Monopolistic Competition & Oligopoly 1

Where Does Monopolistic Competition “fit in?” Perfect Competition Monopoly Monopolistic Competition 6

Monopolistic Competition Characteristics: Many buyers and sellers (no firm has a significant share of the market) Firms produces a similar, yet differentiated product (gives us downward sloping, elastic demand) Ease of entry and exit Nonprice Competition 7

Monopolistic Competition Characteristics: Relatively Large Numbers Small Market Share No Collusion Independent Actions Product Differentiation Product Attributes (quality or gimmicks) Services Location Brand Names and Packaging Some Control Over Price

Product Differentiation The more that a Firm can Differentiate their product, the more Inelastic the Demand becomes. Thus, firms may Advertise, improve quality or service, or find better locations. 17

Examples of Monopolistically Competitive Markets Book Publishers Paperboard Boxes Sawmills Light Fixtures Wood Furniture Kitchen Cabinets Pizza Places (Pizza Hut, Dominos) Hairdressers Grocery Stores (Ramey, Price Chopper Richards Brothers 8

Monopolistic Competition in the Short Run Looks and Acts Like Monopoly Faces Downward Sloping Demand and MR Produces where MR=MC and may make a profit. 9

Monopolistic Competition in the Short Run Economic Profit Firms will Enter $10 MC 8 ATC p* 6 atc* 4 2 D MR Q 1 2 3 4 5 10

Monopolistic Competition in the Long Run Firm Demand Shifts In and Gets More Elastic. Demand Shifts Back Because More Firms Enter the Industry, So There is Less Demand Per Firm. Demand Gets More Elastic Because More Firms Means More Substitutes and More Substitutes Means More Elastic 11

Monopolistic Competition in the Long Run Like Perfect Competition, Firms Will Continue to Enter Until There are No More Profits to Attract Them. 12

Monopolistic Competition in the Short Run Economic Profit Firms will Enter $10 MC 8 ATC p* 6 atc* 4 2 D MR Q 1 2 3 4 5

Monopolistic Competition in the Long Run Zero Economic Profit $10 MC ATC 8 6 p*= atc* 4 D1 2 MR D2 Q 1 2 3 4 5 13

Monopolistic Competition in the Short Run ATC MC ATC P Firms will Exit Economic Losses Price and Costs D MR Q Q

Monopolistic Competition in the Long Run ATC MC ATC P Zero Economic Profit D2 Price and Costs D1 MR Q Q

Long Run Conditions of Monopolistic Competition Excess Capacity Inefficiency 14

Excess Capacity Excess Capacity is the Difference Between The Long Run Perfectly Competitive Quantity Produced and the Long Run Monopolistically Competitive Quantity Produced. Generally Speaking, There Will be Excess Capacity in the Long Run of Monopolistic Competition. 15

Excess Capacity P Q Zero Economic Profit MC ATC P* D MR Q Q Q Q Q Excess Capacity 16

Comparison of Perfect Competition and Monopolistic

Efficiency Productive Efficiency Allocative Efficiency Generally, A Monopolistically Competitive Firm is not Productively Efficient, since it is not producing at the bottom of it’s ATC curve Allocative Efficiency Generally, A Monopolistically Competitive Firm is not Allocatively Efficient, since MR > MC and there is excess capacity. 18

Oligopoly For a Market to be Described as Oligopolistic, it must satisfy the following conditions: Few Sellers Mutual Interdependence The Firm’s products may be identical or unique (Homogeneous or Differentiated) The are Barriers to Entry (like monopoly) non-price competition 19

Where Does Oligopoly “fit in?” Perfect Competition Monopoly Monopolistic Competition Oligopoly 20

Oligopoly Model Oligopoly is a market in which a small number of firms supply the entire market and where natural barriers to entry prevent other firms from entering Examples: beer, breakfast cereals, automobiles, long-distance telephones, airplanes, database software,...

Concentration Ratios One Way to Determine Whether a Market is Oligopolistic is to look at a Concentration Ratio A Concentration Ratio Let’s Us Know if the Whole Industry’s Sales are Dominated by the Sales of a Few Firms. 21

The X-Firm Concentration Ratio The X-Firm (usually X = 4) Concentration Ratio is the Percentage of Industry Sales Accounted for by the Sales of the Top X (4) Firms in the Industry: Sales of the Top 4 Firms Total Industry Sales 22

Herfindahl Index This index ix the sum of the squared percentages of all firms in the industry. Hindex =  (%Si)2 Suppose firms have 50%, 30%, 10% and 10% respectively the Herfindahl Index would be: Hindex = (50)2 + (30)2 + (10)2 + (10)2 Hindex = 2,500 + 900 + 100 + 100 = 3,600

Herfindahl Index Hindex = (25)2 + (20)2 + (15)2 + (10)2 + (10)2 + (10)2 + (10)2 Hindex = 625 + 400 + 225 + 400 = 1,650 A Herfindahl Index below 1000 is not considered a concentrated market. Industries with a Herfindahl Index between 1000 and 1800 have some degree of concentration. If the Herfindahl Index is greater than 1800, the degree of monopoly power potentially exists

Mutual Interdependence The oligopoly problem is that the demand curve facing one oligopolist depends on actions (price and advertising) of other firms. If one firm lowers price it will reduce other firms demand. The quantity that combined firms produce will influence the market price. So we all must restrict combined output and cooperate to make maximum profit.

Oligopolies and Collusion Overt Collusion OPEC Cartel Covert Collusion Electrical Equipment Price Fixing Tacit Collusion Price Leadership

Game Theory Game Theory is a Technique That Allows Us to Examine The Strategies of Oligopolists This Technique Allows Us to Determine the Best Strategy for a Oligopolist if the Other Oligopolists are Aware of the All of Avaliable Strategies

The Prisoner’s Dilemma Consider the Following Story: Bill and Jill Have Cheated on an Exam They are Both Caught Bill in Prof. Martin’s Office and Jill is Prof. White’s Office Each Are Told That Their Punishment Will Be Somewhat Lighter if They Confess

The Prisoner’s Dilemma Jill and Bill cheat on an Exam Jill is Silent Jill Confesses They Fail The Class and Their Transcript is Noted Bill is Silent Jill Fails, Bill is Expelled They Are Both Suspended For a Year, Fail the Class and Transcipts are Noted. Bill Confesses Bill Fails, Jill is Expelled

Oligopoly Behavior A C B D Mutual Interdependence $12 $15 $6 $4 RareAir’s Price Strategy High Low A C B $12 $15 $6 $4 D High Uptown’s Price Strategy Low

Game Theory A C B D Greatest Combined Profit $12 $15 $6 $4 RareAir’s Price Strategy High Low A C B $12 $15 $6 $4 D Greatest Combined Profit High Uptown’s Price Strategy Low

Game Theory A C B D $12 $15 $6 $4 Independent Actions Stimulate RareAir’s Price Strategy High Low A C B $12 $15 $6 $4 D Independent Actions Stimulate Response High Uptown’s Price Strategy Low

Game Theory A C B D $12 $15 $6 $4 Independent Actions Stimulate RareAir’s Price Strategy High Low A C B $12 $15 $6 $4 D Independent Actions Stimulate Response Gravitating to the Worst Case High Uptown’s Price Strategy Low

Game Theory A C B D Mutual Interdependence Collusion Invites a RareAir’s Price Strategy High Low A C B $12 $15 $6 $4 D Collusion Invites a Different Solution High Uptown’s Price Strategy Low

The Payoff Matrix You’ve now seen the four possible outcomes. They are: both collude and make an economic profit of $12 million a week each one cheats and makes an economic profit of $15 million a week while the other complies and earns a profit of $6 million a week both cheat and make $4 million a week.

Models of Oligopoly 1 - Kinked Demand Curve 2 - Collusive Pricing No Standard Model due to... Diversity Interdependence 1 - Kinked Demand Curve 2 - Collusive Pricing 3 - Price Leadership 4 - Break-Even Model

Kinked Demand Curve Each Oligopolist believes that if it raises its price, other firms will keep their prices constant, so the quantity demanded will fall by a large amount (demand is elastic). Each firm also believes that if it cuts its price, other firms will cut their prices too, so the quantity demanded will rise by a small amount (demand is inelastic).

Kinked Demand Curve Effectively creating P a kinked demand curve This is an attempt to explain the “sticky prices” in oligopoly industries. P P D2 D1 Q Quantity

The Kinked Demand Curve Theory The current price is P And at this price, the firm is selling the quantity Q P

The Kinked Demand Curve Theory The marginal revenue curve from “b” down. The marginal revenue curve for a price increase runs from “a” up.

The Kinked Demand Curve Theory Between a and b, there is no marginal revenue curve Cost can increase considerably without causing the firm to increase price. So long as the MC curve passes through the break in the MR curve, the firms keeps its price and quantity constant.

The Kinked Demand Curve Theory Summary: The demand curve has a kink at the current price The marginal revenue curve is discontinuous Price is sticky and remains at the kink point unless a large enough change in marginal cost occurs The elasticity of demand indicates a decrease in TR for any price change.

Cartels and Collusion Oligopoly is conducive to collusion If a few firms face identical or highly similar demand and costs... They will seek joint profit maximization...

Collusive Pricing Model The Cartel Model: The Oligopolists Get Together (Since There are So Few of Them) and Act As If They Were One Monopolist. Collectively Produce the Monopolistic Quantity (establish quotas) - Thus Maximizing Profit as a group. Example: OPEC 23

Cartel Model Collusive agreement --a cartel--is an agreement between two (or more) producers to restrict output in order to raise prices and make bigger profits (act like a monopoly). Strategies for a firm in a cartel comply with the agreement cheat on the agreement

Cartel Model M C P r i c e A T C If the firms compete the price would fall to the minimum of the ATC A P C P R O F I T S C B P 1 D M R Q Q Q u a n t i t y C 1 a

Problems With Cartels Generally, They Are Not Legal (Price Fixing) They Are Difficult to Organize and Monitor Can’t Force New Firms to Join Usually there is Cheating 24

The Incentive to Cheat On A Cartel If the Cartel Maintains the Monopoly Price, The Individual Member of the Cartel Can Act Like a Price Taker (They Can Sell the Quota amount at the Market Price) As a Price Taker, They Maximize Profit Where MC = MR. This Quantity is Greater Than the Cartel Wants the Individual Firm to Produce. All Firms in the Cartel Do This and the Cartel Falls Apart 25

The Incentive to Cheat On A Cartel $ $ If I lower the price, MR > MC. Profit. MC MC ATC P MR MR D Q Q Qcheater Market Qquota Firm 27

A Duopoly Model determine the profit maximizing output for the industry. assign a production quota to each firm.

Duopoly Model One firm cheats on the agreement and increases production to 3,000 units a week. With 5,000 units supplied, the price falls to $7,500 a unit.

Duopoly Model Despite the fall in price, the cheat makes a bigger profit, because its average total cost falls. The cheat’s profit becomes $4.5 million a week.

Duopoly Model Here, both firms cheat and increase production to 3,000 units a week. With 6,000 units on offer for sale, the price falls to $6,000 a unit (zero economic profit).

Obstacles to Collusion Demand & Cost Differences Number of Firms Cheating Recession Potential Entry (or new)Entry Legal Obstacles: Antitrust