Feb 25

Monopolistic competition

The analysis of monopolies, oligopolies and perfect competition shows us that neither is real. Monopolies and oligopolies (when collusion exists) are illegal and considered as really harmful for the economy and consumer’s welfare. On the other hand, if perfect competition was real, firms would not make any profits, and therefore prices will be lower (yes, let’s face it: it does not take around 9 dollars to cook and serve a Big Mac menu). That’s where monopolistic competition comes in.

Monopolistic competition basically covers all the flaws in monopoly and perfect competition models. Edward Chamberlin and Joan Robinson can be considered as parents to this subject.

In this LP we’ll learn about:

“Competition”

Monopolistic competition, a quick definition;

Chamberlin’s model, which represent the economist’s view;

Characteristics demand, a theory by Kelvin Lancaster.

Differentiation

Product differentiation, or how to sell something different;

Linear city model, by economist Harold Hotelling;

Circular city model, by Steven C. Salop;

Shaked-Sutton model, which illustrate vertical differentiation.

Feb 24

Lope Gallego

Oligopoly II

In the previous Learning Path on oligopolies we learned what they are and what kinds of oligopolies exist. In this LP, we’ll learn about how oligopolists can collude in order to maximise their profits, even though this agreement will not likely last. Also, we’ll see what entry and exit barriers are, and how they affect the number of oligopolists in the market. Finally, we’ll also learn about contestable markets, which mean competitive results can also be reached in oligopolistic markets.

More precisely, in this LP we’ll learn about:

Cooperation:

Collusion, when two or more competitors agree to cooperate;

Folk theorem, indicates how likely the collusion is to last;

Repeated games, which analyses for how long it will last.

Stability:

Entry and exit barriers will determine the number of oligopolists in the market;

Contestable market, which explains why even oligopolies can reach perfect competition results.

Feb 20

Lope Gallego

Oligopoly I

The bigger a firm is, the more efficient. Therefore, bigger and fewer firms in the market should mean lower prices and more goods produced. However, as we can see everyday, this is not really the case, since firms can be greedy. In this first Learning Path on Oligopolies, we’ll see what oligopolies are, and how their behaviour affects the economy. We’ll also see what different types of duopolies there are, and which ones are best suited to analyse this kind of market structure.

In this LP, we’ll look at:

Basic definitions:

Oligopoly, when few firms have great power;

Duopoly, a market structure with only two firms.

Types of duopoly:

Cournot duopoly, the analysis of simultaneous duopolies;

Stackelberg duopoly, the analysis of sequential decision making;

Bertrand duopoly, which analyses price competition;

Edgeworth duopoly, which solved the Bertrand paradox.

Feb 19

Lope Gallego

Monopoly II

In the first Learning Path on monopolies, we learned about what they are, how they affect social welfare and we learned about a few types. In this second LP on monopolies, we’ll learn about a few more types, quite particular ones. We’ll learn about discriminating monopolies, how the implement different prices in order to extract all consumer surplus. We’ll also learn about natural monopolies, which are tricky since they are actually good for society.

In this LP we’ll learn about:

Discriminating monopolies:

Price discrimination, implemented by monopolies, can be either really harmful, or really sweet;

First degree price discrimination, really harmful, but quite impossible to implement;

Second degree price discrimination, it may hide an entrance fee in the form of discounts;

Third degree price discrimination, the good kind, takes the form of discounts to some people such as students;

Two-part tariff, which consist of an entrance fee and a price per unit.

Natural monopolies:

Subadditivity, the reason why natural monopolies exist;

Natural monopoly, which should not be regulated.

Feb 18

Lope Gallego

Monopoly I

Irving Fisher described monopolies as market structures where there is no competition. To neoclassical economists, a monopoly is the exact opposite to perfect competition. And an even simpler definition would be that a monopoly is just a market where there is only one seller. However, monopolies must be well understood, in order to understand why they are so harmful. In this Learning Path we’ll learn about monopolies, starting with a few basic definitions and starting to learn about a few types of monopolies.

Basic definitions:

Monopoly, the polar opposite to perfect competition;

Surplus, diminished for consumers, increased for the firm;

Lerner index, a good way to measure market power.

Types of monopolies:

Monopsony, not some kind of monopoly, but its opposite;

Bilateral monopoly, when a monopoly and monopsony meet;

Multiproduct monopoly, when monopolies produce multiple goods;

Multiplant monopoly, when monopolies produce in multiple plants.

Nov 5

Lope Gallego

C.9 Experience curve

Description

This video explains what the experience curve is. We start by learning how to build an experience curve, then we compare two companies competing with the same learning curve, and finally we analyse two particular scenarios.

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The experience curve (not to be confused with learning curve) is a graphical representation of the phenomenon explained in the mid-1960s by Bruce D. Henderson, founder of the Boston Consulting Group. It refers to the effect that firms learn from doing, which means that the higher the cumulative volume of production (X), the lower the direct cost per new unit produced (C). Therefore, the experience curve will be convex and have a downward slope.

There is a simple rationalisation behind all this: there is a reduction in the average cost of production of a particular product, as a consequence of an increase in the firm’s experience. The time and cost of producing a unit of output will be reduced, as learning economies, economies of scale, economies of scope, etc. appear due to the cumulative output increase and other process related growth. The difference between learning curves and experience curves is that learning curves only consider time of production (only in terms of labour costs), while experience curve is a broader phenomenon related to the total output of any function such as manufacturing, marketing, or distribution.

Some important implications arise from this curve. If direct costs decrease as the cumulative output increases, this will mean that firms that have been producing more and for a longer period, will have lower direct costs per unit and thus dominate the market.

Learn more by reading the dictionary entry.

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Nov 5

Lope Gallego

C.8 Learning curve

Description

This video explains what the learning curve is. We start by learning how to build a learning curve, and then we compare two companies competing with the same learning curve.

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The learning curve (not to be confused with experience curve) is a graphical representation of the phenomenon explained by Theodore P. Wright in his “Factors Affecting the Cost of Airplanes”, 1936. It refers to the effect that learning had on labour productivity in the aircraft industry, which translates into a relation between the cumulative number of units produced (X) and the average time (or labour cost) per unit (Y), which resulted in a convex downward slope.

There is a simple rationalisation behind all this: the more units produced by a given worker, the less time this same worker will need to produce the following units, because he will learn how to do it faster and better. Therefore, when a firm has higher cumulative volume of production, its time (or labour cost) per unit will be lower.

Some important implications arise from this curve. If the time (or labour cost) per unit decreases as the cumulative output increases, this will mean that firms that have been producing more and for a longer period, will have lower average time per unit and thus dominate the market.

Learn more by reading the dictionary entry.

Related videos:

Related articles:

Nov 5

Lope Gallego

C.7 Economies of scope

Description

This video explains what economies of scope are. We analyse how different production possibility frontiers show different types of economies (or diseconomies) of scope.

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The concept of economy of scope is very similar to that of economies of scale. When we talk about economies of scope, we mean that average costs are reduced by introducing another product into our portfolio that can share some of the infrastructure or know how, thus reducing overall average cost per product. It is essentially the same concept as economies of scale, but based on producing more than one product instead of producing more of the same one.

This can happen for various reasons. Firstly, because fixed costs do not increase proportionally with production but rather in stages, we can introduce a second production line that benefits from the common infrastructure whilst reducing average cost per unit.

We can also see a reduction in average variable costs. Employees can benefit from shared know how or from a certain skill set that can be transferred to a much wider range of products, raising productivity across the board. In this way, labour need not increase proportionally with production output, as it is the case for economies of scale. What we can also see here are skills being transferred from one production range to another, resulting in synergies that are unique to economies of scope instead of economies of scale.

Learn more by reading the dictionary entry.

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Nov 5

Lope Gallego

C.6 Subadditivity

Description

This video explains what subadditivity is. We start with economies of scale for one firm, and then analyse what happens when a second firm enters the market.

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Subadditivity is an important concept because it is often used to justify imperfect competition, the classic nemesis of neo-classicists. The only real way to justify less than perfect competition is the kind of sector that lends itself to natural monopolies. Natural monopolies are those where barriers to entry are so high that it is worth making the investment only once, and where one producer will operate more efficiently than two. Traditionally, natural monopolies are state-run, generally in energy or communication sectors, although current trends are leaning towards privatisation.

When a large investment is required in order to begin production, these costs must naturally be passed on to the consumer. What differentiates natural monopolies is that generally, once the investment is made, marginal costs are infinitely small. In these cases, if there is only one company in the market, prices for consumers may actually be lower than if there are rivals, because of the way average costs drop with additional users.

So what exactly is the difference between subadditivity and economies of scale? Subadditivity is a more generic concept which encompasses economies of scale. We say subadditivity exists when the costs function (including initial investment) for the sum of all units at a given level of production is actually smaller than the sum of the various cost functions (given multiple companies) at the same given level.

This is why subadditivity is considered a necessary but insufficient condition for a natural monopoly to be considered optimal, whereas if economies of scale exist, this is a sufficient but not necessary condition for a natural monopoly to be sustainable.

Learn more by reading the dictionary entry.

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Nov 5

Lope Gallego

C.5 Economies of scale

Description

This video explains how economies of scale affect production. We start by explaining how the average cost curve defines when economies of scale appear, and then analyse the difference between economies and diseconomies of scale.

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This economic phenomenon occurs when increasing output is translated into a decline of the firm’s average cost of production. Alfred Marshall was the first economist to distinguish economies of scale depending on their origin:

Internal economies of scale occur when something inside the firm makes the average cost of production lower:

Purchasing: buying raw materials in large quantities or big bulks brings better prices and discounts which allow average cost to be reduced.
Specialisation: covering all areas of management and work can be very difficult, however when operating on a large scale, workers can specialize in the activities in which they are best and more productive.
Flexibility: a more efficient production process can be achieved by managers when scale means that different arrangement of the inputs can be made. Better capital can be purchased by firms that have more money, increasing the quality of their products and/or reducing cost of production.

External economies of scale occur when something outside the business, but inside its industry, makes average cost of production lower. As the industry of the firm grows, more support may come from the suppliers’ side: more variety, more quality, more quantity, etc. Government may give extra aid if it considers that the industry has some special interest.

Learn more by reading the dictionary entry.

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