ch11 monopolistic competition_and_oligopoly[1]

Chapter Objectives • Characteristics of monopolistic

competition

• Normal profit in the long run

• Characteristics of oligopoly

• Game theory

• Three Oligopoly Models

• Oligopoly and Efficiency

Monopolistic Competition

• Attributes of Monopolistic Competition

– Many sellers

– Product differentiation

– Free entry and exit

• Many Sellers

– There are many firms competing for the same group

of customers.

• Product examples include books, CDs, movies, computer

games, restaurants, piano lessons, cookies, furniture, etc.

• Product Differentiation

– Each firm produces a product that is at least slightly

different from those of other firms.

• Free Entry or Exit

– Firms can enter or exit the market without

restriction.

– The number of firms in the market adjusts until

economic profits are zero.

Relationship to other market models

• Monopolistic competition is similar to perfect competition in that:

– There are many buyers and sellers

– There are no barriers to entry or exit

• Monopolistic competition is similar to monopoly in that:

– Each firm is the sole producer of a particular product

– The firm faces a downward sloping demand curve for its product

Demand curve facing a monopolistically

competitive firm

Short-run equilibrium with

economic profit

• Short-run economic profits encourage new firms

to enter the market. This:

• Increases the number of products offered.

• Reduces demand faced by firms already in the market.

• Incumbent firms’ demand curves shift to the left.

• Demand for the incumbent firms’ products fall, and their

profits decline.

Monopolistic Competition in the Short Run

Quantity 0

Profit-

maximizing

quantity

Demand

(a) Firm Makes Profit

Average

total cost Profit

Short-run equilibrium with

economic losses

• Short-run economic losses encourage firms to

exit the market. This:

• Decreases the number of products offered.

• Increases demand faced by the remaining firms.

• Shifts the remaining firms’ demand curves to the right.

• Increases the remaining firms’ profits.

Monopolistic Competitors in the Short Run

Demand

Quantity 0

minimizing

quantity

Average

total cost

(b) Firm Makes Losses

Losses ATC

The Long-Run Equilibrium

• Firms will enter and exit until the firms are

making exactly zero economic profits.

• The long run: only a normal profit

A Monopolistic Competitor in the Long Run

Quantity

Demand MR

Profit-maximizing

quantity

P = ATC

Long-Run Equilibrium

• Two Characteristics

– As in a monopoly, price exceeds MC.

• The downward-sloping demand curve makes MR less

than price.

– As in a competitive market, price equals ATC.

• Free entry and exit drive economic profit to zero.

Monopolistic versus Perfect Competition

• Excess Capacity

– There is no excess capacity in perfect competition in the long run.

• Free entry results in competitive firms producing at the point where ATC is minimized, which is the efficient scale of the firm.

– There is excess capacity in monopolistic competition in the long run.

• In monopolistic competition, output is less than the efficient scale of perfect competition.

Monopolistic versus Perfect Competition

Quantity 0

Demand

(a) Monopolistically Competitive Firm

Quantity 0

P = MC P = MR (demand

curve)

(b) Perfectly Competitive Firm

MC ATC

Efficient scale

Quantity produced

Quantity produced = Efficient scale

A monopolistically competitive firm, in the long run, has “excess capacity” – (i.e., it produces a level of output that is below the least-cost level).

Quantity

MR = MC

P3= A3

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

Price is Lower

Excess Capacity at Minimum ATC

Monopolistic competition is not efficient

Oligopoly

• Oligopoly

• Only a few sellers, each offering a similar or

identical product to the others.

Oligopoly

• A few large producers

• Homogeneous or differentiated products

• Control over price – Mutual interdependence

– Strategic behavior

• Entry barriers

• Mergers

Oligopoly

• Control over price – Because firms are few in oligopoly, each firm is a

price maker.

– But unlike monopoly, the oligopoly must consider how the rivals will react to any change in its price, output, product…

– Oligopoly is thus characterized by: • Mutual interdependence

• Strategic behavior

Mutual interdependence

• A situation in which each firm’s profit depends

not entirely on its own price and sales strategies

but also on the other firms.

Strategic behavior

• Strategic behavior occurs when the best

outcome of the firm depends upon the actions

and reactions of other firms.

Oligopoly

• Entry barriers – The same barriers to entry that create pure

monopoly also contribute to the creation of oligopoly.

– Economies of scale are important entry barriers source.

Oligopoly

• Mergers – The merging or combining of two or more

competing firms.

– It may substantially increase their market share, and in turns may allows the new firm to achieve greater economies of scale.

Game theory

• Game theory is the study of how people behave in

strategic situations.

• Strategic decisions are those in which each

person, in deciding what actions to take, must

consider how others might respond to that

action.

Game theory

• Because the number of firms in an oligopolistic

market is small, each firm must act strategically.

• Each firm knows that its profit depends not

only on how much it produces but also on how

much the other firms produce.

Game theory

• We assume that we have a duopoly.

• A duopoly is an oligopoly with only two

members. It is the simplest type of oligopoly.

Game theory

RareAir’s Price Strategy

Low •2 competitors •2 price strategies •Each strategy has a payoff (profit) matrix •Greatest combined

profit •Independent actions

stimulate a response

Game theory

RareAir’s Price Strategy

Low •Independently lowered prices in expectation of greater profit leads to the worst combined outcome •Eventually low outcomes make firms return to higher prices

Game theory

• Both firm realize they would make higher profits

if each used a high-pricing strategy.

• But each firm ends up choosing a low-price

strategy because it fears that it will be worse off

if the other firm use a low-price strategy against

Game theory

• Self-interest makes it difficult for the oligopoly

to maintain a cooperative outcome with low

production, high prices, and monopoly profits.

Three Oligopoly Models

• Kinked-demand curve (Noncollusive oligopoly)

• Cartels and Other Collusion: Collusive pricing

• Price leadership

Kinked-Demand Curve

• Noncollusive oligopoly

• Strategies

– Match price changes

– Ignore price changes

• Combined strategy

• Price inflexibility

• The kinked-demand curve

Kinked demand curve model

• Other firms are assumed to match price

decreases, but not price increases.

• There is little evidence suggesting that this

model describes the behavior of oligopoly firms.

• Game theory models are more commonly used.

Quantity Quantity

Rivals Ignore Price Increase

Rivals Match Price Decrease

Competitor and rivals strategize versus each other Consumers effectively have 2 partial demand curves

and each part has its own marginal revenue part

MR1 Q0

Resulting in a kinked-demand curve to the consumer – price and output are optimized at the kink

Kinked-Demand Curve

• Criticisms of the model

– It does not explain how the going price gets to P0

– The linked-demand curve explains price inflexibility but not price itself

– Prices are not that rigid

– Price wars: successive and continuous rounds of price cuts by rivals as they attempt to maintain their market shares.

Kinked-Demand Curve

Cartels and Other Collusion

• Cartels are legal in some countries

• A cartel arrangement can maximize industry profits

• Each firm can increase its profits by violating the

agreement

• Cartel agreements have generally been unstable.

Quantity

• Price and output – The oligopolistic firms face identical demand

and cost conditions – Joint profit maximization (common price)

Economic Profit

Effectively Sharing The Monopoly Profit

• Obstacles to collusion – Demand and cost differences

– Number of firms

– The potential for cheating

– Break down during recessions

– Legal obstacles: antitrust law

Price Leadership Model

• Price leadership involves an informal understanding among oligopolists to match any price change initiated by a designated firm.

Oligopoly and Efficiency

• Not productively efficient (P = min ATC)

• Not allocatively efficient (P =MC)

• Tendency to share the monopoly profit

• Qualifications

– Increased foreign competition

– Limit pricing

– Technological advance

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