### Principles of Economics

```Principles of Economics
Imperfect competition:
Monopoly, Oligopoly and
Monopolistic competition
Perfect competition on a product
market
Perfect competition
Imperfect competition
Demand
Horizontal (p = constant)
Downward sloping (p(q))
Product
Homogeneous
Heterogeneous
Information
Perfect
Imperfect
Profit
Zero profit
Extra profit
Number of sellers
Many
One or few
Price formation
Price takers
Price makers
•Smaller total surplus of the economy
•Smaller quantity on the market
•Technological progress (Schumpeter says innovations overpower
negative effect of smaller total surplus – SCHUMPETER HYPOTHESIS)
•Economies of scale
Market power
• Market power is analyzed using several
indicators:
1. Share of 4 biggest companies on the market
2. Share of 8 biggest companies on the market
3. Herfindahl-Hirschmann index:
HHI  S  S  ...  S   S
n
2
1
2
2
2
n
2
i
i 1
0  HHI  10000
Where S is a percentage share of each company on
the market. In monopoly HHI = 10000, in perfect
competition 0.
• Imperfect competition causes total surplus
decline – DEAD WEIGHT LOSS – it is a
difference between total surplus in perfect
competition (p = MC) and imperfect
equilibrium (MR = MC)
Monopoly
Properties:
• 1 seller, no substitutes.
• Monopolist can change price.
• There are barriers for entry (patents,
• In perfect competition demand is horizontal (p
= MR), in monopoly demand is falling (MR < p)
• Monopolist maximizes profit: MC = MR < p
(in real life p = AC + margin
P
MC
M
AC
DWL
MR
0
P = AR
Q
•
•
•
•
Total revenue (TR) and marginal
revenue (MR)
TR = p×q
AR = p×q/q = p
MR = ΔTR/ Δq
When demand is falling TR
has bell-like form
• TR reaches its maximum
when │Ed│ = 1
• Note that MR and demand
are not the same curve as
in perfect competition
P
│Ed │ = 1
TR
MR
0 │Ed │ > 1
elastic
p = AR
│Ed │ < 1
inelastic
Q
Exercise 1
• Total cost function of a company is TC=40+2Q
and demand function is P=10-0,1Q. If TC=120,
what is the monopolist’s profit?
•
•
•
•
•
•
TC=40+2Q
120=40+2Q
Q=40
P=10-0,1Q=10-0,1*40=6
Π=TR-TC=P*Q-TC=240-(40+2*40)
Π=240-120=120
• Demand function is Q=200-10P. Marginal
revenue is MR=20-0.2Q, average costs are
AC=0,05Q+5+225/Q and marginal costs
MC=5+0,1Q. Find optimum price, production
and profit of this monopolist.
• MR=MC
• 20-0,2Q=5+0,1Q
• Q=50
• Q=200-10P
• P=15
• Π=TR-TC=P*Q-AC*Q=15*50(0,05*50+5+225/50)*50=750-600=150
Exercise 3
• Demand is p = 32 – 2q. Find total revenue
function. When it reaches its maximum?
• TR = (32 – 2q)q = -2q2 +32q
• TR is at its maximum when Ed = -1, which is
exactly at the half-point of a linear demand:
32 – 2q = 0
Q = 16, half-point: q = 8
TR(8) = -128 + 256 = 128
Oligopoly
• Oligopoly is a market structure where there are only few
• Demand is falling
• Sellers can affect price, but les than monopolist. This
interaction is analyzed using game theory
• Oligopolist used to compete with prices, today with
promotion and differentiation
• Pure oligopolies (homogeneous product) and differentiated
oligopolies
• Duopoly: the simplest oligopoly (only two players)
• Price is greater than in perfect competition, smaller than
monopolistic price
Game theory
•
•
•
•
Players choose between options
Depending on decision of others they have different outcomes (profits)
John Nash won a Nobel prize for analysis of game theory
Nash Equilibrium: nobody can improve its position without change in the
opponents decision
• Dominant strategy: a company chooses 1 option no matter what the other
does
• Maximin strategy: traditional (risk averse) strategy
• Simultaneous or sequential games
Company B
Cheap product
Company A
Cheap
product
Quality
product
Quality product
100
100
350
300
320
400
50
50
Maximin strategy: (100, 100)
Nash equilibria: blue
No dominant strategy
If A has advantage: (400, 100)
If B has advantage: (300, 350)
Cooperative strategy: (300, 350)
Exercise 4
• Air transport compaines’ shares in the USA in 1986 are
given with the following table:
Company
United
American
Delta
Eastern
Northwest
TWA
Pan Am
Other
Market share
17
14
12
12
9
8
7
21
a) Find C4 concentration ratio.
b) Find HHI indeks (be careful – “the others” should not be put into
the index)
a)
• C4 = P1+P2+P3+P4
• Shares should be sorted from biggest to
smallest!
• C4 = 17 + 14 + 12 + 12
• C4 = 55%
• Four major air transport companies account
for 55% of the American airlines market.
b)
• HHI = P12 + P22 + … Pn2
• HHI = 172+152+122+122+92+82+72
• HHI = 967 out of 10000
=> Low concentration
Monopolistic competition
• Many sellers, no barriers for entry
• Differentiated product
• In the short run companies behave like
monopolists and earn extra profit
• In the long run newcomers offer substitutes
=> demand declines, profits fall to zero (p =
AC)
Short run equilibrium in monopolistic
competition
P
• Equilibrium similar to monopolistic
(MR = MC)
• Extra profit (grey).
MC
M
AC
DWL
MR
0
P = AR
Q
Long run equilibrium in monopolistic
competition
P
• In the long run demand becomes more
elastic because of the new companies
• MR = MC, P = AC (no profit)
MC
AC
DWL
MR
0
P = AR
Q
Exercise 5
• Monopolistically competitive company
maximizes profit at TR=40 Its marginal
revenue is MR=10 and MC=6+0.5Q. If it
maximizes profit, what is the optimal price,
quantity and MC? If it is a long-run
equilibrium what is the value of total cost?
(note: TC = TR in the long run in monopolistic
competition)
•
•
•
•
•
•
•
MR=MC
10=6+0,5Q
Q=8
TR=P*Q
40=P*8
P=5
TC = 40 since in the long run profits are zero
Risk and uncertainty
• Speculation is the activity of moving goods
from places and times of abundancy to places
and times of scarcity
• Speculation improves alocation and brings
markets to equilibrium
• Arbitrage is the activity of simulatenous
purchase on one market and sale on the other
(riskless speculation)
• Hedging is a process of risk neutralization
• Person is RISK AVERSE if loss displeasure is
stronger than gain pleasure
• Person is RISK FRIENDLY if gain pleasure is
stronger than loss displeasure
• Person is RISK NEUTRAL if it regards gains as
positive as losses negative.
• Insurance spreads risk among many insurance
contractees (moral hazard – insurance fraud)
Exercise 6
Discuss individuals’ position towards risk:
• Agatha would pay 1000\$ for the insurance from
loss of 10000\$ that occurs in 5% of the cases.
• Ben would pay no more than 1000\$ for the
insurance from loss of 10000\$ that occurs in 20%
of the cases.
• Max would pay 1000\$ for the insurance from loss
of 10000\$ that occurs in 10% of the cases.
• Agatha: averse, Ben: friendly, Max: neutral
```