Abstract
This chapter discusses real-world competition in product markets. It distinguishes flexible-prices markets from administered-prices markets; it argues that manufacturing firms mostly adopt full-cost pricing, which is associated with planned spare capacity; it discusses the determinants of spare capacity and concludes that capacity utilization is highly variable, which requires a reformulation of cost curves, and has important macroeconomic implications. The determination of desired capacity brings to discuss the determinants of the investment decisions of firms, and some widely accepted theories on this issue, in particular adjustment costs, are found unacceptable. Then the chapter passes to the theory of monopoly, which is straightforward although monopolies often do not exploit all their power in order not to incur sanctions by antitrust authorities (for space reasons the extensions of monopoly theory to discrimination and natural monopolies are in the online Appendix to the chapter). On oligopoly, all the standard oligopoly models are presented, including the Bertrand-Edgeworth model which produces no equilibrium; the game-theoretic interpretation of both the Cournot and the Bertrand model is found objectionable; monopolistic competition s compared with full-cost pricing; price matching is found a plausible hypothesis, with its consequence the kinked demand curve. Repeated interaction, cartels, and folk theorems are also discussed. The indeterminateness of oligopoly theory is greatly reduced by actual or potential free entry, which is argued to be extremely relevant because competition is more active than one might think even in markets with few firms and differentiated products. The online Appendix includes: a section on discrimination, patents, and natural monopolies; the proof that the Bertrand equilibrium is the same even admitting mixed strategies; a section on advertising and the Dorfman-Steiner model; and a presentation of the Cournot-Bertrand model by Kreps and Scheinkman, with a discussion of proportional versus efficient rationing.
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Notes
- 1.
On how product markets actually work there is an enormous mass of empirical studies, surveyed in Industrial Organization textbooks; the wealth of acute observations and illustrative examples of these textbooks cannot be reproduced here. Some of the old textbooks, for example the one by Scherer, are particularly rich of enlightening examples. The underestimation of the importance of full-cost pricing in these textbooks can be corrected by reading F. Lee, Post-Keynesian price theory.
- 2.
I acknowledge here the influence of Robinson and Eatwell (1973, pp. 148–58).
- 3.
A ‘market day’ must be intended as the time stretch over which supply is fixed, therefore it may mean a whole month or even a longer period for seasonal agricultural products.
- 4.
In some agricultural productions that use tractors, mechanical mowers and other big machinery, minimum efficient scale is kept small by the possibility to rent these machines, rather than having to buy them.
- 5.
Scope economies are the reductions in average cost obtained by enlarging the range of products produced by the same firm (or conglomerate). For example, reputation of high quality acquired through one product can help sales of other products by the same firm, reducing marketing expenses.
- 6.
See Gandolfo (1971, Ch. 5, Sect. 3 and Ch. 7, Sect. 2) for some mathematical dynamical models of inventory adjustment. As nearly always with dynamical systems, stability is not always guaranteed, but for these models stability is very plausible.
- 7.
I am assuming that bread is a non-basic whose price does not influence the prices of its inputs.
- 8.
Remember from the proof of (2.37) that (xk−1 + xk−2 + … + 1) = (xk–1)/(x–1); setting (1 + R) = x the inequality k \(\frac{{R(1 + R)^{t} }}{{(1 + R)^{t} - 1}}\) > (1 + R) can be written k \(\frac{{x^{t} }}{{x^{t - 1} + x^{t - 2} + ... + 1}}\) > x, which is proved for x > 1 and k > 1 by multiplying both sides by the denominator of the fraction on the left-hand side.
- 9.
Kurz (1990) shows that re-switching is possible among techniques that differ in the number of shifts adopted in one industry.
- 10.
But Shaikh complicates things by assuming labour efficiency changes depending on how many hours a shift lasts, plus other special assumptions, so his analysis is not easy to follow.
- 11.
Overhead labour is the amount of labour that, once the productive capacity (fixed plant) of the firm is chosen, is independent of output; its wages are therefore a fixed cost as long as the firm is active (a quasi-fixed cost, in standard microeconomics terminology).
- 12.
Shaikh’s treatment is more complicated because it assumes a labour efficiency that varies with the number of hours worked by a worker; but this aspect disappears if, as assumed here, all workers work the same number of hours, a full shift, and what changes with output is their number, proportional to the number of activated machines.
- 13.
In the case of shops which close down because of too few sales outside normal hours, the output is sales, so outside normal hours there is a lower productive efficiency because the same inputs produce fewer sales.
- 14.
Of course other possibilities exist, e.g. a single-shift method plus some overtime.
- 15.
Cf. e.g. Hay and Morris (1991), p. 54.
- 16.
The separation between macroeconomics and microeconomics must be reconsidered if one adopts a classical-Keynesian approach, as argued in the Preface of this book.
- 17.
- 18.
Keynes seems not to have been clear about the impossibility to assume a given schedule of the marginal product of capital if labour employment is not given. This emerges in Chapter 14 of The General Theory (Keynes 1936–1967, pp. 178–180), where Keynes treats the demand curve for capital as given, unaffected by changes of the rate of interest, in spite of admitting that the latter changes affect the level of aggregate income, and hence labour employment, which affects the marginal product of capital.
- 19.
Thus the rising supply price argument was dismissed as implausible by Kalecki (1937).
- 20.
And the possibility of reverse capital deepening shows that the influence of the interest rate on adopted methods offers no guarantee that a lower interest rate will induce a rise of normal value capital per unit of net output.
- 21.
Even traditional neoclassical capital-labour substitution is considerably weakened by taking desired productive capacity as given, rather than labour employment. In Fig. 12.2 if labour employment is given at L1, the change in desired K/L ratio from α to β raises demand for capital from K1 to K3; if what is given is desired productive capacity (so that firms move along a given isoquant), the demand for capital rises only to K2. Also, a lower real wage induces a lower desired K/L ratio in new plants, hence less investment; see Petri (2013, 2015).
- 22.
A good introduction to the argument is Ackley (1978, Ch. 8 and Ch. 19).
- 23.
Thus R. E. Hall (1993, pp. 278–9): ‘established models are unhelpful in understanding this [1990–91] recession, and probably most of its predecessors….In spite of low interest rates, firms cut all forms of investment….Little of this falls into the type of behavior predicted by neoclassical models.’ Chatelain and Tiomo (2003, p. 195): ‘… empirical estimates of the sensitivity of investment to cost of capital measures are very low and range from zero to 0.15 … In fact, as is well known and indeed very well explained by Chirinko et al. (1999), one of the difficulties found in the empirical analysis of the relationship between investment and the user cost is that these estimates usually turn out to be very low.’. Sharpe and Suarez (2014) on the basis of the Global Business Outlook Survey, that reviews opinions of entrepreneurs and managers on the influence of the interest rate on investment, conclude that there is nearly no influence, only some limited discouragement of investment when the interest rate rises. Khotari et al. (2014) perform a panel analysis of aggregate investment of US firms from 1952 to 2010 and conclude that there is no relationship between interest rates and investment. And there seems to have been no visible stimulus to investment in the euro area coming from the considerable reduction in the European Central Bank’s rate of interest in recent years.
- 24.
Profit of enterprise is the minimum such excess of revenue over costs inclusive of interest; it will generally differ depending on the field of investment, since risk, possibility of innovations, obsolescence, changes of laws etc. are not the same in all industries.
- 25.
The same rise would happen to the rentals of lands, if land is admitted.
- 26.
This indeterminacy problem arose because of a view of the whole of ‘capital’ as ‘putty’, easily re-adaptable to a different capital-labour ratio; the traditional neoclassical approach explained in Chap. 7 and briefly remembered in Sect. 12.8.1 implicitly took care of this problem, by admitting a putty-clay nature of capital, and a possibility to change the capital-labour ratio only in the new plants re-employing the flow of labour ‘freed’ by the gradual closure of the oldest plants. But this was not clearly perceived: at the time of Keynes’s General Theory and in the following decades there was great confusion and approximation in the treatment of capital; and anyway even if the traditional neoclassical approach had been well understood, it could hardly be advocated: the continuous full employment of labour was impossible to assume after the Great Crisis of the 1930s and after Keynes.
- 27.
As noticed for example by Kalecki (1937), who argued that replication of plants (including hired managers) is always possible, so firms have constant returns to scale, and then a price-taking firm with even only one project with an expected rate of return (net of profit of enterprise) greater than the rate of interest would plan to replicate the project indefinitely, that is, would plan an infinite investment, unless some extra cost prevents it. Kalecki found the solution in the ‘principle of increasing risk’, discussed later.
- 28.
Up to the optimal dimension if the latter exists, or otherwise indefinitely.
- 29.
The reasons for these costs and for their more-than-proportional increment have been found unpersuasive by many commentators. It is not clear why building two new plants, each one with the needed supervising expert managers to follow the operation, should cost more than twice the cost of starting only one new plant: the usual possibility of discounts associated with bigger orders would rather suggest the opposite. For further comments and for references see Petri (2004, pp. 277–280).
- 30.
For example Heijdra and van der Ploeg (2002) assume ‘that the prices of goods and labour … have no time index, because we assume that firms expect these to be constant over time’ (p. 40).
- 31.
The given number of firms is also assumed in the slightly different formulation of the adjustment costs approach in David Romer’s advanced macro textbook (see e.g. the 4th edition, 2012, Chap. 9, but the treatment is the same in the earlier editions), which tries to avoid the given-for-ever product price by assuming that the firm is part of an industry facing a decreasing demand curve. But the number of firms in the industry is given, and they are identical. In Romer’s treatment too (although the industry’s demand curve makes it less visible) prices and wages are unaffected by changes of the interest rate, see Petri (2015). The definition of ‘profit’ is also very peculiar and potentially misleading.
- 32.
In Chapter 1 it was argued that Marx too seems to have conceived of output in this way, as growing owing to the reinvestment of savings out of normal aggregate output, except for the interruptions due to crises.
- 33.
The admission of an influence both of capacity utilization, and of the profit rate, on the propensity to invest has given rise to a distinction between wage-led and profit-led growth, depending on whether a greater share of wages in aggregate income, and hence a higher multiplier, stimulates investment via its positive influence on aggregate demand more (wage-led) or less (profit-led) than the discouragement to investment due to the lower rate of profit. The extremely informative book by Lavoie (2014, pp. 375–7) reports empirical enquiries that suggest that nearly all nations are wage-led if one neglects the generally negative influence of higher wages on the trade balance, while a few (heavily dependent on exports) become profit-led when one admits the latter influence. This empirical evidence strongly supports the influence of aggregate demand on investment, and appears to belittle the influence of the rate of profit, since the profit-led nations appear to owe this character only to the influence of the wage level on exports and imports, which is again an aggregate-demand influence.
- 34.
The non-neoclassical framework prevents the applicability of the argument used in Sect. 12.7.4 to deny that a divergence of profit of enterprise from its normal level can be other than strictly temporary.
- 35.
Even activities classified as services generally have relevant fixed or quasi-fixed costs, for example rent to be paid for office space.
- 36.
Expenditure in R&D is not considered investment in national accounting, but it has every right to be considered as autonomous an expenditure as fixed investment, which is why occasionally I will call it ‘investment’.
- 37.
The main ones are monopolies, to be studied presently, and productions with nearly zero marginal cost and/or strong network effects, increasingly important because common in the Internet, briefly discussed at the end of the chapter.
- 38.
It will be explained below that this notion of normal price does not exactly correspond to the marginalist notion of long-period price although it seems to correspond well to the classical notion.
- 39.
The graph is from Koutsoyiannis (1975), pp. 272 and 275. Pages 256–282 of this textbook are highly recommended. Also see Elizabeth Brunner (1975); and Andrews (1949). These are attempts to complete and synthesize the views on industrial pricing developed by the Oxford Economists’ Research Group in the 1930s on the basis of interviews of managers, views famously expounded in Hall and Hitch (1939), also highly recommended. The stress on cross-entry in the main text is from Andrews. No discontinuity of marginal cost due to higher overtime wages appears in this graph (nor in the graphs in the other two papers), probably because the issue of time-specific labour costs and utilizability of overtime had not yet conquered general attention. For a more recent survey of the evidence on the prevalence of full-cost pricing cf. Lee (1998).
- 40.
This corresponds well to the idea of dominant method of production, which is the one that must appear in the ‘Sraffian’ matrix of technical coefficients that determines normal prices. The notion of long-period equilibrium of the industry, in the sense of a situation in which no firm has any more an incentive to change because they all have identical plants of the size that minimizes minimum average total cost among all plant dimensions, can then be dismissed as (i) indeterminable because the efficiency of plants of not yet experienced dimensions is not known, and (ii) anyway irrelevant because technology and preferences change too fast relative to the time required to approximate such an industry equilibrium. For this reason, Andrews and Brunner qualified their analysis as short-period; but the relevance of actual or potential entry in their analysis makes it a long-period one, albeit not in the neoclassical sense of complete adaptation of all firms in the industry.
- 41.
Predatory pricing is the lowering of price by a firm, which is costly to the firm and dictated only by the desire to push competitors to exit the market.
- 42.
‘Predatory’ conduct is condemned by antitrust law and juridical decisions, because aimed at reducing competition, but is an ambiguous notion. Consider the following effort to arrive at a clear definition: ‘Considerable care is required in an investigation of predatory conduct. For example, we must be careful not to characterize actions by a firm either to improve its cost-efficiency or to promote its product as predatory, even if such actions have the effect of enhancing the firm’s market position …. Economists define predatory conduct to be actions taken by a firm that are profitable only if they drive existing rivals out of the market or deter potential rivals from coming into the market. Predatory conduct is some costly action for which the only justification is the reduction in competition that such action is designed to achieve. If there is no cost to the firm to engage in some conduct, then that behaviour could simply be part of profit-maximizing strategy and, hence, not explicitly ‘anti-competitive’. To put it somewhat loosely, predatory conduct must appear on the surface to reduce the predator firm’s profit and seem to be ‘irrational’ (Pepall et al. 2005, pp. 266, 269). Now consider a firm with a cost advantage relative to competitors, which decides to undercut the price until then common, and there is a high chance that the competitors will match the price reduction. Relative to leaving price unaltered, the firm reduces its profit unless it enlarges its share of the market, which requires that some competitor exits and can be interpreted as a reduction in competition. So is this price reduction predatory? Plenty of leeway seems to be left for the judge to decide on the basis of personal opinion, or of money accruing to him/her on anonymous Swiss bank accounts.
- 43.
- 44.
Here too the given demand curve, sufficiently persistent for the monopolist to have been able to discover its position and slope, needs given and persistent consumer incomes, which requires given and persistent aggregate employment level and income distribution. A demand curve for a capital good is a much more complicated notion, not by chance seldom mentioned in neoclassical literature, because it requires specifying how a change in the price of a capital good affects technical choice and product price in the industries that use it, and then how these price changes affect demand for the products of these several industries: the partial-equilibrium methodology is inapplicable, because many other prices cannot be assumed nearly unaffected by changes in the price under study.
- 45.
If, as I assume, there is a p° such that q = 0 for p ≥ p°, then one avoids having to deal with correspondences by defining the inverse demand function as taking the sole value p° for q = 0.
- 46.
Exercise: Assume profit is maximized with respect to price, maxp π(p) = pq(p)–C(q(p)), and show this yields condition (12.1) again.
- 47.
With a demand function of constant elasticity for all values of p, when |ε| = 1 revenue is independent of output so the firm finds it convenient to minimize total cost by decreasing output indefinitely (price tends to + ∞) but at q = 0 revenue and profit jump discontinuously to zero, there is no maximum profit. Same problem with constant elasticity |ε| < 1, then marginal revenue is always negative. I have excluded these cases by assuming that p(0) exists.
- 48.
Here we have one example of the economists’ habit to refer to the absolute value of the elasticity of demand: a less elastic demand means a smaller |ε|.
- 49.
Simple proof: on both sides of q° average revenue (that is, price) is less than average cost, so total revenue and total cost do not cross. Both curves are assumed smooth, so they must be tangent at q°.
- 50.
Chamberlin avoided the term ‘industry’, preferring the term ‘group’, because of the traditional association of ‘industry’ with the production of a specified product. I think that ‘industry’ is still a useful notion, although more and more it must refer to connected products produced by multiproduct firms, e.g. generally toothpaste producers produce several types of toothpaste and also mouthwashes, toothbrushes, dental floss, shaving cream, aftershave lotions, etc.
- 51.
Or analogous increases in the marketing expenses of competitors if the product’s price is not decreased but advertising or other marketing expenses are raised.
- 52.
So full-cost pricing entails less inefficiency due to underutilization of capacity than monopolistic competition, because excess capacity is due to a search for production flexibility which helps the economy’s efficiency by making production capable of quick adaptation to demand variations.
- 53.
For example, two opera singers unanimously recognized as way superior to all others. Their agents can compete on how many performances per year to offer and at what price.
- 54.
Cournot actually assumed zero cost but this makes no essential difference.
- 55.
Actually this is the reaction function for 0 ≤ q2 ≤ (a − c)/b; it continues as q1 = 0 for q2 > (a − c)/b, where the condition q1∙dp(Q)/dQ + p(Q) = c cannot be satisfied for non-negative values of q1. Indeed the rigorous first-order condition is, qi∙dp(Q)/dQ + p(Q) ≤ c with equality if qi > 0.
- 56.
Exercise: prove that, if both firms have zero marginal cost and demand is linear, then the Cournot outcome corresponds to each firm supplying 1/3 of the demand that would be forthcoming at price zero.
- 57.
If the reaction function of firm 1 is entirely above the other, the Cournot equilibrium has q2 = 0, and q1 equal to the monopoly amount; but the two reaction functions, if continuous, have nonetheless a point in common, because firm 2’s reaction function continues upwards along the ordinate (i.e. with q2 = 0) as q1 increases beyond the level where q2 becomes zero, so the vertical intercept of firm 1’s reaction function is a point in common. The absence of a point in common requires a discontinuity. It has been proved, with numerical examples of general equilibria where the production side is a Cournot duopoly (Roberts and Sonnenschein 1977; Bonnisseau and Florig 2004), that there may be no Nash equilibrium even in mixed strategies.
- 58.
Careful: these isoprofit curves are in (q2, q1) space, differently from the isoprofit curves in Fig. 12.10 that are in (q1, p) space.
- 59.
If price is not a perfectly continuous variable, being only divisible down to a smallest unit ε (or if ε is the smallest price difference that induces buyers to prefer a supplier to other suppliers), then p1 = p2 = c + ε is another Nash equilibrium: if one firm charges c + ε, for the other it is not convenient to charge p = c because it would make zero profit; if one firm charges p = c the other firm is indifferent between charging p = c or p = c + ε, because if p1 = c and p2 = c + ε, firm 2 sells nothing and makes zero profit, but charging p2 = c would mean zero profit too; since there is a possibility that, for the same reason, firm 1 may charge p1 = c + ε, firm 2 finds it preferable to charge p2 = c + ε (it is a weakly dominant strategy); on the basis of the same reasoning, firm 1 too will charge the same price, hence, although p1 = p2 = c is also a Nash equilibrium, the Nash equilibrium that one can expect to be established is p1 = p2 = c + ε.
- 60.
Of course sometimes a firm does choose to start a price war, usually because it counts on winning it, and remaining for some time a monopolist, which will allow it to more than make up for the losses. Let me remember that predatory pricing is the name used for pricing at a level that would be unsustainable in the long run, in order to push competitors out of the market.
- 61.
I follow the presentation in Marrama (1968, p. 321).
- 62.
And steeper than the DDA curve if α > 1/2, which will be the case if the price of firm B is greater than P”.
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Petri, F. (2021). Product Markets: Pricing, Capacity, Investment, Imperfect Competition. In: Microeconomics for the Critical Mind. Classroom Companion: Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-62070-7_12
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