Monopolistic Competition

Ref. Ch 17 of the text book

What is Monopolistic Competition?

Monopolistic competition is a market structure in which: Large number of firms (sellers) are there Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc Differentiated products produced by the different firms. Each firm produces a product that is at least slightly different from those of other firms. Rather than being a price taker, each firm faces a downward-sloping demand curve. Multiple dimensions of competition. Entry and exit occur easily The number of firms in the market adjusts until economic profits 2 are zero

Output, Price, and Profit of a Monopolistic Competitor in the short run

A monopolistically competitive firm prices in the same manner as a monopolist where MC = MR.

But the monopolistic competitor is not only a monopolist but a competitor as well.

A Monopolistically Competitive Firm: Above Normal Profit

A Monopolistically Competitive Firm: Normal Profit

A Monopolistically Competitive Firm: Economic Loss

Entry and Normal Profit

Output, Price, and Profit of a Monopolistic Competitor in the long run

At equilibrium, ATC equals price and economic profits are zero. This occurs at the point of tangency of the ATC and demand curve at the output chosen by the firm.

Monopolistic Competition in the long run

Price

MC ATC

PM

MR
0 QM

D Quantity
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Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm Price MC Price MC (b) Perfectly Competitive Firm

ATC

ATC

Make up

P = MC

P = MR (demand curve)

MR

Demand

Quantity produced

Efficient scale

Quantity

Quantity produced = Efficient scale

Quantity

Excess capacity

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Comparing Monopolistic Competition with Monopoly

It is possible for the monopolist to make economic profit in the long-run. No long-run economic profit is possible in monopolistic competition.

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Non price Competition

The firm attempts to establish its product as a different product from that offered by its rivals. Differentiation means that in the consumers mind, the product is not the same. Marketing is often the key to successful differentiation. Firms may differentiate products by perceived quality, reliability, color, style, safety features, packaging, purchase terms, warranties and guarantees, location, availability (hours of operation) or any other features. Brand names may signal information regarding the product, reducing consumer risk.

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Goals of Advertising
The goals of advertising include shifting the demand curve to the right and making it more inelastic. Advertising shifts the ATC curve up.

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Does Advertising Help or Hurt Society?

There is a sense of trust in buying brands we know. If consumers are willing to pay for differentness, its a benefit to them.

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Advertising, Prices, and Profits

Product differentiation reduces the price elasticity of demand, which appears as a steeper demand curve. Successful product differentiation enables the firm to charge a higher price.
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Brand Name
A brand name is valuable to a firm; it makes the demand less elastic and can enable the firm to earn higher profits.

Once a consumer has had a positive experience with a good, the price elasticity of demand for that good typically decreasesthe consumer becomes loyal to the product.

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Oligopoly

Ref. Ch 16 of the text book

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Oligopoly
An oligopoly is a market structure characterized by: Few firms Either standardized or differentiated products Difficult entry between monopoly and perfect competition Ex. Tennis ball manufactured by Wilson, Penn, Dunlop and Spalding No single general model of oligopoly behavior exists
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A Duopoly Example
A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. Two Supplier, many buyer
Possibility of cartel and collusion leading to monopoly

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The Demand Schedule for Water

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A Duopoly Example
Price and Quantity Supplied
The price of water in a perfectly competitive market would be driven to where the marginal cost is zero:
P = MC = $0 Q = 120 gallons

The price and quantity in a monopoly market would be where total profit is maximized:
P = $60 Q = 60 gallons
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A Duopoly Example
Price and Quantity Supplied
The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water. So what outcome then could be expected from duopolists?

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The Market for Water

Cost
$120 In a competitive market, quantity would equal 120 and P = MC = $0.

$60

A monopoly would produce 60 gallons and charge $60. Note that P > MC. Total industry output with a duopoly will probably exceed 60, but be less than 120. MC is constant and = $0.

Demand

60

Marginal Revenue

120

Quantity of Output
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Competition, Monopolies, and Cartels

The duopolists may agree on a monopoly outcome.
Collusion
An agreement among firms in a market about quantities to produce or prices to charge.

Cartel
A group of firms acting in unison.

Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.
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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.

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The Equilibrium for an Oligopoly

When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).
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Characteristics Oligopoly
Oligopolies are made up of a small number of mutually interdependent firms. Each firm must take into account the expected reaction of other firms.

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Interdependence
A key characteristic of oligopolies is that each firm can affect the market, making each firms choices dependent on the choices of the other firms. They are interdependent. The importance of interdependence is that it leads to strategic behavior. Strategic behavior is the behavior that occurs when what is best for A depends upon what B does, and what is best for B depends upon what A does. Oligopolistic behavior includes both ruthless competition and cooperation.
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Game Theory
Strategic behavior has been analyzed using the mathematical techniques of game theory.
Game theory provides a description of oligopolistic behavior as a series of strategic moves and countermoves.
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Game Theory and Strategic Decision Making

The prisoners dilemma is a well-known game that demonstrates the difficulty of cooperative behavior in certain circumstances. In the prisoners dilemma, where mutual trust gets each one out of the dilemma, confessing is the rational choice. The prisoners dilemma has its simplest application when the oligopoly consists of only two firmsa duopoly.
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Prisoners Dilemma and a Duopoly Example

By analyzing the strategies of both firms under all situations, all possibilities are placed in a payoff matrix.

A payoff matrix is a box that contains the outcomes of a strategic game under various circumstances.
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The Prisoners Dilema

A confess A silent

A 8 years jail B confess B 8 years jail B free

A 20 years jail

A free B silent B 20 years jail B 1 year

A 1 year

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Duopoly and a Payoff Matrix

The duopoly is a variation of the prisoner's dilemma game. The results can be presented in a payoff matrix that captures the essence of the prisoner's dilemma.

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The Payoff Matrix of Strategic Pricing Duopoly

A Does not cheat A $75,000 B Does not cheat B $75,000 A $75,000 B Cheats B +$200,000 B0
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A Cheats

A +$200,000
B $75,000 A0

Dominant Strategy
In an oligopoly, firms try to achieve a dominant strategya strategy that produces better results no matter what strategy other firms follow.
The interdependence of oligopolies decisions can often lead to the prisoners dilemma.
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Implicit Price Collusion

Formal collusion is illegal in the U.S. while informal collusion is permitted. Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another. Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.
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Cooperation and Cartels

If the firms in an oligopoly cooperate, they may earn more profits than if they act independently.
Collusion, which leads to secret cooperative agreements, is illegal in the U.S., although it is legal and acceptable in many other countries.
Implicit Price Collusion

Price-Leadership Cartels may form in which firms simply do whatever a single leading firm in the industry does. This avoids strategic behavior and requires no illegal collusion.
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Why Are Prices Sticky?

Informal collusion is an important reason why prices are sticky. Another is the kinked demand curve. When there is a kink in the demand curve, there has to be a gap in the marginal revenue curve. The kinked demand curve is not a theory of oligopoly but a theory of sticky prices.
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The Kinked Demand Curve

Price a P

MC0 MC1

D1 MR1
D2

d
0

MR2

Quantity
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The Kinked Demand Curve

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Firm and Industry Duopoly Cooperative Equilibrium

MC ATC $800 700 575 600 500 Price 400 300 200 100 0 1 2 3 4 5 6 7 8 Price $800 700 600 500 400 D 300 200 100 0 1 2 3 4 5 6 MR Competitive solution Monopolist solution MC

9 10 11

Quantity (in thousands)

(a) Firm's cost curves

Quantity (in thousands)

(b) Industry: Competitive and monopolist solution

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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Firm and Industry Duopoly Equilibrium When One Firm Cheats

$900 $800 700 600 550 500 Price 400 300 200 100 0 1 2 3 4 5 6 7 Quantity (in thousands) (a) Noncheating firms loss McGraw-Hill/Irwin MC ATC MC ATC $800 700 600 550 500 Price 400 300 200 100 0 1 2 3 4 5 6 7 800 700 600 550 500 Price C B A

NonCheating 400 cheating firms firms output 300 output 200 100 0 1 2 3 4 5 6 7 8

Quantity (in thousands) (b) Cheating firms profit

Quantity (in thousands) (c) Cheating solution

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2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Cartels
A cartel is an organization of independent firms whose purpose is to control and limit production and maintain or increase prices and profits. Like collusion, cartels are illegal in the United States.
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Conditions necessary for a cartel to be stable (maintainable):

There are few firms in the industry. There are significant barriers to entry. An identical product is produced. There are few opportunities to keep actions secret. There are no legal barriers to sharing agreements.

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OPEC as an Example of a Cartel

OPEC: Organization of Petroleum Exporting Countries. Attempts to set prices high enough to earn member countries significant profits, but not so high as to encourage dramatic increases in oil exploration or the pursuit of alternative energy sources. Controls prices by setting production quotas for member countries. Such cartels are difficult to sustain because members have large incentives to cheat, exceeding their quotas.
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The Diamond Cartel

In 1870 huge diamond mines in South Africa flooded the gem market with diamonds. Investors at the time wanted to control production and created De Beers Consolidated Mines, Ltd., which quickly took control of all aspects of the world diamond trade. The Diamond Cartel, headed by DeBeers, has been extremely successful. While other commodities prices, such as gold and silver respond to economic conditions, diamonds prices have increased every year since the Depression. This success has been achieved by DeBeers influence on the supply of diamonds, but also via the cartels influence on demand. In the 1940s DeBeers instigated an advertising campaign 46 making the diamond a symbol of status and romance.

Behavior of a Cartel: Firms Agree to Act as a Monopolist

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Cartel: Firms Act Alone

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Cartels and Technological Change

Cartels can be destroyed by an outsider with technological superiority. Thus, cartels with high profits will provide incentives for significant technological change.

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Facilitating Practices
Facilitating practices are actions by oligopolistic firms that can contribute to cooperation and collusion even thought the firms do not formally agree to cooperate. Cost-plus or mark-up pricing is a pricing policy whereby a firm computes its average costs of producing a product and then sets the price at some percentage above this cost.

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Thank You All

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