1. Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 9 MONOPOLISTIC COMPETITION AND OLIGOPOLY Part Two: Microeconomics of Product Markets

2. ©2007 McGraw-Hill Ryerson Ltd.Chapter 92 In this chapter you will learn: 9.1 The characteristics of monopolistic competition 9.2 Why monopolistic competitors earn only a normal profit in the long run 9.3 The characteristics of oligopoly 9.4 How game theory relates to oligopoly 9.5 The incentives and obstacles to collusion among oligopolies 9.6 The positive and potential negative effects of advertising

3. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.13 Characteristics of Monopolistic Competition Relatively Large Number of Sellers –Small Market Shares –No Collusion –Independent Action

4. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.14 Characteristics of Monopolistic Competition Differentiated Products –Product Attributes –Service –Location –Brand Names and Packaging –Some Control Over Price

5. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.15 Characteristics of Monopolistic Competition Relatively Large Number of Sellers Differentiated Products Easy Entry and Exit Advertising

6. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.16

7. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.27 Q D MRMCP Price and Costs Q p Figure 9-2 A Monopolistically Competitive Firm Elastic Demand Curve ATC Economic profit Expect new competitors

8. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.28 Q D MR MC P ATC Price and Costs Q p EconomicprofitsdecreaseEconomicprofitsdecrease Demand curve shifts left In the long run, profits are zero A Monopolistically Competitive Firm

9. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.29 Q D MR MC P ATC Price and Costs Q pLoss Expect fewer competitors A Monopolistically Competitive Firm

10. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.210 Q D MR MC P ATC Price and Costs Q p Some firms exit - D shifts right - Losses get smaller Some firms exit - D shifts right - Losses get smaller A Monopolistically Competitive Firm In the long run, profits are zero

11. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.211 Price and Output in Monopolistic Competition Complications: Persistent positive profits may persist if: –there is continuing and significant product differentiation –entry is somewhat limited by the financial investment required to establish product differentiation Cverall, we still expect the general results

12. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.212 1. Allocative Efficiency P > MC Too little is produced 2. Productive Efficiency Costs high Excess capacity Monopolistic Competition and Efficiency

13. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.213 Q D MR MC P ATC Price and Costs Q p ExcessCapacityExcessCapacity Figure 9-3 The Inefficiency of Monopolistic Competition

14. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.214 Product Variety Benefits –Better match to consumer tastes –Better products –Tradeoff between variety and efficiency Further Complexity –Price, product, and advertising must be juggled to achieve maximum profit

15. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.315 The Characteristics of Oligopoly A Few Large Producers Homogeneous or Differentiated Products Control Over Price, but Mutual Interdependence Entry Barriers –Economies of scale –High capital costs –Ownership of raw materials Mergers

16. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.316 Concentration Ratio The % of total output produced and sold by an industry’s largest firms Industry considered oligopolistic if four- firm concentration ratio > 40% Measures of Industry Concentration

17. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.317 Concentration Ratio Three shortcomings: 1.Localized Markets 2.Interindustry Competition 3.World Trade Herfindahl Index = (%S 1 ) 2 + (%S 2 ) 2 + (%S 3 ) 2 + … + (%S n ) 2 Measures of Industry Concentration

18. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.318 4775 4365 3481 2453 2273 2069 1965 1038 Herfindahl Index

19. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.419 Game Theory Overview Oligopolists must make plans in light of the actions and expected reactions of their rivals Basic concepts: –Players –Rules –Strategies –Payoffs Equilibrium

20. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.420 Prisoner’s Dilemma Two prisoners cannot communicate Difficult to cooperate, even when mutually beneficial

21. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.421 Figure 9-5 Prisoner’s Dilemma Payoff Matrix Confess Not confess Confess Not confess confess Al’s strategies Bruno’s strategies A B CD 412 22 4 2 12 2

22. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.422 Figure 9-6 Profit Payoff for a Two-Firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 If both firms choose a high-price strategy, each choose a high-price strategy, each earns $12 million in profit If both firms choose a high-price strategy, each choose a high-price strategy, each earns $12 million in profit Collusive tendencies

23. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.423 Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 If RareAir uses a low- price strategy against Uptown’s high prices, profits will increase to $15 million Uptown’s profits fall to $6 million

24. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.424 Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 Uptown could also profit by switching to lower prices, as long as RareAir charges high prices

25. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.425 Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 If both firms shift to a low-price strategy, profits are $8 million

26. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.426 Strategies in a Two-firm Oligopoly High Low High Low RareAir’s price strategy Uptown’s price strategy A B CD $12$15 $6$8 $12 $6 $15 $8 Incentive to cheat

27. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.527 Two Oligopoly Strategies: The Incentives and Obstacles to Collusion Two distinct pricing strategies: 1.Collusive pricing 2.Price leadership There is no one simple model to predict outcomes due to: –Diversity of oligopolies –Complications of interdependence

28. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.528 Cartels and Other Collusion: Cooperative Strategies Collusion: any agreement to fix prices, divide up the market, or otherwise restrict competition Each firm acts as if it were a pure monopolist Illustrated…

29. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.529 Q D MC ATC MR P MR=MC Price and Costs Q0Q0Q0Q0 A0A0A0A0 P0P0P0P0 Economic profit Figure 9-7 Collusion and Joint-Profit Maximization

30. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.530 Cartels and Other Collusion: Cooperative Strategies Three identical firms Each firm finds it most profitable to charge P 0, but only if its rivals do The answer: collude and agree on price P 0

31. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.531 Daily Oil Production (July 1, 2005), barrels Saudi Arabia9,099,000 Iran4,110,000 Venezuela3,223,000 United Arab Emirates2,444,000 Nigeria2,306,000 Kuwait2,247,000 Libya1,500,000 Indonesia1,451,000 Algeria894,000 Qatar725,000 Iraqnot available GLOBAL PERSPECTIVE 9.1 Overt Collusion – The OPEC Cartel

32. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.532 Cartels and Other Collusion Covert Collusion: Relatively Recent Examples –Cement firms in Quebec –Tacit understandings

33. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.533 Obstacles to Collusion Demand and Cost Differences Number of Firms Cheating Recession Potential Entry Legal Obstacles: Anticombines Laws

34. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.534 Price Leadership Model Dominant firm leads the way Leadership strategy: –Infrequent Price Changes –Communications –Limit Pricing Breakdowns in price leadership: price wars

35. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.635 Oligopoly and Advertising Oligopolists prefer not to compete on price Product development and advertising preferred: –Less easily duplicated –Oligopolists have sufficient financial resources

36. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.636 The Largest Canadian Advertisers Company Advertising Spending ($ millions) Procter & Gamble 174.5 Rogers Communications 102.0 General Motors 99.1 Bell Canada Enterprises 72.9 Hudson’s Bay Company 70.2 Ford Motor Co. 60.0 Table 9-1

37. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.637 Positive Effects of Advertising 1.Low cost source of information 2.Can diminish monopoly power 3.Can speed up technological progress

38. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.638 Potential Negative Effects of Advertising 1.Only persuasion 2.Misleading claims 3.Barrier to entry 4.Self-cancelling advertising

39. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.639 GLOBAL PERSPECTIVE 9.2 The World’s Top 10 Brand Names Coca-Cola Microsoft IBM General Electric Intel Nokia Disney McDonald’s Toyota Marlboro

40. ©2007 McGraw-Hill Ryerson Ltd.Chapter 9.640 Oligopoly and Efficiency Impossible to say anything definitive Outcomes could be identical to pure monopoly Unlikely because of: 1.Increased foreign competition 2.Limit pricing 3.Technological advance

41. ©2007 McGraw-Hill Ryerson Ltd.Chapter 941 Chapter Summary 9.1 Characteristics of Monopolistic Competition 9.2 Price and Output in Monopolistic Competition 9.3 The Characteristics of Oligopoly 9.4 Oligopoly Pricing Behaviour –A Game Theory Overview 9.5 Two Oligopoly Strategies –Collusive oligopolists –Price leadership 9.6 Oligopoly and Advertising