1. Monopolistic Competition and Oligopoly
Chapter 12
Monopolistic Competition and Oligopoly

2. Topics to be Discussed Monopolistic Competition Oligopoly
Price Competition
Competition Versus Collusion: The Prisoners’ Dilemma
Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Cartels
Chapter 12 2

3. Monopolistic Competition
Characteristics
Many firms
Free entry and exit
Differentiated product
Chapter 12 4

4. 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 12 5

5. 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 12 6

6. Monopolistic Competition
Two important characteristics
Differentiated but highly substitutable products
Free entry and exit
Chapter 12 7

7. 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

8. 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
Chapter 12 13

9. A Monopolistically Competitive Firm in the Short and 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 12 14

10. Monopolistically and Perfectly Competitive Equilibrium (LR)
Perfect Competition
Monopolistic Competition
$/Q
$/Q
Deadweight
loss MC AC MC AC
DLR
MRLR
QMC P QC PC
D = MR
Quantity
Quantity 17

11. Monopolistic Competition and 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.
Chapter 12 18

12. 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
Chapter 12

13. Monopolistic Competition
If inefficiency is bad for consumers, should monopolistic competition be regulated?
Market power is relatively small. Usually there are enough firms to compete with enough substitutability between firms – deadweight loss small.
Inefficiency is balanced by benefit of increased product diversity – may easily outweigh deadweight loss.
Chapter 12 20

14. The Market for Colas and Coffee
Each market has much differentiation in products and tries to gain consumers through that differentiation
Coke vs. Pepsi
Maxwell House vs. Folgers
How much monopoly power do each of these producers have?
How elastic is demand for each brand?
Chapter 12 21

15. Elasticities of Demand for Brands of Colas and Coffee
Chapter 12 22

16. The Market for Colas and Coffee
The demand for Royal Crown is 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
Chapter 12 23

17. Oligopoly – Characteristics
Small number of firms
Product differentiation may or may not exist
Barriers to entry
Scale economies
Patents
Technology
Name recognition
Strategic action
Chapter 12 24

18. Oligopoly Examples Automobiles Steel Aluminum Petrochemicals
Electrical equipment
Chapter 12 25

19. 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
Chapter 12 28

20. 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
Chapter 12 29

21. 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
Chapter 12 30

22. Oligopoly The Cournot Model
Oligopoly model in which firms produce a homogeneous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce
Firm will adjust its output based on what it thinks the other firm will produce
Chapter 12 32

23. Firm 1’s Output Decision
MR1(0)
Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing.
D1(50)
MR1(50) 25
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(75)
D1(75)
12.5
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MC1 50 Q1
Chapter 12 38

24. Oligopoly The Reaction Curve
The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce
A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2
Chapter 12 39

25. Reaction Curves and Cournot Equilibrium
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.
100 75
Firm 2’s Reaction
Curve Q*2(Q1) 50
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce. x
Firm 1’s Reaction
Curve Q*1(Q2) x 25 x x Q2 25 50 75
100
Chapter 12 43

26. Reaction Curves and Cournot Equilibrium
100
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits. 75
Firm 2’s Reaction
Curve Q*2(Q1) 50 x
Cournot
Equilibrium
Firm 1’s Reaction
Curve Q*1(Q2) x 25 x x Q2 25 50 75
100
Chapter 12 43

27. Cournot Equilibrium
Each firm’s reaction curve tells it how much to produce given the output of its competitor
Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly
Chapter 12

28. Oligopoly
Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium)
The Cournot equilibrium says nothing about the dynamics of the adjustment process
Since both firms adjust their output, neither output would be fixed
Chapter 12 44

29. The Linear Demand Curve
An Example of the Cournot Equilibrium
Two firms face linear market demand curve
We can compare competitive equilibrium and the equilibrium resulting from collusion
Market demand is P = 30 - Q
Q is total production of both firms:
Q = Q1 + Q2
Both firms have MC1 = MC2 = 0
Chapter 12 4 45

30. Oligopoly Example
Firm 1’s Reaction Curve  MR = MC
Chapter 12 4 46

31. Oligopoly Example An Example of the Cournot Equilibrium Chapter 12 447

32. Oligopoly Example An Example of the Cournot Equilibrium Chapter 12 448

33. The demand curve is P = 30 - Q and both firms have 0 marginal cost.
Duopoly Example Q1
The demand curve is P = 30 - Q and
both firms have 0 marginal cost.
Firm 2’s
Reaction Curve 30 15 10
Cournot Equilibrium
Firm 1’s
Reaction Curve 15 30 Q2
Chapter 12 54

34. Oligopoly Example
Profit Maximization with Collusion
Chapter 12 4 55

35. Profit Maximization w/ Collusion
Contract Curve
Q1 + Q2 = 15
Shows all pairs of output Q1 and Q2 that maximize total profits
Q1 = Q2 = 7.5
Less output and higher profits than the Cournot equilibrium
Chapter 12 4 56

36. Duopoly Example Q1 30 15 10 7.5 For the firm, collusion is the best
outcome followed by the Cournot
Equilibrium and then the
competitive equilibrium
Firm 2’s
Reaction Curve 15
Competitive Equilibrium (P = MC; Profit = 0) 10
Cournot Equilibrium
Firm 1’s
Reaction Curve
Collusion
Curve
7.5
Collusive Equilibrium 30 Q2
Chapter 12 54

37. First Mover Advantage – The Stackelberg Model
Oligopoly model in which one firm sets its output before other firms do
Assumptions
One firm can set output first
MC = 0
Market demand is P = 30 - Q where Q is total output
Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1’s output
Chapter 12 58

38. First Mover Advantage – The Stackelberg Model
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: Q2 = 15 - ½(Q1)
Chapter 12 59

39. First Mover Advantage – The Stackelberg Model
Firm 1
Choose Q1 so that:
Firm 1 knows Firm 2 will choose output based on its reaction curve. We can use Firm 2’s reaction curve as Q2 .
Chapter 12 60

40. First Mover Advantage – The Stackelberg Model
Using Firm 2’s Reaction Curve for Q2:
Chapter 12 61

41. First Mover Advantage – The Stackelberg Model
Conclusion
Going first gives Firm 1 the advantage
Firm 1’s output is twice as large as Firm 2’s
Firm 1’s profit is twice as large as Firm 2’s
Going first allows Firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless it wants to reduce profits for everyone.
Chapter 12 62

42. Price Competition
Competition in an oligopolistic industry may occur with price instead of output
The Bertrand Model is used
Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge
Chapter 12 63

43. Price Competition – Bertrand Model
Assumptions
Homogenous good
Market demand is P = 30 - Q where Q = Q1 + Q2
MC1 = MC2 = $3
Can show the Cournot equilibrium if Q1 = Q2 = 9 and market price is $12, giving each firm a profit of $81.
Chapter 12 64

44. Price Competition – Bertrand Model
Assume here that the firms compete with price, not quantity
Since good is homogeneous, consumers will buy from lowest price seller
If firms charge different prices, consumers buy from lowest priced firm only
If firms charge same price, consumers are indifferent who they buy from
Chapter 12 64

45. Price Competition – Bertrand Model
Nash equilibrium is competitive output since have incentive to cut prices
Both firms set price equal to MC
P = MC; P1 = P2 = $3
Q = 27; Q1 & Q2 = 13.5
Both firms earn zero profit
Chapter 12 65

46. Price Competition – Bertrand Model
Why not charge a different price?
If charge more, sell nothing
If charge less, lose money on each unit sold
The Bertrand model demonstrates the importance of the strategic variable
Price versus output
Chapter 12 66

47. Bertrand Model – 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
Chapter 12 69

48. Price Competition – 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
In these markets, more likely to compete using price instead of quantity
Chapter 12 70

49. Price Competition – Differentiated Products
Example
Duopoly with fixed costs of $20 but zero variable costs
Firms face the same demand curves
Firm 1’s demand: Q1 = P1 + P2
Firm 2’s demand: Q2 = P1 + P2
Quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price
Chapter 12 71

50. Price Competition – Differentiated Products
Firms set prices at the same time
Chapter 12 72

51. Price Competition – Differentiated Products
If P2 is fixed:
Chapter 12 73

52. Nash Equilibrium in Prices
What if both firms collude?
They both decide to charge the same price that maximizes both of their profits
Firms will charge $6 and will be better off colluding since they will earn a profit of $16
Chapter 12 78

53. Nash Equilibrium in Prices
Firm 2’s Reaction Curve $4
Nash Equilibrium
Equilibrium at price of $4 and profits of $12 $6
Collusive Equilibrium
Firm 1’s Reaction Curve P2
Chapter 12 77

54. Nash Equilibrium in Prices
If Firm 1 sets price first and then Firm 2 makes pricing decision:
Firm 1 would be at a distinct disadvantage by moving first
The firm that moves second has an opportunity to undercut slightly and capture a larger market share
Chapter 12

55. 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
Chapter 12 79

56. 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(PU)0.25(PK)0.25
Where P, PU, PK are P&G’s, Unilever’s, and Kao’s prices respectively
Chapter 12 80

57. 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
Chapter 12 81

58. P&G’s Profit (in thousands of $ per month)
Chapter 12

59. 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
Collusion agreements are hard to enforce
Chapter 12 83

60. 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?
Chapter 12 84

61. 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
Chapter 12

62. Competition Versus Collusion: The Prisoners’ Dilemma
Assume:
Chapter 12 85

63. Competition Versus Collusion: The Prisoners’ Dilemma
Possible Pricing Outcomes:
Chapter 12 86

64. Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $6
Charge $4
$12, $12
$20, $4
$16, $16
$4, $20
Firm 1
Charge $6
Chapter 12 88

65. 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
Chapter 12 89

66. 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
Chapter 12 90

67. Payoff Matrix for Prisoners’ Dilemma
Prisoner B
Confess
Don’t confess
Confess
-5, -5
-1, -10
-2, -2
-10, -1
Prisoner A
Would you choose to confess?
Don’t
confess
Chapter 12 92

68. Oligopolistic Markets
Conclusions
Collusion will lead to greater profits
Explicit and implicit collusion is possible
Once collusion exists, the profit motive to break and lower price is significant
Chapter 12 95

69. Payoff Matrix for the P&G Pricing Problem
Unilever and Kao
Charge $1.40
Charge $1.50
Charge
$1.40
$12, $12
$29, $11
$3, $21
$20, $20
P&G
What price should P & G choose?
Charge
$1.50
Chapter 12 97

70. Observations of Oligopoly Behavior
In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur
In other oligopoly markets, the firms are very aggressive and collusion is not possible
Chapter 12 99

71. Observations of Oligopoly Behavior
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
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100

72. 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
Chapter 12

73. Price Rigidity Basis of kinked demand curve model of oligopoly
Each firm faces a demand curve kinked at the current prevailing price, P*
Above P*, demand is very elastic
If P > P*, other firms will not follow
Below P*, demand is very inelastic
If P < P*, other firms will follow suit
Chapter 12

74. Price Rigidity
With a kinked demand curve, marginal revenue curve is discontinuous
Firm’s costs can change without resulting in a change in price
Kinked demand curve does not really explain oligopolistic pricing
Description of price rigidity rather than an explanation of it
Chapter 12

75. 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 12
109

76. 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 12 MR
109

77. Price Signaling and Price Leadership
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
Chapter 12
110

78. 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
Chapter 12
110

79. The Dominant Firm Model
Dominant firm must determine its demand curve, DD
Difference between market demand and supply of fringe firms
To maximize profits, dominant firm produces QD where MRD and MCD cross
At P*, fringe firms sell QF and total quantity sold is QT = QD + QF
Chapter 12

80. Price Setting by a Dominant Firm
MCD
MRD SF
The dominant firm’s demand
curve is the difference between
market demand (D) and the supply
of the fringe firms (SF).
Price D DD
At this price, fringe firms
sell QF, so that total
sales are QT. P1 QF QT P2 QD P*
Quantity
Chapter 12
115

81. 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
Chapter 12
116

82. Cartels Examples of successful cartels
OPEC
International Bauxite Association
Mercurio Europeo
Examples of unsuccessful cartels
Copper
Tin
Coffee
Tea
Cocoa
Chapter 12
117

83. Cartels – Conditions for Success
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
Chapter 12
119

84. Cartels – Conditions for Success
Potential for monopoly power
Even if cartel can succeed, there might be little room to raise prices if it faces highly elastic demand
If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work
Chapter 12
120

85. 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
Chapter 12

86. The OPEC Oil Cartel Price P* QOPEC TD SC MCOPEC MROPEC DOPEC Quantity
TD is the total world demand
curve for oil, and SC is the
competitive supply. OPEC’s
demand is the difference
between the two.
Price
MROPEC
DOPEC
QOPEC P*
OPEC’s profit maximizing
quantity is found at the
intersection of its MR and
MC curves. At this quantity
OPEC charges price P*.
Quantity
Chapter 12
124

87. Cartels About OPEC Very low MC TD is inelastic
Non-OPEC supply is inelastic
DOPEC is relatively inelastic
Chapter 12
125

88. The OPEC Oil Cartel Price QC QT P* Pc QOPEC TD SC MCOPEC
The price without the cartel:
Competitive price (PC) where
DOPEC = MCOPEC QC QT
MROPEC
DOPEC P* Pc
QOPEC
Quantity
Chapter 12
124

89. The CIPEC Copper Cartel
Price
QCIPEC P* PC QC QT
TD and SC are relatively elastic
DCIPEC is elastic
CIPEC has little monopoly power
P* is closer to PC
MRCIPEC TD
DCIPEC SC
MCCIPEC
Quantity
Chapter 12
130

90. 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
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131

91. The Cartelization of Intercollegiate Athletics
Large number of firms (colleges)
Large number of consumers (fans)
Very high profits
Chapter 12
132

92. 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
Chapter 12
133

93. 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
Chapter 12