Monopolistic Competition and Oligopoly Chapter 11 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Characteristics of monopolistic competition Normal profit in the long run Characteristics of oligopoly The oligopolist’s kinked demand curve Collusion among oligopolists The effects of advertising 11-2

Monopolistic Competition Monopolistic competition is characterized by a relatively large number of sellers who offer similar but not identical products –Each firm has a small percentage of the total market –Collusion (working together to establish a price every firm agrees upon) is nearly impossible with so many firms –Firms act independently, the actions of one firm are ignored by the other firms in the industry 11-3

Monopolistic Competition Product differentiation and other types of nonprice competition give the individual firm some degree of monopoly power –Product differentiation may be physical –There may be special services and conditions that go along with the product –Brand names and packaging may be different –Product differentiation allow producers to have some control over the prices of their products

Monopolistic Competition The monopolistic firm’s demand curve is highly elastic, but not perfectly so –This relatively high elasticity means that increases in price result in a significant loss of customers –The seller has many rivals producing close substitutes –It is less elastic than in pure competition because the seller’s product is differentiated from its rivals, so that the firm has some control over price

Monopolistic Competition In the short-run situation, the firm will maximize profits or minimizes losses by producing where MC = MR, as in both pure competition and monopoly

Short-Run Profits Quantity Price and Costs MR = MC MC MR D1D1 ATC Economic Profit Q1Q1 A1A1 P1P1 0 Monopolistic Competition 11-7

Short-Run Losses Quantity Price and Costs MR = MC MC MR D2D2 ATC Loss Q2Q2 A2A2 P2P2 0 Monopolistic Competition 11-8

Long-run Situation In the long-run situation, the firm will tend to earn a normal profit only, that it, it will break even –Firms can enter the industry easily and will when an economic profit can be made –As firms enter the industry, this decreases the demand curve facing an individual firm as buyers shift some demand to new firms –The demand curve will shift until the firm just breaks even –If the demand shifts below the break-even point, some firms will leave the industry in the long run –When firms leave the industry, the demand curve facing each firm will be raised (fewer substitutes for buyers) and the break-even point (normal profits) will be reached

Long-Run Equilibrium Quantity Price and Costs MR = MC MC MR D3D3 ATC Q3Q3 P 3 = A 3 0 Monopolistic Competition 11-10

Exceptions to long-run normal profit scenario The products of some firms may become so differentiated that they are not easily duplicated by rivals –These firms may enjoy economic profits in the long-run Some restrictions to entry in the industry such as financial barriers may exist, especially for small firms

Economics Efficiency Monopolistic firms do not have allocative or productive efficiency –Allocative efficiency occurs when price = marginal cost; i.e., the right amount of resources are allocated to the product –Productive efficiency occurs when price = minimum average total cost; where production occurs using the least-cost combination of resources –The gap between price and marginal cost for each firm creates a loss in efficiency

Quantity Price and Costs MR = MC MC MR D3D3 ATC Q3Q3 0 P 3 = A 3 P=MC=Min ATC for pure competition (recall) P4P4 Q4Q4 Price is Lower Excess Capacity at Minimum ATC Monopolistic competition is not efficient Monopolistic Competition 11-13

Oligopoly Oligopoly exists where a few large firms that produce either a homogeneous (almost identical) or differentiated product dominate the market There are few enough firms in the industry that firms are mutually interdependent Because there are so few firms in the industry, oligopolists have considerabe control over their prices 11-14

–Some oligopolistic industries produce standardized products such as steel and cement, while others produce differentiated products such as automobiles –They must consider the reactions of their business rivals when ever they change prices, output, or advertise.

Oligopoly There are barriers to entry by new firms –Economies of scale may exist due to technology and market share –Capital investment requirements may be very large –Other barriers may exist such as patents, control of raw materials, retaliatory pricing, large advertising budgets, and brand loyality While some firms have become oligopolists through growth of the business, others have acquired the status through mergers and acquistions

Three Oligopoly Models Because of the diversity in oligopolistic firms, there are three models used to explain the price- output behavior –Kinked-demand curve –Collusive pricing –Price leadership 11-17

The kinked-demand Model Assumes firms do not act together in a collusive manner Each firm believes the other firm will match any price cuts –Because of that, they do not want to lower prices since total revenue will fall when demand is inelastic However, they do not believe any other firm would raise prices if they did –With a price raise, the demand would be elastic; revenue would decrease This analysis is one explanation of the fact that prices tend to be inflexible in oligopolistic industries

The kinked-demand Model Movement of the demand curve will depend upon whether there is a price cut or a price increase involved, and the response of the other rival firms If firm A cuts their price, its sales increase only a little because business rivals will also cut their price to prevent firm A from gaining an advantage over them –The small increase in sales that firm A receives is from other firms in the industry –Firm A probably wouldn’t raise their prices, and lose market share

The kinked-demand Model Other firms might choose to ignore the price changes by firm A –If firm A lowers price and its rivals do not, firm A will gain significantly at the expense of its rivals –If the firm raises its price, and its rivals do not, firm A will lose customers to its rivals because it will be undersold –However, even if firm A raises its price, it will not be totally priced out of the market because of product loyalty.

Price Price and Costs Quantity 0 0 P0P0 MR 2 D2D2 D1D1 MR 1 e f g Rivals Ignore Price Increase Rivals Match Price Decrease Q0Q0 Competitor and rivals strategize versus each other Consumers effectively have 2 partial demand curves and each part has its own marginal revenue part MR 2 D2D2 D1D1 MR 1 Q0Q0 MC 1 MC 2 P0P0 Resulting in a kinked-demand curve to the consumer – price and output are optimized at the kink e f g Kinked-Demand Curve 11-21

Collusions Collusion between firms reduces uncertainty, increases profits, and may prohibit the entry of new rivals A cartel is a group of producers that sign formal agreements as to how each may produce and charge (such as OPEC) –Assuming each member had identical cost, demand, and marginal-revenue data, the resulting cartel would behave economically as if they were made up of a single monopoly

The OPEC Cartel Source: A. T. Kearney, Foreign Policy Iran3,843,000 Kuwait2,538,000 Venezuela2,368,000 Iraq2,297,000 Nigeria2,183,000 UAE2,117,000 Angola1,804,000 Libya1,737,000 Algeria1,417,000 Qatar 848,000 Indonesia 843,000 Ecuador 530,000 Daily oil production (barrels), November 2008 Saudi Arabia8,904,

Cartels and Other Collusion Covert collusion – not formalized –Tacit understandings Obstacles to collusion –Demand and cost differences among firms –Too many firms in the industry –An incentive to cheat –Recession with decreasing demand and increasing average total costs –Potential entry when profits become too high –Legal obstacles: antitrust law that prohibit collusion 11-24

Price Leadership Model Price leadership is a type of gentleman’s agreement to coordinate their prices legally –No formal agreements –One firm, usually the largest, changes the price first and then the other firms follow 11-25

Price Leadership Model Several price leadership tactics are practiced by the leading firm Prices are changed only when cost and demand conditions have been significantly altered industry-wide Publicizing the “need to raise prices” through publications and speeches puts other firms on alert The new price may be below the short-run profit- maximizing level (an economic loss) to discourage new firms from entering the industry Price leadership in oligopoly occasionally breaks down and a price war may result

Oligopoly and Advertising The Largest U.S. Advertisers, 2006 Company Advertising Spending Millions of $ Proctor and Gamble AT&T General Motors Time Warner Verizon Ford Motor GlaxoSmithKline Walt Disney Johnson & Johnson Unilever $ Source: Advertising Age 11-27

World’s Top 10 Brand Names, 2007 Source: Interbrand Coca-Cola Microsoft IBM General Electric Nokia Toyota Intel McDonald’s Disney Mercedes-Benz Oligopoly and Advertising 11-28

Oligopoly and Efficiency Not productively efficient Not allocatively efficient Tendency to share the monopoly profit 11-29

Key Terms monopolistic competition product differentiation nonprice competition four-firm concentration ratio Herfindahl index excess capacity oligopoly homogeneous oligopoly differentiated oligopoly strategic behavior mutual interdependence interindustry competition import competition game theory collusion kinked-demand curve price war cartel price leadership 11-30

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