Begin2 Mon Comp4 Oligopoly5 Olig Models3 Profit Max6 O & PC End 1 Session 9 Monopoly, Competition,...

Begin 2 Mon Comp 4 Oligopoly 5 Olig Models3 Profit Max 6 O & PC End1

Session 9 Monopoly, Competition, Oligopoly

Chapter 10 and 11 in the text

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Monopolistic Competition Example

Which one do you select? Is it because of price, quality, image, subliminal impulse, or some combination?

Many similar products, with little price difference. Advertising seeks to create a niche image for each, with the goal of persuading the customer to buy their item.

Begin 2 Mon Comp 4 Oligopoly 5 Olig Models3 Profit Max 6 O & PC End

Example of Domestic Cartels The price fixing among sellers is generally illegal in the US. In price fixing agreements firms collude to maximize profits. Price fixing is an excellent illustration of the cartel model we will learn about in this session. Collusion allows small firms, which would other wise be similar to perfectly competitive firms, to enlarge profits by acting a monopolist.

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SEPTEMBER 23, 2008

Federal Prosecutors Probe Food-Price Collusion


Example of Price WarsThe price war behavior -- where Vanguard is following the price cuts of Fidelity, is an excellent illustration of the Kinked Demand Curve model that we will learn about in this session. The price cut war is represented by the lower inelastic portion of the kinked demand curve. It is inelastic because initially the first firm to drop price gets a few customers, but the other firms quickly follow thus reducing the advantage of price cut.

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Vanguard Ups Ante In Fee Wars; Move Gives Thousands of Fund Investors Access To Lowest-Cost Shares; Follows Fidelity's Cuts


Lecture Outline

1.0 First Slide2.0 Monopolistic Competition Market Structure3.0 Profit Maximization4.0 Oligopoly Market Structure 5.0 Models of Oligopoly 6.0 Comparison with Perfect Competition7.0 Last Slide


2.0 Market Structure

2.1 Monopolistic Competition Market Structure

2.2 Key Characteristics: Product Differentiation Low Barriers to Entry

2.3 Comparison to other structures

Mon Comp


2.1 Market Structures: Mon. Comp.

Key Characteristics Describing Market Structure

Number of suppliers• Many or few: MC--Many

Product’s degree of uniformity• Do firms in the market supply identical products

or are there differences across firms? MC—slight differences, thussome control over price

The ease of entry into the market• Can new firms enter easily or are they blocked

by natural or artificial barriers?: MC—Easy (low barriers), thus zero profits in the long run

Control over Price• Do firms have control over price?: MC—Some but

with in narrow limits


2.2 Product Differentiation

Sellers differentiate their products in four basic ways

Physical differences and qualities: For example: The choices in laptops: weight, screen size, hard drive, video card, chip, RAMLocation: restaurants: For example: similar Italian menu but some nearer home, or located in a trendy area v off a highway. Accompanying service: For example: extended warranties or zero percent financing, or a rebate. Product image: For example: A basket ball with Larry Bird’s signature v Kobe Bryant—same ball different image


2.3 Market Structure Matrix

# of suppliers

Product Standardized

Entry/Exit Control over Price

Perfect Competition

Many Yes Very easy None

Monopoly One Unique, no close substitutes

Blocked Considerable

Monopsony One buyer

Monopolistic Competition

Many Not much as much differences as they want you to think

Relatively easy

Some, but within narrow limits

Oligopoly Few Not much Significant obstacles

Limited by interdependence, but considerable with collusion


3.0 Profit Maximization

3.1 Substitutes & Price Elasticity3.2 Short Run: MC=MR3.3 Shut Down Point: Min Pt. of AVC3.4 Long Run: Zero Economic Profit3.5 Comparison with Perfect Competition

Excess Capacity,Price>MC, Higher price, Lowerl outputExample


3.1 Price Elasticity of DemandThe price elasticity of the monopolistic competitor’s demand depends on

The number of rival firms that produce similar productsThe firm’s ability to differentiate its product from those of its rivals

A firm’s demand curve will be more elastic the greater the number of competing firms and the less differentiated its product

or

ri

o

$3,750

0Marginal revenue

Elastic

Inelastic

Unit elastic

D = Average revenue

1-carat diamonds per day

(a) Demand and Marginal Revenue


3.2 Profit Maximization MC=MR

p c

0 q Quantity per period

MC

ATC

D

MR

Profit

b

e

c

In the short run, a firm that can at least cover its variable cost will increase output as long as marginal revenue exceeds marginal cost profits are maximized where marginal revenue equals marginal cost. This occurs at point e.The profit maximizing price for that quantity is found on the demand curve point b.

The monopolistic competitor, like the monopolist, has no supply curve there is no curve that uniquely relates price and quantity supplied.

Dol

lars

per

un

it

Average total cost is measured as c which is below the price.

Price minus average total cost is the firm’s profit per unit, which, when multiplied by the quantity is economic profit, shown by the blue shaded rectangle.


3.3 Shut Down Point

Do

lla

r s p

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Quantity per period

c

p

0 q

MC

ATC

D

MR

b

e

c

AVCLoss

The monopolistic competitor is not assured economic profit. Here the firm’s average total cost curve lies entirely above the demand curve all quantities result in losses the firm must decide whether to shut down temporarily.

The rule here is the same: as long as the price covers average variable cost, the firm should produce in the short run. Alternatively, it should shut down if no price covers average variable cost.

The loss-minimization solution is for the firm to produce quantity q and charge the price p. However, since per unit costs are c, the firm incurs a loss shown by the red shaded area.


3.4a Long-run Equilibrium

Do

lla

rs p

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p

0 q

MC

ATC

MR

Da

b

Quantity per period

In the long run, entry and exit will shift each firm’s demand curve until economic profit disappears price equals average total cost.

This long-run outcome occurs where the marginal revenue curve intersects the marginal cost curve at point a equilibrium q, and the average total cost curve is tangent to the demand curve at point b no economic profit.

In the case of short-run losses, some firms will leave the industry the demand curve shifts to the right and become less elastic until the loss disappears and remaining firms earn just a normal profit.


3.4b Long Run Equilibrium

Short Run Positive Economic Profits

Long Run Zero Economic Profits


3.5a Monopolistic Comp. V Perfect Competition: P>MC

D oll a

r s p

er u

nit

p

0 q

MC

ATC

d Marginalrevenue=Averagerevenue

Quantity per period

(a) Perfect Competition)

Dolla

rs p

er u

nit

p'

0 q'

MC

MR

ATC

Quantity per period

(b) Monopolistic Competition

D = Averagerevenue

Here we are assuming that the two firms have identical cost curves. In each case, the marginal cost curve intersects the marginal revenue curve at the quantity where the average total cost curve is tangent to the firm’s demand curve.The point of tangency between d, MC and ATC in perfect competition implies that the firm is producing at the lowest possible average cost in the long run.

In monopolistic competition, the price and average cost, identified as p’ in the right panel, exceed the price and average cost under perfect competition, identified as p in the left panel.


3.5b Example: The Cachet Single Malt Scotch“Single malt" is malt whiskey sourced from a single distillery. Single malts take at least 10 years to mature and are distilled using centuries-old techniques and are made from malted barley.Blended scotches, about 95% of Scotch whisky brands -- including leaders such as Johnnie Walker and Chivas include malts from more than one distillery and some are a mixture of malted barley and grain .In the past few years,. global sales pf single malt scotch grew by 37% from 1992 to 2002, according to Impact Databank, compared with a 1% contraction in sales of Scotch whisky as a whole. How did they do it? By creating “cachet”

The scotch industry has come a long way in shaking off the slippers-and-fireside image of your grandfather's whiskey Today distillers pitch high-end scotch, or "single malts," as a hip drink with origins as exclusive as a fine vintage wine. Sales of single malts have taken off in recent years with affluent baby boomers and increasingly sophisticated 30-somethings seeking new status symbols. The industry investing heavily in educating consumers about the differences in whiskey brands from different regions. Single malts from the island of Islay, for instance, taste smoky and briny because a lot of peat is used in the process; distillers near the River Spey, on the other hand, use little or no peat, producing a scotch with a sweeter taste..

Outline: MC


3.5c Example: The Cachet Single Malt Scotch

An economic analysis of the sales growth would include:Change in tastes and preferences -- An increase in demand for single malt, a decrease in demand for blended scotch Slope of the Demand Curve: customers may be willing to pay a slightly higher price for single malt than blended scotch becomes of the “cachet” status. Thus, the demand curve for the single malt scotch may become downward sloping and producers will then be able to pick a price and output, whereas the demand curve for blended scotch may remain horizontal and those producers will have to accept the market price and only worry about choosing the output to produce.

Adapted from: Scotch on the Rocks? 'Single Malt' DiversifiesDeborah Ball. Wall Street Journal. (Eastern edition). New York, N.Y.: Dec 30, 2003


4.0 Oligopoly Market Structure4.1 Key Characteristics

4.2 Barriers to EntryEconomies of ScaleLarge Minimum Plant Size Brand Names

4.3 Matrix

Oligopoly


4.1 Market Structures: Oligopoly

Key Characteristics Describing Market StructureNumber of suppliers

• Many or few: O—Few, thus control over price, but each must consider the effect of its own actions on competitors’ behavior the firms in an oligopoly are interdependent

Product’s degree of uniformity• Do firms in the market supply identical products or

are there differences across firms? O--slight differences

The ease of entry into the market• Can new firms enter easily or are they blocked by

natural or artificial barriers?: O—Difficult (high barriers), thus positive economic profits in the long run

Buyer information• Do buyers have full information of prices and product

attributes?: O--No


4.2a Economies of Scale as a Barrier to Entry

Do

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pe

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c a

cb

Autos per year S

b

a

Long-runaverage

cost

0

Here we have a long-run average cost curve for a typical firm in the industry.

If a new entrant sells only S cars, the average cost per unit, ca, far exceeds the average cost, cb, of a manufacturer that sells enough cars to reach the minimum efficiency scale, M.

If autos sell for a price less than ca, a potential entrant can expect to lose money. This tends to discourage entry into the industry. M


4.2b Barriers to Entry: High Advertising Costs

Established Brand Names: High start up cost for advertising a new product enough to compete with established brands may also require enormous outlays

Oligopolists often compete with existing rivals and try to block new entry by offering a variety of models and products

Firms often spend billions trying to differentiate their productsSome of these expenditures have the beneficial effects of providing valuable information to consumers and offering them a wide variety of products


4.3 Market Structure Matrix

# of suppliers

Product Standardized

Entry/Exit Control over Price

Perfect Competition

Many Yes Very easy None

Monopoly One Unique, no close substitutes

Blocked Considerable

Monopsony One buyer

Monopolistic Competition

Many Not much as much differences as they want you to think

Relatively easy

Some, but within narrow limits

Oligopoly Few Not much Significant obstacles

Limited by interdependence, but considerable with collusion


5.0 Models of Oligopoly

5.1 Cartels 5.2 Price Leadership 5.3 Kinked demand curve


5.1a Cartel

Formal collusion and cartels are illegal in the United States; other countries are more tolerant and some even promote cartels OPEC

The next slide provides us with an illustration of the impact of firms colluding and forming a cartel


5.1b Cartel Model

p

c

0 QQuantity per period

MC

D

MR

The market demand curve is shown as D. The two key issues are:•what price will maximize the cartel’s profit•how will production be allocated among participating firms?

The first task of the cartel is to determine its marginal cost of production. Since the cartel acts as a monopoly operating many plants, the marginal cost curve is the horizontal sum of the marginal cost curves of all firms in the cartel .

Profit maximization occurs where the cartel’s marginal cost curve intersects the market’s marginal revenue curve. This intersection yields price p, industry output Q, and marginal cost of production c. D

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nit


5.1c Cartel ModelTo maximize cartel profit, output must be allocated so that the marginal cost for the final unit produced by each firm is identical

Assuming two firms with identical costs, output and profit are determined from the intersection of industry MR and MC each firm charges the industry Price, and sells ½ the industry output.


5.1d CheatingPerhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement

By offering a price slightly below the established price, a firm can usually increase its sales and economic profit


5.1e Cheating

However, as more cheat the outcome approaches that of perfect competition

With increases in market price is forced down until Price = min ATC, as in perfect competition


5.2 Leadership Model

An informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry

A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition

Price leader also initiates price changes


5.3a Kinked Demand Curve ModelA type of Price Leadership ModelIn the kinked demand curve model, each oligopolistic firm believes that

if it raises its price all its competitors will not follow suit. if it lowers its price all its competitors will follow suit.

These assumptions imply that:the firm’s demand curve is elastic above the current price the firm’s demand curve is inelastic below that price. the firm’s demand curve is kinked at the current price, P

Prices increase only when all firms raise them at the same time


5.3b Kinked Demand Curve Model

the firm’s demand curve is elastic above the current price

the firm’s demand curve is inelastic below that price.

the firm’s demand curve is kinked at the current price, P

•The kink in the demand curve means that the MR curve is discontinuous immediately below the kink (as indicated by the vertical dotted segment of the MR curve).

•Kink discourages competitors from changing prices

•Thus, fluctuations in MC that remain within the discontinuous portion of the MR curve do not cause changes in either the firm’s price or quantity produced .


5.3c Diaper War: Example of Kinked Demand Curve

the firm’s demand curve is elastic above the current price (Huggies)

the firm’s demand curve is inelastic below that price. (Pampers)

•In the summer of 2003 Kimberly Clark (producer of Huggies) covertly raised the price of its diaper 5% by reducing the number of diapers in each package and reducing the package price by a few cents.

•Procter & Gamble (producer of Pampers) responded by keeping the number of diapers per pack constant and reducing its package price by the same amount .

•Huggies market share fell and Pampers’ share rose

•Source: WSJ 9/5/03, In Lean Times Big Companies Make A Grab for Market Share, By Sarah Ellison


6.0 Comparison of Oligopoly & Perfect Competition

Higher price, lower output, positive economic profitsPrice is usually higher under oligopoly

With fewer competitors after the merger, remaining firms would become more interdependent they will try to coordinate pricing policies if they engage in some sort of implicit or explicit collusion, industry output would be lower and price would be higher than under perfect competition

Higher profits under oligopolyIf there are barriers to entry into the oligopoly, profits will be higher than under perfect competition in the long run


End of Presentation

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Oligopoly

Begin2 Mon Comp4 Oligopoly5 Olig Models3 Profit Max6 O & PC End 1 Session 9 Monopoly, Competition,...

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