Monopolistic Competition and Oligopoly Cheryl Carleton Asher Villanova University

©2005 Pearson Education, Inc. Chapter 122 Monopolistic Competition  Many producers offer products that are either close substitutes but are not viewed as identical  Each supplier has some power over the price it charges : price makers  Low barriers to entry: firms in the long run can enter or leave the market with ease  Act independently of each other  Differentiate their products

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

©2005 Pearson Education, Inc. Chapter 124 A Monopolistically Competitive Firm in the Short and Long Run 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

©2005 Pearson Education, Inc. Chapter 125 Exhibit 1a: Maximizing Short-Run Profit  The monopolistically competitive firm produces the level of output at which marginal revenue equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping demand curve.  In panel (a), the firm produces q units, sells them at price p, and earns a short-run economic profit equal to (p – c) multiplied by q, shown by the blue rectangle.

©2005 Pearson Education, Inc. Chapter 126 A Monopolistically Competitive Firm in the Short and Long Run Long-run  Profits will attract new firms to the industry (no barriers to entry)  The old firm’s demand will decrease to  Firm’s output and price will fall  Industry output will rise  No economic profit (P = AC)  P > MC  some monopoly power

©2005 Pearson Education, Inc. Chapter 127 Exhibit 2: Long-run Equilibrium p 0 q MC ATC MR D a b Quantity per period  In the long run, entry and exit will shift each firm’s demand curve until economic profit disappears and price equals ATC  Long-run outcome occurs where the MR curve intersects the MC curve at point a, where the ATC curve is tangent to the demand curve at point b and there is no economic profit  In the case of short-run losses, some firms will leave the industry and the demand curve shifts to the right, becoming less elastic until the loss disappears and the remaining firms earn a normal profit Dollars per unit

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

©2005 Pearson Education, Inc. Chapter 129 Monopolistic Competition & Economic Efficiency The monopoly power 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 – deadweight loss. With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.

©2005 Pearson Education, Inc. Chapter 1210 Monopolistic Competition and Economic Efficiency Firm faces downward sloping demand so zero profit point is to the left of minimum average cost Excess capacity is inefficient because average cost would be lower with fewer firms  Inefficiencies would make consumers worse off

©2005 Pearson Education, Inc. Chapter 1211 Monopolistic Competition If inefficiency bad for consumers, should monopolistic competition be regulated?  Market power relatively small. Usually enough firms to compete with enough substitutability between firms – deadweight loss small  Inefficiency is balance by benefit of increased product diversity – may easily outweigh deadweight loss

©2005 Pearson Education, Inc. Chapter 1212 The Market for Colas and Coffee Each market has much differentiation in products and try to gain consumers through that differentiation  Coke versus Pepsi  Maxwell House versus Folgers How much monopoly power do each of these producers have?  How elastic demand for each brand?

©2005 Pearson Education, Inc. Chapter 1213 Elasticities of Demand for Brands of Colas and Coffee

©2005 Pearson Education, Inc. Chapter 1214 The Market for Colas and Coffee The demand for Royal Crown more price inelastic than for Coke There is significant monopoly power in these two markets The greater the elasticity, the less monopoly power and vice versa.

©2005 Pearson Education, Inc. Chapter 1215 Oligopoly – Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry  Scale economies  Patents  Technology  Name recognition  Strategic action

©2005 Pearson Education, Inc. Chapter 1216 Oligopoly Examples  Automobiles  Steel  Aluminum  Petrochemicals  Electrical equipment

©2005 Pearson Education, Inc. Chapter 1217 Exhibit 4: Economies of Scale as a Barrier to Entry D o l l a r s p e r u n i t c a c b Autos per year S b a Long-run average cost 0  If a new entrant sells only S cars, the average cost per unit, c a, exceeds the average cost, c b, of a manufacturer that sells enough cars to reach the minimum efficiency scale, M.  If autos sell for a price less than c a, a potential entrant can expect to lose money. M

©2005 Pearson Education, Inc. Chapter 1218 High Costs of Entry  Total investment needed to reach the minimum size  Advertising a new product enough to compete with established brands  High start-up costs and presence of established brand names: the fortunes of a new product are very uncertain

©2005 Pearson Education, Inc. Chapter 1219 Oligopoly Management Challenges  Strategic actions to deter entry Threaten to decrease price against new competitors by keeping excess capacity  Rival behavior Because only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react.

©2005 Pearson Education, Inc. Chapter 1220 Oligopoly – Equilibrium If one firm decides to cut their price, they must consider what the other firms in the industry will do  Could cut price some, the same amount, or more than firm  Could lead to price war and drastic fall in profits for all Actions and reactions are dynamic, evolving over time

©2005 Pearson Education, Inc. Chapter 1221 Oligopoly – Equilibrium Defining Equilibrium  Firms are 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. Nash Equilibrium  Each firm is doing the best it can given what its competitors are doing. We will focus on duopoly  Markets in which two firms compete

©2005 Pearson Education, Inc. Chapter 1222 A Pricing Problem: Procter & Gamble Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd were entering the market for Gypsy Moth Tape. All three would be choosing their prices at the same time. Each firm was using same technology so had same production costs  FC = $480,000/month & VC = $1/unit

©2005 Pearson Education, Inc. Chapter 1223 A Pricing Problem: Procter & Gamble Procter & Gamble had to consider competitors prices when setting their price. 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 DON’T WORRY ABOUT EXACT DEMAND CURVE…JUST THAT THEY ARE INTERDEPENDENT

©2005 Pearson Education, Inc. Chapter 1224 A Pricing Problem: Procter & Gamble What price should P&G choose and what is the expected profit? Can calculate profits by taking different possibilities of prices you and the other companies could charge. Nash equilibrium is at $1.40 – the point where competitors are doing the best they can as well

©2005 Pearson Education, Inc. Chapter 1225 PRICING PROBLEM Remember that competitors have the same info and making the same decision SUPPOSE that competitors charged $1.50 OR MORE…best for you to do is charge $1.40. Competitors know the same thing, so it is true for them as well. SUPPOSE that competitors charged $1.30? Lose the least by charging $1.40

©2005 Pearson Education, Inc. Chapter 1226 P&G’s Profit (in thousands of $ per month)

©2005 Pearson Education, Inc. Chapter 1227 A Pricing Problem for Procter & Gamble Collusion with competitors will give larger profits.  If all agree to charge $1.50, each earn profit of $20,000  Collusions agreement hard to enforce

©2005 Pearson Education, Inc. Chapter 1228 Competition Versus Collusion: The Prisoners’ Dilemma Nash equilibrium is a noncooperative equilibrium: each firm makes decision that gives greatest profit, given actions of competitors Although collusion is illegal, why don’t firms cooperate without explicitly colluding?  Why not set profit maximizing collusion price and hope others follow?

©2005 Pearson Education, Inc. Chapter 1229 Competition Versus Collusion: The Prisoners’ Dilemma Competitor is not likely to follow Competitor can do better by choosing a lower price, even if they know you will set the collusive level price. We can use example from before to better understand the firms’ choices

©2005 Pearson Education, Inc. Chapter 1230 Competition Versus Collusion: The Prisoners’ Dilemma Assume:

©2005 Pearson Education, Inc. Chapter 1231 Competition Versus Collusion: The Prisoners’ Dilemma Possible Pricing Outcomes:

©2005 Pearson Education, Inc. Chapter 1232 Payoff Matrix for Pricing Game Firm 2 Firm 1 Charge $4Charge $6 Charge $4 Charge $6 $12, $12$20, $4 $16, $16$4, $20

©2005 Pearson Education, Inc. Chapter 1233 Competition Versus Collusion: The Prisoners’ Dilemma We can now answer the question of why firm does not choose cooperative price. Cooperating means both firms charging $6 instead of $4 and earning $16 instead of $12 Each firm always makes more money by charging $4, no matter what its competitor does Unless enforceable agreement to charge $6, will be better off charging $4

©2005 Pearson Education, Inc. Chapter 1234 Competition Versus Collusion: The Prisoners’ Dilemma An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.  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.

©2005 Pearson Education, Inc. Chapter , -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?

©2005 Pearson Education, Inc. Chapter 1236 Oligopolistic Markets Conclusions 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

©2005 Pearson Education, Inc. Chapter 1237 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?

©2005 Pearson Education, Inc. Chapter 1238 Observations of Oligopoly Behavior 1.In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur. 2.In other oligopoly markets, the firms are very aggressive and collusion is not possible.

©2005 Pearson Education, Inc. Chapter 1239 Observations of Oligopoly Behavior 2.In other oligopoly markets, the firms are very aggressive and collusion is not possible. a.Firms are reluctant to change price because of the likely response of their competitors. b.In this case prices tend to be relatively rigid.

©2005 Pearson Education, Inc. Chapter 1240 Price Rigidity Firms have strong desire for stability Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change  Fear lower prices will send wrong message to competitors leading to price war  Higher prices may cause competitors to raise theirs

©2005 Pearson Education, Inc. Chapter 1241 Price Signaling and Price Leadership Price Signaling  Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Leadership  Pattern of pricing in which one firm regularly announces price changes that other firms then match

©2005 Pearson Education, Inc. Chapter 1242 Price Signaling and Price Leadership 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 maximizes its own profits.

©2005 Pearson Education, Inc. Chapter 1243 Cartels Producers in a cartel explicitly agree to cooperate in setting prices and output. Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels

©2005 Pearson Education, Inc. Chapter 1244 Cartels Examples of successful cartels  OPEC  International Bauxite Association  Mercurio Europeo Examples of unsuccessful cartels  Copper  Tin  Coffee  Tea  Cocoa

©2005 Pearson Education, Inc. Chapter 1245 Cartels – Conditions for Success 1.Stable cartel organization must be formed – price and quantity settled on and adhered to  Members have different costs, assessments of demand and objectives  Tempting to cheat by lowering price to capture larger market share

©2005 Pearson Education, Inc. Chapter 1246 Cartels – Conditions for Success 2.Potential for monopoly power  Even if cartel can succeed, there might be little room to raise price if faces highly elastic demand  If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work

©2005 Pearson Education, Inc. Chapter 1247 Analysis of Cartel Pricing Members of cartel must take into account the actions of non-members when making pricing decisions Cartel pricing can be analyzed using the dominant firm model  OPEC oil cartel – successful  CIPEC copper cartel – unsuccessful

©2005 Pearson Education, Inc. Chapter 1248 Cartels About OPEC  Very low MC  TD is inelastic  Non-OPEC supply is inelastic  DOPEC is relatively inelastic

©2005 Pearson Education, Inc. Chapter 1249 Cartels 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

©2005 Pearson Education, Inc. Chapter 1250 The Cartelization of Intercollegiate Athletics 1.Large number of firms (colleges) 2.Large number of consumers (fans) 3.Very high profits

©2005 Pearson Education, Inc. Chapter 1251 The Cartelization of Intercollegiate Athletics NCAA is the cartel  Restricts competition  Reduces bargaining power by athletes – enforces rules regarding eligibility and terms of compensation  Reduces competition by universities – limits number of games played each season, number of teams per division, etc.  Limits price competition – sole negotiator for all football television contracts

©2005 Pearson Education, Inc. Chapter 1252 The Cartelization of Intercollegiate Athletics Although members have occasionally broken rules and regulations, has been a successful cartel In 1984, Supreme Court ruled that the NCAA’s monopolization of football TV contracts was illegal  Competition led to drop in contract fees  More college football on TV, but lower revenues to schools

©2005 Pearson Education, Inc. Chapter 1253 Oligopoly and Perfect Competition  Price is usually higher under oligopoly  Profits are higher under oligopoly  If there are barriers to entry into the oligopoly, profits will be higher than under perfect competition, in the long run

©2005 Pearson Education, Inc. Chapter 1254 Comparison of Market Structures