11 Between Competition and Monopoly... Neither fish nor fowl. JOHN HEYWOOD (CIRCA 1565) Between Competition and Monopoly... Neither fish nor fowl. JOHN HEYWOOD (CIRCA 1565)

●Monopolistic Competition ●Oligopoly ●Monopolistic Competition, Oligopoly, and Public Welfare ●A Glance Backward: Comparing the Four Market Forms ●Monopolistic Competition ●Oligopoly ●Monopolistic Competition, Oligopoly, and Public Welfare ●A Glance Backward: Comparing the Four Market Forms Contents Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Companies That Are Richer Than Most Nations Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 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© 2003 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 facing the firm 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 facing the firm is negatively sloped. ♦Majority of U.S. firms are in this type of market structure.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition ●Price and Output Determination under Monopolistic Competition ♦MR = MC rule applies for setting output. ♦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. ♦Long-run equilibrium: the firm’s demand curve must be tangent to its average cost curve.

FIGURE 11-1 Short-Run Equil. 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© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 11-2 Long-Run Equil. Under Monopolistic Competition 15,000 $1.35 Price per Gallon Gallons of Gasoline per Week 10,000 $1.45 MR MC AC D E M P Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The 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© 2003 Southwestern/Thomson Learning All rights reserved. The 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© 2003 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© 2003 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© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●A Shopping List ♦Ignore interdependence ♦Strategic interaction ♦Cartels ♦Price leadership and tacit collusion ♦Sales maximization ♦Kinked demand curve ♦Game theory ●A Shopping List ♦Ignore interdependence ♦Strategic interaction ♦Cartels ♦Price leadership and tacit collusion ♦Sales maximization ♦Kinked demand curve ♦Game theory

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●Sales Maximization: An Oligopoly Model with Interdependence Ignored ♦Firms may attempt to maximize revenue rather than profit if ■control is separated from ownership. ■compensation of managers is related to the size of the firm. ●Sales Maximization: An Oligopoly Model with Interdependence Ignored ♦Firms may attempt to maximize revenue rather than profit if ■control is separated from ownership. ■compensation of managers is related to the size of the firm.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●Sales Maximization: An Oligopoly Model with Interdependence Ignored ♦Output set where marginal revenue = 0 (rather than marginal cost) ♦Compared to a profit-maximizer ■Higher output ■Lower price ●Sales Maximization: An Oligopoly Model with Interdependence Ignored ♦Output set where marginal revenue = 0 (rather than marginal cost) ♦Compared to a profit-maximizer ■Higher output ■Lower price

FIGURE 11-3 Sales-Maximization Equilibrium $1.00 MR B D E AC Price per Box Millions of Boxes per Year F MC A Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Kinked Demand Curve Model ●Because the managers of a firm think that other firms will match any cut they make in price, but not any increase, they may think they face an inelastic demand curve with respect to price cuts and an elastic curve with respect to price increases. ?

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Kinked Demand Curve Model ●The demand curve is kinked, and the marginal revenue curve is discontinuous. ●If so, neither price nor output will change in response to moderate shifts in costs. ●The demand curve is kinked, and the marginal revenue curve is discontinuous. ●If so, neither price nor output will change in response to moderate shifts in costs. ?

FIGURE 11-4 The Kinked Demand Curve 0 7 Quantity per Year Price $8 D (Competitors’ prices are fixed) D 1,4001,1001,000 (Competitors respond to price changes) d d A Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

FIGURE 11-5 The Kinked Demand Curve and Sticky Prices mr MR Quantity Supplied per Year Price $8 1,000 MC D D d d A E B C Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●The Game-Theory Approach ♦Each oligopolist is seen as a competing player in a game of strategy. ♦Managers act as though their opponents will adopt the most profitable countermove to any move they make. ●The Game-Theory Approach ♦Each oligopolist is seen as a competing player in a game of strategy. ♦Managers act as though their opponents will adopt the most profitable countermove to any move they make.

TABLE 11-1 A Payoff Matrix Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●The Game-Theory Approach ♦Maximin = a strategy in which one seeks the maximum of the minimum payoffs to the available strategies. ♦“Prisoners’ Dilemma” ●The Game-Theory Approach ♦Maximin = a strategy in which one seeks the maximum of the minimum payoffs to the available strategies. ♦“Prisoners’ Dilemma”

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●The Game-Theory Approach ♦Nash equilibrium = both players adopt moves such that each player’s move is its most profitable response to the other’s move. ♦Often, no such mutually accommodating solution is possible. ●The Game-Theory Approach ♦Nash equilibrium = both players adopt moves such that each player’s move is its most profitable response to the other’s move. ♦Often, no such mutually accommodating solution is possible.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●The Game-Theory Approach ♦Repeated games ■Most markets feature repeat buyers. ■Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. ■“Tit for tat” ●The Game-Theory Approach ♦Repeated games ■Most markets feature repeat buyers. ■Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. ■“Tit for tat”

Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ●The Game-Theory Approach ♦Threats and credibility ■Induce rivals to change their behavior ■Threat must be credible ●The Game-Theory Approach ♦Threats and credibility ■Induce rivals to change their behavior ■Threat must be credible

FIGURE 11-6 Entry and Entry- Blocking Strategy –2 Profits (millions $) Old FirmNew Firm Possible Reactions of New Firm Possible Choices of Old Firm Enter Don’t Enter Enter Small Factory Big Factory Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 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© 2003 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition, Oligopoly, & Public Welfare ●When an oligopolistic market is perfectly contestable--if firms can enter and exit without losing the money they have invested--then the performance of the firms is likely to be socially efficient.

Copyright© 2003 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© 2003 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 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 in long-run equilibrium under these two market forms.

Copyright© 2003 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© 2003 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 11-2 Attributes of the Four Market Forms Copyright© 2003 South-Western/Thomson Learning. All rights reserved.