DD209: Running the Economy Tutorial 4: February 2017
DD209: Running the Economy Tutorial 4: February 2017 Introduction to Book 2: Microeconomics Microeconomics is the study of individual markets within the economy as a whole Markets exist for goods and services, housing, labour, currencies, financial assets, carbon emissions, and commodities such as oil The interaction of supply and demand determines market prices and the quantity of scarce resources allocated to a particular use Block 4 is concerned primarily with the structures of
the supply-side of individual markets The market for domestic energy The ex-Prime Ministers view http://www.bbc.co.uk/news/uk-politics-24706 853 Small firms competing on price to sell an identical product or large firms able to benefit from economies of scale? Modelling competition
There are four main models of market structure: Monopoly Perfect competition Oligopoly Monopolistic competition Look for the conditions / assumptions that most clearly match the market under consideration
(e.g. the oil market) Market structures in practice Market structures differ according to: the number and relative size of firms the level of market concentration the extent of product differentiation the degree of market power in influencing prices consumers and producers knowledge of market conditions firms objectives the existence of barriers to entry and exit
Spot the structure Which of the four structures would seem most appropriate for the following markets? (Guess before clicking to reveal.) Domestic energy supply? a clear oligopoly Bookmakers at Newmarket races? very close to perfect competition Driving schools? a differentiated product, so monopolistic competition Cinema (i.e. exhibitors)? an oligopoly nationally, but may be a monopoly locally Punts in Cambridge / Gondolas in Venice? a monopoly / what appears to be a cartel!
Think about your current job or one from the past Number of firms Sizes of firms Degree of competition
Methods of competition Profitability The ease with which new firms can enter and leave the market Does the market match any of the structures youve read about? Examples from previous tutorials A very interesting range of jobs and markets A monopoly within the pharmaceutical industry where a patent is held Male shaving products: a classic duopoly between Gillette and Wilkinson Sword
An oligopolistic recruitment industry Double glazing: many firms with a differentiated product suggests monopolistic competition Osteopathy very close to perfect competition? TMA04 Due in: Tuesday 14th March 1600 words Using evidence from the extract below, explain the recent and expected developments in the global oil market structure and price, as a result of the entry of US shale producers in the market. Your answer should use theories taught in Block 4 together with appropriate diagrams.
You must set up a clear line of argument developed through a logically-ordered series of distinct paragraphs Read the Student Notes for guidance A possible approach Identify and explain the oil markets initial position Which market structure appears most relevant? Is there a diagram that shows the outcomes in the market? Are market conditions changing? Is there a diagram that shows the effects of any changes on market price? Which market structure seems most appropriate
now? The initial situation What are the characteristics of the market? the number and relative size of firms, the concentration ratio the degree of market power in influencing prices the extent of product differentiation consumers and producers knowledge of market conditions firms objectives the existence of barriers to entry and exit OPEC is a producers cartel that acts like a monopoly plus smaller non-OPEC producers that add a limited
element of competition Monopoly Conditions / Assumptions: Pure monopoly - when a single firm is the sole supplier in a market or a dominant firm with significant market power (often regarded as a market share above 25%) Barriers to entry (e.g. legal, marketing, financial) Examples? define the market carefully first! Diagrammatic analysis: see page 147 Output is set where MC = MR
Outcomes Supernormal profits, traditionally maintained in the long run due to barriers to entry but these may allow firms to reinvest to develop improved products and processes for the future referred to as dynamic efficiency But price exceeds MC allocative inefficiency ATC not minimised productive inefficiency Contestability Contestability is the ease with which new firms
can enter a market Depends on the existence of barriers to entry Contestability indicates the threat of competition which can make incumbent firms act as though they are in a competitive market Prices must be kept relatively low to deter new entrants, especially so-called hit and run competition in the global oil market The extract refers to the (mainly) US shale operators being able to set up wells far more quickly than the traditional field producers
What does this suggest about the level of contestability in the global oil market? What effect does this have on market price? How might this change the market structure? Supply and demand OPEC has traditionally been the swing producer In recent years OPEC has continued to extract oil to push the price down in an attempt to force the shale producers out of the market How can supply and demand be used to show this situation diagrammatically? Can elasticities be considered to refine the
analysis? The new market structure OPEC is still the dominant producer of what remains an homogeneous product within the many different grades of oil that exist (e.g. WTI) There are relatively few independent firms or groups in the market but they are very uneven in size With the entry of the shale producers there is an increasing number of small price-takers Which market structure seems most appropriate now? Oligopoly? Perfect competition?
Perfect competition The benchmark against which all other market structures are compared. Conditions / Assumptions: Many small buyers and sellers, none of which are large enough to influence the market price firms are said to be pricetakers Homogeneous product Perfect knowledge of prices and quantities Free entry and exit Diagrammatic analysis: see page 105 and page 112, and page 128 The competitive process
The existence of supernormal profit (profit above the minimum normal level required to keep the entrepreneur in their current occupation) attracts new entrants into the market leading to an increase in the market supply and a reduction in the market price resulting in the supernormal profit being competed away until only normal profit can be earned removing the incentive for new firms to enter the market Efficiency Perfectly competitive markets achieve
economic efficiency Allocative efficiency the right quantities of resources are allocated to goods and services in accordance with consumers preferences Productive efficiency resources are combined in the most effective way to minimise average total cost (or cost per unit) Perfect competition and monopoly compared Diagrammatic analysis: see page 150 The greater the level of competition the lower the price the greater the quantity
the greater the allocative and productive efficiency but the lower the level of profit Is monopoly always undesirable? Higher price and lower quantity compared to a competitive market Long run supernormal profit Income redistributed from consumer to producer Lack of competitive pressure (higher ATC?) BUT The supernormal profit means there may be possible dynamic gains over time in the form of product and process innovation Natural monopolies may be highly desirable in certain markets
see pages 140-141 Larger firms may be more competitive in international markets Oligopoly
A few large firms Relatively high concentration ratio Interdependence and uncertainty Stable or sticky prices Non-price competition Barriers to entry Tendency for collusion Tendency to integrate Analysis is based on game theory Game theory to explain the lack of price competition in
oligopolistic markets (Not needed for TMA04 but a useful introduction for Block 5.) What would each of the two firms (players) do if they didnt know what the other was planning to do? Gillette If Gillette maintained its prices it would always be best for Wilkinson Sword to cut its prices as the 70m pay-off exceeds the 50m from maintaining them.
20m 40m 40m Wilkinson Sword If Gillette cut its prices it would always be best for WS to cut its prices as 40m is greater than 20m. The pay-off matrix is symmetrical so cutting prices is the dominant strategy for both firms,
leading to the worst joint outcome of a 40m pay-off each. Colluding to maintain prices might work but both firms would be tempted to break any agreement, leading back to the original outcome. Both firms would eventually learn that it is best to simply avoid price competition. Cut prices 70m
Monopolistic competition A competitive market with an element of monopoly power in the form of a differentiated product Diagrammatic analysis: page 147 for the short run (the same diagram as for monopoly but note that the demand curve is now the firms demand curve and not the market demand curve) Diagrammatic analysis: page 155 (long run) SR equilibrium for a firm in conditions of monopolistic competition
SR -> LR adjustment process Supernormal profits earned in the short run attract new entrants existing firms find market shares falling demand decreases and their demand curves shift to the left firms continue to enter the market until only
normal profits are earned where the demand curve is tangential to the ATC curve and price = ATC LR equilibrium Effects on consumers
More choice Increased competition Higher quality Lower prices However Monopolistic competition is associated with high levels of spare capacity productive inefficiency Average cost per unit and prices might be higher due to firms not being large enough to benefit fully from economies of scale Lower profits leading to less innovation?
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