1. Monopolistic Competition and Oligopoly
Chapter 11
Monopolistic Competition and Oligopoly 1

2. Topics to be Discussed Monopolistic Competition Oligopoly
Price Competition
Competition Versus Collusion: The Prisoners’ Dilemma
Chapter 1 2

3. Topics to be Discussed
Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Cartels
Chapter 1 3

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

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 1 5

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 1 6

7. Monopolistic Competition
Question
Does Procter & Gamble have much monopoly power in the market for Crest?
Chapter 1 6

8. Monopolistic Competition
The Makings of Monopolistic Competition
Two important characteristics
Differentiated but highly substitutable products
Free entry and exit
Chapter 1 7

9. A Monopolistically Competitive Firm in the Short and Long Run
$/Q
Short Run
$/Q
Long Run MC AC MC AC
DSR
MRSR
QSR
PSR
DLR
MRLR
QLR
PLR
Quantity
Quantity 12

10. A Monopolistically Competitive Firm in the Short and Long Run
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
Chapter 1 13

11. A Monopolistically Competitive Firm in the Short and Long Run
Observations (long-run)
Profits will attract new firms to the industry (no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC -- some monopoly power
Chapter 1 14

12. Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium
Perfect Competition
Monopolistic Competition
$/Q
$/Q
Deadweight
loss MC AC MC AC
DLR
MRLR
QMC P QC PC
D = MR
Quantity
Quantity 17

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 1 18

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 1 19

15. Monopolistic Competition
Questions
1) If the market became competitive, what would happen to output and price?
2) Should monopolistic competition be regulated?
Chapter 1 20

16. Monopolistic Competition
Questions
3) What is the degree of monopoly power?
4) What is the benefit of product diversity?
Chapter 1 20

17. Monopolistic Competition in the Market for Colas and Coffee
The markets for soft drinks and coffee illustrate the characteristics of monopolistic competition.
Chapter 1 21

18. Elasticities of Demand for Brands of Colas and Coffee
Brand Elasticity of Demand
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
Chapter 1 22

19. Elasticities of Demand for Brands of Colas and Coffee
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.
Chapter 1 23

20. Oligopoly Characteristics Small number of firms
Product differentiation may or may not exist
Barriers to entry
Chapter 1 24

21. Oligopoly Examples Automobiles Steel Aluminum Petrochemicals
Electrical equipment
Computers
Chapter 1 25

22. Oligopoly The barriers to entry are: Natural Scale economies Patents
Technology
Name recognition
Chapter 1 26

23. Oligopoly The barriers to entry are: Strategic action
Flooding the market
Controlling an essential input
Chapter 1 27

24. Oligopoly Management Challenges Question Strategic actions
Rival behavior
Question
What are the possible rival responses to a 10% price cut by Ford?
Chapter 1 28

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 1 29

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 1 30

27. Oligopoly Nash Equilibrium
Each firm is doing the best it can given what its competitors are doing.
Chapter 1 31

28. 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 1 99

29. Implications of the Prisoners’ Dilemma for Oligipolistic Pricing
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.
Chapter 1
100

30. The Kinked Demand Curve
$/Q
If the producer raises price the
competitors will not and the
demand will be elastic. MR D
If the producer lowers price the
competitors will follow and the
demand will be inelastic.
Quantity
Chapter 1
109

31. The Kinked Demand Curve
$/Q MC
MC’
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant. D P* Q*
Quantity
Chapter 1 MR
109

32. Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership
Price Signaling
Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit
Chapter 1
110

33. Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership
Price Leadership
Pattern of pricing in which one firm regularly announces price changes that other firms then match
Chapter 1
110

34. 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 1
110

35. Cartels Characteristics 1) Explicit agreements to set output and price
2) May not include all firms
Chapter 1
116

36. Cartels Characteristics 3) Most often international
Examples of unsuccessful cartels
Copper
Tin
Coffee
Tea
Cocoa
Examples of successful cartels
OPEC
International Bauxite Association
Mercurio Europeo
Chapter 1
117

37. Cartels Characteristics 4) Conditions for success
Competitive alternative sufficiently deters cheating
Potential of monopoly power--inelastic demand
Chapter 1
119

38. Cartels Comparing OPEC to CIPEC
Most cartels involve a portion of the market which then behaves as the dominant firm
Chapter 1
120

39. Cartels About OPEC Very low MC TD is inelastic
Non-OPEC supply is inelastic
DOPEC is relatively inelastic
Chapter 1
125

40. 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 1
131

41. The Cartelization of Intercollegiate Athletics
Observations
1) Large number of firms (colleges)
2) Large number of consumers (fans)
3) Very high profits
Chapter 1
132

42. The Cartelization of Intercollegiate Athletics
Question
How can we explain high profits in a competitive market? (Hint: Think cartel and the NCAA)
Chapter 1
133

43. 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 1
134

44. 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 1
135

45. 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 1
136

46. 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.
Chapter 1
137

47. Monopolistic Competition and Oligopoly
End of Chapter 12
Monopolistic Competition and Oligopoly 1