Chapter 15
REAL-WORLD
COMPETITION
AND
TECHNOLOGY
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-2
Today’s lecture will:
• Discuss the monitoring problem and its
implications for economics.
• Explain how corporate takeovers can limit Xinefficiency.
• Discuss why competition should be seen as a
process, not a state.
• Explain two actions firms take to break down
•
monopoly and three they take to protect
monopoly.
Discuss why oligopoly is the best market
structure for technological change.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-3
Short-Run versus
Long-Run Profits
• Firms care about both short-run and
•
•
long-run profit.
They must be profit maximizers in the
short run as well as the long run.
Any expenditures on good will and good
reputation can reduce short-run profits
but increase long-run profits.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-4
Executive Compensation
Are these salaries in the best interest of the firm?
Compensation in 2006
Company
(in millions)
Capital One Financial
$249.4
Yahoo
230.6
Cendant
140.0
KB Home
135.5
Lehman Brothers Holdings
122.7
Occidental Petroleum
80.7
Oracle
75.3
Symantec
71.8
Caremark Rx
70.0
Countrywide Financial
69.0
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-5
Need for Monitoring
• Managers have an incentive to keep costs
•
down, but their salaries are included in
costs. This creates a monitoring problem –
the need to oversee employees to ensure
that their actions are in the best interest of
the firm.
To address this problem, firms sometimes
give managers incentive-compatible
contracts in which the incentives of each of
the two parties to the contract are made to
correspond as closely as possible.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-6
True Cost Efficiency and
the Lazy Monopoly
Cost
per unit
MC
PM
CLM
ATC
(Producing
efficiently)
B
A
CM
0
McGraw-Hill/Irwin
ATC
(Producing
inefficiently)
MR
QM
D
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-7
How Competition Limits
the Lazy Monopolist
• New firms or international competition can
•
•
•
push lazy monopolies to be more competitive.
Corporate takeovers, or the threat of one, can
improve efficiency.
Corporate takeover – another firm issues a
tender offer to gain control and install its own
managers.
Nonprofit organizations may display lazy
monopolist tendencies.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-8
Fight between Competitive
and Monopolistic Forces
• Real-world competition is a fight
•
between the forces of
monopolization and the forces of
competition.
Self-interest-seeking individuals
don’t like competition for themselves
and may use political and social
means to fight competition.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-9
How Monopolistic Forces
Affect Perfect Competition
• Our laws, social values, and customs do not
•
•
allow perfect competition to work because our
government emphasizes other social goals
besides efficiency.
The Robinson-Patman Act and several state
laws prevent firms from charging a price that
is too low.
The U.S. has laws, regulations, and programs
that prevent agricultural markets from working
competitively.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-10
Movement Away from
Competitive Markets
S
PL
A
PM
B
C
D
0
McGraw-Hill/Irwin
L
M
If producers of OL can keep
producers of LM out of the
market, price increases to PL
and their profit increases by
A.
The suppliers kept out of the
market lose C in producer
surplus and consumers lose
B in consumer surplus.
Deadweight loss is B+C.
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-11
How Competitive Forces
Affect Monopoly
• Competitive forces work to break down
monopoly by
 Political or economic forces
Lobby to change the law protecting monopoly
Develop a similar product without violating a
patent
 Reverse engineering – buy another firm’s
product, disassemble it, study it, and copy it
within the limit of the law
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-12
Competition and
Natural Monopolies
• Natural monopolies can make large
•
•
profits because their average total
cost decreases as output increases.
To prevent abuse of their market
power, many natural monopolies are
regulated.
New technologies can compete with
and undermine natural monopolies.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-13
Regulating Natural
Monopolies
• Regulated natural monopolies have been
•
•
given the exclusive right to operate in the
industry.
In return, they are allowed to charge a fair
price, which includes all costs plus a
normal return on capital investment.
Regulation to allow regulated monopolies
to earn a normal profit means they can
pass all cost increases on to consumers.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-14
Deregulating Natural Monopolies
• Many formerly regulated natural monopolies
are being deregulated.
• In the 1980s and 1990s deregulation and
•
•
competitive supply of parts of both electric
and phone service grew.
In the electricity industry, power supply has
been deregulated, but because of the
existence of economies of scale, the power
line industry has remained a regulated
monopoly.
Only portions of industries which are likely to
be competitive are being deregulated.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-15
Cost-Benefit Analysis of Creating
and Maintaining Monopolies
• Firms will buy monopoly until the
•
marginal cost of maintaining the
monopoly equals the marginal benefit.
Firms protect their monopolies by:
 Advertising and lobbying
 Producing products as nearly unique as
possible
 Charging low prices
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-16
Establishing Market Position
• In winner-take-all markets, the initial
•
competition is on establishing
market position.
The winner who achieves a
monopoly can charge significantly
higher prices without facing any
competition.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-17
Technology, Efficiency, and
Market Structure
•
•
•
•
Technological development – the discovery of
new or improved products or methods of
production.
Because the global market is significantly larger
than a domestic one, globalization provides an
incentive to develop new technology.
Market structures that best promote
technological change are dynamically efficient.
Dynamic efficiency – the market’s ability to
promote technological change.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-18
Perfect Competition
and Technology
• Perfectly competitive firms have no
•
•
incentive to develop new
technologies.
They earn no profits to fund research.
Even if they did innovate, competitors
would gain from the new technology
without having to pay for it.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-19
Monopolistic Competition,
Monopoly, and Technology
• Monopolistic competition
 Because of market power, monopolistic

competition is more conducive to technological
change.
They lack long-run profits because of easy entry,
but their ability to recoup their investment is
limited.
• Monopoly
 Monopolists have profits but little incentive to
innovate since they are protected by barriers to
entry.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-20
Oligopoly and Technology
• Oligopoly is the market structure most
•
•
economists feel is most conducive to
technological change.
Because they receive ongoing economic
profit, oligopolists have the money to
carry out research and development.
The belief that its competitors are
innovating, forces them to do so as well.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-21
Network Externalities, Standards,
and Technological Lock-in
• Network externalities – greater use of
•
•
a product increases the benefit of
that product to everyone
Standards – a firm whose standard is
accepted dominates the market
Technological lock-in – prior use of a
technology makes the adoption of
subsequent technology difficult
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-22
Summary
• Profit is an important goal of firms, but
•
•
actual goals depend on the incentive
structure of the firm.
The monitoring problems arises
because managers’ incentives are not
always to maximize the firm’s profit.
Incentive-compatible contracts help
alleviate the monitoring problem.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-23
Summary
• Monopolists facing no competition can
•
•
•
become subject to X-inefficiency – operating
less efficiently than is technically possible.
X-inefficiency can be limited by the threat of
competition or takeovers.
Firms will spend money on monopolization
until the marginal cost equals the marginal
benefit.
Firms protect their monopolies by advertising,
lobbying, and producing products that are
difficult to copy.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-24
Summary
• Firms compete against patents that create
•
•
monopolies by making slight modifications to
existing patents and engaging in reverse
engineering.
The U.S. is deregulating the portions of
natural monopolies where competition is
feasible.
Oligopoly is the best market structure for
technological advance because oligopolists
have an incentive to innovate since they can
earn economic profits, which can also be
used to invest in research and development.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
15-25
Review Question 14-1 The electricity industry is a
natural monopoly which has been completely
deregulated. True or False?
False. Wholesale electricity supply has been
deregulated, but since there are significant economies
of scale in the power line industry, that portion has
remained a regulated natural monopoly.
Review Question 14-2 Why is oligopoly thought to be
the best market structure for technological advances?
Oligopolies have an incentive to invest in new
technologies because they are able to make economic
profits due to the new technology in the long run.
These profits can be used to fund research and
development of new technologies.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.