Between Competition and Monopoly: Real World Markets Ch. 13:Monopolistic Competition Ch. 14: Oligopoly Econ

Origin of Monopolistic Competition  There was much debate among economists before this market structure was included into the economic principles mainstream because its analysis is similar to monopoly in many respects.  Contributors to its development include: -Edward Chamberlain The Theory of Monopolistic Competition -Joan Robinson The Theory of Imperfect Competition 2

3 Ch.13: Monopolistic competition 1. Features of monopolistic competition 'Relatively large number of small sellers competing for the same group of customers 'Each firm produces slightly differentiated products 'Entry into the industry is relatively easy. 2. Product differentiation is the main distinguishing feature of this market from the rest.

4 3. Examples: Starbucks coffee house, fast food restaurants, gas stations, dry cleaners, grocery stores, e-commerce (Retail and service industries belong to monopolistic competition) 4. The short-run price and output decisions are similar to that of monopoly i.e. A firm in this industry can make profit, break-even, operate at a loss provided AVC<price<ATC, or minimize losses by going out of business if price ≤ AVC (See the SR cases for Monopoly). The main difference is that the demand for a firm in monopolistic competition is relatively more elastic than the demand for the monopolist.

Monopoly vs Monopolistic Competition Note the monopoly demand line less elastic than monopolistic competition 5 D D P1 P2 Q1 Q2 P P Q Q P MonopolyMonopolistic Competition

6 5. A firm in monopolistic competition will be in the long-run by producing the rate of output for which MR=LRMC and price=LRAC. Therefore, the firm’s profit is zero in the LR. Why? See graph D=P MR LRAC LRAC=P LRMC Pc Excess Capacity= =75 Q P

7 6.There exists an underutilization (misallocation) of resources in monopolistic competition because firms will not utilize their maximum capacity by producing at the lowest average per unit cost. This results in excess capacity is referred to as “wastes of monopolistic competition.”. Chamberlain argues that this is not necessarily a “waste” of resources, but a price that consumers pay for getting variety, quality, and service.

8 7. Forms of non-price competition  Product differentiation  Product quality improvements  Advertising

9 8. Cases for advertising . informs consumers of new products .supports the communication industry .stimulates product development Cases against advertising .persuasion not information .wastes of resources .sometimes it is misleading .increases in costs which are passed to consumers

10 Ch. 14: Oligopoly 1. Basic features or characteristics  It is a market of few large firms with significant market power  Its products may be identical or differentiated  There is recognized “mutual interdependence  Entry into the industry is difficult due to financial and other barriers 2.Examples: Automobile, Chemical industry, steel, airlines, long distance telephone

Oligopoly 3. There is recognized “mutual interdependence,” meaning that the action of any one oligopoly firm has a significant impact on the profitability of the other firm(s). Suppose GM unilaterally reduces the price of Buick cars, how would this affect the sales at Ford Taurus and profits? Because of a possible reaction to any action by a given firm, there is no single model for determining price and output in oligopoly. 11

12 4. Price and Output decisions under oligopoly are very difficult due to the “mutual interdependence” of firms i.e. the uncertainty of how the actions of one firm has a significant impact on other firms’ profits. Hence price and output decisions are based on the assumptions one desires to make. 5. The kinked demand theory (no collusion)- developed by Paul Sweezy of the UC. Illustrate graphically.  It assumes one firm’s price increases will be ignored by its rivals whereas its price decrease will be matched  It seeks to explain the observed existence of price rigidity or inflexibility in oligopoly

13 6. Cartel - a group of firms that collude by agreeing to restrict output to increase price and profits ( charging a uniform price). Under a cartel, the price and output decisions for oligopoly is similar to that of monopoly. Example: OPEC price/barrel of oil = $ price/barrel of oil =$ price/barrel of oil < $ /30/2006 price/barrel of oil = $ /2008 price/barrel of oil = $ /13/11 price/barrel of oil = $ /11/12 price/barrel of oil = $101.92

14 There are, however, a number of problems associated with a cartel. .Differences in the cost of production will not allow firms to charge a uniform price. .There is always a problem of cheating by cartel members .The larger the number of cartel members, the more difficult it is to keep a cartel together .A cartel is illegal in the U.S.

15 7. Price leadership by a dominant firm or low cost (efficient) firm (tacit collusion)  A price leader is a firm whose prices are followed by the rest of the industry  USX sets the price of various steel products  GM sets price of various autos

16 Cost - plus- pricing - a pricing policy whereby a firm computes its average cost of producing a good and then sets the price by adding the per unit cost plus some percentage above this cost. This pricing method is used by the auto industry widely because of its practical application. Price = AC at maximum production capacity + markup (return on investment) Price of 2015 Saturn car= $ 10, (25% of cost) = $12,500.00

17 Game theory is the study of how firms behave in strategic situations in which they take into account the possible responses by others. A simple example of game theory is the prisoners’ dilemma. In its original version, a police interrogates two accused criminals separately to a confession. Even though they gain collectively when they refuse to confess, they eventually will confess because if either one caves in and confesses and the other doesn’t, he/she who holds out would be worse off. His or her sentence is reduced by confessing regardless of the strategy chosen by the other party.

Game Theory as Price and Output Solution Game theory has 3 Key Elements  Players (firms)  Strategies (Dominant strategy and Nash Equilibrium)  Pay-off matrix (Profits or losses) The Prisoner’s Dilemma Example: Jack & Jill, Confess or Holdout? 18

19 A dominant strategy - a strategy that is clearly superior no matter which strategy is chosen by the other person. Nash Equilibrium-a situation in which each player chooses his/her best strategy given the strategy chosen by the other player. Strategies

An Example of Duopoly Game Pepsi Don’t AD Advertise Don’t AD C $750M/ P $750m C $400m/ P $900m Coca-Cola Advertise C $900m/ P $400 C $500m/ P $500m a.What is the dominant strategy for Coca-Cola and Pepsi? Advertise b.What is the Nash equilibrium strategy for Coca-Cola and Pepsi? Advertise c.Why do both end up in cell 4 rather than cell 1 for the Nash Equilibrium? This will help either company to minimize the worst outcome if either one tries to cheat by advertising when the other does not. This strategy is called minimax strategy=> a way of minimizing the worst outcome 20