Monopolistic Competition and Oligopoly

1
Chapter 12

• Monopolistic Competition and Oligopoly

2
Topics to be Discussed

• Monopolistic Competition
• Oligopoly
• Price Competition
• Competition Versus Collusion The Prisoners
  Dilemma

3
Topics to be Discussed

• Implications of the Prisoners Dilemma for
  Oligopolistic Pricing
• Cartels

4
Monopolistic Competition

• Characteristics
• 1) Many firms
• 2) Free entry and exit
• 3) Differentiated product

5
Monopolistic Competition

• The amount of monopoly power depends on the
  degree of differentiation.
• Examples of this very common market structure
  include
• Toothpaste
• Soap
• Cold remedies

6
Monopolistic Competition

• The Makings of Monopolistic Competition
• Two important characteristics
• Differentiated but highly substitutable products
• Free entry and exit

7
A Monopolistically CompetitiveFirm in the Short
and Long Run
/Q
/Q
Short Run
Long Run
Quantity
Quantity
8
A Monopolistically CompetitiveFirm in the Short
and Long Run

• Observations (short-run)
• Downward sloping demand--differentiated product
• Demand is relatively elastic--good substitutes
• MR lt P
• Profits are maximized when MR MC
• This firm is making economic profits

9
A Monopolistically CompetitiveFirm in the Short
and Long Run

• Observations (long-run)
• Profits will attract new firms to the industry
  (no barriers to entry)
• The old firms demand will decrease to DLR
• Firms output and price will fall
• Industry output will rise
• No economic profit (P AC)
• P gt MC -- some monopoly power

10
Comparison of Monopolistically CompetitiveEquilib
rium and Perfectly Competitive Equilibrium
Monopolistic Competition
Perfect Competition
/Q
/Q
Quantity
Quantity
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Monopolistic Competition

• Monopolistic Competition and Economic Efficiency
• The monopoly power (differentiation) yields a
  higher price than perfect competition. If price
  was lowered to the point where MC D,
  consumer surplus would increase by the yellow
  triangle.

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Monopolistic Competition

• Monopolistic Competition and Economic Efficiency
• With no economic profits in the long run, the
  firm is still not producing at minimum AC and
  excess capacity exists.

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Monopolistic Competition

• Questions
• 1) If the market became competitive, what would
  happen to output and price?
• 2) Should monopolistic competition be regulated?

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Monopolistic Competition

• Questions
• 3) What is the degree of monopoly power?
• 4) What is the benefit of product diversity?

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Oligopoly

• Characteristics
• Small number of firms
• Product differentiation may or may not exist
• Barriers to entry

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Oligopoly

• Examples
• Automobiles
• Steel
• Aluminum
• Petrochemicals
• Electrical equipment
• Computers

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Oligopoly

• The barriers to entry are
• Natural
• Scale economies
• Patents
• Technology
• Name recognition

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Oligopoly

• The barriers to entry are
• Strategic action
• Flooding the market
• Controlling an essential input

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Oligopoly

• Management Challenges
• Strategic actions
• Rival behavior
• Question
• What are the possible rival responses to a 10
  price cut by Ford?

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Oligopoly

• Equilibrium in an Oligopolistic Market
• In perfect competition, monopoly, and
  monopolistic competition the producers did not
  have to consider a rivals response when choosing
  output and price.
• In oligopoly the producers must consider the
  response of competitors when choosing output and
  price.

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Oligopoly

• Equilibrium in an Oligopolistic Market
• Defining Equilibrium
• Firms doing the best they can and have no
  incentive to change their output or price
• All firms assume competitors are taking rival
  decisions into account.

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Oligopoly

• Nash Equilibrium
• Each firm is doing the best it can given what its
  competitors are doing.

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Oligopoly

• The Cournot Model
• Duopoly
• Two firms competing with each other
• Homogenous good
• The output of the other firm is assumed to be
  fixed

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Firm 1s Output Decision
P1
What is the output of Firm 1 if Firm 2 produces
100 units?
Q1
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Oligopoly

• The Reaction Curve
• A firms profit-maximizing output is a decreasing
  schedule of the expected output of Firm 2.

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Reaction Curves and Cournot Equilibrium
Q1
100
75
50
25
Q2
25
50
75
100
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Oligopoly

• Questions
• 1) If the firms are not producing at the
  Cournot equilibrium, will they adjust until the
  Cournot equilibrium is reached?
• 2) When is it rational to assume that its
  competitors output is fixed?

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Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium
• Duopoly
• Market demand is P 30 - Q where Q Q1 Q2
• MC1 MC2 0

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Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium
• Firm 1s Reaction Curve

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Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium

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Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium

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Duopoly Example
Q1
The demand curve is P 30 - Q and both firms
have 0 marginal cost.
Q2
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Oligopoly
Profit Maximization with Collusion
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Oligopoly
Profit Maximization with Collusion

• Contract Curve
• Q1 Q2 15
• Shows all pairs of output Q1 and Q2 that
  maximizes total profits
• Q1 Q2 7.5
• Less output and higher profits than the Cournot
  equilibrium

35
Duopoly Example
Q1
30
Q2
30
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First Mover Advantage--The Stackelberg Model

• Assumptions
• One firm can set output first
• MC 0
• Market demand is P 30 - Q where Q total
  output
• Firm 1 sets output first and Firm 2 then makes an
  output decision

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First Mover Advantage--The Stackelberg Model

• Firm 1
• Must consider the reaction of Firm 2
• Firm 2
• Takes Firm 1s output as fixed and therefore
  determines output with the Cournot reaction
  curve Q2 15 - 1/2Q1

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First Mover Advantage--The Stackelberg Model

• Firm 1
• Choose Q1 so that

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First Mover Advantage--The Stackelberg Model

• Substituting Firm 2s Reaction Curve for Q2

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First Mover Advantage--The Stackelberg Model

• Conclusion
• Firm 1s output is twice as large as firm 2s
• Firm 1s profit is twice as large as firm 2s
• Questions
• Why is it more profitable to be the first mover?
• Which model (Cournot or Shackelberg) is more
  appropriate?

41
Price Competition

• Competition in an oligopolistic industry may
  occur with price instead of output.
• The Bertrand Model is used to illustrate price
  competition in an oligopolistic industry with
  homogenous goods.

42
Price Competition
Bertrand Model

• Assumptions
• Homogenous good
• Market demand is P 30 - Q where
  Q Q1 Q2
• MC 3 for both firms and MC1 MC2 3

43
Price Competition
Bertrand Model

• Assumptions
• The Cournot equilibrium
• Assume the firms compete with price, not quantity.

44
Price Competition
Bertrand Model

• How will consumers respond to a price
  differential? (Hint Consider homogeneity)
• The Nash equilibrium
• P MC P1 P2 3
• Q 27 Q1 Q2 13.5

45
Price Competition
Bertrand Model

• Why not charge a higher price to raise profits?
• How does the Bertrand outcome compare to the
  Cournot outcome?
• The Bertrand model demonstrates the importance of
  the strategic variable (price versus output).

46
Price Competition
Bertrand Model

• Criticisms
• When firms produce a homogenous good, it is more
  natural to compete by setting quantities rather
  than prices.
• Even if the firms do set prices and choose the
  same price, what share of total sales will go to
  each one?
• It may not be equally divided.

47
Price Competition

• Price Competition with Differentiated Products
• Market shares are now determined not just by
  prices, but by differences in the design,
  performance, and durability of each firms
  product.

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Price Competition
Differentiated Products

• Assumptions
• Duopoly
• FC 20
• VC 0

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Price Competition
Differentiated Products

• Assumptions
• Firm 1s demand is Q1 12 - 2P1 P2
• Firm 2s demand is Q2 12 - 2P1 P1
• P1 and P2 are prices firms 1 and 2 charge
  respectively
• Q1 and Q2 are the resulting quantities they sell

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Price Competition
Differentiated Products

• Determining Prices and Output
• Set prices at the same time

51
Price Competition
Differentiated Products

• Determining Prices and Output
• Firm 1 If P2 is fixed

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Nash Equilibrium in Prices
P1
P2
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Nash Equilibrium in Prices

• Does the Stackelberg model prediction for first
  mover hold when price is the variable instead of
  quantity?
• Hint Would you want to set price first?

54
Competition Versus CollusionThe Prisoners
Dilemma

• Why wouldnt each firm set the collusion price
  independently and earn the higher profits that
  occur with explicit collusion?

55
Competition Versus CollusionThe Prisoners
Dilemma

• Assume

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Competition Versus CollusionThe Prisoners
Dilemma

• Possible Pricing Outcomes

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Payoff Matrix for Pricing Game
Firm 2
Charge 4
Charge 6
Charge 4
Firm 1
Charge 6
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Competition Versus CollusionThe Prisoners
Dilemma

• These two firms are playing a noncooperative
  game.
• Each firm independently does the best it can
  taking its competitor into account.
• Question
• Why will both firms both choose 4 when 6 will
  yield higher profits?

59
Competition Versus CollusionThe Prisoners
Dilemma

• An example in game theory, called the Prisoners
  Dilemma, illustrates the problem oligopolistic
  firms face.

60
Competition Versus CollusionThe Prisoners
Dilemma

• Scenario
• Two prisoners have been accused of collaborating
  in a crime.
• They are in separate jail cells and cannot
  communicate.
• Each has been asked to confess to the crime.

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Payoff Matrix for Prisoners Dilemma
Prisoner B
Confess
Dont confess
Confess
Prisoner A
Would you choose to confess?
Dont confess
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Payoff Matrix forthe P G Prisoners Dilemma

• Conclusions Oligipolistic Markets
• 1) Collusion will lead to greater profits
• 2) Explicit and implicit collusion is possible
• 3) Once collusion exists, the profit motive to
  break and lower price is significant

63
Implications of the PrisonersDilemma for
Oligipolistic Pricing

• Observations of Oligopoly Behavior
• 1) In some oligopoly markets, pricing behavior
  in time can create a predictable pricing
  environment and implied collusion may occur.

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Implications of the PrisonersDilemma for
Oligipolistic Pricing

• Observations of Oligopoly Behavior
• 2) In other oligopoly markets, the firms are
  very aggressive and collusion is not possible.
• Firms are reluctant to change price because of
  the likely response of their competitors.
• In this case prices tend to be relatively rigid.

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The Kinked Demand Curve
/Q
Quantity
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The Kinked Demand Curve
/Q
Quantity
MR
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Implications of the PrisonersDilemma for
Oligopolistic Pricing
Price Signaling Price Leadership

• Price Signaling
• Implicit collusion in which a firm announces a
  price increase in the hope that other firms will
  follow suit

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Implications of the PrisonersDilemma for
Oligopolistic Pricing
Price Signaling Price Leadership

• Price Leadership
• Pattern of pricing in which one firm regularly
  announces price changes that other firms then
  match

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Implications of the PrisonersDilemma for
Oligopolistic Pricing

• The Dominant Firm Model
• In some oligopolistic markets, one large firm has
  a major share of total sales, and a group of
  smaller firms supplies the remainder of the
  market.
• The large firm might then act as the dominant
  firm, setting a price that maximized its own
  profits.

70
Price Setting by a Dominant Firm
Price
Quantity
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Cartels

• Characteristics
• 1) Explicit agreements to set output and price
• 2) May not include all firms

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Cartels

• Characteristics
• 3) Most often international

• Examples of unsuccessful cartels
• Copper
• Tin
• Coffee
• Tea
• Cocoa

• Examples of successful cartels
• OPEC
• International Bauxite Association
• Mercurio Europeo

73
Cartels

• Characteristics
• 4) Conditions for success
• Competitive alternative sufficiently deters
  cheating
• Potential of monopoly power--inelastic demand

74
Cartels

• Comparing OPEC to CIPEC
• Most cartels involve a portion of the market
  which then behaves as the dominant firm

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The OPEC Oil Cartel
Price
Quantity
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Cartels

• About OPEC
• Very low MC
• TD is inelastic
• Non-OPEC supply is inelastic
• DOPEC is relatively inelastic

77
The OPEC Oil Cartel
Price
P
QOPEC
Quantity
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The CIPEC Copper Cartel
Price
Quantity
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Cartels

• Observations
• To be successful
• Total demand must not be very price elastic
• Either the cartel must control nearly all of the
  worlds supply or the supply of noncartel
  producers must not be price elastic

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Summary

• In a monopolistically competitive market, firms
  compete by selling differentiated products, which
  are highly substitutable.
• In an oligopolistic market, only a few firms
  account for most or all of production.

81
Summary

• In the Cournot model of oligopoly, firms make
  their output decisions at the same time, each
  taking the others output as fixed.
• In the Stackelberg model, one firm sets its
  output first.

82
Summary

• The Nash equilibrium concept can also be applied
  to markets in which firms produce substitute
  goods and compete by setting price.
• Firms would earn higher profits by collusively
  agreeing to raise prices, but the antitrust laws
  usually prohibit this.

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Summary

• The Prisoners Dilemma creates price rigidity in
  oligopolistic markets.
• Price leadership is a form of implicit collusion
  that sometimes gets around the Prisoners Dilemma.
• In a cartel, producers explicitly collude in
  setting prices and output levels.

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End of Chapter 12

• Monopolistic Competition and Oligopoly