Imperfect competition and strategic behaviour Monopolistic Competition and

Imperfect competition and strategic behaviour: Monopolistic Competition and Oligopoly 2012 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 1

Characteristics of Monopolistic Competition • A large number of firms: collusion not possible, independent firms (like PC). • Differentiated products. • Firms compete on product quality, price, marketing and branding. • Firms are free to enter and exit: small economies of scale, low set up costs . • Some market power Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 2

Short-Run Price and Output Determination • How much to produce? – MR = MC – Demand curve sets price • Profits or losses in the short run – Profits: When AC < AR (D )—entry of new firms – Losses: When AC > AR (D )—exit of existing firms Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 3

Short-Run Price and Output Determination: Short-Run Profits Price and Costs P MC Economic Profits AC D MR Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. Q 4

Short-Run Price and Output Determination: Short-Run Losses MC Price and Costs P AC Losses D MR Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. Q 5

Long Run • How much to produce? – MR = MC • Firms tend to break even, i. e. normal profit – Tangency solution: profit-maximising firm will produce an output when its demand curve is at a tangent to its AC curve – When AC = AR (D ) Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 6

Long-Run Equilibrium Price and Costs P MC AC D MR Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. Q 7

Monopolistic competition firm market diagram MC MR D Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 8

Excess Capacity and Markup Price & cost (dollars per French Connection jacket) 50 MC Price ATC 40 30 25 20 Markup 10 Marginal cost D Excess capacity 50 MR 75 Efficient scale 150 100 Quantity (French Connection jackets per day)

Monopolistic Competition & Economic Efficiency • Productive inefficiency: – Minimum ATC is not necessarily chosen – excess capacity • Allocative inefficiency: – price does not necessarily equal MC • Dynamic inefficiency – product variety and innovation Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 10

Non-Price Competition • Assists firms to improve their long-run equilibrium position • Product differentiation and product development • Marketing and adverting to increase demand • Price competition is a crash or crash through strategy. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 11

What is Oligopoly? • Oligopoly is a market structure in which a small number of firms compete, from the Greek “oligos” meaning few. • There a number of different models of oligopoly and we will look at three today.

Characteristics of Oligopoly • Product differentiation? Homogeneous products e. g. commodities and simple transformed manufactures or – differentiated product e. g. elaborately transformed manufactures – Depends where in the production chain the firm operates. – Product differentiation may be real or actual or perceived, think about the Toyota Harrier and the Lexus lx 350 – • Concentration ratios: The percentage of total industry sales accounted for by a given (small) number of the largest firms in each industry • Mutual interdependence Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 13

Characteristics of Oligopoly • Incentives to collude • Incentive to cheat • High Barriers to Entry (same as monopoly) – Economies of scale (and scope) – Ownership of patents, copyrights – Control of strategic raw materials – Technological progress – Super normal profits may exist, but these barriers prevent entry and hence the restoration of normal profits. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 14

Production differentiation; real/actual or perceived? Toyota harrier vs Lexus LX 350 Maybe the cost reflects different production costs, but do they explain the $60, 000 difference in price Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 15

Production differentiation; real/actual or perceived? Toyota Soarer SC 3000 vs Lexus Soarer SC 300 Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 16

1976 the First JVC VHS player 1975 the first Sony Betamax machine Product differentiation; Real or perceived Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 17

Commodities: Product differentiation? Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 18

One: The Kinked Demand: Non -Collusive Oligopoly Model • Output occurs where MR = MC • Price remains stable over a variety of cost scenarios Avoiding price wars – Firms ignore price increases – Firms match price decreases – • Criticisms How is the current price set? – Prices may not be as inflexible as the model suggests – Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 19

The Kinked Demand Curve P The firm’s demand marginal revenue curves MR 1 D 1 Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 20

The Kinked Demand Curve P The rival’s demand marginal revenue curves D 2 MR 1 D 1 Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. MR 2 21

The Kinked Demand Curve P Rivals tend to follow a price cut D 2 MR 1 D 1 Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. MR 2 22

The Kinked Demand Curve P Rivals tend to follow a price cut or ignore a price increase D 2 MR 1 D 1 Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. MR 2 23

The Kinked Demand Curve P Effectively creating… D 2 MR 1 D 1 Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. MR 2 24

The Kinked Demand Curve Effectively creating a kinked demand curve P D 2 MC 1 P MR 2 X Q MR 1 MC 2 D 1 Q Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 25

The original Sony walkman vs a cheap Sanyo clone, different production costs? Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 26

Collusion and Cartels • Incentives and opportunities to collude • Incentive to cheat, Visy and Amcor for example vs OPEC • Are illegal in Australia and you will go to jail and may be pay ha huge fine. • Enough said Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 27

Two: Oligopoly Behaviour: A Game Theory Approach • Compare the behaviour of oligopolists to a simple duopoly game of strategy, actions and pay-offs as shown in the profit pay-off matrix • Mutual interdependence – the fate of one firm lies partially or wholly with the performance or decisions of other firms in that same industry • Incentives to collude, reduce Q and increase P • Incentive to cheat, firms now have excess capacity and may be able to sell more than their quota and not get caught Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 28

Game theory and the economics of cooperation • Game theory is the study of how people behave in strategic situations. • Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

Game theory and the economics of cooperation • Because the number of firms in an oligopolistic market is small, each firm must act strategically. • Each firm knows that its profit depends not only on how much it produces, but also on how much the other firms produce.

The prisoners’ dilemma • The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation. • Often people (of firms) fail to cooperate with one another even when cooperation would make them all better off.

The prisoners’ dilemma • The prisoners’ dilemma is a particular 'game' between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

The prisoners’ dilemma Kelly’ s decision Confess Kelly gets 8 years Remain silent Kelly gets 20 years Confess Ned gets 8 years Ned’s decision Kelly goes free Ned goes free Kelly gets 1 year Remain Silent Ned gets 20 years Ned gets 1 year

The prisoners’ dilemma • The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. • Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

An oligopoly game Number 1 Toyota High Price High price Toyota $100 billion Nissan Toyota $40 billion Low price Nissan $150 billion Where is the Nash Equilibrium? Low price Toyota $150 billion Nissan $40 billion Toyota $50 billion Nissan $50 billion

An oligopoly game Number 2 Toyota High Price High price Toyota $100 billion Nissan Toyota $60 billion Low price Nissan $150 billion Where is the Nash Equilibrium? Low price Toyota $150 billion Nissan $60 billion Toyota $50 billion Nissan $50 billion

An oligopoly game Number 3 Toyota High Price High price Toyota $100 billion Nissan Toyota $40 billion Low price Nissan $90 billion Where is the Nash Equilibrium? Low price Toyota $ 90 billion Nissan $40 billion Toyota $50 billion Nissan $50 billion

Game theory and the economics of cooperation • Because the number of firms in an oligopolistic market is small, each firm must act strategically. • Each firm knows that its profit depends not only on how much it produces, but also on how much the other firms produce.

Game theory and the economics of cooperation • Game theory is the study of how people behave in strategic situations. • Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

The equilibrium for an oligopoly • A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

Oligopoly and Economic Efficiency • Productive inefficiency – Minimum ATC is not necessarily chosen < under-allocation of resources • Allocative inefficiency: – Price does not necessary equal MC < output is restricted Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 41

Three: Price leadership; tacit collusion • This is when one firm has a dominant position in the market and the firms with lower market shares follow the pricing changes prompted by the dominant firm. • We see examples of this with the major mortgage lenders and petrol retailers where most suppliers follow the pricing strategies of leading firms. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 42

Price leadership • If most of the leading firms in a market are moving prices in the same direction, it can take some time for relative price differences to emerge which might cause consumers to switch their demand. Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 43

Price leadership • Firms who market to consumers that they are “never knowingly undersold” or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion. Does the consumer really benefit from this? Probably not Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 44

Oligopoly and Economic Efficiency Dynamic efficiency: • Long-term improvements in product quality and production methods may occur • Technical progress Copyright 2004 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Microeconomics 7/e by Jackson and Mc. Iver Slides prepared by Muni Perumal, University of Canberra, Australia. 45