Monopolistic Competition and Oligopoly

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12
CHAPTER
Monopolistic Competition and Oligopoly
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

• Explain how price and quantity are determined in
  monopolistic competition.

Explain why selling costs are in monopolistic
competition.
Explain the dilemma faced by firms in oligopoly.
Use game theory to explain how price and quantity
are determined in oligopoly.
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12.1 MONOPOLISTIC COMPETITION

• Monopolistic competition is a market structure in
  which
• A large number of firms compete.
• Each firm produces a differentiated product.
• Firms compete on price, product quality, and
  marketing.
• Firms are free to enter and exit.

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12.1 MONOPOLISTIC COMPETITION

• Large Number of Firms
• Like perfect competition, the market has a large
  number of firms. Three implications are
• Small market share
• No market dominance
• Collusion impossible

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12.1 MONOPOLISTIC COMPETITION

• Product Differentation
• Product differentiation is making a product that
  is slightly different from the products of
  competing firms.
• A differentiated product has close substitutes
  but it does not have perfect substitutes.
• When the price of one firms product rises, the
  quantity demanded of that firms product
  decreases.

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12.1 MONOPOLISTIC COMPETITION

• Competing on Quality, Price, and Marketing
• Quality
• Design, reliability, after-sales service, and
  buyers ease of access to the product.
• Price
• Because of product differentiation, the demand
  curve for the firms product is downward sloping.
• Marketing
• Advertising and packaging

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12.1 MONOPOLISTIC COMPETITION

• Entry and Exit
• No barriers to entry.
• So the firm cannot make economic profit in the
  long run.

• Identifying Monopolistic Competition
• Two indexes
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index

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12.1 MONOPOLISTIC COMPETITION

• The Four-Firm Concentration Ratio
• The four-firm concentration ratio is the
  percentage of the value of sales accounted for by
  the four largest firms in the industry.
• The range of concentration ratio is from almost
  zero for perfect competition to 100 percent for
  monopoly.
• A ratio that exceeds 60 percent is an indication
  of oligopoly.
• A ratio of less than 40 percent is an indication
  of a competitive marketmonopolistic competition.

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12.1 MONOPOLISTIC COMPETITION

• The Herfindahl-Hirschman Index
• The Herfindahl-Hirschman Index (HHI) is the
  square of the percentage market share of each
  firm summed over the largest 50 firms in a
  market.
• Example, four firms with market shares as 50
  percent, 25 percent, 15 percent, and 10 percent.
• HHI 502 252 152 102 3,450
• A market with an HHI less than 1,000 is regarded
  as competitive and between 1,000 and 1,800 is
  moderately competitive.

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12.1 MONOPOLISTIC COMPETITION

• How, given its costs and the demand for its
  jeans, does Tommy Hilfiger decide the quantity of
  jeans to produce and the price at which to sell
  them?
• The Firms Profit-Maximizing Decision
• The firm in monopolistic competition makes its
  output and price decision just like a monopoly
  firm does.
• Figure 12.1 on the next slide illustrates this
  decision.

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12.1 MONOPOLISTIC COMPETITION
1. Profit is maximized when MR MC.
2. The profit-maximizing output is 125 pairs of
Tommy jeans per day.
3. The profit-maximizing price is 75 per pair.
ATC is 25 per pair, so
4. The firm makes an economic profit of 6,250 a
day.
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12.1 MONOPOLISTIC COMPETITION

• Long Run Zero Economic Profit
• Economic profit induces entry and economic loss
  induces exit, as in perfect competition.
• Entry decreases the demand for the product of
  each firm.
• Exit increases the demand for the product of each
  firm.
• In the long run, economic profit is competed away
  and firms earn normal profit.
• Figure 12.2 on the next slide illustrates
  long-run equilibrium.

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12.1 MONOPOLISTIC COMPETITION
1. The output that maximizes profit is 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 is zero.
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12.1 MONOPOLISTIC COMPETITION

• Monopolistic Competition and Efficiency
• Efficiency requires that marginal benefit (price)
  equal marginal cost.
• In monopolistic competition, price exceeds
  marginal costa sign of inefficiency.
• But this inefficiency arises from product
  differentiationvarietythat consumers value and
  for which they are willing to pay.
• So in a broader view, monopolistic competition
  brings gains to consumers.

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12.1 MONOPOLISTIC COMPETITION

• Firms in monopolistic competition always have
  excess capacity in the long run.
• Excess Capacity
• A firm has excess capacity if the quantity it
  produces is less that the quantity at which
  average total cost is a minimum.
• A firms efficient scale is the quantity of
  production at which average total cost is a
  minimum.
• Figure 12.3 on the next slide shows the firms
  excess capacity in the long-run equilibrium.

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12.1 MONOPOLISTIC COMPETITION
1. The efficient scale is 100 pairs of jeans a
day.
2. In the long run, the firm produces less than
the efficient scale and has excess capacity.
3. Price exceeds 4. marginal cost.
5. Deadweight loss arise.
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12.2 DEVELOPMENT AND MARKETING

• Innovation and Product Development
• Wherever economic profits are earned, imitators
  emerge.
• To maintain economic profit, a firm must seek out
  new products.
• Cost Versus Benefit of Product Innovation
• The firm must balance the cost and benefit at the
  margin.

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12.2 DEVELOPMENT AND MARKETING

• Efficiency and Product Innovation
• Regardless of whether a product improvement is
  real or imagined, its value to the consumer is
  its marginal benefit, which equals the amount the
  consumer is willing to pay.
• The marginal benefit to the producer is the
  marginal revenue, which in equilibrium equals
  marginal cost.
• Because price exceeds marginal cost, product
  improvement is not pushed to its efficient level.

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12.2 DEVELOPMENT AND MARKETING

• Marketing
• Firms in monopolistic competition spend a large
  amount on advertising and packaging their
  products.
• Marketing Expenditures
• A large proportion of the prices that we pay
  cover the cost of selling a good.
• Figure 12.4 on the next slide shows some
  estimates of marketing expenditures for some
  familiar markets.

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12.2 DEVELOPMENT AND MARKETING
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12.2 DEVELOPMENT AND MARKETING

• Selling Costs and Total Costs
• Selling costs such as advertising costs increase
  the costs of a monopolistically competitive firm
  above those of a perfectly competitive firm or a
  monopoly.
• Advertising costs are fixed costs.
• Advertising costs per unit decrease as production
  increases.
• Figure 12.5 on the next slide illustrates the
  effects of selling costs on total cost.

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12.2 DEVELOPMENT AND MARKETING
1. When advertising costs are added to
2. The average total cost of production,
3. Average total cost increases by a greater
amount at small outputs than at large outputs.
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12.2 DEVELOPMENT AND MARKETING

• 4. If advertising enables sales to increase from
  25 pairs of jeans a day to 100 pairs a day, it
  lowers the average total cost from 60 a pair to
  40 a pair.

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12.2 DEVELOPMENT AND MARKETING

• Selling Costs and Demand
• Advertising and other selling efforts change the
  demand for a firms product.
• The effects are complex
• A firms own advertising increases the demand for
  its product.
• Advertising by all firms might decrease the
  demand for any one firms product and make demand
  more elastic.
• The price might fall.

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12.2 DEVELOPMENT AND MARKETING

• Efficiency The Bottom Line
• Because price exceeds marginal cost, monopolistic
  competition creates deadweight lossan indicator
  of inefficiency.
• Price exceeds marginal cost because of product
  differentiation. But product variety is valued.
• The bottom line is ambiguous. But compared to the
  alternative, monopolistic competition looks
  efficient.

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12.3 OLIGOPOLY

• Another market type that stands between perfect
  competition and monopoly.
• Oligopoly is a market type in which
• A small number of firms compete.
• Natural or legal barriers prevent the entry of
  new firms.

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12.3 OLIGOPOLY

• In contrast to monopolistic competition and
  perfect competition, an oligopoly consists of a
  small number of firms.
• Each firm has a large market share
• The firms are interdependent
• The firms have an incentive to collude

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12.3 OLIGOPOLY

• Collusion
• A cartel is a group of firms acting together to
  limit output, raise price, and increase economic
  profit.
• Cartels are illegal but they do operate in some
  markets.
• To study oligopoly, we look at the special case
  of duopoly.
• A duopoly is a market in which there are only two
  producers.

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12.3 OLIGOPOLY

• Duopoly in Airplanes
• Airbus and Boeing are the only makers of large
  commercial jets.
• Monopoly Outcome
• If this industry had only one firm, it would
  operate as a single-price monopoly.
• Figure 12.6 on the next slide shows the monopoly
  outcome.

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12.3 OLIGOPOLY
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12.3 OLIGOPOLY

• The Duopolists Dilemma

To achieve the monopoly profit, Airbus and Boeing
might attempt to form a cartel.
If the firms can agree to produce the monopoly
output of 6 airplanes a week, joint profits will
be 72 million .
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12.3 OLIGOPOLY

• Would it be in the self-interest of Airbus and
  Boeing to stick to the agreement and limit
  production to 3 planes a week each?
• With price exceeding marginal cost, one firm can
  an increase its profit by increasing its output.
• If both firms increased output when price exceeds
  marginal cost, the end of the process would be
  the same as perfect competition.

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12.3 OLIGOPOLY

• Perfect Competition
• Equilibrium occurs where the marginal revenue
  curve intersects the demand curve.
• The quantity produced is 12 planes a week and the
  price would be 1 million a plane.
• Figure 12.6 shows the perfect competition outcome
  and the range of possible oligopoly outcomes.

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12.3 OLIGOPOLY
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12.3 OLIGOPOLY
Boeing Increases Output to 4 Airplanes a Week

• Boeing can increase its economic profit by 4
  million, from 36 million to 40 million.

And cause the economic profit of Airbus to fall
by 6 million, from 36 million to 30 million.
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12.3 OLIGOPOLY

• Airbus Increases Output to 4 Airplanesa Week

For Airbus, this outcomeis an improvement on the
previous one by 2 milliona week.
For Boeing, the outcomeis worse than the
previous one by 8 million a week.
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12.3 OLIGOPOLY

• Boeing Increases Output to 5 Airplanesa Week

If Boeing increases output to 5 airplanes a week,
its economic profit falls.
Similarly, if Airbus increases output to 5
airplanes a week, its economic profit falls.
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12.3 OLIGOPOLY

• The Dilemma
• If both firms stick to the monopoly output, they
  each produce 3 airplanes and make 36 million.
• If they both increase production to 4 airplanes a
  week, they make 32 million each.
• If only one firm increases production to 4
  airplanes a week, that firm makes 40 million.
• What do they do?
• Game theory provides an answer.

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12.4 GAME THEORY

• Game theory
• The tool used to analyze strategic
  behaviorbehavior that recognizes mutual
  interdependence and takes account of the expected
  behavior of others.

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12.4 GAME THEORY

• What Is a Game?
• All games involve three features
• Rules
• Strategies
• Payoffs
• Prisoners dilemma
• 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.

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12.4 GAME THEORY

• The Prisoners Dilemma
• Art and Bob been 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, the
  DA makes the prisoners play a game.

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12.4 GAME THEORY

• Rules
• Players cannot communicate with one another.
• If both confess to the larger crime, each will
  receive a sentence 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 a10-year sentence.
• If neither confesses, both receive a 2-year
  sentence.

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12.4 GAME THEORY

• Strategies
• The strategies of a game are all the possible
  outcomes of each player.
• The strategies in the prisoners dilemma are
• Confess to the bank robbery.
• Deny the bank robbery.

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12.4 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 payoffs
  for every possible action by each player given
  every possible action by the other player.

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12.4 GAME THEORY

• Table 12.5 shows the prisoners dilemma payoff
  matrix for Art and Bob.

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12.4 GAME THEORY

• Equilibrium
• Occurs when each player takes the best possible
  action given the action of the other player.
• Nash equilibrium
• An equilibrium in which each player takes the
  best possible action given the action of the
  other player.

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12.4 GAME THEORY

• The Nash equilibrium for Art and Bob is to
  confess.
• Not the Best Outcome
• The equilibrium of the prisoners dilemma is not
  the best outcome.

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12.4 GAME THEORY

• The Duopolists Dilemma as a Game
• Each firm has two strategies. It can produce
  airplanes at the rate of
• 3 a week
• 4 a week

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12.4 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 4 a
  week.
• Boeing produces 3 a week and Airbus produces 4 a
  week.

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12.4 GAME THEORY

• The Payoff Matrix
• Table 12.6 shows the payoff matrix as the
  economic profits for each firm in each possible
  outcome.

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12.4 GAME THEORY

• Equilibrium of the Duopolists Dilemma
• Both firms produce 4 a week.

Like the prisoners, the duopolists fail to
cooperate and get a worse outcome than the one
that cooperation would deliver.
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12.4 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 an international oil cartel, OPEC, countries
  frequently break the cartel agreement and
  overproduce.

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12.4 GAME THEORY

• Advertising and Research Games in Oligopoly
• Advertising campaigns by Coke and Pepsi, and
  research and development (RD) competition
  between Procter Gamble and Kimberly-Clark are
  like the prisoners dilemma game.

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12.4 GAME THEORY
Advertising Game

• Coke and Pepsi have two strategies advertise or
  not advertise.

Table 16.8 shows the payoff matrix as the
economic profits for each firm in each possible
outcome.
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12.4 GAME THEORY

• The Nash equilibrium for this game is for both
  firms advertise.

• But they could earn a larger joint profit if they
  could collude and not advertise.

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12.4 GAME THEORY
Research and Development Game

• PG and Kimberly-Clark have two strategies spend
  on RD or do no RD.
• Table 16.9 shows the payoff matrix as the
  economic profits for each firm in each possible
  outcome.

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12.4 GAME THEORY
The Nash equilibrium for this game is for both
firms to undertake RD.
But they could earn a larger joint profit if they
could collude and not do RD.
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12.4 GAME THEORY

• Repeated Games
• Most real-world games get played repeatedly.
• Repeated games have a larger number of strategies
  because a player can be punished for not
  cooperating.
• This suggests that real-world duopolists might
  find a way of learning to cooperate so that they
  can enjoy monopoly profit.
• The next slide shows the payoffs with a
  tit-for-tat response.

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12.4 GAME THEORY

• Week 1 Suppose Boeing contemplates producing 4
  planes a week.
• Boeings profit will increase from 36 million to
  40 million and Airbuss profit will decrease
  from 36 million to 30 million.
• Week 2 Airbus punishes Boeing and produces 4
  planes a week.

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12.4 GAME THEORY

• But Boeing must go back to 3 planes a week to
  induce Airbus to cooperate in week 3.
• In week 2, Airbuss profit is 40 million and
  Boeings profit is 30 million.
• Over the two weeks, Boeings profit would have
  been 72 million if it cooperated but only 70
  million with Airbuss tit-for-tat response.

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12.4 GAME THEORY

• In reality, where a duopoly works like a one-play
  game or a repeated game depends on the number of
  players and the ease of detecting and punishing
  overproduction.
• The larger the number of players, the harder it
  is to maintain the monopoly outcome.

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12.4 GAME THEORY

• Is Oligopoly Efficient?
• In oligopoly, price usually exceeds marginal
  cost.
• So the quantity produced is less than the
  efficient quantity.
• Oligopoly suffers from the same source and type
  of inefficiency as monopoly.
• Because oligopoly is inefficient, antitrust laws
  and regulations are used to try to reduce market
  power and move the outcome closer to that of
  competition and efficiency.

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A Game in YOUR Life
The payoff matrix here describes a game that
might be familiar to you the lovers dilemma.
Jane and Jim like to do things together. But Jane
likes the movies more than the ball game, and Jim
likes the ball game more than movies.
What do they do?
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A Game in YOUR Life
You can figure out that Jim never goes to the
movies alone and Jane never goes to the game
alone.
So they out together. To the movies or the ball
game?
This game, unlike the prisoners dilemma, has no
unique equilibrium.
What do the payoffs tell you?