Chapter 10 monopolistic competition & oligopoly

Chapter 10Monopolistic Competition & Oligopoly

The Monopolistic Competition Market Structure•A market structure characterized by:

▫Many small sellers▫A differentiated product▫Easy market entry & exit

•This market structure fits many real-world industries

Many Small Sellers

•The exact number cannot be stated.•This structure is one where the seller can

set prices slightly higher or improve services independently without fear that competitors will react by changing their prices or giving better service.

Differentiated Product

•This is the key difference between perfect competition and monopolistic competition▫Def: Production differentiation is the

process creating real or apparent differences between goods and services

Examples of Differentiated Products•Design•Reliability•Location•Costly information

How do they compete

•They often compete on non-price competition▫Advertising▫Packaging▫Product development▫Better quality▫Better services

Easy Entry & Exit

•They face low barriers to entry, but it is not as easy to enter as perfect competition.

•Because there are differentiated products it is hard for firms to get established in these markets.▫Example: new restaurants in town

Monopolistically Competitive Firms are Price Makers•They are not price takers, meaning they

let the market set the price.•Thus the demand curve is less elastic than

the perfectly competitive firm, but more elastic than the monopolist.

What do the Demand and Marginal Revenue Curve look like

•Demand and marginal revenue are negatively-sloped▫Negatively-sloped demand curvemarginal

revenue is less than price at each quantity.▫Marginal revenue curve is negatively-

sloped and lies below the demand curve.

Short-Run•The monopolistically competitive firm will

maximize profit at MR=MC.•If short-run economic losses occur, then

the firm will exit the market.

Long-Run

•The firms will not earn a profit, like perfect competition. ▫Long-run equilibrium: Sellers earn zero

economic profit (or a normal accounting profit).

Monopolistic Competition and Oligopoly

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The maximum price consumers are willing to pay for 150 pairs is $70 per pair.

so economic profit is $50 per pair or $7,500 a day.

The profit-maximizing quantity where marginal revenue equals marginal cost . . .

The average total cost to produce 150 pairs is $20 per pair, . . .

Short-Run Equilibrium

is 150 pairs of jeans per day.


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With increased competition, demand decreases to D' and marginal revenue decreases to MR'.

Short-run economic profit creates an incentive for entry of new resources.

Adjustment from Short Run to Long Run

How does it Compare to Perfect Competition

•The monopolistically competitive firm also fails the efficiency test, P>MC.

•The value to consumers is greater than the cost of producing it.

•The L-R equilibrium output is lower than the perfect competitive firm and the price is higher.

•What does this mean?

The Oligopoly Market Structure•An imperfectly competitive market

structure in which a few large firms dominate the market

•How to define an oligopoly?▫Few sellers▫Either a homogenous or a differentiated

product▫Difficult market entry

Few Sellers•Again, there is no specific number that

must dominate an industry before it is an oligopoly.

•The components of an oligopoly are the mutual interdependence .▫Def: Mutual interdependence in which an

action by one firm may cause a reaction from other firms.

•Being there are only a few firms in the market, it is easy to collude in the market

Homogenous or Differentiated Product•The goods produced may be identical or

may not be identical.

Difficult Entry

•Some barriers:▫Exclusive financial requirements▫Control over an essential resource▫Patent rights▫Other legal barriers▫Economies of Scale- this is the major one

Examples of Oligopolies

•Characteristics of Oligopoly▫Examples

• Do sellers in these markets behave competitively or monopolistically?

•Beverages (soft drinks)

•Music (CD’s)

•Tobacco

•Automobiles

•Characteristics of Oligopoly• In 2007 (after 2008, “the Big Three” went from 70% of the market to 50%):

U.S. Market Share of Largest Sellers in Market

Beverages Tobacco Cars

Seller Share Seller Share Seller Share

Coke 44.5% Phillip Morris 49.4% GM 29.3%

Pepsi 31.4%R.J.

Reynolds24.0% Ford 24.9%

Cadbury 14.4% Brown and Williamson 15.0% Chrysler 16.1%

Total 90.3% Total 88.4% Total 70.3%

Price and Output for an Oligopolist•The maximize price is not as simple at

MR=MC. One player’s move depends on the anticipated reactions of the opposing player.

•The oligopoly can compete on several different levels.▫Non-price competition▫Price Leadership▫The Cartel▫Game Theory

Non-price Competition•They often compete using advertising &

product differentiation•This is why research & development is so

important in these type of firms.

Price Leadership•They play a game of follow the leader.

▫Def: Price leadership is a pricing strategy in which a dominant firm sets the price for an industry and the other firms follow

Collusion

•An agreement among firms in the industry to divide the market and fix the prices

The Cartel

•Firms may decide to avoid price wars and they may openly or secretly conspire to form a monopoly called a “cartel.”▫Def: A cartel is a group of firms that

formally agree to control the price and the output of a product


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CARTELSAnatomy of a Cartel: OPEC

In the 1970’s, OPEC succeeded in limiting the supply of crude oil produced by member countries so as to increase the price.

After 1980, however, the market imploded. Price fell almost as much as it had risen.

What happened? Why was the cartel’s success so short-lived?

Monopolistic Competition and Oligopoly29

CARTELS

•Anatomy of a Cartel: OPEC

▫Reaching agreement


CARTELS•Anatomy of a Cartel: OPEC

▫New sources of supply


•Anatomy of a Cartel: OPEC▫Greater energy efficiency and consumer

substitution



▫Detecting and preventing cheating


CARTELS


▫Enforcing the agreement

Game Theory•Def: Game theory is a model of strategic

moves and countermoves of rivals▫They are mutually interdependence

because an action by one firm may cause a reaction from the other firm.

Game Theory•In an oligopoly structure, a few firms

compete for their customers. One firm may gain customers by decreasing the price at the expense of the other firms or they may increase advertising.

• In an oligopoly, the important element is those firms that do not follow suit will lose customers. However, if the other firms react competitively by doing the same, then all the firms lose. Thus, each firm finds itself on the horns of a dilemma- this example is known as the classic “prisoner’s dilemma.”

Game Theory•Economists have increasingly used game

theory (like the example of the prisoner’s dilemma) to analyze strategic choices made by competitors.

Example of Game Theory

Example of Game Theory•To see how this works, think about two

touring Americans who just met at a train station in a small foreign country : Joe and William.

•The two are taken into the local police station under the suspicion of being involved in a local robbery of the bakery.

•The two are told that it will make the polices’ job easier if they confess immediately, giving them 6 months of jail time each. But they are also told that if one confesses and the other does not, then the one who confesses will get 6 months of jail time, but the one who does not confess will get 12 months.

Example of Game Theory•If neither confesses, both will be held for

three months while the investigation continues. William and Joe are not allowed to communicate with each other. Will they confess?▫In order to figure this out, we must lay out

the alternative outcomes and show how they would relate to the choices made by the players of the game. This is done in a matrix form.

Example of Game Theory

Confess Not Confess

Confess 6 months each Joe: 12 monthsWilliam: 6

months

Not Confess Joe: 6 monthsWilliam: 12

months

3 months each

Joe’s Choice

William’s Choice

Example of Game Theory•For both Joe and William, the best choice

depends on what the other does. If Joe confesses, then William can save 6 months of jail time by also confessing. The same will hold for William if he thinks that Joe is going to confess. But if neither confesses then they both will only receive 3 months of jail time. Joe and William must each decide, without communicating with each other, whether to confess.

Example of Game Theory•Joe knows that if William does not

confess, then he can either confess and spend 6 months in jail, or not confess and spend 3 months. But if William does confess, then Joe’s failure to confess will cost him an additional 6 months in jail. The story for William is the same… Thus, each man has an incentive to confess if he thinks the other one will, but an incentive not to confess if he thinks the other will also remain silent.

How does this apply to Oligopoly?•The firms must make decisions in this

same way, they are dependent on what the other firm is going to do. For instance, if one firm cuts its price, then how do the other firms react? Do they choice to advertise or not?▫There is always a trade-off for the

individual firms.

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Chapter 10 monopolistic competition & oligopoly