Chapter 10 Monopolistic Competition and Oligopoly Lecture Slides Economics for Today Irvin B. Tucker © 2011 South-Western, a part of Cengage Learning

What will I learn in this chapter? The theories of price and output decisions in the real-world markets of monopolistic competition and oligopoly © 2011 South-Western, a part of Cengage Learning

What is monopolistic competition? A market structure characterized by: 1. many small sellers 2. differentiated product 3. easy entry and exit © 2011 South-Western, a part of Cengage Learning

What are examples of monopolistic competition? grocery stores hair salons gas stations video rental stores restaurants © 2011 South-Western, a part of Cengage Learning

How many is many small sellers? The many sellers condition is met when each firm is so small relative to the total market that its pricing decisions have a negligible effect on the market price © 2011 South-Western, a part of Cengage Learning

What is product differentiation? The process of creating real or apparent differences between goods and services © 2011 South-Western, a part of Cengage Learning

What does easy entry and easy exit mean? There are low barriers to entry, but entry is not quite as easy as in a perfectly competitive market because monopolistically competitive firms sell differentiated products. © 2011 South-Western, a part of Cengage Learning

What is a barrier to entry in monopolistic competition? Firms can differentiate themselves from their competitors in ways other than price (nonprice competition). © 2011 South-Western, a part of Cengage Learning

What is nonprice competition? A firm competes using reputation, location, advertising, packaging, product development, and better service rather than lower prices © 2011 South-Western, a part of Cengage Learning

Why is a monopolistic competitive firm a price maker? Product differentiation gives the firm some control over its price © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning How does the elasticity of demand curve for a monopolistically competitive firm compare to a perfectly competitive firm and a monopolist? It is less elastic (steeper) than for a perfectly competitive firm and more elastic (flatter) than for a monopolist © 2011 South-Western, a part of Cengage Learning

What effect does advertising have on average costs? It raises the long-run average cost curve © 2011 South-Western, a part of Cengage Learning

Exhibit 1 The Effect of Advertising on Average Cost 4.00 3.50 C 3.00 2.50 Cost per unit (dollars) With advertising 2.00 A LRAC2 B 1.50 1.00 LRAC1 0.50 Without advertising 2 4 6 8 10 12 14 16 18 20 22 Quantity of frozen yogurt (thousands of dishes units per month) 13 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning How does a firm decide what price to charge and how many units to produce? MR = MC © 2011 South-Western, a part of Cengage Learning

Exhibit 2 A Monopolistically Competitive Firm in Short Run 40 MC 35 ATC 30 25 Price, Costs, and Revenue (dollars) 18 Profit=$1,800 15 D 10 5 MR=MC MR 0 1 2 3 4 5 7 8 9 10 11 12 6 Quantity of Seafood Meals (hundreds per week) 15 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What happens in the long run when economic profits are being made in the short run? With easy entry, firms will enter the industry, and the demand curve for each firm shifts leftward because each firm’s market share declines. The market price declines, and economic profits are eliminated. © 2011 South-Western, a part of Cengage Learning

What happens to a firm’s costs in the long run? In addition to decreased demand from new entrants sharing the market, the cost curve for firms increases from increasing advertising and other expenses to compete against the new competition. © 2011 South-Western, a part of Cengage Learning

Zero economic profit New firms enter Firm’s LRAC curve increases Firm increases advertising expenses Firm’s demand curve decreases New firms enter © 2011 South-Western, a part of Cengage Learning

Exhibit 3 Monopolistic Competition Firm in the Long Run 40 MC 35 30 LRAC Minimum LRAC 25 Price, Costs, and Revenue (dollars) 20 17 15 D MR=MC 10 5 MR 1 2 3 4 5 6 7 8 9 Quantity of Seafood Meals (hundreds per week) 19 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning How does monopolistic competition compare to perfect competition in the long run? Price is lower and quantity is greater in perfect competition compared to monopolistic competition © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Why is price higher and quantity lower in monopolistic competition compared to perfect competition? Because firms in monopolistic competition face a downward sloping demand curve and a MR curve beneath it which is more steeply sloped © 2011 South-Western, a part of Cengage Learning

How efficient is monopolistic competition? Less resources are used and a higher price is charged than would be the case under perfect competition © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Exhibit 4 A Comparison of Monopolistic Competition and Perfect Competition in the Long Run 23 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is oligopoly? A market structure characterized by: 1. Few sellers 2. Homogeneous or differentiated product 3. Difficult entry © 2011 South-Western, a part of Cengage Learning

How few are a few sellers? When the firms are so large relative to the total market that they can affect the market price © 2011 South-Western, a part of Cengage Learning

What is mutual interdependence? A condition of oligopoly in which an action by one firm may cause a reaction from other firms © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What are examples of homogeneous and differentiated product oligopolies? Homogeneous or standardized product industries include steel, oil, and aluminum Differentiated product industries include automobile, detergents, and breakfast cereals © 2011 South-Western, a part of Cengage Learning

What are some examples of difficult entry? Similar to monopoly, formidable barriers to entry exist Examples include financial requirements, control over an essential resource, patents, and economies of scale © 2011 South-Western, a part of Cengage Learning

What are different possible oligopoly models? Nonprice competition Kinked demand curve Price leadership Cartel Game theory © 2011 South-Western, a part of Cengage Learning

What is nonprice competition? Because of a differentiated product, there is competition in ways other than price, such as developing new products and advertising © 2011 South-Western, a part of Cengage Learning

What does a kinked demand curve show? It shows that rivals will match a firm’s price decrease, but ignore a price increase © 2011 South-Western, a part of Cengage Learning

D D Exhibit 5 The Kinked Demand Curve X Y 1 1.5 2 4 30,000 Rivals ignore price increases D 27,250 25,000 Y Price per automobile (dollars) 20,000 Rivals match price decreases 15,000 D 1 1.5 2 3 3.2 4 Quantity of automobiles (millions per year) © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning The Tucker The Tucker was an advanced car briefly produced in 1948. © 2011 South-Western, a part of Cengage Learning

What is price leadership? A pricing strategy in which a dominant firm sets the price for an industry and the other firms follow © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is a cartel? A group of firms formally agreeing to control the price and output of a product © 2011 South-Western, a part of Cengage Learning

What are examples of cartels? Organization of Petroleum Exporting Countries (OPEC) International Telephone Cartel (ITU) International Airline Cartel (IATA) © 2011 South-Western, a part of Cengage Learning

What is formal collusion? A group of firms openly agree to control the price and output of a product © 2011 South-Western, a part of Cengage Learning

Is formal collusion legal? No, it is against the law in the U.S. for firms to come together and agree on the price or output for products. But this is not true outside the U.S. © 2011 South-Western, a part of Cengage Learning

What is informal collusion? Companies find alternative ways to agree on a price without any tacit communication. For example, firms follow established rules of an industry. © 2011 South-Western, a part of Cengage Learning

What is the major weakness of a cartel? As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits © 2011 South-Western, a part of Cengage Learning

Price per barrel (dollars) Exhibit 6 Why Cartel Members May Cheat 165 MC LRAC 150 135 Price per barrel (dollars) 120 MR2 Profit without cheating=$80 million Extra profit from cheating=$80 million 105 90 75 MR1 60 45 30 15 0 1 2 3 5 6 7 8 9 10 11 12 4 Quantity of Oil (millions of barrels per day) 41 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is game theory? A model of the strategic moves and countermoves of rivals © 2011 South-Western, a part of Cengage Learning

What are two pricing methods in game theory? Tit for tat Price leadership © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is tit-for-tat? Under this informal approach, a player will do whatever the other player did the last time © 2011 South-Western, a part of Cengage Learning

What is game theory price leadership? Another informal approach is to play “follow the leader” in which firms set whatever price the leader sets © 2011 South-Western, a part of Cengage Learning

What if cartels were legal? Another approach would be for firms to make a formal agreement To avoid cheating, rivals could agree on a penalty for cheaters © 2011 South-Western, a part of Cengage Learning

Exhibit 7 A Two-Firm Payoff Matrix 47 © 2011 South-Western, a part of Cengage Learning

What conclusion can be drawn from oligopolies? The price charged for the product will be higher than under perfect competition More money is spent on forms of nonprice competition © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Exhibit 8 © 2011 South-Western, a part of Cengage Learning

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