Lecture 5: Market structure and firm behavior

Objectives

• Understand the different market models for different

market structures
• Explain the strategic behavior of individual shipping
companies in different market
• Able to use different models to analyze the individual
behavior in different market conditions
• Practical example: Strategic capacity expansion and
overcapacity in shipping
 Issues in practice

• Shipping companies often blame the others for

passing the rent to the shippers, which reduces profit
margin.
– From individual companies, it is a rational decision to
charge a lower price to increase market share.
• For shippers, lower freight rate is always better.
• Shipping companies often blame the others for “short
memory”.
– In good market, build too many capacities.
 Market Structure

• Describing the level of competition in a market.

• Market players have different strategies under
different market structures.
• The society have different concerns for different
market structure.
• Perfect competition, Monopoly, Duopoly, Oligopoly,
Monopolistic competition
 Perfect competition

• There are large number of carriers and shippers in this

market.
• The carriers provide homogeneous services.
• The entry and exit of carriers are free.
– The development of ship financing, second-hand market
and demolition markets.
• Both carriers and shippers have complete information
on the market.
• No government intervention.
 Perfect competition
Carriers’ response under perfectly competitive market

• They take market price as given.

– No matter how many products a company produce,
the market price will stay constant.
• They produces as much as they can as long as
the marginal cost equal to market price.
• Ships with better technology may earn more.
– The most inefficient ship remaining in the market
earns zero profit.
 Individual suppliers determine their
outputs based on the market price. They
Perfect competition take market price as given. Their profit
$ maximizing behavior is to set price equal
$ to marginal cost, i.e., p=mc.
Market Demand Market Supply Individual supply

s5 s4 s3 s2 s1

Market Price

Q q4 q3 q2 q1

If demand is p=a-bQ, and the aggregated marginal cost is c, the

𝑎−𝑐
market output is: 𝑄=
𝑏
 Perfect competition
• Individual behavior of carriers
– Produce as much as they can to earn profit.
– Charge at the marginal cost. Too high, client leave;
too low, low profit.
– Improve efficiency, reduce cost.
• Possible social concern
– Quality of the goods/services may be a concern.
– Overcapacity.
– Need to have a close monitor.
 Monopoly
• The market is monopoly when there is only one supplier in the
market.
• Monopoly often appears when
– Exclusive ownership; Patent/copyright; Government grant; Natural
condition; Exclusive law.
• Most port enjoyed monopoly position in the past.

• Unlike in perfect competition, monopolist maximizes its profit

by setting marginal revenue equal to marginal cost. If demand
function is 𝑝 = 𝑝(𝑞), then MR = 𝑝′ 𝑞 ∙ 𝑞 + 𝑝(𝑞)
 Profit maximization
in monopoly

$
MC
What if the demand
function is 𝑝 = 100 − 5𝑞 ,
pm p(q)
and the total cost function
is 𝑐 = 𝑞 3 − 12𝑞 2 + 60𝑞?
pPC
MR
AC If demand is p=a-bQ, and
marginal cost is c, the
market output is: 𝑄=
𝑎−𝑐
qm qPC output
2𝑏
 Comparison

• Perfect competition

• Price lower, total

output larger,
consumer surplus
higher, producer
surplus lower, total
social welfare bigger.
 Monopoly

• Individual behavior
– Low product/service quality, less concern about
customer needs, no incentive to invest in
improving organization efficiency;
– Very careful about the potential competitor.
• Social concern
– High price/low quantity, low customer
satisfaction, low efficiency.
– A need to break the monopoly.
Between PC and Monopoly

• The behavior of a shipping company affects

the other(s).
– My strategy depends on the strategy of the
competitor
• Duopoly
– Bertrand competition
– Cournot competition
– Stackelberg competition
• Monopolistic competition
 Duopoly : Bertrand Competition
In the simple Bertrand model (e.g., Gibbons 1992), two firms face
demand curves given by

𝑞𝑖 𝑝𝑖 , 𝑝𝑗 = 𝑎 − 𝑝𝑖 + 𝑏𝑝𝑗 .
The quantity demanded from firm i, qi, is determined by the pi,
the price charged by i, and pj, the price charged by the competitor j.
If the products are not perfect substitutes, b<1 indicates that j’s
price has a smaller effect on qi than does pi.
• Each has its own demand function, which is affected by the
price of its own and of the competitor.
 Duopoly : Bertrand Competition

Both firms choose a price that maximizes their profit, given they
know the other firm will do the same,

max 𝜋1 𝑝1 , 𝑝2 = 𝑞1 𝑝1 − 𝑐 = [𝑎 − 𝑝1 + 𝑏𝑝2∗ ] 𝑝1 − 𝑐
𝑝1
where c is a constant marginal cost of production.
Differentiating each firm’s objective function w.r.t. its own price
and solving the pair of equations for p1* and p2* yields
p1* = p2* = ( a + c ) / ( 2 - b).
At these prices, each firm is maximizing its profit, given the
other firm’s price, a Nash equilibrium.
Duopoly : Bertrand Competition

p1
𝑎+𝑐 𝑏 Best response function
𝑝1 = + 𝑝2
2 2
𝑎+𝑐 𝑏
𝑝2 = + 𝑝1
2 2

𝑝22 𝑝21 p2

The price cutting of one producer is not very effective to attract all the customers.
There will be an equilibrium price.
 Duopoly : Bertrand Paradox When the price cutting is effective.

1. If p2 less than or equal to (≤) marginal cost MC, firm one set its price p1 at marginal cost.
2. If MC<p2≤pm, firm 1 just set its price a little bit lower than p2.
3. If p2>pm, p1 set its price at the monopoly price.
4. The second player will do the same, according to the price of the first player.
5. What is the equilibrium price in the long run?
 Duopoly : Cournot competition

• When the output/capacity is not flexible, the decision on how

many output is more important. Two companies maximize
their respective profits using quantity.

For demand p=a-bQ, where Q=q1+q2 , and two companies have

the same marginal cost, then the problem for company 1 is:
max [𝑎 − 𝑏 𝑞1 + 𝑞2 − 𝑐]𝑞1
𝑞1
Then the equilibrium quantity is
𝑎−𝑐
𝑞1 = 𝑞2 =
3𝑏
What is the market output?
 Duopoly : Cournot-graph
• Company 1 determines
its optimal output D(q1+q2)
knowing that q2 will be
handled by company 2.
rD
– rD is the remaining MR(q2)
demand.
• It maximize like a rMR
monopoly for the
c
demand rD
– rMR is the remain
q2
marginal revenue.
q1(q2)
 Duopoly : Cournot competition
q1

Best response function

q1(q2)

q2(q1)

q2

• If output and capacity are difficult to adjust, Cournot is a better

model; if they are easily changeable, Bertrand is better.
 Duopoly : Stackelberg Game
• Two companies has different market power. Company 1 is the
market leader, 2 is the follower. (many small shipping
companies follow the market leader—Maersk)

• In reality, 1 decide the quantity first, knowing what 2 will do

after seen 1’s decision.

• For economic analysis, we need to analyze 2’s decision first.

• Demand 𝑝 = 𝑎 − 𝑏(𝑞1 + 𝑞2 )
 Duopoly : Stackelberg Game

2’d decision (Follower) 1’s decision (Leader)

• Profit function: • The profit function for 1 is:
𝜋2 = 𝑝 − 𝑐 𝑞2 𝜋1
= [𝑎 − 𝑏 𝑞1 + 𝑞2 − 𝑐]𝑞2 𝑎 − 𝑐 − 𝑏𝑞1
= [𝑎 − 𝑏 𝑞1 +
• The optimal quantity give 1’s 2𝑏
output is: − 𝑐]𝑞1
𝑎 − 𝑐 𝑞1 𝑎−𝑐 𝑏
𝑞2 = − 𝜋1 = [ − 𝑞1 ]𝑞1
2𝑏 2 2 2
• The optimal quantity for 1 is:
𝑎−𝑐−𝑏𝑞1 𝑎−𝑐 𝑎−𝑐
2’s output is: 𝑞2 = = 𝑞1 =
2𝑏 4𝑏 2𝑏
Total market output
 $
p(q1+q2)
Duopoly : Stackelberg
(B)
• Firm 2’s best strategy for given 2’s
1’s output
output by 1 in the lower panel output rD
(A). p
– If 1’s p=c, 2 have 0 output. If 1 has rMR
c
no output, 2 became the monopoly.
• If 1 increase price from c, the
𝑎−𝑐 Q
output of 2 also increase. The q2 2𝑏
(A)
residual demand for 1 is rD, and
the residual marginal revenue is 𝑎−𝑐 2’s decision
rMR. 2𝑏
𝑎 − 𝑐 𝑞1
• 1’s decision rule is equate rMR=c 𝑎−𝑐
4𝑏
𝑞2 =
2𝑏
−
2

𝑎−𝑐 q1
𝑏
 Compare Cournot with Stackelberg

• Cournot:
– two suppliers are of similar size;
– The optimal quantity of one is a function of the
optimal quantity of the other.
• Stackelberg:
– one has market power;
– The follower’s quantity is a function of the leader.
– The leader just determining its own optimal output
level.
 Questions

• Compare PC, Bertrand, Cournot, Stackelberg,

monopoly game on the price, quantity, and firm profit.

• Assume the market demand is p=130-(q1+q2), and

the marginal cost is 10, repeat above comparison, and
calculate the consumer surplus, producer surplus, and
social welfare, and possible deadweight loss.
 Summary

• Use basic economic models , explained the strategic

behavior of individual firms under different market
structure.
• A high level of competitiveness increases market
efficiency.
• The VSA members cannot cooperate on pricing, thus
they may not perform like one company.
– The stability of the alliance
– Whether the allocation of the benefit can keep the members.
 Strategic Capacity Expansion and
Overcapacity in shipping
• In shipping market, demand is derived
demand. As shipping price is only a small part
of the commodity cost, demand for shipping is
always considered as inelastic to market
freight.
– Market demand is given.
– Most of the time, price is also given.
– Capacity expansion may be the only way to
compete with the others.
 When to invest new ships?
• Capacity expansion in
shipping happens not only in
booming market,
– before the 2008 financial crisis;
• It also happens when
everyone in the shipping industry is praying for
decreasing supply to enable market recovery.
• Strategic behavior in capacity investment.
– Having new ship can improve comparative advantage
 Importance of Strategic Capacity Expansion

• New ships are better than old one in many

aspects:
– Better technology, higher energy efficiency,
larger;
• Lower capital cost, crew cost, voyage cost, scale
economy.
o Good market: opportunity of high earning;
Sluggish market: to survive in the market.
o The symbol for market power.
 The market environment
• Market demand is fixed, freight rate is given.
– Shipping companies compete for market share,
which is proportional to its capacity.
• Zero sum game: total market share is 1. You
carry more, others get less.
• In this case, everyone has incentive to invest.
• The result of capacity expansion under
competitive market
– Old ships retire from commercial shipping earlier.