13 • MONOPOLISTIC COMPETITION AND OLIGOPOLY CHAPTER
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
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
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?
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.
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 firm’s actions directly affect the actions of other firms. • Collusion, or conspiring to fix prices, is impossible.
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.
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.
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.
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.
Output and Price in Monopolistic Competition • The Firm’s 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 firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.
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.
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.
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.
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 profit—as 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.
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.
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.
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 firm’s markup is the amount by which its price exceeds its marginal cost.
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.
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.
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.
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.
Product Development and Marketing • Innovation and Product Development • We’ve looked at a firm’s 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.
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.
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.
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 firm’s product.
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.
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.
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.
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.
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.
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.
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. • You’re more likely to overnight at a Holiday Inn than at Joe’s Nite Stop because Holiday Inn has incurred the cost of establishing a brand name and you know what to expect if you stay there.
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.
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
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 duopoly—a market with two firms.
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.
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 firm’s profit depends on every firm’s 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.
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.
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.
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.
Two Traditional Oligopoly Models • Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. • Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.
Two Traditional Oligopoly Models • The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by that gap AB in the figure.
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 MC0 to MC1, the profit maximizing price and quantity would not change.
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 doesn’t maximize profit.
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.
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.
Two Traditional Oligopoly Models • The demand curve, D, is the market demand curve and the supply curve S10 is the supply curve of the 10 small firms. S10
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.
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.