6-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Chapter 6 Monopolistic competition and oligopoly

6-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Learning Objectives Discuss the nature and prevalence of monopolistic competition. Analyse and evaluate the price–output behaviour of monopolistically competitive firms. Discuss the implications of monopolistic competition for economic efficiency. Explain and assess the role of non-price competition —that is, competition based on product quality and advertising—in monopolistically competitive industries.

6-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Learning Objectives (cont.) Define oligopoly, assess its occurrence, and note the reasons for its existence. Examine the behaviour of oligopoly in terms of a simple game theory framework. Survey four models of the possible courses of price– output behaviour that oligopolistic industries might follow. Discuss the role of non-price competition, that is, competition on the basis of product development and advertising in oligopolistic industries. Provide some comments on the economic efficiency and social desirability of oligopoly.

6-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Monopolistic Competition Described Relatively large numbers of firms –small market share –no collusion –independent actions Product differentiation –competition based not just on price:  quality, brands, services, location, promotion and packaging Ease of entry –low economies of scale –low set-up costs.

6-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Price and Output Determination The Firm’s Demand Curve Highly elastic, Why? –More close substitutes than a pure monopolist. –Not perfect substitutes (as is the case with perfect competition). –Elasticity depends on:  number of rivals  degree of product differentiation.

6-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Short-Run Price and Output Determination How much to produce? –MR = MC Profits or losses in the short run –Profits: When AC > AR (D)—entry of new firms –Losses: When AC < AR (D)—exit of existing firms.

6-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Economic Profits Short-Run Price and Output Determination: Short-Run Profits Q D P Price and Costs MR MC Q AC

6-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Losses Q D P Price and Costs MR MC Q AC Short-Run Price and Output Determination: Short-Run Losses

6-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Long Run How much to produce? –MR = MC Firms tend to break even, i.e. normal profit –Tangency solution: profit-maximising firm will produce an output when its demand curve is at a tangent to its AC curve –When AC = AR (D).

6-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Long-Run Equilibrium Why do monopolistically competitive firms tend to break even in the long run? –Profits attract new entrants –Losses encourage exits Complications –some product differentiation –some entry is partially restricted –some economic losses may be tolerated by firms in the long run.

6-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Long-Run Equilibrium (cont.) Q D MR MC P Price and Costs Q AC

6-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Monopolistic Competition and Economic Efficiency Productive inefficiency: Minimum ATC is not necessarily chosen –excess capacity Allocative inefficiency: –price does not necessarily equal MC Redeeming features –product variety.

6-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Non-Price Competition Assists firms to improve their long-run equilibrium position. Product differentiation and product development –at a point in time –over time.

6-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Economics of Advertising The case for advertising –information and efficiency –competition –communication support The case against advertising –persuasion and wastage –concentration –media bias.

6-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Characteristics of Oligopoly ‘Fewness’: few firms dominate the market –Firms are mutually interdependent and must consider the possible reactions of rivals to their price and product development decisions. –Firms may collude or act independently.

6-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Characteristics of Oligopoly (cont.) Product differentiation? –Homogeneous or differentiated product –Examples:  petroleum products  aluminium  insurance  motor vehicles Concentration ratios: the percentage of total industry sales accounted for by a given number of the largest firms in each industry.

6-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Characteristics of Oligopoly (cont.) High Barriers to Entry Causes –economies of scale –mergers  give firms more market power, influence, etc. –ownership of patents, copyrights –control of strategic raw materials –technological progress.

6-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Oligopoly Behaviour: A Game Theory Overview Compare the behaviour of oligopolists to a simple duopoly game of strategy, actions and pay-offs as shown in the profit pay-off matrix. mutual interdependence –the fate of one firm lies partially or wholly with the performance or decisions of other firms in that same industry incentives to collude incentives to cheat.

6-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Profit Pay-offs for a Duopoly Giant’s pricing strategy HighLow Big’s pricing strategy High Low $12m $6m $8m $15m A C B D

6-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Maximin Strategies and Optimal Pricing Strategy Maximin strategies Strategies chosen by players in a game to maximise their minimum expected pay-off from the game. The equilibrium pair of strategies under this rule will result in a Nash equilibrium which is for each firm to charge a low price, regardless of the choice the other firm makes.

6-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Price–Output Behaviour in Four Models Four Models of Oligopoly –the kinked demand curve –collusive pricing –price leadership models –cost-plus pricing No standard model of oligopoly due to: –diversity –Interdependence.

6-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Kinked Demand: Non-Collusive Oligopoly Model Output occurs where MR = MC. Price remains stable over a variety of cost scenarios –Avoiding price wars. –Firms ignore price increases. –Firms match price decreases. Criticisms –How is the current price set? –Prices may not be as inflexible as model suggests.

6-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Kinked Demand Curve P Q D1D1 MR 1 The firm’s demand and marginal revenue curves

6-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Kinked Demand Curve (cont.) P Q D1D1 MR 1 The rival’s demand and marginal revenue curves MR 2 D2D2

6-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Kinked Demand Curve (cont.) P Q D1D1 MR 1 MR 2 D2D2 Rivals tend to follow a price cut

6-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Kinked Demand Curve (cont.) P Q D1D1 MR 1 MR 2 D2D2 Rivals tend to follow a price cut or ignore a price increase

6-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Kinked Demand Curve (cont.) P Q D1D1 MR 1 MR 2 D2D2 Effectively creating …

6-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Kinked Demand Curve (cont.) P Q D1D1 MR 1 Effectively creating a kinked demand curve P X Q D2D2 MC 2 MC 1 MR 2

6-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Collusion and Cartels Overt or covert agreements to fix prices, divide up or share the market or limit competition between firms. Output and price: same as a monopolist Forms: –Cartels  groups of firms that agree either formally or informally to set prices and output levels of a product among members –‘Gentlemen’s agreements’  groups of firms agree verbally to set prices and output levels, usually in an informal setting, such as a golf course.

6-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Profit Collusion and Profit Maximisation Q MC ATC P MR Price Q MR = MC D

6-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Obstacles to Collusion demand and cost differences between firms numbers of firms cheating recession legislative obstacles: Trade Practices Law.

6-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Price Leadership: Tacit Collusion Model Price leadership A type of gentlemen’s agreement in which oligopolists automatically follow the price initiatives of the dominant firm in an industry. Infrequent price changes by price leader. Price announcements often made through indirect channels such as trade publications. Price leader may choose strategies to block potential entrants: limit-pricing or price blocking.

6-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Cost-Plus Pricing Model An oligopolist uses a standard formula to estimate cost per unit of output and adds a mark-up to determine price. Advantages for multi-product firms. Consistent with outright collusion.

6-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Non-Price Competition Oligopolists dislike competing on price. Oligopolists must rely on non-price competition –advertising –product development Oligopolists typically have substantial resources to support non-price competition.

6-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Oligopoly and Economic Efficiency Productive inefficiency – Minimum ATC is not necessarily chosen  under-allocation of resources Allocative inefficiency: – Price does not necessary equal MC  output is restricted Dynamic efficiency.

6-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Oligopoly and Economic Efficiency (cont.) Long-term improvements in product quality and production methods may occur –competitive view –Schumpeter–Galbraith view  Oligopolists have both the incentive and financial and technical resources to be more technologically progressive than competitive firms

6-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Oligopoly and Economic Efficiency (cont.) Technical Advance: what is the evidence? –Giant corporate oligopolies are probably not the leaders in technological advance. –In Australia in the 1980s and 1990s more than half of the research and development efforts were supported by government rather than business. –The private sector has imported much of the technology through parent overseas companies. –Technological advances in Australian industry is science- based and research-orientated rather than market driven.

6-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Next Chapter: Market failure and resource allocation