Between Competition and Monopoly
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Transcript of Between Competition and Monopoly
7
Between Competition and Monopoly
● Monopolistic Competition● Oligopoly● Monopolistic Competition, Oligopoly, and
Public Welfare● A Glance Backward: Comparing the Four
Market Forms
Outline
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Three Real World Puzzles
1. Why are there so many retailers? ● E.g., intersections with 4 gas stations which is more than #
of cars warrants. Why and how do they all stay open?2. Why do oligopolists advertise more than competitive
firms? ● E.g., many big Co. use ads to battle for customers and ad
budgets account for a huge portion of TC. Vs. farmers where few if any farms spend $ on ads.
3. Why do oligopolists seem to ∆P so infrequently?● E.g., ∆P commodities hourly but ∆P cars or refrigerators
only a few times a year.
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Characteristics of Monopolistic Competition
1. Many small buyers and sellers 2. Freedom of entry and exit3. Perfect information4. Heterogeneous products: each seller’s product differs
somewhat from every other seller’s product.♦ E.g., Diff. in packaging, services, or consumers’
perceptions.♦ Only characteristic that differs from perfect competition.
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Monopolistic Competition
● D curve facing firm has (-) slope. ♦ Each seller’s product is different –they are not perfect
substitutes.♦ ↑P will drive away some but not all of firm’s customers. Or ↓P
will attract some but not all customers from rival firms.● Freedom of entry and exit → firms cannot earn econ Π
in LR. ♦ SR Π > 0 → new firms enter and ↓P until P = AC.
● Most U.S. firms are in this market structure.
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Determination of Price and Output under Monopolistic Competition
● Recall when D has (-) slope → P > MR.● Profit-max Q is where MR = MC.● Analysis looks like pure monopoly, but monop. comp.
firm (with rivals producing close substitutes) has a much flatter D curve.
● LR: Π = 0 → each firm produces where P = AC. So firm’s D curve must be tangent to its AC curve.
● Zero econ. Π in LR is seen in real world. ♦ E.g., Gas station owners do not earn higher Π than small
farmers under perfect competition.
FIGURE 1. Short-Run Equilibrium Under Monopolistic Competition
D
AC
P
3.40
Pric
e pe
r Gal
lon
Gallons of Gasoline per Week
12,000
$3.50
MR
MC
E
C
$3.80
$3.00
Π-max Q =12,000 and P = $3.50
Per unit Π = $0.10 → total Π = $1,200.
FIGURE 2. Long-Run Equilibrium Under Monopolistic Competition
15,000
$3.35
Pric
e pe
r Gal
lon
Gallons of Gasoline per Week
10,000
$3.45
MR
MC
AC
D
E
P M
SR profits in Fig. 1 → new firms enter which shifts each firm’s D curve down until P = AC.
Compared with SR profits in Fig. 1:
a. P is lower in LR
b. more firms in industry; each produces a smaller Q with higher AC.
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The Excess Capacity Theorem
● In Fig. 2, AC at LR Q of firm (pt P) > min AC (pt M).● Pt M is where LR Q of a perf. comp. firm would be.● In LR, monop. comp. firm is producing where ↓AC but
has not yet reached its min.● Monopolistic competition leads to firms that have
unused or wasted capacity.● Resolve puzzle 1 –abundance of retailers: intersection
with 4 gas stations where 2 would suffice and operate at lower AC is real world ex. of excess capacity.
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The Excess Capacity Theorem
● Fewer firms in a monop. comp. market → each firm could ↑Q and ↓AC.
● Yet, fewer firms with larger quantities means there is less variety of product.
● Greater efficiency would be achieved at the cost of greater standardization.
● Not clear society would be better off with fewer firms.
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Oligopoly Defined
● Oligopoly = market dominated by a few sellers, where several are large enough to affect market P.
● Great rivalry among firms with new product intros, free samples, and agro marketing campaigns.
● Degree of product differentiation varies by industry: none in steel plates but lots in cars.
● Some industries also contain large # of smaller firms (e.g., soft drinks) but they are dominated by a few large firms that get bulk of industry sales.
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Oligopoly Defined
● Firms strive to create unique products (in terms of features, location, or appeal) to shield themselves from competition that ↓P and ↓sales.
● More intense competition than pure competition. ♦ E.g., A corn farmer doesn’t make tough P decisions. He
accepts market P and reacts by picking Q.♦ A farmer doesn’t need to advertise. He can sell as much as he
likes at current market P.♦ A farmer doesn’t worry about P policies his rivals are
planning.
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Oligopoly Defined
● Oligopolists have some influence over market P, so they must consider rivals’ P; spend a fortune on ads; and try to predict their rivals’ actions.
● Resolve puzzle 2 –why oligopolists advertise and perfectly competitive firms do not.
1. Comp. firms can sell as much as they want at current P, so why advertise? Vs. Toyota faces a (-) sloped D curve, so it must ↓P or ↑ads (try to shift D out) to sell more cars.
2. Products are identical, so farm A’s ads might ↑ sales of farm B. Vs. Toyota’s ads may ↑ its sales and ↓ sales of rival carmakers.
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Why Oligopolistic Behavior is So Difficult to Analyze
● Largest firms can impact P and all firms must watch rivals’ actions.
● Analysis is difficult as firms’ decisions are inter-dependent and oligopolists know that outcomes of their decisions depend on rivals’ responses.♦ E.g., Toyota’s managers know that their actions will cause
reactions by Honda which may require Toyota to adjust its plans.
● Oligopolies have a variety of behavior patterns which requires different models to understand their behavior.
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Models of Oligopoly
● Different models to understand Oligopoly behavior:♦ Ignore interdependence♦ Strategic interaction♦ Cartels♦ Price leadership and tacit collusion♦ Sales maximization♦ Kinked demand curve♦ Game theory
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Ignoring Interdependence
● Simplest model● Firms behave as if their actions will not spark reactions
from rivals.● Each firm seeks to max profits and assumes its P-Q
decision will not affect its rivals’ strategy.● Analyze oligopoly in the same way as pure monopoly.● This doesn’t explain most oligopoly behavior!
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Strategic Interaction
● Consider 2 soap makers: X and Y.● X ↓P to $4.05 and assumes Y will continue its P = $4.12● Say Qx = 5m and X spends $1m on ads.● X may be surprised when Y cuts P to $4.00; ↑Qy to 8m
and sponsors the Super Bowl.● This ↓Πx and X wishes it didn’t cut P in first place.● X cannot afford to ignore how Y will react.
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Cartels
● All firms agree to set P and Q → act as pure monopolist.● OPEC began making joint decisions in 1970’s and has
been successful over time at ↓Q oil and ↑P oil.● Cartels are difficult to organize and hard to enforce.
♦ Each member must produce small Q assigned by group. But once high P is established, every firm is tempted to cheat by ↑Qs. When cheating is suspected, cartel quickly falls apart as others ↑Qs which ↓P.
● Considered worse than monopoly. Cartel charges monopoly P without the cost savings from large scale production.
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Price Leadership and Tacit Collusion
● Overt collusion (where firms meet to pick P-Q) is illegal in the U.S. and rare. But tacit collusion is common.
● Each tacitly colluding firm hopes that if it does not rock the boat (via ↓P or ↑ads), then rivals will do same.
● Price leadership = 1 firm makes P decisions for group.♦ Other firms are expected to adopt P of leader without any
explicit agreement.♦ P leader is often largest firm in industry.
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Sales Maximization: Model with Interdependence Ignored
● Firms may attempt to max revenue rather than profit if:♦ control is separated from ownership♦ compensation of managers is related to size of the firm
● Q set where MR = 0 (rather than MR = MC)♦ Recall: MR is slope of TR curve. So TR is max when MR = 0.
If MR > 0 → ↑Q to ↑TR and if MR < 0 → ↓Q to ↑TR.● Compared to profit-max firm:
♦ Higher Q♦ Lower P
FIGURE 3. Sales-Max Equilibrium
3.75
3.69 3.75 3.80
2.5
$4.00
MR
B
D
E
AC
Pric
e pe
r Box
Millions of Boxes per Year
F
MC
A
Π-max Q = 2.5m where MR = MC. P = $4.00 and total Π = $0.20 x 2.5 m = $500,000.
Sales-max Q = 3.75m where MR = 0. P = $3.75 and total Π = $0.06 x 3.75 m = $225,000.
Total Π (TR) is lower (higher) at point F than point E.
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The Kinked Demand Curve Model
● Resolve puzzle 3 –why do P in oligopolistic markets (cars or appliances) change less often than P of commodities (wheat or gold)?
● Firms think that other firms will match any P cut, but not any P increase. If true, firms face an inelastic D curve with P cuts and an elastic curve with P increases.
??
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The Kinked Demand Curve Model
● In Fig. 4, pt A is firm’s initial P = $8. ● 2 D curves pass through pt A.
♦ DD is more elastic → rivals’ P are fixed♦ dd is less elastic → rivals match ∆P
● If firm ↓P to $7 (and rivals don’t match ↓P) → large ↑customers, so new Qd = 1,400.
● If rivals match ↓P → ↑Qd is small, so new Qd = 1,100.● If firm ↑P (and rivals don’t match ↑P) → large ↓Qd.
??
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The Kinked Demand Curve Model
● The firm’s true demand curve in Fig. 4 is DAd –a kinked demand curve.
● P tend to “stick” to their original level because ↑P → lose many customers and ↓P → gain very few customers.
● Firm will only ∆P if costs change enormously.
??
FIGURE 4. The Kinked Demand Curve
0
7
Quantity per Year
Pric
e
$8 D (Competitors’
prices are fixed)
D
1,400 1,100 1,000
(Competitors respond to price changes)
d
d
A
Typical oligopoly fears the worst. If firm cuts P then rivals will match P cut → relevant demand curve is dd. But if firm raises P then rival will not match the P increase → relevant demand curve is DD. Thus, the firm’s true demand curve is the red line “DAd.”
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The Kinked Demand Curve Model
● MR is associated with DD and mr is associated with dd.● Overall marginal revenue curve is DBCmr.● MC = MR at pt E which shows Π-max Q for oligopolist.● Since relevant MR curve is kinked, even a moderate shift
in MC will leave Q and thereby P unchanged.● Oligopoly prices are “sticky” and do not respond to
minor cost changes.
??
FIGURE 5. The Kinked Demand Curve and Sticky Prices
mr
MR
Quantity Supplied per Year
Pric
e
$8
1,000
MC
D
D
d
d
A
E
B
C
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The Game-Theory Approach
● Most widely used approach to analyze oligopoly behavior.
● Each oligopolist is seen as a competing player in a game of strategy.
● Optimal strategies are determined by examining a payoff matrix showing Π of each firm depending on P strategy that each firm follows.
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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.♦ E.g., Table 1., both firms have an incentive to pick low P
strategy regardless of what other firm does. If B picks high P, then A receives largest payoff choosing low P. Or if B picks low P, then A receives the largest payoff by choosing low P.
♦ “Low Price” is the dominant strategy for both firms, so both charge a low P and each earns $3m.
TABLE 1. Payoff Matrix with Dominant Strategies
A gets $10mB gets $10m
A gets -$2mB gets $12m
A gets $12mB gets -$2m
A gets $3mB gets $3m
Firm B Strategy
High Price Low Price
Firm A Strategy
High Price
Low Price
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Games with Dominant Strategies
● A market with a duopoly serves public interest better than a monopoly because of the competition created between two firms.♦ Both firms would be better off if they could charge high P. But
the presence of a competitor, forces each firm to protect itself by charging low P.
● It is damaging to the public to allow rival firms to collude on what prices to charge for their products.♦ E.g., if two firms collude in Table 1, then we end up with high
P and each earning $10m.
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Games without Dominant Strategies
● Maximin = select the strategy that yields the max payoff assuming your rival does as much damage to you as he can.
● In Table 2, A’s maximin strategy is to pick low P and earn $5m. ♦ Firm A thinks: if I chose a high P → worst outcome is B picks
a low P and I get $3m. If I chose a low P → worst outcome is B picks a low P and I get $5m.
♦ Firm A picks the strategy that offers the best of those bad outcomes.
TABLE 2. A Payoff Matrix without a Dominant Strategy
A gets $10m A gets $3m
A gets $8m A gets $5m
High Price Low Price
High Price
Low Price
Firm B Strategy
Firm A Strategy
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Repeated Games
● Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements.
● Table 1 shows a single round of the game. Each firm picked low P. But if games are repeated, players can escape this trap. ♦ E.g., Firm A could cultivate a reputation of “tit for tat.” Each
time B charges a high P → A would charge a high P. After a few repetitions, B learns that A always matches its P decisions. So B will see that it’s better to stick with a high P.
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Threats and Credibility
● Use threats to induce rivals to change their behavior.♦ E.g., retailer could threaten to double Q and ↓P to $0 if a rival
imitates its product. But this is not credible, because it hurts the retailer who is making the threat.
● A credible threat is a threat that does not harm the threatener if it is carried out.
● Old firms often use credible threats to prevent new firms from entering the industry.♦ E.g., old firm will build a larger factory than it would
otherwise want. Large factory lowers cost of ↑Q –even at low P.
FIGURE 6. Entry and Entry-Blocking Strategy
6 0
2 2
4 0
–2 –2
Profits (millions $) Old Firm New Firm
Possible Reactions of New Firm
Possible Choices of Old Firm
Enter
Don’t Enter
Don’t Enter
Enter
Small Factory
Big Factory
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Threats and Credibility
● In Fig. 6, best outcome for old firm is to have a small factory and no rivals.♦ But if old firm builds a small factory, it can count on new firm
entering to earn $2m. So old firm’s ↓Π to $2m.● If old firm builds a big factory, its ↑Q will ↓P and ↓Π.
Old firm now earns $4m if new firm stays out.♦ Clearly, new firm will stay out to avoid loses of $2m.
● Thus, old firm should build big factory to keep rivals out.
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Monopolistic Competition, Oligopoly, & Public Welfare
● Oligopolistic 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.
● Excess capacity theorem suggests monopolistic competition can lead to inefficiently high production costs.
● Oligopolists may organize into successful cartels to ↓Q and ↑P.
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Monopolistic Competition, Oligopoly, & Public Welfare
● When an oligopolistic market is perfectly contestable –if firms can enter and exit without losing $ they invested –then (P,Q) of firms is likely to be socially efficient.
♦ E.g., airplanes, trucks, and barges can easily be moved.● Constant threat of entry forces oligopolists to keep
their prices down and their costs low.
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Comparing the Four Market Forms
● Perfect competition and pure monopoly are rare.● Most firms are monopolistically competitive, but oligopoly
firms account for largest share of economy’s output.● Π = 0 in LR under perfect competition and monopolistic
competition because of free entry and exit.♦ Thus, P = AC in LR under these 2 market forms.
● Π-max firm under any market form selects Q by setting MR = MC. ♦ However, oligopolists may not set MC = MR when choosing Q –
e.g., if firm max sales.
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Comparing the Four Market Forms
● Perfectly competitive firm and industry efficient allocation of resources.
● Monopoly inefficient allocation of resources by ↓Q and ↑P.
● Monopolistic competition inefficient allocation of resources through excess capacity.
● Under oligopoly, almost anything can happen, impossible to generalize about its vices or virtues.
TABLE 3. Attributes of the Four Market Forms