Chapter 9: Monopolistic Competition and Oligopoly Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Monopolistic Competition Monopolistic competition is a market structure in which many firms sell a differentiated product and entry into and exit from the market are relatively easy. Examples: furniture, jewelry, leather goods, grocery stores, gas stations, restaurants, clothing stores and medical care. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Characteristics of Monopolistic Competition Relatively large number of sellers – firms have small market shares, collusion is unlikely and each firm can act independently Differentiated products – the product is slightly different and is often promoted by heavy advertising Easy entry to, and exit from, the industry – economies of scale are few, capital requirements are low but financial barriers exist Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Differentiated Products Product differentiation is a form of nonprice competition in which a firm tries to distinguish its product or service from all competing ones on the basis of attributes such as design and quality. Production differentiation entails product attributes, service, location, brand name and packaging, and some control over price. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Advertising The goal of product differentiation and advertising is to make price less of a factor in consumer purchases and make product differences a greater factor. The intent is to increase the demand for a product and to make demand less elastic. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Pricing and Output in Monopolistic Competition The demand curve of a monopolistically competitive firm is highly, but not perfectly, elastic. The price elasticity of demand for a monopolistic competitor depends on the number of rivals and the degree of product differentiation. The larger the number of rival firms and the weaker the product differentiation, the greater the price elasticity of each firm’s demand. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Short Run: Profit or Loss The monopolistically competitive firm maximizes profit or minimizes loss in the short run. It produces a quantity Q at which MR = MC and charges a price P based on its demand curve. When P > ATC, the firm earns an economic profit. When P < ATC, the firm incurs a loss. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long Run: Only a Normal Profit In the long-run, firms will enter a profitable monopolistically competitive industry and leave an unprofitable one. A monopolistic competitor will earn only a normal profit and price just equals average total cost at the MR = MC output. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long Run: Only a Normal Profit Because entry to the industry is relatively easy, economic profits attract new rivals. As new firms enter, the demand curve faced by the typical firm shifts to the left, reducing its economic profit. When entry of new firms has reduced demand to the extent that the demand curve is tangent to the ATC curve at the profit-maximizing output, the firm is just making a normal profit, leaving no incentive for new firms to enter. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long Run: Only a Normal Profit When the industry suffers short-run losses, some firms will exit in the long run. As firms exit, the demand curve of surviving firms begins to shift to the right, reducing losses until the firms are just making normal profit. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Pricing and Output in Monopolistic Competition Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Monopolistic Competition and Efficiency In monopolistic competition, neither productive nor allocative efficiency occurs in long-run equilibrium. Since the firm’s profit-maximizing price (and average total cost) slightly exceed the lowest average total cost, productive efficiency is not achieved. Since the profit-maximizing price exceeds marginal cost, monopolistic competition causes an underallocation of resources. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Excess Capacity The gap between the minimum ATC output and the profit-maximizing output is a monopolistically competitive firm’s excess capacity. Plants and equipment are unused because the firm is producing less than the minimum- ATC output. Monopolistically competitive industries are overcrowded with firms each operating below its optimal capacity. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Product Variety and Improvement Despite the overcrowded feature, monopolistic competition does promote product variety and product improvement. A firm earning a normal profit will develop and improve its product in order to regain its economic profit. Successful product improvements by one firm obligates rivals to imitate or improve on that firm’s temporary market advantage or else lose business. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Oligopoly Oligopoly is a market structure dominated by a few large producers of homogeneous or differentiated products. Because of their “fewness”, oligopolists have considerable control over their price. Examples: tires, beer, cigarettes, copper, greeting cards, steel, aluminum, automobiles and breakfast cereals Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Characteristics of Oligopoly A few large producers – firms are generally large and together they dominate the industry. Either homogeneous or differentiated products – the products are standardized, or differentiated with heaving advertising. Price maker – the firm can set its price and output levels to maximize its profit. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Characteristics of Oligopoly Strategic behavior – Self-interested behavior that takes into account the reactions of others. Mutual interdependence – each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms. Blocked entry – barriers to entry exist which make it hard for new firms to enter. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Oligopoly Behavior: A Game-Theory Overview Game theory is the study of how people or firms behave in strategic situations. It can be used to analyze the pricing behavior of oligopolists. Suppose in a two-firm oligopoly (a duopoly), each firm must chose a pricing strategy, high or low. A payoff matrix can be constructed to show payoffs (profit) to each firm that result from each combination of strategies. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Game Theory Example Two firms, A and B, must decide on a pricing strategy: price high or price low. Although firms A and B are mutually interdependent, both can benefit from collusion. However, there may be incentive to cheat. Firm A Price High Price Low $12 $15 Price High $6 $12 Firm B $6 $8 Price Low $8 $15 A B Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Mutual Interdependence Each firm’s profit depends on its own pricing strategy and that of its rival. In the example, if both firms adopt a high-price strategy, each firm will earn $12 million; if both adopt a low-price strategy, each will earn $8 million. If one firm adopts a low-price strategy while the other adopts a high-price strategy, the low-price firm will earn $15 million while the other firm earns $6 million. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Collusive Tendencies Oligopolists can often benefit from cooperation, or collusion. Collusion is a situation in which firms act together and in agreement to fix prices, divide markets, or otherwise restrict competition. In the example, firms A and B can agree to establish and maintain a high-price strategy so each can earn $12 million. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Incentive to Cheat Oligopolists might have an incentive to cheat on a collusive agreement if they can benefit from such action. In the example, suppose firms A and B agree to establish and maintain a high-price strategy. Either firm can cheat and lower its price in order to increase profit to $15 million (a $3 million increase). Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Incentive to Cheat Because of possible incentives to cheat, independent action by oligopolists may lead to mutually “competitive” low-price strategies, which benefit consumers but not the oligopolists. In the example, firms A and B will choose a low-price strategy and earn $8 million each. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Kinked-Demand Model In the kinked-demand model, oligopolists face a demand curve based on the assumption that rivals will ignore a price increase and follow a price decrease. An oligopolist’s rivals will ignore a price increase above the going price but follow a price decrease below the going price. The demand curve is kinked at this price and the marginal-revenue curve has a vertical gap. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Kinked-Demand Model Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Leadership Price leadership involves an implicit understanding that other firms will follow the lead when a certain firm in the industry initiates a price change. A price leader is likely to observe the following tactics: Infrequent price changes Communications Avoidance of price wars Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Collusion Collusion, through price control, may allow oligopolists to reduce uncertainty, increase profits, and possibly block potential entry. One form of collusion is the cartel: a formal agreement among producers to set the price and the individual firm’s output levels of a product. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Joint-Profit Maximization If oligopolistic firms produce an identical product, and have identical cost, demand, and marginal-revenue curves, than each firm can maximize profit using the MR=MC rule. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A profitable oligopolist when rivals charge the same price, Po MC Price Po Economic Profit ATC D Q0 MR Quantity of output

Joint-Profit Maximization If rivals charge prices lower than Po, then the demand curve of the firm charging Po will shift to the left as its customers turn to its rivals, and its profits will fall. The firm can retaliate and cut its price, too, however, all firms’ profits would eventually fall. Firms will choose to charge Po and produce Qo because it is the most profitable price-output combination. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Obstacles to Collusion Barriers to collusion beyond the antitrust laws include: Demand and cost differences Number firms Cheating Recession Potential entry Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Oligopoly and Advertising Each firm’s share of the total market is generally determined through product development and advertising for two reasons: Product development and advertising campaigns are less easily duplicated than price cuts. Oligopolists have sufficient financial resources to engage in product differentiation and advertising.

Oligopoly and Advertising Positive effects of advertising are: Enhances competition Reduces consumers’ search time, direct costs, and indirect costs Facilitates the introduction of new products Negative effects of advertising include: Alters consumers’ preferences in favor of the advertiser’s product Brand-loyalty promotes monopoly power

Oligopoly and Efficiency Many economists believe the oligopoly market structure is neither productively efficient nor allocatively efficient. This is because many oligopolistic firms price higher than average total cost and produce less than the optimal output level. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Oligopoly and Efficiency A few believe that oligopoly is actually less desirable than pure monopoly, because government can guard against abuses of monopoly power but not against informal collusion among oligopolists that give the outward appearance of competition involving independent firms. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.