McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition, Oligopoly, and Strategic Pricing Chapter 13

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve In Canada, there is a small radical group that refuses to speak English and no one can understand them. They are called “separatists.”

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve In the United States we have the same kind of group. They are called “economists.” — Nations Business

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Market structure is the focus real-world competition. n Market structure refers to the physical characteristics of the market within which firms interact.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Market structure involves the number of firms in the market and the barriers to entry.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Perfect competition, with an infinite number of firms, and monopoly, with a single firm, are polar opposites. n Monopolistic competition and oligopoly lie between these two extremes.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Monopolistic competition is a market structure in which there are many firms selling differentiated products. n There are few barriers to entry.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Oligopoly is a market structure in which there are a few interdependent firms. n There are often significant barriers to entry.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Problems Determining Market Structure n Defining a market has problems: l What is an industry and what is its geographic market -- local, national, or international? l What products are to be included in the definition of an industry?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Classifying Industries n One of the ways in which economists classify markets is by cross-price elasticities. l Cross-price elasticity measures the responsiveness of the change in demand for a good to change in the price of a related good.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Classifying Industries n Industries are classified by government using the North American Industry Classification System (NAICS). l The North American Industry Classification System ( NAICS ) is a classification system of industries adopted by Canada, Mexico, and the U.S. in 1997.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Classifying Industries n When economists talk about industry structure the general practice is to refer to three-digit industries. l Under the NAICS, a two-digit industry is a broadly based industry. l A three-digit industry is a specific type of industry within a broadly defined two-digit industry.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Two- and Four- Digit Industry Groups

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Industry Structure n Economists use one of two methods to measure industry structure: l The concentration ratio. l The Herfindahl index.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Concentration Ratio n The concentration ratio is the value of sales by the top firms of an industry stated as a percentage of total industry sales.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Concentration Ratio n The most commonly used concentration ratio is the four-firm concentration ratio. n The higher the ratio, the closer to an oligopolistic or monopolistic type of market structure.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Herfindahl Index n The Herfindahl index is an index of market concentration calculated by adding the squared value of the individual market shares of all firms in the industry.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Herfindahl Index n The Herfindahl index gives higher weights to the largest firms in the industry because it squares market shares.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Herfindahl Index n The Herfindahl Index is used as a rule of thumb by the Justice Department to determine whether a merger be allowed to take place. l If the index is less than 1,000, the industry is considered competitive thus allowing the merger to take place.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Concentration Ratios and the Herfindahl Index

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Conglomerate Firms and Bigness n Neither the four-firm concentration ratio or the Herfindahl index gives a complete picture of corporations’ bigness.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Conglomerate Firms and Bigness n This is because many firms are conglomerates – huge corporations whose activities span various unrelated industries.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Classifying Industry Structure n The less concentrated industries are more likely to resemble perfectly competitive markets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Classifying Industry Structure n The number of firms in an industry play a role in determining whether firms explicitly take other firms’ actions into account.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Classifying Industry Structure n It is unlikely that an monopolistically competitive firm will explicitly take into account rival firms’ responses to its decisions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Importance of Classifying Industry Structure n In oligopoly, with fewer firms, each firm explicitly engages in strategic decision making. n Strategic decision making – taking explicit account of a rival’s expected response to a decision you are making.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition n The four distinguishing characteristics of monopolistic competition are: l Many sellers. l Differentiated products. l Multiple dimensions of competition. l Easy entry of new firms in the long run.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Many Sellers n When there are many sellers, they do not take into account rivals’ reactions. n The existence of many sellers makes collusion difficult. n Monopolistically competitive firms act independently.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Differentiated Products n The “many sellers” characteristic gives monopolistic competition its competitive aspect. n Product differentiation gives monopolistic competition its monopolistic aspect.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Differentiated Products n Differentiation exists so long as advertising convinces buyers that it exists. n Firms will continue to advertise as long as the marginal benefits of advertising exceed its marginal costs.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Multiple Dimensions of Competition n One dimension of competition is product differentiation. n Another is competing on perceived quality. n Competitive advertising is another. n Others include service and distribution outlets.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Easy Entry of New Firms in the Long Run n There are no significant barriers to entry. n Barriers to entry prevent competitive pressures. n Ease of entry limits long-run profit.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Output, Price, and Profit of a Monopolistic Competitor n A monopolistically competitive firm prices in the same manner as a monopolist— where MC = MR. n But the monopolistic competitor is not only a monopolist but a competitor as well.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Output, Price, and Profit of a Monopolistic Competitor n At equilibrium, ATC equals price and economic profits are zero. n This occurs at the point of tangency of the ATC and demand curve at the output chosen by the firm.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition MC ATC MRD QMQM PMPM Price 0Quantity

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Perfect and Monopolistic Competition n Both the monopolistic competitor and the perfect competitor make zero economic profit in the long run.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Perfect and Monopolistic Competition n The perfect competitors demand curve as perfectly elastic. n Zero economic profit means that it produces at the minimum of the ATC curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Perfect and Monopolistic Competition n A monopolistic competitor faces a downward sloping demand curve, and produces where MC = MR. n The ATC curve is tangent to the demand curve at that level, which is not at the minimum point of the ATC curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Perfect and Monopolistic Competition n Increasing market share is a relevant concern for a monopolistic competitor but not for a perfect competitor.

Perfect competitionMonopolistic competition Comparing Perfect and Monopolistic Competition MC PCPC D QCQC Price 0 Quantity ATC PMPM MC ATC DMR QMQM Quantity 0 Price QCQC PCPC McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Monopolistic Competition with Monopoly n It is possible for the monopolist to make economic profit in the long-run. n No long-run economic profit is possible in monopolistic competition.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Advertising and Monopolistic Competition n Firms in a perfectly competitive market have no incentive to advertise n Monopolistic competitors have a strong incentive to do so.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Goals of Advertising n The goals of advertising include shifting the demand curve to the right and making it more inelastic. n Advertising shifts the ATC curve up.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Does Advertising Help or Hurt Society? n There is a sense of trust in buying brands we know. n If consumers are willing to pay for “differentness,” it’s a benefit to them.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics Oligopoly n Oligopolies are made up of a small number of mutually interdependent firms. n Each firm must take into account the expected reaction of other firms.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Models of Oligopoly Behavior n No single general model of oligopoly behavior exists. n Two models of oligopoly behavior are the cartel model and the contestable market model.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cartel Model n A cartel is a combination of firms that acts as it were a single firm. n A cartel is a shared monopoly. n In the cartel model, an oligopoly sets a monopoly price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cartel Model n If oligopolies can limit the entry of other firms and form a cartel, they can increase the profits going to the firms in the cartel.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cartel Model n The cartel model of oligopoly: l Oligopolies act as if they were monopolists, l That have assigned output quotas to individual member firms, l So that total output is consistent with joint profit maximization.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Implicit Price Collusion n Formal collusion is illegal in the U.S. while informal collusion is permitted. n Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Implicit Price Collusion n Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Cartels and Technological Change n Cartels can be destroyed by an outsider with technological superiority. n Thus, cartels with high profits will provide incentives for significant technological change.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Are Prices Sticky? n Informal collusion is an important reason why prices are sticky. n Another is the kinked demand curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Are Prices Sticky? n When there is a kink in the demand curve, there has to be a gap in the marginal revenue curve. n The kinked demand curve is not a theory of oligopoly but a theory of sticky prices.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. D2D2 The Kinked Demand Curve D1D1 MR 2 MR 1 Price Quantity 0 Q P a b c d MC 0 MC 1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Contestable Market Model n According to the contestable market model, barriers to entry and barriers to exit determine a firm’s price and output decisions. l Even if the industry contains only one firm, it could still be a competitive market if entry is open.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Contestable Market Model n In the contestable market model, an oligopoly with no barriers to entry sets a competitive price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing the Contestable Market and Cartel Models n The stronger the ability of oligopolists to collude and prevent market entry, the closer it is to a monopolistic situation. n The weaker the ability to collude is, the more competitive it is. n Oligopoly markets lie between these two extremes.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Strategic Pricing and Oligopoly n Both the cartel and contestable market models use strategic pricing decisions – firms set their price based on the expected reactions of other firms.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. New Entry as a Limit on the Cartelization Strategy n The threat from outside competition limits oligopolies from acting as a cartel. n The newcomer may not want to cooperate with the other firms.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Wars n Price wars are the result of strategic pricing decisions gone wild. n Sometimes a firm engages in this activity because it hates its competitor.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Wars n A firm may develop a predatory pricing strategy as a matter of policy. n A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Game Theory and Strategic Decision Making n Most oligopolistic strategic decision making is carried out with explicit or implicit use of game theory. n Game theory is the application of economic principles to interdependent situations.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Game Theory and Strategic Decision Making n The prisoner’s dilemma is a well-known game that demonstrates the difficulty of cooperative behavior in certain circumstances.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Game Theory and Strategic Decision Making n In the prisoner’s dilemma, where mutual trust gets each one out of the dilemma, confessing is the rational choice.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Prisoner’s Dilemma and a Duopoly Example n The prisoners dilemma has its simplest application when the oligopoly consists of only two firms—a duopoly.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Prisoner’s Dilemma and a Duopoly Example n By analyzing the strategies of both firms under all situations, all possibilities are placed in a payoff matrix. n A payoff matrix is a box that contains the outcomes of a strategic game under various circumstances.

Firm and Industry Duopoly Cooperative Equilibrium McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Firm and Industry Duopoly Equilibrium When One Firm Cheats McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Duopoly and a Payoff Matrix n The duopoly is a variation of the prisoner's dilemma game. n The results can be presented in a payoff matrix that captures the essence of the prisoner's dilemma.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. B Cheats B Does not cheat A Does not cheatA Cheats B +$200,000 B 0 A 0 A +$200,000 B $75,000 A $75,000 A – $75,000 B – $75,000 The Payoff Matrix of Strategic Pricing Duopoly

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Models, Structure, and Performance n Oligopoly models are based either on structure or performance. l The four-fold division of markets considered so far are based on market structure. l Structure means the number, size, and interrelationship of firms in the industry.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Models, Structure, and Performance n A monopoly is the least competitive, perfectly competitive industries are the most competitive.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Models, Structure, and Performance n The contestable market model gives less weight to market structure. l Markets in this model are judged by performance, not structure. l Close relatives of it have previously been called the barriers-to-entry model, the stay- out pricing model, and the limited-pricing model.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Models, Structure, and Performance n There is a similarity in the two approaches. l Often barriers to entry are the reason there are only a few firms in an industry. l When there are many firms, that suggests that there are few barriers to entry. l In the majority of cases, the two approaches come to the same conclusion.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition, Oligopoly, and Strategic Pricing End of Chapter 13