PRINCIPLES OF ECONOMICS Third Edition Oxford Fajar Sdn

PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 1

CHAPTER 8 MARKET STRUCTURE 2: MONOPOLISTIC COMPETITION AND OLIGOPOLY PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 2

MONOPOLISTIC COMPETITION q Definition – Market structure in which there are large numbers of small sellers selling differentiated products but these are close substitute products and have easy entry into and exit from the market. q Characteristics – Large number of and sellers – there is a large number of sellers under the monopolistic competition and no individual firm can influence the market price. However, each firm follows an independent priceoutput policy. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 3

MONOPOLISTIC COMPETITION (cont. ) – Differentiated products – product differentiation could be through packaging, design, labelling, advertising and brand name. – Free of entry and exit into the market – not as easy as perfect competition because of the existence of product differentiation. – Role of non-price competition is significant – various methods used to attract the customers to buy a particular brand. – Selling cost – different types of expenditure on advertisement would incur additional cost. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 4

MONOPOLISTIC COMPETITION (cont. ) The demand curve for monopolistic competitive firm is downward sloping due to product differentiation. Price AR=P Demand curve for monopolistic competitive firm is more elastic than demand curve for monopolist firm because in monopolistic competition there are many firms and many substitutes. MR Quantity PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 5

PROFIT MAXIMIZATION IN SHORT RUN Monopolistic competitive firm earns economic profit At this output, the firm earns economic profit or supernormal profit equal to the shaded area. Price (RM) The profit maximization level occurs where MR curve and MC curve intersects at Point A. MC To find the price, we use the same vertical line with output up to the demand curve. The profit maximizing price and output is ATC AR AC P* and Q*. PROFIT A DD = AR MR Q* PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 Economic profit or supernormal profit is the profit earned by a monopolist competitive firm when TR > TC. Quantity All Rights Reserved 8– 6

PROFIT MAXIMIZATION IN SHORT RUN (cont. ) Monopolistic competitive firm at break-even Price (RM) The profit maximization level occurs where MR curve and MC curve intersects at Point A. At this output, monopolistic competitive firm is at the breakeven or earns normal profit. MC ATC The profit maximizing price and output is P* and Q*. AC/AR Normal profit or break-even is earned when TR = TC. A DD = AR MR Q* PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 Quantity All Rights Reserved 8– 7

PROFIT MAXIMIZATION IN SHORT RUN (cont. ) Monopolistic competitive firm suffers economic losses Price (RM) AC AR Economic losses or subnormal profit is the losses incurred by a monopolistic competitive firm when TR < TC. At this output, monopolist suffers economic losses or subnormal profit equal to the shaded area. ATC MC The profit maximization level occurs where MR curve and MC curve intersect at Point A. LOSSES The profit maximizing price and output is P* and Q*. A DD = AR MR Q* PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 Quantity All Rights Reserved 8– 8

PROFIT MAXIMIZATION IN LONG RUN Monopolistic competitive firm earns normal profit in long run Price (RM) A monopolistic competitive firm earns normal profit in the long run due to free entry and exit. LRMC LRATC P* A DD = LRAR LRMR Q* PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 Quantity All Rights Reserved 8– 9

OLIGOPOLY q Definition – Market structure in which there are only a few firms selling either standardized or differentiated products and it restricts the entry into and exit from the market. q Characteristics – Few numbers of firms – the number of firms is small but size of the firms is large. – Homogeneous or differentiated product – Mutual interdependence – firms in an oligopoly market always consider the reaction of their rivals when choosing price, sales target, advertising budgets and other business policies. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 10

OLIGOPOLY (cont. ) – Barriers to entry – restrict new entrants into the market through various types of barriers to entry such as control of certain resources, ownership of patent and copyright, exclusive financial requirements and other legal barriers. q Price Rigidity and Kinked Demand Curve – Since there is mutual interdependence between oligopoly firms, the prices in the market are more stable. This is called price rigidity in oligopoly market. – The price rigidity explains the behaviour of an oligopoly firm that has no incentive to increase or decrease the price. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 11

OLIGOPOLY (cont. ) – The theory of the kinked demand curve is based on two assumptions. First assumption: If an oligopolist reduces its price, its rivals will follow and cut their prices to prevent losing the customers. 2. Second assumption: If an oligopolist increases its price, its rivals do not increase the price and keep their prices the same, thereby they gain customers from the firm that increases the price. 1. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 12

OLIGOPOLY (cont. ) q Price Leadership – Price leadership means the pricing strategy in which the firms in an oligopolistic industry follow the price set by the leading firm. – Price leadership is one form of collusion under oligopoly. – There is no formal or tacit agreement. – There are two types of price leadership: • Dominant price leadership – The dominant price leadership firm may be the largest firm that dominates the overall industry. – The dominant price leader firm can act as a monopoly where it sets its price to maximize profits; other firms will set their prices at the same level. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 13

OLIGOPOLY (cont. ) • Barometric price leadership – One firm will be the first to announce price change. This firm does not dominate the industry. – Its price will be followed by others. q Cartel – A cartel is a group of firms whose objective is to limit the scope of competitiveness in the market. – Cartel arises because firms want to eliminate uncertainty and improve profits by stabilizing market shares and prices, reducing competitiveness and eliminating promotional cost. – The most famous cartel is Organization of Petroleum Exporting Countries (OPEC). PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 14

OLIGOPOLY (cont. ) – Cartel agreement is an arrangement among the oligopoly firms to cooperate with one another to act together as a monopoly. – An ideal cartel will be powerful to establish monopoly price and earns supernormal profits. – Profits are divided among firms based on their individual level of production. – Each firm sells at different quantities and obtains different profits depending on the level of AC at the point of production. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 15

OLIGOPOLY (cont. ) q Non-price Competition – Non-price competition is the means for growing market share and profitability in the face of new rivals through advertising, marketing, after sales service, free gift and others. – The difference with price cuts by oligopoly firm and nonprice competition. – Opting for price cut – If a firm reduces a price of a product, it can attract customers, and establish in the industry. • Reactions of competitors – the reaction from rivals are quick by reducing their prices. There is a risk of price war if the price reduction continues. However, customers are better off. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 16

OLIGOPOLY (cont. ) – Opting for non-price competition – This strategy will attract more customers to the firm. • Reactions of competitors – the reaction from rivals toward non-price competition is slow and less direct. The firms will gain more advantages if it practices non-price competition because product variation, improvements in quality and successful advertising techniques cannot be duplicated so easily. Some consumers are more attracted to the advertisement and quality of the product compared to price. PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 17

SUMMARY OF MARKET STRUCTURE Characteristics Number of sellers Perfect competition Monopoly Monopolistic competition Large One Type of product Identical or homogenous Unique or no Differentiated close substitution Homogenous or differentiated Entry condition Very easy Impossible Easy Difficult Control price None Some Considerable Examples Wheat, corn Local phone Food, clothing service, electricity Automobiles, cigarettes Profit maximization MR = MC over PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 Many Oligopoly MR = MC Few All Rights Reserved 8– 18

SUMMARY OF MARKET STRUCTURE (cont. ) Characteristics Perfect competition Monopoly Monopolistic competition Oligopoly Subnormal, supernormal or normal profit Normal profit due to free entry and exit Subnormal, supernormal or normal profit Supernormal profit because of barriers to entry Production efficiency (at minimum AC) Yes No No No Shut down S/run: AR<AVC L/run: AR< AC S/run: AR<AVC L/run: AR< AC Short run equilibrium Long run equilibrium PRINCIPLES OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974 -T), 2013 All Rights Reserved 8– 19