Managerial Economics Topic 4 Market Types

Chapter 10: Imperfect competition and alternative theories of the firm

Introduction

In perfect competition there are many firms selling similar products; in a monopoly one business
dominates and sets the price. However, there are a number of market structures that lie in these
extremes. These structures are called imperfect competition.

Monopolistic competition

Monopolistic competition is another market structure in which managers have the same control over
the markets, there is freedom of entry and exit in and out of the market. Each business is different in
some way from its rivals, and so the demand curve for each one is downward sloping. A price increase
would lead to a loss of some customers, who switch to competitors, but it will not lead to the loss of all
customers. Similarly, a price decrease will attract customers from competitors.

If existing firms are making abnormal profits, other businesses will be attracted into the market. Entry
will stop when profits are only normal profits so there is no further incentive for firms to enter.

In a monopolistically competitive market, managers will try to differentiate their products and gain
even more monopoly power. In the short run, it is possible to earn abnormal profits, but this will lead to
more entry into the market; to regain abnormal profits, the manager will want to try to shift demand for
their own business outwards again and regain more control over the market or develop barriers to
entry to stop others from entering.

In the long run equilibrium, the price is above the marginal costs, so the business is allocatively
inefficient.

Profits in monopolistic competition. Short run abnormal profits (a) are completed away by the entry of
other firms so normal profits are earned in the long run (b)

As with monopoly, the firm is more interested in profit maximizing than serving societies interests and
this means pushing the price up by restricting output to the point at which marginal revenue equals
marginal cost.

Oligopoly

Oligopoly is a market that is dominated by a few firms. The firms are interdependent; this means that
managers realize that the actions of one business affect the others, and therefore they must consider
each other’s possible actions and reactions when making decisions. Therefore, price and quantity

1
Managerial Economics Topic 4 Market Types

outcomes in oligopoly depend on the assumption that managers make about their rivals and how they
will behave.

The kinked demand curve model

It assumes that managers are pessimistic about how their rivals act and believe that their competitors
will not collaborate with them. Managers assume if they cut their prices, their rivals will follow because
they will be worried about losing sales. Therefore, they assume that the man will be price inelastic if
they cut price.

However, they assume that if they push the price up, their rivals will be happy for them to be the only
ones doing well and will not follow. This means that the demand will be price elastic if they put the price
up- the fall in quantity demanded will be larger than the rise in price.

These assumptions mean that the demand curve is kinked around the existing prices and that there is
no incentive to change price. A price cut leads to a relatively small increase in quantity demanded, so
revenue would fall. A price increase leads to a relatively large decrease in quantity demanded, revenue
would fall because although the price is higher, sales have fallen significantly.

Rather than start price cutting, firms often compete in ways other than price, for example investing in
technology.

The kinked demand curve in an oligopoly. The kinked demand curve motor also highlights a costs can
change from MC1 to MC2 and the profit maximizing price and output are still P1Q1.

The cartel

The cartel assumes that firms will collude and work together. They will try to maximize the profits
available to them by restricting output and pushing up prices. Under a cartel arrangement, the member
firms may decide how much output each one will make and at what price it will be sold. in effect, the
individual businesses are joining together to act like a single monopolist. Customers may end up paying
more or less compared with the competitive market. The result is that a cartel can maximize their total
profits of the members.

Cartels will differ in terms of the nature of the agreements but include deals involving the choice of area
in which members will sell, to which customers different members will sell, prices, terms and conditions,
and even who will gain the contract.

In a cartel, the combined membership maximizes profits at the point at which the marginal revenue in
the industry equals the marginal cost (P1Q1).

2
Managerial Economics Topic 4 Market Types

The cartel model:

The factors that make collusion more likely include:

o Relatively few businesses can monitor each other's actions easily.

o Significant barriers to entry, providing existing firms with strong control over the market.
o Similar costs, so that they will gain similar rewards and disputes are less likely.
o Stable market conditions so that any agreements will remain valid.

However, cartel agreements are often unstable. This is because individual members of the agreement
might try to increase their own rewards at the expense of others in the cartel. Some members might
also object to setting price and quantities if they think that they are unfair.

Game Theory

The interdependence of firms within an oligopolistic market and the importance of considering the
reactions of other firms is highlighted in game theory. This highlights how the strategy of one business
is likely to depend on its assumptions about the behavior of other firms. Game theory examines various
strategies based on different assumptions about their actions and the reactions of other firms. A lack of
trust may lead to an outcome in which firms are worse off than if they trusted each other.

If they both produce low output, this will push the price up and both will win. But if one firm produces
relatively low and its competitor produces a lot, this will increase the supply and drive the price down;
the first producer will do badly because its rival wins the market and is selling more. As a result, both
producers will flood the market, fearing that the other would do this anyway; the total output in the
market ends up very high and the market price is low, meaning that both are worse off compared with
the situation in which both had restricted their output.

The prisoner's dilemma in a business context (the top area of each quadrant shows the payoff for A; the
bottom area shows the payoff for B)

3
Managerial Economics Topic 4 Market Types

Pricing options (the top area of the quandrants shows the payoff for A; the bottom area shows the
payoff for B):

A ‘maximax’ strategy occurs when the manager is optimistic and bases decisions on the best of the best
outcomes.

Choosing a promotional strategy

A Nash equilibrium occurs in a game involving two or more players, in which each player is assumed to
know the equilibrium strategies of other players. If each player has chosen a strategy and no player
would benefit by changing their strategy while the other players keep theirs unchanged, the current set
of strategy choices and the corresponding payoffs represent a Nash equilibrium.

How to protect your success

Intellectual Property (IP) refers to the ownership of a brand, invention, design or any other kind of
creation. The protection that managers can gain for their IP includes the following:

o Patents. Patents protect new inventions. It gives the owner a right to prevent from others
making it, using, importing, or selling the invention without permission.
o Trademarks- trademark is a sign that can distinguish your goods and services from those of your
competitors.
o Copyright. Copyrights protect literacy works.
o Registering a design. This is a legal right that protects the overall visual appearance of a product
in the geographical area in which you register it.

Contestability

When making decisions about price and output, managers will consider not only how many firms are in
the market already called but also the likelihood of entry and exit in the future. This affects the
contestability of the open market.

4
Managerial Economics Topic 4 Market Types

The importance of possible future entry is highlighted in the theory of contestable markets. If markets
are heavily contestable, this puts more pressure on the existing firm to be competitive, where if the
market is very predicted, managers are able to be more inefficient and survive.

Market structure and profits

Summary of the market structure:

Perfect Monopolistic Oligopoly Monopoly

Competition Competition
Differentiated No Yes Yes Yes
products
Number of firms Many Many Few One
Entry and exit in Yes Yes No No
the long run

Michael Porter (1985) ‘five forces’ model:

o Rivalry. This describes the extent to which firms are competing

with each other for stop the greater the rivalry, the fewer profits
any firm is likely to make. The degree of rivalry will depend on
factors such as the number of firms in the industry and their
relative size of common market growth and how they compete.
o The entry threat. If there is a higher entry threat, competitors are
able to enter the market and take away profits.
o Substitutes. These are alternative goods and services that perform
a similar function in the eyes of a competitor. The more
substitutes that are available the more pressure on a business to
keep prices down or risk losing customers.
o Buyer power. If you are heavily reliant on one or two buyers, the buyer is likely to push down
the price to negotiate very favorable terms, giving it more of the profit available.
o Supplier power. If you are heavily reliant on suppliers, they have the power to push up prices
and take away your profit. The greater the supply of power, the lower your profits are likely to
be.

Porter’s ‘five forces’

Regulation of markets

Competition laws are established to protect consumers and to ensure that they are not exploited.

It aims to make sure that consumers have as much choice as possible, believing that ‘when consumers
have choice, they have genuine and enduring power’.

The OFT implements many pieces of legislation and there's a range of enforcement options for slow one
level, it provides advice and guidance; that's another level, if prosecutes and can levy fines up to 10% of
a firm’s turnover.

5
Managerial Economics Topic 4 Market Types

Business objectives

Reasons why managers will want to maximize profits, but they may also have other objective which
include the following:

o We often assess the performance of a business in terms of size or revenue, rather than its
profits. We may be impressed by business with many stores or with a very visible brand even if
we don't know much about its profitability therefore, manager may want to be running a bigger
business with more output for more sales revenue in order to be seen as being successful by the
general public.
o Manager's rewards are often linked to target set for them that are not necessarily directly linked
to profits

Possible objectives of managers, apart from profit maximization may include the following:

o Sales revenue maximization. This occurs when a firm produces at an optimal level when the
total revenue cannot increase anymore. This happens when marginal revenue is 0.
o Growth maximization. This occurs at the highest level of output at which your firm can produce
without making a loss. This occurs when the average revenue price is equal to the average cost.

Business objectives

A business will maximize revenue when marginal revenue equals 0 (Q3) this is the highest level on the
total revenue curve.

A business will produce the highest output possible without making a loss by producing that Q4. At this
output the total revenue equals the total cost.

In reality, in both revenue and growth maximization models, managers may have to achieve minimum
level of profit to satisfy their investors. In this case, they may aim for the output for which marginal
revenue equals zero or for which average revenue equals average cost, but they have to be as close to
this as they can while making a given level of output.

Forms of growth

Managers may want their business to grow because of their potential gains, turning economies of scale
this growth may be organic (internal) or external. Internal growth is achieved by generating more sales

6
Managerial Economics Topic 4 Market Types

from the existing business. This type of growth is unusually slow and therefore may be relatively easy to
manage. External growth occurs when one business joins together with another (merger) or one
business takes over another (takeover or acquisition) . External growth can lead to certain changes in
the sales of a business. This can be difficult to manage because it involves two different enterprises
coming together and rapid transactions in size.

When undertaking merger or takeover, managers may seek to join with one of the following:

o A supplier. This is known as ‘backward vertical integration’ because the business joins with
another organization at an earlier stage of the same production process.
o A distributor or a retailer of their products. This is known as ‘forward vertical integration’ -
occurs when one business joins with another at a later stage of the same process. A business
may undertake this form of integration to guarantee access to the market. This gives these
businesses complete control over the production and marketing processes but requires heavy
investment in many different skills to understand and operate in these different markets. This is
why many businesses prefer to specialize in a particular stage of the process rather than to
control the whole process.
o A business at the same stage or the same type of production process. This is known as
‘horizontal integration’ - often undertaken to achieve greater market power and economies of
scale. Horizontal integration can enable a business to increase its market share rapidly. It may
also help business to expand into different regional markets quickly.
o A business that operates in a different market. This is known as ‘conglomerate integration’ -
may be undertaken because the business wants to operate in different markets. This may
reduce the risk if demand falls or slows in one market. However, managing a conglomerate may
be difficult, because it means bringing together very different types of businesses.

What can prevent a business from growing?

Both internal and external growth will require money. There may be restrictions on your growth.
Governments have enacted legislation to control monopolies.

Limitations of models that assume maximization

Managers avoid maximizing profits because they want a certain degree of ‘organizational slack’ within
their business. And managers allow costs to be higher than they could be in good years, this means that
they can make cut box relatively quickly and easily when demanded conditions are less favorable. having
slack such as excess labor and stocks, also allows them to meet the changes in demand easily. Managers
may set targets that are relatively easily to achieve, rather than ones that maximize results but which
may be difficult to achieve. Certain conservative targets may enable them to look better when
responding to it investors on what they have achieved.

A further problem with the maximization model is that the decision to maximize profit will vary
depending on the time of period involved.

Profits and risk

Profit maximizing behavior may lead to firms taking too many risks. The precise price and output
decision will depend on the objective of the managers. But it is possible that, because of a lack of

7
Managerial Economics Topic 4 Market Types

information, they do not actually maximize profits; rather, they end up aiming to make what they and
their owners regard as a satisfactory level.