BUSINESS (NO PLAGARISM A+ WORK, ON TIME)

Discussion Ventured Capitalist (no more than 250 words)

In the hope of high returns, venture capitalists provide funds to finance new (start up) companies. However, potential competitors and structures of the market into which the new firm enters are extremely important in realization of profits. Among different market structures, which one do you believe provides the highest possible return for a new company and why?

https://www.youtube.com/watch?v=9Hxy-TuX9fs

RESPOND TO Discussion Ventured Capitalist (no more than 150 words) ATT

In the hope of high returns, venture capitalists fund new companies, but the profitability of these ventures depends greatly on the market structure in which the firm operates. Among the four major market structures - perfect competition, monopolistic competition, oligopoly, and monopoly - I believe that monopoly or near-monopoly conditions provide the highest possible returns for a start-up.

In a monopoly, the firm is the sole provider of a product or service, which allows it to set output where marginal revenue equals marginal cost and then charge the maximum price consumers are willing to pay. This results in prices above marginal cost and the possibility of long-run economic profits (Saylor Academy, n.d.-a). Unlike firms in perfect competition that earn zero economic profit in the long run, a monopolist can maintain profitability by restricting output and raising prices.

From a managerial economics perspective, the ability to establish and maintain barriers to entry is critical. Patents, economies of scale, and brand loyalty can all serve as protective mechanisms that allow a start-up to secure and defend a dominant position (Saylor Academy, n.d.-b). These barriers help sustain pricing power and discourage competitors, which is particularly appealing for venture capitalists seeking outsized returns.

While monopolies are often criticized for inefficiency and reduced consumer welfare, for investors the potential upside is substantial. Even if pure monopoly is rare, start-ups that can achieve monopoly-like advantages through innovation, technology, or first-mover status are far more likely to generate exceptional profits compared to those operating in competitive markets.

RESPOND TO Discussion Ventured Capitalist (no more than 150 words) PS

In hopes of high returns for venture capitalists to earn the maximum profit, I believe venturing into a monopolistic market is ideal. Monopolistic markets have a relatively low entry barrier and may have a similar platform but distinguish themselves by the features of their products. A great example of this is the current AI race within the technology sector. Although many are investing in AI, there are very distinct sectors such as medical, defense, finance, logistics, and manufacturing. Even so, many sectors have distinguishing characteristics that allow a company to set the price, to an extent. The more recognizable a company becomes, the more it differentiates itself from its competitors, and the more customers are willing to pay for its technology. Eventually, the more technology a company differentiates from its competitors, the closer it gets to market domination, which leads to venture capitalists maximizing their investment gains. Oligopoly markets and monopoly have too high entry barriers for venture capitalists to jump headfirst into, which runs a risk of their investment being swallowed up by entry costs. A perfectly competitive market leaves little room for maximizing profits. Competition is fierce in this market, and it seems there’s always another company lurking to slash prices to undercut the next. 

When a venture capitalist looks towards investment, they typically want a market that is not saturated, with high growth potential, and a competitive advantage to set itself apart from potential competitors. Ideally, a venture capitalist wants opportunities with the potential to grab a large share of the market. Typically, these investors want a new company that has the magic key to solve a significant problem that has yet to be addressed. In doing so, they likely attain the maximized growth and investment return..

Reference

Peng, T. (2006).  A study of imperfect competition of the Asian dairy markets: The impacts of Doha round agricultural negotiations and further trade liberalization (Order No. 3234586). Available from ProQuest Central; ProQuest Dissertations & Theses Global. (304977109). http://ezproxy.apus.edu/login?qurl=https%3A%2F%2Fwww.proquest.com%2Fdissertations-theses%2Fstudy-imperfect-competition-asian-dairy-markets%2Fdocview%2F304977109%2Fse-2%3Faccountid%3D8289

SOMETHING VENTURED: Venture Capitalists Set Sights on Cloud Security. (2012, Dec 13).  Dow Jones Institutional News http://ezproxy.apus.edu/login?qurl=https%3A%2F%2Fwww.proquest.com%2Fwire-feeds%2Fsomething-ventured-venture-capitalists-set-sights%2Fdocview%2F2104657781%2Fse-2%3Faccountid%3D8289

References

Samuelson W.F. & Marks S.G. (2015).  Managerial Economics. Hoboken, NJ: Wiley & Sons Inc.

U.S. Census Bureau. https://www.census.gov/econ/concentration.html

Firm Competition and Market Structure

Although highly competitive markets similar to the models in the previous chapter are desirable for an economy and occur for some goods and services, many important markets deviate significantly from the assumptions made in that discussion and operate differently. In this chapter we will consider some concepts and theories that help explain some of these other markets.

7.1 Why Perfect Competition Usually Does Not Happen

The perfect competition model (and its variants like monopolistic competition and contestable markets) represents an ideal operation of a market. As we noted in  Chapter 6 "Market Equilibrium and the Perfect Competition Model" , not only do the conditions of these models encourage aggressive competition that keeps prices as low as possible for buyers, but the resulting dynamics create the greatest value for all participants in the market in terms of surplus for consumers and producers.

Some markets resemble perfect competition more than others. Agricultural markets, particularly up through the beginning of the 20th century, were viewed as being close to a real-world version of a perfectly competitive market. There were many farmers and many consumers. No farmer and no consumer individually constituted sizeable fractions of the market activity, and both groups acted as price takers. With a modest amount of capital, one could acquire land, equipment, and seed or breeding stock to begin farming, especially when the United States was expanding and large volumes of unused land were available for purchase or homesteading. Although some farmers had better land and climate or were better suited for farming, the key information about how to farm was not impossible to learn.

However, in recent decades circumstances have changed, even for farming, in a way that deviates from the assumptions of perfect competition. Now farmers are unlikely to sell directly to consumers. Instead, they sell to food processing companies, large distributors, or grocery store chains that are not small and often not price takers. Many farming operations have changed from small, family-run businesses to large corporate enterprises. Even in markets where farming operations are still relatively small, the farmers form cooperatives that have market power. Additionally, the government takes an active role in the agriculture market with price supports and subsidies that alter farm production decisions.

One reason so few markets are perfectly competitive is that minimum efficient scales are so high that eventually the market can support only a few sellers. Although the contestable market model suggests that this factor alone does not preclude aggressive price competition between sellers, in most cases there is not really free entry for new firms. A new entrant will often face enormous startup capital requirements that prohibit entry by most modest-sized companies or individual entrepreneurs. Many markets are now influenced by brand recognition, so a new firm that lacks brand recognition faces the prospect of large promotional expenses and several periods with losses before being able to turn a profit. To justify the losses in the startup period, new entrants must expect they will see positive economic profits later to justify these losses, so the market is not likely to reach the stage of zero economic profit even if the new entrants join.

Due to economies of scope, few sellers offer just one product or are organized internally such that production of that one product is largely independent of the other products sold by that business. Consequently, it will be very difficult for a competitor, especially a new entrant in the market, to readily copy the breadth of operations of the most profitable sellers and immediately benefit from potential economies of scope.

Sellers that are vertically integrated may have control of upstream or downstream markets that make competition difficult for firms that focus on one stage in the value chain. For example, one firm may have control of key resources required in the production process, in terms of either the overall market supply or those resources of superior quality, making it hard for other firms to match their product in both cost and quality. Alternatively, a firm may control a downstream stage in the value chain, making it difficult for competitors to expand their sales, even if they price their products competitively.

As we will discuss in the next chapter, markets are subject to regulation by government and related public agencies. In the process of dealing with some perceived issues in these markets, these agencies will often block free entry of new firms and free exit of existing firms.

In our complex technological world, perfect information among all sellers and buyers is not always a reasonable assumption. Some sellers may possess special knowledge that is not readily known by their competition. Some producers may have protection of patents and exclusive rights to technology that gives them a sustained advantage that cannot be readily copied. On the buyer side, consumers usually have a limited perspective on the prices and products of all sellers and may not always pay the lowest price available for a good or service (although the Internet may be changing this to some degree).

Finally, for the perfect competition model to play out according to theory, there needs to be a reasonable level of stability so that there is sufficient time for the long-run consequences of perfect competition to occur. However, in our fast-changing world, the choices of goods and services available to consumers, the technologies for producing those products and services, and the costs involved in production are increasingly subject to rapid change. Before market forces can begin to gel to create price competition and firms can modify their operations to copy the most successful sellers, changes in circumstances may stir enough such that the market formation process starts anew.

7.2 Monopoly

Often, the main deterrent to a highly competitive market is market power possessed by sellers. In this section, we will consider the strongest form of seller market power, called a monopoly. In a monopoly there is only one seller, called a monopolist.

Recall that in perfect competition, each firm sees the demand curve it faces as a flat line, so it presumes it can sell as much as it wants, up to its production limit, at the prevailing market price. Even though the overall market demand curve decreases with increased sales volume, the single firm in perfect competition has a different perception because it is a small participant in the market and takes prices as given. In the case of flat demand curves, price and marginal revenue are the same, and since a profit-maximizing producer decides whether to increase or decrease production volume by comparing its marginal cost to marginal revenue, in this case the producer in perfect competition will sell more (if it has the capability) up the point where marginal cost equals price.

In a monopoly, the demand curve seen by the single selling firm is the entire market demand curve. If the market demand curve is downward sloping, the monopolist knows that marginal revenue will not equal price. As we discussed in  Chapter 2 "Key Measures and Relationships" , when the demand curve is downward sloping, the marginal revenue corresponding to any quantity and price on the demand curve is less than the price (see  Figure 7.1 "Graph Showing the Optimal Quantity and Price for a Monopolist Relative to the Free Market Equilibrium Price and Quantity" ). Because the condition for optimal seller profit is where marginal revenue equals marginal cost, the monopolist will elect to operate at a quantity where those two quantities are in balance, which will be at volume marked QM in  Figure 7.1 "Graph Showing the Optimal Quantity and Price for a Monopolist Relative to the Free Market Equilibrium Price and Quantity" .

Since the monopolist has complete control on sales, it will only sell at the quantity where marginal revenue equals marginal cost but will sell at the higher price associated with that quantity on the demand curve, PM, rather than the marginal cost at a quantity of QM.

Figure 7.1 Graph Showing the Optimal Quantity and Price for a Monopolist Relative to the Free Market Equilibrium Price and Quantity

If the marginal cost curve for the monopolist were instead the combined marginal cost curves of small firms in perfect competition, the marginal cost curve would correspond to the market supply curve. The perfect competition market equilibrium would occur at a volume QC, with a price PC. The monopolist could afford to function at this same volume and price and may even earn some economic profit. However, at this volume, marginal cost is greater than marginal revenue, indicating greater profit by operating at a lower volume at a higher price. The highest profit will result from selling QM units at a price of PM. Unfortunately, consumers do worse at the monopolist’s optimal operation as they pay a higher price and purchase fewer units. And as we noted in the previous chapter, the loss in consumer surplus will exceed the profit gain to the monopolist. This is the main reason monopolies are discouraged, if not outlawed, by governments.

7.3 Oligopoly and Cartels

Unless a monopoly is allowed to exist due to a government license or protection from a strong patent, markets have at least a few sellers. When a market has multiple sellers, at least some of which provide a significant portion of sales and recognize (like the monopolist) that their decisions on output volume will have an effect on market price, the arrangement is called an oligopoly.

At the extreme, sellers in an oligopoly could wield as much market power as a monopolist. This occurs in an oligopoly arrangement called a cartel, where the sellers coordinate their activities so well that they behave in effect like divisions of one enterprise, rather than as a competing business, that make independent decisions on quantity and price. (You may be familiar with the term cartel from the OPEC oil exporting group that is frequently described as a cartel. However, though OPEC has considerable market power and influence on prices, there are oil exporters that are not in OPEC, and internally OPEC only sets member targets rather than fully coordinating their operations.)

In theory, a cartel would operate at the same production volume and price as it would if its productive resources were all run by a monopolist. In a cartel, every member firm would sell at the same price and each firm would set its individual production volume such that every firm operates at the same marginal cost.

For the same reason that monopolies are considered harmful, cartels are usually not tolerated by governments for the regions in which those markets operate. Even the collusion that is a necessary component of a true cartel is illegal.

However, although cartels could theoretically function with the same power as a monopolist, if the cartel truly contains multiple members making independent decisions, there is a potential instability that can undo the cartel arrangement. Because monopolists gain added profit by reducing production volume and selling at a price above marginal cost, individual members may see an opportunity to defect, particularly if they can do so without being easily detected. Since the cartel price will be well above their marginal cost, they could profit individually by increasing their own production. Of course, if the defection is discovered and the other members retaliate by increasing their volumes as well, the result could be a substantially lower market price and lower economic profits for all cartel members.

Another problem for cartels is how to divide the profits. Suppose a cartel had two member firms, A and B. Firm A has more efficient facilities than Firm B, so the cartel solution will be to allow Firm A to provide the bulk of the production volume. However, if Firm A claims its share of the profits should be proportional to its share of the production volume, Firm B may object to voluntarily withholding its production only to allow to Firm A to grab most of the sales and profit, and the arrangement could end.

Also, since optimal cartel operation means that all firms set production so all have the same marginal cost, the firms need to share internal information for the cartel to determine the total volume where marginal revenue equals marginal cost and how that volume gets divided between firms. Again, some firms may have the incentive to keep the details of their operations private from other firms in the cartel.

7.4 Production Decisions in Noncartel Oligopolies

Oligopolies exist widely in modern economies. However, due to the reasons just cited, most do not function as cartels. Still, since these markets have relatively few sellers and each has a significant share of market sales, in many cases the total market production by oligopoly firms is less than would be expected if the market were perfectly competitive, and prices will be somewhat higher.

From the point of theory, the expected operation of the firm in perfect competition or in monopoly/cartel is straightforward. Assuming the firm in the perfect competition sufficiently understands its production costs, it will increase volume up to the point where its marginal cost exceeds the price. For a monopolist or cartel, production should increase up to point where marginal cost equals marginal revenue.

Oligopolies fall somewhere in between perfect competition and a cartel. However, the prescription of how to set optimal production volume is considerably more complex than either of the extremes. Like the monopolist, the oligopoly firm is aware that significant changes in its production level will have a significant effect on the market supply quantity, requiring a change in the market price to be in agreement with a downward sloping demand curve. However, while the firm is aware its production decisions will affect the market price, it is difficult to forecast the actual impact on price, even if the firm knows the behavior of the market demand curve.

A major reason for the complexity in determining the optimal production level is that the firm does not know how its oligopoly competitors will respond to its production decisions. For example, suppose a firm looks at the current market price and decides based on the market demand curve that it could increase its production volume by 1000 units per day and make a greater profit, even if the price dropped according to the market demand curve. Other sellers in the market will see the action taken and may decide that if the price is dropping and market demand is increasing that they could benefit by increasing their production to take advantage. As a consequence, the total market volume may increase more than expected, prices will drop more than expected, and the resulting gain in profit will be less than what the initial firm expected when it did its analysis.

Trying to figure out how to deal with reactions of other sellers not only is a vexing problem for sellers in oligopolies but has been a difficult challenge for academic economists who try to develop theories of oligopoly. The scholarly literature of economics is filled with elaborate mathematical models that attempt to address oligopoly operation. Next we will consider some of the insights of these analyses without the mathematics.

One approach that economists have used to model the behavior of oligopoly firms, known as the Bertrand model or price competition, is to assume all firms can anticipate the prices that will be charged by their competitors. If firms can reasonably anticipate the prices that other firms will charge and have a reasonable understanding of market demand, each firm can determine how customers would react to its own price and decide what production level and price leads to highest profit. The soft drink market is an example of a market that could operate in this manner.

Another approach for modeling oligopoly behavior, known as the Cournot model or quantity competition, is to assume all firms can determine the upcoming production levels or operating capacities of their competitors. For example, in the airline industry, schedules and gate arrangements are made months in advance. In essence, the airlines have committed to a schedule, their flying capacities are somewhat fixed, and what remains is to make the necessary adjustments to price to use the committed capacity effectively.

In comparing models where firms anticipate price to those where firms anticipate production volume or capacity commitment, firms that anticipate quantity levels tend to operate at lower production levels and charge higher prices. This occurs because in a quantity competition model, firms subtract the planned operation of their rivals from the market demand curve and assume the residual is the demand curve they will face. This leads to the presumption that the price elasticity of their own demand is the same as the price elasticity of overall market demand, whereas in price competition models the elasticity of the firm’s own demand is seen as greater than the price elasticity of overall market demand (as was the case in the perfect competition model).

The number of selling firms also has an effect on the likely outcome of oligopoly competition. As the number of firms increases, the market equilibrium moves toward the equilibrium that would be expected in a perfectly competitive market of firms with the same aggregate production resources.

Another issue that can affect the prices and quantity volumes in an oligopoly market is the existence of a “leader” firm. A leader firm will make a decision on either its price or its volume/capacity commitment and then the remaining “follower firms” determine how they will react. An example of a leader firm in an industry might be Apple in the portable media player market. Apple decides on how it will price its iPod products and other manufacturers then decide how to price their products. Although the leader firm commits first in these models, in order to determine its own best course of action, it needs to anticipate how the follower firms will react to its decision.

7.5 Seller Concentration

Sellers in oligopolies can limit competition by driving out competitors, blocking entry by new competitors, or cooperating with other sellers with market power to keep prices higher than would be the case in a market with strong price competition. In order for sellers to exercise market power, either the market will have fairly few selling firms or there will be some selling firms that account for a large portion of all the market sales. When this happens, the market is said to have high seller concentration. Although high seller concentration in itself is not sufficient for exercise of seller power, it is generally a necessary condition and constitutes a potential for the exercise of seller power in the future. In this section, we will consider two numerical measures of market concentration: concentration ratios and the Herfindahl-Hirschmann Index (HHI).

Both measures of seller concentration are based on seller market shares. A firm’s market share is the percentage of all market sales that are purchased from that firm. The highest possible market share is 100%, which is the market share of a monopolist. Market shares may be based either on the number of units sold or in terms of monetary value of sales. The latter use of monetary value is convenient when there are variations in the good or service sold and different prices are charged.

Concentration ratios are the result of sorting all sellers on the basis of market share, selecting a specified number of the firms with the highest market shares, and adding the market shares for those firms. For example, the concentration ratio CR4 is the sum of the market shares for the four largest firms in terms of volume in a market and CR8 is the sum of the eight largest firms in terms of volume. The U.S. Census Bureau periodically publishes concentration ratios for different industries in the United States.See U.S. Census Bureau (2010).

Suppose a market has 10 sellers with market shares (ranked from high to low) of 18%, 17%, 15%, 13%, 12%, 8%, 7%, 5%, 3%, and 2%. The CR4 ratio for this market would be 63 (18 + 17 + 15 + 13), and the CR8 ratio would be 95 (18 + 17 + 15 + 13 + 12 + 8 + 7 + 5).

Although concentration ratios are easy to calculate and easily understood, there are two shortcomings. First, the number of firms in the ratio is arbitrary. There is no reason that a four-firm concentration ratio indicates concentration potential any better than a three-firm or five-firm concentration ratio. Second, the ratio does not indicate whether there are one or two very large firms that clearly dominate all other firms in market share or the market shares for the firms included in the concentration ratio are about the same.

An alternative concentration measure that avoids these problems is the HHI. This index is computed by taking the market shares of all firms in the market, squaring the individual market shares, and finally summing them. The squaring has the effect of amplifying the larger market shares. The highest possible value of the HHI is 10,000, which occurs in the case of a monopoly (10,000 = 1002). If, on the other hand, you had a market that had 100 firms that each had a market share of 1%, the HHI would be 100 (1 = 12, summed 100 times). For the previous 10-firm example, the HHI would be 1302. Although there is no inherent reason for squaring market shares, the HHI includes all firms in the computation (avoiding the issue of how many firms to include) and reflects the variation in magnitude of market shares.

As far as interpreting these concentration measures, the following statements provide some guidance on the potential for market power by sellers:

· If CR4 is less than 40 or the HHI is less than 1000, the market has fairly low concentration and should be reasonably competitive.

· If CR4 is between 40 and 60 or the HHI is between 1000 and 2000, there is a loose oligopoly that probably will not result in significant exercise of market power by sellers.

· If CR4 is above 60 or the HHI is above 2000, then there is a tight oligopoly that has significant potential for exercise of seller power.

· If CR1 is above 90 or the HHI is above 8000, one firm will be a clear leader and may function effectively as a monopoly.

Again, a high concentration measure indicates a potential for exploitation of seller power but not proof it will actually happen. Another important caution about these measures is that the scope of the market needs to be considered. In the case of banking services, even with the mergers that have resulted in higher seller concentration, if you look at measures of bank concentration at the national level, there seems be a loose oligopoly. However, if you limit the scope to banking in a single city or region, it is very likely that only few banks serve those areas. There can be modest concentrations when examining national markets but high concentration at the local level.

7.6 Competing in Tight Oligopolies: Pricing Strategies

In recent decades, economists have employed the applied mathematical tools of game theory to try to capture the dynamics of oligopoly markets. The initial research papers are generally abstract and very technical, but the acquired insights of some of this research have been presented in textbooks geared to nontechnical readers.A text that applies game theory to management is Brandenburger and Nalebuff (1996). Game theory is outside the scope of this text, but we will consider some of the insights gained from the application of game theory in discussions about strategy in this and the following sections.

In this section, we will consider the economics underlying some of pricing strategies used by firms in monopolies and tight oligopolies.

1. Deep discounting. One exercise of seller power is to try to drive out existing competition. Deep discounting attempts to achieve this by setting the firm’s price below cost, or at least below the average cost of a competitor. The intent is to attract customers from the competitor so that the competitor faces a dilemma of losses from either lost sales or being forced to follow suit and also set its price below cost. The firm initiating the deep discounting hopes that the competitor will decide that the best reaction is to exit the market. In a market with economies of scale, a large firm can better handle the lower price, and the technique may be especially effective in driving away a small competitor with a higher average cost. If and when the competitor is driven out of the market, the initiating firm will have a greater market share and increased market power that it can exploit in the form of higher prices and greater profits than before.

2. Limit pricing. A related technique for keeping out new firms is the technique of limit pricing. Again, the basic idea is to use a low price, but this time to ward off a new entrant rather than scare away an existing competitor. Existing firms typically have lower costs than a new entrant will initially, particularly if there are economies of scale and high volume needed for minimum efficient scale. A limit price is enough for the existing firm to make a small profit, but a new entrant that needs to match the price to compete in the market will lose money. Again, when the new entrant is no longer a threat, the existing firm can reassert its seller power and raise prices for a sustained period well above average cost. As a game of strategy, the new entrant may reason that if it is willing to enter anyway and incur an initial loss, once its presence is in the market is established, the existing firm will realize their use of limit pricing did not work and decide it would be better to let prices go higher so that profits will increase, even if that allows the new entrant to be able to remain in the market.

3. Yield management. Another method for taking advantage of the power to set prices is yield management, where the firm abandons the practice of setting a fixed price and instead changes prices frequently. One goal is to try to extract higher prices from customers who are willing to pay more for a product or service. Normally, with a fixed announced price, customers who would have been willing to pay a significantly higher price get the consumer surplus. Even if the firm employs third-degree price discrimination and charges different prices to different market segments, some customers realize a surplus from a price well below the maximum they would pay. Using sophisticated software to continuously readjust prices, it is possible to capture higher prices from some of these customers. Yield management can also make it more difficult for other firms to compete on the basis of price since it does not have a known, fixed price to work against.

A good example of yield management is the airline industry. Airlines have long employed price discrimination in forms of different classes of customers, different rates for flyers traveling over a weekend, and frequent flyer programs. However, in recent years, the price to buy a ticket can change daily, depending on the amount of time until the flight occurs and the degree to which the flight has already filled seats.

4. Durable goods. When firms in monopolies and oligopolies sell long-lived durable goods like cars and televisions, they have the option to sell to customers at different times and can attempt to do something similar to first-degree price discrimination by setting the price very high at first. When the subset of customers who are willing to pay the most have made their purchase, the firms can drop the price somewhat and attract another tier of customers who are willing to pay slightly less than the first group. Progressively, the price will be dropped over time to attract most customers at a price close to the maximum they would be willing to pay.

However, economists have pointed out that customers may sense this strategy, and if patient, the customer can wait and pay a much lower price than the perceived value of the item. Even if the firm has little competition from other firms, a firm may find itself in the interesting situation of competing with itself in other production periods. In theoretical analyses of monopolies that sold durable goods, it has been demonstrated that when durable goods last a long time and customers are patient, even a monopolist can be driven to price items at marginal cost.The durable goods problem is discussed in Kreps (2004).

One response to the durable goods dilemma is to sell goods with shorter product lives so that customers will need to return sooner to make a purchase. U.S. car manufacturers endeavored to do this in the middle of the 20th century but discovered that this opened the door for new entrants who sold cars that were designed to last longer.

Another response is to rent the use of the durable good rather than sell the good outright. This turns the good into a service that is sold for a specified period of time rather than a long-lived asset that is sold once to the customer (for at least a long time) and allows more standard oligopoly pricing that is applied for consumable goods and services. This arrangement is common with office equipment like copiers.

7.7 Competing in Tight Oligopolies: Nonpricing Strategies

Oligopoly firms also use a number of strategies that involve measures other than pricing to compete and maintain market power. Some of these strategies try to build barriers to entry by new entrants, whereas the intention of other measures is to distinguish the firm from other existing competitors.

1. Advertising. As we noted in  Chapter 3 "Demand and Pricing" , most firms incur the expense of advertising. To some extent, advertising is probably necessary because buyers, particularly household consumers, face a plethora of goods and services and realistically can actively consider only a limited subset of what is available. Advertising is a means of increasing the likelihood a firm’s product or service is among those services actually considered.

When the firm is an upstream seller in a value chain with downstream markets, advertising may be directed at buyers in downstream markets. The intent is to encourage downstream buyers to look for products that incorporate the upstream firm’s output. An example of such advertising is in pharmaceuticals, where drug manufacturers advertise in mass media with the intent of encouraging consumers to request a particular drug from their physicians.

In tight oligopolies, firms may boost the intensity of advertising well beyond the amount needed to inform buyers of the existence of their goods and services. Firms may advertise almost extravagantly with the idea of not only establishing brand recognition but making strong brand recognition essential to successful competition in the market. Once strong brand recognition takes hold in the market, new firms will need to spend much more to establish brand recognition than existing firms spend to maintain brand recognition. Hence new entrants are discouraged by what is perceived as a high startup fee, which is a type of barrier to entry.

2. Excess capacity. Ordinarily a firm will plan for a capacity that is sufficient to support the production volume. Because capacity is often planned in advance and actual production volume may vary from period to period, the firm may have some excess capacity in some periods. And since there is inherent uncertainty in future demand, firms may even invest in capacity that is never fully utilized.

However, firms in oligopolies may invest, or partially invest, in capacity well beyond what is needed to cover fluctuations in volume and accommodation of uncertainty as a means of competing. If the sellers in an oligopoly have been successful in collectively holding back on quantity to drive up the price and profits, since the price is well above average cost, there is an opportunity for one firm to offer the product at a lower price, attract a sizeable fraction of the new customers attracted by the lower price, and make a sizeable individual gain in profit. This gambit may come from a new entrant or even an existing seller. This tactic may work, at least for a time, if the firm introducing the lower price does it by surprise and the other firms are not prepared to ramp up production rapidly to match the initiator’s move.

One way to protect against an attack of this nature is to have a significant amount of excess capacity, or at least some additional capacity that could be upgraded and brought online quickly. The firm doing this may even want to clearly reveal this to other sellers or potential sellers as a signal that if another firm were to try an attack of this nature, they are prepared to respond quickly and make sure they take advantage of the increased sales volume.

3. Reputation and warranties. As a result of fluctuations in cost or buyer demand, being a seller in a market may be more attractive in some periods than others. During periods that are lucrative for being a seller, some firms may be enticed to enter on a short-term basis, with minimal long-term commitments, enjoy a portion of the spoils of the favorable market, and then withdraw when demand declines or costs increase.

Firms that intend to remain in the market on an ongoing basis would prefer that these hit-and-run entrants not take away a share of the profits when the market is attractive. One measure to discourage this is to make an ongoing presence desired by the customer so as to distinguish the product of the ongoing firms from the product of the short-term sellers. As part of advertising, these firms may emphasize the importance of a firm’s reputation in providing a quality product that the firm will stand behind.

Another measure is to make warranties a part of the product, a feature that is only of value to the buyer if the seller is likely to be available when a warranty claim is made. Like high-cost advertising, even the scope of the warranty may become a means of competition, as is seen in the automobile industry where warranties may vary in time duration, number of driven miles, and systems covered.

4. Product bundling. In  Chapter 3 "Demand and Pricing" , we discussed the notion of complementary goods and services. This is a relationship in which purchasers of one good or service become more likely to purchase another good or service. Firms may take advantage of complementary relationships by selling products together in a bundle, where consumers have the option to purchase multiple products as a single item at lower total cost than if the items were purchased separately. This can be particularly effective if there are natural production economies of scope in these complementary goods. If competitors are unable to readily match the bundled product, the firm’s gain can be substantial.

A good example of successful product bundling is Microsoft Office. Microsoft had developed the word processing software Word, the spreadsheet software Excel, the presentation software PowerPoint, and the database software Access. Individually, each of these products was clearly outsold by other products in those specialized markets. For example, the favored spreadsheet software in the late 1980s was Lotus 1-2-3. When Microsoft decided to bundle the packages and sell them for a modest amount more than the price of a single software package, customers perceived a gain in value, even if they did not actively use some of the packages. Since all the components were software and distributed on floppy disks (and later on CDs and via web downloads), there was a strong economy of scope. However, when Microsoft introduced the bundle, the firms selling the leader products in the individual markets were not able to match the product bundling, even though some attempted to do so after Microsoft has usurped the market. Consequently, not only was the product bundle a success, but the individual components of Microsoft Office each became the dominant products.

5. Network effects and standards. In some markets, the value of a product to a buyer may be affected by the number of other buyers of the product. For example, a cell phone becomes more valuable if most of the people you would like to phone quickly also carry a cell phone. Products that increase in value when the adoption rate of the product increases, even if some units are sold by competitors, are said to have “network effects.”

One impact of network effects is that industry standards become important. Often network effects occur because the products purchased need to use compatible technologies with other products. In some markets, this may result in some level of cooperation between firms, such as when appliance manufacturers agree to sell units with similar dimensions or connections.

However, sometimes multiple standards emerge and firms may select to support one standard as a means of competing against a firm that uses another standard. Sellers may group into alliances to help improve their success via network effects. In the once-vibrant market for VCR tapes and tape players, the initial standard for producing tapes was called Betamax. This Betamax standard was developed by Sony and used in the VCR players that Sony produced. Soon after Betamax was introduced, the electronics manufacturer JVC introduced the VHS standard. Consumers first had to purchase the VCR player, but the value of the product was affected by the availability and variety of tapes they could acquire afterward, which was determined by whether their player used the Betamax standard or the VHS standard. Eventually the VHS standard prevailed, favoring JVC and the other firms that allied with JVC.

Up until the videotape was eclipsed by the DVD, the VCR industry moved to using the VHS standard almost exclusively. This illustrates a frequent development in a market with strong network effects: a winner-take-all contest. Another example of a winner-take-all situation can be seen with operating systems in personal computers. Although there were multiple operating systems available for PCs in the 1980s, eventually Microsoft’s MS-DOS and later Windows operating systems achieved a near monopoly in personal computer operating systems. Again, the driver is network effects. Companies that produced software saw different markets depending on the operating system used by the buyer. As MS-DOS/Windows increased its market share, companies were almost certain to sell a version of their product for this operating system, usually as their first version and perhaps as their only version. This, in turn, solidified Microsoft’s near monopoly. Although other operating systems still exist and the free operating system Linux and the Apple Macintosh OS have succeeded in some niches, Microsoft Windows remains the dominant operating system.

7.8 Buyer Power

The bulk of this chapter looked at facets of market power that is possessed and exploited by sellers. However, in markets with a few buyers that individually make a sizeable fraction of total market purchases, buyers can exercise power that will influence the market price and quantity.

The most extreme form of buyer power is when there is a single buyer, called a monopsony. If there is no market power among the sellers, the buyer is in a position to push the price down to the minimum amount needed to induce a seller to produce the last unit. The supply curve for seller designates this price for any given level of quantity. Although the monopsonist could justify purchasing additional units up to the point where the supply curve crosses its demand curve, the monopsonist can usually get a higher value by purchasing a smaller amount at a lower price at another point on the supply curve.

Assuming the monopsonist is not able to discriminate in its purchases and buy each unit at the actual marginal cost of the unit, rather buying all units at the marginal cost of the last unit acquired, the monopsonist is aware that when it agrees to pay a slightly higher price to purchase an additional unit, the new price will apply to all units purchased. As such, the marginal cost of increasing its consumption will be higher than the price charged for an additional unit. The monopsonist will maximize its value gained from the purchases (amount paid plus consumer surplus) at the point where the marginal cost of added consumption equals the marginal value of that additional unit, as reflected in its demand curve. This optimal solution is depicted in  Figure 7.2 "Graph Showing the Optimal Quantity and Price for a Monopsonist Relative to the Free Market Equilibrium Price and Quantity" , with the quantity QS being the amount it will purchase and price PS being the price it can impose on the sellers. Note, as with the solution with a seller monopoly, the quantity is less than would occur if the market demand curve were the composite of small buyers with no market power. However, the monopsonist price is less than the monopoly price because the monopsonist can force the price down to the supply curve rather than to what a unit is worth on the demand curve.

When there are multiple large buyers, there will be increased competition that will generally result in movement along the supply curve toward the point where it crosses the market demand curve. However, unless these buyers are aggressively competitive, they are likely to pay less than under the perfect competition solution by either cooperating with other buyers to keep prices low or taking other actions intended to keep the other buyers out of the market.

An example of a monopsonist would be an employer in a small town with a single large business, like a mining company in a mountain community. The sellers in this case are the laborers. If laborers have only one place to sell their labor in the community, the employer possesses significant market power that it can use to drive down wages and even change the nature of the service provided by demanding more tiring or dangerous working conditions. When the industrial revolution created strong economies of scale that supported very large firms with strong employer purchasing power, laborers faced a difficult situation of low pay and poor working conditions. One of the reasons for the rise of the labor unions in the United States was as a way of creating power for the laborers by requiring a single transaction between the employer and all laborers represented by the union.

Figure 7.2 Graph Showing the Optimal Quantity and Price for a Monopsonist Relative to the Free Market Equilibrium Price and Quantity

10.3 Assessing Monopoly

Learning Objectives

1. Explain and illustrate that a monopoly firm produces an output that is less than the efficient level and why this results in a deadweight loss to society.

2. Explain and illustrate how the higher price that a monopoly charges, compared to an otherwise identical perfectly competitive firm, transfers part of consumer surplus to the monopolist and raises questions of equity.

3. Considering both advantages and disadvantages, discuss the potential effects that a monopoly may have on consumer choices, price, quality of products, and technological innovations.

4. Discuss the public policy responses to monopoly.

We have seen that for monopolies pursuing profit maximization, the outcome differs from the case of perfect competition. Does this matter to society? In this section, we will focus on the differences that stem from market structure and assess their implications.

Efficiency, Equity, and Concentration of Power

A monopoly firm determines its output by setting marginal cost equal to marginal revenue. It then charges the price at which it can sell that output, a price determined by the demand curve. That price exceeds marginal revenue; it therefore exceeds marginal cost as well. That contrasts with the case in perfect competition, in which price and marginal cost are equal. The higher price charged by a monopoly firm may allow it a profit—in large part at the expense of consumers, whose reduced options may give them little say in the matter. The monopoly solution thus raises problems of efficiency, equity, and the concentration of power.

Monopoly and Efficiency

The fact that price in monopoly exceeds marginal cost suggests that the monopoly solution violates the basic condition for economic efficiency, that the price system must confront decision makers with all of the costs and all of the benefits of their choices. Efficiency requires that consumers confront prices that equal marginal costs. Because a monopoly firm charges a price greater than marginal cost, consumers will consume less of the monopoly’s good or service than is economically efficient.

To contrast the efficiency of the perfectly competitive outcome with the inefficiency of the monopoly outcome, imagine a perfectly competitive industry whose solution is depicted in  Figure 10.7 "Perfect Competition, Monopoly, and Efficiency" . The short-run industry supply curve is the summation of individual marginal cost curves; it may be regarded as the marginal cost curve for the industry. A perfectly competitive industry achieves equilibrium at point C, at price  Pc and quantity  Qc.

Figure 10.7 Perfect Competition, Monopoly, and Efficiency

Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of a perfectly competitive industry. The marginal cost curve may be thought of as the supply curve of a perfectly competitive industry. The perfectly competitive industry produces quantity Qc and sells the output at price Pc. The monopolist restricts output to Qm and raises the price to Pm.

Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the competitive case to the monopoly firm.

Now, suppose that all the firms in the industry merge and a government restriction prohibits entry by any new firms. Our perfectly competitive industry is now a monopoly. Assume the monopoly continues to have the same marginal cost and demand curves that the competitive industry did. The monopoly firm faces the same market demand curve, from which it derives its marginal revenue curve. It maximizes profit at output  Qm and charges price  Pm. Output is lower and price higher than in the competitive solution.

Society would gain by moving from the monopoly solution at  Qm to the competitive solution at  Qc. The benefit to consumers would be given by the area under the demand curve between  Qm and  Qc; it is the area  QmRC Qc. An increase in output, of course, has a cost. Because the marginal cost curve measures the cost of each additional unit, we can think of the area under the marginal cost curve over some range of output as measuring the total cost of that output. Thus, the total cost of increasing output from  Qm to  Qc is the area under the marginal cost curve over that range—the area  QmGC Qc. Subtracting this cost from the benefit gives us the net gain of moving from the monopoly to the competitive solution; it is the shaded area GRC. That is the potential gain from moving to the efficient solution. The area GRC is a deadweight loss.

Monopoly and Equity

The monopoly solution raises issues not just of efficiency but also of equity.  Figure 10.7 "Perfect Competition, Monopoly, and Efficiency"  shows that the monopolist charges price  Pm rather than the competitive price  Pc; the higher price charged by the monopoly firm reduces consumer surplus. Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay. It is measured by the area under the demand curve and above the price of the good over the range of output produced.

If the industry were competitive, consumer surplus would be the area below the demand curve and above  PcC. With monopoly, consumer surplus would be the area below the demand curve and above  PmR. Part of the reduction in consumer surplus is the area under the demand curve between  Qc and  Qm; it is contained in the deadweight loss area GRC. But consumers also lose the area of the rectangle bounded by the competitive and monopoly prices and by the monopoly output; this lost consumer surplus is transferred to the monopolist.

The fact that society suffers a deadweight loss due to monopoly is an efficiency problem. But the transfer of a portion of consumer surplus to the monopolist is an equity issue. Is such a transfer legitimate? After all, the monopoly firm enjoys a privileged position, protected by barriers to entry from competition. Should it be allowed to extract these gains from consumers? We will see that public policy suggests that the answer is no. Regulatory efforts imposed in monopoly cases often seek to reduce the degree to which monopoly firms extract consumer surplus from consumers by reducing the prices these firms charge.

Monopoly and the Concentration of Power

The objections to monopoly run much deeper than worries over economic efficiency and high prices. Because it enjoys barriers that block potential rivals, a monopoly firm wields considerable market power. For many people, that concentration of power is objectionable. A decentralized, competitive market constantly tests the ability of firms to satisfy consumers, pushes them to find new products and new and better production methods, and whittles away economic profits. Firms that operate in the shelter of monopoly may be largely immune to such pressures. Consumers are likely to be left with fewer choices, higher costs, and lower quality.

Perhaps more important in the view of many economists is the fact that the existence of economic profits provides both an incentive and the means for monopolists to aggressively protect their position and extend it if possible. These economists point out that monopolists may be willing to spend their economic profits in attempts to influence political leaders and public authorities (including regulatory authorities) who can help them maintain or enhance their monopoly position. Graft and corruption may be the result, claim these critics. Indeed, Microsoft has been accused by its rivals of bullying computer manufacturers into installing its web browser, Internet Explorer, exclusively on their computers.

Attitudes about Microsoft reflect these concerns. Even among people who feel that its products are good and fairly priced, there is uneasiness about our seeming dependence on them. And once it has secured its dominant position, will it charge more for its products? Will it continue to innovate?

Public Policy Toward Monopoly

Pulling together what we have learned in this chapter on monopoly and previously on perfect competition,  Table 10.1 "Characteristics of Perfect Competition and Monopoly"  summarizes the differences between the models of perfect competition and monopoly. Most importantly we note that whereas the perfectly competitive firm is a price taker, the monopoly firm is a price setter. Because of this difference, we can object to monopoly on grounds of economic efficiency; monopolies produce too little and charge too much. Also, the high price and persistent profits strike many as inequitable. Others may simply see monopoly as an unacceptable concentration of power.

Table 10.1 Characteristics of Perfect Competition and Monopoly

Characteristic or Event	Perfect Competition	Monopoly
Market	Large number of sellers and buyers producing a homogeneous good or service, easy entry.	Large number of buyers, one seller. Entry is blocked.
Demand and marginal revenue curves	The firm’s demand and marginal revenue curve is a horizontal line at the market price.	The firm faces the market demand curve; marginal revenue is below market demand.
Price	Determined by demand and supply; each firm is a price taker. Price equals marginal cost.	The monopoly firm determines price; it is a price setter. Price is greater than marginal cost.
Profit maximization	Firms produce where marginal cost equals marginal revenue	Firms produce where marginal cost equals marginal revenue and charge the corresponding price on the demand curve.
Profit	Entry forces economic profit to zero in the long run.	Because entry is blocked, a monopoly firm can sustain an economic profit in the long run.
Efficiency	The equilibrium solution is efficient because price equals marginal cost.	The equilibrium solution is inefficient because price is greater than marginal cost.

Public policy toward monopoly generally recognizes two important dimensions of the monopoly problem. On the one hand, the combining of competing firms into a monopoly creates an inefficient and, to many, inequitable solution. On the other hand, some industries are characterized as natural monopolies; production by a single firm allows economies of scale that result in lower costs.

The combining of competing firms into a monopoly firm or unfairly driving competitors out of business is generally forbidden in the United States. Regulatory efforts to prevent monopoly fall under the purview of the nation’s antitrust laws, discussed in more detail in a later chapter.

At the same time, we must be careful to avoid the mistake of simply assuming that competition is the alternative to monopoly, that every monopoly can and should be replaced by a competitive market. One key source of monopoly power, after all, is economies of scale. In the case of natural monopoly, the alternative to a single firm is many small, high-cost producers. We may not like having only one local provider of water, but we might like even less having dozens of providers whose costs—and prices—are higher. Where monopolies exist because economies of scale prevail over the entire range of market demand, they may serve a useful economic role. We might want to regulate their production and pricing choices, but we may not want to give up their cost advantages.

Where a natural monopoly exists, the price charged by the firm and other aspects of its behavior may be subject to regulation. Water or natural gas, for example, are often distributed by a public utility—a monopoly firm—at prices regulated by a state or local government agency. Typically, such agencies seek to force the firm to charge lower prices, and to make less profit, than it would otherwise seek.

Although economists are hesitant to levy blanket condemnations of monopoly, they are generally sharply critical of monopoly power where no rationale for it exists. When firms have substantial monopoly power only as the result of government policies that block entry, there may be little defense for their monopoly positions.

Public policy toward monopoly aims generally to strike the balance implied by economic analysis. Where rationales exist, as in the case of natural monopoly, monopolies are permitted—and their prices are regulated. In other cases, monopoly is prohibited outright. Societies are likely to at least consider taking action of some kind against monopolies unless they appear to offer cost or other technological advantages.

The Fragility of Monopoly Power

An important factor in thinking about public policy toward monopoly is to recognize that monopoly power can be a fleeting thing. Firms constantly seek out the market power that monopoly offers. When conditions are right to achieve this power, firms that succeed in carving out monopoly positions enjoy substantial profits. But the potential for high profits invites continuing attempts to break down the barriers to entry that insulate monopolies from competition.

Technological change and the pursuit of profits chip away constantly at the entrenched power of monopolies. Breathtaking technological change has occurred in the telecommunications industry. Catalog companies are challenging the monopoly positions of some retailers; internet booksellers and online textbook companies such as gone.2012books.lardbucket.org are challenging the monopoly power of your university’s bookstore; and Federal Express, UPS, and other companies are taking on the U.S. Postal Service. The assaults on monopoly power are continuous. Thus, even the monopoly firm must be on the lookout for potential competitors.

Potential rivals are always beating at the door and thereby making the monopoly’s fragile market contestable—that is, open to entry, at least in the sense of rival firms producing “close enough,” if not perfect, substitutes—close enough that they might eliminate the firm’s monopoly power.

Key Takeaways

· A monopoly firm produces an output that is less than the efficient level. The result is a deadweight loss to society, given by the area between the demand and marginal cost curves over the range of output between the output chosen by the monopoly firm and the efficient output.

· The higher price charged by the monopoly firm compared to the perfectly competitive firm reduces consumer surplus, part of which is transferred to the monopolist. This transfer generates an equity issue.

· The monopoly firm’s market power reduces consumers’ choices and may result in higher prices, but there may be advantages to monopoly as well, such as economies of scale and technological innovations encouraged by the patent system.

· Public policy toward monopoly consists of antitrust laws and regulation of natural monopolies.

· Forces that limit the power of monopoly firms are the constant effort by other firms to capture some of the monopoly firm’s profits and technological change that erodes monopoly power.

Try It!

Does the statement below better describe a firm operating in a perfectly competitive market or a firm that is a monopoly?

1. The demand curve faced by the firm is downward-sloping.

2. The demand curve and the marginal revenue curves are the same.

3. Entry and exit are relatively difficult.

4. The firm is likely to be concerned about antitrust laws.

5. Consumer surplus would be increased if the firm produced more output.

Case in Point: Technological Change, Public Policy, and Competition in Telecommunications

Back in the olden days—before 1984—to use a telephone in the United States almost certainly meant being a customer of AT&T. Ma Bell, as the company was known, provided local and long-distance service to virtually every U.S. household. AT&T was clearly a monopoly.

The Justice Department began its battle with AT&T in the 1970s, charging it with monopolizing the industry. The case culminated in a landmark 1984 ruling that broke the company up into seven so-called “Baby Bells” that would provide local telephone service. AT&T would continue to provide long-distance service.

In effect, the ruling replaced a single national monopoly with seven regional monopolies in local telephone service. AT&T maintained its monopoly position in long-distance service—for a while. The turmoil that has followed illustrates the fragility of monopoly power.

Technological developments in the industry have brought dramatic changes. Companies found ways to challenge AT&T’s monopoly position in long-distance telephone service. Cable operators sprang up, typically developing monopoly power over the provision of cable television in their regional markets, but also offering phone service. Mobile phone service, provided by AT&T, and others such as Verizon and Sprint, has led many consumers to do without land-line phone service entirely. Companies that had traditionally been telephone companies have begun providing cable services as well as Internet access. The ready availability of video services on the Internet threatens to make cable providers outmoded middlemen.

What is the status of AT&T today? While no longer a monopoly, it is a major player in all of the areas related to telecommunications and larger than all of its competitors in the United States. In 2011, it began the process of buying T-Mobile USA, a mobile service provider focused on the youth market. By the end of that year, however, in the face of strong opposition from the Department of Justice and the Federal Communications Commission on the grounds that the merger would stifle competition in the industry, AT&T announced that it was dropping the deal. Does AT&T have market power today? Undoubtedly. Is it a monopoly? Not anymore.