12

Between Competition and Monopoly

. . . Neither fish nor fowl.
JOHN HEYWOOD (CIRCA 1565)

Contents
Monopolistic Competition Oligopoly Monopolistic Competition, Oligopoly, and Public Welfare A Glance Backward: Comparing the Four Market Forms

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Monopolistic Competition
Characteristics of Monopolistic Competition
Many sellers Freedom of entry and exit Perfect information Heterogeneous products

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Monopolistic Competition
Characteristics of Monopolistic Competition
First three characteristics same as those for perfect competition. Fourth is an important distinction. Demand curve facing the firm is negatively sloped. Majority of U.S. firms are in this type of market structure.
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Monopolistic Competition
Price and Output Determination under Monopolistic Competition
MR = MC rule applies for setting output. Long-run equilibrium: the firms demand curve must be tangent to its average cost curve.

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1: Short-Run Equilibrium Under Monopolistic Competition

FIGURE
MC AC $1.80 $1.50 1.40 P C

Price per Gallon

$1.00

MR 12,000 Gallons of Gasoline per Week

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2: Long-Run Equilibrium Under Monopolistic Competition

FIGURE
MC AC

Price per Gallon

$1.45 $1.35

P M

E D MR 10,000 15,000

Gallons of Gasoline per Week

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The Excess Capacity Theorem

Under monopolistic competition, in the long run the firm will produce an output lower than that which minimizes its unit costs. Hence, unit costs will be higher than necessary.

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The Excess Capacity Theorem

Achievement of minimum average costs would require fewer but larger firms. This inefficiency may, however, be a reasonable price to pay for providing a large range of consumer choice.

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Oligopoly
Oligopoly = market dominated by a few sellers, at least several of which are large enough relative to the total market that they can influence the market price Oligopoly more intense competition than pure competition

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Oligopoly
Why Oligopolistic Behavior is So Difficult to Analyze
Oligopolistic firms interact with each other in complex ways, and almost anything can and sometimes does happen under oligopoly.

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Oligopoly
A Shopping List
Ignore interdependence Strategic interaction Cartels Price leadership and tacit collusion Sales maximization Kinked demand curve Game theory
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Oligopoly
Sales Maximization: An Oligopoly Model with Interdependence Ignored
Firms may attempt to maximize revenue rather than profit if
control is separated from ownership. compensation of managers is related to the size of the firm.

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Oligopoly
Sales Maximization: An Oligopoly Model with Interdependence Ignored
Output set where marginal revenue = 0 (rather than marginal cost) Compared to a profit-maximizer
Higher output Lower price

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3: Sales-Maximization Equilibrium
FIGURE
MC AC

$1.00
Price per Box

.80
.75 .69

2.5
Millions of Boxes per Year

3.75

MR

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The Kinked Demand Curve Model

Because the managers of a firm think that other firms will match any cut they make in price, but not any increase, they may think they face an inelastic demand curve with respect to price cuts and an elastic curve with respect to price increases.

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The Kinked Demand Curve Model

The demand curve is kinked, and the marginal revenue curve is discontinuous. If so, neither price nor output will change in response to moderate shifts in costs.

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FIGURE

4: The Kinked Demand

Curve
d

Price

$8 7

A D (Competitors prices are fixed) (Competitors d respond to price changes)

1,000

1,100

1,400

Quantity per Year

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5: The Kinked Demand Curve and Sticky Prices

FIGURE
d MC

D Price A $8 B E MR C d

1,000

mr Quantity Supplied per Year

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Oligopoly
The Game-Theory Approach
Each oligopolist is seen as a competing player in a game of strategy. Managers act as though their opponents will adopt the most profitable countermove to any move they make.

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TABLE

1: A Payoff Matrix

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Oligopoly
The Game-Theory Approach
Games with dominant strategies
Dominant strategy = one that gives the bigger payoff to the firm that selects it, no matter which of the two strategies the competitor selects Prisoners Dilemma

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2: A Payoff Matrix with Dominant Strategies

TABLE

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Oligopoly
The Game-Theory Approach
Games with dominant strategies
A market with a duopoly serves the public interest better than a monopoly because of the competition created between the duopolists. It is damaging to the public to allow rival firms to collude on what prices to charge for their products and what quantity of product to supply.

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Oligopoly
The Game-Theory Approach
Games without dominant strategies
Maximin = a strategy in which one seeks the maximum of the minimum payoffs to the available strategies.

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3: A Payoff Matrix without a Dominant Strategy

TABLE

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Oligopoly
The Game-Theory Approach
Other strategies: Nash Equilibrium
Nash equilibrium = both players adopt moves such that each players move is its most profitable response to the others move. Often, no such mutually accommodating solution is possible.

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Oligopoly
The Game-Theory Approach
Zero-sum games
Zero-sum game = if one player gains, the other must lose such

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Oligopoly
The Game-Theory Approach
Repeated games
Most markets feature repeat buyers. Repeated games give players the opportunity to learn something about each others behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. Threats and credibility
Induce rivals to change their behavior Threat must be credible
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6: Entry and EntryBlocking Strategy

FIGURE
Possible Choices of Old Firm Possible Reactions of New Firm Profits (millions $) Old Firm New Firm 2 2

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Monopolistic Competition, Oligopoly, & Public Welfare

Behavior is so varied that it is hard to come to a simple conclusion about welfare implications. In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum.

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Monopolistic Competition, Oligopoly, & Public Welfare

When an oligopolistic market is perfectly contestable--if firms can enter and exit without losing the money they have invested--then the performance of the firms is likely to be socially efficient.

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Comparing the Four Market Forms

Perfect competition and pure monopoly are uncommon in reality. Many monopolistically competitive firms exist. Oligopoly firms account for the largest share of the economys output.

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Comparing the Four Market Forms

Profits are zero in long-run equilibrium under perfect competition and monopolistic competition because of free entry and exit. Consequently, AC = AR in long-run equilibrium under these two market forms.

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Comparing the Four Market Forms

In equilibrium, MC = MR for the profitmaximizing firm under any market form. In the equilibrium of the oligopoly firm, MC may be unequal to MR.

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Comparing the Four Market Forms

Perfectly competitive firm and industry theoretically efficient allocation of resources. Monopoly and monopolistic competition are likely inefficient allocation of resources. Under oligopoly, almost anything can happen, impossible to generalize about its vices or virtues.
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5: Attributes of the Four Market Forms

TABLE

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