Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 9 MONOPOLISTIC COMPETITION AND OLIGOPOLY Part Two: Microeconomics of Product Markets

©2007 McGraw-Hill Ryerson Ltd.Chapter 92 In this chapter you will learn: 9.1 The characteristics of monopolistic competition 9.2 Why monopolistic competitors earn only a normal profit in the long run 9.3 The characteristics of oligopoly 9.4 How game theory relates to oligopoly 9.5 The incentives and obstacles to collusion among oligopolies 9.6 The positive and potential negative effects of advertising

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.13 Characteristics of Monopolistic Competition Relatively Large Number of Sellers –Small Market Shares –No Collusion –Independent Action

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.14 Characteristics of Monopolistic Competition Differentiated Products –Product Attributes –Service –Location –Brand Names and Packaging –Some Control Over Price

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.15 Characteristics of Monopolistic Competition Relatively Large Number of Sellers Differentiated Products Easy Entry and Exit Advertising

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.16

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.27 Q D MRMCP Price and Costs Q p Figure 9-2 A Monopolistically Competitive Firm Elastic Demand Curve ATC Economic profit Expect new competitors

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.28 Q D MR MC P ATC Price and Costs Q p EconomicprofitsdecreaseEconomicprofitsdecrease Demand curve shifts left In the long run, profits are zero A Monopolistically Competitive Firm

©2007 McGraw-Hill Ryerson Ltd.Chapter 9.29 Q D MR MC P ATC Price and Costs Q pLoss Expect fewer competitors A Monopolistically Competitive Firm

©2007 McGraw-Hill Ryerson Ltd.Chapter Q D MR MC P ATC Price and Costs Q p Some firms exit - D shifts right - Losses get smaller Some firms exit - D shifts right - Losses get smaller A Monopolistically Competitive Firm In the long run, profits are zero

©2007 McGraw-Hill Ryerson Ltd.Chapter Price and Output in Monopolistic Competition Complications: Persistent positive profits may persist if: –there is continuing and significant product differentiation –entry is somewhat limited by the financial investment required to establish product differentiation Cverall, we still expect the general results

©2007 McGraw-Hill Ryerson Ltd.Chapter Allocative Efficiency P > MC Too little is produced 2. Productive Efficiency Costs high Excess capacity Monopolistic Competition and Efficiency

©2007 McGraw-Hill Ryerson Ltd.Chapter Q D MR MC P ATC Price and Costs Q p ExcessCapacityExcessCapacity Figure 9-3 The Inefficiency of Monopolistic Competition

©2007 McGraw-Hill Ryerson Ltd.Chapter Product Variety Benefits –Better match to consumer tastes –Better products –Tradeoff between variety and efficiency Further Complexity –Price, product, and advertising must be juggled to achieve maximum profit

©2007 McGraw-Hill Ryerson Ltd.Chapter The Characteristics of Oligopoly A Few Large Producers Homogeneous or Differentiated Products Control Over Price, but Mutual Interdependence Entry Barriers –Economies of scale –High capital costs –Ownership of raw materials Mergers

©2007 McGraw-Hill Ryerson Ltd.Chapter Concentration Ratio The % of total output produced and sold by an industry’s largest firms Industry considered oligopolistic if four- firm concentration ratio > 40% Measures of Industry Concentration

©2007 McGraw-Hill Ryerson Ltd.Chapter Concentration Ratio Three shortcomings: 1.Localized Markets 2.Interindustry Competition 3.World Trade Herfindahl Index = (%S 1 ) 2 + (%S 2 ) 2 + (%S 3 ) 2 + … + (%S n ) 2 Measures of Industry Concentration

©2007 McGraw-Hill Ryerson Ltd.Chapter Herfindahl Index

©2007 McGraw-Hill Ryerson Ltd.Chapter Game Theory Overview Oligopolists must make plans in light of the actions and expected reactions of their rivals Basic concepts: –Players –Rules –Strategies –Payoffs Equilibrium

©2007 McGraw-Hill Ryerson Ltd.Chapter Prisoner’s Dilemma Two prisoners cannot communicate Difficult to cooperate, even when mutually beneficial

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 9-5 Prisoner’s Dilemma Payoff Matrix Confess Not confess Confess Not confess confess Al’s strategies Bruno’s strategies A B CD

©2007 McGraw-Hill Ryerson Ltd.Chapter Figure 9-6 Profit Payoff for a Two-Firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 If both firms choose a high-price strategy, each choose a high-price strategy, each earns $12 million in profit If both firms choose a high-price strategy, each choose a high-price strategy, each earns $12 million in profit Collusive tendencies

©2007 McGraw-Hill Ryerson Ltd.Chapter Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 If RareAir uses a low- price strategy against Uptown’s high prices, profits will increase to $15 million Uptown’s profits fall to $6 million

©2007 McGraw-Hill Ryerson Ltd.Chapter Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 Uptown could also profit by switching to lower prices, as long as RareAir charges high prices

©2007 McGraw-Hill Ryerson Ltd.Chapter Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 If both firms shift to a low-price strategy, profits are $8 million

©2007 McGraw-Hill Ryerson Ltd.Chapter Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 Incentive to cheat

©2007 McGraw-Hill Ryerson Ltd.Chapter Two Oligopoly Strategies: The Incentives and Obstacles to Collusion Two distinct pricing strategies: 1.Collusive pricing 2.Price leadership There is no one simple model to predict outcomes due to: –Diversity of oligopolies –Complications of interdependence

©2007 McGraw-Hill Ryerson Ltd.Chapter Cartels and Other Collusion: Cooperative Strategies Collusion: any agreement to fix prices, divide up the market, or otherwise restrict competition Each firm acts as if it were a pure monopolist Illustrated…

©2007 McGraw-Hill Ryerson Ltd.Chapter Q D MC ATC MR P MR=MC Price and Costs Q0Q0Q0Q0 A0A0A0A0 P0P0P0P0 Economic profit Figure 9-7 Collusion and Joint-Profit Maximization

©2007 McGraw-Hill Ryerson Ltd.Chapter Cartels and Other Collusion: Cooperative Strategies Three identical firms Each firm finds it most profitable to charge P 0, but only if its rivals do The answer: collude and agree on price P 0

©2007 McGraw-Hill Ryerson Ltd.Chapter Daily Oil Production (July 1, 2005), barrels Saudi Arabia9,099,000 Iran4,110,000 Venezuela3,223,000 United Arab Emirates2,444,000 Nigeria2,306,000 Kuwait2,247,000 Libya1,500,000 Indonesia1,451,000 Algeria894,000 Qatar725,000 Iraqnot available GLOBAL PERSPECTIVE 9.1 Overt Collusion – The OPEC Cartel

©2007 McGraw-Hill Ryerson Ltd.Chapter Cartels and Other Collusion Covert Collusion: Relatively Recent Examples –Cement firms in Quebec –Tacit understandings

©2007 McGraw-Hill Ryerson Ltd.Chapter Obstacles to Collusion Demand and Cost Differences Number of Firms Cheating Recession Potential Entry Legal Obstacles: Anticombines Laws

©2007 McGraw-Hill Ryerson Ltd.Chapter Price Leadership Model Dominant firm leads the way Leadership strategy: –Infrequent Price Changes –Communications –Limit Pricing Breakdowns in price leadership: price wars

©2007 McGraw-Hill Ryerson Ltd.Chapter Oligopoly and Advertising Oligopolists prefer not to compete on price Product development and advertising preferred: –Less easily duplicated –Oligopolists have sufficient financial resources

©2007 McGraw-Hill Ryerson Ltd.Chapter The Largest Canadian Advertisers Company Advertising Spending ($ millions) Procter & Gamble Rogers Communications General Motors 99.1 Bell Canada Enterprises 72.9 Hudson’s Bay Company 70.2 Ford Motor Co Table 9-1

©2007 McGraw-Hill Ryerson Ltd.Chapter Positive Effects of Advertising 1.Low cost source of information 2.Can diminish monopoly power 3.Can speed up technological progress

©2007 McGraw-Hill Ryerson Ltd.Chapter Potential Negative Effects of Advertising 1.Only persuasion 2.Misleading claims 3.Barrier to entry 4.Self-cancelling advertising

©2007 McGraw-Hill Ryerson Ltd.Chapter GLOBAL PERSPECTIVE 9.2 The World’s Top 10 Brand Names Coca-Cola Microsoft IBM General Electric Intel Nokia Disney McDonald’s Toyota Marlboro

©2007 McGraw-Hill Ryerson Ltd.Chapter Oligopoly and Efficiency Impossible to say anything definitive Outcomes could be identical to pure monopoly Unlikely because of: 1.Increased foreign competition 2.Limit pricing 3.Technological advance

©2007 McGraw-Hill Ryerson Ltd.Chapter 941 Chapter Summary 9.1 Characteristics of Monopolistic Competition 9.2 Price and Output in Monopolistic Competition 9.3 The Characteristics of Oligopoly 9.4 Oligopoly Pricing Behaviour –A Game Theory Overview 9.5 Two Oligopoly Strategies –Collusive oligopolists –Price leadership 9.6 Oligopoly and Advertising