available. Any one will typically do. So condition three is satisfied.
Thus the car industry is an oligopoly. Can you think of other oligopolies?
In some ways oligopolies are like monopolies, and in other ways they are not. Oligopolies are like monopolies in that the high barriers of entry keeps new competitors out. With less competition, it becomes possible to earn greater profits. Both oligopolies and monopolies can do this. But note that both are constrained by the downward-sloping demand curve.
The major difference between the oligopolies and the monopolies are that there is at least some competition in an oligopoly. Ford could cut prices on its cars to attract customers from GM. The pricing decisions of one company in oligopoly shift the demand curve for the other companies. When Ford raises its prices, for example, this causes the demand curve to shift upward for GM, to its benefit.
You can see an oligopoly at some street corners. How? If there are two gas stations at a street corner and no other ones nearby, then that has some characteristics of an oligopoly. Not a monopoly, because there are two of them. But not perfect competition either, because there are only two and they may end up raising their prices in imitation of each other.
There are several models for what the demand curve looks like for an oligopoly. One famous model is the kinked demand curve. In this scenario, if one firm raises its price then the other firms do not have to imitate it. The firm that raises its price sees a sharp falloff in demand. Its demand curve has a lower slope (e.g., more like a horizontal line) than the demand curve for the industry. The change in slope causes the kink in the curve. However, if a firm lowers its price, then the other firms must lower their price also to keep their customers.
The other model for an oligopoly is when there is a dominant firm that sets the price for the entire industry as the price leader. There can be many smaller firms or companies, but they follow the pricing of the dominant firm. If they don’t, then the powerful firm can punish them with price-cutting. If the demand is relatively inelastic, then the dominant firm sets a high and profitable price. The smaller companies must follow it in order to avoid being punished for underselling it.
A cartel takes an oligopoly one step further. In a cartel, the companies have an actual agreement among each other to raise prices, reduce supply, or otherwise reduce competition. This is illegal. Agreements by companies to reduce competition are prohibited by federal law. The federal government can prosecute and convict anyone who agrees or conspires to reduce competition.
Even if the federal government does not get involved, private individuals or companies can sue to recover damages that result from agreements to limit competition. The penalties are harsh: they include treble (triple) damages plus an award of all the attorneys fees of any plaintiff who proves a restraint of competition or trade. These laws are called the antitrust laws, passed in the late 1800s and famously enforced by President Teddy Roosevelt in the early 1900s.
So if it is illegal, then why study it? First of all, important producers in foreign countries ignore our laws. The biggest and most dangerous cartel is the Organization of Petroleum Exporting Countries, or OPEC. Check them out on the internet at http://www.opec.org . It has eleven member countries: Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. The website includes many facts about those countries and their oil production.
You may be wondering why we care what these foreign countries do with their oil production. The problem is that they control a substantial percentage of the production of oil in the world. When they agree to raise prices or reduce output, it directly affects the price of gasoline in America. Some have suggested that the federal government should use antitrust laws and sue this cartel due to its impact on American consumers.
In a cartel, there are (1) relatively few companies, (2) high barriers to entry, and (3) price and output determined by agreement so that all companies act alike. But isn’t that similar to a monopoly, with the only change being a few companies acting as though they are one?
There is one key difference: in a cartel, there is an incentive for each company to cheat. Iran can agree to the price and output of the OPEC cartel, but then secretly sell more oil at a slightly reduced price to maximize its profits. Other ways to maximize profits in a cartel include offering rebates or providing additional services or higher quality. This maximizes the profits of the cheating company, and reduces the profits of other members of the cartel.
Conservative economist, such as Milton Friedman, often predict that cartels cannot survive long-term. The profit incentives to violate the agreement cause the companies to go their different ways. Eventually, competition returns.
In a sense this has even happened to OPEC, the most powerful cartel of all. The Wikipedia encyclopedia entry for OPEC includes this history: OPEC decisions have a large influence on world price of oil and is a rare example of a successful cartel. A good example of this in action was the oil shock following the Yom Kippur War which led to fourfold increases in the price which lasted five months, starting on October 17, 1973 and ending on March 18, 1974. Also, OPEC nations agreed on January 7, 1975 to raise crude oil prices by 10%. http://en.wikipedia.org/wiki/OPEC
Does that convince you about how powerful and successful cartels can be, despite the invisible hand? In other words, can a cartel really be more powerful than the invisible hand?
Maybe not. Wikipedia adds that gold had experienced similar price increases in the intermediate years since the gold standard was ended in 1971 without the existence of any gold cartel. Many maintain that it was US inflation that allowed such pricing power to global commodity producers.
There were enormous lines at gas stations in 1973 due to the oil crisis. Your parents would remember it. It was known as the 1973 Energy Crisis. In some areas of the United States, drivers of cars with odd-numbered license plates were only allowed to purchase gas on Monday, Wednesday and Friday, while even-numbered plates were assigned to Tuesday, Thursday and Saturday. People were prohibited from buying less than certain amounts at gas stations to prevent hoarding and try to reduce lines. But what would be the real cause of any shortage?
Think back on what you have learned earlier in the course. There is one major cause of shortages, and it is not the invisible hand. It is government price controls. In 1973, the government imposed certain price controls on gas, and that caused the shortages and inefficiently long lines at gas stations.
IV. Monopolistic Competition
Finally, we need to explore the concept of monopolistic competition. It has four conditions: (1) many buyers and sellers, (2) goods that have differences among each other, (3) sufficient knowledge about the market, and (4) free entry into the industry by new companies.
Earlier we mentioned barber or hairdresser shops as an example. They have relatively small start-up costs (low barrier to entry), and there are many buyers and sellers. The services are not identical. They are not perfect substitutes for each other, so differentiation is possible. Each company is able to develop a loyal clientele. Knowledge is fairly high about the market.
Each company asks like a mini-monopoly over its loyal customer base, and it also competes against the other mini-monopolies.
Can you think of other examples? Perhaps CDs by popular singers, or books by popular authors?
V. Nash Equilibrium
Here is the insight that won John Nash a Nobel prize in economics and led to a popular, Academy-Award winning movie called A Beautiful Mind. This is called the Nash equilibrium. It applies in particular to oligopolies.
When you have a small number of sellers, as in an oligopoly, the Nash equilibrium occurs when no seller can benefit by changing his price while the other sellers keep their prices unchanged.
Here is an example from Wikipedia: Consider the following two-player game: both players simultaneously choose a whole number between 0 and 10, inclusive. Both players then win the minimum of the two numbers in dollars. In addition, if one player chooses a larger number than the other, then he has to pay $2 to the other. This game has a unique Nash equilibrium: both players have to choose 0. Any other choice of strategies can be improved if one of the players lowers his number. If the game is modified so that the two players win the named amount if they both choose the same number, and otherwise win nothing, then there are 11 Nash equilibria.
The point is this: if there is a unique Nash equilibrium and the sellers are rational, then the price will be at the Nash equilibrium. Note that there is not always a Nash equilibrium.
The most famous example of the Nash equilibrium is the Prisoner’s dilemma, where two accused persons are separated and interrogated. If neither confess, then no crime is proven and they must be released. If both confess, then they receive harsh sentences. If one confesses and the other does not, then the confessor is released but the other receives even harsher punishment.
The Nash equilibrium predicts both will confess, which is not their overall optimal result.
Read and, if necessary, reread the above lecture. Use the Wikipedia entries as desired (search Yahoo! or Google on the term and Wikipedia, as in Oligopoly Wikipedia)
- An oligopoly that illegally agrees to raise its prices is called a __________.
- List three industries that are oligopolies and explain why.
- Suppose you saw an abstract boxing match. In one corner is the invisible hand. In the other corner is a cartel. Who wins, and why? Explain.
- As an industry becomes more competitive, what happens to price (P) compared to marginal cost (MC)? Explain.
- Suppose Daniel’s company sells goods in an industry having a demand curve with this set of Qs and Ps: (1,30), (2, 28), (3, 26), (4, 24), (5, 14), (6,8), (7,2). What type of industry is this, and what type of demand curve is this? If marginal cost equals $20 (MC=20), then what are the output and price in this industry?
- Suppose you saw three different advertisements in three different industries: (1) The lowest price in town is at Zack’s!, (2) Buy more channels from your cable service provider!, and (3) Matt is the smartest surveyer in town … call him to survey your property! What type of industry would each ad likely represent?
- Suppose Eric and Chris each sell New York Yankees baseball caps at separate, independently owned concessions at the stadium. Fans will pay $15 apiece for them, and are so obsessed that lowering the price does not increase demand. Their concessions have fixed costs of $700 per game day, and each cap costs $1 to make. Suppose average attendance is 50,000 per game. In the long run, how many concessions would you expect to stay in business at the stadium? Is that the most efficient number? Why not?
- What kind of industries are these: (1) one cleaners in town that sends the clothes out to be cleaned, (2) three car mechanics in town with hydraulic lifts and expensive electronic equipment, and (3) many apparel stores with distinctive fashions? Will consumers obtain the best prices?
- Suppose Mary Rose and Sarah separately own the only widget companies in the entire world. They sell at the same price and have no plans to change that. But they might advertise. If both advertise, then they lose profits due to the advertising expenses. If neither advertises, then they make the largest profit by reducing expenses. But if one advertises and the other does not, then the one that advertised makes phenomenal profits. What happens?
Extra credit questions (4 points apiece for 10 and 11; 6 points for number 12)
- Explain how monopolistically competitive and purely competitive industries are similar.
- Justify the antitrust laws’ prohibitions against agreements by oligopoly sellers, based on use of the Nash Equilibrium.
- Antitrust regulators say they must intervene to protect the public against monopolies. Show why monopolies develop, and then explain whether you think regulators should try to stop them.