Monopolistic Competition And Oligopoly Chapter 10 Monopolistic Competition And Oligopoly ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

Imperfect Competition A market structure More than one firm One or more of the requirements of perfect competition is violated Monopolistic competition Oligopoly

Monopolistic Competition Many buyers and sellers A buyer has no influence on the price A seller has market power A seller - Price setter Sellers act independently of each other No strategic games

Monopolistic Competition Sellers offer a differentiated product Downward-sloping demand curve Product differentiation Quality Location A product is different whenever people think that it is Sellers can easily enter or exit the market No significant barriers to entry

Monopolistic Competition in the Short Run Maximize profit Produce the quantity where MR = MC An increase in price - The customers can buy a similar good from other firm Demand curve Is flatter under monopolistic competition than under monopoly Economic profit Economic loss

Monopolistic Competition in the Short Run Figure 1 A Monopolistically Competitive Firm in the Short Run 1. Kafka services 250 homes per month: MR=MC Dollars Homes Serviced per Month 2. and charges $70 per home A MC $70 ATC d1 30 MR1 3. ATC at 250 units is less than price, so profit per unit is positive. 4. Kafka's monthly profit: $10,000 250

Monopolistic Competition in the Long Run No barriers to entry and exit Economic profit in the short run New sellers enter the market Demand curve - shift leftward Economic loss in the short run Sellers exit the market Demand curve - shift rightward Each firm earns zero economic profit in the long run

Monopolistic Competition in the Long Run Figure 2 A Monopolistically Competitive Firm in the Long Run Dollars Homes Serviced per Month 1. In the long run, profit attracts entry, the firm's demand curve shifts leftward MC ATC E $40 d1 MR1 MR2 d2 100 250 3. The typical firm produces where its new MR = MC 2. Entry continues until P = ATC, and economic profit is zero.

Monopolistic Competition Excess Capacity Never produce at minimum average cost Monopolistic competition Higher costs Higher prices Product differentiation Nonprice Competition Any action a firm takes to shift its demand curve rightward

Oligopoly A market structure in which a small number of firms are strategically interdependent - produce the dominant share of output in the market Market definition Number of firms Market domination

How Oligopolies Arise Barriers to entry Economies of scale Reputation Strategic barriers Legal barriers

Barriers to Entry Economies of scale Reputation Natural oligopoly - the market tends naturally toward oligopoly A large firm supplies a large share of the market - lower cost per unit than a small firm Reputation Established oligopolists are likely to have favorable reputations Initial high advertising costs

Barriers to Entry Strategic Barriers Legal barriers Excess production capacity Saturate the market Special deals with distributors Long-term arrangements with customers Spend large amounts on advertising Legal barriers Patents and copyrights; Lobby Zoning regulations

Oligopoly vs. Other Market Structures Strategic interdependence Anticipate the reactions of rivals when making decisions Game theory An approach to modeling the strategic interaction of oligopolists in terms of moves and countermoves.

The Game Theory Approach Game theory analyzes oligopoly decisions Rules Payoffs Strategies Payoff matrix A table showing the payoffs to each of two players for each pair of strategies they choose

The Prisoner’s Dilemma Figure 3 The Prisoner’s Dilemma Confess Don’t Rose’s Actions Colin gets 20 years Rose 30 years 3 years 5 years Colin’s Actions Don’t Confess

The Prisoner’s Dilemma Regardless of Rose’s strategy, Colin’s best choice is to confess Dominant strategy A strategy that is best for a player no matter what strategy the other player chooses. The outcome – a Nash equilibrium Each player is taking the best action, given actions taken by other players

Simple Oligopoly Games Duopoly Oligopoly market with only two sellers Situations duopolists might face: both players have dominant strategies, only one player has a dominant strategy, neither player has a dominant strategy

Both Players Have Dominant Strategies Figure 4 A Duopoly Game: Both Players Have Dominant Strategies Low Price Low price High Filip’s Actions Gus’s profit= $25,000 profit= -$10,000 $75,000 $50,000 Gus’s Actions High Price

Only One Player Has a Dominant Strategy Figure 5 A Duopoly Game: Only One Player Has a Dominant Strategy Low Price Low price High Filip’s Actions Gus’s profit= $25,000 profit= -$10,000 $75,000 $50,000 Gus’s Actions High Price $40,000

Neither Player Has a Dominant Strategy Figure 6 A Duopoly Game: Neither Player Has a Dominant Strategy Low Price Low price High Filip’s Actions Gus’s profit= $25,000 profit= -$10,000 $75,000 $50,000 Gus’s Actions High Price $40,000

Repeated play Repeated play Both players Cooperative behavior Strategically interdependent sellers compete over many time periods Both players Select a strategy Observe the outcome of the trial Play the game again and again, as long as they remain rivals Cooperative behavior

Explicit collusion Cooperation involving direct communication between competing firms about setting prices Cartel Group of firms Select a common price Maximize total industry profits Usually illegal Severe penalties

Tacit Collusion Oligopolistic cooperation Tit-for-tat Price leadership does not involve an explicit agreement Tit-for-tat Do to another player this period what he has done to you in the previous period Price leadership One firm sets a price that other firms copy

The Limits to Collusion The market demand curve May be illegal Powerful incentives to cheat on any agreement Each player - can do even better by cheating Two players would be back to noncooperative outcome based on their dominant strategies May be in each player’s interest to cheat

The Future of Oligopoly Antitrust Legislation and Enforcement Prevent collusive agreements Break up or limit activities of large Prevent mergers The Globalization of Markets Technological Change

Advertising in Monopolistic Competition Firms advertise to Shift the demand curve rightward Less elastic demand But it will affect the firm’s ATC curve Market Demand for the product in general will increase Each firm - sell more units at any given price The demand curve facing each firm shifts rightward.

Advertising in Monopolistic Competition Increase the size of the market Sell more Long run Each firm earns zero economic profit The price to the consumer may either rise or fall

Advertising in Monopolistic Competition Figure 7 Advertising in Monopolistic Competition a) 1. Before advertising, long-run economic profit is zero Dollars Bottles of Perfume per Month 2. With advertising, in the long run, economic profit returns to zero. dads ATCads 100 1,750 B dno ads ATCno ads 1,000 A 60 3. Advertising can lead to a higher price in the long run as in this panel …

Advertising in Monopolistic Competition Figure 7 Advertising in Monopolistic Competition b) 4. or to a lower price in the long run, as in this panel Dollars Bottles of Perfume per Month dads ATCads dno ads ATCno ads 1,000 A 60 B 50 2,000

Advertising and Collusion in Oligopoly Oligopolists have a strong incentive to engage in tacit collusion Difficult to detect Use simple game theory model prove collusion

Advertising and Collusion in Oligopoly Figure 8 An Advertising Game Run Safety Ads Run Safety Ads Don't United's Actions American's Actions Don't Run Ads American earns low profit American earns high profit United earns very low profit United earns low profit American earns very low profit American earns medium profit United earns medium profit United earns high profit

The Four Market Structures: A Postscript Different market structures Perfect competition Monopoly Monopolistic competition Oligopoly Market structure models help us organize and understand apparent chaos of real-world markets