23 Monopolistic Competition and Oligopoly

Chapter Objectives Characteristics of Monopolistic Competition Why Monopolistic Competitors Earn Only a Normal Profit in the Long-Run Characteristics of Oligopoly How Game Theory Relates to Oligopoly Why the Demand Curve of the Oligopolist May Be Kinked Incentives and Obstacles to Collusion Among Oligopolists Potential Positive and Negative Effects of Advertising

Recall the Four Market Models Pure Competition Pure Monopoly Monopolistic Competition Oligopoly We have covered the extremes, pure competition and monopoly: most real world markets are in the middle, namely monopolistic competition and oligopoly. Pure Competition Monopolistic Competition Pure Monopoly Oligopoly

Monopolistic Competition Characteristics Large number of firms with small market shares No Collusion Independent Action Differentiated Products Product Attributes Service Location Brand Names and Packaging Some Control Over Price due to product differentiation

Monopolistic Competition Easy Entry and Exit Advertising Nonprice Competition Examples of Monopolistically Competitive Industries, see page 446

Price and Output Determination In Monopolistic Competition The Firm’s Demand Curve The Short Run: Profit or Loss The Long Run: Only a Normal Profit Profits: Firms Enter Losses: Firm’s Leave Complications with the normal profit conclusion Product Variety G 23.1

What does the graphic model look like for Monopolistic Competition compared to Monopoly? It looks very similar because both face a downward sloping demand curve—possibly more elastic in monopolistic competition due to more close substitutes.

Price and Output Determination In Monopolistic Competition Short-Run Profits ATC MC P1 A1 Price and Costs Economic Profit D1 MR = MC MR Q1 Quantity

Price and Output Determination In Monopolistic Competition Short-Run Losses ATC MC A2 P2 Loss Price and Costs D2 MR = MC MR Q2 Quantity

Price and Output Determination In Monopolistic Competition Long-Run Equilibrium MC ATC P3= A3 Price and Costs D3 MR = MC MR Q3 Quantity

Pure competition vs. Monopolistic competition Since both pure competition and monopolistic competition tend to result in zero economic profits, are the models equal in efficiency? NO, as can be seen by comparing the two.

Zero Profits in Perfect Competition MC ATC P P = MR P = ATC Q1 12

Monopolistic Competition and Efficiency Recall: P=MC=Minimum ATC Quantity Price and Costs MR = MC MC MR D3 ATC Q3 P3= A3 P4 Price is Higher Excess Capacity at Minimum ATC Q4 Monopolistic Competition is Not Efficient

Excess capacity Firms in MC tend to produce less output than the minimum ATC level of output: the difference is called excess capacity. “Too many firms, each producing too little output” is a phrase to characterize this: towns with many gas stations, restaurants, etc, that tend to operate below their optimal capacity.

Oligopoly Characteristics A Few Large Producers Homogeneous or Differentiated Products Homogeneous Oligopoly Differentiated Oligopoly Control Over Price, But Mutual Interdependence Strategic Behavior Entry Barriers Mergers and oligopoly

Measures of Concentration Concentration Ratio: percent of sales accounted for by the top 4 firms Problems with concentration ratios 1)Localized Markets 2)Interindustry Competition 3)World Trade Import Competition W 23.1

Measures of Concentration Herfindahl Index (HI) (%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2

Problems: For an industry with only 1 firm, (monopoly), what would be the HI?

Suppose the industry has 10 equal size firms, what is the HI? What if the industry has 100 equal size firms?

Answers: Monopoly, HI = 10,000 10 equal size firms, HI = 1,000

Game Theory Approach to Oligopoly Is Oligopoly best analyzed as a strategic game like chess?

Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy 2 Competitors 2 Price Strategies Each Strategy Has a Payoff Matrix Greatest Combined Profit Independent Actions Stimulate a Response High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8 O 23.2

Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy Independently Lowered Prices in Expectation of Greater Profit Leads to the Worst Combined Outcome Eventually Low Outcomes Make Firms Return to Higher Prices High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8 O 23.2

Game Theory: Payoff matrix shows several things, including: Mutual Interdependence of firms in oligopoly The temptation to collude The incentive to Cheat on a collusive arrangement G 23.2

Three Oligopoly Models Kinked Demand Curve Collusive Pricing Price Leadership Why no single model? due to the Diversity of Oligopolies and the complications of Interdependence

Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts but not price increases. Under this assumption, its as if each firm faces a “kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price, since rivals quickly match price cuts.

Kinked-Demand Curve Noncollusive Oligopoly Possible Strategies Match Price Changes Ignore Price Changes Kinked model uses a Combined Strategy: match price cuts but not price increases Price Inflexibility The Kinked-Demand Curve Graphically…

Competitor and Rivals Strategize Versus Each Other Kinked-Demand Curve Noncollusive Oligopoly Competitor and Rivals Strategize Versus Each Other Consumers Effectively Have 2 Partial Demand Curves and Each Part Has Its Own Marginal Revenue Part Price Price and Costs Quantity Rivals Ignore Price Increase D2 MC1 e e P0 P0 MR2 f f D2 MC2 MR2 Rivals Match Price Decrease g g D1 D1 Q0 MR1 Q0 MR1 Resulting in a Kinked-Demand Curve to the Consumer – Price and Output Are Optimized at the Kink

Kinked-Demand Curve Criticisms of the Model Noncollusive Oligopoly Criticisms of the Model Doesn’t Explain How Price Gets to the Kink (P0) Oligopoly Prices Are Not As Rigid During Instability as the Model Indicates Possibility of Price Wars

Second model of oligopoly: Cartels and Other Collusion What is a Cartel? A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares

Collusion and Tendency Toward Joint-Profit Maximization Price and Output Collusion and Tendency Toward Joint-Profit Maximization Price and Costs Quantity Effectively Sharing The Monopoly Profit MC P0 ATC A0 MR=MC Economic Profit D MR Q0

Cartels and Other Collusion Overt Collusion Cartels The OPEC Cartel GLOBAL PERSPECTIVE The 11 OPEC Nations Daily Oil Production, May 2006 Saudi Arabia Iran Venezuela UAE Nigeria Kuwait Iraq Libya Indonesia Algeria Qatar Source: OPEC Country Barrels of Oil 9,099,000 4,110,000 3,233,000 2,444,000 2,306,000 2,247,000 1,903,000 1,500,000 1,451,000 894,000 726,000

Cartels and Other Collusion Covert Collusion Tacit Understandings Obstacles to Collusion Demand and Cost Differences Number of Firms Cheating Recession Potential Entry Legal Obstacles: Antitrust Law

Price leadership in Oligopoly One firm, the dominant firm, sets the price, others follow the leader Often the dominant firm is the low cost producer in the industry Is this a form of “tacit” collusion?

Price Leadership Model Leadership Tactics of the price leader may well include: 1) Infrequent Price Changes 2) Forms of Communications to the other firms, such as press releases, etc. 3) Limit Pricing: perhaps do not choose the monopoly price for fear of enticing entry to your industry Breakdowns in Price Leadership: Price Wars

Oligopoly and Advertising Advertising Prevalent in Monopolistic Competition and Oligopoly Positive Effects of Advertising Potential Negative Effects of Advertising

Oligopoly and Advertising The Largest U.S. Advertisers, 2005 Company Advertising Spending Millions of $ Proctor and Gamble General Motors Time Warner Verizon AT&T Ford Motor Walt Disney Johnson & Johnson GlaxoSmithKline DaimlerChrysler $4609 4353 3494 2484 2471 2398 2279 2209 2194 2179 Source: Advertising Age

Oligopoly and Advertising World’s Top 10 Brand Names GLOBAL PERSPECTIVE Source: Interbrand Coca-Cola Microsoft IBM General Electric Intel Nokia Toyota Disney McDonalds Mercedes-Benz

Oligopoly and Efficiency Productive and Allocative Efficiency P = MC = Minimum ATC Neither Exists Tendency to Share the Monopoly Profit Qualifications Increased Foreign Competition Limit Pricing Technological Advance

Oligopoly in the Beer Industry Last Word Once Hundreds of Firms Now a Very Small Group Demand Side Changes Taste Shifts to Lighter Beers of Large Breweries Shift From Tavern-Tap Consumption to Can or Bottles Supply Side Changes Technology Increased Minimum Efficient Scale Creating a Barrier to Entry National Brands Enjoy Cost Advantages Consolidation of Firms into Oligopoly

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

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