Chapter 12 Monopolistic Competition Oligopoly and Strategic Pricing

Chapter Objectives n 1. Describe two methods of determining market structure. n 2. List

Chapter Objectives n 4. State the central element of oligopoly. n 5 a. Explain

Chapter Objectives n 6. Illustrate a strategic decision facing a duopolist using the prisoner’s

Introduction n Market structure involves the number of firms in the market and the

Defining a Market n Defining a market has problems: n What is an industry

Classifying Industries n One of the ways in which economists classify markets is by

Classifying Industries n Industries are classified by government using the North American Industry Classification

Concentration Ratio n The concentration ratio is the percentage of industry sales by the

Herfindahl Index n The Herfindahl index is an index of market concentration calculated by

Monopolistic Competition n The four distinguishing characteristics of monopolistic competition are: q Many sellers.

Output, Price, and Profit n A monopolistically competitive firm produces in the same manner

Output, Price, and Profit n If price exceeds ATC, the firm will earn positive

Output, Price, and Profit n Entry causes the existing firm’s demand curve to shift

Output, Price, and Profit n At the long-run equilibrium, ATC equals price and economic

Monopolistic Competition: Short Run Price P 1 C 1 MC ATC 1 MR 0

Monopolistic Competition: Short Run Price MC ATC 2 ATC 1 P 2 C 1

Monopolistic Competition: Long Run Price MC P 1 P 2 P 3 =C 3

Comparing Monopolistic Competition and Perfect Competition n Both the monopolistic competitor and the perfect

Comparing Monopolistic Competition and Perfect Competition Price MC ATC D PC 0 Monopolistic Competition

Excess Capacity n The Excess Capacity theorem indicates that a monopolistically competitive firm will

Characteristics of Oligopoly n Oligopolies are made up of a small number of very

Cartel Model n In the cartel model of oligopoly, q q q Oligopolies act

Implicit Price Collusion n Formal collusion is illegal in Canada, but informal collusion is

Why Are Prices Sticky? n Sticky prices are prices that don’t change very much.

Kinked Demand Curve Model n Assumption 1: If a firm raises its price, no

Kinked Demand Curve Model n Assumption 2: If a firm lowers its price, all

Kinked Demand Curve Model No-one follows a price increase. Price a P b MC

Kinked Demand Curve Model n A high-cost firm and a low-cost firm will both

Contestable Market Model n According to the contestable market model, barriers to entry and

Strategic Pricing and Oligopoly n Both the cartel and contestable market models use strategic

Cooperative Equilibrium MC ATC $800 700 600 500 400 Price 575 Price $800 300

One Firm Cheats MC ATC $800 700 700 600 550 500 400 300 A

Payoff Matrix A Does not cheat A Cheats A +$200, 000 A $75, 000

Payoff Matrix n If both firms cooperate, they can both get higher profits. q

Payoff Matrix n A dominant strategy is one which always yields the highest payoff,

Payoff Matrix n If both firms choose to cheat on their agreement, the outcome

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Monopolistic Competition, Oligopoly, and Strategic Pricing End of Chapter 12 © 2006 Mc. Graw-Hill

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Chapter 12: Monopolistic Competition, Oligopoly, and Strategic Pricing Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 1

Chapter Objectives n 1. Describe two methods of determining market structure. n 2. List four distinguishing characteristics of monopolistic competition. n 3 a. Demonstrate graphically the equilibrium of a monopolistic competitor. 3 b. Discuss how differentiated products relate to the excess capacity theorem. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 2

Chapter Objectives n 4. State the central element of oligopoly. n 5 a. Explain sticky prices using the kinked demand model of oligopoly. 5 b. Explain why decisions in the cartel model depend on market share and decisions in the contestable market model depend on barriers to entry. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 3

Defining a Market n Defining a market has problems: n What is an industry and what is its geographic market? q n Local, national, or international? What products are to be included in the definition of an industry? © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 6

Classifying Industries n One of the ways in which economists classify markets is by cross-price elasticities. n Cross-price elasticity measures the responsiveness of the change in demand for a good to change in the price of a related good. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 7

Classifying Industries n Industries are classified by government using the North American Industry Classification System (NAICS). n The North American Industry Classification System (NAICS) is a classification system of industries adopted by Canada, Mexico, and the U. S. in 1997. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 8

Herfindahl Index n The Herfindahl index is an index of market concentration calculated by adding the squared values of the individual market shares of all the firms in the industry. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 10

Monopolistic Competition n The four distinguishing characteristics of monopolistic competition are: q Many sellers. q Differentiated products. q Multiple dimensions of competition. q Easy entry of new firms in the long run. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 11

Output, Price, and Profit n A monopolistically competitive firm produces in the same manner as a monopolist—to maximize profit, it chooses the quantity where MC = MR. n Having determined output, the firm will charge what consumers are willing to pay (determined by the demand curve). © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 12

Output, Price, and Profit n If price exceeds ATC, the firm will earn positive economic profits. n These profits attract entry. n Some customers of the existing firms switch to become customers of the new firm. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 13

Output, Price, and Profit n Entry causes the existing firm’s demand curve to shift left (decrease) as they lose customers. n Competition, therefore, implies zero economic profit in the long run. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 14

Output, Price, and Profit n At the long-run equilibrium, ATC equals price and economic profits are zero. n This occurs at the point of tangency of the ATC and demand curve at the output chosen by the firm. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 15

Comparing Monopolistic Competition and Perfect Competition n Both the monopolistic competitor and the perfect competitor make zero economic profit in the long run. n A monopolistic competitor produces less than a perfect competitor. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 19

Comparing Monopolistic Competition and Perfect Competition Price MC ATC D PC 0 Monopolistic Competition QC Quantity MC ATC PM PC 0 © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. QM MR D QCQuantity 20

Excess Capacity n The Excess Capacity theorem indicates that a monopolistically competitive firm will have excess capacity in long-run equilibrium. n It occurs because of product differentiation. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 21

Characteristics of Oligopoly n Oligopolies are made up of a small number of very large firms. n Products may be homogeneous or differentiated n Firms are mutually interdependent. n Each firm must take into account the expected reaction of other firms. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 22

Cartel Model n In the cartel model of oligopoly, q q q Oligopolies act as if they were monopolists That have assigned output quotas to individual member firms So that total output is consistent with joint profit maximization. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 23

Implicit Price Collusion n Formal collusion is illegal in Canada, but informal collusion is permitted. n Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 24

Why Are Prices Sticky? n Sticky prices are prices that don’t change very much. n Informal collusion is an important reason why prices are sticky. n Another is the kinked demand curve. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 25

Kinked Demand Curve Model n Assumption 1: If a firm raises its price, no other firms will raise their prices. n This make the firm’s own demand curve very elastic. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 26

Kinked Demand Curve Model n Assumption 2: If a firm lowers its price, all the other firms will lower their prices too. n This make the firm’s own demand curve very inelastic. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 27

Kinked Demand Curve Model n A high-cost firm and a low-cost firm will both produce the same quantity and charge the same price. n If a firm’s costs decrease, consumers will not see any change. q n Price will not decrease. The firm’s profits will increase. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 29

Contestable Market Model n According to the contestable market model, barriers to entry and barriers to exit determine a firm’s price and output decisions. q Even if the industry contains a very small number of firms, it could still be a competitive market if entry is open. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 30

Strategic Pricing and Oligopoly n Both the cartel and contestable market models use strategic pricing decisions – firms set their prices based on the expected reactions of other firms. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 31

Cooperative Equilibrium MC ATC $800 700 600 500 400 Price 575 Price $800 300 200 100 1 2 3 4 5 6 7 8 Competitive solution D 0 MR 1 2 Quantity (in thousands) (a) Firm's cost curves MC 300 200 0 Monopolist solution 3 4 5 6 7 8 9 10 11 Quantity (in thousands) (b) Industry: Competitive and monopolist solution © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 32

One Firm Cheats MC ATC $800 700 700 600 550 500 400 300 A 400 Price A Price $800 $900 MC ATC 300 200 100 1 2 3 4 5 6 7 Quantity (in thousands) (a) Noncheating firm’s loss 0 1 2 3 4 5 0 6 7 Quantity (in thousands) (b) Cheating firm’s profit B A Non. Cheating 400 cheating firm’s output 300 output 200 0 C 1 2 3 4 5 6 7 8 Quantity (in thousands) (c) Cheating solution © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 33

Payoff Matrix n If both firms cooperate, they can both get higher profits. q n $75, 000 each. However, both firms have an incentive to cheat on their agreement. q $200, 000 for the one that cheats. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 35

Payoff Matrix n A dominant strategy is one which always yields the highest payoff, no matter what the other player does. n The dominant strategy is to not cooperate. q i. e. to cheat. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 36

Payoff Matrix n If both firms choose to cheat on their agreement, the outcome will be a Nash equilibrium, a non-cooperative equilibrium in which no player can achieve a better outcome by switching strategies, given the strategy of the other player. © 2006 Mc. Graw-Hill Ryerson Limited. All rights reserved. 37