1. MONOPOLISTIC COMPETITION AND OLIGOPOLY 13 CHAPTER

2. Objectives After studying this chapter, you will able to Define and identify monopolistic competition Explain how output and price are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry

3. Objectives After studying this chapter, you will able to Define and identify oligopoly Explain two traditional oligopoly models Use game theory to explain how price and output are determined in oligopoly Use game theory to explain other strategic decisions

4. Searching for a Global Niche Globalization brings enormous diversity in products and thousands of firms seek to make their own product special and different from the rest of the pack. Two firms produce the chips that drive most PCs. Firms in these markets are neither price takers like those in perfect competition, nor are they protected from competition by barriers to entry like a monopoly. How do such firms choose the quantity to produce and price?

5. Monopolistic Competition Monopolistic competition is a market with the following characteristics: A large number of firms. Each firm produces a differentiated product. Firms compete on product quality, price, and marketing. Firms are free to enter and exit the industry.

6. Monopolistic Competition Large Number of Firms The presence of a large number of firms in the market implies: Each firm has only a small market share and therefore has limited market power to influence the price of its product. Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firms actions directly affect the actions of other firms. Collusion, or conspiring to fix prices, is impossible.

7. Monopolistic Competition Product Differentiation Firms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms.

8. Monopolistic Competition Competing on Quality, Price, and Marketing Product differentiation enables firms to compete in three areas: quality, price, and marketing. Quality includes design, reliability, and service. Because firms produce differentiated products, each firm has a downward-sloping demand curve for its own product. But there is a tradeoff between price and quality. Differentiated products must be marketed using advertising and packaging.

9. Monopolistic Competition Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. Examples of Monopolistic Competition Figure 13.1 on the next slide shows market share of the largest four firms and the HHI for each of ten industries that operate in monopolistic competition.

10. Monopolistic Competition The red bars refer to the 4 largest firms. Green is the next 4. Blue is the next 12. The numbers are the HHI.

11. Output and Price in Monopolistic Competition The Firms Short-Run Output and Price Decision A firm that has decided the quality of its product and its marketing program produces the profit maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC). Price is determined from the demand curve for the firms product and is the highest price the firm can charge for the profit-maximizing quantity.

12. Output and Price in Monopolistic Competition Figure 13.2 shows a short-run equilibrium for a firm in monopolistic competition. It operates much like a single-price monopolist.

13. Output and Price in Monopolistic Competition The firm produces the quantity at which price equals marginal cost and sells that quantity for the highest possible price. It earns an economic profit (as in this example) when P > ATC.

14. Output and Price in Monopolistic Competition Profit Maximizing Might be Loss Minimizing A firm might incur an economic loss in the short run. Here is an example. In this case, P < ATC.

15. Output and Price in Monopolistic Competition Long Run: Zero Economic Profit In the long run, economic profit induces entry. And entry continues as long as firms in the industry earn an economic profitas long as (P > ATC). In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.

16. Output and Price in Monopolistic Competition As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward. The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity. Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.

17. Output and Price in Monopolistic Competition Figure 13.4 shows a firm in monopolistic competition in long-run equilibrium. If firms incur an economic loss, firms exit to achieve the long-run equilibrium.

18. Output and Price in Monopolistic Competition Monopolistic Competition and Perfect Competition Two key differences between monopolistic competition and perfect competition are: Excess capacity Markup A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firms markup is the amount by which its price exceeds its marginal cost.

19. Output and Price in Monopolistic Competition Firms in monopolistic competition operate with excess capacity in long- run equilibrium. The downward-sloping demand curve for their products drives this result.

20. Output and Price in Monopolistic Competition Firms in monopolistic competition operate with positive mark up. Again, the downward- sloping demand curve for their products drives this result.

21. Output and Price in Monopolistic Competition In contrast, firms in perfect competition have no excess capacity and no markup. The perfectly elastic demand curve for their products drives this result.

22. Output and Price in Monopolistic Competition Is Monopolistic Competition Efficient Because in monopolistic competition P > MC, marginal benefit exceeds marginal cost. So monopolistic competition seems to be inefficient. But the markup of price above marginal cost arises from product differentiation. People value variety but variety is costly. Monopolistic competition brings the profitable and possibly efficient amount of variety to market.

23. Product Development and Marketing Innovation and Product Development Weve looked at a firms profit maximizing output decision in the short run and the long run of a given product and with given marketing effort. To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development. New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.

24. Product Development and Marketing Innovation is costly, but it increases total revenue. Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation. Production development may benefit the consumer by providing an improved product, or it may only the appearance of a change in product quality. Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which is the amount the consumer is willing to pay for it.

25. Product Development and Marketing Advertising Firms in monopolistic competition incur heavy advertising expenditures. Figure 13.6 shows estimates of the percentage of sale price for different monopolistic competition markets. Cleaning supplies and toys top the list at almost 15 percent.

26. Product Development and Marketing Selling Costs and Total Costs Selling costs, like advertising expenditures, fancy retail buildings, etc. are fixed costs. Average fixed costs decrease as production increases, so selling costs increase average total costs at any given level of output but do not affect the marginal cost of production. Selling efforts such as advertising are successful if they increase the demand for the firms product.

27. Product Development and Marketing Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced. Here, with no advertising, the firm produces 25 units of output at an average total cost of $60.

28. Product Development and Marketing With advertising, the firm produces 100 units of output at an average total cost of $40. The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.

29. Product Development and Marketing Advertising might also decrease the markup. In Figure 13.8(a), with no advertising, demand is not very elastic and the markup is large. In Figure 13.8(b), advertising makes demand more elastic, increases the quantity and lowers the price and markup.

30. Product Development and Marketing Using Advertising to Signal Quality Why do Coke and Pepsi spend millions of dollars a month advertising products that everyone knows? One answer is that these firms use advertising to signal the high quality of their products. A signal is an action taken by an informed person or firm to send a message to uninformed persons.

31. Product Development and Marketing Using Advertising to Signal Quality Coke is a high quality cola and Oke is a low quality cola. If Coke spends millions on advertising, people think Coke must be good. If it is truly good, when they try it, they will like it and keep buying it. If Oke spends millions on advertising, people think Oke must be good. If it is truly bad, when they try it, they will hate it and stop buying it.

32. Product Development and Marketing Using Advertising to Signal Quality So if Oke knows its product is bad, it will not bother to waste millions on advertising it. And if Coke knows its product is good, it will spend millions on advertising it. Consumers will read the signals and get the correct message. None of the ads need mention the product. They just need to be flashy and expensive.

33. Product Development and Marketing Brand Names Why do firms spend millions of dollars to establish a brand name or image? Again, the answer is to provide information about quality and consistency. Youre more likely to overnight at a Holiday Inn than at Joes Nite Stop because Holiday Inn has incurred the cost of establishing a brand name and you know what to expect if you stay there.

34. Product Development and Marketing Efficiency of Advertising and Brand Names To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are efficient.

35. What is Oligopoly? The distinguishing features of oligopoly are: Natural or legal barriers that prevent entry of new firms A small number of firms compete

36. What is Oligopoly? Barriers to Entry Either natural or legal barriers to entry can create oligopoly. Figure 13.9 shows two oligopoly situations. In part (a), there is a natural duopolya market with two firms.

37. What is Oligopoly? In part (b), there is a natural oligopoly market with three firms. A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms.

38. What is Oligopoly? Small Number of Firms Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. Interdependence: With a small number of firms, each firms profit depends on every firms actions. Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit. Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.

39. What is Oligopoly? Examples of Oligopoly Figure 13.10 shows some examples of oligopoly. An HHI that exceeds 1800 is generally regarded as an oligopoly. An HHI below 1800 is generally regarded as monopolistic competition.

40. Two Traditional Oligopoly Models The Kinked Demand Curve Model In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.

41. Two Traditional Oligopoly Models Figure 13.11 shows the kinked demand curve model. The demand curve that a firm believes it faces has a kink at the current price and quantity.

42. Two Traditional Oligopoly Models Above the kink, demand is relatively elastic because all other firms prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms prices change in line with the price of the firm shown in the figure.

43. Two Traditional Oligopoly Models The kink in the demand curve means that the MR curve is discontinuous at the current quantityshown by that gap AB in the figure.

44. Two Traditional Oligopoly Models Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit- maximizing quantity and price unchanged. For example, if costs increased so that the MC curve shifted upward from MC 0 to MC 1, the profit maximizing price and quantity would not change.

45. Two Traditional Oligopoly Models The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesnt maximize profit.

46. Two Traditional Oligopoly Models Dominant Firm Oligopoly In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. The large firm operates as a monopoly, setting its price and output to maximize its profit. The small firms act as perfect competitors, taking as given the market price set by the dominant firm.

47. Two Traditional Oligopoly Models Figure 13.12 shows a dominant firm industry. On the left are 10 small firms and on the right is one large firm.

48. Two Traditional Oligopoly Models The demand curve, D, is the market demand curve and the supply curve S 10 is the supply curve of the 10 small firms. S 10

49. Two Traditional Oligopoly Models At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing.

50. Two Traditional Oligopoly Models But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm.

51. Two Traditional Oligopoly Models The demand curve for the large firms output is the curve XD on the right.

52. Two Traditional Oligopoly Models The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.

53. Two Traditional Oligopoly Models The large firm maximizes profit by setting MR = MC. Lets suppose that the marginal cost curve is MC in the figure.

54. Two Traditional Oligopoly Models The profit maximizing quantity for the large firm is 10 units. The price charged is $1.00.

55. Two Traditional Oligopoly Models The small firms take this price and supply the rest of the quantity demanded.

56. Two Traditional Oligopoly Models A dominant firm oligopoly can arise only if one firm has lower costs than the others.

57. Two Traditional Oligopoly Models In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.

58. Oligopoly Games Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. What Is a Game? All games share four features: Rules Strategies Payoffs Outcome.

59. Oligopoly Games The Prisoners Dilemma The prisoners dilemma game illustrates the four features of a game. The rules describe the setting of the game, the actions the players may take, and the consequences of those actions. In the prisoners dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. Each is held in a separate cell and cannot communicate with each other.

60. Oligopoly Games Each is told that both are suspected of committing a more serious crime. If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes. If both confess to the more serious crime, each receives 3 years in jail for both crimes. If neither confesses, each receives a 2-year sentence for the minor crime only.

61. Oligopoly Games In game theory, strategies are all the possible actions of each player. Art and Bob each have two possible actions: Confess to the larger crime Deny having committed the larger crime. Because there are two players and two actions for each player, there are four possible outcomes: Both confess Both deny Art confesses and Bob denies Bob confesses and Art denies

62. Oligopoly Games Each prisoner can work out what happens to himcan work out his payoffin each of the four possible outcomes. We can tabulate these outcomes in a payoff matrix. A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player. The next slide shows the payoff matrix for this prisoners dilemma game.

63. Oligopoly Games

64. If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player. If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibriumfirst proposed by John Nash. The following slides show how to find the Nash equlibrium.

65. Bobs view of the world

67. Arts view of the world

69. Equilibrium

70. Oligopoly Games An Oligopoly Price-Fixing Game A game like the prisoners dilemma is played in duopoly. A duopoly is a market in which there are only two producers that compete. Duopoly captures the essence of oligopoly. Figure 13.13 on the next slide describes the demand and cost situation in a natural duopoly.

71. Oligopoly Games Part (a) shows each firms cost curves. Part (b) shows the market demand curve.

72. Oligopoly Games This industry is a natural duopoly. Two firms can meet the market demand at the least cost.

73. Oligopoly Games How does this market work? What is the price and quantity produced in equilibrium?

74. Oligopoly Games Suppose that the two firms enter into a collusive agreement. A collusive agreement is an agreement between two (or more) firms to restrict output, raise price, and increase profits. Such agreements are illegal in the United States and are undertaken in secret. Firms in a collusive agreement operate a cartel.

75. Oligopoly Games The possible strategies are: Comply Cheat Because each firm has two strategies, there are four possible outcomes: Both comply Both cheat Trick complies and Gear cheats Gear complies and Trick cheats

76. Oligopoly Games The first possible outcomeboth complyearns the maximum economic profit, which is the same as a monopoly would earn.

77. Oligopoly Games To find that profit, we set marginal cost for the cartel equal to marginal revenue for the cartel. Figure 13.14 shows this outcome.

78. Oligopoly Games The cartels marginal cost curve is the horizontal sum of the MC curves of the two firms and the marginal revenue curve is like that of a monopoly.

79. Oligopoly Games The firms maximize economic profit by producing the quantity at which MC I = MR.

80. Oligopoly Games Each firm agrees to produce 2,000 units and each firm shares the maximum economic profit.

81. Oligopoly Games When each firm produces 2,000 units, the price is greater than the firms marginal cost, so if one firm increased output, its profit would increase.

82. Oligopoly Games Figure 13.15 shows what happens when one firm cheats and increases its output to 3,000 units. Industry output rises to 5,000 and the price falls.

83. Oligopoly Games For the complier, ATC now exceeds price. For the cheat, price exceeds ATC.

84. Oligopoly Games For the complier incurs an economic loss. The cheat earns an increased economic profit.

85. Oligopoly Games Either firm could cheat, so this figure shows two of the possible outcomes. Next, lets see the effects of both firms cheating.

86. Oligopoly Games Figure 13.16 shows the outcome if both firms cheat and increase their output to 3,000 units.

87. Oligopoly Games Industry output is 6,000 units, the price falls, and both firms earn zero economic profitthe same as in perfect competition.

88. Oligopoly Games Youve now seen the four possible outcomes: If both comply, they make $2 million a week each. If both cheat, they earn zero economic profit. If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million. If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million. The next slide shows the payoff matrix for the duopoly game.

89. Payoff Matrix

90. Tricks view of the world

92. Gears view of the world

94. Equilibrium

95. Oligopoly Games The Nash equilibrium is where both firms cheat. The quantity and price are those of a competitive market, and the firms earn normal profit. Other Oligopoly Games Advertising and R & D games are also prisoners dilemmas. An R & D Game Procter & Gamble and Kimberley Clark play an R & D game in the market for disposable diapers.

96. Oligopoly Games Here is the payoff matrix for the Pampers Versus Huggies game.

97. Oligopoly Games The Disappearing Invisible Hand In all the versions of the prisoners dilemma that weve examined, the players end up worse off than they would if they were able to cooperate. The pursuit of self-interest does not promote the social interest in these games.

98. Oligopoly Games A Game of Chicken In the prisoners dilemma game, the Nash equilibrium is a dominant strategy equilibrium, by which we mean the best strategy for each player is independent of what the other player does. Not all games have such an equilibrium. One that doesnt is the game of chicken.

99. Payoff Matrix

100. KCs view of the world

102. P&Gs view of the world

104. Equilibrium

105. Repeated Games and Sequential Games A Repeated Duopoly Game If a game is played repeatedly, it is possible for duopolists to successfully collude and earn a monopoly profit. If the players take turns and move sequentially (rather than simultaneously as in the prisoners dilemma), many outcomes are possible. In a repeated prisoners dilemma duopoly game, additional punishment strategies enable the firms to comply and achieve a cooperative equilibrium, in which the firms make and share the monopoly profit.

106. Repeated Games and Sequential Games One possible punishment strategy is a tit-for-tat strategy, in which one player cooperates this period if the other player cooperated in the previous period but cheats in the current period if the other player cheated in the previous period. A more severe punishment strategy is a trigger strategy in which a player cooperates if the other player cooperates but plays the Nash equilibrium strategy forever thereafter if the other player cheats.

107. Repeated Games and Sequential Games Table 13.5 shows that a tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game. Price wars might result from a tit-for-tat strategy where there is an additional complicationuncertainty about changes in demand. A fall in demand might lower the price and bring forth a round of tit-for-tat punishment.

108. Repeated Games and Sequential Games A Sequential Entry Game in a Contestable Market In a contestable marketa market in which firms can enter and leave so easily that firms in the market face competition from potential entrantsfirms play a sequential entry game.

109. Repeated Games and Sequential Games Figure 13.17 shows the game tree for a sequential entry game in a contestable market.

110. Repeated Games and Sequential Games In the first stage, Agile decides whether to set the monopoly price or the competitive price.

111. Repeated Games and Sequential Games In the second stage, Wanabe decides whether to enter or stay out.

112. Repeated Games and Sequential Games In the equilibrium of this entry game, Agile sets a competitive price and earns a normal profit to keep Wanabe out. A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out.

113. THE END