Chapter 12 Monopolistic Competition and Oligopoly

Chapter 12Slide 2 Topics to be Discussed Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners ’ Dilemma

Chapter 12Slide 3 Topics to be Discussed Implications of the Prisoners ’ Dilemma for Oligopolistic Pricing Cartels

Chapter 12Slide 4 Monopolistic Competition Characteristics 1)Many firms 2)Free entry and exit 3)Differentiated product

Chapter 12Slide 5 Monopolistic Competition The amount of monopoly power depends on the degree of differentiation. Examples of this very common market structure include: Toothpaste Soap Cold remedies

Chapter 12Slide 6 Monopolistic Competition Toothpaste Crest and monopoly power  Procter & Gamble is the sole producer of Crest  Consumers can have a preference for Crest---taste, reputation, decay preventing efficacy  The greater the preference (differentiation) the higher the price.

Chapter 12Slide 7 Monopolistic Competition Question Does Procter & Gamble have much monopoly power in the market for Crest?

Chapter 12Slide 8 Monopolistic Competition The Makings of Monopolistic Competition Two important characteristics  Differentiated but highly substitutable products  Free entry and exit

A Monopolistically Competitive Firm in the Short and Long Run Quantity $/Q Quantity $/Q MC AC MC AC D SR MR SR D LR MR LR Q SR P SR Q LR P LR Short RunLong Run

Chapter 12Slide 10 Observations (short-run) Downward sloping demand--differentiated product Demand is relatively elastic--good substitutes MR < P Profits are maximized when MR = MC This firm is making economic profits A Monopolistically Competitive Firm in the Short and Long Run

Chapter 12Slide 11 Observations (long-run) Profits will attract new firms to the industry (no barriers to entry) The old firm ’ s demand will decrease to D LR Firm ’ s output and price will fall Industry output will rise No economic profit (P = AC) P > MC -- some monopoly power A Monopolistically Competitive Firm in the Short and Long Run

Deadweight loss MCAC Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium $/Q Quantity $/Q D = MR QCQC PCPC MCAC D LR MR LR Q MC P Quantity Perfect Competition Monopolistic Competition

Chapter 12Slide 13 Monopolistic Competition Monopolistic Competition and Economic Efficiency The monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle.

Chapter 12Slide 14 Monopolistic Competition Monopolistic Competition and Economic Efficiency With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.

Chapter 12Slide 15 Monopolistic Competition Questions 1)If the market became competitive, what would happen to output and price? 2)Should monopolistic competition be regulated?

Chapter 12Slide 16 Monopolistic Competition Questions 3)What is the degree of monopoly power? 4)What is the benefit of product diversity?

Chapter 12Slide 17 Monopolistic Competition in the Market for Colas and Coffee The markets for soft drinks and coffee illustrate the characteristics of monopolistic competition.

Chapter 12Slide 18 Elasticities of Demand for Brands of Colas and Coffee Colas:Royal Crown-2.4 Coke-5.2 to -5.7 Ground Coffee:Hills Brothers-7.1 Maxwell House-8.9 Chase and Sanborn-5.6 BrandElasticity of Demand

Chapter 12Slide 19 Questions 1)Why is the demand for Royal Crown more price inelastic than for Coke? 2)Is there much monopoly power in these two markets? 3)Define the relationship between elasticity and monopoly power. Elasticities of Demand for Brands of Colas and Coffee

Chapter 12Slide 20 Oligopoly Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry

Chapter 12Slide 21 Oligopoly Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment Computers

Chapter 12Slide 22 Oligopoly The barriers to entry are: Natural  Scale economies  Patents  Technology  Name recognition

Chapter 12Slide 23 Oligopoly The barriers to entry are: Strategic action  Flooding the market  Controlling an essential input

Chapter 12Slide 24 Oligopoly Management Challenges Strategic actions Rival behavior Question What are the possible rival responses to a 10% price cut by Ford?

Chapter 12Slide 25 Oligopoly Equilibrium in an Oligopolistic Market In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival ’ s response when choosing output and price. In oligopoly the producers must consider the response of competitors when choosing output and price.

Chapter 12Slide 26 Oligopoly Equilibrium in an Oligopolistic Market Defining Equilibrium  Firms doing the best they can and have no incentive to change their output or price  All firms assume competitors are taking rival decisions into account.

Chapter 12Slide 27 Oligopoly Nash Equilibrium Each firm is doing the best it can given what its competitors are doing.

Chapter 12Slide 28 Oligopoly The Cournot Model Duopoly  Two firms competing with each other  Homogenous good  The output of the other firm is assumed to be fixed

Chapter 12Slide 29 MC 1 50 MR 1 (75) D 1 (75) 12.5 If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. Firm 1 ’ s Output Decision Q1Q1 P1P1 What is the output of Firm 1 if Firm 2 produces 100 units? D 1 (0) MR 1 (0) If Firm 1 thinks Firm 2 will produce nothing, its demand curve, D 1 (0), is the market demand curve. D 1 (50)MR 1 (50) 25 If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount.

Chapter 12Slide 30 Oligopoly The Reaction Curve A firm ’ s profit-maximizing output is a decreasing schedule of the expected output of Firm 2.

Chapter 12Slide 31 Firm 2 ’ s Reaction Curve Q*2(Q 2 ) Firm 2 ’ s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Reaction Curves and Cournot Equilibrium Q2Q2 Q1Q Firm 1 ’ s Reaction Curve Q* 1 (Q 2 ) x x x x Firm 1 ’ s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The x ’ s correspond to the previous model. In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. Cournot Equilibrium

Chapter 12Slide 32 Oligopoly Questions 1)If the firms are not producing at the Cournot equilibrium, will they adjust until the Cournot equilibrium is reached? 2)When is it rational to assume that its competitor ’ s output is fixed?

Chapter 12Slide 33 Oligopoly An Example of the Cournot Equilibrium Duopoly  Market demand is P = 30 - Q where Q = Q 1 + Q 2  MC 1 = MC 2 = 0 The Linear Demand Curve

Chapter 12Slide 34 Oligopoly An Example of the Cournot Equilibrium Firm 1 ’ s Reaction Curve The Linear Demand Curve

Chapter 12Slide 35 Oligopoly An Example of the Cournot Equilibrium The Linear Demand Curve

Chapter 12Slide 36 Oligopoly An Example of the Cournot Equilibrium The Linear Demand Curve

Chapter 12Slide 37 Duopoly Example Q1Q1 Q2Q2 Firm 2 ’ s Reaction Curve Firm 1 ’ s Reaction Curve Cournot Equilibrium The demand curve is P = 30 - Q and both firms have 0 marginal cost.

Chapter 12Slide 38 Oligopoly Profit Maximization with Collusion

Chapter 12Slide 39 Oligopoly Contract Curve Q 1 + Q 2 = 15  Shows all pairs of output Q 1 and Q 2 that maximizes total profits Q 1 = Q 2 = 7.5  Less output and higher profits than the Cournot equilibrium Profit Maximization with Collusion

Chapter 12Slide 40 Firm 1 ’ s Reaction Curve Firm 2 ’ s Reaction Curve Duopoly Example Q1Q1 Q2Q Cournot Equilibrium 15 Competitive Equilibrium (P = MC; Profit = 0) Collusion Curve 7.5 Collusive Equilibrium For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium

Chapter 12Slide 41 First Mover Advantage-- The Stackelberg Model Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q = total output Firm 1 sets output first and Firm 2 then makes an output decision

Chapter 12Slide 42 Firm 1 Must consider the reaction of Firm 2 Firm 2 Takes Firm 1 ’ s output as fixed and therefore determines output with the Cournot reaction curve: Q 2 = /2Q 1 First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 43 Firm 1 Choose Q 1 so that: First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 44 Substituting Firm 2 ’ s Reaction Curve for Q 2 : First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 45 Conclusion Firm 1 ’ s output is twice as large as firm 2 ’ s Firm 1 ’ s profit is twice as large as firm 2 ’ s Questions Why is it more profitable to be the first mover? Which model (Cournot or Shackelberg) is more appropriate? First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 46 Price Competition Competition in an oligopolistic industry may occur with price instead of output. The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods.

Chapter 12Slide 47 Price Competition Assumptions Homogenous good Market demand is P = 30 - Q where Q = Q 1 + Q 2 MC = $3 for both firms and MC 1 = MC 2 = $3 Bertrand Model

Chapter 12Slide 48 Price Competition Assumptions The Cournot equilibrium:  Assume the firms compete with price, not quantity. Bertrand Model

Chapter 12Slide 49 Price Competition How will consumers respond to a price differential? (Hint: Consider homogeneity) The Nash equilibrium:  P = MC; P 1 = P 2 = $3  Q = 27; Q 1 & Q 2 = 13.5  Bertrand Model

Chapter 12Slide 50 Price Competition Why not charge a higher price to raise profits? How does the Bertrand outcome compare to the Cournot outcome? The Bertrand model demonstrates the importance of the strategic variable (price versus output). Bertrand Model

Chapter 12Slide 51 Price Competition Criticisms When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices. Even if the firms do set prices and choose the same price, what share of total sales will go to each one?  It may not be equally divided. Bertrand Model

Chapter 12Slide 52 Price Competition Price Competition with Differentiated Products Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm ’ s product.

Chapter 12Slide 53 Price Competition Assumptions Duopoly FC = $20 VC = 0 Differentiated Products

Chapter 12Slide 54 Price Competition Assumptions Firm 1 ’ s demand is Q 1 = P 1 + P 2 Firm 2 ’ s demand is Q 2 = P 1 + P 1  P 1 and P 2 are prices firms 1 and 2 charge respectively  Q 1 and Q 2 are the resulting quantities they sell Differentiated Products

Chapter 12Slide 55 Price Competition Determining Prices and Output Set prices at the same time Differentiated Products

Chapter 12Slide 56 Price Competition Determining Prices and Output Firm 1: If P 2 is fixed: Differentiated Products

Chapter 12Slide 57 Firm 1 ’ s Reaction Curve Nash Equilibrium in Prices P1P1 P2P2 Firm 2 ’ s Reaction Curve $4 Nash Equilibrium $6 Collusive Equilibrium

Chapter 12Slide 58 Nash Equilibrium in Prices Does the Stackelberg model prediction for first mover hold when price is the variable instead of quantity? Hint: Would you want to set price first?

Chapter 12Slide 59 A Pricing Problem for Procter & Gamble Scenario 1)Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd were entering the market for Gypsy Moth Tape. 2)All three would be choosing their prices at the same time. Differentiated Products

Chapter 12Slide 60 Scenario 3)Procter & Gamble had to consider competitors prices when setting their price. 4)FC = $480,000/month and VC = $1/unit for all firms Differentiated Products A Pricing Problem for Procter & Gamble

Chapter 12Slide 61 Scenario 5)P&G ’ s demand curve was: Q = 3,375P -3.5 (P U ).25 (P K ).25  Where P, P U, P K are P&G ’ s, Unilever ’ s, and Kao ’ s prices respectively Differentiated Products A Pricing Problem for Procter & Gamble

Chapter 12Slide 62 Problem What price should P&G choose and what is the expected profit? Differentiated Products A Pricing Problem for Procter & Gamble

P&G ’ s Profit (in thousands of $ per month) Competitor ’ s (Equal) Prices ($) P&G ’ s Price ($)

Chapter 12Slide 64 What Do You Think? 1)Why would each firm choose a price of $1.40? Hint: Think Nash Equilibrium 2) What is the profit maximizing price with collusion? A Pricing Problem for Procter & Gamble

Chapter 12Slide 65 Competition Versus Collusion: The Prisoners ’ Dilemma Why wouldn ’ t each firm set the collusion price independently and earn the higher profits that occur with explicit collusion?

Chapter 12Slide 66 Assume: Competition Versus Collusion: The Prisoners ’ Dilemma

Chapter 12Slide 67 Possible Pricing Outcomes: Competition Versus Collusion: The Prisoners ’ Dilemma

Chapter 12Slide 68 Payoff Matrix for Pricing Game Firm 2 Firm 1 Charge $4Charge $6 Charge $4 Charge $6 $12, $12$20, $4 $16, $16$4, $20

Chapter 12Slide 69 These two firms are playing a noncooperative game. Each firm independently does the best it can taking its competitor into account. Question Why will both firms both choose $4 when $6 will yield higher profits? Competition Versus Collusion: The Prisoners ’ Dilemma

Chapter 12Slide 70 An example in game theory, called the Prisoners ’ Dilemma, illustrates the problem oligopolistic firms face. Competition Versus Collusion: The Prisoners ’ Dilemma

Chapter 12Slide 71 Scenario Two prisoners have been accused of collaborating in a crime. They are in separate jail cells and cannot communicate. Each has been asked to confess to the crime. Competition Versus Collusion: The Prisoners ’ Dilemma

Chapter 12Slide 72 -5, -5-1, , -2-10, -1 Payoff Matrix for Prisoners ’ Dilemma Prisoner A ConfessDon ’ t confess Confess Don ’ t confess Prisoner B Would you choose to confess?

Chapter 12Slide 73 Payoff Matrix for the P & G Prisoners ’ Dilemma Conclusions: Oligipolistic Markets 1)Collusion will lead to greater profits 2)Explicit and implicit collusion is possible 3)Once collusion exists, the profit motive to break and lower price is significant

Chapter 12Slide 74 Charge $1.40Charge $1.50 Charge $1.40 Unilever and Kao Charge $1.50 P&G $12, $12$29, $11 $3, $21$20, $20 Payoff Matrix for the P&G Pricing Problem What price should P & G choose?

Chapter 12Slide 75 Implications of the Prisoners ’ Dilemma for Oligipolistic Pricing Observations of Oligopoly Behavior 1)In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur.

Chapter 12Slide 76 Observations of Oligopoly Behavior 2)In other oligopoly markets, the firms are very aggressive and collusion is not possible.  Firms are reluctant to change price because of the likely response of their competitors.  In this case prices tend to be relatively rigid. Implications of the Prisoners ’ Dilemma for Oligipolistic Pricing

Chapter 12Slide 77 The Kinked Demand Curve $/Q Quantity MR D If the producer lowers price the competitors will follow and the demand will be inelastic. If the producer raises price the competitors will not and the demand will be elastic.

Chapter 12Slide 78 The Kinked Demand Curve $/Q D P* Q* MC MC ’ So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MR Quantity

Chapter 12Slide 79 Implications of the Prisoners ’ Dilemma for Oligopolistic Pricing Price Signaling Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Signaling & Price Leadership

Chapter 12Slide 80 Implications of the Prisoners ’ Dilemma for Oligopolistic Pricing Price Leadership Pattern of pricing in which one firm regularly announces price changes that other firms then match Price Signaling & Price Leadership

Chapter 12Slide 81 Implications of the Prisoners ’ Dilemma for Oligopolistic Pricing The Dominant Firm Model In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. The large firm might then act as the dominant firm, setting a price that maximized its own profits.

Chapter 12Slide 82 Price Setting by a Dominant Firm Price Quantity DD QDQD P* At this price, fringe firms sell Q F, so that total sales are Q T. P1P1 QFQF QTQT P2P2 MC D MR D SFSF The dominant firm ’ s demand curve is the difference between market demand (D) and the supply of the fringe firms (S F ).

Chapter 12Slide 83 Cartels Characteristics 1) Explicit agreements to set output and price 2)May not include all firms

Chapter 12Slide 84 Cartels Examples of successful cartels  OPEC  International Bauxite Association  Mercurio Europeo Examples of unsuccessful cartels  Copper  Tin  Coffee  Tea  Cocoa Characteristics 3) Most often international

Chapter 12Slide 85 Cartels Characteristics 4) Conditions for success  Competitive alternative sufficiently deters cheating  Potential of monopoly power--inelastic demand

Chapter 12Slide 86 Cartels Comparing OPEC to CIPEC Most cartels involve a portion of the market which then behaves as the dominant firm

Chapter 12Slide 87 The OPEC Oil Cartel Price Quantity MR OPEC D OPEC TDSCSC MC OPEC TD is the total world demand curve for oil, and S C is the competitive supply. OPEC ’ s demand is the difference between the two. Q OPEC P* OPEC ’ s profits maximizing quantity is found at the intersection of its MR and MC curves. At this quantity OPEC charges price P*.

Chapter 12Slide 88 Cartels About OPEC Very low MC TD is inelastic Non-OPEC supply is inelastic D OPEC is relatively inelastic

Chapter 12Slide 89 The OPEC Oil Cartel Price Quantity MR OPEC D OPEC TDSCSC MC OPEC Q OPEC P* The price without the cartel: Competitive price (P C ) where D OPEC = MC OPEC QCQC QTQT PcPc

Chapter 12Slide 90 The CIPEC Copper Cartel Price Quantity MR CIPEC TD D CIPEC SCSC MC CIPEC Q CIPEC P* PCPC QCQC QTQT TD and S C are relatively elastic D CIPEC is elastic CIPEC has little monopoly power P* is closer to P C

Chapter 12Slide 91 Cartels Observations To be successful:  Total demand must not be very price elastic  Either the cartel must control nearly all of the world ’ s supply or the supply of noncartel producers must not be price elastic

Chapter 12Slide 92 The Cartelization of Intercollegiate Athletics Observations 1)Large number of firms (colleges) 2)Large number of consumers (fans) 3)Very high profits

Chapter 12Slide 93 Question How can we explain high profits in a competitive market? (Hint: Think cartel and the NCAA) The Cartelization of Intercollegiate Athletics

Chapter 12Slide 94 The Milk Cartel 1990s with less government support, the price of milk fluctuated more widely In response, the government permitted six New England states to form a milk cartel (Northeast Interstate Dairy Compact -- NIDC)

Chapter 12Slide 95 The Milk Cartel 1999 legislation allowed dairy farmers in Northeastern states surrounding NIDC to join NIDC, 7 in 16 Southern states to form a new regional cartel. Soy milk may become more popular.

Chapter 12Slide 96 Summary In a monopolistically competitive market, firms compete by selling differentiated products, which are highly substitutable. In an oligopolistic market, only a few firms account for most or all of production.

Chapter 12Slide 97 Summary In the Cournot model of oligopoly, firms make their output decisions at the same time, each taking the other ’ s output as fixed. In the Stackelberg model, one firm sets its output first.

Chapter 12Slide 98 Summary The Nash equilibrium concept can also be applied to markets in which firms produce substitute goods and compete by setting price. Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this.

Chapter 12Slide 99 Summary The Prisoners ’ Dilemma creates price rigidity in oligopolistic markets. Price leadership is a form of implicit collusion that sometimes gets around the Prisoners Dilemma. In a cartel, producers explicitly collude in setting prices and output levels.

End of Chapter 12 Monopolistic Competition and Oligopoly