Chapter 8 Monopolistic Competition and Oligopoly Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Learning Objectives Discuss the nature and prevalence of monopolistic competition. Analyse and evaluate the price–output behaviour of monopolistically competitive firms. Discuss the implications of monopolistic competition for economic efficiency. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Learning Objectives (cont.) Explain and assess the role of non-price competition. Define oligopoly, assess its occurrence, and note the reasons for its existence. Examine the behaviour of oligopoly in terms of a simple game theory framework. Survey four models of the possible courses of price–output behaviour that oligopolistic industries might follow. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Learning Objectives (cont.) Discuss the role of non-price competition, that is, competition on the basis of product development and advertising in oligopolistic industries. Provide some comments on the economic efficiency and social desirability of oligopoly. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Monopolistic Competition Described Relatively large numbers of firms small market share no collusion independent actions Product differentiation competition based not just on price quality, brands, services, location, promotion and packaging Ease of entry low economies of scale low set-up costs Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Price and Output Determination The Firm’s Demand Curve Highly elastic, Why? More close substitutes than a pure monopolist Not perfect substitutes (as is the case with perfect competition) Elasticity depends on: number of rivals degree of product differentiation Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Short-Run Price and Output Determination How much to produce? MR = MC Profits or losses in the short run Profits: When AC > AR (D )—entry of new firms Losses: When AC < AR (D )—exit of existing firms Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Short-Run Price and Output Determination: Short-Run Profits MC AC D MR Economic Profits Price and Costs Q Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Short-Run Price and Output Determination: Short-Run Losses MC AC D MR Losses Price and Costs Q Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Long Run How much to produce? MR = MC Firms tend to break even, i.e. normal profit Tangency solution: profit-maximising firm will produce an output when its demand curve is at a tangent to its AC curve When AC = AR (D ) Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Long-Run Equilibrium Why do monopolistically competitive firms tend to break even in the long run? Profits attract new entrants Losses encourage exits Complications Some product differentiation Some entry is partially restricted Some economic losses may be tolerated by firms in the long run Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Long-Run Equilibrium (cont.) AC P D MR Price and Costs Q Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Monopolistic Competition & Economic Efficiency Productive inefficiency: Minimum ATC is not necessarily chosen excess capacity Allocative inefficiency: price does not necessarily equal MC Redeeming features product variety Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Non-Price Competition Assists firms to improve their long-run equilibrium position Product differentiation and product development at a point in time over time Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Economics of Advertising The case for advertising information and efficiency competition communication support The case against advertising persuasion and wastage concentration media bias Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Characteristics of Oligopoly ‘Fewness’: few firms dominate the market Firms are mutually interdependent and must consider the possible reactions of rivals to their price and product development decisions Firms may collude or act independently Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Characteristics of Oligopoly (cont.) Product differentiation? Homogeneous or differentiated product Examples: Petroleum products Aluminium Insurance Motor vehicles Concentration ratios: the percentage of total industry sales accounted for by a given number of the largest firms in each industry Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Characteristics of Oligopoly (cont.) High Barriers to Entry Causes Economies of scale Mergers Give firms more market power, influence, etc. Ownership of patents, copyrights Control of strategic raw materials Technological progress Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Oligopoly Behaviour: A Game Theory Overview Compare the behaviour of oligopolists to a simple duopoly game of strategy, actions and pay-offs as shown in the profit pay-off matrix Mutual interdependence the fate of one firm lies partially or wholly with the performance or decisions of other firms in that same industry Incentives to collude Incentive to cheat Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Profit Pay-offs for a Duopoly Giant’s pricing strategy High Low A B $12m $15m High Big’s pricing strategy $12m $6m C D $6m $8m Low $15m $8m Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Maximin Strategies and Optimal Pricing Strategy Strategies chosen by players in a game to maximise their minimum expected pay-off from the game Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Price–Output Behaviour in Four Models Four Models of Oligopoly the kinked demand curve collusive pricing price leadership models cost-plus pricing No standard model of oligopoly due to: diversity interdependence Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Kinked Demand: Non-Collusive Oligopoly Model Output occurs where MR = MC Price remains stable over a variety of cost scenarios Avoiding price wars Firms ignore price increases Firms match price decreases Criticisms How is the current price set? Prices may not be as inflexible as model suggests Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Kinked Demand Curve P The firm’s demand and marginal revenue curves D1 MR1 Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Kinked Demand Curve (cont.) P The rival’s demand and marginal revenue curves MR2 D2 D1 MR1 Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Kinked Demand Curve (cont.) P Rivals tend to follow a price cut MR2 D2 D1 MR1 Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Kinked Demand Curve (cont.) P Rivals tend to follow a price cut or ignore a price increase MR2 D2 D1 MR1 Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Kinked Demand Curve (cont.) P Effectively creating… MR2 D2 D1 MR1 Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

The Kinked Demand Curve (cont.) P Effectively creating a kinked demand curve D2 MC2 MC1 P MR2 X D1 MR1 Q Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Collusion and Cartels Overt or covert agreements to fix prices, divide up or share the market or limit competition between firms Output and price: same as a monopolist Forms: Cartels groups of firms that agree either formally or informally to set prices and output levels of a product among members ‘Gentlemen’s agreements’ groups of firms agree verbally to set prices and output levels, usually in an informal setting such as a golf course Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Collusion and Profit Maximisation MC Price ATC MR P Economic Profit D MR = MC Q Q Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Obstacles to Collusion Demand and cost differences between firms Numbers of firms Cheating Recession Legislative obstacles: Trade Practices Law Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Price Leadership: Tacit Collusion Model A type of gentlemen’s agreement in which oligopolists automatically follow the price initiatives of the dominant firm in an industry Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Price Leadership: Tacit Collusion Model (cont.) Infrequent price changes by price leader Price announcements often made through indirect channels such as trade publications Price leader may choose strategies to block potential entrants: limit-pricing or price blocking Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Cost-Plus Pricing Model An oligopolist uses a standard formula to estimate cost per unit of output and adds a mark-up to determine price Advantages for multi-product firms Consistent with outright collusion Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Non-Price Competition Oligopolists dislike competing on price Oligopolists must rely on non-price competition advertising product development Oligopolists typically have substantial resources to support non-price competition Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Oligopoly and Economic Efficiency Productive inefficiency Minimum ATC is not necessarily chosen under-allocation of resources Allocative inefficiency: Price does not necessary equal MC output is restricted Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Oligopoly and Economic Efficiency (cont.) Dynamic efficiency: Long-term improvements in product quality and production methods may occur competitive view Schumpeter–Galbraith view Technical progress: the evidence Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University

Next Chapter: Market Failure and Resource Allocation Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University