Chapter 11 Monopolistic Competition and Oligopoly Mc GrawHillIrwin

Chapter 11 Monopolistic Competition and Oligopoly Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Objectives • Characteristics of monopolistic competition • Normal profit in the long run • Characteristics of oligopoly • Game theory • The oligopolist’s kinked demand curve • Collusion among oligopolists • The effects of advertising 11 -2

Monopolistic Competition • Large number of sellers – Small market shares – No collusion – Independent action • Differentiated Products – Product attributes – Service – Location – Brand names and packaging – Some control over price 11 -3

Monopolistic Competition • Easy entry and exit • Need for advertising – Nonprice Competition • Which industries? – Degree of concentration – Four-firm concentration ratio – Herfindahl index 11 -4

Monopolistic Competition • Firm’s demand curve – Highly elastic • Short run profit or loss – Produce where MR=MC • Long run normal profit – Entry and exit • Inefficient • Product variety 11 -5

Monopolistic Competition Short-Run Profits Price and Costs MC ATC P 1 A 1 Economic Profit D 1 MR = MC MR 0 Q 1 Quantity 11 -6

Monopolistic Competition Short-Run Losses Price and Costs MC ATC A 2 P 2 Loss D 2 MR = MC MR 0 Q 2 Quantity 11 -7

Monopolistic Competition Long-Run Equilibrium MC Price and Costs ATC P 3= A 3 D 3 MR = MC MR 0 Q 3 Quantity 11 -8

Monopolistic Competition P=MC=Min ATC for pure competition (recall) Price and Costs MC ATC P 3= A 3 P 4 Price is Lower D 3 MR = MC Excess Capacity at Minimum ATC 0 MR Q 3 Q 4 Quantity Monopolistic competition is not efficient 11 -9

Oligopoly • A few large producers • Homogeneous or differentiated products • Control over price – Mutual interdependence – Strategic behavior • Entry barriers • Mergers 11 -10

Oligopoly • Four-firm concentration ratio – Needs to be more than 40% – Half of U. S. manufacturing • Localized markets • Interindustry competition • World trade – Import Competition • Herfindahl index 11 -11

Game Theory Rare. Air’s Price Strategy High Uptown’s Price Strategy • 2 competitors • 2 price strategies • Each strategy has a payoff matrix • Greatest combined profit • Independent actions stimulate a response A $12 Low B $15 High $12 C $6 $6 D $8 Low $15 $8 11 -12

Game Theory Rare. Air’s Price Strategy High Uptown’s Price Strategy • Independently lowered prices in expectation of greater profit leads to the worst combined outcome • Eventually low outcomes make firms return to higher prices A $12 Low B $15 High $12 C $6 $6 D $8 Low $15 $8 11 -13

Game Theory • Mutual interdependence –Pricing policy • Collusion –Enhances profit • Incentive to cheat • Prisoner’s dilemma 11 -14

Three Oligopoly Models • • Kinked-demand curve Collusive pricing Price leadership Why three models? – Diversity of oligopolies – Complications of interdependence 11 -15

Kinked-Demand Curve • Noncollusive oligopoly • Strategies – Match price changes – Ignore price changes • Combined strategy • Price inflexibility • The kinked-demand curve 11 -16

Kinked-Demand Curve Price Rivals Ignore Price Increase P 0 e f D 2 Rivals Match g Price Decrease 0 Q 0 MR 1 Quantity MR 2 Price and Costs Competitor and rivals strategize versus each other Consumers effectively have 2 partial demand curves and each part has its own marginal revenue part MC 1 D 2 P 0 MR 2 e f MC 2 g D 1 0 Q 0 MR 1 Quantity Resulting in a kinked-demand curve to the consumer – price and output are optimized at the kink 11 -17

Kinked-Demand Curve • Criticisms of the model – How does price get to P 0 – Explains inflexibility, not price – Prices are not that rigid – Price wars 11 -18

Cartels and Other Collusion • Price and output – Joint profit maximization Price and Costs MC Effectively Sharing The Monopoly Profit P 0 ATC A 0 MR=MC Economic Profit D MR Q 0 Quantity 11 -19

The OPEC Cartel Daily oil production (barrels) , November 2008 Saudi Arabia Iran Kuwait Venezuela Iraq Nigeria UAE Angola Libya Algeria Qatar Indonesia Ecuador 8, 904, 000 3, 843, 000 2, 538, 000 2, 368, 000 2, 297, 000 2, 183, 000 2, 117, 000 1, 804, 000 1, 737, 000 1, 417, 000 848, 000 843, 000 530, 000 Source: A. T. Kearney, Foreign Policy 11 -20

Cartels and Other Collusion • Covert collusion – Tacit understandings • Obstacles to collusion – Demand cost differences – Number of firms – Cheating – Recession – Potential entry – Legal obstacles: antitrust law 11 -21

Price Leadership Model • • • Leadership tactics Infrequent price changes Communications Limit pricing Breakdowns in price leadership: – Price wars 11 -22

Advertising • Prevalent in monopolistic competition and oligopoly • Capture market share • Better than a price cut • Information for consumers • Manipulation 11 -23

Oligopoly and Advertising The Largest U. S. Advertisers, 2006 Company Advertising Spending Millions of $ Proctor and Gamble AT&T General Motors Time Warner Verizon Ford Motor Glaxo. Smith. Kline Walt Disney Johnson & Johnson Unilever Source: Advertising Age $4898 3345 3296 3089 2822 2577 2444 2320 2291 2098 11 -24

Oligopoly and Advertising World’s Top 10 Brand Names, 2007 Coca-Cola Microsoft IBM General Electric Nokia Toyota Intel Mc. Donald’s Disney Mercedes-Benz Source: Interbrand 11 -25

Oligopoly and Efficiency • Not productively efficient • Not allocatively efficient • Tendency to share the monopoly profit • Qualifications – Increased foreign competition – Limit pricing – Technological advance 11 -26

Oligopoly in the Beer Industry • From hundreds to a few firms • Demand side changes – Taste shifts to lighter beers – Shift from tap to cans or bottles • Supply side changes – Technological change increased minimum efficient scale – National brands enjoy cost advantages • Consolidation into oligopoly 11 -27

Key Terms • monopolistic competition • product differentiation • nonprice competition • four-firm concentration ratio • Herfindahl index • excess capacity • oligopoly • homogeneous oligopoly • differentiated oligopoly • • • strategic behavior mutual interdependence interindustry competition import competition game theory collusion kinked-demand curve price war cartel price leadership 11 -28

Next Chapter Preview… Technology, R&D, And Efficiency 11 -29