Chapter 10 Monopolistic Competition and Oligopoly

Monopolistic Competition Characteristics –many small buyers & sellers –nonhomogeneous or differentiated product –no barriers to entry/exit –perfect information –mobile resources –no public goods / externalities The only difference between perfect competition and monopolistic competition is the nature of the product 2

Monopolistic Competition Product differentiation –Physical differences, location, product image –Results in the firm facing a downward sloping demand for its own product 3

Short-Run Profit Max. or Loss Min. Maximize profit –Produce q where MR=MC –Price is found on firm’s D curve (like a monopoly) –Profit can be positive, zero or negative Depends on AC 4

Max. Profit or Min. Loss in Short-Run If P>AC –Economic profit If AC>P>AVC –Economic loss –Produce in short run If P<AVC: AVC curve above D curve –Economic loss –Shut down in short run 5

Long-Run Profit Maximization If SR economic profit exists –New firms enter the market –Draw customers away from other firms –Reduce demand facing other firms Shift firm’s demand to left –Profit disappears in long run Zero economic profit P = LRAC Demand is tangent to LRAC 6

Long-Run Profit Maximization If SR economic loss exists –Some firms exit the market –Their customers switch to other firms –Increase demand facing the remaining firms shift firm’s demand to right –Loss is erased in the long run Zero economic profit for remaining firms P = LRAC Demand is tangent to LRAC 7

Profit Maximization In monopolistic competition equilibrium –P > MC –Inefficient (deadweight loss exists) –AC at q* > min AC –Excess Capacity is the difference between the profit max. rate of output and the cost min. rate of output “too many firms each producing too little” diversity of products?? 8

Monopolistic vs. Perfect Competition Both –Zero economic profit in long run –MR = MC for quantity where D is tangent to AC Perfect competition –Firm’s demand is horizontal line –Produces at minimum average cost –Productive and allocative efficiency 9

Advertising Occurs in monopolistic competition –Shifts demand for firm Increases demand More inelastic demand Increasing potential for profit –Increases costs to firm 10

Oligopoly Few, large sellers Homogeneous or differentiated product May be barriers to entry Oligopolistic interdependence –each firm must take its rival’s behavior into account in their own decision making Many models exist in oligopoly 11

Models of Oligopoly Cartel / Collusion Kinked Demand Price leadership Game theory 12

Collusion and Cartels Collusion –Agreement among firms to Divide the market Fix the price Cartel –Group of firms that agree to collude to maximize industry profit Act as monopoly Increase economic profit Illegal in U.S. 13

Cartel Example 5 firms in industry –Divide up output equally –MC i = 5 Q M = 100,000 Q i = 20,000 P M = 10 Π i = 20,000 (10 – 5) = $100,000 Π M = $500,000 14

Cartel & Cheating Firm 1 cheats –Q 1 = 40,000 –Q M = 120,000 –P M = 9 –Π 1 = 40,000 (9 – 5) = $160,000 –Π i = 20,000 (9 – 5) = $80,000 –Π M = $480,000 Incentive exists to cheat! 15

Collusion and Cartels Difficulties to maintain a cartel: –Differences in average cost –Increase # of firms –Differentiated product –Low barriers to entry –Cheating by cartel members 16

Kinked Demand Each firm assumes that –Rivals will follow all price decreases –Rivals will not follow any price increases Demand is more elastic for price increases than for price decreases –Results in price rigidity in the face of increasing costs 17

Price Leadership 1 large firm Many small firms (competitive fringe) Price leader –Sets the price for the industry –Initiate price changes –Followed by the other firms Tacit Price coordination 18

Price Leadership Obstacles –U.S. antitrust laws –# & size of firms –Nature of product –Growth and innovation in industry –Ease of entry/exit Contestable Market –costs of entry and exit are low Enough firms so P = MC 19

Game Theory Analyzes firm behavior as a series of strategic moves and countermoves Payoff matrix –Shows all possible outcomes for the “players” Dominant-strategy equilibrium –Each player’s action does not depend on what he thinks the other player will do 20

Game Theory 2 firms 2 strategies –maintain current price –raise price Goal –minimize the worst case outcome Can result in suboptimal solution –but is a dominant strategy 21

Game Theory One-shot versus repeated games –One-shot game Game is played just once –Repeated games Establish reputation for cooperation Tit-for-tat strategy –Highest payoff results Coordination game 22

Oligopoly vs. Perfect Competition Oligopoly –If firms collude or operate with excess capacity Higher price (P > MC) Lower output –If price wars Lower price –Higher profits in the long run 23