Between Competition and Monopoly: Monopolistic Competition and Oligopoly

●Monopolistic Competition ●Oligopoly ●Monopolistic Competition, Oligopoly, and Public Welfare ●A Glance Backward: Comparing the Four Market Forms ●M●Monopolistic Competition ●O●Oligopoly ●M●Monopolistic Competition, Oligopoly, and Public Welfare ●A●A Glance Backward: Comparing the Four Market Forms Contents Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. A Dose of Reality ●Monopolistic Competition is the most widespread industry structure in the U.S. ●Output generated by oligopolistic industries generates more than half of U.S. GDP ♦GDP – gross domestic product ♦Roughly speaking – total annual output ●Analysis is complicated – won’t say much ●Monopolistic Competition is the most widespread industry structure in the U.S. ●Output generated by oligopolistic industries generates more than half of U.S. GDP ♦GDP – gross domestic product ♦Roughly speaking – total annual output ●Analysis is complicated – won’t say much

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition ●Characteristics of Monopolistic Competition ♦Many sellers ♦Freedom of entry and exit ♦Perfect information ♦Heterogeneous products ●Characteristics of Monopolistic Competition ♦Many sellers ♦Freedom of entry and exit ♦Perfect information ♦Heterogeneous products

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition ●Characteristics of Monopolistic Competition ♦First three characteristics same as those for perfect competition. ♦Fourth is an important distinction. ♦Demand curve that every firm faces is negatively sloped. ♦Majority of U.S. firms are in this type of market structure. ●Characteristics of Monopolistic Competition ♦First three characteristics same as those for perfect competition. ♦Fourth is an important distinction. ♦Demand curve that every firm faces is negatively sloped. ♦Majority of U.S. firms are in this type of market structure.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition ●Price and Output Determination under Monopolistic Competition ♦MR = MC rule applies for setting output. ■i.e. individual firm acts like monopoly ♦Long-run equilibrium: the firm’s demand curve must be tangent to its average cost curve. ●Price and Output Determination under Monopolistic Competition ♦MR = MC rule applies for setting output. ■i.e. individual firm acts like monopoly ♦Long-run equilibrium: the firm’s demand curve must be tangent to its average cost curve.

FIGURE 1: Short-Run Equilibrium Under Monopolistic Competition D AC P 1.40 Price per Gallon Gallons of Gasoline per Week 12,000 $1.50 MR MC E C Copyright© 2006 South-Western/Thomson Learning. All rights reserved. $1.80 $1.00

FIGURE 2: Long-Run Equilibrium Under Monopolistic Competition 15,000 $1.35 Price per Gallon Gallons of Gasoline per Week 10,000 $1.45 MR MC AC D E P Copyright© 2006 South-Western/Thomson Learning. All rights reserved. M

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Excess Capacity Theorem ●Under monopolistic competition, in the long run the firm will produce an output lower than that which minimizes its unit costs. ●Hence, unit costs will be higher than necessary. ●Under monopolistic competition, in the long run the firm will produce an output lower than that which minimizes its unit costs. ●Hence, unit costs will be higher than necessary.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Excess Capacity Theorem ●Achievement of minimum average costs would require fewer but larger firms. ●This inefficiency may, however, be a reasonable price to pay for providing a large range of consumer choice. ●Achievement of minimum average costs would require fewer but larger firms. ●This inefficiency may, however, be a reasonable price to pay for providing a large range of consumer choice.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Oligopoly ●Oligopoly = market dominated by a few sellers, at least several of which are large enough relative to the total market that they can influence the market price ●Oligopoly  more intense competition than pure competition ●Oligopoly = market dominated by a few sellers, at least several of which are large enough relative to the total market that they can influence the market price ●Oligopoly  more intense competition than pure competition

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Oligopoly ●Why Oligopolistic Behavior is So Difficult to Analyze ♦Oligopolistic firms interact with each other in complex ways, and almost anything can and sometimes does happen under oligopoly. ●Why Oligopolistic Behavior is So Difficult to Analyze ♦Oligopolistic firms interact with each other in complex ways, and almost anything can and sometimes does happen under oligopoly.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Oligopoly ●Lines of Attack: ♦Ignore interdependence ♦Strategic interaction ♦Cartels ♦Price leadership and tacit collusion ●To understand everything except first point, you must understand Game Theory ●Lines of Attack: ♦Ignore interdependence ♦Strategic interaction ♦Cartels ♦Price leadership and tacit collusion ●To understand everything except first point, you must understand Game Theory

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Oligopoly and Game Theory ●Game Theory analyzes problems where agents account for others’ actions when taking a decision ●Ex: duopoly – two firms serving one market ♦Each firm supplies half of total quantity ♦Choice of firm 1 affects choice of firm 2 and vice versa ● Will study Game Theory after Midterm 2 ●Game Theory analyzes problems where agents account for others’ actions when taking a decision ●Ex: duopoly – two firms serving one market ♦Each firm supplies half of total quantity ♦Choice of firm 1 affects choice of firm 2 and vice versa ● Will study Game Theory after Midterm 2

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition, Oligopoly, & Public Welfare ●Behavior is so varied that it is hard to come to a simple conclusion about welfare implications. ●In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum. ●Behavior is so varied that it is hard to come to a simple conclusion about welfare implications. ●In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition, Oligopoly, & Public Welfare ●Oligopolistic market can be perfectly contestable: ♦If firms can enter and exit without losing the money they have invested ●If so, then the performance of the firms is likely to be close to perfectly competitive ●And thus, socially efficient ●Oligopolistic market can be perfectly contestable: ♦If firms can enter and exit without losing the money they have invested ●If so, then the performance of the firms is likely to be close to perfectly competitive ●And thus, socially efficient

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ●Perfect competition and pure monopoly are uncommon in reality. ●Many monopolistically competitive firms exist. ●Oligopoly firms account for the largest share of the economy’s output. ●Perfect competition and pure monopoly are uncommon in reality. ●Many monopolistically competitive firms exist. ●Oligopoly firms account for the largest share of the economy’s output.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ●Profits are zero in long-run equilibrium under perfect competition and monopolistic competition because of free entry and exit. ●Consequently, AC = AR = P in long-run equilibrium under these two market forms. ●Profits are zero in long-run equilibrium under perfect competition and monopolistic competition because of free entry and exit. ●Consequently, AC = AR = P in long-run equilibrium under these two market forms.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ●In equilibrium, MC = MR for the profit- maximizing firm under any market form. ●In the equilibrium of the oligopoly firm, MC may be unequal to MR. ●In equilibrium, MC = MR for the profit- maximizing firm under any market form. ●In the equilibrium of the oligopoly firm, MC may be unequal to MR.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ●Perfectly competitive firm and industry theoretically  efficient allocation of resources. ●Monopoly and monopolistic competition are likely  inefficient allocation of resources. ●Under oligopoly, almost anything can happen,  impossible to generalize about its vices or virtues. ●Perfectly competitive firm and industry theoretically  efficient allocation of resources. ●Monopoly and monopolistic competition are likely  inefficient allocation of resources. ●Under oligopoly, almost anything can happen,  impossible to generalize about its vices or virtues.

TABLE 5: Attributes of the Four Market Forms Copyright© 2006 South-Western/Thomson Learning. All rights reserved.