MONOPOLISTIC COMPETITION AND OLIGOPOLY

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MONOPOLISTIC COMPETITION AND OLIGOPOLY
CHAPTER
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Objectives

• After studying this chapter, you will able to
• Define and identify monopolistic competition
• Explain how output and price are determined in a
  monopolistically competitive industry
• Explain why advertising costs are high in a
  monopolistically competitive industry

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Objectives

• After studying this chapter, you will able to
• Define and identify oligopoly
• Explain two traditional oligopoly models
• Use game theory to explain how price and output
  are determined in oligopoly
• Use game theory to explain other strategic
  decisions

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Searching for a Global Niche

• Globalization brings enormous diversity in
  products and thousands of firms seek to make
  their own product special and different from the
  rest of the pack.
• Two firms produce the chips that drive most PCs.
• Firms in these markets are neither price takers
  like those in perfect competition, nor are they
  protected from competition by barriers to entry
  like a monopoly.
• How do such firms choose the quantity to produce
  and price?

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Monopolistic Competition

• Monopolistic competition is a market with the
  following characteristics
• A large number of firms.
• Each firm produces a differentiated product.
• Firms compete on product quality, price, and
  marketing.
• Firms are free to enter and exit the industry.

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Monopolistic Competition

• Large Number of Firms
• The presence of a large number of firms in the
  market implies
• Each firm has only a small market share and
  therefore has limited market power to influence
  the price of its product.
• Each firm is sensitive to the average market
  price, but no firm pays attention to the actions
  of the other, and no one firms actions directly
  affect the actions of other firms.
• Collusion, or conspiring to fix prices, is
  impossible.

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Monopolistic Competition

• Product Differentiation
• Firms in monopolistic competition practice
  product differentiation, which means that each
  firm makes a product that is slightly different
  from the products of competing firms.

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Monopolistic Competition

• Competing on Quality, Price, and Marketing
• Product differentiation enables firms to compete
  in three areas quality, price, and marketing.
• Quality includes design, reliability, and
  service.
• Because firms produce differentiated products,
  each firm has a downward-sloping demand curve for
  its own product.
• But there is a tradeoff between price and
  quality.
• Differentiated products must be marketed using
  advertising and packaging.

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Monopolistic Competition

• Entry and Exit
• There are no barriers to entry in monopolistic
  competition, so firms cannot earn an economic
  profit in the long run.
• Examples of Monopolistic Competition
• Figure 13.1 on the next slide shows market share
  of the largest four firms and the HHI for each of
  ten industries that operate in monopolistic
  competition.

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Monopolistic Competition

• The red bars refer to the 4 largest firms.
• Green is the next 4.
• Blue is the next 12.
• The numbers are the HHI.

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Output and Price in Monopolistic Competition

• The Firms Short-Run Output and Price Decision
• A firm that has decided the quality of its
  product and its marketing program produces the
  profit maximizing quantity at which its marginal
  revenue equals its marginal cost (MR MC).
• Price is determined from the demand curve for the
  firms product and is the highest price the firm
  can charge for the profit-maximizing quantity.

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Output and Price in Monopolistic Competition

• Figure 13.2 shows a short-run equilibrium for a
  firm in monopolistic competition.
• It operates much like a single-price monopolist.

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Output and Price in Monopolistic Competition

• The firm produces the quantity at which price
  equals marginal cost and sells that quantity for
  the highest possible price.
• It earns an economic profit (as in this example)
  when P ATC.

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Output and Price in Monopolistic Competition

• Profit Maximizing Might be Loss Minimizing
• A firm might incur an economic loss in the short
  run.
• Here is an example.
• In this case, P

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Output and Price in Monopolistic Competition

• Long Run Zero Economic Profit
• In the long run, economic profit induces entry.
• And entry continues as long as firms in the
  industry earn an economic profitas long as (P
  ATC).
• In the long run, a firm in monopolistic
  competition maximizes its profit by producing the
  quantity at which its marginal revenue equals its
  marginal cost, MR MC.

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Output and Price in Monopolistic Competition

• As firms enter the industry, each existing firm
  loses some of its market share. The demand for
  its product decreases and the demand curve for
  its product shifts leftward.
• The decrease in demand decreases the quantity at
  which MR MC and lowers the maximum price that
  the firm can charge to sell this quantity.
• Price and quantity fall with firm entry until P
  ATC and firms earn zero economic profit.

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Output and Price in Monopolistic Competition

• Figure 13.4 shows a firm in monopolistic
  competition in long-run equilibrium.
• If firms incur an economic loss, firms exit to
  achieve the long-run equilibrium.

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Output and Price in Monopolistic Competition

• Monopolistic Competition and Perfect Competition
• Two key differences between monopolistic
  competition and perfect competition are
• Excess capacity
• Markup
• A firm has excess capacity if it produces less
  than the quantity at which ATC is a minimum.
• A firms markup is the amount by which its price
  exceeds its marginal cost.

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Output and Price in Monopolistic Competition

• Firms in monopolistic competition operate with
  excess capacity in long-run equilibrium.
• The downward-sloping demand curve for their
  products drives this result.

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Output and Price in Monopolistic Competition

• Firms in monopolistic competition operate with
  positive mark up.
• Again, the downward-sloping demand curve for
  their products drives this result.

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Output and Price in Monopolistic Competition

• In contrast, firms in perfect competition have no
  excess capacity and no markup.
• The perfectly elastic demand curve for their
  products drives this result.

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Output and Price in Monopolistic Competition

• Is Monopolistic Competition Efficient
• Because in monopolistic competition P MC,
  marginal benefit exceeds marginal cost.
• So monopolistic competition seems to be
  inefficient.
• But the markup of price above marginal cost
  arises from product differentiation.
• People value variety but variety is costly.
• Monopolistic competition brings the profitable
  and possibly efficient amount of variety to
  market.

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Product Development and Marketing

• Innovation and Product Development
• Weve looked at a firms profit maximizing output
  decision in the short run and the long run of a
  given product and with given marketing effort.
• To keep earning an economic profit, a firm in
  monopolistic competition must be in a state of
  continuous product development.
• New product development allows a firm to gain a
  competitive edge, if only temporarily, before
  competitors imitate the innovation.

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Product Development and Marketing

• Innovation is costly, but it increases total
  revenue.
• Firms pursue product development until the
  marginal revenue from innovation equals the
  marginal cost of innovation.
• Production development may benefit the consumer
  by providing an improved product, or it may only
  the appearance of a change in product quality.
• Regardless of whether a product improvement is
  real or imagined, its value to the consumer is
  its marginal benefit, which is the amount the
  consumer is willing to pay for it.

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Product Development and Marketing

• Advertising
• Firms in monopolistic competition incur heavy
  advertising expenditures.
• Figure 13.6 shows estimates of the percentage of
  sale price for different monopolistic competition
  markets.
• Cleaning supplies and toys top the list at almost
  15 percent.

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Product Development and Marketing

• Selling Costs and Total Costs
• Selling costs, like advertising expenditures,
  fancy retail buildings, etc. are fixed costs.
• Average fixed costs decrease as production
  increases, so selling costs increase average
  total costs at any given level of output but do
  not affect the marginal cost of production.
• Selling efforts such as advertising are
  successful if they increase the demand for the
  firms product.

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Product Development and Marketing

• Advertising costs might lower the average total
  cost by increasing equilibrium output and
  spreading their fixed costs over the larger
  quantity produced.
• Here, with no advertising, the firm produces 25
  units of output at an average total cost of 60.

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Product Development and Marketing

• With advertising, the firm produces 100 units of
  output at an average total cost of 40.
• The advertising expenditure shifts the average
  total cost curve upward, but the firm operates at
  a higher output and lower ATC than it would
  without advertising.

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Product Development and Marketing

• Advertising might also decrease the markup.
• In Figure 13.8(a), with no advertising, demand is
  not very elastic and the markup is large.
• In Figure 13.8(b), advertising makes demand more
  elastic, increases the quantity and lowers the
  price and markup.

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Product Development and Marketing

• Using Advertising to Signal Quality
• Why do Coke and Pepsi spend millions of dollars a
  month advertising products that everyone knows?
• One answer is that these firms use advertising to
  signal the high quality of their products.
• A signal is an action taken by an informed person
  or firm to send a message to uninformed persons.

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Product Development and Marketing

• Using Advertising to Signal Quality
• Coke is a high quality cola and Oke is a low
  quality cola.
• If Coke spends millions on advertising, people
  think Coke must be good.
• If it is truly good, when they try it, they will
  like it and keep buying it.
• If Oke spends millions on advertising, people
  think Oke must be good.
• If it is truly bad, when they try it, they will
  hate it and stop buying it.

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Product Development and Marketing

• Using Advertising to Signal Quality
• So if Oke knows its product is bad, it will not
  bother to waste millions on advertising it.
• And if Coke knows its product is good, it will
  spend millions on advertising it.
• Consumers will read the signals and get the
  correct message.
• None of the ads need mention the product. They
  just need to be flashy and expensive.

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Product Development and Marketing

• Brand Names
• Why do firms spend millions of dollars to
  establish a brand name or image?
• Again, the answer is to provide information about
  quality and consistency.
• Youre more likely to overnight at a Holiday Inn
  than at Joes Nite Stop because Holiday Inn has
  incurred the cost of establishing a brand name
  and you know what to expect if you stay there.

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Product Development and Marketing

• Efficiency of Advertising and Brand Names
• To the extent that advertising and selling costs
  provide consumers with information and services
  that they value more highly than their cost,
  these activities are efficient.

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What is Oligopoly?

• The distinguishing features of oligopoly are
• Natural or legal barriers that prevent entry of
  new firms
• A small number of firms compete

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What is Oligopoly?

• Barriers to Entry
• Either natural or legal barriers to entry can
  create oligopoly.
• Figure 13.9 shows two oligopoly situations.
• In part (a), there is a natural duopolya market
  with two firms.

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What is Oligopoly?

• In part (b), there is a natural oligopoly market
  with three firms.
• A legal oligopoly might arise even where the
  demand and costs leave room for a larger number
  of firms.

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What is Oligopoly?

• Small Number of Firms
• Because an oligopoly market has a small number of
  firms, the firms are interdependent and face a
  temptation to cooperate.
• Interdependence With a small number of firms,
  each firms profit depends on every firms
  actions.
• Cartel A cartel and is an illegal group of firms
  acting together to limit output, raise price, and
  increase profit.
• Firms in oligopoly face the temptation to form a
  cartel, but aside from being illegal, cartels
  often break down.

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What is Oligopoly?

• Examples of Oligopoly
• Figure 13.10 shows some examples of oligopoly.
• An HHI that exceeds 1800 is generally regarded as
  an oligopoly.
• An HHI below 1800 is generally regarded as
  monopolistic competition.

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Two Traditional Oligopoly Models

• The Kinked Demand Curve Model
• In the kinked demand curve model of oligopoly,
  each firm believes that if it raises its price,
  its competitors will not follow, but if it lowers
  its price all of its competitors will follow.

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Two Traditional Oligopoly Models

• Figure 13.11 shows the kinked demand curve model.
• The demand curve that a firm believes it faces
  has a kink at the current price and quantity.

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Two Traditional Oligopoly Models

• Above the kink, demand is relatively elastic
  because all other firms prices remain unchanged.
• Below the kink, demand is relatively inelastic
  because all other firms prices change in line
  with the price of the firm shown in the figure.

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Two Traditional Oligopoly Models

• The kink in the demand curve means that the MR
  curve is discontinuous at the current
  quantityshown by that gap AB in the figure.

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Two Traditional Oligopoly Models

• This slide helps to envisage why the kink in the
  demand curve puts a break in the marginal revenue
  curve.

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Two Traditional Oligopoly Models

• Fluctuations in MC that remain within the
  discontinuous portion of the MR curve leave the
  profit-maximizing quantity and price unchanged.
• For example, if costs increased so that the MC
  curve shifted upward from MC0 to MC1, the profit
  maximizing price and quantity would not change.

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Two Traditional Oligopoly Models

• The beliefs that generate the kinked demand curve
  are not always correct and firms can figure out
  this fact
• If MC increases enough, all firms raise their
  prices and the kink vanishes.
• A firm that bases its actions on wrong beliefs
  doesnt maximize profit.

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Two Traditional Oligopoly Models

• Dominant Firm Oligopoly
• In a dominant firm oligopoly, there is one large
  firm that has a significant cost advantage over
  many other, smaller competing firms.
• The large firm operates as a monopoly, setting
  its price and output to maximize its profit.
• The small firms act as perfect competitors,
  taking as given the market price set by the
  dominant firm.

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Two Traditional Oligopoly Models

• Figure 13.12 shows a dominant firm industry. On
  the left are 10 small firms and on the right is
  one large firm.

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Two Traditional Oligopoly Models

• The demand curve, D, is the market demand curve
  and the supply curve S10 is the supply curve of
  the 10 small firms.

S10
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Two Traditional Oligopoly Models

• At a price of 1.50, the 10 small firms produce
  the quantity demanded. At this price, the large
  firm would sell nothing.

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Two Traditional Oligopoly Models

• But if the price was 1.00, the 10 small firms
  would supply only half the market, leaving the
  rest to the large firm.

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Two Traditional Oligopoly Models

• The demand curve for the large firms output is
  the curve XD on the right.

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Two Traditional Oligopoly Models

• The large firm can set the price and receives a
  marginal revenue that is less than price along
  the curve MR.

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Two Traditional Oligopoly Models

• The large firm maximizes profit by setting MR
  MC. Lets suppose that the marginal cost curve is
  MC in the figure.

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Two Traditional Oligopoly Models

• The profit maximizing quantity for the large firm
  is 10 units. The price charged is 1.00.

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Two Traditional Oligopoly Models

• The small firms take this price and supply the
  rest of the quantity demanded.

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Two Traditional Oligopoly Models

• A dominant firm oligopoly can arise only if one
  firm has lower costs than the others.

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Two Traditional Oligopoly Models

• In the long run, such an industry might become a
  monopoly as the large firm buys up the small
  firms and cuts costs.

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Oligopoly Games

• Game theory is a tool for studying strategic
  behavior, which is behavior that takes into
  account the expected behavior of others and the
  mutual recognition of interdependence.
• What Is a Game?
• All games share four features
• Rules
• Strategies
• Payoffs
• Outcome.

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Oligopoly Games

• The Prisoners Dilemma
• The prisoners dilemma game illustrates the four
  features of a game.
• The rules describe the setting of the game, the
  actions the players may take, and the
  consequences of those actions.
• In the prisoners dilemma game, two prisoners
  (Art and Bob) have been caught committing a petty
  crime.
• Each is held in a separate cell and cannot
  communicate with each other.

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Oligopoly Games

• Each is told that both are suspected of
  committing a more serious crime.
• If one of them confesses, he will get a 1-year
  sentence for cooperating while his accomplice get
  a 10-year sentence for both crimes.
• If both confess to the more serious crime, each
  receives 3 years in jail for both crimes.
• If neither confesses, each receives a 2-year
  sentence for the minor crime only.

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Oligopoly Games

• In game theory, strategies are all the possible
  actions of each player.
• Art and Bob each have two possible actions
• Confess to the larger crime
• Deny having committed the larger crime.
• Because there are two players and two actions for
  each player, there are four possible outcomes
• Both confess
• Both deny
• Art confesses and Bob denies
• Bob confesses and Art denies

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Oligopoly Games

• Each prisoner can work out what happens to
  himcan work out his payoffin each of the four
  possible outcomes.
• We can tabulate these outcomes in a payoff
  matrix.
• A payoff matrix is a table that shows the payoffs
  for every possible action by each player for
  every possible action by the other player.
• The next slide shows the payoff matrix for this
  prisoners dilemma game.

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Oligopoly Games
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Oligopoly Games

• If a player makes a rational choice in pursuit of
  his own best interest, he chooses the action that
  is best for him, given any action taken by the
  other player.
• If both players are rational and choose their
  actions in this way, the outcome is an
  equilibrium called Nash equilibriumfirst
  proposed by John Nash.
• The following slides show how to find the Nash
  equlibrium.

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Bobs view of the world
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Bobs view of the world
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Arts view of the world
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Arts view of the world
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Equilibrium
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Oligopoly Games

• An Oligopoly Price-Fixing Game
• A game like the prisoners dilemma is played in
  duopoly.
• A duopoly is a market in which there are only two
  producers that compete.
• Duopoly captures the essence of oligopoly.
• Figure 13.13 on the next slide describes the
  demand and cost situation in a natural duopoly.

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Oligopoly Games

• Part (a) shows each firms cost curves.
• Part (b) shows the market demand curve.

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Oligopoly Games

• This industry is a natural duopoly.
• Two firms can meet the market demand at the least
  cost.

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Oligopoly Games

• How does this market work?
• What is the price and quantity produced in
  equilibrium?

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Oligopoly Games

• Suppose that the two firms enter into a collusive
  agreement.
• A collusive agreement is an agreement between two
  (or more) firms to restrict output, raise price,
  and increase profits.
• Such agreements are illegal in the United States
  and are undertaken in secret.
• Firms in a collusive agreement operate a cartel.

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Oligopoly Games

• The possible strategies are
• Comply
• Cheat
• Because each firm has two strategies, there are
  four possible outcomes
• Both comply
• Both cheat
• Trick complies and Gear cheats
• Gear complies and Trick cheats

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Oligopoly Games

• The first possible outcomeboth complyearns the
  maximum economic profit, which is the same as a
  monopoly would earn.

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Oligopoly Games

• To find that profit, we set marginal cost for the
  cartel equal to marginal revenue for the cartel.
  Figure 13.14 shows this outcome.

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Oligopoly Games

• The cartels marginal cost curve is the
  horizontal sum of the MC curves of the two firms
  and the marginal revenue curve is like that of a
  monopoly.

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Oligopoly Games

• The firms maximize economic profit by producing
  the quantity at which MCI MR.

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Oligopoly Games

• Each firm agrees to produce 2,000 units and each
  firm shares the maximum economic profit.

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Oligopoly Games

• When each firm produces 2,000 units, the price is
  greater than the firms marginal cost, so if one
  firm increased output, its profit would increase.

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Oligopoly Games

• Figure 13.15 shows what happens when one firm
  cheats and increases its output to 3,000 units.
  Industry output rises to 5,000 and the price
  falls.

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Oligopoly Games

• For the complier, ATC now exceeds price.
• For the cheat, price exceeds ATC.

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Oligopoly Games

• For the complier incurs an economic loss.
• The cheat earns an increased economic profit.

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Oligopoly Games

• Either firm could cheat, so this figure shows two
  of the possible outcomes.
• Next, lets see the effects of both firms
  cheating.

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Oligopoly Games

• Figure 13.16 shows the outcome if both firms
  cheat and increase their output to 3,000 units.

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Oligopoly Games

• Industry output is 6,000 units, the price falls,
  and both firms earn zero economic profitthe same
  as in perfect competition.

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Oligopoly Games

• Youve now seen the four possible outcomes
• If both comply, they make 2 million a week
  each.
• If both cheat, they earn zero economic profit.
• If Trick complies and Gear cheats, Trick incurs
  an economic loss of 1 million and Gear makes an
  economic profit of 4.5 million.
• If Gear complies and Trick cheats, Gear incurs
  an economic loss of 1 million and Trick makes an
  economic profit of 4.5 million.
• The next slide shows the payoff matrix for the
  duopoly game.

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Payoff Matrix
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Tricks view of the world
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Tricks view of the world
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Gears view of the world
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Gears view of the world
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Equilibrium
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Oligopoly Games

• The Nash equilibrium is where both firms cheat.
• The quantity and price are those of a competitive
  market, and the firms earn normal profit.
• Other Oligopoly Games
• Advertising and R D games are also prisoners
  dilemmas.
• An R D Game
• Procter Gamble and Kimberley Clark play an R
  D game in the market for disposable diapers.

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Oligopoly Games

• Here is the payoff matrix for the Pampers Versus
  Huggies game.

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Oligopoly Games

• The Disappearing Invisible Hand
• In all the versions of the prisoners dilemma
  that weve examined, the players end up worse off
  than they would if they were able to cooperate.
• The pursuit of self-interest does not promote the
  social interest in these games.

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Oligopoly Games

• A Game of Chicken
• In the prisoners dilemma game, the Nash
  equilibrium is a dominant strategy equilibrium,
  by which we mean the best strategy for each
  player is independent of what the other player
  does.
• Not all games have such an equilibrium.
• One that doesnt is the game of chicken.

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Payoff Matrix
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KCs view of the world
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KCs view of the world
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PGs view of the world
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PGs view of the world
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Equilibrium
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Repeated Games and Sequential Games

• A Repeated Duopoly Game
• If a game is played repeatedly, it is possible
  for duopolists to successfully collude and earn a
  monopoly profit.
• If the players take turns and move sequentially
  (rather than simultaneously as in the prisoners
  dilemma), many outcomes are possible.
• In a repeated prisoners dilemma duopoly game,
  additional punishment strategies enable the firms
  to comply and achieve a cooperative equilibrium,
  in which the firms make and share the monopoly
  profit.

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Repeated Games and Sequential Games

• One possible punishment strategy is a tit-for-tat
  strategy, in which one player cooperates this
  period if the other player cooperated in the
  previous period but cheats in the current period
  if the other player cheated in the previous
  period.
• A more severe punishment strategy is a trigger
  strategy in which a player cooperates if the
  other player cooperates but plays the Nash
  equilibrium strategy forever thereafter if the
  other player cheats.

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Repeated Games and Sequential Games

• Table 13.5 shows that a tit-for-tat strategy is
  sufficient to produce a cooperative equilibrium
  in a repeated duopoly game.
• Price wars might result from a tit-for-tat
  strategy where there is an additional
  complicationuncertainty about changes in demand.
• A fall in demand might lower the price and bring
  forth a round of tit-for-tat punishment.

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Repeated Games and Sequential Games

• A Sequential Entry Game in a Contestable Market
• In a contestable marketa market in which firms
  can enter and leave so easily that firms in the
  market face competition from potential
  entrantsfirms play a sequential entry game.

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Repeated Games and Sequential Games

• Figure 13.17 shows the game tree for a sequential
  entry game in a contestable market.

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Repeated Games and Sequential Games

• In the first stage, Agile decides whether to set
  the monopoly price or the competitive price.

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Repeated Games and Sequential Games

• In the second stage, Wanabe decides whether to
  enter or stay out.

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Repeated Games and Sequential Games

• In the equilibrium of this entry game, Agile sets
  a competitive price and earns a normal profit to
  keep Wanabe out.
• A less costly strategy is limit pricing, which
  sets the price at the highest level that is
  consistent with keeping the potential entrant out.

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THE END