Copyright 2008 The McGraw-Hill Companies 23-1 23 Monopolistic Competition and Oligopoly.

Copyright 2008 The McGraw-Hill Companies23-1

23Monopolistic Competition and Oligopoly


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


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


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


Monopolistic Competition• Easy Entry and Exit• Advertising

– Nonprice Competition• Examples of Monopolistically

Competitive Industries, see page 446

O 23.1


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


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.


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



Short-Run Losses

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D2

ATC

Loss

Q2

A2

P2

0



Long-Run Equilibrium

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D3

ATC

Q3

P3=A3

0


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.


ATC

MC

Zero Profits in Perfect CompetitionZero Profits in Perfect Competition

12

P

Q1

P = MR

P = ATC


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


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.


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


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


Measures of Concentration

• Herfindahl Index (HI)(%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2


Problems: For an industry with only 1 firm, (monopoly), what

would be the HI?


Suppose the industry has 10 equal size firms, what is the HI?

• What if the industry has 100 equal size firms?


Answers:

• Monopoly, HI = 10,000

• 10 equal size firms, HI = 1,000

• 100 equal size firms, HI = 100


Game Theory Approach to Oligopoly

• Is Oligopoly best analyzed as a strategic game like chess?


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


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


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


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


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.


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


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


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


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


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


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


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


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?


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


Oligopoly and Advertising

• Advertising Prevalent in Monopolistic Competition and Oligopoly

• Positive Effects of Advertising

• Potential Negative Effects of Advertising


Oligopoly and AdvertisingThe Largest U.S. Advertisers, 2005

CompanyAdvertising Spending

Millions of $

Proctor and GambleGeneral MotorsTime WarnerVerizonAT&TFord MotorWalt DisneyJohnson & JohnsonGlaxoSmithKlineDaimlerChrysler

$4609435334942484247123982279220921942179Source: Advertising Age


Oligopoly and AdvertisingWorld’s Top 10 Brand Names

GLOBAL PERSPECTIVE

Source: Interbrand

Coca-ColaMicrosoftIBMGeneral ElectricIntelNokiaToyotaDisneyMcDonaldsMercedes-Benz


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


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


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


Next Chapter Preview…

Technology, R&D,And Efficiency

Copyright 2008 The McGraw-Hill Companies 23-1 23 Monopolistic Competition and Oligopoly.

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Transcript of Copyright 2008 The McGraw-Hill Companies 23-1 23 Monopolistic Competition and Oligopoly.