Monopolistic Competition and Oligopoly

Monopolistic Competition and Oligopoly
CHAPTER Monopolistic Competition and Oligopoly © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Concept of Imperfect Competition
A market structure in which there is more than one firm But one or more of the requirements of perfect competition is violated Imperfectly competitive markets Monopolistic competition Oligopoly © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monopolistic Competition
A market structure in which there are: Many firms Selling products that are differentiated And in which there is easy entry and exit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Sellers offer a differentiated product Downward-sloping demand curve Sell more by charging less Raise its price without losing all of its customers Price setters Product differentiation Quality or location Can be subjective © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Many buyers and sellers No strategic interaction among firms in the market Easy entry and exit No significant barriers to entry Zero economic profit in the long run © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Maximize profit Producing where MR=MC In the short-run Economic profit Zero economic profit Economic loss Demand curve facing a firm More elastic than under monopoly © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 A Monopolistically Competitive Firm in the Short Run Dollars MC A
Homes Serviced per Month Like any other firm, a monopolistic competitor maximizes profit by producing the level of output where its MR and MC curves intersect. Kafka exterminators maximizes profit by servicing 250 homes per month. The profit-maximizing price ($70) is found on the demand curve at an output level of 250 (point A). Profit per unit of $40 is the difference between the price ($70) and average total cost ($30) at output of 250. Total profit is profit per unit times output ($40 × 250 = $10,000), equal to the area of the shaded rectangle. d1 MR1 MC $70 A 250 ATC 30 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic profit in the short-run; in the long-run: New firms enter the market Existing firms: lose some of its customers Demand curve shifts left Long run: zero economic profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 A Monopolistically Competitive Firm in the Long Run Dollars
Homes Serviced per Month 1. In the long run, profit attracts entry, which shifts the firm’s demand curve leftward. d1 MR1 MC ATC d2 MR2 2. Entry continues until P=ATC at the best output level, and economic profit is zero. E $40 250 100 3. The typical firm produces where its new MR crosses MC © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic loss in the short-run; in the long-run: Some firms exit the market Firms that remain: gain customers Demand curve shifts right Long run: zero economic profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Excess capacity under monopolistic competition Long-run equilibrium: firm produces on the downward-sloping portion of its ATC curve Never at minimum average cost Its long-run output level is always too small to minimize cost per unit The firm operates with excess capacity © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Excess Capacity in Monopolistic Competition Dollars
Homes Serviced per Month In long-run equilibrium, a monopolistic competitor earns zero profit and operates on the downward-sloping portion of its ATC curve (100 units, at point E). As a result, it does not use enough of its capacity to minimize its average total cost. “Capacity output” (where ATC is minimized) is 200 units. But for any rise in output beyond 100, MR < MC, so profit would decrease (the firm would go from zero to negative profit). MC ATC MR2 d2 E $40 100 200 LR equilibrium output “Capacity output” © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Excess capacity and prices In the long-run: P > minimum ATC Higher price under monopolistic competition than under perfect competition Because of product differentiation Consumers usually benefit from product differentiation © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nonprice competition Any action a firm takes to shift the demand curve for its output to the right Better service, product guarantees Free home delivery, more attractive packaging Better locations, advertising May lead to short run economic profit Long run: zero economic profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nonprice competition Zero economic profit in the long-run because: Imitation by others reverses the initial rightward shift in demand The costs of nonprice competition shift the ATC curve upward © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Oligopoly Oligopoly Strategically interacting firms
A market dominated by a small number of strategically interacting firms Strategically interacting firms Try to raise their profits by colluding with each other to raise prices To the detriment of consumers Strategic interaction Is greater when a market is highly concentrated © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Oligopoly Measuring market concentration Concentration ratio
Concentration ratios The Herfindahl-Hirschman Index Concentration ratio The percentage of total output or sales by a given number of the largest firms in the market © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Concentration Ratios and HHI Values in Selected Industries, 2007
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Oligopoly The Herfindahl-Hirschman Index (HHI)
A measure of market concentration obtained by summing the squares of each firm's market share Most useful when the firms are not of equal size The fewer the number of firms in the market, the larger the HHI © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Oligopoly The Herfindahl-Hirschman Index (HHI)
Used by the Federal Trade Commission and the Department of Justice Approve or block mergers between firms No government scrutiny or opposition if: Increase the HHI by less than 100 Or keep the HHI under 1,500 (“unconcentrated” market) Government opposition: any merger that raises the HHI by more than 200 to a value of 2,500 or greater © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Oligopoly Some provisions on the measures of market concentration (U.S. Census Bureau) May distort the true degree of market concentration U.S. production only (does not include foreign production) The census data is nationwide, while the relevant markets are sometimes local © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

How Oligopolies Arise Barriers to entry Economies of scale Reputation
Strategic barriers Legal barriers Natural oligopolies: minimum efficient scale is a large fraction of the market © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

How Oligopolies Arise Reputation as a barrier
Established oligopolists: likely to have favorable reputations Heavy advertising expenditure: build and maintain brand loyalty A new entrant might be able to catch up After a substantial period of high advertising costs, low revenue, and economic loss © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

How Oligopolies Arise Strategic barriers Legal barriers
Maintain excess production capacity Special deals with distributors: best shelf space Long-term arrangements with customers Legal barriers Patents and copyrights Lobbying Zoning regulations © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Oligopoly vs. Other Market Structures
Strategic interaction Impossible to use the “MR=MC” approach Firm: anticipate how the competitors respond to a change in price © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 An Oligopolist’s Demand Curve Depends on Its Competitors’ Responses
For Apple, the quantity of downloaded songs demanded at each price depends on the response of its rival, Amazon. Demand curve D1 facing Apple is drawn assuming that as Apple changes its price, Amazon maintains its current price. In that case, if Apple raises its price from $0.99 to $1.29 per song, it will move from point A to point B. However, if Amazon matches Apple’s price hike, Apple’s demand curve will shift rightward, to D2. In that case, Apple’s price rise will move it from point A to point B′, with a smaller decrease in sales. Finally, if Amazon responds by lowering its price, Apple’s demand curve will shift leftward, to D3, and Apple will move to point B″, with a much greater decrease in sales. Price Millions of Songs per Week D2 D1 B” B’ D3 B $1.29 2.5 3.25 A $0.99 4 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Game Theory Approach
An approach to modeling the strategic interaction of oligopolists in terms of moves and countermoves The prisoner’s dilemma Two players (Colin, Rose) Strategies (Confess, Don’t confess) Payoff matrix (years in jail) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Column: strategy that Colin might choose Row: strategy that Rose might select Possible strategy combinations: Upper left box: Both confess Lower left box: Colin confesses and Rose doesn’t Upper right box: Rose confesses and Colin doesn’t Lower right box: Neither confesses © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 The Prisoner’s Dilemma Colin’s Actions Confess Don’t Confess
Rose’s Actions Don’t Colin gets 20 years Rose gets 20 years Rose gets 3 years Colin gets 30 years Colin gets 3 years Rose gets 30 years Rose gets 5 years Colin gets 5 years © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Payoff matrix A table showing the payoffs to each of two players for each pair of strategies they choose Dominant strategy Strategy that is best for a player no matter what strategy the other player chooses © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Simple Oligopoly Games
Duopoly An oligopoly market with only two sellers Situations duopolists might face Both players have dominant strategies Only one player has a dominant strategy Neither player has a dominant strategy © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duopoly Players: the only two gas stations in town (Gus and Filip) Strategies: charge a low price, charge a high price Payoff matrix: profits or losses © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 A Duopoly Game: Both Players Have Dominant Strategies Gus’s Actions
Low Price High Price Filip’s Actions Gus’s profit = $25,000 Filip’s profit = $25,000 Filip’s profit = $75,000 Gus’s profit = - $10,000 Gus’s profit = $75,000 Filip’s profit = - $10,000 Filip’s profit = $50,000 Gus’s profit = $50,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Both players have dominant strategies We can predict the game’s outcome: Both will choose the dominant strategy Gus’s dominant strategy: charge the low price Filip’s dominant strategy: charge the low price Both charge the low price © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 A Duopoly Game: Only One Player Has a Dominant Strategy
Gus’s Actions Low Price High Price Filip’s Actions Gus’s profit = $25,000 Filip’s profit = $25,000 Filip’s profit = $75,000 Gus’s profit = - $10,000 Gus’s profit = $75,000 $40,000 Filip’s profit = - $10,000 Filip’s profit = $50,000 Gus’s profit = $50,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Only one player has a dominant strategy We can predict the game’s outcome: The player with the dominant strategy will choose it The other player will choose the best strategy given the dominant strategy played by his/her competitor Gus: no dominant strategy Filip’s dominant strategy: the low price Both charge the low price © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8 A Duopoly Game: Neither Player Has a Dominant Strategy Gus’s Actions
Low Price High Price Filip’s Actions Gus’s profit = $25,000 Filip’s profit = $25,000 Filip’s profit = $75,000 $40,000 Gus’s profit = - $10,000 Gus’s profit = $75,000 $40,000 Filip’s profit = - $10,000 Filip’s profit = $50,000 Gus’s profit = $50,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

No player has a dominant strategy Gus: no dominant strategy Filip: no dominant strategy More difficult to predict an outcome to this game © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Complications More than two strategies from which to choose More than two players Repeated play Players select a strategy, observe the outcome of that trial, and play the game again and again Strategically interdependent sellers compete over many time periods © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cooperative Behavior in Oligopoly
Explicit collusion Cooperation involving direct communication between competing firms about setting prices Cooperative outcome: maximize payoffs Cartel (price-fixing agreement) A group of firms that selects a common price that maximizes total industry profits The most extreme form of explicit collusion Behave as a monopoly © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price-fixing agreements OPEC (Organization of Petroleum Exporting Countries) Among governments Illegal in the United States, Canada, the European Union, and many other developed countries © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Some Recent U.S. Price-Fixing Cases

Tacit collusion Any form of oligopolistic cooperation that does not involve an explicit agreement Depends on adopting strategies that send the right signals and discouraging other firms from breaking the agreement Tit-for-tat Price leadership © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tit-for-tat A game-theoretic strategy of doing to another player this period what he has done to you in the previous period Price leadership A form of tacit collusion in which one firm sets a price that other firms copy © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Limits to collusion Constrained by the market demand curve Weakened by new technologies Powerful incentives to cheat Government Prosecuting managers who participate in price-fixing agreements Blocking mergers that would result in highly concentrated markets where collusion of all types is more likely © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Four Market Structures: A Postscript
Four different market structures Perfect competition, monopoly, monopolistic competition, and oligopoly Each has different characteristics Each leads to different predictions about pricing, profit, nonprice competition, and firms’ responses to changes in their environments © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 A Summary of Market Structures

Advertising in Monopolistic Competition and Oligopoly
Perfect competitors Never advertise (standardized product) Monopolistic competitors Almost always advertise (differentiated products) Oligopolists Very often advertise (differentiated products) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monopolistic competitor advertises To shift its demand curve rightward To make demand for its output less elastic Long run Greater average cost per unit Each firm sells more: demand curve shifts right May raise or lower prices © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9 Advertising in Monopolistic Competition (a) Dollars
Bottles of Perfume per Month 1. Before advertising, long-run economic profit is zero. dads ATCads 2. With advertising, in the long run, economic profit returns to zero. dno ads B $100 ATC no ads 3. Advertising can lead to a higher price in the long run, as in this panel . . . 1,750 A 60 1,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9 Advertising in Monopolistic Competition (b) Dollars
Bottles of Perfume per Month dads dno ads ATC no ads A ATCads $60 C 1,000 50 4. or to a lower price in the long run, as in this panel. 2,000 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategic decisions about advertising Dominant strategy: run the ads Earn low profit Tacit collusion: don’t run ads Earn medium profit Tit-for-tat Airline industry © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10 An Advertising Game American’s Actions Run safety ads Don’t run ads
United’s Actions American earns low profit United earns low profit United earns high profit American earns very low profit American earns high profit United earns very low profit United earns medium profit American earns medium profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Two importers of bananas form a cartel
Cartel Pricing Two importers of bananas form a cartel Market demand curve: demand curve facing the cartel Restricts output Each member is allotted a fixed quantity Price: higher then the competitive price Profit: maximized (cartel) As long as the members stick to the agreement © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A.1 The Profit Maximizing Price and Output Level for a Cartel Dollars
Millions of Pounds per Month Facing the market demand curve D, a cartel’s profit is maximized by the output level (120 million pounds) where MR = MC, charging $0.45 per pound. Total cartel profit is the area of the blue-shaded rectangle. The profit is divided among the members by allotting a quantity of output for each firm, such that the sum of each firm’s quantity is the profit-maximizing total output (120 million pounds). D MR $0.45 A 120 0.15 MC = ATC © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cartel Pricing The incentive to cheat Cheating
One firm sells more then its allotment Market price falls Profit per pound falls The cheater earns a higher profit The other firm earns a smaller profit Cheating Dominant strategy for both firms © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A.2 Cheating Reduces the Cartel's Total Profit Dollars
Millions of Pounds per Month The cartel members initially sell 60 million pounds each (a total of 120 million pounds) and charging $0.45 per pound at point A. If one cartel member cheats by producing an extra 20 million pounds, total output rises to 140 million, and the market price falls to $0.40 (point B). Total cartel profit falls as well, to the area of the new shaded rectangle. However (from separate calculations described in this appendix), the cheater’s profit rises, while the non-cheater’s profit falls. D MR $0.45 A $0.40 B 120 140 0.15 MC = ATC © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monopolistic Competition and Oligopoly

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