Monopolistic Competition and Oligopoly Chapter 12 Monopolistic Competition and Oligopoly 1

Topics to be Discussed Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners’ Dilemma Chapter 12 2

Topics to be Discussed Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Cartels Chapter 12 3

Monopolistic Competition Characteristics 1) Many firms 2) Free entry and exit 3) Differentiated product Chapter 12 4

Monopolistic Competition The amount of monopoly power depends on the degree of differentiation. Examples of this very common market structure include: Toothpaste Soap Cold remedies Chapter 12 5

Monopolistic Competition Toothpaste Crest and monopoly power Procter & Gamble is the sole producer of Crest Consumers can have a preference for Crest---taste, reputation, decay preventing efficacy The greater the preference (differentiation) the higher the price. Chapter 12 6

Monopolistic Competition Question Does Procter & Gamble have much monopoly power in the market for Crest? Chapter 12 6

Monopolistic Competition The Makings of Monopolistic Competition Two important characteristics Differentiated but highly substitutable products Free entry and exit Chapter 12 7

A Monopolistically Competitive Firm in the Short and Long Run $/Q Short Run $/Q Long Run MC AC MC AC DSR MRSR QSR PSR DLR MRLR QLR PLR Quantity Quantity 12

A Monopolistically Competitive Firm in the Short and Long Run Observations (short-run) Downward sloping demand--differentiated product Demand is relatively elastic--good substitutes MR < P Profits are maximized when MR = MC This firm is making economic profits Chapter 12 13

A Monopolistically Competitive Firm in the Short and Long Run Observations (long-run) Profits will attract new firms to the industry (no barriers to entry) The old firm’s demand will decrease to DLR Firm’s output and price will fall Industry output will rise No economic profit (P = AC) P > MC -- some monopoly power Chapter 12 14

Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium Perfect Competition Monopolistic Competition $/Q $/Q Deadweight loss MC AC MC AC DLR MRLR QMC P QC PC D = MR Quantity Quantity 17

Monopolistic Competition Monopolistic Competition and Economic Efficiency The monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle. Chapter 12 18

Monopolistic Competition Monopolistic Competition and Economic Efficiency With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12 19

Monopolistic Competition Questions 1) If the market became competitive, what would happen to output and price? 2) Should monopolistic competition be regulated? Chapter 12 20

Monopolistic Competition Questions 3) What is the degree of monopoly power? 4) What is the benefit of product diversity? Chapter 12 20

Monopolistic Competition in the Market for Colas and Coffee The markets for soft drinks and coffee illustrate the characteristics of monopolistic competition. Chapter 12 21

Elasticities of Demand for Brands of Colas and Coffee Brand Elasticity of Demand Colas: Royal Crown -2.4 Coke -5.2 to -5.7 Ground Coffee: Hills Brothers -7.1 Maxwell House -8.9 Chase and Sanborn -5.6 Chapter 12 22

Elasticities of Demand for Brands of Colas and Coffee Questions 1) Why is the demand for Royal Crown more price inelastic than for Coke? 2) Is there much monopoly power in these two markets? 3) Define the relationship between elasticity and monopoly power. Chapter 12 23

Oligopoly Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry Chapter 12 24

Oligopoly Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment Computers Chapter 12 25

Oligopoly The barriers to entry are: Natural Scale economies Patents Technology Name recognition Chapter 12 26

Oligopoly The barriers to entry are: Strategic action Flooding the market Controlling an essential input Chapter 12 27

Oligopoly Management Challenges Question Strategic actions Rival behavior Question What are the possible rival responses to a 10% price cut by Ford? Chapter 12 28

Oligopoly Equilibrium in an Oligopolistic Market In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price. In oligopoly the producers must consider the response of competitors when choosing output and price. Chapter 12 29

Oligopoly Equilibrium in an Oligopolistic Market Defining Equilibrium Firms doing the best they can and have no incentive to change their output or price All firms assume competitors are taking rival decisions into account. Chapter 12 30

Oligopoly Nash Equilibrium Each firm is doing the best it can given what its competitors are doing. Chapter 12 31

Oligopoly The Cournot Model Duopoly Two firms competing with each other Homogenous good The output of the other firm is assumed to be fixed Chapter 12 32

Firm 1’s Output Decision MR1(0) If Firm 1 thinks Firm 2 will produce nothing, its demand curve, D1(0), is the market demand curve. P1 D1(50) MR1(50) 25 If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. MR1(75) D1(75) 12.5 If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MC1 50 What is the output of Firm 1 if Firm 2 produces 100 units? Q1 Chapter 12 38

Oligopoly The Reaction Curve A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2. Chapter 12 39

Reaction Curves and Cournot Equilibrium Firm 1’s Reaction Curve Q*1(Q2) x Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous model. Q1 100 Firm 2’s Reaction Curve Q*2(Q2) Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. 75 In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. Cournot Equilibrium 50 25 Q2 25 50 75 100 Chapter 12 43

Oligopoly Questions 1) If the firms are not producing at the Cournot equilibrium, will they adjust until the Cournot equilibrium is reached? 2) When is it rational to assume that its competitor’s output is fixed? Chapter 12 44

The Linear Demand Curve Oligopoly The Linear Demand Curve An Example of the Cournot Equilibrium Duopoly Market demand is P = 30 - Q where Q = Q1 + Q2 MC1 = MC2 = 0 Chapter 12 4 45

The Linear Demand Curve Oligopoly The Linear Demand Curve An Example of the Cournot Equilibrium Firm 1’s Reaction Curve Chapter 12 4 46

The Linear Demand Curve Oligopoly The Linear Demand Curve An Example of the Cournot Equilibrium Chapter 12 4 47

The Linear Demand Curve Oligopoly The Linear Demand Curve An Example of the Cournot Equilibrium Chapter 12 4 48

The demand curve is P = 30 - Q and both firms have 0 marginal cost. Duopoly Example Q1 The demand curve is P = 30 - Q and both firms have 0 marginal cost. Firm 2’s Reaction Curve 30 15 10 Cournot Equilibrium Firm 1’s Reaction Curve 15 30 Q2 Chapter 12 54

Profit Maximization with Collusion Oligopoly Profit Maximization with Collusion Chapter 12 4 55

Profit Maximization with Collusion Oligopoly Profit Maximization with Collusion Contract Curve Q1 + Q2 = 15 Shows all pairs of output Q1 and Q2 that maximizes total profits Q1 = Q2 = 7.5 Less output and higher profits than the Cournot equilibrium Chapter 12 4 56

Duopoly Example Q1 30 15 10 7.5 Firm 2’s Collusion Curve 7.5 Collusive Equilibrium For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium Firm 2’s Reaction Curve 15 Competitive Equilibrium (P = MC; Profit = 0) 10 Cournot Equilibrium Firm 1’s Reaction Curve Q2 30 Chapter 12 54

First Mover Advantage-- The Stackelberg Model Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q = total output Firm 1 sets output first and Firm 2 then makes an output decision Chapter 12 58

First Mover Advantage-- The Stackelberg Model Firm 1 Must consider the reaction of Firm 2 Firm 2 Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = 15 - 1/2Q1 Chapter 12 59

First Mover Advantage-- The Stackelberg Model Firm 1 Choose Q1 so that: Chapter 12 60

First Mover Advantage-- The Stackelberg Model Substituting Firm 2’s Reaction Curve for Q2: Chapter 12 61

First Mover Advantage-- The Stackelberg Model Conclusion Firm 1’s output is twice as large as firm 2’s Firm 1’s profit is twice as large as firm 2’s Questions Why is it more profitable to be the first mover? Which model (Cournot or Shackelberg) is more appropriate? Chapter 12 62

Price Competition Competition in an oligopolistic industry may occur with price instead of output. The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods. Chapter 12 63

Price Competition Assumptions Bertrand Model Homogenous good Market demand is P = 30 - Q where Q = Q1 + Q2 MC = $3 for both firms and MC1 = MC2 = $3 Chapter 12 64

Price Competition Assumptions Bertrand Model The Cournot equilibrium: Assume the firms compete with price, not quantity. Chapter 12 64

Price Competition Bertrand Model How will consumers respond to a price differential? (Hint: Consider homogeneity) The Nash equilibrium: P = MC; P1 = P2 = $3 Q = 27; Q1 & Q2 = 13.5 Chapter 12 65

Price Competition Bertrand Model Why not charge a higher price to raise profits? How does the Bertrand outcome compare to the Cournot outcome? The Bertrand model demonstrates the importance of the strategic variable (price versus output). Chapter 12 66

Price Competition Criticisms Bertrand Model When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices. Even if the firms do set prices and choose the same price, what share of total sales will go to each one? It may not be equally divided. Chapter 12 69

Price Competition Price Competition with Differentiated Products Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product. Chapter 12 70

Differentiated Products Price Competition Differentiated Products Assumptions Duopoly FC = $20 VC = 0 Chapter 12 71

Differentiated Products Price Competition Differentiated Products Assumptions Firm 1’s demand is Q1 = 12 - 2P1 + P2 Firm 2’s demand is Q2 = 12 - 2P1 + P1 P1 and P2 are prices firms 1 and 2 charge respectively Q1 and Q2 are the resulting quantities they sell Chapter 12 71

Differentiated Products Price Competition Differentiated Products Determining Prices and Output Set prices at the same time Chapter 12 72

Differentiated Products Price Competition Differentiated Products Determining Prices and Output Firm 1: If P2 is fixed: Chapter 12 73

Nash Equilibrium in Prices Firm 2’s Reaction Curve $4 Nash Equilibrium $6 Collusive Equilibrium Firm 1’s Reaction Curve P2 Chapter 12 77

Nash Equilibrium in Prices Does the Stackelberg model prediction for first mover hold when price is the variable instead of quantity? Hint: Would you want to set price first? Chapter 12 78

A Pricing Problem for Procter & Gamble Differentiated Products Scenario 1) Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd were entering the market for Gypsy Moth Tape. 2) All three would be choosing their prices at the same time. Chapter 12 79

A Pricing Problem for Procter & Gamble Differentiated Products Scenario 3) Procter & Gamble had to consider competitors prices when setting their price. 4) FC = $480,000/month and VC = $1/unit for all firms Chapter 12 80

A Pricing Problem for Procter & Gamble Differentiated Products Scenario 5) P&G’s demand curve was: Q = 3,375P-3.5(PU).25(PK).25 Where P, PU , PK are P&G’s, Unilever’s, and Kao’s prices respectively Chapter 12 81

A Pricing Problem for Procter & Gamble Differentiated Products Problem What price should P&G choose and what is the expected profit? Chapter 12 81

P&G’s Profit (in thousands of $ per month) Competitor’s (Equal) Prices ($) P&G’s Price ($) 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80 1.10 -226 -215 -204 -194 -183 -174 -165 -155 1.20 -106 -89 -73 -58 -43 -28 -15 -2 1.30 -56 -37 -19 2 15 31 47 62 1.40 -44 -25 -6 12 29 46 62 78 1.50 -52 -32 -15 3 20 36 52 68 1.60 -70 -51 -34 -18 -1 14 30 44 1.70 -93 -76 -59 -44 -28 -13 1 15 1.80 -118 -102 -87 -72 -57 -44 -30 -17 82

A Pricing Problem for Procter & Gamble What Do You Think? 1) Why would each firm choose a price of $1.40? Hint: Think Nash Equilibrium 2) What is the profit maximizing price with collusion? Chapter 12 83

Competition Versus Collusion: The Prisoners’ Dilemma Why wouldn’t each firm set the collusion price independently and earn the higher profits that occur with explicit collusion? Chapter 12 84

Competition Versus Collusion: The Prisoners’ Dilemma Assume: Chapter 12 85

Competition Versus Collusion: The Prisoners’ Dilemma Possible Pricing Outcomes: Chapter 12 86

Payoff Matrix for Pricing Game Firm 2 Charge $4 Charge $6 Charge $4 $12, $12 $20, $4 $16, $16 $4, $20 Firm 1 Charge $6 Chapter 12 88

Competition Versus Collusion: The Prisoners’ Dilemma These two firms are playing a noncooperative game. Each firm independently does the best it can taking its competitor into account. Question Why will both firms both choose $4 when $6 will yield higher profits? Chapter 12 89

Competition Versus Collusion: The Prisoners’ Dilemma An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face. Chapter 12 90

Competition Versus Collusion: The Prisoners’ Dilemma Scenario Two prisoners have been accused of collaborating in a crime. They are in separate jail cells and cannot communicate. Each has been asked to confess to the crime. Chapter 12 91

Payoff Matrix for Prisoners’ Dilemma Prisoner B Confess Don’t confess Confess -5, -5 -1, -10 -2, -2 -10, -1 Prisoner A Would you choose to confess? Don’t confess Chapter 12 92

Payoff Matrix for the P & G Prisoners’ Dilemma Conclusions: Oligipolistic Markets 1) Collusion will lead to greater profits 2) Explicit and implicit collusion is possible 3) Once collusion exists, the profit motive to break and lower price is significant Chapter 12 95

Payoff Matrix for the P&G Pricing Problem Unilever and Kao Charge $1.40 Charge $1.50 Charge $1.40 $12, $12 $29, $11 $3, $21 $20, $20 P&G What price should P & G choose? Charge $1.50 Chapter 12 97

Implications of the Prisoners’ Dilemma for Oligipolistic Pricing Observations of Oligopoly Behavior 1) In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur. Chapter 12 99

Implications of the Prisoners’ Dilemma for Oligipolistic Pricing Observations of Oligopoly Behavior 2) In other oligopoly markets, the firms are very aggressive and collusion is not possible. Firms are reluctant to change price because of the likely response of their competitors. In this case prices tend to be relatively rigid. Chapter 12 100

The Kinked Demand Curve $/Q If the producer raises price the competitors will not and the demand will be elastic. MR D If the producer lowers price the competitors will follow and the demand will be inelastic. Quantity Chapter 12 109

The Kinked Demand Curve $/Q MC MC’ So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. D P* Q* Quantity Chapter 12 MR 109

Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Price Signaling & Price Leadership Price Signaling Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Chapter 12 110

Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Price Signaling & Price Leadership Price Leadership Pattern of pricing in which one firm regularly announces price changes that other firms then match Chapter 12 110

Implications of the Prisoners’ Dilemma for Oligopolistic Pricing The Dominant Firm Model In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. The large firm might then act as the dominant firm, setting a price that maximized its own profits. Chapter 12 110

Price Setting by a Dominant Firm MCD MRD SF The dominant firm’s demand curve is the difference between market demand (D) and the supply of the fringe firms (SF). Price D DD At this price, fringe firms sell QF, so that total sales are QT. P1 QF QT P2 QD P* Quantity Chapter 12 115

Cartels Characteristics 1) Explicit agreements to set output and price 2) May not include all firms Chapter 12 116

Cartels Characteristics 3) Most often international Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa Examples of successful cartels OPEC International Bauxite Association Mercurio Europeo Chapter 12 117

Cartels Characteristics 4) Conditions for success Competitive alternative sufficiently deters cheating Potential of monopoly power--inelastic demand Chapter 12 119

Cartels Comparing OPEC to CIPEC Most cartels involve a portion of the market which then behaves as the dominant firm Chapter 12 120

The OPEC Oil Cartel Price P* QOPEC TD SC MCOPEC MROPEC DOPEC Quantity TD is the total world demand curve for oil, and SC is the competitive supply. OPEC’s demand is the difference between the two. Price MROPEC DOPEC QOPEC P* OPEC’s profits maximizing quantity is found at the intersection of its MR and MC curves. At this quantity OPEC charges price P*. Quantity Chapter 12 124

Cartels About OPEC Very low MC TD is inelastic Non-OPEC supply is inelastic DOPEC is relatively inelastic Chapter 12 125

The OPEC Oil Cartel Price QC QT P* Pc QOPEC TD SC MCOPEC The price without the cartel: Competitive price (PC) where DOPEC = MCOPEC QC QT MROPEC DOPEC P* Pc QOPEC Quantity Chapter 12 124

The CIPEC Copper Cartel QCIPEC P* PC QC QT TD and SC are relatively elastic DCIPEC is elastic CIPEC has little monopoly power P* is closer to PC Price MRCIPEC TD DCIPEC SC MCCIPEC Quantity Chapter 12 130

Cartels Observations To be successful: Total demand must not be very price elastic Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic Chapter 12 131

The Cartelization of Intercollegiate Athletics Observations 1) Large number of firms (colleges) 2) Large number of consumers (fans) 3) Very high profits Chapter 12 132

The Cartelization of Intercollegiate Athletics Question How can we explain high profits in a competitive market? (Hint: Think cartel and the NCAA) Chapter 12 133

The Milk Cartel 1990s with less government support, the price of milk fluctuated more widely In response, the government permitted six New England states to form a milk cartel (Northeast Interstate Dairy Compact -- NIDC) Chapter 12

The Milk Cartel 1999 legislation allowed dairy farmers in Northeastern states surrounding NIDC to join NIDC, 7 in 16 Southern states to form a new regional cartel. Soy milk may become more popular. Chapter 12

Summary In a monopolistically competitive market, firms compete by selling differentiated products, which are highly substitutable. In an oligopolistic market, only a few firms account for most or all of production. Chapter 12 134

Summary In the Cournot model of oligopoly, firms make their output decisions at the same time, each taking the other’s output as fixed. In the Stackelberg model, one firm sets its output first. Chapter 12 135

Summary The Nash equilibrium concept can also be applied to markets in which firms produce substitute goods and compete by setting price. Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this. Chapter 12 136

Summary The Prisoners’ Dilemma creates price rigidity in oligopolistic markets. Price leadership is a form of implicit collusion that sometimes gets around the Prisoners Dilemma. In a cartel, producers explicitly collude in setting prices and output levels. Chapter 12 137

Monopolistic Competition and Oligopoly End of Chapter 12 Monopolistic Competition and Oligopoly 1