7 Between Competition and Monopoly Outline Monopolistic Competition

7 Between Competition and Monopoly

Outline ● Monopolistic Competition ● Oligopoly ● Monopolistic Competition, Oligopoly, and Public Welfare ● A Glance Backward: Comparing the Four Market Forms

Three Real World Puzzles 1. Why are there so many retailers? ● 2. E. g. , intersections with 4 gas stations which is more than # of cars warrants. Why and how do they all stay open? Why do oligopolists advertise more than competitive firms? ● 3. E. g. , many big Co. use ads to battle for customers and ad budgets account for a huge portion of TC. Vs. farmers where few if any farms spend $ on ads. Why do oligopolists seem to ∆P so infrequently? ● E. g. , ∆P commodities hourly but ∆P cars or refrigerators only a few times a year. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Characteristics of Monopolistic Competition 1. 2. 3. 4. Many small buyers and sellers Freedom of entry and exit Perfect information Heterogeneous products: each seller’s product differs somewhat from every other seller’s product. ♦ ♦ E. g. , Diff. in packaging, services, or consumers’ perceptions. Only characteristic that differs from perfect competition. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Monopolistic Competition ● D curve facing firm has (-) slope. ♦ Each seller’s product is different –they are not perfect substitutes. ♦ ↑P will drive away some but not all of firm’s customers. Or ↓P will attract some but not all customers from rival firms. ● Freedom of entry and exit → firms cannot earn econ Π in LR. ♦ SR Π > 0 → new firms enter and ↓P until P = AC. ● Most U. S. firms are in this market structure. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Determination of Price and Output under Monopolistic Competition ● Recall when D has (-) slope → P > MR. ● Profit-max Q is where MR = MC. ● Analysis looks like pure monopoly, but monop. comp. firm (with rivals producing close substitutes) has a much flatter D curve. ● LR: Π = 0 → each firm produces where P = AC. So firm’s D curve must be tangent to its AC curve. ● Zero econ. Π in LR is seen in real world. ♦ E. g. , Gas station owners do not earn higher Π than small farmers under perfect competition. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

FIGURE 1. Short-Run Equilibrium Under Monopolistic Competition Π-max Q =12, 000 and P = $3. 50 MC Price per Gallon AC $3. 80 $3. 50 3. 40 $3. 00 P C E D MR 12, 000 Gallons of Gasoline per Week Per unit Π = $0. 10 → total Π = $1, 200.

FIGURE 2. Long-Run Equilibrium Under Monopolistic Competition MC Price per Gallon AC SR profits in Fig. 1 → new firms enter which shifts each firm’s D curve down until P = AC. Compared with SR profits in Fig. 1: $3. 45 $3. 35 P a. P is lower in LR M b. more firms in industry; each produces a smaller Q with higher AC. E D MR 10, 000 15, 000 Gallons of Gasoline per Week

The Excess Capacity Theorem ● In Fig. 2, AC at LR Q of firm (pt P) > min AC (pt M). ● Pt M is where LR Q of a perf. comp. firm would be. ● In LR, monop. comp. firm is producing where ↓AC but has not yet reached its min. ● Monopolistic competition leads to firms that have unused or wasted capacity. ● Resolve puzzle 1 –abundance of retailers: intersection with 4 gas stations where 2 would suffice and operate at lower AC is real world ex. of excess capacity. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

The Excess Capacity Theorem ● Fewer firms in a monop. comp. market → each firm could ↑Q and ↓AC. ● Yet, fewer firms with larger quantities means there is less variety of product. ● Greater efficiency would be achieved at the cost of greater standardization. ● Not clear society would be better off with fewer firms. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Oligopoly Defined ● Oligopoly = market dominated by a few sellers, where several are large enough to affect market P. ● Great rivalry among firms with new product intros, free samples, and agro marketing campaigns. ● Degree of product differentiation varies by industry: none in steel plates but lots in cars. ● Some industries also contain large # of smaller firms (e. g. , soft drinks) but they are dominated by a few large firms that get bulk of industry sales. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Oligopoly Defined ● Firms strive to create unique products (in terms of features, location, or appeal) to shield themselves from competition that ↓P and ↓sales. ● More intense competition than pure competition. ♦ E. g. , A corn farmer doesn’t make tough P decisions. He accepts market P and reacts by picking Q. ♦ A farmer doesn’t need to advertise. He can sell as much as he likes at current market P. ♦ A farmer doesn’t worry about P policies his rivals are planning. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Oligopoly Defined ● Oligopolists have some influence over market P, so they must consider rivals’ P; spend a fortune on ads; and try to predict their rivals’ actions. ● Resolve puzzle 2 –why oligopolists advertise and perfectly competitive firms do not. 1. Comp. firms can sell as much as they want at current P, so why advertise? Vs. Toyota faces a (-) sloped D curve, so it must ↓P or ↑ads (try to shift D out) to sell more cars. 2. Products are identical, so farm A’s ads might ↑ sales of farm B. Vs. Toyota’s ads may ↑ its sales and ↓ sales of rival carmakers. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Why Oligopolistic Behavior is So Difficult to Analyze ● Largest firms can impact P and all firms must watch rivals’ actions. ● Analysis is difficult as firms’ decisions are interdependent and oligopolists know that outcomes of their decisions depend on rivals’ responses. ♦ E. g. , Toyota’s managers know that their actions will cause reactions by Honda which may require Toyota to adjust its plans. ● Oligopolies have a variety of behavior patterns which requires different models to understand their behavior. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Models of Oligopoly ● Different models to understand Oligopoly behavior: ♦ ♦ ♦ ♦ Ignore interdependence Strategic interaction Cartels Price leadership and tacit collusion Sales maximization Kinked demand curve Game theory Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Ignoring Interdependence ● Simplest model ● Firms behave as if their actions will not spark reactions from rivals. ● Each firm seeks to max profits and assumes its P-Q decision will not affect its rivals’ strategy. ● Analyze oligopoly in the same way as pure monopoly. ● This doesn’t explain most oligopoly behavior! Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Strategic Interaction ● ● Consider 2 soap makers: X and Y. X ↓P to $4. 05 and assumes Y will continue its P = $4. 12 Say Qx = 5 m and X spends $1 m on ads. X may be surprised when Y cuts P to $4. 00; ↑Qy to 8 m and sponsors the Super Bowl. ● This ↓Πx and X wishes it didn’t cut P in first place. ● X cannot afford to ignore how Y will react. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Cartels ● All firms agree to set P and Q → act as pure monopolist. ● OPEC began making joint decisions in 1970’s and has been successful over time at ↓Q oil and ↑P oil. ● Cartels are difficult to organize and hard to enforce. ♦ Each member must produce small Q assigned by group. But once high P is established, every firm is tempted to cheat by ↑Qs. When cheating is suspected, cartel quickly falls apart as others ↑Qs which ↓P. ● Considered worse than monopoly. Cartel charges monopoly P without the cost savings from large scale production. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Price Leadership and Tacit Collusion ● Overt collusion (where firms meet to pick P-Q) is illegal in the U. S. and rare. But tacit collusion is common. ● Each tacitly colluding firm hopes that if it does not rock the boat (via ↓P or ↑ads), then rivals will do same. ● Price leadership = 1 firm makes P decisions for group. ♦ Other firms are expected to adopt P of leader without any explicit agreement. ♦ P leader is often largest firm in industry. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Sales Maximization: Model with Interdependence Ignored ● Firms may attempt to max revenue rather than profit if: ♦ control is separated from ownership ♦ compensation of managers is related to size of the firm ● Q set where MR = 0 (rather than MR = MC) ♦ Recall: MR is slope of TR curve. So TR is max when MR = 0. If MR > 0 → ↑Q to ↑TR and if MR < 0 → ↓Q to ↑TR. ● Compared to profit-max firm: ♦ Higher Q ♦ Lower P Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

FIGURE 3. Sales-Max Equilibrium Π-max Q = 2. 5 m where MR = MC MC. P = $4. 00 and total Π = $0. 20 x 2. 5 m = $500, 000. AC Sales-max Q = 3. 75 m where E Price per Box $4. 00 3. 80 MR = 0. P = $3. 75 and total Π = $0. 06 x 3. 75 m = $225, 000. F 3. 75 3. 69 Total Π (TR) is lower (higher) at point F than point E. A D B 2. 5 3. 75 Millions of Boxes per Year MR

? The Kinked Demand Curve Model ● Resolve puzzle 3 –why do P in oligopolistic markets (cars or appliances) change less often than P of commodities (wheat or gold)? ● Firms think that other firms will match any P cut, but not any P increase. If true, firms face an inelastic D curve with P cuts and an elastic curve with P increases. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

? The Kinked Demand Curve Model ● In Fig. 4, pt A is firm’s initial P = $8. ● 2 D curves pass through pt A. ♦ DD is more elastic → rivals’ P are fixed ♦ dd is less elastic → rivals match ∆P ● If firm ↓P to $7 (and rivals don’t match ↓P) → large ↑customers, so new Qd = 1, 400. ● If rivals match ↓P → ↑Qd is small, so new Qd = 1, 100. ● If firm ↑P (and rivals don’t match ↑P) → large ↓Qd. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

? The Kinked Demand Curve Model ● The firm’s true demand curve in Fig. 4 is DAd –a kinked demand curve. ● P tend to “stick” to their original level because ↑P → lose many customers and ↓P → gain very few customers. ● Firm will only ∆P if costs change enormously. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

FIGURE 4. The Kinked Demand Curve Price d D $8 7 Typical oligopoly fears the worst. If firm cuts P then rivals will match P cut → relevant demand curve is dd. But if firm raises P then rival will not match the P increase → relevant demand curve is DD. Thus, the firm’s true demand curve is the red line “DAd. ” A D (Competitors’ prices are fixed) (Competitors d respond to price changes) 0 1, 000 1, 100 Quantity per Year 1, 400

? The Kinked Demand Curve Model ● ● MR is associated with DD and mr is associated with dd. Overall marginal revenue curve is DBCmr. MC = MR at pt E which shows Π-max Q for oligopolist. Since relevant MR curve is kinked, even a moderate shift in MC will leave Q and thereby P unchanged. ● Oligopoly prices are “sticky” and do not respond to minor cost changes. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

FIGURE 5. The Kinked Demand Curve and Sticky Prices d MC Price D A $8 B D E MR C 1, 000 Quantity Supplied per Year mr d

The Game-Theory Approach ● Most widely used approach to analyze oligopoly behavior. ● Each oligopolist is seen as a competing player in a game of strategy. ● Optimal strategies are determined by examining a payoff matrix showing Π of each firm depending on P strategy that each firm follows. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Games with Dominant Strategies ● Dominant strategy = one that gives the bigger payoff to the firm that selects it, no matter which of the two strategies the competitor selects. ♦ E. g. , Table 1. , both firms have an incentive to pick low P strategy regardless of what other firm does. If B picks high P, then A receives largest payoff choosing low P. Or if B picks low P, then A receives the largest payoff by choosing low P. ♦ “Low Price” is the dominant strategy for both firms, so both charge a low P and each earns $3 m. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

TABLE 1. Payoff Matrix with Dominant Strategies Firm B Strategy High Price Low Price High Price A gets $10 m B gets $10 m A gets -$2 m B gets $12 m Low Price A gets $12 m B gets -$2 m A gets $3 m B gets $3 m Firm A Strategy

Games with Dominant Strategies ● A market with a duopoly serves public interest better than a monopoly because of the competition created between two firms. ♦ Both firms would be better off if they could charge high P. But the presence of a competitor, forces each firm to protect itself by charging low P. ● It is damaging to the public to allow rival firms to collude on what prices to charge for their products. ♦ E. g. , if two firms collude in Table 1, then we end up with high P and each earning $10 m. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Games without Dominant Strategies ● Maximin = select the strategy that yields the max payoff assuming your rival does as much damage to you as he can. ● In Table 2, A’s maximin strategy is to pick low P and earn $5 m. ♦ Firm A thinks: if I chose a high P → worst outcome is B picks a low P and I get $3 m. If I chose a low P → worst outcome is B picks a low P and I get $5 m. ♦ Firm A picks the strategy that offers the best of those bad outcomes. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

TABLE 2. A Payoff Matrix without a Dominant Strategy Firm B Strategy Firm A Strategy High Price Low Price High Price A gets $10 m A gets $3 m Low Price A gets $8 m A gets $5 m

Repeated Games ● Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. ● Table 1 shows a single round of the game. Each firm picked low P. But if games are repeated, players can escape this trap. ♦ E. g. , Firm A could cultivate a reputation of “tit for tat. ” Each time B charges a high P → A would charge a high P. After a few repetitions, B learns that A always matches its P decisions. So B will see that it’s better to stick with a high P. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Threats and Credibility ● Use threats to induce rivals to change their behavior. ♦ E. g. , retailer could threaten to double Q and ↓P to $0 if a rival imitates its product. But this is not credible, because it hurts the retailer who is making the threat. ● A credible threat is a threat that does not harm the threatener if it is carried out. ● Old firms often use credible threats to prevent new firms from entering the industry. ♦ E. g. , old firm will build a larger factory than it would otherwise want. Large factory lowers cost of ↑Q –even at low P. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

FIGURE 6. Entry and Entry-Blocking Strategy Possible Choices of Old Firm Possible Reactions of New Firm r Ente tory c a g. F ll Fa ctor y – 2 4 0 2 2 6 0 Don’t E nter Bi Sma Profits (millions $) Old Firm New Firm Ente Don r ’t En ter

Threats and Credibility ● In Fig. 6, best outcome for old firm is to have a small factory and no rivals. ♦ But if old firm builds a small factory, it can count on new firm entering to earn $2 m. So old firm’s ↓Π to $2 m. ● If old firm builds a big factory, its ↑Q will ↓P and ↓Π. Old firm now earns $4 m if new firm stays out. ♦ Clearly, new firm will stay out to avoid loses of $2 m. ● Thus, old firm should build big factory to keep rivals out. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Monopolistic Competition, Oligopoly, & Public Welfare ● Oligopolistic behavior is so varied that it is hard to come to a simple conclusion about welfare implications. ● In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum. ● Excess capacity theorem suggests monopolistic competition can lead to inefficiently high production costs. ● Oligopolists may organize into successful cartels to ↓Q and ↑P. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Monopolistic Competition, Oligopoly, & Public Welfare ● When an oligopolistic market is perfectly contestable – if firms can enter and exit without losing $ they invested –then (P, Q) of firms is likely to be socially efficient. ♦ ● E. g. , airplanes, trucks, and barges can easily be moved. Constant threat of entry forces oligopolists to keep their prices down and their costs low. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Comparing the Four Market Forms ● Perfect competition and pure monopoly are rare. ● Most firms are monopolistically competitive, but oligopoly firms account for largest share of economy’s output. ● Π = 0 in LR under perfect competition and monopolistic competition because of free entry and exit. ♦ Thus, P = AC in LR under these 2 market forms. ● Π-max firm under any market form selects Q by setting MR = MC. ♦ However, oligopolists may not set MC = MR when choosing Q –e. g. , if firm max sales. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Comparing the Four Market Forms ● Perfectly competitive firm and industry efficient allocation of resources. ● Monopoly inefficient allocation of resources by ↓Q and ↑P. ● Monopolistic competition inefficient allocation of resources through excess capacity. ● Under oligopoly, almost anything can happen, impossible to generalize about its vices or virtues. Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

TABLE 3. Attributes of the Four Market Forms