Chapter 12 Monopolistic Competition and Oligopoly Monopolistic Competition

Chapter 12 Monopolistic Competition and Oligopoly

Monopolistic Competition n Characteristics 1) Many firms 2) Free entry and exit 3) Differentiated product

Monopolistic Competition n The amount of monopoly power depends on the degree of differentiation. n Examples of this very common market structure include: l Toothpaste l Soap l Cold remedies

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

A Monopolistically Competitive Firm in the Short and Long Run $/Q Short Run $/Q MC Long Run MC AC AC PSR PLR DSR DLR MRSR Quantity MRLR Quantity

A Monopolistically Competitive Firm in the Short and Long Run n Observations (short-run) l Downward sloping demand--differentiated product l Demand is relatively elastic--good substitutes l MR < P l Profits are maximized when MR = MC l This firm is making economic profits

A Monopolistically Competitive Firm in the Short and Long Run n Observations (long-run) l Profits will attract new firms to the industry (no barriers to entry) l The old firm’s demand will decrease to DLR l Firm’s output and price will fall l Industry output will rise l No economic profit (P = AC) l P > MC -- some monopoly power

Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium Monopolistic Competition Perfect Competition $/Q MC Deadweight loss AC MC AC P PC D = MR DLR MRLR QC Quantity QMC Quantity

Monopolistic Competition n Monopolistic Competition and Economic Efficiency l 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.

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

Oligopoly n Characteristics l Small number of firms l Product differentiation may or may not exist l Barriers to entry

Oligopoly n Examples l Automobiles l Steel l Aluminum l Petrochemicals l Electrical equipment l Computers

Oligopoly n The barriers to entry are: l Natural u Scale economies u Patents u Technology u Name recognition

Oligopoly n The barriers to entry are: l Strategic action u Flooding the market u Controlling an essential input

Oligopoly n Equilibrium in an Oligopolistic Market l In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price. l In oligopoly the producers must consider the response of competitors when choosing output and price.

Oligopoly n Equilibrium in an Oligopolistic Market l Defining Equilibrium u u 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.

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

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

Firm 1’s Output Decision If Firm 1 thinks Firm 2 will produce nothing, its demand curve, D 1(0), is the market demand curve. P 1 D 1(0) If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. MR 1(0) D 1(75) If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MR 1(75) MC 1 MR 1(50) 12. 5 25 D 1(50) 50 What is the output of Firm 1 if Firm 2 produces 100 units? Q 1

The Kinked Demand Curve $/Q If the producer raises price the competitors will not and the demand will be elastic. If the producer lowers price the competitors will follow and the demand will be inelastic. D Quantity MR

The Kinked Demand Curve $/Q So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MC’ MC P* D Quantity Q* MR

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

Cartels n Characteristics 3) Most often international l Examples of successful cartels u OPEC u International Bauxite Association u Mercurio Europeo l Examples of unsuccessful cartels u Copper u Tin u Coffee u Tea u Cocoa

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

Cartels n Observations l To be successful: u u Total demand must not be very price elastic Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic

End of Chapter 12 Monopolistic Competition and Oligopoly