Monopolistic Competition and Oligopoly

1. 23 Monopolistic Competition and Oligopoly

2. Chapter Objectives • Characteristics of Monopolistic Competition • Why Monopolistic Competitors Earn Only a Normal Profit in the Long-Run • Characteristics of Oligopoly • How Game Theory Relates to Oligopoly • Why the Demand Curve of the Oligopolist May Be Kinked • Incentives and Obstacles to Collusion Among Oligopolists • Potential Positive and Negative Effects of Advertising

3. Monopolistic Competition • Most markets in U.S. economy fall b/w monopoly and pure competition • Monopolistic competition – large # of sellers and easy entry into industry (provide “competitive” aspect) and differentiated products, often advertised (provide for “monopolistic” aspect)

4. O 23.1 Monopolistic Competition • Characteristics • Small Market Shares – each firm has a relatively small % of market • No Collusion – groups of producers do not agree to set price • Independent Action – no interdependence

5. Differentiated Products • Firms produce variations of a particular product • Product Attributes – functional features, design, workmanship • Service – level or service and conditions surrounding sale of product • Location – proximity to customers • Brand Names and Packaging • Some Control over Price

6. O 23.1 Monopolistic Competition • Easy Entry and Exit – compared to oligopoly and monopoly • Advertising • Nonprice Competition • Monopolistically Competitive Industries – See Figure 23.1

7. G 23.1 Price and Output Determination In Monopolistic Competition • The Firm’s Demand Curve • The Short Run: • Profit or Loss • The Long Run: • Only a Normal Profit • Profits: Firms Enter • Losses: Firm’s Leave • Complications • Product Variety

8. Firm’s Demand Curve • More elastic than the demand faced by a monopolist , but it is not perfectly elastic • Profit –Maximizing rule applies: MR=MC • Monopolistic competitor can experience profits or losses in short-run • In long run, only normal profit is possible since firms can enter or exit industry

9. The Long Run • Short-run profits will attract new competitors, since entry into market is fairly easy • Short-run losses will cause some firms to exit in the long run

10. Complications • In the real world, a firm may not earn only normal profit in long run • Why? • Some firms may achieve product differentiation that cannot be duplicated, even over time • Firms may not be as free from barriers to entry as they are in theory

11. Price and Output Determination In Monopolistic Competition Short-Run Profits ATC MC P1 A1 Price and Costs Economic Profit D1 MR = MC MR 0 Q1 Quantity

12. Price and Output Determination In Monopolistic Competition Short-Run Losses ATC MC A2 P2 Loss Price and Costs D2 MR = MC MR 0 Q2 Quantity

13. Price and Output Determination In Monopolistic Competition Long-Run Equilibrium MC ATC P3= A3 Price and Costs D3 MR = MC MR 0 Q3 Quantity

14. Monopolistic Competition and Efficiency • Neither productive nor allocative efficiency • P exceeds minimum ATC, also exceeds MC • Excess Capacity: • Gap b/w minimum-ATC output and profit-maximizing output • Represents plants and equipment that are underused b/c firms are producing less than the minimum-ATC output

15. Product Variety • Firms can stay ahead of competitors through further differentiation of products and better advertising • Benefits: • Product variety and improvement are beneficial to society, may offset costs of inefficiency • Creates tradeoff b/w consumer choice and efficiency

16. MC ATC P3= A3 Price and Costs D3 MR = MC MR 0 Q3 Quantity Monopolistic Competition and Efficiency Recall:P=MC=Minimum ATC P4 Price is Higher Excess Capacity at Minimum ATC Q4 Monopolistic Competition is Not Efficient

17. Characteristics • A Few Large Producers (Ex. steel or aluminum industries in U.S) • Homogeneous or Standardized products – homogeneous oligopoly – standardized products, often industrial (Ex. steel, copper) -differentiated oligopoly – many consumer goods industries (Ex. cereal, autos)

18. Control over Price, but Mutual Interdependence • Oligopolist must consider how will react to changes in its price, output, products • Characterized by strategic behavior – self-interested behavior that takes into account the reactions of others. • Mutual interdependence b/w firms exists

19. Entry Barriers and Mergers • Extensive barriers to entry • Some oligopolies have been created through mergers

20. W 23.1 Measures of Concentration • Concentration Ratio • Localized Markets • Interindustry Competition • World Trade • Import Competition • Herfindahl Index (%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2

21. Measures of Concentration • Concentration ratio – when the largest 4 firms in an industry control 40% or more of the market; apply to nation as whole, localized markets may see more oligopolies • Interindustry competition and world trade • Herfindahl Index – sum of the squared percentage market shares of all firms in the industry; larger the index, greater market power within the industry

22. O 23.2 Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy • 2 Competitors • 2 Price Strategies • Each Strategy Has a Payoff Matrix • Greatest Combined • Profit • Independent Actions • Stimulate a Response High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8

23. O 23.2 Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy • Independently Lowered Prices in Expectation of Greater Profit Leads to the Worst Combined Outcome • Eventually Low Outcomes Make Firms Return to Higher Prices High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8

24. G 23.2 Game Theory • Role of Mutual Interdependence • Collusive Tendencies • Collusion • Incentive to Cheat

25. Three Oligopoly Models • Kinked Demand Curve • Collusive Pricing • Price Leadership • Diversity of Oligopolies • Complications of Interdependence

26. Kinked-Demand Curve Noncollusive Oligopoly • Strategies • Match Price Changes • Ignore Price Changes • A Combined Strategy • Price Inflexibility • The Kinked-Demand Curve Graphically…

27. Three Oligopoly Models • 1. Kinked Demand Theory – assumes firms are independent and do not engage in collusive pricing • Will rivals match price changes of firm or ignore price changes? • Rivals will use a combined strategy, and this will result in a kinked demand curve • See page 456 Figure 23.4 • Explains price inflexibility

28. Price Price and Costs 0 0 Quantity Quantity Kinked-Demand Curve Noncollusive Oligopoly Competitor and Rivals Strategize Versus Each Other Consumers Effectively Have 2 Partial Demand Curves and Each Part Has Its Own Marginal Revenue Part Rivals Ignore Price Increase MC1 D2 e e P0 P0 MR2 f f D2 MC2 MR2 g Rivals Match Price Decrease g D1 D1 Q0 Q0 MR1 MR1 Resulting in a Kinked-Demand Curve to the Consumer – Price and Output Are Optimized at the Kink

29. Kinked-Demand Curve Noncollusive Oligopoly • Criticisms of the Model • Doesn’t Explain How Price Gets to the Kink (P0) • Oligopoly Prices Are Not As Rigid During Instability as the Model Indicates • Possibility of Price Wars

30. 2. Cartels and other Collusion • Game-theory model demonstrates that oligopolists may benefit from collusion • Allows oligopolists to reduce uncertainty, increase profits, and prohibit entry of new firms • Firms communicate, agree to charge same price, and maximize profit

31. Price and Costs Quantity Cartels and Other Collusion • Price and Output • Collusion and Tendency Toward Joint-Profit Maximization Effectively Sharing The Monopoly Profit MC P0 ATC A0 MR=MC Economic Profit D MR Q0

32. GLOBAL PERSPECTIVE Barrels of Oil Country Saudi Arabia Iran Venezuela UAE Nigeria Kuwait Iraq Libya Indonesia Algeria Qatar 9,099,000 4,110,000 3,233,000 2,444,000 2,306,000 2,247,000 1,903,000 1,500,000 1,451,000 894,000 726,000 Source: OPEC Cartels and Other Collusion • Overt Collusion • Cartels – formal agreements of price and output • The OPEC Cartel The 11 OPEC Nations Daily Oil Production, May 2006

33. Cartels and Other Collusion • Covert Collusion • Tacit Understandings –verbal agreements • Obstacles to Collusion • Demand and Cost Differences – among firms • Number of Firms – more firms = more difficult to collude • Cheating – secret price cutting • Recession • Potential Entry • Legal Obstacles: • Antitrust Law

34. Price Leadership Model • Leadership Tactics • Infrequent Price Changes • Communications • Limit Pricing • Breakdowns in Price Leadership: • Price Wars

35. Oligopoly and Advertising • Advertising Prevalent in Monopolistic Competition and Oligopoly • Positive Effects of Advertising – enhances efficiency by informing consumers about competition • Potential Negative Effects of Advertising – may be self-cancelling

36. Advertising Spending Millions of $ Company Oligopoly and Advertising The Largest U.S. Advertisers, 2005 Proctor and Gamble General Motors Time Warner Verizon AT&T Ford Motor Walt Disney Johnson & Johnson GlaxoSmithKline DaimlerChrysler $4609 4353 3494 2484 2471 2398 2279 2209 2194 2179 Source: Advertising Age

37. Coca-Cola Microsoft IBM General Electric Intel Nokia Toyota Disney McDonalds Mercedes-Benz GLOBAL PERSPECTIVE Source: Interbrand Oligopoly and Advertising World’s Top 10 Brand Names

38. Oligopoly and Efficiency • Productive and Allocative Efficiency P = MC = Minimum ATC • Neither Exists • Tendency to Share the Monopoly Profit • Qualifications • Increased Foreign Competition • Limit Pricing • Technological Advance

39. Oligopoly in the Beer Industry Last Word • Once Hundreds of Firms Now a Very Small Group • Demand Side Changes • Taste Shifts to Lighter Beers of Large Breweries • Shift From Tavern-Tap Consumption to Can or Bottles • Supply Side Changes • Technology Increased Minimum Efficient Scale Creating a Barrier to Entry • National Brands Enjoy Cost Advantages • Consolidation of Firms into Oligopoly