Monopolistic Competition and Oligopoly

14

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Monopolistic Competition

• Relatively large number of sellers

• Differentiated products

• Easy entry and exit

• Advertising

LO1

Monopolistically Competitive

• Industry concentration

• Measured by:

• Four-firm concentration ratios

•Percentage of 4 largest firms

• Herfindahl index

• Sum of squared market shares

LO1

4-Firm CR = Output of four largest firmsTotal output in the industry

HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2

Low Concentration Industries(1)

Industry(2)

4-Firm Concentration

Ratio

(3)Herfindahl

Index

(1)Industry

(2)4-Firm

Concentration Ratio

(3)Herfindahl

Index

Adhesives 23 235Wood containers and pallets 11 51

Ready-mix concrete 23 313Textile bags and canvas 10 68

Asphalt paving 22 188Metal working machinery 9 33

Bolts, nuts, and rivets 21 162 Apparel 8 44

Plastic pipe 21 187Plastics and rubber products 8 31

Sawmills 15 98 Sheet metal work 7 30

Wood trusses 14 102 Signs 7 28

Metal stamping 14 88 Stone products 7 23

Curtains and draperies 14 85 Quick printing 4 8

Metal windows and doors 13 109 Retail bakeries 4 7

LO1

Price and Output in Monopolistic Comp

• Demand is highly elastic

• Short run profit or loss

• Produce where MR=MC

• Long run normal profit

• Entry and exit

• Inefficient

• Product variety

LO2

The Short Run: Profit or Loss

LO2

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D1

ATC

EconomicProfit

Q1

A1

P1

0

The Short Run: Profit or Loss

LO2

Quantity

Pri

ce

an

d C

os

ts

MC

MR

D2

ATC

Loss

Q2

A2

P2

0

MR = MC

The Long Run: Only a Normal Profit

LO2

Quantity

Pri

ce

an

d C

os

ts

MC

MR

D3

ATC

Q3

P3= A3

0

MR = MC

Monopolistic Competition: Efficiency

• Inefficient

• Productive inefficiency

•P > ATC

• Allocative inefficiency

•P > MC

LO2

Monopolistic Competition: Efficiency

LO2

P=MC=Min ATC for pure competition (recall)

P4

Q4

Price is Lower

Excess Capacity atMinimum ATC

Monopolistic competition is not efficient

Product Variety

• The firm constantly manages price, product, and advertising.

• Better product differentiation

• Better advertising

• The consumer benefits by greater array of choices and better products.

• Types and styles

• Brands and quality

LO2

Oligopoly

• A few large producers

• Homogeneous or differentiated products

• Limited control over price

• Mutual interdependence

• Strategic behavior

• Entry barriers

• Mergers

LO3

Oligopolistic Industries

• Four-firm concentration ratio

• 40% or more to be oligopoly

• Shortcomings

• Localized markets

• Inter-industry competition

• World price

• Dominant firms

LO3

High Concentration Industries(1)

Industry(2)

4-Firm Concentration

Ratio

(3)Herfindahl

Index

(1)Industry

(2)4-Firm

Concentration Ratio

(3)Herfindahl

Index

Primary copper 99 ND Phosphate fertilizers 83 ND

Household laundry equipment 98 ND Aircraft 81 ND

Cigarettes 98 ND Breakfast cereals 80 2426

Cane sugar refining 95 ND Petrochemicals 80 2535

Household refrigerators/freezers 92 ND

Small-arms ammunition 79 2447

Beer 90 ND Primary aluminum 77 2250

Glass containers 87 2507 Metal cans 77 1786

Electronic computers 87 ND Burial caskets 74 1979

Women’s handbags and purses 86 ND Tires 73 1540

Light trucks and utility vehicles 84 2680

Household vacuum cleaners 71 1519

LO1

Game Theory Overview

• Oligopolies display strategic pricing behavior

• Mutual interdependence

• Collusion

• Incentive to cheat

• Prisoner’s dilemma

LO4

Game Theory Overview

LO4

RareAir’s Price Strategy

Up

tow

n’s

Pri

ce

Str

ate

gy A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low•2 competitors•2 price strategies

•Each strategy has a payoff matrix

•Greatest combinedprofit

• Independent actionsstimulate a response

Game Theory Overview

LO4

RareAir’s Price Strategy

Up

tow

n’s

Pri

ce

Str

ate

gy A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low• Independently lowered prices in expectation of greater profit leads to worst combined outcome

•Eventually low outcomes make firms return to higher prices.

3 Oligopoly Models

• Kinked Demand Curve

• Collusive Pricing

• Price Leadership

• Reasons for 3 models

• Diversity of oligopolies

• Complications of interdependence

LO5

Kinked-Demand Theory

• Noncollusive oligopoly

• Uncertainty about rivals reactions

• Rivals match any price change

• Rivals ignore any price change

• Assume combined strategy

• Match price reductions

• Ignore price increases

LO5

Kinked Demand Curve

LO5

P0

MR2

D2

D1

MR1

e

f

g

Rivals IgnorePrice Increase

Rivals MatchPrice Decrease

Q0

MR2

D2

D1

MR1Q0

MC1

MC2

P0

e

f

g

Kinked Demand Curve

• Criticisms

• Explains inflexibility, not price

• Prices are not that rigid

• Price wars

LO6

Cartels and Other Collusion

LO6

D

MR=MC

ATC

MC

MR

P0

A0

Q0

EconomicProfit

Global Perspective

LO6

Overt Collusion

• Cartels - a group of firms or nations that collude

• Formally agreeing to the price

• Sets output levels for members

• Collusion is illegal in the United States

• OPEC

LO6

Obstacles to Collusion

• Demand and cost differences

• Number of firms

• Cheating

• Recession

• New entrants

• Legal obstacles

LO6

Price Leadership Model

• Price Leadership

• Dominant firm initiates price changes

• Other firms follow the leader

• Use limit pricing to block entry of new firms

• Possible price war

LO6

Oligopoly and Advertising

• Prevalent to compete with product development and advertising

• Less easily duplicated than a price change

• Financially able to advertise

LO7

Positive Effects of Advertising

• Low-cost way of providing information to consumers

• Enhances competition

• Speeds up technological progress

• Can help firms obtain economies of scale

LO7

Oligopoly and Advertising

LO7

The Largest U.S. Advertisers, 2010

CompanyAdvertising Spending Millions of $

Procter & Gamble $3124

General Motors $2131

AT&T $2093

Verizon $1823

News Corp $1368

Pfizer $1229

Time Warner $1194

Johnson & Johnson $1140

Ford Motor $1132

L’Oreal $1112

Source: Kantar Media, www.kantarmedia.com

Negative Effects of Advertising

• Can be manipulative

• Contains misleading claims that confuse consumers

• Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product.

LO7

Global Perspective

LO7

Oligopoly and Efficiency

• Oligopolies are inefficient

• Productively inefficient P > min ATC

• Allocatively inefficient P > MC

• Qualifications

• Increased foreign competition

• Limit pricing

• Technological advance

LO7

Oligopoly in the U.S. Beer Industry

• The U.S. beer industry is now an oligopoly

• Changes in demand• Change in tastes• Consumed at home and mass

produced• Changes in supply

• Technological advance• Economies of scale