Monopolistic Competition and Olgipoly

The perfectly competitive solution is considered the socially optimum solution to market supply issues but it is the lure of profits that generates excitement of being in business.The monopolist has the best chance of making a profit but in so doing is readily identified for government action.In markets where there are a few competitors but a downward sloping demand curve the possibility of profit does exist.If the market has persistent over supply it is characterized by monopolistic competition.If the market has consistent profit it is characterized as an oligopoly.In both cases the markets are contestable amongst the competitors and some win and some loose.

The Over Supply Case• In a monopolistic competitive market all profits are short run and in the long run the competition

amongst sellers leads to a case where the ATD is equal to the demand curve and profit disappears but funds can be carried over as a proxy and can be used to subsidize further business activity.

• The timing in the market is often set by the firms themselves and does not necessarily respond to any natural pressures.

• May be heavily government regulated in service of non economic objectives of government such as environmental concerns, health and safety issues, local ownership considerations, or treaty obligations.

• In these markets there are :– Few competitors– High barriers to entry– A highly substitutable product– Significant supplier opportunities.– Imperfect information which enables price discrimination.– High advertising expenditures that lead to “trends” in product design and appearance.– Relatively high technology that is changing continuously and appears to “push” out the demand curve.– No Long Run Deadweight Loss

Analytics of Monopolistic Competition

• The market has chronic Over Supply.

Price

Quantity

Long Run Average Total Cost

Short RunAverage Total Cost

Short Run Marginal Cost =Long Run Marginal Cost

Demand

Marginal Revenue

Short RunPrice Received

Short RunCost Incurred

Long RunPrice Received=Cost Incurred

“Perceived” ShortageActual Over Supply

Short RunQuantity Sold

Long RunQuantity Sold

Oligopoly : 3 Views• Oligopolists may operate from one of three theoretical perspectives:• There may be a “Kinked Demand Curve” which argues that there is a point at which a

linear demand curve becomes more steep due to various external factors and as a result there is so much discord in the market that profits must be maintained in order to secure continuity of the industry. This is common in areas where there are a fixed number of outputs that will expire and the last units will be more valuable outside of the market than inside of it. The mission of the firm will be to capture these potential benefits inside the market.

• There may be a Cartel of Sellers who agree to fix prices at a specific level in order to extract the maximum profit from the market and then divide this up amongst each other.

• There may also be a Contested Market in which firms attempt to drive each other out of business and in the end undercut to a perfectly competitive solution.

• In all three cases there are– Few competitors– High barriers to entry– A highly substitutable product– Significant supplier opportunities.– Imperfect information which enables market differentiation– Relatively low technology – No Long Run Deadweight Loss

“Kinked Demand Curve”• Firms attempt to capture as much surplus “inside” the market as possible, but there is a pricing “range.” which

seems to be ineffective in selling and the firm will stop and accept an unsold inventory. However outside of the firm there is an apparent external marginal cost at which an arbitrager will still sell the same product at a higher price and take up the slack quantity .

Price

Quantity

Demand

Marginal Revenue

Kink

Marginal CostInternal

Marginal Cost External

Average Total Cost

Pricing Range

Quantity SoldInternal

Quantity SoldExternal

Projected Demand facing an Arbitrager

Price Received

Cost Incurred High

Cost Incurred Low

Cartel of Sellers• The industry participants decide to work together as if they were one monopolist and attempt to

earn a long term profit under the guise of competition. The cartel will work unless one party decides that it wants a bigger share. Q^ = 2 Q* : P^ = P* : C^ = C*

Price

Quantity

MC

ATC

ARMR

P*

C*

Q*

Profit

Price

Quantity

MC

ATC

ARMR

P*

C*

Q*

Profit

Price

Quantity

MC

ATC

ARMR

P^

C^

Q^

CombinedProfit

Firm 1 Firm 2 Industry

Contested Market• Each firm reacts to the other in order to drive the other out of business by undercutting the costs

of the other below the break even point. P=C” This works only if there is a true “advantage” to Firm 1

Price

Quantity

MC

ATC

ARMR

P*

C*

Q*

Profit

Price

Quantity

MC

ATC

ARMR

P^

C^

Q^

CombinedProfit

Firm 1 Firm 2 Industry

Price

Quantity

MC

ATC

ARMR

P*

C*

Q*

Profit

P=C”

The problems with Monopolistic Competition and Oligopoly

• Accuracy of market projections cannot be set with confidence and in industries where cost structures are moved by exogenous factors such as the weather, it may not be possible to avoid overproduction.

• Market control is also difficult to establish and maintain over a long term and the presence of arbitragers may force any kinks in the demand curve to increase costs in order to maintain its market control.

• Cooperation in markets is difficult to maintain as each firm in the industry has the allure of profits to tempt it to change its behavior and take markets away from the others. Legal parameters have been set up to ensure that competition is free and fair through consumer protection legislation ,but that is also costly and can if proven to be unnecessary result in a deadweight loss of its own. Any cost incurred policing a non-problem is a waste of resources and hence a deadweight loss.

• As a result markets which are in turmoil trend to have very high advertising expenditures and also very high degrees of mergers and acquisitions.

Accuracy• Each competitor will attempt to understand the nature of the activity that each competitor will

most likely undertake in a given situation. This can take the form of industrial espionage, bidding employees away from a competitor, conducting major charitable campaigns in order to raise public approval ratings, and also funding primary research into consumer attitudes including focus groups and roundtable forums.

• Each approach attempts to find out what the market will bear and the responses that may be expected from competitors.

• There is a tendency for market projections to lead financial and human resource decisions in firms that face imperfectly competitive markets.

• Generally market projections have a five percent confidence interval based on a normal distribution of expected results but in markets where margins are relatively low (less than 1.5 %) and social trends dominate the motivation of the consumer , the statistical probability of success may not be assuring.

• As a result management decisions are likely to favor overproduction as a method of preserving market share by following down any drop in prices from inventory where costs are known with certainty, by lagging the market by a long enough lag that production can be restarted with minimum disruption, and by following and perhaps even advocating for certain favorable trends.

Market Control• Controlling the market is difficult to establish as products that can be stored by the

consumer, that can be resold by third parties and which carry with them the information that is needed to use them effectively.

• Technology changes continuously and therefore how the product may be used will depend on the technology background or social climate and the “relative” value of patents and copyrights.

• Products have a “life cycle” and from invention to becoming dated is increasingly shorter . There are few models that are produced continuously of anything and often production “runs” are one time occurrences with the manufacturer often dissolving before repeat orders are placed.

• As a result management decision about control are likely to look to government regulation as a method of securing the future for the “status quo” which can lead to stability and influence beyond a particular market at any point in time or space.

Cooperation• There is an inherent drive to cheating when the future is unstable .• This is known as the “prisoners dilemma” wherein two individuals, who are each

accused of a crime, are promised a minimal sentence if they confess to the crime but a serious punishment if they do not. The result is that when the penalties have a wide dispersion there will most assuredly be a confession. There may also be an inducement to implicate the other in this scenario.

• Given this tendency it is quite difficult to maintain cooperation over an extended period of time as any variability in market outcomes will lead to the temptation to break the agreement and leads to an outcome that is less than optimal for all parties. This is called a Nash Equilibrium after John Nash. “A Beautiful Mind”.

• Moreover there is a trend in large cartels to assume that anyone who would break away from the cartel would have also caused the instability in the market, which can lead to severe market retaliations.

Imperfections Persist

• Imperfect competition models seem to be increasing dismissed by economists as being only temporary, but the fact that markets produce outcomes that suggest either monopolistic competition or some form of oligopoly is still present and if only temporary may still have profound impacts on welfare allocations.

• The reactions to imperfect competition fill a great deal of public policy and the enforcement of these regulations is a costly element in many industries.

• The nature of these expenditures may outweigh the potential losses and may in and of themselves reduce welfare.