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Reminder: Homework #5 due this Friday. It includes left-over questions from Chapter 8 (from previous assignment, Homework 4) as well as three questions from Chapter 9 and a short "thought" question. Question 9 in Ch. 9 is difficult (but worthwhile). This week we focus on Chapter 9, forms of imperfect competition. My goal is to cover the main points in the text and also illustrate some points with examples from the real world--market manipulation during the California energy crisis and a case-study of the Coca Cola company. The most important thing to remember about imperfect competition is that it represents a more realistic picture of the economy, one in which firms have some discretion about the prices they charge and engage in strategic thinking about how other firms will react to their decision. This is very different from the the world of perfect competition, in which firms are simply price-takers. Let's start with some terms:
A recent example: , March 27, 2002 WASHINGTON, March 26. California electricity and natural gas prices were driven higher because of widespread manipulation and misconduct by Enron and more than 30 other energy companies during the 2000-2001 energy crisis that threatened the state's solvency, federal energy regulators said today. Despite those findings, the Federal Energy Regulatory Commission strongly signaled that it was likely to refuse to overturn any of the more than $40 billion in long-term power contracts that California and others on the West Coast signed at the height of the crisis. The state had agreed to the high-cost contracts as a means of bringing raging power prices under control, but state officials now say that pervasive evidence of price manipulation means the deals should be abrogated. At the same time, the commission today increased to $3.3 billion the refund it contends is owed to California to compensate for electricity overcharging. An administrative law judge had previously recommended $1.8 billion in refunds, but commission officials said manipulation of the prices paid for natural gas used to fuel many power plants in the state meant that the refund should be larger. Because the state still owes the power suppliers $3 billion, it is unlikely to gain much money from this ruling. California signaled today that it was likely to go to court to try to increase its refunds. In a series of reports and orders released today, the commission demanded that Enron, Reliant Energy Services and BP Energy show why their ability to trade electricity at market rates should not be revoked, citing "numerous" manipulations by Enron and "apparent manipulation" of electricity prices at the Palo Verde hub in Arizona by Reliant and BP. Reliant noted that the commission had not taken formal action yet and said the episode was "an isolated incident" and that the employee responsible for those trades had been fired. Nevertheless, shares of Reliant Resources dropped 24 percent, to $3.05, in trading after the ruling today. Shares of other larger energy traders named by the commission also fell sharply. In addition, the commission staff proposed requiring more than 30 other large companies, including Idaho Power , the Los Angeles Department of Water and Power, Mirant and the Williams Companies , to return "any unjust enrichment related to their misconduct" that stemmed from inflated bidding, withholding of power or other violations of market rules. The commission will decide whether to take action against these companies later. In an exhaustive report today, Donald Gelinas, who led the commission's investigation of market abuses, said investigators had found "significant market manipulation" but that the root causes of the state's meltdown were a shortage of electricity and a "fatally flawed market design." All the same, Mr. Gelinas said investigators had found an "epidemic" number of efforts to manipulate gas prices. In one of the more blatant examples, Reliant was able to inflate the average price paid for gas in California during December 2000 by $8.54 per million British thermal units C what investigators described as a very significant amount C by "churning" gas trades. In addition, the Gelinas report found that Enron's online trading platform was "a key enabler" of gas-price manipulation. The platform, Enron Online, generated more than $500 million in speculative profits for Enron in 2000 and 2001 by manipulating actual physical prices for gas and electricity that greatly boosted Enron's profits on derivative financial contracts tied to those physical prices, the report stated. These high prices for electricity, Mr. Gelinas found, "significantly influenced" longer-term electricity sales agreements signed during 2000 and 2001. Mr. Gelinas also recommended a number of changes to ensure better reporting and monitoring of energy trading and price reporting. His report also found that accusations that Williams had "cornered" the market for gas in California in January 2001 were "unsubstantiated." A former Williams executive stated in a news article in June 2002 that the company had managed to drive up gas prices in California. All of the rulings by the commission today are likely to be reviewed eventually by a federal appeals court. For California officials, the decisions are a bittersweet result to more than two years of efforts to obtain refunds and penalties for what they have long maintained was widespread price gouging. On one hand, the findings by the commission, which is made up of two members appointed by President Bush and one selected by President Bill Clinton, are likely to put to rest any serious arguments that manipulation and misconduct played little or no role in the California energy crisis. Initially, state officials were widely mocked for accusing the energy companies of profiteering, but an increasing body of evidence has emerged that illegal behavior contributed to price spikes.
Three types of imperfect market structure ranged from "most competitive" to "least competitive:"
Note that much depends on how you define the product. The Coca-Cola company has a monopoly over the sale of Coca Cola. It is part of a soft-drink industry that is an oligopoly (its primary competitor is Pepsi). It engages in monopolistic competition in the bottled liquid industry (that includes juices and bottled water). Now, let's look more closely at the implications of a downward sloping demand curve. Because the demand curve slopes down, marginal revenue is no longer equal to price. Hold on to your hats. This sounds confusing, at least initially. The reason is that when a firm lowers price, it has to lower it for everyone, not just for the most recent consumer....so the effect of lowering the price of one unit is multiplied by the number of units that are sold; marginal revenue will be lower than price. And the difference between marginal revenue and price will increase, the greater the number of units sold. Example: you can sell 4 units at a price of $8 per unit, or 5 units at a price of $7 per unit. At the first price, your review is $32. At the second, your revenue is $35. The marginal revenue from moving from a sale of 4 units to 5 is $3. Look at Figures 9.4 and 9.5 in the book. Note that Figure 9.6 should help you with homework question. The individual firm STILL maximizes profits at the point at which marginal cost equals marginal revenue. See Figure 9.9. What determines market power? according to book:
but also relevant is ability to "collude" in price setting
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