Monopolistic Competition and Oligopoly

Monopolistic Competition What are the characteristics of monopolistic competition? 1. large number of independent sellers 2. no or low barriers to entry 3. differentiated product

Recall: differentiated products are products that are distinguished from similar products by such characteristics as quality, design, and location. examples: service stations, aspirin, tissues, retail stores

Demand Curve for the Monopolistic Competitor’s Product Since the product is differentiated, there is some brand loyalty and the firm has some control over price. So the demand curve for the monopolistically competitive firm’s product is NOT horizontal. Since good substitutes are available, however, the demand curve is fairly elastic, that is, fairly flat.

The demand curve for the monopolistic competitor’s product is flatter than the demand curve for the monopolist’s product, but not horizontal like the demand curve for the perfect competitor’s product. p.c. m.c. monopoly P P P D D D Q Q Q

The firm’s profits are maximized where MR = MC. $ MC ATC In the short run the firm may have positive, negative, or zero profits. P*  ATC* D MR Q Q*

In the long run, however, since barriers to entry are small, positive profits will attract new firms. $ That will expand industry output, which will lower prices and reduce profits to zero. MC P* ATC ATC*=P* D MR Q Q*

Advertising Perfectly competitive firms don’t advertise because everyone knows the products are all the same. Monopolistic competitors advertise to convince consumers that their product is better than others.

Whether advertising is socially beneficial or detrimental depends on the type of advertising. When it is informative to consumers, it is beneficial. When it is misleading, however, it is detrimental.

How does advertising affect price and profits? Advertising can create brand loyalty and decrease the price elasticity of demand. Advertising can also provide information about where products can be found, thereby increasing competition. As a consequence, advertising can result in either an increase or a decrease in the price of the product compared to what it would be if there were no advertising in the industry. Advertising increases costs. However, advertising can also increase revenues. So advertising may cause profits to either increase or decrease relative to what they would be if there were no advertising in the industry.

Oligopoly What are the characteristics of oligopoly? 1. few firms 2. either homogeneous or differentiated products 3. interdependence of firms - policies of one firm affect the other firms substantial barriers to entry examples: auto industry and cigarette industry

Profits in Oligopolistic Markets The fact that there are substantial barriers to entry implies that it is possible in oligopoly to earn positive long run profits. However, if oligopolists compete in a cutthroat manner, undercutting each other’s prices, they may drive prices down to where profits are zero.

Sweezy’s kinked demand curve model of oligopoly Assumptions: 1. If a firm raises prices, other firms won’t follow and the firm loses a lot of business. So demand is very responsive or elastic to price increases. 2. If a firm lowers prices, other firms follow and the firm doesn’t gain much business. So demand is fairly unresponsive or inelastic to price decreases.

The Kinked Demand Curve $ P* D Q* quantity

MR Curve for the top part of the Demand Curve $ D P* MR Q* quantity

Drawing MR Curve for the bottom part of the Demand Curve $ P* MR D Q* quantity

MR Curve for the bottom part of the Demand Curve $ P* MR D Q* quantity

The Kinked Demand Curve and the MR Curve $ P* MR D quantity Q*

The MC curve intersects the MR curve in the vertical segment. $ MC P* MR D quantity Q*

$ MC ATC P* D MR quantity Q* The ATC curve can be added to the graph. To show positive profits, part of ATC curve must lie under part of the demand curve. $ MC ATC P* D MR quantity Q*

The ATC* value can be found on the ATC curve above Q*. $ MC ATC P* ATC* D MR quantity Q*

TC = ATC . Q $ MC ATC P* ATC* D MR quantity Q*

TR = P . Q $ MC ATC P* ATC* D MR quantity Q*

Profit = TR - TC $ MC ATC P* profit ATC* D MR quantity Q*

Price Rigidity in Oligopoly Markets Suppose costs change slightly. So the MC curve moves up or down a little, but still intersects the MR curve in the vertical segment. Then the profit-maximizing levels of output and price remain the same. Thus, based on the kinked demand curve model of oligopoly, price rigidity would be expected. This expectation is consistent with price rigidity that is often observed in oligopoly markets. $ MC P* MR D quantity Q*

Price Leadership Models Dominant firm price leadership Barometric price leadership

Dominant firm price leadership To maintain its dominance, the dominant firm may Keep industry prices low enough to deter entry or expansion by other firms, Use non-price competition (for example, quality differences), or Act defensively, using confrontation, disciplinary action, & persecution of troublesome firms.

Dominant firm price leadership Strategies for the smaller firms include product differentiation, cost-cutting, and instituting new ways of distributing the product and serving the customer.

Barometric price leadership There may be several principal firms, with or without a competitive fringe of small firms. One firm is not powerful enough to impose its will on the others. The firm just appraises industry conditions & acts first to announce new prices consistent with these conditions.

Oligopoly is sometimes studied using game theory. In game theory, we have information on the players, the possible strategies, and the payoffs associated with those strategies.

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Example 1 Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $90 $100 (25, 50) (45, 10) (10, 75) (70, 20) If A chooses a price of $90, B will be better off choosing $90 as well. B’s payoff would be $50 million instead of $10 million. If A chooses $100, B will still be better off with a price of $90. B’s payoff would be $75 million instead of $20 million. So B will choose a price of $90, regardless of what A does.

Dominant Strategy a strategy that a player is better off adopting regardless of the strategy adopted by the other player. In example 1, we found that firm B would choose a price of $90 regardless of what A chose. Thus, for B, a price of $90 is a dominant strategy.

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Example 1 Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $90 $100 (25, 50) (45, 10) (10, 75) (70, 20) Notice that if B chooses a price of $90, A will be better off choosing $90 as well. A’s payoff would be $25 million instead of $10 million. If B chooses $100, A will be better off with a price of $100. A’s payoff would be $70 million instead of $45 million. So A does NOT have a dominant strategy.

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Example 1 Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $90 $100 (25, 50) (45, 10) (10, 75) (70, 20) We found that B will choose a price of $90, no matter what A does. Then since B chooses $90, A will choose $90 also. A’s payoff will be $25 million instead of $10 million.

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Example 2 If B chooses a price of $10, A will be better off choosing $10 as well. A’s payoff would be $10 million instead of $5 million. If B chooses $15, A will still be better off with a price of $10. A’s payoff would be $18 million instead of $15 million. So A will choose a price of $10, regardless of what B does. So A has a dominant strategy. Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $10 $15 (10, 8) (18, 3) (5, 17) (15, 12)

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Example 2 If A chooses a price of $10, B will be better off choosing $10 as well. B’s payoff would be $8 million instead of $3 million. If A chooses $15, B will still be better off with a price of $10. B’s payoff would be $17 million instead of $12 million. So B will choose a price of $10, regardless of what A does. So B has a dominant strategy. Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $10 $15 (10, 8) (18, 3) (5, 17) (15, 12)

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) When both players have a dominant strategy, the result is called a dominant strategy equilibrium. Some games have a dominant strategy equilibrium, but some do not. In this example, the dominant strategy equilibrium is the situation is which both A and B charge $10. Here, both players had the same dominant strategy; that does NOT have to be the case in a dominant strategy equilibrium. Example 2 Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $10 $15 (10, 8) (18, 3) (5, 17) (15, 12)

Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Example 2 Payoffs in millions of dollars (Firm A’s payoff, Firm B’s payoff) Firm B’s price strategy Firm A‘s price strategy $10 $15 (10, 8) (18, 3) (5, 17) (15, 12) Suppose that they had both chosen $15 instead of both choosing $10. A would have had $15 million instead of $10 million & B would have had $12 million instead of $8 million. So both A & B would have been better off. In this type of situation, communication would enable them to agree on the more profitable solution.

Example 3 Payoffs (A, B) B’s strategy A‘s strategy X Y Z (6,4) (4, 3) (4,2) (2, 1) (5, 5) (2, 2) (1, 1) (1, 3) (3, 6) We can see in this example that no matter what B chooses, A will be better off with a strategy other than Z. If B chose strategy X, A would be better off with strategy X. If B chose strategy Y, A would be better off with strategy Y. If B chose strategy Z, A would be better off with strategy X. So A will not choose strategy Z.

Example 3 Payoffs (A, B) B’s strategy A‘s strategy X Y Z (6,4) (4, 3) (4,2) (2, 1) (5, 5) (2, 2) (1, 1) (1, 3) (3, 6) Look at the remaining 2 rows. If A chooses X, then B is better off with strategy X than with strategy Z. If A chooses Y, B is better off with strategy Y than with strategy Z. So B would not choose strategy Z either. Beyond that, if A & B act simultaneously & independently, we can’t say what will happen.

Example 3 Payoffs (A, B) B’s strategy A‘s strategy X Y Z (6,4) (4, 3) (4,2) (2, 1) (5, 5) (2, 2) (1, 1) (1, 3) (3, 6) Suppose, however, that A acts first. A knows that if he/she chooses X, B would choose X too. If A chooses Y, B would choose Y too. Of those two outcomes, A would be better off at (X, X) than at (Y, Y). So A would choose X & so would B.

Example 3 Payoffs (A, B) B’s strategy A‘s strategy X Y Z (6,4) (4, 3) (4,2) (2, 1) (5, 5) (2, 2) (1, 1) (1, 3) (3, 6) Suppose B acts first. B knows that if he/she chooses X, A would choose X too. If B chooses Y, A would choose Y too. Of those two outcomes, B would be better off at (Y, Y) than at (X, X). So B would choose Y & so would A.

Sometimes a set of strategies is a “Nash equilibrium.” A Nash equilibrium is a set of strategies for the players, such that no player can improve his or her payoff unilaterally, that is, acting individually without consulting the other player(s). So, if player A can NOT improve its situation by switching to another strategy, and player B can NOT improve its situation by switching to another strategy, then you have a Nash equilibrium. A game may have more than one Nash equilbrium.

Example 3 Payoffs (A, B) B’s strategy A‘s strategy X Y Z (6,4) (4, 3) (4,2) (2, 1) (5, 5) (2, 2) (1, 1) (1, 3) (3, 6) Each of these two points is a Nash equilibrium. Look first at point (X,X) with payoffs (6,4). If A switches to a different strategy (that is, a different row), A’s payoff will be less than 6. If B switches to a different strategy (that is, a different column), B’s payoff will be less than 4. So neither player can unilaterally improve his/her situation and (X,X) is a Nash equilibrium.

Example 3 Payoffs (A, B) B’s strategy A‘s strategy X Y Z (6,4) (4, 3) (4,2) (2, 1) (5, 5) (2, 2) (1, 1) (1, 3) (3, 6) Look now at point (Y,Y) with payoffs (5,5). If A switches to a different strategy (that is, a different row), A’s payoff will be less than 5. If B switches to a different strategy (that is, a different column), B’s payoff will be less than 5. So neither player can unilaterally improve his/her situation and (Y,Y) is a Nash equilibrium.

The Prisoners’ Dilemma Problem Two individuals have committed a burglary. The police know it, but don’t have the evidence to prove it. Lacking a confession by either one, the police would have to let them both go free. The police separate the partners & say to each individually: “We are willing to make a deal with you. Confess to the crime, implicating your partner and we will let you go free and you get the loot for yourself and your partner will be locked up for a long time. If you both confess, you both go to jail but for a shorter time. If you do not confess, but your partner does, he/she goes free to enjoy the loot and you get locked up for a long time.” The criminals also know that if they both remain silent they both go free and split the loot.

So the payoff table might look like this: Whether A confesses or not, B is better off confessing. Whether B confesses or not, A is better off confessing. Both criminals’ confessing is a Nash equilibrium: If A is going to confess, B will make things worse for him/herself by remaining silent, & vice versa. Prisoner B remain silent confess Prisoner A (4, 4) (-10, 8) (8,-10) (-5, -5) Both remaining silent is not a Nash equilibrium: If A remained silent, B could improve his/her situation by confessing, & vice versa.