Introduction to Competition Theory MICROECONOMICS APRIL 2010.

Introduction to Competition Theory

MICROECONOMICS APRIL 2010

How do Economists classify competition?

There are four major theoreticalframeworks:• Perfect Competition• Monopoly• Monopolistic Competition• Oligopoly (including Duopoly)

Introduction to Perfect CompetitionAssumptions:

• The industry is made up of a very large number of firms.

• Each firm is so small relative to the size of the industry, that it is not capable of altering its own output to have a noticeable effect upon the output of the industry as a whole.

• A firm cannot affect the supply chain of the industry and so cannot effect the price of the product.

• Individual firms have to sell at whatever price is set by demand and supply in the industry as a whole. The individual firms are “price takers”

The Assumptions of Perfect Competition

• The firms all produce exactly identical products. Their goods are “homogeneous”.

• It is not possible to distinguish between a good produced in one firm and good produced in another.

• There are no brand names and there is no marketing to attempt to make good different from each other.

The Assumptions of Perfect Competition

• Firms are completely free to enter or leave the industry.

• This means that firms already in the industry do not have the ability to stop new firms from entering it and are also free to leave the industry, if they wish.

• There are no barriers to entry or barriers to exit.

The Assumptions of Perfect Competition

• All producers and consumers have a perfect knowledge of the market.

• The producers are fully aware of market price, costs in the industry and the workings of the market.

• The consumers are fully aware of prices in the market, the quality of the products and the availability of goods.

Perfect Competition in the Real World

• Although we generally say the perfect competition is completely theoretical, there are some industries in the world, that get quite close to be perfectly competitive markets.

• The industries most often used an examples by economists are usually agricultural markets.

Agricultural Markets and Perfect Competition

Case Study: Wheat European Union• There are some large wheat farms in the EU, but they are

very small in relation to the whole wheat-growing industry. • An individual farm could increase its output many times

over without have any noticeable effect on total supply of wheat in the EU.

• A single farm is not able to affect the price of wheat in the EU, since it cannot shift the industry supply curve.

• The farm has to sell at whatever the industry price is.• In addition wheat is wheat, and so there is no way to tell

one farm’s wheat from another.

Introduction to Monopoly

• There is one firm producing the product, so the firm is the industry.

• Barriers to entry exist, which stop new firms from entering the industry and maintains the monopoly.

• As a consequence of barriers to entry, the monopolist may be able to make abnormal profits in the long run.

What firms are monopolies?

• Whether a firm really is a monopoly depends upon how narrowly we define the industry.

• While Microsoft may be the only producer of a particular kind of software, it does not have a monopoly on all software.

• The important question here is not whether the firm is a monopoly, but rather how much monopoly power the firm has.

The Extent of Monopoly Power

Key Questions

• To what extent is the firm able to set its own prices without worrying about other firms?

• To what extent can it keep people out of the industry?

The Strength of Monopoly Power

• The strength of monopoly power possessed by a firm will really depend upon how many competing substitutes are available.

• For example, the underground railway in a city may have the monopoly of underground travel, but it will face competition from other industries, such as buses, taxis and private transport.

Introduction to Monopolistic Competition

• The theory of monopolistic competition was developed by the American Economist Edward Chamberlin (1899-1967).

• He was dissatisfied with two extreme theories that existed at the time – perfect competition and monopoly.

• He wanted to devise something more realistic that would sit between the two existing theories.

What is monopolistically competitive market?

• In simple terms a monopolistically competitive market is one with many competing firms where each firm has a little bit of market part.

• This is why we have the term “monopolistic” as firms have some ability to set their own prices.

The assumptions of monopolistic competition

• The industry is made up of a fairly large number of firms.

• The firms are small, relative to the size of the industry. This means that the actions of one firm is unlikely to have a great effect on any of its competitors.

• The firms assume that they are able to act independently of each other.

The assumptions of monopolistic competition

• The firms all produce slightly differentiated products.

• This means that is possible for a consumer to tell one firm’s product from another.

• Firms are completely free to enter or leave the industry. There are no barriers to entry or exist.

How is Monopolistic Competition different to Perfect Competition ?

• The most significant difference from perfect competition, is that in monopolistic competition, there is product differentiation.

• Product differentiation exists when a good or service is perceived to be different from other goods or services in some way.

• Products may be differentiated by brand name, colour, appearance, packaging design, quality of service, skill levels and many other methods.

Examples of Monopolistically Competitive Industries

• Examples of monopolistically competitive industries are car mechanics, plumbers and jewellers.

How is the market structure different?

• Although it may appear to be a small difference from the assumptions of perfect competition, this leads to a markedly different market structure.

• As the products are differentiated there will some extent of brand loyalty.

Introduction to OligopolyAssumptions:

• Oligopoly is where a few firms dominate an industry.

• The industry may have quiet a few firms or not many, but the key factor is that a large proportion of the industry’s output is shared by just a small number of firms.

• What constitutes a small number varies, but a common indicator of concentration in an industry is known as the concentration ratio.

Concentration Ratios

• Concentration ratios are expressed in the form of CRx where X represents the number of the largest firms.

• For example: CR4 would show the percentage of market share or output held by the largest four firms in the industry.

• The higher the percentage, the more concentrated is the market power of the four largest firm.

Duopoly

• Two firms dominate an industry, instead of 3 or 4.

• Duopoly is part of Oligopoly theory and it is generally not considered a separate field of study.

Classifying Competition in Specific Industries

Industry Competition Classification Why do you say that??

(1) US Domestic Airline Industry(2) US Car Industry

(3)BreakfastCereal Market

Classifying Competition in Specific Industries

Industry Competition Classification Why do you say that??

(4) Online Search Engines(5)BottledWater Industry(6)Office Computer Software

Classifying Competition in Specific Industries

Industry Competition Classification Why do you say that??

(1) US Domestic Airline Industry(2) US Car Industry

(3)BreakfastCereal Market

Classifying Competition in Specific Industries

Industry Competition Classification Why do you say that??

(7)GlobalWineIndustry(8)GlobalSugarIndustry (9)GlobalOilIndustry(10)SocialNetworkSites

Sourcehttp://vhirsch.com/blog/wp-content/uploads/2009/09/market-domination.jpg

Stimulus 1:What do they mean by industry consolidation?

What impact would this have on competition?

http://www.cartoonstock.com/newscartoons/cartoonists/mba/lowres/mban1698l.jpg

Sourcehttp://www.co2partners.com/images/cartoons/competition.jpg

Stimulus 2.

In practical terms how do companies outrun the competition?

Source:http://www.cartoonstock.com/lowres/dcr0443l.jpg

Stimulus 3

The expression `being one step ahead of the competition` in real term means…

Source: http://www.cartoonstock.com/newscartoons/cartoonists/jgr/lowres/jgrn830l.jpg

Stimulus 4

What do they mean by the expression `In this business it’s Dog Eat Dog`…?

Source: http://www.fastupfront.com/pics/small-business-competition.jpg

Stimulus 5

Which one of these pricing strategies do you feel is the most effective?

What does the cartoon say about the existing competition?

Stimulus 6

Why are patents so important in highly competitive industries?

Stimulus 7

What do we mean by `anti-trust`?

How does it relate to competition?

Stimulus 8

Explain the current battle betwee Microsoft and Google. Who will win?

http://www.seppo.net/cartoons/albums/cartoons/global/economy/eu_vs_microsoft_04.jpg

Stimulus 9

Explainthe symbolism in this cartoon.

Source: http://www.cartoonstock.com/lowres/ssm0019l.jpg

Stimulus 10. Why has Bill Gates made some lawyers very rich?

Stimulus 11

In the past how did Microsoft make its products incompatible with competitors?

Provide examples

Stimulus 11

Why does absolute power corrupt absolutely in the corporate world?

Sourcehttp://4.bp.blogspot.com/_wgns7r5yd8c/Sjuv_ALuu8I/AAAAAAAAH1M/4POUXzI3b2M/s400/Dynamic+Duopoly.jpg

Stimulus 12

What does this say about the relative market power in this industry?

Who are the competitors to these companies? Why do they have less market share?

Source: http://www.stopunfaircardfees.eu/uploads///images/PaymentCard-TollPort.jpg

Stimulus 13: What is the key message(s) from this cartoon?

Source: http://www.jaunted.com/files/6193/BransonNoBA.jpg

Stimulus 14: Who is featured in this picture? What are the key issues?

Stimulus 15: What illegal activity may be taking place in this cartoon? Why? Would it be hard to prove? How common is this in the real business world?

Source: http://www.rudebarbs.com/images/antitrust.jpg

Stimulus 16. In a paragraph response, explain the messages from this cartoon?

Source: http://www.johnsonbottini.com/images/cartoon.jpg

Stimulus 17

How does thiscartoon relate to a previous question?

Source: http://tyrannybusters.org/images/home/duopoly.gif