ECONOMICS EXPLORE APPLY by Ayers and Collinge Chapter

Learning Objectives 1. Explain the meaning and significance of mutual interdependence. 2. Identify the models associated with oligopoly. 3. Describe the characteristics of monopolistic competition. 4. Define product differentiation and state its implications. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2

Learning Objectives 5. Relate how and why firms charge some consumers more than others for the same products. 6. Explain why oligopoly brings economic change. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3

21. 1 OLIGOPLY • Oligopoly is characterized by multiple firms, one or more of which will produce a significant portion of industry output. • Oligopoly firms are mutually interdependent, with actions of one firm inducing other firms to take counteractions. • Oligopoly products may be differentiated or homogeneous. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 4

Oligopoly Products May Be Differentiated or Homogeneous • Differentiated Oligopolies: cigarettes and automobiles • Homogeneous Oligopolies: steel, aluminum, and copper © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5

Measuring Market Power 1. Market power is the ability of a firm to control the price it charges for its output. 1. Purely competitive firms have no market power, as they are price takers. 2. Monopoly firms have the most market power because they have no competition. 2. We must assess the market power of the firms that are neither purely competitive and monopolistic, and one method to measure market power is the four firm concentration ratio. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6

Measuring Market Power § To compute a four-firm concentration ratio: = Sales by four largest firms in an industry Sales by all firms in and industry § The larger the concentration ratio, the more market power the firms in the industry possess. § Concentration ratios do not take into account sales by foreign firms, nor do they account for differences in size among the four firms. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7

Measuring Market Power © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8

Mergers and Spin-offs 4 A merger occurs when one firm combines with another firm to form a single firm. 4 Horizontal merger occurs when an firm merges another in the same line of business. 4 Vertical Integration occurs when a firm acquires another firm that supplies it with an input. 4 Conglomerate Merger occurs when firms in unrelated businesses merge. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9

21. 2 OLIGOPOLY MODELS 1. Oligopoly is the only market structure for which there a variety of models. 2. Contestable markets occur when new rivals can enter or exit the market cheaply. 3. Price leadership model is based on observable oligopoly behavior. When one firm changes its selling price, the remaining firms in the industry. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10

Oligopoly Models 1. A Cartel is a form of oligopoly in which firms in an industry collude. 1. Collusion means that firms jointly plan price and output. 2. Cartels are illegal in the United States. 2. A dominant firm with a competitive fringe is an oligopoly model that combines the competitive and monopoly models © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11

Reasons for Difficulty in Keeping Cartels Together 4 Illegal in the U. S. 4 Any member has the incentive to cheat 4 Cartel members may drop out 4 High cartel profits may induce competition 4 Higher prices can lead to the development of substitute goods © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 12

The Nominal and Real Price of Oil production (percentage of world market) 50 Price ($ per barrel) 35 OPEC oil production 30 25 40 Nominal price 20 30 15 20 10 Real price 10 5 0 0 ’ 75 © 2004 Prentice Hall Publishing ’ 80 ’ 85 ’ 90 ’ 95 ‘ 00 Ayers/Collinge, 1/e 13

Oligopoly Models Marginal Competitive cost supply #3 The price #1 The firm's computes its from step #2 becomes the market price. Firmsresidual demand, the shortage in the competitive fringe are price The dominant firm with a competitive fringe takers at that price. The total quantity of output that would occur in the chooses its output and price in three steps: equals the quantity supplied by the competitive market at each fringe plus the quantity supplied by the price below the competitive dominant firm. Actual market equilibrium. occurs at this point, as other firms take this price Price competitive equilibrium. • • Competitive Dominant fringe firm’s quantity © 2004 Prentice Hall Publishing Total quantity Market quantity Dominant firm’s #2 The dominant firm chooses demand its quantity by equating marginal revenue to marginal Firm’s Marginal cost, which determines quantity revenue the price. Ayers/Collinge, 1/e 14

Game Theory • Game theory employs mathematics to analyze the behavior of parties whose interests conflict. This method may be employed to deepen the understanding of oligopoly behavior. • The tool of analysis is the payoff matrix. • An example of game theory is the prisoners dilemma. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 15

Game Theory Decision 1 √ ss fe con Decision 2 Al: Confess or keep quiet? Happy: Confess or keep quiet? √s es conf Happy Al 5 5 Keep Happy Al 1 20 quiet √ Ke ep qu iet Al: Confess or keep quiet? Outcome Prison sentence (years) ess conf Keep q Happy Al 20 1 Happy Al 3 3 uiet Prisoner’s Dilemma: Happy is better off confessing no matter what Al does. The outcome of these decisions is a prison sentence of 5 years apiece, as shown in the yellow boxes. Note that Al and Happy's collective interest is better served by collusion, in which they both keep quiet 16 © 2004 Prentice Hallto. Publishing Ayers/Collinge, 1/e and are sentenced 3 years each.

Game Theory Decision 1 Decision 2 ce ri hp Hig X-co: High or low price? Y-co: High or low price? rice p High Low p √ Lo w pri √ ce X-co: High or low price? rice p High rice Low p rice Outcome Profit (loss) X–co Y–co $10 m X–co Y–co $15 m ($5 m) X–co Y–co ($5 m) $15 m X–co Y–co $1 m √ firms face the dilemma of Prisoner’s Dilemma in a Two-Firm Oligopoly: These whether to price high or low. Their collective interest calls for a high price. In the 17 © 2004 of Prentice Hall Publishing absence collusion, however, their dominant strategies cause the. Ayers/Collinge, price to be 1/elow.

The Model of Kinked Demand • Prices in oligopoly sometimes seems “sticky”, meaning resistant to change. • The kinked demand curve model offers an explanation. • In this model, any firm that raises its price, loses a significant fraction of its customers to other firms that are assumed to keep their prices constant. • However if a firm lowers its price, it does not gain customers from other firms, because the other firms in the industry would feel the competitive need to lower their prices too. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18

The Kinked Demand Curve Dollars Marginal cost can shift, yet still intersect marginal revenue at the same quantity. Kink Price • Marginal Cost The demand curve As a kinked consequence, marginal model assumes that firms revenue is discontinuous match price decreases by their (vertical) at the quantity competitors, butthe dokink. not match associated with price increases. Firm’s Demand Profit maximizing quantity © 2004 Prentice Hall Publishing Marginal revenue Quantity Ayers/Collinge, 1/e 19

21. 3 MONOPOLISTIC COMPETITION q Monopolistic competition is a market characterized by many firms, product differentiation, and relatively easy entry of new firms. q Monopolistically competitive firms face a downward sloping demand curve that is less elastic than that of a purely competitive firm, but more elastic than that of a monopolist. q Specifically, each firm faces a demand curve that is highly elastic, which gives it a relatively flat appearance. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20

Monopolistic Competition q The firm’ demand curve is influenced by its own actions , and the actions of its competitors. q Monopolistically competitive firm’s have the incentive to advertise and vary their products as a way of increasing their demand at the expense of their competitors. q In the short-run monopolistically competitive firms will continue to enter or exit a market until a long-run equilibrium is reached in which additional entrants would expect additional profits. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 21

Output and Price in Monopolistic Competition Dollars Marginal Cost Price • • Marginal cost = marginal revenue Profitmaximizing quantity © 2004 Prentice Hall Publishing Under monopolistic competition, demand is much more elastic. As a result, the profit-maximizing output occurs close to the efficient output, given by the intersection of marginal cost and the firm’s demand. Firm’s Demand Marginal revenue Quantity Ayers/Collinge, 1/e 22

Profit, Loss, and Breakeven in Monopolistic Competition Dollars Marginal Cost Profitable firm Price • Profit • • Average cost Firm’s Demand Marginal revenue Profitmaximizing quantity © 2004 Prentice Hall Publishing Quantity Ayers/Collinge, 1/e 23

Profit, Loss, and Breakeven in Monopolistic Competition Dollars Marginal Cost Price Average cost Loss • • • Firm with a loss Firm’s Demand Marginal revenue Profitmaximizing quantity © 2004 Prentice Hall Publishing Quantity Ayers/Collinge, 1/e 24

Profit, Loss, and Breakeven in Monopolistic Competition Dollars Marginal Cost Price Average cost Firm that breaks even • • Firm’s Demand Marginal revenue Profitmaximizing quantity © 2004 Prentice Hall Publishing Quantity Ayers/Collinge, 1/e 25

21. 4 WAYS TO COMPLETE Ø The key to riches in monopolistic competition is successful product differentiation in such things as… Ø Size Ø Taste Ø Shape © 2004 Prentice Hall Publishing Ø Style Ø Color Ø Texture Ø Quality Ø Location Ø Packaging Ø Advertising Ø Service Ayers/Collinge, 1/e 26

Advertising and Product Differentiation v. If the marginal revenue generated by advertising exceeds the marginal cost of advertising, advertising raises profits. v. Otherwise it does not. v. The profit-maximizing firm will adjust its hours of operation, selection of merchandise, and every other aspect of product differentiation with this same principle in mind. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 27

Advertising to Shift Demand $ Advertising aims to strengthen preferences for the firm’s products.

Price Discrimination Under Monopolistic Competition and Oligopoly Price discrimination is selling a good or service at different prices when such differences are not cause by differences in production cost. Price discrimination is feasible when different prices can be charged to different market segments. A firm cannot practice price discrimination if buyers who buy at a low price, can resell those goods to other buyers at a higher price, which is a practice called arbitrage. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 29

21. 5 EXPLORE & APPLY Oligopoly –Changing Way of Life FOUR-FIRM CONCENTRATION RATIOS FOR RETAILING KIND OF BUSINESS CONCENTRATION COMMENT RATIO Discount department 87. 9 Highly concentrated, stores indicating probable oligopoly Radio, television, and 62. 3 Relatively high other electronics stores concentration ratio, indicating possible oligopoly Pharmacies and drug 46. 6 Moderate concentration stores ratio Clothing stores 25. 5 Fairly competitive Nursery and garden centers 12. 4 Competitive All retail firms 7. 9 Low concentration ratio indicates retailing is highly 30 © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e competitive

Oligopoly –Changing Way of Life TOP TEN U. S. RETAILERS FIRM SALES (IN BILLIONS OF DOLLARS) 1. Wal-Mart 2. Home Depot 3. Kroger 4. Sears, Roebuck, and Co. 5. Target Corp. 6. Albertson’s Inc. 7. K-Mart 8. Costco Wholesale Corp. 9. Safeway 10. J. C. Penney © 2004 Prentice Hall Publishing 219. 8 53. 55 50. 1 41. 1 39. 4 37. 9 37. 0 34. 8 34. 3 32. 0 Ayers/Collinge, 1/e 31

Terms along the Way • • • oligopoly mutually interdependent differentiated product monopolistic competition four-firm concentration ratio • merger • horizontal merger © 2004 Prentice Hall Publishing • • • vertical merger conglomerate merger contestable market price leadership cartel dominant firm with a contestable market • game theory • kinked demand curve • monopolistic competition Ayers/Collinge, 1/e 32

Test Yourself 1. Which is the best example of a vertical merger? a. A computer manufacturer merges with a computer store. b. Two book publishers merge. c. A jewelry store merges with a furniture store. d. A Cosmetics manufacturer merges with a pizza restaurant. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 33

Test Yourself 2. a. b. c. d. Price leadership describes a model of cartel

Test Yourself 3. Cartels are difficult to maintain over time for each of the following reasons, EXEPT that a. Individual members cheat by charging less than the cartel price. b. consumers substitute other goods for the product of the cartel. c. new competitors that are not cartel members may enter the market. d. legal barriers prohibit any member of the cartel from dropping out. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 35

Test Yourself 4. In the game theory model of oligopoly, prices a. are set with little concern for whether profits are maximized. b. are set strategically, as though firms are all playing in the same game. c. fall when cost rise, and when cost fall. d. remain stable in response to moderate changes in cost. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 36

Test Yourself 5. In which market structure do firms ALWAYS produce differentiated products? a. Pure competition. b. Monopoly. c. Monopolistic competition. d. Game theory. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 37

Test Yourself 6. a. b. c. d. Fast food restaurants are examples of pure

Test Yourself 7. a. b. c. Monopolistically competitive firms are mutually interdependent. are also called price takers. maximize profits by setting marginal revenue equal to marginal cost. d. are few in number. © 2004 Prentice Hall Publishing Ayers/Collinge, 1/e 39