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 Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Cartels Chapter 12 2

Monopolistic Competition Characteristics 1) Many firms 2) Free entry and exit 3) Differentiated product The amount of monopoly power depends on the degree of differentiation. Examples of this very common market structure include: Toothpaste Soap The Makings of Monopolistic Competition Two important characteristics Differentiated but highly substitutable products Free entry and exit Chapter 12 4

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. With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12 18

Oligopoly Characteristics Examples Small number of firms Product differentiation may or may not exist Barriers to entry Examples Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers Chapter 12 24

Oligopoly The barriers to entry are: Natural Scale economies Patents Technology Name recognition Strategic action Flooding the market Controlling an essential input Chapter 12 26

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

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

Cartels Characteristics 1) Explicit agreements to set output and price 2) May not include all firms 3) Most often international Examples of successful cartels : OPEC Examples of unsuccessful cartels : Copper,Tin,Tea 4) Conditions for success Competitive alternative sufficiently deters cheating Potential of monopoly power--inelastic demand Chapter 12 116

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

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. Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this. In a cartel, producers explicitly collude in setting prices and output levels. Chapter 12 134