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Managerial Economics

MARKET STRUCTURE

Market Characteristics

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The number of firms

The degree of
product differentiation

Competition and Market Types in Economic


Analysis
Market Characteristics

Perfect
competition

Monopoly

Monopolistic
competition

Oligopoly

Number & Size of


Firms

Very large number of


One
relatively small firms

Large number of relatively


small firms

Small number of relatively large


firms

Type of Product

Standardised

Differentiated

Standardised or differentiated

Entry Barriers

Very Easy

Easy

Difficult

Price-Taker or Price
Maker?

Price Taker; price


given by market

Unique
Very Difficult or
Impsibosle
Price-makerno
competitors; no
perfect substitutes

Price-maker (with a
Price-maker (with a strong
recognition of other sellers) recognition of other sellers)

P>MR=MC

P>MR=MC

P>MR=MC or P=MR=MC,
depending on type of
competition and product
differentiation.

Horizontally sloped;
Residual Demand Curve perfectly elastic
demand curve

Downward
sloping

Downward-sloping: slightly
differentiated products are
available

Downwardsloping

Market Power

None

Low to High

Low to High

High

Long-run Economic
Profit

None

None

Low to High, subject to


mutual interdepndence

High, subject to regulation

Price

P=MR=MC

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Competition and Market Types in Economic


Analysis
Perfect competition (no market power)
large number of relatively small buyers and sellers
standardized product
very easy market entry and exit
non-price competition not possible

Examples: perfect competition


agricultural products
financial instruments
commodities

Competition and Market Types in Economic


Analysis
Monopoly (absolute market power, subject to government
regulation)
one firm, firm is the industry
unique product or no close substitutes
market entry and exit difficult or legally impossible
non-price competition not necessary

Examples: monopoly
pharmaceuticals with patents
regulated utilities (although this is changing)
last chance gas station on the edge of the desert

Competition and Market Types in Economic


Analysis
Monopolistic competition (market power based on product
differentiation)
large number of small firms acting independently
differentiated product
market entry and exit relatively easy
non-price competition very important

Examples: monopolistic competition


boutiques
restaurants
repair shops

Competition and Market Types in Economic


Analysis
Oligopoly (product differentiation and/or the firms dominance
of the market)
small number of large mutually interdependent firms
differentiated or standardized product
market entry and exit difficult
non-price competition important

Examples: oligopoly
oil refining
processed foods
airlines
internet access and cell phone service

A Rule of Thumb for Pricing


The extra revenue from an incremental unit of quantity, (PQ)/Q, has two components:
1. Producing one extra unit and selling it at price P brings in revenue (1)(P) = P.
2. But because the firm faces a downward-sloping demand curve, producing and selling this extra unit
also results in a small drop in price P/Q, which reduces the revenue from all units sold (i.e., a
change in revenue Q[P/Q]).
Thus,

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ASTRA-MERCK Prices PRILOSEC


In 1995, Prilosec, represented a new generation of antiulcer
medication. Prilosec was based on a very different biochemical
mechanism and was much more effective than earlier drugs.
By 1996, it had become the best-selling drug in the world and
faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only
about 30 to 40 cents per daily dose.
The price elasticity of demand, ED, should be in the range of
roughly 1.0 to 1.2.
Setting the price at a markup exceeding 400 percent over marginal
cost is consistent with our rule of thumb for pricing.
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Oligopoly (oligoi means a few and polein means to sell)


Oligopolists problem
Like a monopolist, has cost advantages associated with the economies of scale
of oligopoly or other barriers to entry, entry and exit will not necessarily push the
market to zero economic profits in the long run (as is the case with perfect
competition and monopolistic competition).
High degree of interdependence between the few firms that occupy the market.

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Oligopoly
Why oligopoly occurs:
Economies of scale
Barriers to entry
Mergers:
Vertical mergers
o The joining of a firm with another to which it sells an output or from which it buys an input
Horizontal mergers
o The joining of firms that are producing or selling a similar product

Measuring Concentration
Concentration ratio
The percentage of all sales contributed by the
leading four or leading eight firms in an
industry
Sometimes called the industry concentration
ratio
The Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is equal
to the sum of the squared sales shares of all
n
firms
in
n = number of firms in the industry
HH the
S 2 industry.

i 1

Si = firms market share

market concentration (max HHI = 10,000;


unconcentrated markets have HHI < 1,000)
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Pricing in an Oligopolistic Market


Price leader: one firm in the industry takes the lead in changing prices, and
assumes that other firms will follow a price increase but will not go lower in
order to avoid a price war
Non-price leader: firm that leads the differentiation of products on other, nonprice attributes

Competing in Imperfectly Competitive Markets


Non-price competition: any effort made by firms in order to change the
demand for their product (other than the price)
Non-price determinants of demand:
tastes and preferences
income
prices of substitutes and complements
number of buyers
future expectations of buyers
financing terms

Competing in Imperfectly Competitive Markets


Examples: of efforts by managers to influence non-price demand influences:
advertising and promotion
location and distribution channels
market segmentation
loyalty programs
product extensions and new products
special customer services
product lock-in or tie-in
pre-emptive new product announcements

Competing in Imperfectly Competitive Markets


Examples: the reality of imperfect competition
auto industry
small retailers
global credit card issuers

Strategy for Firms in Imperfect


Competition
Structure-Conduct-Performance (S-C-P) paradigm: The theory, developed in
the 1940s, says structure affects conduct which affects performance
structure: number of firms in industry, conditions of entry, product differentiation
conduct: pricing strategies, advertising, product development, legal tactics, collusion
performance: maximization of societys welfare

New Theory of Industrial Organization: says there is no necessary


connection between observed industry structure and performance that uniquely
leads to maximum social welfare
Theory of contestable markets: performance by firms is ultimately influenced not by actual
competition, but by the threat of potential competition

Strategy for Firms in Imperfect


Competition
Porters Five Forces model: illustrates the various factors that affect the ability
of any firm in the industry to earn a profit
Porters generic strategies for earning
above-average return on investment
Differentiation approach: for a monopoly or
monopolistically competitive market following
MR = MC rule, firm sets a price on the demand
line that is above AC
Cost leadership approach: for perfect
competition
maintain cost structure low enough so when P = MC, there
is a positive difference between P and AC

The pricing and output behavior of oligopoly markets


oligopolistic or monopolistically competitive firm use a
strategy:
battle plan of actions (such as setting a price or quantity) it will take to
compete with other firms

oligopolies engage in a
game:
any competition between players (such as firms) in which strategic behavior
plays a major role

Game Theory
Economic optimization has two shortcomings when applied to actual
business situations
assumes factors such as reaction of competitors or tastes and preferences of
consumers remain constant
managers sometimes make decisions when other parties have more
information about market conditions

Game theory
set of tools used by economists, political scientists, military analysts,
and others to analyze decision making by players (such as firms)
who use strategies
these analytic tools can be used to analyze
oligopolistic games
scissor-paper-stone
coin-matching games
tic-tac-toe
elections
nuclear war

Elements of a Game
A game involves players making strategic decisions
Players are the decision-making units
A strategy is an option available to a player
Payoffs are the outcomes
Fundamental aspects of game theory
players are interdependent
uncertainty: other players actions are not entirely predictable

Types of games
zero-sum or non-zero-sum
cooperative or non-cooperative
two-person or n-person

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Game Theory
A payoff matrix is a table that describes the outcome for each player and for
each set of strategic choices.
A dominant strategy (DS) is a strategy that produces the optimal outcome
regardless of what the other players do.
A dominant strategy equilibrium (DSE) occurs if each player in a game
chooses its dominant strategy.
A Nash equilibrium occurs if every players strategy is optimal given its
competitors strategies.

Prisoners Dilemma
two-person, non-zero-sum,
non-cooperative
always has a dominant
strategy
equilibrium is stable
confessing is the dominant
strategy for each player, no
matter what other player
chooses
each player has no incentive
to unilaterally change his
strategy