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23Monopolistic Competition and Oligopoly
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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
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Recall the Four Market Models
• Pure Competition• Pure Monopoly• Monopolistic Competition• Oligopoly• We have covered the extremes, pure competition
and monopoly: most real world markets are in the middle, namely monopolistic competition and oligopoly.
PureCompetition
MonopolisticCompetition Oligopoly
PureMonopoly
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Monopolistic Competition• Characteristics
– Large number of firms with small market shares
– No Collusion– Independent Action
• Differentiated Products– Product Attributes– Service– Location– Brand Names and Packaging– Some Control Over Price due to product
differentiation
O 23.1
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Monopolistic Competition• Easy Entry and Exit• Advertising
– Nonprice Competition• Examples of Monopolistically
Competitive Industries, see page 446
O 23.1
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Price and Output Determination
• 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 with the normal profit conclusion
– Product Variety
In Monopolistic Competition
G 23.1
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What does the graphic model look like for Monopolistic Competition compared to
Monopoly?
• It looks very similar because both face a downward sloping demand curve—possibly more elastic in monopolistic competition due to more close substitutes.
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Price and Output DeterminationIn Monopolistic Competition
Short-Run Profits
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D1
ATC
EconomicProfit
Q1
A1
P1
0
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Price and Output DeterminationIn Monopolistic Competition
Short-Run Losses
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D2
ATC
Loss
Q2
A2
P2
0
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Price and Output DeterminationIn Monopolistic Competition
Long-Run Equilibrium
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D3
ATC
Q3
P3=A3
0
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Pure competition vs. Monopolistic competition
• Since both pure competition and monopolistic competition tend to result in zero economic profits, are the models equal in efficiency? NO, as can be seen by comparing the two.
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ATC
MC
Zero Profits in Perfect CompetitionZero Profits in Perfect Competition
12
P
Q1
P = MR
P = ATC
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Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D3
ATC
Q3
P3=A3
0
Monopolistic Competition and Efficiency
Recall: P=MC=Minimum ATC
P4
Q4
Price is Higher
Excess Capacity atMinimum ATC
Monopolistic Competition is Not Efficient
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Excess capacity
• Firms in MC tend to produce less output than the minimum ATC level of output: the difference is called excess capacity. “Too many firms, each producing too little output” is a phrase to characterize this: towns with many gas stations, restaurants, etc, that tend to operate below their optimal capacity.
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Oligopoly• Characteristics
–A Few Large Producers–Homogeneous or
Differentiated Products• Homogeneous Oligopoly• Differentiated Oligopoly
–Control Over Price, But Mutual Interdependence• Strategic Behavior
–Entry Barriers–Mergers and oligopoly
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Measures of Concentration• Concentration Ratio: percent of
sales accounted for by the top 4 firms
• Problems with concentration ratios
• 1)Localized Markets• 2)Interindustry Competition• 3)World Trade
– Import Competition
W 23.1
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Measures of Concentration
• Herfindahl Index (HI)(%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2
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Problems: For an industry with only 1 firm, (monopoly), what
would be the HI?
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Suppose the industry has 10 equal size firms, what is the HI?
• What if the industry has 100 equal size firms?
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Answers:
• Monopoly, HI = 10,000
• 10 equal size firms, HI = 1,000
• 100 equal size firms, HI = 100
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Game Theory Approach to Oligopoly
• Is Oligopoly best analyzed as a strategic game like chess?
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Game TheoryGame Theory Model to Analyze Behavior
RareAir’s Price Strategy
Up
tow
n’s
Pri
ce
Str
ate
gy A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low•2 Competitors•2 Price Strategies
•Each Strategy Has a Payoff Matrix
•Greatest CombinedProfit
• Independent ActionsStimulate a Response
O 23.2
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Game TheoryGame Theory Model to Analyze Behavior
RareAir’s Price Strategy
Up
tow
n’s
Pri
ce
Str
ate
gy A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low• Independently Lowered Prices in Expectation of Greater Profit Leads to the Worst Combined Outcome
•Eventually Low Outcomes Make Firms Return to Higher Prices
O 23.2
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Game Theory: Payoff matrix shows several things, including:
• Mutual Interdependence of firms in oligopoly
• The temptation to collude• The incentive to Cheat on a
collusive arrangementG 23.2
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Three Oligopoly Models
• Kinked Demand Curve• Collusive Pricing• Price Leadership• Why no single model? due to
the Diversity of Oligopolies and the complications of Interdependence
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Kinked demand curve model of oligopoly: assumption, rivals will match all price cuts
but not price increases. Under this assumption, its as if each firm faces a
“kinked” demand curve, with 2 sections to it: more elastic above the existing price, since rivals won’t match a price increase, and less elastic below the existing price,
since rivals quickly match price cuts.
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Kinked-Demand Curve
• Possible Strategies– Match Price Changes– Ignore Price Changes
• Kinked model uses a Combined Strategy: match price cuts but not price increases
• Price Inflexibility• The Kinked-Demand Curve
Graphically…
Noncollusive Oligopoly
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Pri
ce
Pri
ce a
nd
Co
sts
Quantity Quantity
0 0
Kinked-Demand CurveNoncollusive Oligopoly
P0
MR2
D2
D1
MR1
e
f
g
Rivals IgnorePrice Increase
Rivals MatchPrice Decrease
Q0
Competitor and Rivals Strategize Versus Each OtherConsumers Effectively Have 2 Partial Demand Curves
and Each Part Has Its Own Marginal Revenue Part
MR2
D2
D1
MR1Q0
MC1
MC2
P0
Resulting in a Kinked-Demand Curve to the Consumer – Price and Output
Are Optimized at the Kink
e
f
g
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Kinked-Demand CurveNoncollusive 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
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What is a Cartel?
• A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares
Second model of oligopoly: Cartels and Other Collusion
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Pri
ce a
nd
Co
sts
Quantity
• Price and Output– Collusion and Tendency
Toward Joint-Profit Maximization
D
MR=MC
ATC
MC
MR
P0
A0
Q0
EconomicProfit
Effectively SharingThe Monopoly Profit
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Cartels and Other Collusion• Overt Collusion
–Cartels–The OPEC Cartel
GLOBAL PERSPECTIVE
The 11 OPEC Nations Daily Oil Production, May 2006
Saudi ArabiaIranVenezuelaUAENigeriaKuwaitIraqLibyaIndonesiaAlgeriaQatar
Source: OPEC
Country Barrels of Oil9,099,0004,110,0003,233,0002,444,0002,306,0002,247,0001,903,0001,500,0001,451,000
894,000726,000
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Cartels and Other Collusion• Covert Collusion
–Tacit Understandings• Obstacles to Collusion
–Demand and Cost Differences
–Number of Firms–Cheating–Recession–Potential Entry–Legal Obstacles:
• Antitrust Law
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Price leadership in Oligopoly
• One firm, the dominant firm, sets the price, others follow the leader
• Often the dominant firm is the low cost producer in the industry
• Is this a form of “tacit” collusion?
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Price Leadership Model• Leadership Tactics of the price
leader may well include:• 1) Infrequent Price Changes• 2) Forms of Communications to
the other firms, such as press releases, etc.
• 3) Limit Pricing: perhaps do not choose the monopoly price for fear of enticing entry to your industry
• Breakdowns in Price Leadership:– Price Wars
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Oligopoly and Advertising
• Advertising Prevalent in Monopolistic Competition and Oligopoly
• Positive Effects of Advertising
• Potential Negative Effects of Advertising
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Oligopoly and AdvertisingThe Largest U.S. Advertisers, 2005
CompanyAdvertising Spending
Millions of $
Proctor and GambleGeneral MotorsTime WarnerVerizonAT&TFord MotorWalt DisneyJohnson & JohnsonGlaxoSmithKlineDaimlerChrysler
$4609435334942484247123982279220921942179Source: Advertising Age
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Oligopoly and AdvertisingWorld’s Top 10 Brand Names
GLOBAL PERSPECTIVE
Source: Interbrand
Coca-ColaMicrosoftIBMGeneral ElectricIntelNokiaToyotaDisneyMcDonaldsMercedes-Benz
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Oligopoly and Efficiency• Productive and Allocative
EfficiencyP = MC = Minimum ATC– Neither Exists
• Tendency to Share the Monopoly Profit
• Qualifications–Increased Foreign
Competition–Limit Pricing–Technological Advance
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Oligopoly in the Beer Industry• 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
Last
Word
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Key Terms• monopolistic comp
etition• product
differentiation• nonprice
competition• excess capacity• oligopoly• homogeneous
oligopoly• differentiated
oligopoly• strategic behavior• mutual
interdependence• concentration ratio
• interindustry competition
• import competition• Herfindahl index• game-theory model• collusion• kinked-demand
curve• price war• cartel• tacit
understandings• price leadership
Copyright 2008 The McGraw-Hill Companies23-42
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