Ch 10 monopolistic competition and oligopoly micro econ4

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Chapter 10 ECON4 William A. McEachern

1

Monopolistic

Competition

and

Oligopoly





Monopolistic Competition

• Monopolistic competition

– Many producers

– Low barriers to entry

– Slightly different products

• A firm that raises prices: lose some

customers to rivals

– Some control over price ‘Price makers’

• Downward sloping demand curve

– Act independently or interdependently

2





Monopolistic Competition

• Product differentiation

– Physical differences

• Appearance; quality

– Location

• Spatial differentiation

– Services

– Product image

• Promotion; advertising

3





Short-Run Profit or Loss

• Curves

– Demand curve, D

• Slopes downward

– Marginal revenue, MR

• Below the demand curve

• Slopes downward

– Average total cost, ATC

– Average variable cost, AVC

– Marginal cost, MC

4





Short-Run Profit or Loss

• Maximize profit: MR=MC

– Price: on D curve

• If p>ATC

– Economic profit

• If ATC>p>AVC

– Economic loss; Produce in short run

• If p<AVC: AVC curve above D curve

– Economic loss; Shut down in short run

5



Exhibit 1

6

Monopolistic Competitor in the Short Run

p

c

Dolla

rs p

er

unit

Quantity per periodq0

MC

D

MR

ATC

e

Profit

(a) Maximizing short-run profit

The monopolistically competitive firm produces the level of output at which marginal revenue

equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping

demand curve. In panel (a), the firm produces q units, sells them at price p, and earns a short-run

economic profit equal to (p-c) multiplied by q, shown by the blue rectangle. In panel (b), the

average total cost exceeds the price at the output where marginal revenue equals marginal cost.

Thus, the firm suffers a short-run loss equal to (c p) multiplied by q, shown by the pink rectangle.

p

c

Dolla

rs p

er

unit


MC

D

MR

AVC

e

Loss

(b) Minimizing short-run loss

ATC

b

cb

c





Profit in the Long-Run

• Short run economic profit

– New firms enter the market

– Draw customers away from other firms

– Reduce demand facing other firms

– Profit disappears in long run

• Zero economic profit

7





Profit in the Long-Run

• Short run economic loss

– Some firms exit the market

– Their customers switch to other firms

– Increase demand facing the remaining

firms

– Loss is erased in the long run

• Zero economic profit

8



Exhibit 2

9

Long-Run Equilibrium in Monopolistic Competition

0 q Quantity per period

p

Dolla

rs

per

unit

D

MR

MC

a

ATCb

If existing firms earn economic

profit in the short run, new firms

will enter the industry in the long

run. This entry reduces the

demand facing each firm. In the

long run, each firm’s demand

curve shifts leftward until marginal

revenue equals marginal cost

(point a) and the demand curve is

tangent to the average total cost

curve (point b). Economic profit is

zero at output q. With zero

economic profit, no more firms will

enter, so the industry is in long-

run equilibrium. The same long-

run outcome occurs if firms suffer

a short-run loss. Firms leave until

remaining firms earn just a normal

profit.





Comparison

• Monopolistic competition and perfect

competition

– Zero economic profit in long run

– MR=MC for quantity

• Where demand curve is tangent to average

total cost curve

10





Comparison

• Perfect competition

– Firm’s demand: horizontal line

– Produces at minimum average cost

– Productive and allocative efficiency

11





Comparison

• Monopolistic competition

– Downward sloping demand curve

– Not producing at minimum average cost

• Excess capacity

– Produces less, charges more

• Than perfect competitor

• In the long run

– Spend more to differentiate their

products

12





Comparison

• Excess capacity

– Difference between a firm’s profit-

maximizing quantity

– And the quantity that minimizes average

cost

• Firms with excess capacity

– Could reduce average cost

– By increasing quantity

13



Exhibit 3

14

Perfect Competition Versus Monopolistic Competition in

Long-Run Equilibrium

p

Do

llars

pe

r u

nit


d=MR=AR

(a) Perfect competition

Cost curves are assumed to be the same in each panel. The perfectly competitive firm of panel (a) faces

a demand curve that is horizontal at market price p. Long-run equilibrium occurs at output q, where the

demand curve is tangent to the average total cost curve at its lowest point. The monopolistically

competitive firm of panel (b) is in long-run equilibrium at output q’, where demand is tangent to the

average total cost curve. Because the demand curve slopes downward in panel (b), the tangency does

not occur at the minimum point of average total cost. Thus, the monopolistically competitive firm

produces less output and charges a higher price than does a perfectly competitive firm with the same

cost curves. Neither firm earns economic profit in the long run. The firm in monopolistic competition has

excess capacity, meaning that it could reduce average cost by increasing its rate of output.

(b) Monopolistic competition

p’

Dolla

rs p

er

unit

Quantity per periodq’0

MC

D

MR

ATCATC

MC





Introduction to Oligopoly

• Oligopoly

– Few firms

– Each behaves interdependently

• The more similar the products

– The greater interdependence

• Undifferentiated oligopoly

– Oligopoly that sells a commodity

15






• Differentiated oligopoly

– Oligopoly that sells products that differ

across suppliers

• Product differentiation

• Physical qualities

• Sales location

• Services

• Product image

16






• Barriers to entry

– Economies of scale

– Legal restrictions

– Brand names

– Control over an essential resource

– High cost of entry

• Start-up costs; advertising

– Crowding out the competition

17



Exhibit 4

18

Economies of Scale as a Barrier to Entry

ca

Dolla

rs p

er

unit

cb

Autos per yearS0 M

Long-run average cost

At point b, an existing firm can produce M or more automobiles at an average cost of

cb. A new entrant able to sell only S automobiles would incur a much higher average

cost of ca at point a. If automobile prices are below ca, a new entrant would suffer a

loss. In this case, economies of scale serve as a barrier to entry, insulating firms that

have achieved minimum efficient scale from new competitors.

a

b





Models of Oligopoly

• Interdependence

– Cooperation or

– Fierce competition

• Collusion

• Price leadership

• Game theory

19





Collusion and Cartels

• Collusion

– Agreement among firms to

• Increase economic profit by

– Dividing the market

– Fixing the price

• Cartel

– Group of firms that agree to coordinate

their production and pricing decisions

• To reap monopoly profit

– Illegal in U.S.20



Exhibit 5

21

Cartel as a Monopolist

Quantity per periodQ0

MC

D

MR

p

Dolla

rs p

er

unit

c

A cartel acts like a monopolist.

Here, D is the market demand

curve, MR the associated

marginal revenue curve, and

MC the horizontal sum of the

marginal cost curves of cartel

members (assuming all firms in

the market join the cartel).

Cartel profits are maximized

when the industry produces

quantity Q and charges price p.





Collusion and Cartels

• Maximize profit

– Allocate output among cartel members

– Same MC of the final unit produced

• Difficulties to maintain a cartel:

– Differentiated product

– Differences in average cost

– Many firms in the cartel

– Low barriers to entry

– Cheating22





Price Leadership

• Price leadership

– Informal, tacit collusion

• Price leader

– Sets the price for the industry

– Initiate price changes

– Followed by the other firms

23





Price Leadership

• Obstacles

– U.S. antitrust laws

– Product differentiation

– No guarantee others will follow

– Barriers to entry

– Cheating

24





Game Theory

• Game theory

– Approach that analyzes oligopolistic

behavior

– Series of strategic moves and

countermoves by rival firms

• General approach

– Focus: each player’s incentives to

cooperate or compete

25





Game Theory

• Prisoner’s dilemma

– Game that shows why players have

difficulty cooperating

– Even though they would benefit from

cooperation

• Strategy

– Operational plan pursued by a player

26





Game Theory

• Payoff matrix

– Table listing the payoffs

• That each player can expect from each

move

• Based on the actions of the other player

• Dominant-strategy equilibrium

– Outcome achieved when each player’s

choice does not depend on what the

other player does

27



Exhibit 6

28

The Prisoner’s Dilemma Payoff Matrix (years in jail)

Jerry

Confess Clam up

Ben

Confess

Clam up

10

0

0

10

1

1

5

5

This matrix shows the years each prisoner can expect to spend in jail based on his

actions and the actions of the other prisoner. Ben’s payoff is in red and Jerry’s in blue.





Game Theory

• Duopoly

– Market with only two producers

• Nash equilibrium

– A player chooses the best strategy given

the strategies chosen by others

– No participant can improve his or her

outcome by changing strategies

• Even after learning of the strategies selected

by other participants

29



Exhibit 7

30

Price-Setting Payoff Matrix (profit per day)

Exxon

Low price High price

Texaco

Low

price

High

price

$200

$1,000

$1,000

$200

$700

$700

$500

$500

This matrix shows the daily profit each gas station can expect to earn based on the

price each charges. Texaco’s price is in red and Exxon’s is in blue.



Exhibit 8

31

Cola War Payoff Matrix (annual profit in billions)

Coke

Big

budget

Moderate

budget

Pepsi

Big

budget

Moderate

budget

$1

$4

$4

$1

$3

$3

$2

$2

This matrix shows annual profit each soft-drink company can expect to earn based on

the promotional budget each adopts. Pepsi’s profit is in red and Coke’s is in blue.





Game Theory

• One-shot versus repeated games

– One-shot game

• Game is played just once

– Repeated games

• Establish reputation for cooperation

• Tit-for-tat strategy

– Highest payoff

32





Game Theory

• Tit-for-tat

– Strategy in repeated games

– A player in one round of the game

mimics the other player’s behavior in the

previous round

– Optimal strategy for getting the other

player to cooperate

33





Game Theory

• Coordination game

– Game in which a Nash equilibrium

occurs when each player chooses the

same strategy

– Neither player can do better than

matching the other player’s strategy

34





Comparison

• Oligopoly

– If firms collude or operate with excess

capacity

• Higher price

• Lower output

– If price wars

• Lower price

– Higher profits in the long run

35



Exhibit 9

36

Comparison of Market Structures

Economy & Finance

Ch 10 monopolistic competition and oligopoly micro econ4