CHAPTER 14 Monopolistic Competition and Oligopoly Michael Parkin ECONOMICS 5e CHAPTER 14 Monopolistic Competition and Oligopoly 1

Learning Objectives Explain how price and output are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry 2

Learning Objectives (cont.) Explain how price and output are determined when an industry has one dominant firm and several small firms Use game theory to make predictions about price wars and competition among a small number of firms 3

Learning Objectives Explain how price and output are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry 4

Monopolistic Competition A large number of firms compete. Small market share Ignore other firms Collusion Impossible Each firm produces a differentiated product. A product slightly different from the products of competing firms. 5

Monopolistic Competition Monopolistic competition (cont.) Firms compete on product quality, price, and marketing. Quality - design, reliability, service, ease of access to the product. Price - downward sloping demand curve. A tradeoff between price and quality. Marketing - advertising and packaging. Firms are free to enter and exit. 5

Monopolistic Competition Monopolistic competition (cont.) Consequently, a firm in monopolistic competition cannot make an economic profit in the long-run. 5

Examples of Monopolistic Competition

Monopolistic Competition As a result of the characteristics of monopolistic competition: No one firm can effectively influence what other firms do. The firm faces a downward sloping demand curve. Firms cannot earn long-run economic profit. 16

Output and Price in Monopolistic Competition Short-Run: Economic Profit The firm in monopolistic competition looks just like a single price monopoly. The key difference between monopoly and monopolistic competition lies in the long-run. 18

Monopolistic Competition Short-run 220 MC Price (dollars per jacket) ATC 190 Economic profit 160 D 140 Instructor Notes: 1) Profit is maximized where marginal revenue equals marginal cost. 2) The graphs shows short-run outcome. 3) Profits is maximized by producing quantity QS and selling it for price PS . 4) Average total cost is CS, and the firm makes an economic profit (the blue rectangle). 5) Economic profit encourages new entrants in the long run. 120 MR 50 100 150 200 250 300 Quantity (jackets per day) 23

Output and Price in Monopolistic Competition Long-Run: Zero Economic Profit Economic profit attracts new entrants. As new firms enter the industry, the firm’s demand curve and marginal revenue start to shift leftward. The profit-maximizing quantity and price fall.

Monopolistic Competition Long-run 220 MC Price (dollars per jacket) 180 Zero economic profit ATC 160 145 Instructor Notes: 1) Profit is maximized where marginal revenue equals marginal cost. 2) The graphs shows short-run outcome. 3) Profits is maximized by producing quantity QS and selling it for price PS . 4) Average total cost is CS, and the firm makes an economic profit (the blue rectangle). 5) Economic profit encourages new entrants in the long run. 120 MR D 50 100 150 200 250 300 Quantity (jackets per day) 23

Monopolistic Competition and Efficiency Marginal benefit exceeds marginal cost and production is less than its efficient level. Therefore, the market structure is inefficient. 25

Monopolistic Competition and Efficiency The monopolistically competitive industry produces an output at which price equals average total cost but exceeds marginal cost. This outcome means that firms in monopolistic competition always have excess capacity in long-run equilibrium. 25

Excess Capacity A firm’s capacity output is the output at which average total cost is a minimum - the output at the bottom of the U-shaped ATC curve. The firm produces a smaller output than that which minimizes average total cost. 25

Excess Capacity MC ATC MR D 180 Price (dollars per jacket) 160 145 output Profit maximizing output 120 MR D 50 100 150 Quantity (jackets per day)

Learning Objectives Explain how price and output are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry

Product Development and Marketing Innovation and Product Development To maintain its economic profit, a firm must seek out new products that will provide it with a competitive edge, even if temporarily.

Product Development and Marketing Efficiency and Product Innovation Two views Improved products that bring great benefits to the consumer. But many so-called improvements amount to little more than changing the appearance of a product.

Product Development and Marketing Advertising and packaging are the principle means used by firms to attempt to create a consumer perception of product differentiation even when actual differences are small.

Product Development and Marketing Marketing Expenditures Advertising expenditures affect the profits in two ways: Increase costs Change demand

Product Development and Marketing Selling Costs and Total Costs Advertising expenditures increase the costs of a monopolistically competitive firm above those of a competitive firm or monopoly. Selling costs are fixed costs.

Advertising Expenditures

Product Development and Marketing Selling Costs and Demand Advertising increases competition. To the extent that advertising increases competition, it decreases the demand faced by any one firm. 27

Selling Cost and Total Costs Advertising cost 200 Average total cost with advertising Price (dollars per jacket) 180 170 Average total cost with no advertising By increasing the quantity bought, advertising can decrease ATC 160 140 120 MR 25 130 200 300 Quantity (jackets per day)

Efficiency: The Bottom Line The bottom line on the question of efficiency of monopolistic competition is ambiguous.

Learning Objectives Define monopolistic competition and oligopoly Explain how price and output are determined in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry 28

Oligopoly Price and quantity of a producer depends upon that of the other producers’. Models developed to explain the prices and quantities in oligopoly markets: Traditional Kinked Demand Curve Model Dominant Firm Model Game Theory 29

The Kinked Demand Curve Model Assumption If a firm raises its price, others will not follow. more elastic response If a firm cuts its price, so will the other firms. less elastic response This assumption results in the kinked demand curve. 30

The Kinked Demand Curve Model MC1 MC0 a Price and cost (dollars) P Instructor Notes: 1) The marginal cost curve passes through the break in the marginal revenue curve. 2) Marginal cost changes inside the range ab leave the price and quantity unchanged. MR b D Q Quantity 35

The Kinked Demand Curve Model Problems Beliefs about the demand curve are not always correct. Other firms may, in fact, follow a price increase. This may result in the firm incurring an economic loss. 36

Learning Objectives (cont.) Explain how price and output are determined when an industry has one dominant firm and several small firms Use game theory to make predictions about price wars and competition among a small number of firms 37

Dominant Firm Oligopoly A dominant firm oligopoly may exist if one firm: Has a big cost advantage over the other firms. Sells a large part of the industry output. Sets the market price. Other firms are price takers. 38

Dominant Firm Oligopoly Let’s use Big-G as an example. Big-G is the dominant gas station in a city. 39

Dominant Firm Oligopoly Ten small firms and market demand Big-G’s price and output decision S10 MC 1.50 1.50 MR Price (dollars per gallon) a b a b 1.00 1.00 Instructor Notes: The other 10 firms take this price and each firm sells 1,000 gallons per week. D 0.50 0.50 XD 10 20 10 20 Quantity (thous. of gal./week) Quantity (thous. of gal./week) 43

Learning Objectives (cont.) Explain how price and output are determined when an industry has one dominant firm and several small firms Use game theory to make predictions about price wars and competition among a small number of firms 44

Game Theory Invented by John von Neumann in 1937. We will use it to help understand oligopoly. 45

Game Theory What is a game? Games have 3 features: Rules Strategies Payoffs “The Prisoners Dilemma” is a game that is used to generate predictions. 46

The Prisoners’ Dilemma Art & Bob are caught stealing a car. The D.A. feels they are responsible for a robbery months earlier. The D.A. decides to make them play a game. 47

The Prisoners’ Dilemma Rules of the game Prisoners are put in separate rooms and cannot communicate with the other. They are told that they are a suspect in the earlier crime. If both confess, they will get 3 years. If one confesses and the other does not, the confessor will get 1 year while the other gets 10. 48

The Prisoners’ Dilemma Strategies (possible actions) They can each: Confess to the robbery Deny having committed the robbery 49

The Prisoners’ Dilemma Payoffs Four outcomes are possible: Both confess. Both deny. Art confesses and the Bob denies. Bob confesses and Art denies. 50

Prisoners’ Dilemma Payoff Matrix Arts strategies Confess Deny 3 years 1 year 10 years Confess Bob’s strategies Instructor Notes: 1) Each square shows the payoffs for the two players, Art and Bob, for each possible pair of actions 2) In each square the red triangle shows Arts payoff and the blue triangle shows Bob’s. 3) For example, if both confess, the payoffs are in the top left square. 4) The equilibrium of the game is for both players to confess, and each gets a 3-year sentence. 1 year 10 years 2 years Deny 51

The Prisoners’ Dilemma A dominant strategy emerges. Art and Bob should both deny because: If they both deny, they will only get 2 years—but they don’t know if the other will deny. If Art denies, but Bob does not, Art will only get 1 year. If Art denies, but Bob confesses, Art will get 10 years. They both eventually decide it is best to confess — Nash equilibrium. 52

An Oligopoly Price-Fixing Game Duopoly A market structure with two firms. We will use Trick and Gear as our two firms. They agree with each other to restrict output in order to raise prices and profits — a collusive agreement. 53

An Oligopoly Price-Fixing Game A cartel is a group of firms that enter into a collusive agreement. The firms in the cartel can: Comply Cheat 54

An Oligopoly Price-Fixing Game Four outcomes are possible Both firms comply Both firms cheat Trick complies and Gear cheats Gear complies and Trick cheats. 55

Costs and Demand Conditions The conditions are: Trick and Gear face identical costs. The switchgears they produce are identical. They are a natural duopoly. 56

Costs and Demand Individual Firm Industry MC ATC D 10 10 6 6 1 2 3 4 5 Price and cost (thous. of $/ unit) Price and cost (thous. of $/ unit) 6 6 Minimum ATC Instructor Notes: 1) The average total cost curve for each firm is ATC, and the marginal cost curve is MC (as shown in the first graph). 2) Minimum average total cost is at $6,000 a unit, and it occurs at an output of 3,000 units a week. 3) The second graph shows the industry demand curve. 4) At a price of $6,000, the quantity demanded is 6,000 units per week. 5) The two firms can produce this output at the lowest possible average cost. 6) If the market had one firm, it would be profitable for another to enter. 7) If the market had three firms, one would exit. 8) There is room for just two firms in this industry. 9) It is a natural duopoly. 1 2 3 4 5 1 2 3 4 5 6 7 Quantity (thous. of switchgears/week) Quantity (thous. of switchgears/week) 59

Colluding to Maximize Profits These firms may benefit from colluding. They attempt to behave like a monopoly. They agree to restrict output to a level that makes marginal revenue and marginal cost equal. 60

Colluding to Make Monopoly Profits Individual Firm Industry MC ATC 10 10 9 9 D Collusion achieves monopoly outcome MC1 8 Price and cost (thous. of $/ unit) Economic Profit Price and cost (thous. of $/ unit) 6 6 MR Instructor Notes: Average total cost is $8,000 a unit, so each firm makes an economic profit of $2 million (blue rectangle)--2,000 units multiplied by $1,000 profit a unit. 1 2 3 4 5 1 2 3 4 5 6 7 Quantity (thous. of switchgears/week) Quantity (thous. of switchgears/week) 63

One Firm Cheats on a Collusive Agreement Previous example Each firm produced 2,000 units and earned $2 million in economic profit. Now, Trick convinces Gear that it cannot sell 2,000 units a week and must cut its price to be able to do so. Gear cuts its price, but it does not change output. Trick lies and cheats on their agreement — it increases output. 64

One Firm Cheats Complier Cheater Industry ATC ATC D Economic loss 10.0 10.0 10.0 D Price & cost 8.0 8.0 Price & cost Price & cost 7.5 Economic loss 7.5 7.5 6.0 Economic profit Instructor Notes: 1) At this price the compiler incurs an economic loss of $1 million ($500 per unit x 2,000 units), shown by the red rectangle. 2) In the second graph, the cheater makes an economic profit of $4.5 million ($1,500 per unit x 3,000 units), shown as the blue rectangle. Complier’s output Cheat’s output 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 6 7 Quantity (thousands of switchgears/week) Quantity (thousands of switchgears/week) Quantity (thousands of switchgears/week) 69

Both Firms Cheat Both firms will cheat as long as price exceeds marginal cost. When price equals marginal cost they will no longer have an incentive to cheat. 70

Both Firms Cheat Individual Firm Industry MC ATC MC1 D 10 10 6 6 1 2 3 Price and cost (thous. of $/ unit) Price and cost (thous. of $/ unit) 6 6 Both cheating achieves competitive outcome Instructor Notes: 1) In the second graph, with a total production of 6,000 units, the price falls to $6,000. 2) Each firm now makes zero economic profit because price equals average total cost. 3) The output and price are the ones that would prevail in a competitive industry. 1 2 3 4 5 1 2 3 4 5 6 7 Quantity (thous. of switchgears/week) Quantity (thous. of switchgears/week) 74

The Payoff Matrix Now, let’s illustrate these possibilities using a duopoly payoff matrix. 75

Duopoly Payoff Matrix Gear’s strategies Cheat Comply $0 -$1.0m +$4.5m Trick’s strategies Instructor Notes: 1) Each square shows the payoffs from a pair of actions. 2) For example, if both firms comply with the collusive agreement, the payoffs are recorded in the bottom right square. 3) The red triangle shows Gear’s payoff, and the blue triangle shows Trick’s. 4) The equilibrium is a Nash equilibrium in which both firms cheat. +$4.5m –$1.0m +$2m Comply 76

Equilibrium of the Duopolists Dilemma At equilibrium, it pays both firms to cheat. What if this game is repeated over and over again? Will the outcome differ? 77

Repeated Games If this is repeated, one firm has the opportunity to penalize the other. A cooperative equilibrium may occur. This occurs when the firms make and share the monopoly profit. Must be penalized for cheating. tit-for-tat strategy trigger strategy 78

Games and Price Wars Some price wars resemble the tit-for-tat strategy. Price wars sometimes result from new firms entering a monopoly industry. 79

Other Oligopoly Games An R&D Game Should a firm spend money in R&D? Firms spend large sums of money in R&D in the attempt to: develop the most highly valued product develop the least-cost technology gain a competitive edge to increase market share and profit Should a firm spend money in R&D? 80

Pampers Versus Huggies: An R&D Game Procter & Gambles strategies R&D No R&D +$45m +$5m -$10m +$85m R&D Kimberly- Clark’s strategies +$85m -$10m +$70m +$30m Instructor Notes: 1) If both firms undertake R&D, their payoffs are those shown in the top left square. 2) If neither firm undertakes R&D, their payoffs are in the bottom right square. 3) When one firm undertakes R&D and the other one does not, their payoffs are in the top right and bottom left squares. 4) The red triangle shows Procter & Gamble’s payoff, and the blue triangle shows Kimberly-Clark’s. 5) The dominant strategy equilibrium for this game is for both firms to undertake R&D. 6) The structure of this game is the same as that of the prisoner’s dilemma. No R&D 81

Contestable Markets A market in which one firm (or a small number of firms) operates, but in which both entry and exit are free, so the firm(s) in the market faces competition from potential entrants is a contestable market. 82

Entry-Deterrence Game Let’s see what happens when a firm attempts to enter a market dominated by a single firm. 83

Duopoly Payoff Matrix Agile’s strategies Wannabe’s strategies Monopoly price Competitive price Economic loss profit Economic loss Enter and set price below Agile’s price Wannabe’s strategies Instructor Notes: 1) Agile is the only firm in a contestable market. 2) If Agile sets the monopoly price, Wanabe earns and economic profit by entering and undercutting Agile’s price or a normal profit by not entering. 3) So if Agile sets the price at the monopoly level, Wannabe will enter. 4) If Agile sets the competitive price, Wanabe earns a normal profit if it does not enter or incurs an economic loss if it does enter. 5) So if Agile sets the price at the competitive level, Wanabe will not enter. 6) With entry, Agile incurs and economic loss regardless of the price it sets. 7) The Nash equilibrium of this game is for Agile to set the competitive price, for Wanabe not to enter, and for both firms to make a normal profit. Monopoly profit Normal Normal profit Not enter 84

Entry-Deterrence Game The practice of charging a price below the monopoly profit-maximizing price and producing a quantity greater than that at which marginal revenue equals marginal cost in order to deter entry is limit pricing. 85