Category Archives: Market Structures

Airline price discrimination

Price discrimination involves charging different prices to different sets of consumers for the same good or service. So when you are on your next flight there are going to be different fares for the same class of seat whether it be in economy, business class or first class. What variables at work to bring about price discrimination in airline routes?

  • What day of the week you fly – Monday and Friday are usually peak times for business so you should find that fares are expensive. Also because it is usually for business purposes it is assumed that firms will be paying for the flights and therefore are prepared to pay more.
  • Times of the day – morning and evening tend to be more expensive as this is peak time.
  • How competitive the route is – if there is a lot of competition fares will be cheaper to the extent that there maybe predatory pricing. There is a good piece in the video showing the fares for flights from Montreal to St Johns Newfoundland. Once low cost carriers entered the market Air Canada dropped their price below cost.
  • Reputation of each airline – better reputation = higher fare

The video below is a very good especially the fare structure on the New York to Los Angeles route.

A2 Revision – Imperfect Competition AR, MR and TR curves

fig08-11You should note the following from the graphs:
• to sell an additional unit of a commodity, the monopolist must reduce the price of all units sold. This therefore means the AR curves falls.
• as the price on all units must be lowered to sell the higher output, MR is lower than the price of the marginal unit(AR)
• TR at first increases with output but as price is reduced to sell more goods and services, eventually falls.
• where MR = 0 TR is at a maximum.

A2 Revision – Oligopoly and the kinked demand curve – download

With the A2 Essay paper next week I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.

In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.

With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.

Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.

If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Oligopoly

A2 Revision – Monopoly and Deadweight Loss

A topic in the A2 syllabus is Market Failure with special emphasis on Monopoly and Deadweight Loss.

In Perfect Competition we stated that the force of supply and demand establish an equilibrium situation in which resources are used most efficiently – MC (Supply) = AR(Demand) . Furthermore, in perfect competition the firm produces at MC = MR (profit max) which is also the same as producing at MC = AR (allocative efficiency). This is because AR and MR are the same in perfect competition. Therefore the same output represents allocative efficiency and profit max. Remember that long-run Perfect Competition is a significant output as it is where:
MC = MR – Maximum Profit or Minimum Loss
MC = AR – Allocative Efficiency (Supply = Demand)
AC = MC – Technical Optimum – Productive Efficiency

However for a monopolist because the AR and the MR curves are different we get separate outputs for Allocative Efficiency and Profit Max. The graph below shows that at profit maximising equilibrium, output Q2 is less than that in a competitive market (Q1), and the demand and supply (MC) curves do not intersect. Q1 represents the Allocative Efficiency level of output and P1 the price. The shaded area therefore represents the loss of allocative efficiency or the deadweight loss.

Teaching MC=MR with M&M's

Having just completed Perfect and Imperfect Competition with my Year 13 class I used a couple of packets of M&M’s to drum home the concept of marginal analysis MC=MR. It has always been something that students have struggled with but I am hoping this experience of creating graphs with M&M’s might help their understanding and when to use the concept.

Profit is maximised at the rate of output where the positive difference between total revenues and total costs is the greatest. Using marginal analysis, the firm will produce at a rate of output where marginal revenue equals marginal cost. Below are a few of the graphs done using M&M’s.
MM1MM3MM4.jpegMM2

 

Tacit Collusion at Martha’s Vineyard petrol stations.

The Economist ‘Free Exchange’ had an article about tacit collusion and the role of algorithms in setting prices. Martha’s Vineyard, a popular holiday retreat for the wealthy in the US, has four petrol stations who had a price-fixing suit brought against them for what was seen as extremely high petrol prices when compared to those at nearby Cape Cod. The judges found no evidence that there was agreement between petrol stations to raise prices although they did note that the market encouraged tacit (silent) collusion amongst the four petrol stations. Whereas explicit collusion over prices is illegal, tacit collusion is not. The conditions conducive for tacit collusion include:

  1. The market is concentrated and there are strong barriers to entry from competitors. Martha’s Vineyard is cut off from the mainland.
  2. Prices are transparent in a way that renders any attempt to steal business by lowering prices self-defeating. A price cut posted outside one petrol station will soon be matched by the others. And if one station raises prices, it can always cut them again if the others do not follow.
  3. The product is a small-ticket and frequent purchase, such as petrol. Markets for such items are especially prone to tacit collusion, because the potential profits from “cheating” on an unspoken deal, before others can respond, are small.

Petrol Price App

Although the consumer maybe able to find out the price of petrol at various stations through a smartphone app but this app makes it easier for the petrol stations to monitor and match each others’ prices. A retailer would have little incentive to cut prices and as other competitors would be able to match their prices instantly leaving everyone worse off.

Collusion in oligopoly

It is often observed that oligopolistic firms are torn between two conflicting desires: The wish to compete on one hand, and the wish to collude on the other. The hope of winning any price war tempts some firms (particularly those with significant advantages, such as lower costs) but collusion is an attractive proposition given the desire to remove the uncomfortable uncertainty that interdependence brings to the market. Collusion reduces the fear of competitive price cutting or retaliatory advertising which could reduce industry profits.

Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development.

A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. In the graph below the total market or industry demand curve is shown as D and the corresponding marginal revenue curve is MR. The cartel’s marginal cost curve (MC) is the horizontal sum of the marginal cost curves of the members of the cartel. The cartel will set a price of p1 (MC = MR) where profits are maximised. Alternatively the cartel could set output at q1 by giving each cartel member an output quota. This would produce the same price (p1).

By contrast, p2 shows the marginal cost price which would be the price under perfect competition, with q2 showing the corresponding output. This means that the cartel will operate with a higher price and lower output when compared to perfect competition.

Cartel with Monop Price

Cartel with a monopoly price

Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.

Collusion between firms whether formal or informal is more likely when:

• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.

• they have similar costs of production and methods of production making any agreement on price easier to reach.

• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.

• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.

• the laws against collusion in a country are weak or ineffective.

Collusive agreements often prove difficult to sustain. Most are illegal as they raise prices to the detriment of the consumer. They cannot, therefore, be enforced by contract, even if cheating could be detected. Each and every party to the collusive agreement has an incentive to cheat by producing more than agreed. This will suppress price slightly, but the firm can still take advantage of artificially high prices as long as the other firms do not cheat as well. However, stable market conditions (a small number of firms; similar costs of production; similar products; high barriers to entry; easy detection of cheating on the agreement) make joint profit maximisation feasible.

Sunk Costs, Market Structure and Football Clubs

Over the holidays I read Stefan Szymanski’s book “Money and Football – A Soccernomics Guide”. Szymanski also co-authored “Soccernomics” with Simon Kuper. There were various references to economic theory through the book which I will refer to on this blog.

Market Dominance

Dominance in a market is often associated with the lack of competition whether it be due to monopoly power, predatory pricing, the scale of investment etc. However this is not the case when it comes to football. Szymanski mentions the fact that there are 27 professional teams withn a 50 mile radius of Manchester Utd. If fans don’t like United, there are plenty of alternatives as there are in Madrid which has 5 professional clubs. In some countries football rivals play in the same stadium:

  • In Germany: Bayern Munich and TSV 1860 Munich,
  • In Italy: Inter Milan and AC Milan,
  • In Switzerland: FC Zurich and FC Grasshopper
  • In Brazil: Botafogo, Flamengo and Fluminense

Football Clubs.jpgDominance in markets usually occurs because of the initial investment required to compete in the first place – set-up costs. If you look at the railway industry (which could be said to be a natural monopoly) the cost of putting down new train tracks by the existing ones or a new line would be excessive and the ability to cover these costs would very difficult. Any benefit that may arise from competition would be diminished by the cost of duplication.

Dominance is easy to explain if there are very large set-up costs, which, once spent, cannot be recovered other than by operating in the industry. Economist refers to these costs as Sunk Costs.

Dominance in a market can also occur in markets where there are less sunk costs. Take for instance the soft drinks industry as an example. It remains relatively inexpensive to set-up a production plant to bottle soft drinks but Coca-Cola dominates the world market with 42% market share, followed by Pepsi with 28%. Their dominance is through advertising which makes up the majority of the sunk costs. Advertising is an example of ‘endogenous’ sunk costs which are determined by the firm as opposed to ‘exogenous’ sunk costs which are determined by technological requirements.
Premier League Players.jpgIn professional football the focus is on player investment rather than advertising, where the big clubs are those that spend heavily on players and win league championships. Teams that win are more likely to attract a larger fan base and greater revenue. Szymanski states that the big difference between football and soft drinks is that the pattern of dominance looks the same in small markets. For instance clubs in the English Division 2 (Division 4 in the old days) still stay in existence mainly because they operate in a different market than the Premiership teams. Of the 88 clubs in the English Football League in 1923, 85 still exist, and most of them still play in the 4 English Divisions. Also those clubs in the lower Division do benefit from intense local loyalty especially through tough times with performance. When clubs get relegated to the Championship from the Premier League, although they lose revenue from TV rights their fan base remains fairly constant. However a lot of these clubs will find it hard breaking into the dominant group – Manchester City, Manchester Utd, Liverpool, Arsenal, Chelsea, Spurs – unless they receive significant funding from an investor who doesn’t expect to see a financial return or have an exceptional season without high profile players like Leicester City who won the Premiership in 2015/16.

Unlike most business in which loss-making firms shut down or merge into other businesses, football clubs almost always survive. This does not prevent dominance, but unlike most industries, it does mean that the pattern of dominance tends to look the same everywhere. Source: Szymanski

Monopsony v Monopoly – Tesco v Unilever

Geoff Riley did a very good post on Tutor2u that outlined the recent dispute between Tesco and Unilever. Marmite, PG Tips tea and Pot Noodles are among dozens of brands currently unavailable on Tesco’s online site due to this dispute with Unilever. Unilever raised its price by 10% in the UK to compensate for the sharp drop in the pound’s value.

Tesco is resisting the move and has removed Unilever products from its website. Unilever see the price increase as a  “normal” reaction to shifts in currency values – since the Brexit vote there has been a 17% decrease in the value of the pound which has added to the cost of importing goods. The products currently absent from Tesco’s website also include Comfort fabric conditioner, Hellmann’s mayonnaise and Ben & Jerry’s ice cream. With the A2 exam looming here are some notes on Monopoly and Monopsony.

Monopoly and Monopsony theory

Monopoly. Perfect competition is not to be found in the real world and absolute or pure monopoly is also virtually impossible to achieve since it applies operating in the absence of competition (i.e. no substitutes). While it is not difficult for a firm to become a sole supplier it is extremely difficult to achieve a situation where there are no substitutes for the product. A more realistic definition of monopoly would be ‘a sole supplier of a commodity for which there are no good substitutes’. In fact the degree of monopoly power in the real world tends to be judged on the basis of the share of the total market accounted for by any particular supplier.

The graph below shows that at profit maximising equilibrium, output Qm is less than that in a competitive market (Qe), and the demand and supply (MC) curves do not intersect. Qe represents the Allocative Efficiency level of output and Pe the price. The shaded area therefore represents the loss of allocative efficiency or the deadweight loss.

monopoly-dwl 

Therefore monopolists restrict output and mis-allocate resources leading to a deadweight loss to the economy. However the government, using price controls, can force a shift from the preferred monopoly equilibrium (MC=MR) to one equivalent to the perfectly competitive equilibrium (MC=AR). At the less-preferred equilibrium, a monopolist’s supernormal profit may be either reduced or turned into a subnormal profit. In the latter case, a permanent subsidy may be necessary to keep the firm in business.

Monopsony. Two areas are worthy of mention, including the monopsony power of the large supermarkets (as stated above), who can dictate terms to smaller suppliers, and the monopsony power associated with buyers of labour in the labour market.

A monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. Unlike other examples we have looked at, in this situation we are now dealing with an imperfect rather than a perfectly competitive market. The monopsonist will hire workers where:

monopsony-labour

Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)

You will remember from the notes on the Perfect Labour Market that this is known as the profit maximising position.

From the perspective of the monopsonist firm facing the supply curve directly, if at any point it wants to hire more labour, it has to offer a higher wage to encourage more workers to join the market – after all, this is what the ACL curve tells it. However, the firm would then have to pay that higher wage to all its workers so the marginal cost of hiring the extra worker is not just the wage paid to that worker, but the increased wage paid to all workers as well. So the marginal cost of labour curve (MCL) can be added to the diagram.

If the monopsonist firm wants to maximise profit, it will hire labour up to the point where the marginal cost of labour is equal to the marginal revenue product of labour. Therefore it will use labour up to level of Eq which is where MCL=MRPL. In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.

In this situation the power of the employer in the labour market is of overriding importance and the employer can set a low wage because of this buying power.

A2 Economics Revision: Contestable Markets

Contest MarketsIn the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair