Monopolistic Competition and Oligopoly Superior Cheese CHAPTER TWENTY-FIVE.

Monopolistic Monopolistic CompetitionCompetition

andandOligopolyOligopoly

Monopolistic Monopolistic CompetitionCompetition

andandOligopolyOligopoly

SuperiorCheese

CHAPTER TWENTY-FIVE

Four Market ModelsFour Market Models

Market Structure ContinuumMarket Structure Continuum

PurePureCompetitionCompetition

PurePureMonopolyMonopoly

MonopolisticMonopolisticCompetitionCompetition

Monopolistic CompetitionMonopolistic CompetitionCharacteristics...Characteristics...

• Relatively Large NumbersRelatively Large Numbers

• Relatively Large NumbersRelatively Large NumbersSmall Market ShareSmall Market Share

• Relatively Large NumbersRelatively Large NumbersSmall Market ShareSmall Market ShareNo CollusionNo Collusion

• Relatively Large NumbersRelatively Large NumbersSmall Market ShareSmall Market ShareNo CollusionNo CollusionIndependent ActionsIndependent Actions

• Product DifferentiationProduct Differentiation

• Product DifferentiationProduct DifferentiationProduct AttributesProduct Attributes

• Product DifferentiationProduct DifferentiationProduct AttributesProduct AttributesServicesServices

• Product DifferentiationProduct DifferentiationProduct AttributesProduct AttributesServicesServicesLocationLocation

• Product DifferentiationProduct DifferentiationProduct AttributesProduct AttributesServicesServicesLocationLocationBrand Names and PackagingBrand Names and Packaging

• Product DifferentiationProduct DifferentiationProduct AttributesProduct AttributesServicesServicesLocationLocationBrand Names and PackagingBrand Names and PackagingSome Control Over PriceSome Control Over Price

• Easy Entry and ExitEasy Entry and Exit

• Easy Entry and ExitEasy Entry and Exit• Nonprice CompetitionNonprice Competition

• Easy Entry and ExitEasy Entry and Exit• Nonprice Competition Nonprice Competition • AdvertisingAdvertising

• Easy Entry and ExitEasy Entry and Exit• Nonprice Competition Nonprice Competition • AdvertisingAdvertising• Monopolistically Monopolistically

Competitive Competitive IndustriesIndustries

Short-Run Price and Output DeterminationShort-Run Price and Output Determination

sMonopolistic competitorsMonopolistic competitors

have an elastic demand curve,have an elastic demand curve,but not perfectly elastic... but not perfectly elastic...

Copyright McGraw-Hill, Inc., 1999

MCMCPPP

QQCopyright McGraw-Hill, Inc., 1999

MCMCPP

ATCATCP

QQCopyright McGraw-Hill, Inc., 1999

MCMCPP

ATCATCP

EconomicProfits

Expect New CompetitorsExpect New CompetitorsShort-Run Price and Output DeterminationShort-Run Price and Output Determination

MCMCPP

ATCATCP

EconomicProfits

How wouldHow wouldshort-run lossesshort-run losses

be different?be different?

How wouldHow wouldshort-run lossesshort-run losses

be different?be different?

MCMCPP

ATCATC

EconomicLossesExpectExpect

LessLessCompetitorsCompetitors

MCMCPP

ATCATC

EconomicLossesExpectExpect

LessLessCompetitorsCompetitors

How wouldthe long-run

differ?

How wouldthe long-run

differ?

MCMCPP

ATCATCP

EconomicProfits

MCMCPP

ATCATC

Long-run equilibriumLong-run equilibriumShort-Run Price and Output DeterminationShort-Run Price and Output Determination

Q @ ATC Min ?Q @ ATC Min ?

P = MCP = MC

Monopolistic CompetitionMonopolistic Competitionand Economic Efficiencyand Economic Efficiency

• Not Productively EfficientNot Productively Efficient

• Not Productively EfficientNot Productively Efficient• Not Allocatively EfficientNot Allocatively Efficient

• Not Productively EfficientNot Productively Efficient• Not Allocatively EfficientNot Allocatively Efficient• Excess CapacityExcess Capacity

Nonprice CompetitionNonprice Competition

Nonprice CompetitionNonprice Competition• Product DifferentiationProduct Differentiation

Nonprice CompetitionNonprice Competition• Product DifferentiationProduct Differentiation• Product DevelopmentProduct Development

Features of a Monopolistic Competitive Markets:1. Many sellers 2. Unique Products that have close or identical substitutes:

Big Mac v Whopper3. Small barrier to entry or exit4. Some market power exists5. Price is greater than MR, Separate DARP and MR curves6. Non price competition and advertising exist7. Profits maximized at the Quantity and Price where MC = MR8. Excess or Economic Profits in the Short Run only (P>ATC)9. Profits must be Normal in the Long Run (P=ATC) 10. Firms should shut down when P < AVC11. Excess capacity exists in terms of potential output 12. Demand is relatively elastic by comparison to monopoly13. Example market - Minimarts, Fast food at local franchises14. This market is much closer to perfect competition than

pure monopoly

Four Market ModelsFour Market ModelsOligopolyOligopoly

Market Structure ContinuumMarket Structure Continuum

PurePureCompetitionCompetition

PurePureMonopolyMonopoly

MonopolisticMonopolisticCompetitionCompetition

Oligopoly: CharacteristicsOligopoly: Characteristics

Oligopoly: CharacteristicsOligopoly: Characteristics• Oligopoly DefinedOligopoly Defined

Oligopoly: CharacteristicsOligopoly: Characteristics• Oligopoly DefinedOligopoly Defined• Homogeneous or Homogeneous or

Differentiated ProductsDifferentiated Products

Differentiated ProductsDifferentiated Products• Control over PriceControl over Price

Differentiated ProductsDifferentiated Products• Control over PriceControl over Price• Mutual InterdependenceMutual Interdependence

Differentiated ProductsDifferentiated Products• Control over PriceControl over Price• Mutual InterdependenceMutual Interdependence• Entry BarriersEntry Barriers

Differentiated ProductsDifferentiated Products• Control over PriceControl over Price• Mutual InterdependenceMutual Interdependence• Entry BarriersEntry Barriers• MergersMergers

• Concentration RatiosConcentration RatiosOligopoly: CharacteristicsOligopoly: Characteristics

Ratios that look at what the concentration of firms are in the industry.

• Concentration RatiosConcentration Ratios - Herfindahl Index – The larger- Herfindahl Index – The largerthe index number the higher the the index number the higher the concentration of the industry.concentration of the industry.

Oligopoly: CharacteristicsOligopoly: Characteristics

Oligopoly BehaviorOligopoly BehaviorA Game Theory Overview...A Game Theory Overview...

HighHigh

LowLow

HighHigh LowLow

RareAir’s Price StrategyRareAir’s Price Strategy

B$12 $15

$12 $6

$15 $8

B$12 $15

$12 $6

$15 $8

HighHigh LowLow

GreatestGreatestCombinedCombined

ProfitProfit

HighHigh

LowLow

B$12 $15

$12 $6

$15 $8

HighHigh LowLow

IndependentIndependentActionsActions

StimulateStimulateResponseResponse

HighHigh

LowLow

B$12 $15

$12 $6

$15 $8

HighHigh LowLow

IndependentIndependentActionsActions

StimulateStimulateResponseResponseGravitatingGravitating

to theto theWorst CaseWorst Case

HighHigh

LowLow

B$12 $15

$12 $6

$15 $8

HighHigh LowLow

CollusionCollusionInvites aInvites aDifferentDifferentSolutionSolution

HighHigh

LowLow

B$12 $15

$12 $6

$15 $8

HighHigh LowLow

CollusionCollusionInvites aInvites aDifferentDifferentSolutionSolution

HighHigh

LowLow

B$12 $15

$12 $6

$15 $8

HighHigh LowLow

CollusionCollusionInvites aInvites aDifferentDifferentSolutionSolutionBut, theBut, the

incentiveincentiveto cheatto cheat

is very realis very real

HighHigh

LowLow

Company A High Ads $100,000 – 20,000 = $80,000 Low Ads $50,000 – 10,000 = $40,000

Company B Low Ads $50,000 – 10,000 = $40,000 High Ads $100,000 – 20,000 = $80,000

Company A Low Ads $75,000 – 10,000 = $65,000 High Ads $75,000 – 20,000 = $55,000

Company B Low Ads $75,000 – 10,000 = $65,000 High Ads $75,000 – 20,000 = $55,000

Ads Effect Sales (Q) and P x Q = TR so Ads effect Total Revenue!Low Cost Ads: 120 :30 second Ads/week for $10,000High Cost Ads: 240 :30 second Ads/week for $20,000

Pay Off Matrix Oligopoly – Reasons for Collusion

TR - TC = TP TR - TC = TP

If either duopolist begins running High Ads, its competitor willcounter with High Ads!Games Theory and Collusion’s answer is an agreement by “both”to keep advertising low in order to maximize profits!Would their be incentive to Cheat?

No Standard Model due to...No Standard Model due to...

Three Oligopoly ModelsThree Oligopoly Models

DiversityDiversity

DiversityDiversityInterdependenceInterdependence

1 - Kinked Demand Curve1 - Kinked Demand Curve

1 - Kinked Demand Curve1 - Kinked Demand Curve2 - Collusive Pricing2 - Collusive Pricing

1 - Kinked Demand Curve1 - Kinked Demand Curve2 - Collusive Pricing2 - Collusive Pricing3 - Price Leadership3 - Price Leadership

Kinked Demand: Noncollusive OligopolyKinked Demand: Noncollusive OligopolyPP

QQDD11

MRMR11QuantityQuantity

The firm’s demandThe firm’s demandand marginaland marginal

revenue curvesrevenue curveswhen rivals followwhen rivals followpricing patterns.pricing patterns.

QQDD11

MRMR22

The firms demandThe firms demandand marginaland marginal

revenue curves when revenue curves when rivals don’t followrivals don’t followpricing patterns.pricing patterns.

Kinked Demand: Noncollusive OligopolyKinked Demand: Noncollusive Oligopoly

MRMR22DD11

Rivals tend toRivals tend tofollow a price cutfollow a price cut

MRMR22DD11

Rivals tend toRivals tend tofollow a price cutfollow a price cut

or ignore aor ignore aprice increaseprice increase

MRMR22DD11

Effectively creatingEffectively creatinga kinked demand curvea kinked demand curve

MRMR22

Effectively creatingEffectively creatinga kinked demand curvea kinked demand curve

MCMC22

MCMC11

Cartels and CollusionCartels and Collusion

Oligopoly is conducive to collusionOligopoly is conducive to collusion

If a few firms face identical orIf a few firms face identical orhighly similar demand and costs...highly similar demand and costs...

They will seek joint profitThey will seek joint profitmaximization...maximization...

Colluding Oligopolists WillColluding Oligopolists WillSplit the Monopoly Profits Split the Monopoly Profits

ATCATC

EconomicEconomicProfitProfit

QuantitQuantityy

MR = MCMR = MC

Overt CollusionOvert CollusionCartels and CollusionCartels and Collusion

Overt CollusionOvert CollusionOPEC CartelOPEC Cartel

Covert CollusionCovert Collusion

Obstacles to CollusionObstacles to Collusion

Demand & Cost DifferencesDemand & Cost Differences

Demand & Cost DifferencesDemand & Cost DifferencesNumber of FirmsNumber of Firms

Demand & Cost DifferencesDemand & Cost DifferencesNumber of FirmsNumber of FirmsCheatingCheating

Demand & Cost DifferencesDemand & Cost DifferencesNumber of FirmsNumber of FirmsCheatingCheatingRecessionRecession

Demand & Cost DifferencesDemand & Cost DifferencesNumber of FirmsNumber of FirmsCheatingCheatingRecessionRecessionPotential EntryPotential Entry

Demand & Cost DifferencesDemand & Cost DifferencesNumber of FirmsNumber of FirmsCheatingCheatingRecessionRecessionPotential EntryPotential EntryLegal Obstacles: AntitrustLegal Obstacles: Antitrust

Price LeadershipPrice Leadership

Price LeadershipPrice LeadershipLeadership TacticsLeadership Tactics

Infrequent ChangesInfrequent Changes

CommunicationCommunication

Infrequent ChangesInfrequent ChangesCommunicationCommunicationLimit Pricing - Limit Pricing - sometimessometimessmaller companies will wage price smaller companies will wage price wars to knock the leader down.wars to knock the leader down.

Oligopoly & AdvertisingOligopoly & Advertising

Advertising Effects on Output & Average CostsAdvertising Effects on Output & Average Costs

ATCATCwithoutwithout

advertisingadvertising

ATCATCwithwith

Advertising CostsAdvertising Costs

Oligopoly and Economic EfficiencyOligopoly and Economic Efficiency

Allocative EfficiencyAllocative Efficiency(Price = MC)(Price = MC)

Recall...Recall...

Productive EfficiencyProductive Efficiency(Price = Minimum ATC)(Price = Minimum ATC)

Recall...Recall...

Productive EfficiencyProductive Efficiency(Price = Minimum ATC)(Price = Minimum ATC)

Recall...Recall...

Neither is likely in anNeither is likely in anoligopoly market structureoligopoly market structure

Features of an Oligopolistic Markets:

1. Few sellers (Less than seven), Duopoly - two main sellers + the fringe firms

2. Unique Products but similar products Coke v Pepsi, Chevy v Ford3. Large barrier to entry or exit4. A large measure of market power exists5. Price is greater than MR, Separate DARP and MR curves6. Non price competition and advertising exist

Procter & Gamble: $3,277,000,000 in Ads 19997. Profits maximized at the Quantity and Price where MC = MR8. Excess or Economic Profits possible in the Long Run (P>ATC)9. Interdependence, Collusion, Spies, Pay off Matrix Price and Innovative Leaders exist, Gamesmanship “A Beautiful Mind”10. Firms should shut down when P < AVC11. Excess capacity exists in terms of potential output 12. Demand is relatively inelastic 13. Theory of the Kinked Demand Curve and Price Stickiness results from collusion and gamesmanship14. Example market - Automobiles, Soda, Beer, Steel, Tobacco Products may be differentiated (Toyota v Ford) or homogeneous (Steel)

ATCATCwithwith

Advertising CostsAdvertising Costs

QuestionsQuestionsandand

Discussion...Discussion...

monopolistic monopolistic competitioncompetition

product product differentiationdifferentiation

nonprice competitionnonprice competition excess capacityexcess capacity oligopolyoligopoly homogeneous homogeneous

oligopolyoligopoly differentiated differentiated

oligopolyoligopoly mutual mutual

interdependenceinterdependence concentration ratioconcentration ratio

interindustry interindustry competitioncompetition

import competitionimport competition Herfindahl indexHerfindahl index game theory modelgame theory model collusioncollusion kinked demand kinked demand

curvecurve price warprice war cartelcartel tacit understandingstacit understandings price leadershipprice leadership

Next...Next...

Chapter 26Chapter 26

Technology, Technology, R&D, R&D, and and EfficiencyEfficiency

Monopolistic Competition and Oligopoly Superior Cheese CHAPTER TWENTY-FIVE.

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