Monopolistic Competition and Oligopoly CHAPTER 10 2003 SouthWesternThomson

Monopolistic Competition and Oligopoly CHAPTER 10 © 2003 South-Western/Thomson Learning 1

Characteristics of Monopolistic Competition Characteristics Many producers offer products that are either close substitutes but are not viewed as identical Each supplier has some power over the price it charges are price makers Low barriers to entry firms in the long run can enter or leave the market with ease enough sellers that they behave competitively Sellers act independently of each other 2

Product Differentiation Sellers differentiate their products in four basic ways Physical differences and qualities Location Accompanying services Product image 3

Short-Run Profit Maximization or Loss Minimization Because products are a somewhat different product, each has some control over price each firm’s demand curve slopes downward Since many firms are selling close substitutes, any firm that raises its price can expect to lose some customers, but not all, to rivals demand is more elastic than a monopolist’s but less elastic than a perfect competitors 4

Price Elasticity of Demand The price elasticity of the monopolistic competitor’s demand depends on The number of rival firms that produce similar products The firm’s ability to differentiate its product from those of its rivals A firm’s demand curve will be more elastic the greater the number of competing firms and the less differentiated its product 5

Marginal Revenue Equals Marginal Cost The downward-sloping demand curve means that the marginal revenue curve also slopes downward and lies beneath the demand curve The cost curves are similar to those developed in perfect competition and monopoly 6

Zero Economic Profit in the Long Run Since there are low barriers to entry in monopolistic competition, short-run economic profit will attract new entrants in the long run Because new entrants offer products that are similar to those offered by existing firms, they draw some customers away from existing firms the demand facing each firm declines and becomes more elastic since there are more substitutes for each firm’s product 7

Zero Economic Profit in the Long Run Because of the ease of entry, monopolistically competitive firms earn zero economic profit in the long run In the cases of losses that persist, some monopolistic competitors will leave the industry their customers will switch to the remaining firms increasing the demand for each remaining firm’s demand curve and making it less elastic 8

Comparison How does monopolistic competition compare with perfect competition in terms of efficiency? In the long run, neither can earn economic profit However, a difference arises because of the different demand curves facing individual firms in each of two market structures 9

Comparison Firms in monopolistic competition are said to have excess capacity, since production is lower than the rate that would be associated with the lowest average cost Alternatively, excess capacity means that each producer could easily produce more and in the process would lower the average cost the marginal value of increased output would exceed its marginal cost greater output would increase economic welfare 10

Comparison Another differences is that although the cost curves in the previous exhibit are identical, firms in monopolistic competition spend more on advertising and other promotional expenses to differentiate their products These higher costs shift up their average cost curves 11

Comparison Some argue that monopolistic competition results in too many suppliers and in product differentiation that is often artificial The counterargument is that consumers are willing to pay a higher price for greater selection That is, consumers are willing to pay a higher price for greater selection Consumers benefit from the wider choice 12

Oligopoly refers to a market structure that is dominated by just a few firms Because an oligopoly has only a few firms, each must consider the effect of its own actions on competitors’ behavior the firms in an oligopoly are interdependent There a variety of oligopolies 13

Varieties of Oligopoly The product can be homogeneous across producers or differentiated across producers The more homogeneous the products, the greater the interdependence among the few dominant firms in the industry Products can be differentiated by physical qualities, sales locations, services provided with the product and the image of the product 14

Varieties of Oligopoly Because of interdependence among firms in an industry, the behavior of any particular firm is difficult to analyze Each firm knows that any changes in its product quality, price, output, or advertising policy may prompt a reaction from its rivals Domination by a few firms can often be traced to some form of barrier to entry 15

Economies of Scale Perhaps the most significant barrier to entry is economies of scale Recall that the minimum efficient scale is the lowest rate of output at which the firm takes full advantage of economies of scale If a firm’s minimum efficient scale is relatively large compared to industry output, then only one or a few firms are needed to produce the total output demanded in the market 16

High Cost of Entry The total investment needed to reach the minimum size is often gigantic which may pose another problem for potential entrants into oligopolistic industries Advertising a new product enough to compete with established brands may also require enormous outlays High start-up costs and established brand names can create substantial barriers to entry, especially since the fortunes of a new product are so uncertain 17

High Cost of Entry Product differentiation expenditures create barriers to entry Oligopolists often compete with existing rivals and try to block new entry by offering a variety of models and products Firms often spend billions trying to differentiate their products Some of these expenditures have the beneficial effects of providing valuable information to consumers and offering them a wide variety of products 18

Models of Oligopolies The interdependence of firms in an oligopoly makes analyzing their behavior complicated no one model or approach explains the outcomes At one extreme, the firms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartel At the other extreme, they may compete so fiercely that price wars erupt 19

Models of Oligopoly While there are many theories, we will focus our attention on three of the better-known approaches Collusion Price Leadership Game Theory Each approach has some relevance, although none is entirely satisfactory as a general theory Each is based on the diversity of observed behavior in an interdependent market 20

Collusion is an agreement among firms in the industry to divide the market and fix the price A cartel is a group of firms that agree to collude so they can act as a monopolist and earn monopoly profits Colluding firms usually reduce output, increase price, and block the entry of new firms 21

Collusion and cartels are illegal in the United States; some other countries are more tolerant and some countries even promote cartels OPEC 22

Cartel Model To maximize cartel profit, output must be allocated so that the marginal cost for the final unit produced by each firm is identical Any other allocation would lower cartel profits However, this is much easier said than done in practice 23

Differences in Cost If all firms have identical costs, output and profit are easily allocated across firms each firm produces the same quantity However, if costs differ, as is normally the case, problems arise The greater the differences in average costs across firms, the greater will be the differences in economic profits among firms 24

Differences in Cost If cartel members try to equalize each firm’s total profit, a high-cost firm would need to sell more than a low-cost firm But this allocation scheme violates the cartel’s profit-maximizing condition of finding the output for each firm that results in identical marginal costs across firms if average costs differ across firms, the output allocation that maximizes cartel profit will yield unequal profit across cartel members 25

Number of Firms in the Cartel The more firms in the industry, the more difficult it is to negotiate an acceptable allocation of output among them Consensus becomes harder to achieve as the number of firms grows the greater the chances are that one or more will become dissatisfied with the cartel and break the agreement 26

New Entry Into the Industry If a cartel cannot block the entry of new firms into the industry, new entry will eventually force prices down, squeezing economic profit and undermining the cartel The profit of the cartel attracts entry, entry increases market supply market price is forced down 27

Cheating Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement By offering a price slightly below the established price, a firm can usually increase its sales and economic profit Because oligopolists usually operate with excess capacity, some cheat on the established price 28

Summary Establishing and maintaining an effective cartel will be more difficult If the product is differentiated among firms If costs differ among firms If there are many suppliers in the industry If entry barriers are low, and If cheating on the agreement becomes widespread 29

Price Leadership An informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition Price leader also initiates price changes 30

Price Leadership Obstacles in price leadership industries The practice usually violates U. S. antitrust laws The greater the product differentiation among sellers, the less effective price leadership will be as a means of collusion There is no guarantee that other firms will follow the leader if other firms do not follow, the leader risks losing sales Some firms will try to cheat on the agreement by cutting price to increase sales and profits Unless there are barriers to entry, a profitable price will attract entrants 31

Game Theory Game theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms It analyzes the behavior of decisionmakers, or players, whose choices affect one another Provides a general approach that allows us to focus on each player’s incentives to cooperate or not 32

Prisoner’s Dilemma Two thieves, Ben and Jerry, are caught near the scene of a robbery The police believe they are guilty but they need a confession Each thief faces a choice of confessing or denying any knowledge of the crime If only one confesses he is granted immunity and goes free other gets the maximum of 10 years If both deny the crime, each gets a 1 year sentence and if both confess, each gets 5 years 33

Prisoner’s Dilemma What will each do? The answer depends on the assumptions about their behavior that is, what strategy each pursues A strategy reflects a player’s game plan In the prisoner’s dilemma, each player tries to save his own skin by minimizing his time in jail, regardless of what happens to the other Exhibit 6 shows the payoff matrix for the game 34

Payoff Matrix Payoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues Each prisoner pursues one of two strategies, confessing or clamming up Ben’s strategies are shown along the left margin and Jerry’s across the top The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies 35

Payoff Matrix The number above the diagonal shows Ben’s sentence in years and the number below the diagonal show Jerry’s sentence What strategies are rational assuming that each player tries to minimize jail time? Ben’s perspective: you know that Jerry will either confess or clam up. Suppose Jerry confesses, if you confess also, you both get 5 years, but if you deny involvement you get 10 years while Jerry walks if Ben thinks Jerry will confess, he should also 36

Price Setting Game The prisoner’s dilemma applies to a broad range of economic phenomena such as pricing policy and advertising strategy Consider the market for gasoline in a rural community with only two gas stations a duopoly Suppose customers are indifferent between the two brands and consider only the price 37

Price Setting Game Each station sets its daily price early in the morning before knowing the price set by the other Suppose only two prices are possible a low price and a high price If both charge the low price, they split the market and each earns a profit of $500 per day If both charge the high price, they also split the market and earn $700 profit If one charges the high price but the other the low one, the low price station earns a profit of $1, 000 and the other $200 38

Price Setting Game If each firm thinks other firms in the cartel will stick with their quotas, they can increase their profits by cutting price and increasing quantities If you think other firms will cheat and overproduce, they you should too Either way your incentive as a cartel member is to cheat on the quota 39

One-Shot versus Repeated Games The outcome of a game often depends on whether it is a one-shot game or the repeated game The classic prisoner’s dilemma is a oneshot game the game is to be played only once However, if the same players repeat the prisoner’s dilemma, as would likely occur in the price setting game, other possibilities unfold 40

One-Shot versus Repeated Games In a repeated-game setting, each player has a chance to establish a reputation for cooperation and thereby can encourage the other player to do the same The cooperative solution makes both players better off than if they fail to cooperate 41

Tit-for-Tat Strategy Experiments show that the strategy with the highest payoff in repeated games turns out to be the tit-for-tat strategy You begin by cooperating in the first round of play On every round thereafter you cooperate if the other player cooperated in the previous round, and you cheat if your opponent cheated in the previous round 42

Oligopoly and Perfect Competition Since there is no typical model of oligopoly, no direct comparison with perfect competition is available However, we can imagine an experiment in which we took the many firms in a competitive industry and, through a series of mergers, combine them to form, say, four firms How would the behavior of firms in this industry differ before and after the merger 43

Oligopoly and Perfect Competition Price is usually higher under oligopoly With fewer competitors after the merger, remaining firms would become more interdependent they will try to coordinate pricing policies if they engage in some sort of implicit or explicit collusion, industry output would be lower and price would be higher than under perfect competition Higher profits under oligopoly If there are barriers to entry into the oligopoly, profits will be higher than under perfect competition in the long run 44