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7. Between Competition and Monopoly. Outline. Monopolistic Competition Oligopoly Monopolistic Competition, Oligopoly, and Public Welfare A Glance Backward: Comparing the Four Market Forms. Three Real World Puzzles. Why are there so many retailers?

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7

Between Competition and Monopoly


Outline
Outline

  • Monopolistic Competition

  • Oligopoly

  • Monopolistic Competition, Oligopoly, and Public Welfare

  • A Glance Backward: Comparing the Four Market Forms


Three real world puzzles
Three Real World Puzzles

  • Why are there so many retailers?

    • E.g., intersections with 4 gas stations which is more than # of cars warrants. Why and how do they all stay open?

  • Why do oligopolists advertise more than competitive firms?

    • E.g., many big Co. use ads to battle for customers and ad budgets account for a huge portion of TC. Vs. farmers where few if any farms spend $ on ads.

  • Why do oligopolists seem to ∆P so infrequently?

    • E.g., ∆P commodities hourly but ∆P cars or refrigerators only a few times a year.


Characteristics of monopolistic competition
Characteristics of Monopolistic Competition

  • Many small buyers and sellers

  • Freedom of entry and exit

  • Perfect information

  • Heterogeneous products: each seller’s product differs somewhat from every other seller’s product.

    • E.g., Diff. in packaging, services, or consumers’ perceptions.

    • Only characteristic that differs from perfect competition.


Monopolistic competition
Monopolistic Competition

  • D curve facing firm has (-) slope.

    • Each seller’s product is different –they are not perfect substitutes.

    • ↑P will drive away some but not all of firm’s customers. Or ↓P will attract some but not all customers from rival firms.

  • Freedom of entry and exit → firms cannot earn econ Π in LR.

    • SR Π > 0 → new firms enter and ↓P until P = AC.

  • Most U.S. firms are in this market structure.


Determination of price and output under monopolistic competition
Determination of Price and Output under Monopolistic Competition

  • Recall when D has (-) slope → P > MR.

  • Profit-max Q is where MR = MC.

  • Analysis looks like pure monopoly, but monop. comp. firm (with rivals producing close substitutes) has a much flatter D curve.

  • LR: Π = 0 → each firm produces where P = AC. So firm’s D curve must be tangent to its AC curve.

  • Zero econ. Π in LR is seen in real world.

    • E.g., Gas station owners do not earn higher Π than small farmers under perfect competition.


Figure 1 short run equilibrium under monopolistic competition

MC Competition

AC

P

C

E

D

MR

FIGURE 1. Short-Run Equilibrium Under Monopolistic Competition

Π-max Q =12,000 and P = $3.50

Per unit Π= $0.10 → total Π = $1,200.

$3.80

$3.50

Price per Gallon

3.40

$3.00

12,000

Gallons of Gasoline per Week


Figure 2 long run equilibrium under monopolistic competition

MC Competition

AC

M

P

E

D

MR

FIGURE 2.Long-Run Equilibrium Under Monopolistic Competition

SR profits in Fig. 1 → new firms enter which shifts each firm’s D curve down until P = AC.

Compared with SR profits in Fig. 1:

a. P is lower in LR

b. more firms in industry; each produces a smaller Q with higher AC.

$3.45

$3.35

Price per Gallon

10,000

15,000

Gallons of Gasoline per Week


The excess capacity theorem
The Excess Capacity Theorem Competition

  • In Fig. 2, AC at LR Q of firm (pt P) > min AC (pt M).

  • Pt M is where LR Q of a perf. comp. firm would be.

  • In LR, monop. comp. firm is producing where ↓AC but has not yet reached its min.

  • Monopolistic competition leads to firms that have unused or wasted capacity.

  • Resolve puzzle 1 –abundance of retailers: intersection with 4 gas stations where 2 would suffice and operate at lower AC is real world ex. of excess capacity.


The excess capacity theorem1
The Excess Capacity Theorem Competition

  • Fewer firms in a monop. comp. market → each firm could ↑Q and ↓AC.

  • Yet, fewer firms with larger quantities means there is less variety of product.

  • Greater efficiency would be achieved at the cost of greater standardization.

  • Not clear society would be better off with fewer firms.


Oligopoly defined
Oligopoly Defined Competition

  • Oligopoly = market dominated by a few sellers, where several are large enough to affect market P.

  • Great rivalry among firms with new product intros, free samples, and agro marketing campaigns.

  • Degree of product differentiation varies by industry: none in steel plates but lots in cars.

  • Some industries also contain large # of smaller firms (e.g., soft drinks) but they are dominated by a few large firms that get bulk of industry sales.


Oligopoly defined1
Oligopoly Defined Competition

  • Firms strive to create unique products (in terms of features, location, or appeal) to shield themselves from competition that ↓P and ↓sales.

  • More intense competition than pure competition.

    • E.g., A corn farmer doesn’t make tough P decisions. He accepts market P and reacts by picking Q.

    • A farmer doesn’t need to advertise. He can sell as much as he likes at current market P.

    • A farmer doesn’t worry about P policies his rivals are planning.


Oligopoly defined2
Oligopoly Defined Competition

  • Oligopolists have some influence over market P, so they must consider rivals’ P; spend a fortune on ads; and try to predict their rivals’ actions.

  • Resolve puzzle 2 –why oligopolists advertise and perfectly competitive firms do not.

  • Comp. firms can sell as much as they want at current P, so why advertise? Vs. Toyota faces a (-) sloped D curve, so it must ↓P or ↑ads (try to shift D out) to sell more cars.

  • Products are identical, so farm A’s ads might ↑ sales of farm B. Vs. Toyota’s ads may ↑ its sales and ↓ sales of rival carmakers.


Why oligopolistic behavior is so difficult to analyze
Why Oligopolistic Behavior is So Difficult to Analyze Competition

  • Largest firms can impact P and all firms must watch rivals’ actions.

  • Analysis is difficult as firms’ decisions are inter-dependent and oligopolists know that outcomes of their decisions depend on rivals’ responses.

    • E.g., Toyota’s managers know that their actions will cause reactions by Honda which may require Toyota to adjust its plans.

  • Oligopolies have a variety of behavior patterns which requires different models to understand their behavior.


Models of oligopoly
Models of Oligopoly Competition

  • Different models to understand Oligopoly behavior:

    • Ignore interdependence

    • Strategic interaction

    • Cartels

    • Price leadership and tacit collusion

    • Sales maximization

    • Kinked demand curve

    • Game theory


Ignoring interdependence
Ignoring Interdependence Competition

  • Simplest model

  • Firms behave as if their actions will not spark reactions from rivals.

  • Each firm seeks to max profits and assumes its P-Q decision will not affect its rivals’ strategy.

  • Analyze oligopoly in the same way as pure monopoly.

  • This doesn’t explain most oligopoly behavior!


Strategic interaction
Strategic Interaction Competition

  • Consider 2 soap makers: X and Y.

  • X ↓P to $4.05 and assumes Y will continue its P = $4.12

  • Say Qx = 5m and X spends $1m on ads.

  • X may be surprised when Y cuts P to $4.00; ↑Qy to 8m and sponsors the Super Bowl.

  • This ↓Πx and X wishes it didn’t cut P in first place.

  • X cannot afford to ignore how Y will react.


Cartels
Cartels Competition

  • All firms agree to set P and Q → act as pure monopolist.

  • OPEC began making joint decisions in 1970’s and has been successful over time at ↓Q oil and ↑P oil.

  • Cartels are difficult to organize and hard to enforce.

    • Each member must produce small Q assigned by group. But once high P is established, every firm is tempted to cheat by ↑Qs. When cheating is suspected, cartel quickly falls apart as others ↑Qs which ↓P.

  • Considered worse than monopoly. Cartel charges monopoly P without the cost savings from large scale production.


Price leadership and tacit collusion
Price Leadership and Tacit Collusion Competition

  • Overt collusion (where firms meet to pick P-Q) is illegal in the U.S. and rare. But tacit collusion is common.

  • Each tacitly colluding firm hopes that if it does not rock the boat (via ↓P or ↑ads), then rivals will do same.

  • Price leadership = 1 firm makes P decisions for group.

    • Other firms are expected to adopt P of leader without any explicit agreement.

    • P leader is often largest firm in industry.


Sales maximization model with interdependence ignored
Sales Maximization: Model with Interdependence Ignored Competition

  • Firms may attempt to max revenue rather than profit if:

    • control is separated from ownership

    • compensation of managers is related to size of the firm

  • Q set where MR = 0 (rather than MR = MC)

    • Recall: MR is slope of TR curve. So TR is max when MR = 0. If MR > 0 → ↑Q to ↑TR and if MR < 0 → ↓Q to ↑TR.

  • Compared to profit-max firm:

    • Higher Q

    • Lower P


Figure 3 sales max equilibrium

MC Competition

AC

E

F

A

D

B

MR

FIGURE 3.Sales-Max Equilibrium

Π-max Q = 2.5m where MR = MC. P = $4.00 and total Π = $0.20 x 2.5 m = $500,000.

Sales-max Q = 3.75m where MR = 0. P = $3.75 and totalΠ= $0.06 x 3.75 m = $225,000.

TotalΠ(TR) is lower (higher) at point F than point E.

$4.00

3.80

Price per Box

3.75

3.69

2.5

3.75

Millions of Boxes per Year


The kinked demand curve model

? Competition

The Kinked Demand Curve Model

  • Resolve puzzle 3 –why do P in oligopolistic markets (cars or appliances) change less often than P of commodities (wheat or gold)?

  • Firms think that other firms will match any P cut, but not any P increase. If true, firms face an inelastic D curve with P cuts and an elastic curve with P increases.


The kinked demand curve model1

? Competition

The Kinked Demand Curve Model

  • In Fig. 4, pt A is firm’s initial P = $8.

  • 2 D curves pass through pt A.

    • DD is more elastic → rivals’ P are fixed

    • dd is less elastic → rivals match ∆P

  • If firm ↓P to $7 (and rivals don’t match ↓P) → large ↑customers, so new Qd = 1,400.

  • If rivals match ↓P → ↑Qd is small, so new Qd = 1,100.

  • If firm ↑P (and rivals don’t match ↑P) → large ↓Qd.


The kinked demand curve model2

? Competition

The Kinked Demand Curve Model

  • The firm’s true demand curve in Fig. 4 is DAd –a kinked demand curve.

  • P tend to “stick” to their original level because ↑P → lose many customers and ↓P → gain very few customers.

  • Firm will only ∆P if costs change enormously.


Figure 4 the kinked demand curve

d Competition

D

A

(Competitors’

D

prices are fixed)

(Competitors

respond to price

d

changes)

FIGURE 4.The Kinked Demand Curve

Typical oligopoly fears the worst. If firm cuts P then rivals will match P cut → relevant demand curve is dd. But if firm raises P then rival will not match the P increase → relevant demand curve is DD. Thus, the firm’s true demand curve is the red line “DAd.”

Price

$8

7

0

1,000

1,100

1,400

Quantity per Year


The kinked demand curve model3

? Competition

The Kinked Demand Curve Model

  • MR is associated with DD and mr is associated with dd.

  • Overall marginal revenue curve is DBCmr.

  • MC = MR at pt E which shows Π-max Q for oligopolist.

  • Since relevant MR curve is kinked, even a moderate shift in MC will leave Q and thereby P unchanged.

  • Oligopoly prices are “sticky” and do not respond to minor cost changes.


Figure 5 the kinked demand curve and sticky prices

d Competition

MC

D

A

B

D

E

MR

d

C

mr

FIGURE 5.The Kinked Demand Curve and Sticky Prices

Price

$8

1,000

Quantity Supplied per Year


The game theory approach
The Game-Theory Approach Competition

  • Most widely used approach to analyze oligopoly behavior.

  • Each oligopolist is seen as a competing player in a game of strategy.

  • Optimal strategies are determined by examining a payoff matrix showing Π of each firm depending on P strategy that each firm follows.


Games with dominant strategies
Games with Dominant Strategies Competition

  • Dominant strategy = one that gives the bigger payoff to the firm that selects it, no matter which of the two strategies the competitor selects.

    • E.g., Table 1., both firms have an incentive to pick low P strategy regardless of what other firm does. If B picks high P, then A receives largest payoff choosing low P. Or if B picks low P, then A receives the largest payoff by choosing low P.

    • “Low Price” is the dominant strategy for both firms, so both charge a low P and each earns $3m.


Table 1 payoff matrix with dominant strategies
TABLE 1. CompetitionPayoff Matrix with Dominant Strategies

Firm B Strategy

High Price

Low Price

High Price

Firm A Strategy

Low Price


Games with dominant strategies1
Games with Dominant Strategies Competition

  • A market with a duopoly serves public interest better than a monopoly because of the competition created between two firms.

    • Both firms would be better off if they could charge high P. But the presence of a competitor, forces each firm to protect itself by charging low P.

  • It is damaging to the public to allow rival firms to collude on what prices to charge for their products.

    • E.g., if two firms collude in Table 1, then we end up with high P and each earning $10m.


Games without dominant strategies
Games without Dominant Strategies Competition

  • Maximin = select the strategy that yields the max payoff assuming your rival does as much damage to you as he can.

  • In Table 2, A’s maximin strategy is to pick low P and earn $5m.

    • Firm A thinks: if I chose a high P → worst outcome is B picks a low P and I get $3m. If I chose a low P → worst outcome is B picks a low P and I get $5m.

    • Firm A picks the strategy that offers the best of those bad outcomes.


Table 2 a payoff matrix without a dominant strategy
TABLE 2. CompetitionA Payoff Matrix without a Dominant Strategy

Firm B Strategy

High Price

Low Price

High Price

Firm A Strategy

Low Price


Repeated games
Repeated Games Competition

  • Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements.

  • Table 1 shows a single round of the game. Each firm picked low P. But if games are repeated, players can escape this trap.

    • E.g., Firm A could cultivate a reputation of “tit for tat.” Each time B charges a high P → A would charge a high P. After a few repetitions, B learns that A always matches its P decisions. So B will see that it’s better to stick with a high P.


Threats and credibility
Threats and Credibility Competition

  • Use threats to induce rivals to change their behavior.

    • E.g., retailer could threaten to double Q and ↓P to $0 if a rival imitates its product. But this is not credible, because it hurts the retailer who is making the threat.

  • A credible threat is a threat that does not harm the threatener if it is carried out.

  • Old firms often use credible threats to prevent new firms from entering the industry.

    • E.g., old firm will build a larger factory than it would otherwise want. Large factory lowers cost of ↑Q –even at low P.


Figure 6 entry and entry blocking strategy

Possible Choices Competition

Possible Reactions

of Old Firm

of New Firm

–2

–2

Enter

Don’t Enter

Big Factory

4

0

2

2

Enter

Small Factory

Don’t Enter

6

0

FIGURE 6. Entry and Entry-Blocking Strategy

Profits (millions $)

Old Firm

New Firm


Threats and credibility1
Threats and Credibility Competition

  • In Fig. 6, best outcome for old firm is to have a small factory and no rivals.

    • But if old firm builds a small factory, it can count on new firm entering to earn $2m. So old firm’s ↓Π to $2m.

  • If old firm builds a big factory, its ↑Q will ↓P and ↓Π. Old firm now earns $4m if new firm stays out.

    • Clearly, new firm will stay out to avoid loses of $2m.

  • Thus, old firm should build big factory to keep rivals out.


Monopolistic competition oligopoly public welfare
Monopolistic Competition, Oligopoly, & Public Welfare Competition

  • Oligopolistic behavior is so varied that it is hard to come to a simple conclusion about welfare implications.

  • In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum.

  • Excess capacity theorem suggests monopolistic competition can lead to inefficiently high production costs.

  • Oligopolists may organize into successful cartels to ↓Q and ↑P.


Monopolistic competition oligopoly public welfare1
Monopolistic Competition, Oligopoly, & Public Welfare Competition

  • When an oligopolistic market is perfectly contestable –if firms can enter and exit without losing $ they invested –then (P,Q) of firms is likely to be socially efficient.

    • E.g., airplanes, trucks, and barges can easily be moved.

  • Constant threat of entry forces oligopolists to keep their prices down and their costs low.


Comparing the four market forms
Comparing the Four Market Forms Competition

  • Perfect competition and pure monopoly are rare.

  • Most firms are monopolistically competitive, but oligopoly firms account for largest share of economy’s output.

  • Π = 0 in LR under perfect competition and monopolistic competition because of free entry and exit.

    • Thus, P = AC in LR under these 2 market forms.

  • Π-max firm under any market form selects Q by setting MR = MC.

    • However, oligopolists may not set MC = MR when choosing Q –e.g., if firm max sales.


Comparing the four market forms1
Comparing the Four Market Forms Competition

  • Perfectly competitive firm and industry  efficient allocation of resources.

  • Monopoly inefficient allocation of resources by ↓Q and ↑P.

  • Monopolisticcompetition inefficient allocation of resources through excess capacity.

  • Under oligopoly, almost anything can happen,  impossible to generalize about its vices or virtues.


Table 3 attributes of the four market forms
TABLE 3. CompetitionAttributes of the Four Market Forms


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