Copyright 1995, Froeb
With perfect competition, we learn that the forces of entry and the ability of firms to copy rivals eliminate long run profits. Without the possibility of making long run profits, how are business students going to get rich?
Fortunately, firms do earn profits in the short run, and can learn to do things to make the short run as long as possible, and learn to exploit any advantages you may have over your rivals. If a firm is able to earn economic profits for a long period of time then we say that it is a monopoly
Analytically, monopolies differ from perfectly competitive firms in that they face a downward sloping demand. Sometimes this is referred to as possessing market power, or monopoly power.
Perfectly competitive firms price according to the rule: price=marginal cost and earn zero long run economic profits; they can earn positive economic profits only in the short run.
Without a source of market power, a firm must compete on cost alone. Unless you have a cost advantage, this is not a very promising avenue to follow. By analogy to an auction, we know that if bidders have identical costs then they earn no profits in the auction.
Monopolies price according to the rule: (price-marginal cost)/price=1/|e|, and earn positive economic profits for a longer period of time than competitive firms.
Discussion Question: Does this mean that we can make money in the stock market by investing in monopolies?
It is mistaken to confuse "big" with "monopoly." Small firms are perhaps more likely to be monopolies than large ones. Ironically, before the Sherman Act in 1890, there were probably many more "local" and small monopolies than there were after the Sherman Act. It was only the advent of cheap transportation that allowed large companies to grow and market their products all over the country. For example, small countries without free trade are more likely to have monopolies, which are likely to be much smaller than competitive firms in the United States.
Bad Monopoliesare ones that should be competitive industries
Obviously, if you can get the monopoly to produce more, consumers would be better off: no unconsummated transactions. Following are examples of bad monopolies.
Good Monopoliesare firms that face downward sloping demand curves for a good reason Patents.
Note that patents, brands, good geographical locations, distribution systems, good management, or good products have all been called "entry barriers." I prefer to look at them as inherent advantages that give firms a downward sloping demand.
Other firms imitate the monopolist's product, or produce a close substitute, and this causes the monopolist's demand to become more elastic. As demand becomes more elastic, the markup of price over marginal cost decreases (i.e. price decreases): (price-marginal cost)/price= 1/|e|. If the markup is not big enough to allow the monopolist to recover fixed costs, then it goes out of business, or tries to create a new product that has a less elastic demand. Schumpeter called this the process of "creative destruction." Note that this is similar to the mechanism that drives long run competition in a competitive market.
Examples: Gummy Bears; RAM chips in the US; IBM PC's; Macintosh operating system.
When firms are are very close substitutes to one another, then it is naive to think that they would behave independently. They recognize their mutual dependence upon one another. This leads to "less competitive" outcomes than would occur had the firms not recognized their interdependence.
We have already studied such prisoner's dilemmas.
Change the structure of the game by making your product less sensitive to rival's prices. Be creative.
Communicate, but this violates section 1 of the Sherman Act. Often phone records are used in court as evidence that the firms were communicating with one another. "Wire fraud" is much easier to prove than price fixing.
Economist Axelrod ran a tournament among economists to see which strategy would win a repeated prisoners dilemma. He ran computer simulations to determine the winner. Tit-for-Tat was the winning strategy. Axelrod identified 5 factors that characterized successful strategies:
Develop a reputation for "punishing" aggressive rival behavior, i.e. following a rival's price cut, you price even lower. This is sometimes referred to as commitment and to study it we use what is called a decision tree, or the extensive form of a game (as opposed to the reduced forms above). Exensive form games allow you to analyze sequential move games, and games where one player is committed to following a certain strategy. To analyze these games, look ahead, and then reason back.
Here, firm 2 tells firm 1 that it will punish severely if firm 1 prices low. If firm 1 believes firm 2, the equilibrium is to both price high. The more severe the punishment, the less likely rivals will price low. However, the more severe the punishment, the less credible it is. What if you actually have to use it? If firm 1 does price low, then firm 2 would do better by not punishing firm 1, i.e. the threat is not credible.
It is possible to apply the same logic to entry deterring strategies. Here, if firm 1 believes that firm 2 will punish her if she enters, then the equilibrium is to not enter. But the punishment threat is not credible because if she did enter, then firm 2 would accommodate (not punish) her.