Mbad 5110 - Ch 13 Revised

8/8/2019 Mbad 5110 - Ch 13 Revised

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Monopolistic Competitionand Oligopoly

CHAPTER13

Profits, like sausages, are esteemed

most by those that know least

about what goes into them.Alvin Toffler

Futurist, Author (1928 - )

8/8/2019 Mbad 5110 - Ch 13 Revised


C H A P T E R C H E C K L I S T

When you have completed your study of thischapter, you will be able to

1 Explain how price and quantity are determined inmonopolistic competition.

2 Explain why selling costs are high in monopolisticcompetition.

3 Explain the dilemma faced by firms in oligopoly.

4 Use game theory to explain how price and quantity aredetermined in oligopoly.

8/8/2019 Mbad 5110 - Ch 13 Revised


MARKET CHARACTERISTICS

Perfect Competition

MonopolisticCompetition

Monopoly

Many, many, many, manysellers, none so large that theycan influence price

Relatively many sellers, littleinfluence on price

One seller that likely caninfluence price

Homogeneous product (buyersdon’t care who they by from) Heterogeneous products, withsubstitutes Heterogeneous product,no close substitutes

No barriers to entry or exit (easyto get in and out of market)

Low to no barriers to entry or exit

HIGH barriers to entry or exit

Long run economic profit = zero(only earning normal profit)

Long run economic profit =zero (only earning normal profit)

Long run economic profitis positive

Firms are price takers (nomarket power, so market setssame price for all firms)

Firms have power over their own pricing becauseproducing different, but

similar, products

Firms are price makers(lots of market power,market IS the firm)

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Relatively Large Number of Firms

• Fewer than perfect competition.

• Three implications are:

– Small market share

– No market dominance

– Collusion impossible

13.1 MONOPOLISTIC COMPETITION

8/8/2019 Mbad 5110 - Ch 13 Revised


Product Differentation

Product differentiation - making a product that

is slightly different from the products of competing firms.

•A differentiated product has close substitutes, but not

perfect substitutes.•When the price of one firm’s product rises, the quantity

demanded of that firm’s product decreases.


8/8/2019 Mbad 5110 - Ch 13 Revised


Competition on Quality, Price, and Marketing

Quality

Design, reliability, after-sales service, and buyer’sease of access to the product.

Price

Because of product differentiation, the demand

curve for the firms’ product is downward sloping.

Marketing

Advertising and packaging.


8/8/2019 Mbad 5110 - Ch 13 Revised


Entry and Exit

Low to no barriers to entry, so the firm is

unlikely to make economic profit in the long run.

Examples:

•Restaurants

•Gas stations•Hair salons

•Dry Cleaners


These firms are monopolistic inthat each one has a monopolyon their brand, image, service,

ambience, menu, etc. They arecompetitive in the sense thatthere are many, many of them,and consumers can easily sub

one for another.

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Concentration ratio – percentage of sales accounted for by specified number of top firms in a market.

•Usually reported as 4-firm, 8-firm, or 20-firm.

• The higher the concentration ratio, the greater thedegree of market dominance by small number of firms.

• The range of concentration ratio is from almost zerofor perfect competition to 100 percent for monopoly.

• Can distinguish between market structures byconcentration ratio

Industry Concentration

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CR1 > 90% Effective monopoly 2-3%

CR4

> 60% Tight oligopoly 10%

CR4 between

40% & 60%

Loose oligopoly 12%

CR4 < 40% Effectively competitive

PC and monopolisticcompetition

75%

% of GDP


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Herfindahl-Hirschman Index (HHI) – sum of the squaredmarket shares of all firms.

• HHI = s1

2 + s2

2 + . . . .sn

2

• Ranges from 10,000 for pure monopolist to zero for infinite number of small firms.

•The more unequal the market share, the higher the HHIvalue. The greater the number of firms, the lower theHHI.


8/8/2019 Mbad 5110 - Ch 13 Revised


• Increases in concentration typically yield increasedprices and profits, ceteris paribus.

• Squaring gives greater weight to larger shares.

• Example: If there are five firms in a market with

market shares of 40%, 30%, 16%, 10% and 4%:

HHI = 402 + 302 + 162 + 102 + 42 = 2,872


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Level Ratio / Range Firm Structure

Extreme High 10,000 Only one firmHigh 1,800 up High concentration

Medium 1,000-1,800 Moderately competitive

Low 1,000 down Very competitive

Extreme Low Nearly zero Infinite number firms


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The Firm’s Profit-Maximizing Decision

The firm in monopolistic competition makes

its output and price decision just like amonopoly firm does (MC=MR).

8/8/2019 Mbad 5110 - Ch 13 Revised


1. Profit is maximizedwhen MR = MC.

3. The profit-maximizing

price is $75 per pair.

4. The firm makes aneconomic profit of

$6,250 a day.

2. The profit-maximizing

output is 125 pairs of Tommy jeans per day.

ATC is $25 per pair, so


8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


Long Run: Zero Economic Profit

• Economic profit induces entry and economic lossinduces exit, as in perfect competition.

• Entry decreases the demand for the product of eachfirm. (demand curve shifts left)

• Exit increases the demand for the product of eachfirm. (demand curve shifts right)

• In the long run, economic profit is competed awayand firms earn normal profit.


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1. In LR, the outputthat maximizes profitis 75 pairs of

Tommy jeans a day.

2. The price is $50 per pair. Average total

cost is also $50 per pair.

3. Economic profit iszero.


8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


Equilibrium in Monopolistic Competition

Quantity(units per period)

0

ATC

MC

Priceor

Cost(dollars

pe

runit

)

Initialdemand

The long run

Priceor

Cost( d

ollars

pe

runit

)

MR

qa0

pa

F MC

ATC

Quantity (units per period)

Demand

K

The short run

c a

Later MRqg

pg

G

Later demand

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Monopolistic Competition and Efficiency

• Efficiency requires that the MB of the consumer equal

the MC of the producer.• Price measures marginal benefit, so efficiency requires

P=MC.

• In monopolistic competition, P > MR and MR=MC, so P

> MC – a sign of inefficiency.

• Demand curve can’t lie tangent to minimum ATC, so

tangency is at higher ATC – inefficient.


8/8/2019 Mbad 5110 - Ch 13 Revised


• But this inefficiency arises from product differentiation

—variety—that consumers value and for which they

are willing to pay.

• So the loss that arises because MB > MC must be

weighed against the gain that arises from greater

product variety.

• In a broader view of efficiency, monopolisticcompetition brings gains for consumers.

• But firms in monopolistic competition always have

excess capacity in long-run equilibrium.


8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


1. The efficient scale is 100pairs of Tommy jeans aday. (min ATC)

2. The firm produces lessthan the efficient scale andhas excess capacity.

3. Price exceeds 4. marginal

cost.

5. Deadweight loss arise.


8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


MARKET CHARACTERISTICS

Perfect Competition MonopolisticCompetition Oligopoly Monopoly

Many, many, many, manysellers, none so large thatthey can influence price

Relatively many sellers,little influence on price

Few (usually 3-5)sellers, but little directprice control becauseof rivals

One seller that likelycan influence price

Homogeneous product(buyers don’t care who

they by from)

Heterogeneous products,with substitutes

Heterogeneousproduct, but rivals are

close substitutes

Heterogeneousproduct, no close

substitutes

No barriers to entry or exit(easy to get in and out of market)

Low to no barriers toentry or exit

HIGH barriers to entry HIGH barriers to

Long run economic profit =

zero (only earning normalprofit)

Long run economic profit

= zero (only earning normalprofit)

Long run economic

profit is positive

Long run economic

profit is positive

Firms are price takers (nomarket power, so marketsets same price for allfirms)

Firms have power over their own pricing becauseproducing different, butsimilar, products

Firms are price makersbecause their outputinfluences price

Firms are price makers(lots of market power,market IS the firm)

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13.3 OLIGOPOLY

Tight oligopoly – concentration ratio > 60

• Duopoly - market in which there are only two producers.

Loose oligopoly – concentration ratio between 40 and 60.

Firms in an oligopoly are closely interdependent. Priceand output changes will impact rivals, and likely draw

some reaction from the rival firms.

Examples: airlines, aircraft, soft drinks, cellular service,computer chips, athletic shoes, cigarettes.

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The Battle for Market SharesIncreased sales on the part of one firm will

be noticed immediately by the other firms.

Increases in the market share of one oligopolist will

reduce the shares of the remaining oligopolists. There isn’t any way that a firm can do so without

causing alarms to go off in the industry.

An attempt by one oligopolist to increase its marketshare by cutting prices will lead to a general reduction inthe market price, eventually harming everyone.

This is why oligopolists avoid price competition andinstead pursue non-price competition.

OLIGOPOLY

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OLIGOPOLY

NON-PRICE COMPETITION Product differentiation – Features that make one

product appear different from competing products in thesame market.

Advertising - strengthens brand loyalty, and makes itexpensive for new producers to enter the market

Training - Customers of training-intensive products(computer hardware, software) become familiar with aparticular system. Creates barriers to later competition.

Network Economies - The widespread use of a particular product may heighten its value to consumers, thereby

making potential substitutes less viable.

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The Kinked Demand Curve

Close interdependence between firms

The degree to which sales increase when theprice is reduced depends on the response of rivaloligopolists. We expect oligopolists to match any price

cuts by rival oligopolists.

Rival oligopolists may not match price

increases in order to gain market share.

OLIGOPOLY

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The Kinked Demand Curve

The shape of the demand curve facing an

oligopolist depends on how its rivals

respond to a change in the price of its ownoutput.

The demand curve will be “kinked” if rival

oligopolists match price cuts, but not price

increases.

OLIGOPOLY

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Price Rigidity (Kinked Demand)

• Oligopolistic firms are interdependent – when one firmchanges, others will have to consider whether action isrequired on their part.

• Firms tend to match price cuts and NOT match price

increases.

• When firm cuts price, Q will increase – if other firms alsocut price, increase in Q will be minimal (inelastic)

• When firm raises price, Q will decrease. If other firms do

not raise their price, increase in Q will be moresubstantial (elastic).

• Difference in relative elasticity will cause kink in demandcurve at current price.

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Dnomatch

Dmatch

M R n o m a t c h

M R m a t c h

P1

Q1

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Dnomatch

Dmatch

M R n o m a t c h

M R m a t c h

P1

Q1

Profit max output is

8/8/2019 Mbad 5110 - Ch 13 Revised


Profit max output is

where the MR curve

is discontinuous

(where MC runs

thru discontinuity).

Marginal costs can

increase or

decrease without

changing profit max

output as long as

MC stays in gap.

D

M R

P1

Q1

MC3

MC1

MC2

8/8/2019 Mbad 5110 - Ch 13 Revised


D

M R

P1

Q1

MC3

MC1

MC2

Response by

other firms tends

to discourage this

firm from

changing price,keeping prices

stable (price

rigidity).

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Oligopoly vs. Competition

Oligopolists may try to coordinate their behavior

in a way that maximizes industry profits.

An oligopoly will want to behave like amonopoly, choosing a rate of industry outputthat maximizes total industry profit.

To maximize industry profit, the firms in anoligopoly must agree on a monopoly price andagree to maintain it by limiting production andallocating market shares.

OLIGOPOLY

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13.3 OLIGOPOLY

Collusion

When a small number of firms share a market,

they can increase their profit by forming a cartel

and acting like a monopoly.Cartel - group of firms acting together to limit

output, raise price, and increase economic

profit.

•Firms would behave collectively like a multi-firm profit-

maximizing monopolist

•Cartels are illegal in U.S., but they can operate covertly in

some markets.

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Price Fixing

• Explicit agreement among producers about price atwhich goods will be sold.

• The most explicit form of coordination amongoligopolists.

• NOT LEGAL.

OLIGOPOLY

8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


Price Leadership (Dominant Firm Strategy)

• Often one firm in oligopolistic market owns dominantmarket share.

• Dominant firm can establish profit max price based ontheir cost structure, then smaller, or less aggressive,firms behave as price takers.

• Example: Airlines

OLIGOPOLY

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13.4 GAME THEORY

Game theory is the tool used to analyze

strategic behavior—behavior that

recognizes mutual interdependence and

takes account of the expected behavior of

others.

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13.4 GAME THEORY

What Is a Game?

All games involve three features:

• Rules• Strategies

• Payoffs

Prisoners’ dilemma is a game between two

prisoners that shows why it is hard to

cooperate, even when it would be beneficial

to both players to do so.

8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

The Prisoners’ Dilemma

Art and Bob are caught stealing a car: sentence

is 2 years in jail.DA wants to convict them of a big bank robbery:

sentence is 10 years in jail.

DA has no evidence and to get the conviction,

he makes the prisoners play a game.

8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

Rules

Players cannot communicate with one another.

• If both confess to the larger crime, each will receive asentence of 3 years for both crimes.

• If one confesses and the accomplice does not,the one who confesses will receive a 1-year sentence,while the accomplice receives a

10-year sentence.• If neither confesses, both receive a 2-year sentence.

8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

Payoffs

Four outcomes:

• Both confess.

• Both deny.

• Art confesses and Bob denies.

• Bob confesses and Art denies.

A payoff matrix is a table that shows the payoffsfor every possible action by each player given

every possible action by the other player.

8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

Equilibrium

•Occurs when each player takes the best possible action given

the action of the other player.

•Nash equilibrium is an equilibrium in which each player takesthe best possible action given the action of the other player.

•The Nash equilibrium for Art and Bob is to confess.

•The equilibrium of the prisoners’ dilemma is not the best

outcome possible for the players, but is the best option if playersdon’t know what the other is doing.

8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

The Duopolists’ Dilemma as a Game

The dilemma of Boeing and Airbus is similar

to that of Art and Bob.Each firm has two strategies. It can produce

airplanes at the rate of:

• 3 a week

• 4 a week

8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

Because each firm has two strategies, there

are four possible combinations of actions:

• Both firms produce 3 a week (monopoly outcome).

• Both firms produce 4 a week.

• Airbus produces 3 a week and Boeing produces 4a week.

• Boeing produces 3 a week and Airbus produces 4a week.

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The Payoff Matrix

Table 13.6 shows

the payoff matrix

as the economic

profits for each

firm in eachpossible

outcome.

13.4 GAME THEORY

8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


Equilibrium of the

Duopolists’ Dilemma

Both firms produce 4 a

week.

Like the prisoners, the

duopolists fail to

cooperate and get aworse outcome than

the one that

cooperation would

deliver.

13.4 GAME THEORY

8/8/2019 Mbad 5110 - Ch 13 Revised


8/8/2019 Mbad 5110 - Ch 13 Revised


13.4 GAME THEORY

Collusion Is Profitable but Difficult to Achieve

•The duopolists’ dilemma explains why it is difficult for firms to

collude and achieve the maximum monopoly profit.

•Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output.

•In OPEC, member countries frequently break the cartel agreement

and overproduce (more players = more difficult to prevent

cheating).

8/8/2019 Mbad 5110 - Ch 13 Revised


Mbad 5110 - Ch 13 Revised

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