Monopolistic Competition and Oligopoly

1. 13 Monopolistic Competition and Oligopoly CHAPTER Profits, like sausages, are esteemed most by those that know least about what goes into them. Alvin Toffler Futurist, Author (1928 - )

2. C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • 1Explain how price and quantity are determined in monopolistic competition. • 2 Explain why selling costs are high in monopolistic competition. 3 Explain the dilemma faced by firms in oligopoly. 4 Use game theory to explain how price and quantity are determined in oligopoly.

3. MARKET CHARACTERISTICS

4. 13.1 MONOPOLISTIC COMPETITION • Relatively Large Number of Firms • Fewer than perfect competition. • Three implications are: • Small market share • No market dominance • Collusion impossible

5. 13.1 MONOPOLISTIC COMPETITION • Product Differentation • Product differentiation -making a product that is slightly different from the products of competing firms. • A differentiated product has close substitutes, but not perfect substitutes. • When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases.

6. 13.1 MONOPOLISTIC COMPETITION • Competition on Quality, Price, and Marketing • Quality • Design, reliability, after-sales service, and buyer’s ease of access to the product. • Price • Because of product differentiation, the demand curve for the firms’ product is downward sloping. • Marketing • Advertising and packaging.

7. 13.1 MONOPOLISTIC COMPETITION • Entry and Exit • Low to no barriers to entry, so the firm is unlikely to make economic profit in the long run. • Examples: • Restaurants • Gas stations • Hair salons • Dry Cleaners These firms are monopolistic in that each one has a monopoly on their brand, image, service, ambience, menu, etc. They are competitive in the sense that there are many, many of them, and consumers can easily sub one for another.

8. Industry Concentration • Concentration ratio – percentage of sales accounted for by specified number of top firms in a market. • Usually reported as 4-firm, 8-firm, or 20-firm. • The higher the concentration ratio, the greater the degree of market dominance by small number of firms. • The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. • Can distinguish between market structures by concentration ratio

9. Industry Concentration % of GDP

10. Industry Concentration • Herfindahl-Hirschman Index (HHI) – sum of the squared market shares of all firms. • HHI = s12 + s22 + . . . .sn2 • Ranges from 10,000 for pure monopolist to zero for infinite number of small firms. • The more unequal the market share, the higher the HHI value. The greater the number of firms, the lower the HHI.

11. Industry Concentration • Increases in concentration typically yield increased prices and profits, ceteris paribus. • Squaring gives greater weight to larger shares. • Example: If there are five firms in a market with market shares of 40%, 30%, 16%, 10% and 4%: • HHI = 402 + 302 + 162 + 102 + 42 = 2,872

12. Industry Concentration

13. 13.1 MONOPOLISTIC COMPETITION • The Firm’s Profit-Maximizing Decision • The firm in monopolistic competition makes its output and price decision just like a monopoly firm does (MC=MR).

14. 13.1 MONOPOLISTIC COMPETITION 1. Profit is maximized when MR = MC. 2.The profit-maximizing output is 125 pairs of Tommy jeans per day. 3.The profit-maximizing price is $75 per pair. ATC is $25 per pair, so 4. The firm makes an economic profit of $6,250 a day.

15. 13.1 MONOPOLISTIC COMPETITION • Long Run: Zero Economic Profit • Economic profit induces entry and economic loss induces exit, as in perfect competition. • Entry decreases the demand for the product of each firm. (demand curve shifts left) • Exit increases the demand for the product of each firm. (demand curve shifts right) • In the long run, economic profit is competed away and firms earn normal profit.

16. 13.1 MONOPOLISTIC COMPETITION 1. In LR, the output that maximizes profit is 75 pairs of Tommy jeans a day. 2. The price is $50 per pair. Average total cost is also $50 per pair. 3. Economic profit is zero.

17. The short run The long run MC MC F ATC pa ATC Price or Cost (dollars per unit) Price or Cost (dollars per unit) G pg Initial demand ca Demand K Later demand MR 0 0 qa qg Later MR Quantity (units per period) Quantity(units per period) Equilibrium in Monopolistic Competition

18. 13.1 MONOPOLISTIC COMPETITION • Monopolistic Competition and Efficiency • Efficiency requires that the MB of the consumer equal the MC of the producer. • Price measures marginal benefit, so efficiency requires P=MC. • In monopolistic competition, P > MR and MR=MC, so P > MC – a sign of inefficiency. • Demand curve can’t lie tangent to minimum ATC, so tangency is at higher ATC – inefficient.

19. 13.1 MONOPOLISTIC COMPETITION • But this inefficiency arises from product differentiation—variety—that consumers value and for which they are willing to pay. • So the loss that arises because MB > MC must be weighed against the gain that arises from greater product variety. • In a broader view of efficiency, monopolistic competition brings gains for consumers. • But firms in monopolistic competition always have excess capacity in long-run equilibrium.

20. 13.1 MONOPOLISTIC COMPETITION • Excess Capacity • Excess capacity-quantity produced is less than the quantity at minimum ATC. • Efficient scale = quantity at minimum ATC. • Figure 13.3 on the next slide illustrates excess capacity.

21. 13.1 MONOPOLISTIC COMPETITION 1. The efficient scale is 100 pairs of Tommy jeans a day. (min ATC) 2. The firm produces less than the efficient scale and has excess capacity. 3. Price exceeds 4.marginal cost. 5. Deadweight loss arise.

22. MARKET CHARACTERISTICS

23. 13.3 OLIGOPOLY • Tight oligopoly – concentration ratio > 60 • Duopoly - market in which there are only two producers. • Loose oligopoly – concentration ratio between 40 and 60. Firms in an oligopoly are closely interdependent. Price and output changes will impact rivals, and likely draw some reaction from the rival firms. Examples: airlines, aircraft, soft drinks, cellular service, computer chips, athletic shoes, cigarettes.

24. OLIGOPOLY The Battle for Market Shares • Increased sales on the part of one firm will be noticed immediately by the other firms. • Increases in the market share of one oligopolist will reduce the shares of the remaining oligopolists. • There isn’t any way that a firm can do so without causing alarms to go off in the industry. • An attempt by one oligopolist to increase its market share by cutting prices will lead to a general reduction in the market price, eventually harming everyone. • This is why oligopolists avoid price competition and instead pursue non-price competition.

25. OLIGOPOLY • NON-PRICE COMPETITION • Product differentiation – Features that make one product appear different from competing products in the same market. • Advertising - strengthens brand loyalty, and makes it expensive for new producers to enter the market • Training - Customers of training-intensive products (computer hardware, software) become familiar with a particular system. Creates barriers to later competition. • Network Economies - The widespread use of a particular product may heighten its value to consumers, thereby making potential substitutes less viable.

26. Close interdependence between firms OLIGOPOLY The Kinked Demand Curve • The degree to which sales increase when the price is reduced depends on the response of rival oligopolists. • We expect oligopolists to match any price cuts by rival oligopolists. • Rival oligopolists may not match price increases in order to gain market share.

27. The shape of the demand curve facing an oligopolist depends on how its rivals respond to a change in the price of its own output. The demand curve will be “kinked” if rival oligopolists match price cuts, but not price increases. The Kinked Demand Curve OLIGOPOLY

28. Price Rigidity (Kinked Demand) • Oligopolistic firms are interdependent – when one firm changes, others will have to consider whether action is required on their part. • Firms tend to match price cuts and NOT match price increases. • When firm cuts price, Q will increase – if other firms also cut price, increase in Q will be minimal (inelastic) • When firm raises price, Q will decrease. If other firms do not raise their price, increase in Q will be more substantial (elastic). • Difference in relative elasticity will cause kink in demand curve at current price.

29. P1 Dno match MRno match MRmatch Dmatch Q1

30. P1 Dno match MRno match MRmatch Dmatch Q1

31. Profit max output is where the MR curve is discontinuous (where MC runs thru discontinuity). Marginal costs can increase or decrease without changing profit max output as long as MC stays in gap. MC3 MC2 P1 MC1 MR D Q1

32. Response by other firms tends to discourage this firm from changing price, keeping prices stable (price rigidity). MC3 MC2 P1 MC1 MR D Q1

33. Oligopolists may try to coordinate their behavior in a way that maximizes industry profits. Oligopoly vs. Competition OLIGOPOLY • An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit. • To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares.

34. 13.3 OLIGOPOLY • Collusion • When a small number of firms share a market, they can increase their profit by forming a cartel and acting like a monopoly. • Cartel- group of firms acting together to limit output, raise price, and increase economic profit. • Firms would behave collectively like a multi-firm profit-maximizing monopolist • Cartels are illegal in U.S., but they can operate covertly in some markets.

35. OLIGOPOLY Price Fixing • Explicit agreement among producers about price at which goods will be sold. • The most explicit form of coordination among oligopolists. • NOT LEGAL.

36. Coca Cola – The Coca-Cola Bottling Co. of North Carolina agreed to pay a fine and give consumers discount coupons to settle charges of conspiring to fix soft-drink prices from 1982 to 1985. Examples of Price Fixing Examples of Price Fixing School Milk – Between 1988 and 1991, the U.S. Justice Department filed charges against 50 companies for fixing the price of milk sold to public schools in 16 states. Beer – In 2007, the European Commission fined Heineken and three other beer producers €273.7 (about $380 million) for operating a price fixing cartel in Holland. The beer cartel operated between 1996 and 1999 in the EU market. Cases currently pending in court: Chocolate – Hershey’s, Mars, Nestle and Cadbury (control 75% of chocolate candy industry) accused of conspiring to fix prices since 2002. – Accused of price fixing and squeezing out internet competition by colluding with manufacturers on prices.

37. OLIGOPOLY Price Leadership (Dominant Firm Strategy) • Often one firm in oligopolistic market owns dominant market share. • Dominant firm can establish profit max price based on their cost structure, then smaller, or less aggressive, firms behave as price takers. • Example: Airlines

38. 13.4 GAME THEORY • Game theory is the tool used to analyze strategic behavior—behavior that recognizes mutual interdependence and takes account of the expected behavior of others.

39. 13.4 GAME THEORY • What Is a Game? • All games involve three features: • Rules • Strategies • Payoffs • Prisoners’ dilemma is a game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.

40. 13.4 GAME THEORY • The Prisoners’ Dilemma • Art and Bob are caught stealing a car: sentence is 2 years in jail. • DA wants to convict them of a big bank robbery: sentence is 10 years in jail. • DA has no evidence and to get the conviction, he makes the prisoners play a game.

41. 13.4 GAME THEORY • Rules • Players cannot communicate with one another. • If both confess to the larger crime, each will receive a sentence of 3 years for both crimes. • If one confesses and the accomplice does not,the one who confesses will receive a 1-year sentence, while the accomplice receives a10-year sentence. • If neither confesses, both receive a 2-year sentence.

42. 13.4 GAME THEORY • Strategies • The strategies of a game are all the possible outcomes of each player. • The strategies in the prisoners’ dilemma are • Confess to the bank robbery. • Deny the bank robbery.

43. 13.4 GAME THEORY • Payoffs • Four outcomes: • Both confess. • Both deny. • Art confesses and Bob denies. • Bob confesses and Art denies. • A payoff matrix is a table that shows the payoffs for every possible action by each player given every possible action by the other player.

44. 13.4 GAME THEORY Table 13.5 shows the prisoners’ dilemma payoff matrix for Art and Bob.

45. 13.4 GAME THEORY • Equilibrium • Occurs when each player takes the best possible action given the action of the other player. • Nash equilibrium is an equilibrium in which each player takes the best possible action given the action of the other player. • The Nash equilibrium for Art and Bob is to confess. • The equilibrium of the prisoners’ dilemma is not the best outcome possible for the players, but is the best option if players don’t know what the other is doing.

46. 13.4 GAME THEORY • The Duopolists’ Dilemma as a Game • The dilemma of Boeing and Airbus is similar to that of Art and Bob. • Each firm has two strategies. It can produce airplanes at the rate of: • 3 a week • 4 a week

47. 13.4 GAME THEORY • Because each firm has two strategies, there are four possible combinations of actions: • Both firms produce 3 a week (monopoly outcome). • Both firms produce 4 a week. • Airbus produces 3 a week and Boeing produces 4 a week. • Boeing produces 3 a week and Airbus produces 4 a week.

48. 13.4 GAME THEORY • The Payoff Matrix • Table 13.6 shows the payoff matrix as the economic profits for each firm in each possible outcome.

49. 13.4 GAME THEORY • Equilibrium of the Duopolists’ Dilemma • Both firms produce 4 a week. • Like the prisoners, the duopolists fail to cooperate and get a worse outcome than the one that cooperation would deliver.

50. 13.4 GAME THEORY • Collusion Is Profitable but Difficult to Achieve • The duopolists’ dilemma explains why it is difficult for firms to collude and achieve the maximum monopoly profit. • Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output. • In OPEC, member countries frequently break the cartel agreement and overproduce (more players = more difficult to prevent cheating).