Notes on Competition and Monopoly (ECON 262)

COMPETITION -- Economists don't agree on how we should look at competition in an industry.  So we will look at two different theories and you can make up your own mind.

But first - some definitions (and please -- forget the definitions you have learned elsewhere):

Monopoly:

Oligopoly:

Duopoly:

Monopsony:

Economists don't agree on how to look at competition.  Therefore, I will give you an abbreviated version of the old view (which textbooks tend to hold on to).  We will discuss the better view (in my opinion) in more detail.

The Old View:  The Structuralist View of Competition

Became popular in the 1930s.  Competition is defined by the structure of the industry (number and size of firms).  The ideal situation (and most competitive) is an industry with many small firms -- known as the model of perfect competition.  This model assumes that all firms are small, there are a lot of them, all firms sell the exact same good and it is costless to exit or enter an industry.  Each individual firm has no say on what price it charges -- simply has to just take the price that is determined by supply and demand in the market.

Basically: The Structure leads to the Conduct (what price is charged, how much is produced, etc.) which leads to the Performance (are the firms in the industry efficient or not). 

By definition a monopoly is anti-competitive under this view.  An oligopoly is also considered much less competitive than many small firms.

Barriers to Entry:    If an industry is making economic profit and entry does not occur -- this model assumes there is a barrier to entry.  The important barriers to entry (constraint that keeps firms from entering an industry) in this view are: 

capital costs,

advertising,

economies of scale,

legal barriers to entry.

Policy Implications of this View:

The Anti-trust laws are based upon the structuralist view.  The idea is to make firms smaller by breaking them up, or not allowing firms to get larger (keep firms from merging with other firms for example).  The law is trying to force industries to look like the "ideal world of perfect competition." 

Some Examples of Antitrust Laws - Some Major Ones

1890 - Sherman Act - Special Interest Legislation

    Section I:  "Every contract, . . . in restraint of trade or commerce . . . is hereby declared to be illegal."

    Section II:  "Every person who shall monopolize, or attempt to monopolize, or combine or conspire 

    with any other person or persons, to monopolize any part of the trade or commerce  . . . shall be 

    deemed guilty of a felony."

1914 - Clayton Act 

1936 - Robinson-Patman Act

1950 - Celler-Kefauver Act

The More Contemporary (and Realistic) View:  The Process View of Competition

Under this view there are two parts to the definition of competition:

(1)  rivalry or rivalrous behavior:

(What are the people in the firm doing?  Are they trying to improve?  Trying to gain customers by creating better quality products at lower prices?  - It is the behavior that matters.)

and

(2)  discovery procedure or process:

in the act of competing we learn what is competitive and what is not competitive (via F. A. Hayek).  But we must compete to find out.  No one can ever know what structure any particular industry should have -- the structure will emerge as firms try new ways of competing and see what works and what does not work.  Looking at a structure at any given time is not relevant, because OVER TIME the industry will change and the profits and losses of different firms will change.  Large profits in an industry for an extended period of time is not necessarily anything to worry about -- those profits will generate competitive behavior through time.

The structure of the industry, therefore, is not important unless it in some way affects rivalry or the behavior of the firms.  We then ask, what rules increase rivalry and what rules hamper rivalry?  

Barriers to Entry under this View:

The only relevant barriers to entry under this view are legal barriers to entry (government granting of a public franchise, license, patent, copyrights, or regulations such as tariffs and quotas).  Under this view a monopolist can be competitive -- but only if there is potential entry.  The only barriers to entry that keep firms from entering a profitable industry OVER TIME are legal barriers to entry.  Therefore, the only monopolies worth worrying about are those created by legal barriers to entry (for example the taxi situation in NYC or the US Post Office or tariffs).

Efficiency:

Efficiency under this view is simply what works at any given time.... and we can never know if a firm is being (perfectly) allocatively efficient or productively efficient -- therefore, those are impossible standards to use in deciding government policy.  The managers/owners of a firm at any time never really know if they are being the most efficient they could be -- all they can do is try something and see if profit goes up or down (which tells them relative efficiency with respect to the value they are creating for consumers). 

In any case each individual manager/owner of a firm is in a better position to ascertain what works and what does not work than some abstract theory that defines efficiency based upon the owners (and economists and government officials) having perfect knowledge.

Structure Does NOT determine Performance:

The Performance of the firms in the industry is based upon what individual owners want (did they make money or did they achieve other goals the owners of the firm might have or not).  In other words, is the business owner satisfied with his or her return relative to their opportunity cost?  The answer to this then will determine the Conduct (or continuing conduct) of the owners - which then influences the Structure (which changes through time).

Policy Implications of this View:

Under this view the Antitrust laws are actually anti-competitive.   Instead of using their resources to try to come up with something that will please consumers more than their more successful competitor(s), firms are using resources to encourage the Justice Dept. or the Federal Trade Commission to prosecute their more successful competitors.  Not only is there a waste in the opportunity cost of these resources used in lobbying, but also the consumers are the one's who are ultimately hurt.  Instead of getting better products, they get higher tax bills.  In other words, less profitable firms are trying to eliminate their more profitable competitors not by producing something better, but by having the government remove the competitor.

DO ICE SIXTEEN

Cartels and Collusion

A cartel is a group of firms (or sometimes individuals or governments) acting together to raise price and (sometimes) limit output in order to increase economic profit.  (Note:  are labor unions cartels?).

Similar to monopolies, cartels are rarely very successful over time without the help of government (labor unions, for example) or violence (drug cartels, for example).  Economic theory can explain why.

Cartels are usually assumed to take place in markets characterized by an oligopoly and sometimes even by a duopoly.

According to economists - for a cartel to even begin to be successful, certain criteria must be met.  The book mentions four - I want to add one more:

1.

2.

3.

4.

5. 

But even if these criteria are met - there are still two problems cartels face (which is why cartels are very rarely successful through time without the help of government) :

1.  The first problem is that the members of all cartels will have an incentive to cheat.  This is the main reason why we don't see many successful cartels.  Once the members begin cheating (lowering price or expanding output for example), the cartel falls apart.  We will go into this in detail later.

2.  There is a second problem.  Other firms will now have an incentive to enter the industry once the cartel is formed. When this happens, again, the cartel breaks down as new competitors pull customers away.

Game Theory Applied to a Cartel

A good way to explain the incentive for cartel members to cheat is through what is called game theory (a tool that some economists sometimes use to analyze strategic behavior -- where the players take into consideration the expected behavior of others).  It's application to real world issues is questionable - but in the issue of a cartel it might help understand the behavior of cartel members.

    All "games" share three features:  rules, strategies, and payoffs (how useful this is in the real world is questionable - but perhaps one of the few places it might help explain human action - to an extent - is in the case of cartels).

John Nash - pointed out (1951) that Adam Smith was right, people act in their own self interest.  But he added that people act in their own self interest while taking into consideration what they think others will do (who are, of course, also acting in their own self interest).

    Good example:  the prisoners' dilemma:  Two prisoners, Bob and Betty are questioned about a crime the police think they have committed.  They are put in separate rooms and given terms to either confessing or not confessing (depending upon what the other does).  The payoff matrix:

For both players the incentive is to confess (given the action of the other player).  There is both a defensive reason to confess and an offensive reason to confess.  Take Betty for example:  if she doesn't confess but Bob does, she gets 10 years (defensive reason to confess).  On the other hand, if she confesses and Bob doesn't, she only gets one year (offensive reason to confess).  It's the same situation for Bob.  They both confess!  

Not the best outcome for them -- if they both deny the crime, they are both better off.  But without communication, they are in a dilemma and they end up confessing (most of the time).

Basic Game Theory Applied To A Cartel -- or "Why Cartel Members Cheat":

    Two companies attempt to form a cartel and agree upon a price and output level.  Cheating on the agreement would mean lowering their price or increasing their output level or both.

Again, both have a defensive and an offensive reason to cheat!  They end up back to competing with each other (both cheating on the agreement). 

Offensive Reason To Cheat: 

Defensive Reason To Cheat:

Therefore, as Nash demonstrated, competition between firms, not collusion, is the norm.  The "Nash Equilibrium" is the square where both cheat.

DO ICE SEVENTEEN