Monopolistic Competition & Oligopoly

T.J. Joseph

Monopolistic Competition Model

Many buyers each one small relative to the overall market Many sellers - each with small market share Differentiated (heterogeneous) products Seller are price makers Buyers are price takers No barriers to entry

Monopolistic Competition
The Makings of Monopolistic Competition
Two important characteristics
Differentiated but highly substitutable products Free entry and exit Examples: Grocery shops, Beauty Parlors, Detergent, etc.

Short-run Equilibrium
Rupees

Representative Firm

P1

MCSR ACSR

Dn

Q1

MRn

Output per period

A Monopolistically Competitive Firm in the Short Run

Observations (short-run)
    

Downward sloping demand--differentiated product Demand is relatively elastic--good substitutes P > MR Profits are maximized when MR = MC This firm is making economic profits

Long-run Equilibrium
Rupees Zero profit, but not minimum LRAC
MCLR ACLR

P2

ARLR = DLR MRn

Q2

Output per period

A Monopolistically Competitive Firm in the Long Run

Observations (long-run)
 Profits will attract new firms to the industry

(no barriers to entry)

 The old firm  Firm

s demand will decrease to DLR rise AC)

s output and price will fall

 Industry output will

 No economic profit (P = P>

MC -- some monopoly power

Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium

Perfect Competition
$/Q $/Q

Monopolistic Competition
Deadweight loss

MC

AC

MC

AC

P PC D = MR DLR MRLR QC
Quantity

QMC

Quantity

Monopolistic Competition
Monopolistic Competition and Economic Efficiency
The monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle. With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.

Limitations of the Model

There are various problems in applying the model of monopolistic competition in real world: Information may be imperfect: Unaware of the supernormal profits made by current firms or not sure about the exact demand for a particular product Entry may not be completely unrestricted in the long run: Producing a product that is impossible to duplicate completely The problem of indivisibilities: Supernormal profit in the short run when shared may come below normal level

OLIGOPOLY

Definitions
 Oligopoly: A market structure in which a few sellers dominate the sales of a product and entry is difficult or impossible
Examples: Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers, etc.

 Duopoly: A market with two sellers and a large number of buyers

It is a special case of oligopoly

Oligopoly Model
Few sellers, each with large market share Many buyers each one small relative to the overall market Homogeneous or differentiated products Sellers are price makers Buyers are price takers Sellers behave strategically Interdependence among firms Significant barriers to entry

Features of Oligopoly
Sellers are aware of their interdependence They know that if they or their rivals change their prices or outputs, the profits of all the firms will be affected

Features of Oligopoly
The demand curve faced by an oligopolist cannot be exactly determined Quantities of output cannot be definitely determined because the quantities will be different depending on the reactions of the rivals And the reaction patterns of rivals are uncertain Therefore, to derive the demand curve, certain specific assumptions about the reactions of other firms to the actions of the firm should be made

Features of Oligopoly
Oligopoly is concerned with group behavior, and there is no generally accepted theory on group behavior Members of the group may compete with one another (Non-collusive oligopoly) or Members may come to an understanding among themselves (Collusive oligopoly) or There is a leader in the group and other members follow the leader (Price leadership)

Equilibrium in an Oligopolistic Market

In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival s response when choosing output and price. In oligopoly the producers must consider the response of competitors when choosing output and price.

Equilibrium in an Oligopolistic Market

 Defining

Equilibrium

Firms doing the best they can, and have no incentive to change their output or price All firms assume competitors are taking rival decisions into account.

NonNon-Collusive Oligopoly

Cournot Duopoly Model

Two firms in the industry, A & B Selling homogeneous (identical) products Identical, constant marginal cost Each firm seeks to maximise his total profit in each period, assuming the other firm will hold its output constant

Firm As Output Decision

P1
D1(0) If Firm A thinks Firm B will produce nothing, its demand curve, D1(0), is the market demand curve. If Firm A thinks Firm B will produce 50 units, its demand curve is shifted to the left by this amount.
If Firm A thinks Firm B will produce 75 units, its demand curve is shifted to the left by this amount.

D1(75)

MR1(0) MC1

MR1(75) MR1(50) 12.5 25 50 D1(50)

What is the output of Firm A if Firm B produces 100 units?

Q1

Reaction Curves and Cournot Equilibrium

A s Output 100

75

Firm As reaction curve shows how much it will produce as a function of how much it thinks Firm B will produce. The xs correspond to the previous model.

50 x

25

x
Firm 1s Reaction Curve Q*1(Q2)

x
75 100

25

50

B s Output

Reaction Curves and Cournot Equilibrium

A s Output 100
Firm As reaction curve shows how much it will produce as a function of how much it thinks Firm B will produce. The xs correspond to the previous model. Firm Bs reaction curve shows how much it will produce as a function of how much it thinks Firm A will produce.

75

Firm Bs Reaction Curve Q2* (Q1) Cournot Equilibrium

50 x

25

x
Firm As Reaction Curve Q1* (Q2)

In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits.

x
50 75 100

25

B s Output

Cournot Equilibrium
 Found at the intersection of the two reaction curves  Each firm is choosing its best strategy (output level), given the strategy of the other firm  A self-enforcing agreement  Each firm sticks to this equilibrium if it believes the other firm will do so

Cournot Equilibrium - An Example

Market demand is P = 30 Q, MC1 = MC2 = 0 Firm 1 s Reaction Curve
To maximize profit firm sets MR = MC

where Q = Q1 + Q2

Total Revenue, R1 ! PQ1 ! (30  Q )Q1

! 30Q1  (Q1  Q2 )Q1 ! 30Q1  Q12  Q2Q1

Example
MR1 ! (R1 (Q1 ! 30  2Q1  Q2 MR1 ! 0 ! MC1 Firm 1' s Reaction Curve Q1 ! 15  1 2 Q2 Firm 2' s Reaction Curve Q2 ! 15  1 2 Q1

Example
Cournot Equilibrium : Q1 ! Q2 15  1 2(15  1 2Q1 ) ! 10 Q ! Q1  Q2 ! 20 P ! 30  Q ! 10

Duopoly Example
Q1 30 The demand curve is P = 30 - Q and both firms have 0 marginal cost.
Firm 2s Reaction Curve

15 10

Cournot Equilibrium

Firm 1s Reaction Curve 10 15 30 Q2

Price Competition Bertrand Model

 Competition in an oligopolistic industry may occur with price instead of output.  The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods.  Each firm assumes that the other firm holds its price (rather than output) constant

The Kinked Demand Curve

Introduced by Paul Sweezy (1939) The essence: Each firm assumes that its competitors will follow a reduction in price, but will not follow a price rise Assumptions: A number of similar-sized firms Producing homogenous product or close substitutes

The Kinked Demand Curve

Price Rigidity can be a characteristic of oligopolistic
industries Even if costs or demand change, firms are reluctant to change price (why?) Firms fear that lower prices might send wrong signals to competitors or reluctant to raise prices fearing competitors may not raise their prices

The Kinked Demand Curve

$/Q If the producer raises price the competitors will not and the demand will be more elastic. If the producer lowers price the competitors will follow and the demand will be inelastic.

P*

Q* MR

Quantity

The Kinked Demand Curve

$/Q So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MC P* MC

Q* MR

Quantity

The Kinked Demand Curve

Criticism:
It does not really explain oligopolistic pricing Says nothing about how firms arrived at P*, and why they didn t arrive at some other price

Collusive Oligopoly

Incentive to Collude
Oligopolists have a strong incentive to collude and raise their prices. However, each firm has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand curve. This conflict makes collusive agreements difficult to maintain.

Cartels
A cartel is an agreement between firms to restrict output and raise price in order to increase the total profit of the cartel The cartel tries to maximise joint profit the full cartel outcome Attained when firms collectively produce where industry MR equal industry MC May not include all firms

Cartels
Most often international
Examples of successful cartels OPEC International Bauxite Association

Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa

Conditions for Cartel Success

Individual firm has incentive to cheat by increasing its own output So, cartel must be able to prevent and/or punish cheating Different members may have different costs, different assessment of market demand, etc. therefore want to set price at different levels Economic Profit attracts new firms So, cartel must be able to limit entry Potential for monopoly power

Exercise
Read the case OPEC the Rise and Fall and Rise again of a Cartel: The history of the world s most famous cartel and discuss.

Market-Sharing Cartels
A collusion more common in practice The firms agree to share the market, but keep a considerable degree of freedom in output and other decisions There are two basic methods for sharing the market: Non-price competition agreements, and Determination of quotas

Market-Sharing Cartels
Non-Price Competition Agreement: Firms agree on a common price, at which each firm can sell any quantity demanded The price is set by bargaining The agreed price must allow some profits to all members Firms agree not to charge price below cartel price, but they are free to vary output and selling activities Compete non-price basis based on quality, appearance of the product, advertising, etc.

Market-Sharing Cartels
Agreement on quotas: Firms agree on the quantity that each member may sell at the agreed price (or prices) If the firms have identical costs, market will be shared equally by the members If costs are different, the shares and quotas will differ The final quota of each firm, however, depends on the level of its costs as well as its bargaining power

The Dominant Firm Model

In some oligopolistic markets, one large firm (or lowcost firm)has a major share of total sales, and a group of smaller firms supplies the remainder of the market. The large firm might then act as the dominant firm, setting a price that maximized its own profits. Price leadership is the form of imperfect collusion in which the firms tacitly (i.e., without formal agreement) decide to set the same price as that of the leader

Questions for Thought

1. What makes a market oligopolistic? 2. When are oligopolists likely to collude? Why is it impossible to construct a general theory of output and price for an oligopolist? 3. In the past it seems the number of cartels failed is more than the number of cartels succeeded. Why do cartels often fail?

Exercise
Consider two firms facing the demand curve P = 50 5Q where Q=Q1 + Q2. The firms cost functions are C1(Q1) = 20 + 10Q1 and C2(Q2) = 10 + 12Q2 (a) What is each firm s equilibrium output and profit if they behave noncooperatively? Use the Cournot model. Draw the firm s reaction curves and show the equilibrium. (b) What is the joint profit-maximising level of output? How much will each firm produce?.

References
1. Chapter 11 in Dominick Salvatore (2009),

Principles of Microeconomics, 5th edition, Oxford Publications.

2. Chapters 26 in William Boyes and Michael

Melvin (2009), Textbook of Economics, 6th edition, Biztantra publications.