Chapter 11 Monopolistic Competition & Oligopoly Characteristics of Monopolistic Competition S/R and L/R models Oligopoly and Game Theory

What is monopolistic competition? Relatively large number of sellers Each seller has a small market share and minimal control of market price No collusion—output restriction and price setting don’t occur Independent action—each firm’s pricing policy has minimal influence on rivals.

Differentiated Products “unique” attributes—features, materials, design, workmanship Service Location (minimarts, gas stations, hotels) Branding and packaging Some control over price—sellers of favorable products may command slightly higher price

Easy Entry and Exit Not as easy as pure competition (brand names, patents, trademarks) Most monopolistic competitors are small; economies of scale are few

Nonprice Competition and Advertising The goal of nonprice competition is to make price less of a factor in consumer purchases If successful, nonprice competition shifts a demand curve to the right and makes it less (elastic/inelastic?) Which market structure does the most advertising? Examples of monopolistic competition?

Monopolistic Competition: Price and Output Demand curve is between monopoly and pure competition and the degree of price elasticity depends on the number of rivals and degree of differentiation. (More rivals, less differentiation—close to pure competition.) One educated guess as to where the firm will maximize profits??

MR = MC !! Profits or losses are possible in the short run, but in the long run… Only a normal profit! Economic profits lead to entry of new firms. As new firms enter, the demand curve faced by the typical firm will shift to the left (more close substitutes.) Economic Losses lead to exit of firms.

Long Run Equilibrium: ATC tangent to the demand curve at output where MR=MC. Real world complications: firms do consistently earn economic profits. Rivals can’t duplicate the differentiation Differentiation acts as a barrier (financial/legal) to entry.

Economic Efficiency—NOT! Monopolistic competition is neither productively nor allocatively efficient. P>min. ATC P>MC

Excess Productive Capacity—plant and equipment underused when firms produce at less than min. ATC. Result: many monopolistically competitive industries are overcrowded with firms producing below optimal capacity (retail, hotel vacancies, restaurants, barber chairs.)

Nonprice Competition In order to differentiate, firms advertise. Fixed cost: increases ATC Increases demand Differentiation provides consumers variety and satisfies diverse tastes. Differentiation may lead to product improvements and innovation.

Can you guess the industry? The largest firm in the industry has 42.0% market share. Top 3 firms control 89% of market. Most consumers are brand loyal. It’s the “real thing” and “open happiness”

Which industry? 3 firms control 81% of market; top 2 control 63% Large profit margins Lots of nonprice competition No single dominant firm Huge barriers to entry Lots of consumer choice

Last one… Since 1990, less oligopolistic Top 4 firms now control 59% compared to nearly 70% ten years ago Huge barriers to entry Huge advertisers You can easily name 10 companies.

Oligopoly Characteristics Rule of Thumb: 4 large firms control 70-80% of market. Key Understanding: Some price control, but mutual interdependence & strategic behavior are key characteristics. Each firm sets its price, but must consider how its rivals will react to its strategy. Considerable nonprice competition.

Typically Huge Barriers to Entry: Economies of scale (aircraft, autos,) Control of raw materials (mining, towers) Patents/technology (cell phones, copiers) Predatory practices (airlines, soft drinks) “Urge to merge” to gain economies of scale: Exxon+Mobil, Sears+Kmart, AT&T+Cingular, AT&T+DirectTV, JPMorgan+Chase, HP+Compaq, US Airways+American

Modeling Oligopolies Mutual interdependence creates complications for modeling this market structure. Without being able to predict actions of rivals, oligopolists can’t estimate D and MR. “Governing Dynamics:” was Adam Smith wrong?

Game Theory: the study of how people behave in strategic situations Required: Players (we use two) Strategies (choices) available to each player (we use two) The payoffs each player receives Setting up the game—using a payoff matrix.

Finding a dominant strategy and/or Nash Equilibrium Dominant strategy—an option that is better than any alternative option regardless of what the other player does. Nash Equilibrium—an outcome from which neither player wants to deviate. The best choice given the action of the other player.

Find the dominant strategy CASE #1: Airbus and Boeing can both produce either 3 or 4 planes each week. If they both produce 4, they both earn $32 mil. If they both produce 3, they both earn $36 mil. If one produces 3 and the other produces 4, the one who produced 4 earns $40 mil. and the one who produced only 3 earns $30 mil.

CASE #2: Kimberly Clark and Proctor & Gamble can choose to spend on R&D or not. If both spend, PG will earn $45 mil. while KMB will earn $5 mil. If neither spends, PG earns $70 and KMB earns $30. If one spends and the other doesn’t, the spender earns $85 and the non-spender loses $10.

CASE #3: “Chicken.” If you both go straight, you both get injured (-50). If you both swerve, you are both “chicken” (0). If one of you goes straight and the other swerves, the one who went straight is the brave one (without any sense!) (+10) and the one who swerved is a “chicken” (-5).

Oligopoly Pricing In a stable economy, oligopolist prices are generally stable. Price, if it does change, tends to move “in concert.” Kinked Demand Theory explains why prices are generally stable Rivals match or ignore price changes (steep vs. flat demand curves), which leads to the likely outcome that rivals will match price cuts and ignore price increases (key graph p. 229)

Kinked Demand Curve Price Inflexibility: Raising price results in losing customers (yikes!) Lowering price results in only small sales increases (so why bother?) Changes in costs may not even cause a firm to change price (MR is vertical.)

Price Leadership Model One firm, usually the largest, initiates price changes and others follow. Infrequent price changes Limit Pricing—price may not be the profit maximizing price because that price may entice firms to enter the market Potential problem: price wars

Cartels and Collusion Attempts to act as monopolies Collusion—firms reach agreement to fix prices, divide market, restrict competition (illegal!) Cartel—formal agreement among producers to limit production and control price (OPEC) Problem: incentive to cheat—earns more economic profit.