McGraw-Hill/Irwin Chapter 9: Monopolistic Competition and Oligopoly Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Characteristics of Monopolistic Competition  Large number of sellers:  Small market shares  No collusion  Independent action  Differentiated products:  Firms have some control over prices.  Products may differ in  attributes  services  location  brand name and packaging  Easy entry and exit LO: 9-1 Examples: furniture, jewelry, leather goods, grocery stores, gas stations, restaurants, clothing stores, medical care. 9-2

 Monopolistically competitive firms engage in non-price competition (such as advertising) in order to differentiate their products.  Because products are differentiated, the demand curve of a monopolistically competitive firm is not perfectly elastic (although it is more elastic than pure monopolist’s demand).  The price elasticity of firm’s demand is higher  The larger the number of rival firms  The weaker the product differentiation Pricing and Output in Monopolistic Competition LO:

Profits and Losses in Monopolistic Competition Short run  The monopolistically competitive firm uses the MC=MR Rule to maximize profit or minimize loss in the short run.  It produces a quantity Q at which MR = MC and charges a price P based on its demand curve.  When P > ATC, the firm earns an economic profit.  When P < ATC, the firm incurs a loss. Long run  Because entry and exit are easy,  Economic profits attract new firms, which lowers profits of existing firms, until P=ATC.  Economic losses make firms exit until P=ATC.  As a result, monopolistic competitors will earn only a normal profit in the long run. LO:

Quantity Price and Costs MR = MC MC MR D in SR ATC Economic Profit Q ATC P 0 Short-Run Profits in Monopolistic Competition LO:

Long-Run Profits in Monopolistic Competition Quantity Price and Costs MR = MC MC MR D in SR ATC Economic Profit Q ATC P 0 LO: 9-2 D in LR P= ATC 9-6

Quantity Price and Costs MR = MC MC MR D3D3 ATC Q MC P MC 0 P PC Q PC Price is Higher Excess Capacity at Minimum ATC Monopolistic competition is not efficient LO: 9-2 Monopolistic Competition vs. Pure Competition 9-7

Characteristics of Oligopoly  A few large producers:  Firms are price makers  Firms engage in strategic behavior  Firms’ profits depend on action of other firms  Homogeneous or differentiated products:  If products are differentiated, firms engage in advertising  Blocked entry LO: 9-3 Examples: tires, beer, cigarettes, copper, greeting cards, automobiles, breakfast cereals, airlines. 9-8

Oligopoly and Game Theory  Behavior of firms in the oligopoly can be analyzed using game theory.  Consider an example of two firms (a duopoly) which decide whether to set their price high or low.  A payoff matrix can be constructed to show payoffs (profit) to each firm that result from each combination of strategies. LO: 9-4 Game theory is the study of how people or firms behave in strategic situations. 9-9

RareAir’s Price Strategy Uptown’s Price Strategy AB CD $12 $15 $6 $8 $6 $15 High Low 2 competitors 2 price strategies Each strategy has a payoff matrix Greatest combined profit Independent actions stimulate a response LO: 9-4 Oligopoly and Game Theory: Example 9-10

RareAir’s Price Strategy Uptown’s Price Strategy AB CD $12 $15 $6 $8 $6 $15 High Low Independently lowered prices in expectation of greater profit leads to the worst combined outcome Eventually low outcomes make firms return to higher prices There is a gain from collusion LO: 9-4 Oligopoly and Game Theory: Example 9-11

Kinked-Demand Model of Oligopoly  In the kinked-demand model, oligopolists face a demand curve based on the assumption that rivals will ignore a price increase and follow a price decrease.  An oligopolist’s rivals will ignore a price increase above the going price but follow a price decrease below the going price.  The demand curve is kinked at this price and the marginal- revenue curve has a vertical gap.  Price and output are optimized at the kink.  This model helps explain why prices are generally stable in noncollusive oligopolistic industries. LO:

Price Price and Costs Quantity 0 0 P0P0 MR 2 D2D2 D1D1 MR 1 e f g Rivals Ignore Price Increase Rivals Match Price Decrease Q0Q0 Competitor and rivals strategize versus each other Consumers effectively have 2 partial demand curves and each part has its own marginal revenue part MR 2 D2D2 D1D1 MR 1 Q0Q0 MC 1 MC 2 P0P0 e f g Kinked-Demand Model of Oligopoly LO:

Collusion  Collusion, through price control, may allow oligopolists to reduce uncertainty, increase profits, and possibly block potential entry.  If oligopolistic firms produce an identical product and have identical cost, demand, and marginal-revenue curves, then each firm can maximize profit using the MR=MC Rule.  Firms will choose the price and quantity according to MR=MC Rule because it is the most profitable price-output combination.  One form of collusion is the cartel. LO: 9-6 Cartel is a formal agreement among producers to set the price and the individual firm’s output levels of a product. One example is OPEC. 9-14

Price and Costs Quantity D MR=MC ATC MC MR P0P0 A0A0 Q0Q0 Economic Profit Effectively Sharing The Monopoly Profit LO: 9-6 Profit Maximization by a Cartel Cartel-type oligopoly is inefficient 9-15

Obstacles to Collusion  Anti-trust law prevents cartels from forming  Demand and costs may be different across firms  There may be too many firms to coordinate  There are strong incentives to cheat  If rivals charge prices lower than P o, then the demand curve of the firm charging P o will shift to the left as customers turn to its rivals, and profits will fall.  The firm can retaliate and cut its price, too. However, all firms’ profits would eventually fall.  Recessions increase excess capacity and strengthen incentives to cheat  High profits attract potential entry LO:

Oligopoly and Advertising Positive effects of advertising  Enhances competition  Reduces consumers’ search time, direct costs, and indirect costs  Facilitates the introduction of new products Negative effects of advertising  Alters consumers’ preferences in favor of the advertiser’s product  Brand-loyalty promotes monopoly power LO: 9-7 Oligopolists have sufficient financial resources to engage in product differentiation through product development and advertising. 9-17