Monopolistic and Monopolistic and OligopolyOligopoly

Monopolistic CharacteristicsMonopolistic Characteristics

►1) Relatively large # sellers (small market 1) Relatively large # sellers (small market share, no collusion, independent action)share, no collusion, independent action)

►2) Differentiated products (product 2) Differentiated products (product attributes, service, location, brand name attributes, service, location, brand name and packaging)and packaging) some control over price some control over price

►3) Easy entry and exit3) Easy entry and exit►4) Nonprice competition and advertising: 4) Nonprice competition and advertising:

successsuccess D shifts and less elastic D shifts and less elastic

Price and Output Price and Output DeterminationDetermination

►D highly, not perfectly, elastic: more D highly, not perfectly, elastic: more substitutes than M; fewer rivals and substitutes than M; fewer rivals and substitutes than PCsubstitutes than PC more rivals and more rivals and substitutes, more elastic; less, lesssubstitutes, more elastic; less, less

►MR=MC (MR<D)MR=MC (MR<D)

Short-/Long-Run Profit/LossShort-/Long-Run Profit/Loss

► Economic profit possible short-run, usually Economic profit possible short-run, usually eliminated long-run (easy entrance)eliminated long-run (easy entrance)

► Complications:Complications:► 1) Sufficient product differentiation1) Sufficient product differentiation others others

cannot duplicatecannot duplicate some monopoly power some monopoly power sliver economic profit long-runsliver economic profit long-run

► 2) Entry easy not free2) Entry easy not free some monopoly some monopoly powerpower sliver economic profit long-run sliver economic profit long-run

► But, long-run normal profit equilibrium But, long-run normal profit equilibrium realisticrealistic

Economic EfficiencyEconomic Efficiency

► Neither productively or allocativelyNeither productively or allocatively Slightly off: under-allocation resources, slightly too Slightly off: under-allocation resources, slightly too

high of pricehigh of price►Must charge P>competitive price in long run Must charge P>competitive price in long run

for normal profitfor normal profit► Amount of productive inefficiency: excess Amount of productive inefficiency: excess

capacitycapacity ““plant and equipment that are underused because plant and equipment that are underused because

firms are producing less than the minimum-ATC firms are producing less than the minimum-ATC output”output”

► If produced more efficientlyIf produced more efficiently fewer firms fewer firms producing more + lower priceproducing more + lower price

Nonprice CompNonprice Comp

► economic profiteconomic profit► product variety + improvement product variety + improvement

(profit motive)(profit motive)►Tradeoff choice + efficiency: greater Tradeoff choice + efficiency: greater

differentiationdifferentiation greater excess greater excess capacitycapacity

Product DifferentiationProduct Differentiation

►Good: wide range of choices that more fully Good: wide range of choices that more fully meet consumers’ demandsmeet consumers’ demands

► Bad: too many types of peanut butterBad: too many types of peanut butter rational choices difficult + time consuming; rational choices difficult + time consuming; price becomes measure of quality (incorrectly)price becomes measure of quality (incorrectly)

► ““Paradox of choice”: “maximizers” vs. Paradox of choice”: “maximizers” vs. “satisficers”“satisficers” For maximizer, all choices lead to unhappinessFor maximizer, all choices lead to unhappiness

paralysisparalysis Satisficer doesn’t let perfect become enemy of Satisficer doesn’t let perfect become enemy of

goodgood Barry Schwartz, Barry Schwartz, The Paradox of ChoiceThe Paradox of Choice

Product DevelopmentProduct Development

►Process, over time, to develop more Process, over time, to develop more useful/improved product (differentiation)useful/improved product (differentiation)

►Self-reinforcing: 1)rivals imitate/improve Self-reinforcing: 1)rivals imitate/improve or suffer loss; 2) profitor suffer loss; 2) profit ability to further ability to further improveimprove

►But: 1) some change more apparent than But: 1) some change more apparent than real (no change durability, efficiency, real (no change durability, efficiency, usefulness); 2) “planned obsolescence”usefulness); 2) “planned obsolescence”

Competition and Economic Competition and Economic AnalysisAnalysis

►Graph assumes given product and Graph assumes given product and advertising: in reality not fixedadvertising: in reality not fixed constant trial + error w/combinations constant trial + error w/combinations price, product, advertisingprice, product, advertising

►Game theory: must also respond to Game theory: must also respond to rivals’ actions—competitive rivals’ actions—competitive advertising decision, rivals’ patents, advertising decision, rivals’ patents, etc.etc.

Oligopoly CharacteristicOligopoly Characteristic

► 1) Few, large producers1) Few, large producers► 2) Homogenous or Differentiated: industrial 2) Homogenous or Differentiated: industrial

oligopolies tend to be “homogenous oligopolies tend to be “homogenous oligopolies” while consumer goods tend to be oligopolies” while consumer goods tend to be “differentiated oligopolies”“differentiated oligopolies”

► 3) Control over price, w/mutual 3) Control over price, w/mutual interdependence: “each firm’s profit depends interdependence: “each firm’s profit depends not on its own price and sales strategies but not on its own price and sales strategies but on those of its rivals”on those of its rivals”

► 4) Entry barriers: many same as monopoly4) Entry barriers: many same as monopoly► 5) Mergers: internal growth vs. external 5) Mergers: internal growth vs. external

mergermerger monopoly power + economies of monopoly power + economies of scalescale

Measures of ConcentrationMeasures of Concentration

►Concentration ratio: % total sales Concentration ratio: % total sales obtained by largest firms: obtained by largest firms: four-firm four-firm concentration ratioconcentration ratio: >40%: >40% oligopoly oligopoly (about ½ all US industries oligopoly)(about ½ all US industries oligopoly)

►3 shortcomings: 1) Localized markets 3 shortcomings: 1) Localized markets (ratio national); 2) Interindustry (ratio national); 2) Interindustry competition; 3) World Trade (import competition; 3) World Trade (import competition)competition)

Herfindahl IndexHerfindahl Index

►““Sum of the squared percentage of Sum of the squared percentage of market shares of all firms in the market shares of all firms in the industry”industry” greater weight to larger greater weight to larger firmsfirms

►Monopoly: 100Monopoly: 10022 10,000 10,000►Oligopoly of 4 equalOligopoly of 4 equal 25 2522 + 25 + 2522 + 25 + 2522

+ 25+ 2522= 2500= 2500►Perfect competition: approaches 0Perfect competition: approaches 0

Game TheoryGame Theory

► Prisoner’s DilemmaPrisoner’s Dilemma► Payoff matrixPayoff matrix

collusive tendenciescollusive tendencies► Incentive to cheatIncentive to cheat

3 Oligopoly Models3 Oligopoly Models

►Why not single: 1) diversity of oligopolies Why not single: 1) diversity of oligopolies (tight: two or three dominate vs. loose: six (tight: two or three dominate vs. loose: six or seven control 70-80% w/“competitive or seven control 70-80% w/“competitive fringe”; collusive vs. not; commodity vs. diff, fringe”; collusive vs. not; commodity vs. diff, etc.); 2) Complications of interdependenceetc.); 2) Complications of interdependence cannot estimate own D and MRcannot estimate own D and MR

►However, tendencies: 1) stable However, tendencies: 1) stable macroeconomymacroeconomy inflexible prices inflexible prices (sticky/rigid); 2) prices tend to change (sticky/rigid); 2) prices tend to change togethertogether

1) Kinked-Demand Theory: 1) Kinked-Demand Theory: noncollusive oligopolynoncollusive oligopoly

►The worst graph you will ever seeThe worst graph you will ever see

Advantages of ModelAdvantages of Model

►Combined strategy: makes sense of how Combined strategy: makes sense of how rivals actrivals act

►Price inflexibility: Price inflexibility: ►Demand side: price change will be for Demand side: price change will be for

worseworse up P=customers desert; lower up P=customers desert; lower P=rivals match and little increase sales P=rivals match and little increase sales and therefore TR and profit falland therefore TR and profit fall

►Cost side: even w/substantial cost Cost side: even w/substantial cost change, no incentive change price or change, no incentive change price or outputoutput

CriticismCriticism

►1) Does not explain how price got to 1) Does not explain how price got to P0 in first placeP0 in first place

►2) Unstable macroeconomy2) Unstable macroeconomy not as not as rigid: price warrigid: price war Successive and continuous rounds of price Successive and continuous rounds of price

cuts by rivals as they attempt to maintain cuts by rivals as they attempt to maintain market sharemarket share

2) Cartels and other collusion2) Cartels and other collusion

►““Collusion occurs whenever firms in an Collusion occurs whenever firms in an industry reach an agreement to fix industry reach an agreement to fix prices, divide up the market, or prices, divide up the market, or otherwise restrict competition among otherwise restrict competition among themselves”: reduce uncertainty, themselves”: reduce uncertainty, increase profits, prohibit entry increase profits, prohibit entry (maintain long-run economic profits)(maintain long-run economic profits)

► Assume essentially identical firmsAssume essentially identical firms► All want to act as monopoly; what if rivals sell All want to act as monopoly; what if rivals sell

lower?lower? price war and loss of profit price war and loss of profit colludecollude oligopoly acts as monopoly (w/same oligopoly acts as monopoly (w/same graph)graph)

► Overt: cartel (“a group of producers which Overt: cartel (“a group of producers which typically develops a formal written agreement typically develops a formal written agreement as to how much each member will produce as to how much each member will produce and charge”): OPECand charge”): OPEC less supply, higher costs less supply, higher costs

► Covert: tacit understandings (learn to play golf Covert: tacit understandings (learn to play golf and drink more: earn 10-14% moreand drink more: earn 10-14% more social social capital: remember Rachel’s smoking on capital: remember Rachel’s smoking on FriendsFriends?)?)

ObstaclesObstacles

►Demand and cost differences: diff Demand and cost differences: diff costscosts diff profit maximizing P and Q diff profit maximizing P and Q

►# Firms: more= harder# Firms: more= harder►CheatingCheating►RecessionRecession up ATC: left shift MR up ATC: left shift MR

operate higher ATCoperate higher ATC►Potential EntryPotential Entry►Antitrust LawAntitrust Law

OPECOPEC

►New Suppliers (remember Canada)New Suppliers (remember Canada)►Declining Demand: extremely Declining Demand: extremely

inelastic, but stillinelastic, but still►Cheating: Saudi Arabia wants Cheating: Saudi Arabia wants

relatively low prices; poorer members relatively low prices; poorer members need higher prices; large militaries need higher prices; large militaries need funding or face revolutionneed funding or face revolution

3) Price Leadership Model3) Price Leadership Model

►““Dominant firm” initiates prices Dominant firm” initiates prices changes, rest followchanges, rest follow

►Tactics: infrequent changes (response Tactics: infrequent changes (response to large cost/demand changes), to large cost/demand changes), communications (signaling through communications (signaling through speeches; see: Fed Chair), limit pricingspeeches; see: Fed Chair), limit pricing

►Breakdowns: price warsBreakdowns: price wars loss profit loss profit return to leadershipreturn to leadership

Oligopoly and AdvertisingOligopoly and Advertising

►D determined by product development D determined by product development and advertisingand advertising

►1) PD and ads less easily copied than 1) PD and ads less easily copied than pricesprices

►2) O firms have sufficient $ to do both2) O firms have sufficient $ to do both►Ad Positives:Ad Positives:►1) reduce search costs; 2) breakdown 1) reduce search costs; 2) breakdown

monopoly power; 3) introduction new monopoly power; 3) introduction new products (how else compete w/existing products (how else compete w/existing brands?)brands?) greater efficiency greater efficiency

Potential NegativesPotential Negatives

►1) Manipulation; 2) 1) Manipulation; 2) misleading/extravagant claims (truth misleading/extravagant claims (truth in advertising laws); 3) brand loyaltyin advertising laws); 3) brand loyalty monopoly power; 4) ads raise start up monopoly power; 4) ads raise start up costscosts less entrance; 5) self- less entrance; 5) self-cancelingcanceling higher costs and price higher costs and price

► inefficiencyinefficiency

►Ads shift ATC upAds shift ATC up►But, if increased sales (Q up)But, if increased sales (Q up) lower lower

ATC pointATC point►Or, self-canceling: shift ATC, no Q Or, self-canceling: shift ATC, no Q

changechange higher ATC higher ATC►No general conclusions can be drawn No general conclusions can be drawn

about impact advertisingabout impact advertising

EfficiencyEfficiency

►Less desirable monopoly? Less desirable monopoly? (unregulated)(unregulated)

►1) Increased foreign competition1) Increased foreign competition►2) Limit pricing: benefits of comp w/o 2) Limit pricing: benefits of comp w/o

compcomp►3) Technological advance: large econ 3) Technological advance: large econ

profit (unlike PC) + competition (unlike profit (unlike PC) + competition (unlike Mono)Mono) R+D R+D

Tech, R+D, EfficiencyTech, R+D, Efficiency

►Technological advance: better Technological advance: better products better madeproducts better made

►Very long run: tech variableVery long run: tech variable►Terms: Invention, Innovation (product Terms: Invention, Innovation (product

and process), Diffusion, R+D and process), Diffusion, R+D Expenditures (biz and gov)Expenditures (biz and gov)

Modern View of Tech Modern View of Tech AdvanceAdvance

► Internal to capitalism: rivalryInternal to capitalism: rivalry search search for new profit opp’yfor new profit opp’y

►Role of Entrepreneurs and OthersRole of Entrepreneurs and Others►Start-upsStart-ups► Innovation w/in existing firmsInnovation w/in existing firms►Anticipating futureAnticipating future►Exploiting University and Gov’t Exploiting University and Gov’t

Scientific ResearchScientific Research

A Firm’s Optimal Amount of A Firm’s Optimal Amount of R+DR+D

►R+D profitable in future; MB=MC R+D profitable in future; MB=MC difficult to determine accuratelydifficult to determine accurately

► Interest-Rate Cost of FundsInterest-Rate Cost of Funds 1) Bank loans; 2) Bonds; 3) Retained 1) Bank loans; 2) Bonds; 3) Retained

earnings; 4) Venture capital; 5) Personal earnings; 4) Venture capital; 5) Personal savingssavings

► Interest-rate cost-of-funds curve Interest-rate cost-of-funds curve (flat at i)(flat at i)

Expected Rate of Return Expected Rate of Return CurveCurve

►Downsloping (diminishing marginal Downsloping (diminishing marginal returns)returns)

►Optimal level (duh)Optimal level (duh) intersection of intersection of curvescurves

►However: 1) optimal vs. affordable; 2) However: 1) optimal vs. affordable; 2) expected, not guaranteed, returnsexpected, not guaranteed, returns

Increased ProfitIncreased Profit

►1) Increased Revenue: product 1) Increased Revenue: product innovationinnovation Importance of price (increased MU and Importance of price (increased MU and

affordable price); Unsuccessful new affordable price); Unsuccessful new products; Product improvementsproducts; Product improvements

►2) Decreased Costs: process 2) Decreased Costs: process innovationinnovation increased output + lower increased output + lower ATCATC

Role of Market StructureRole of Market Structure

► Pure Competition: more willing and more Pure Competition: more willing and more pressured; less able and less willing (easy pressured; less able and less willing (easy entranceentrance low/negative rates of return) low/negative rates of return)

►Monopolistic: basically same PCMonopolistic: basically same PC►Oligopoly: 1) able to finance, 2) barriersOligopoly: 1) able to finance, 2) barriers

higher expected rates of return, 3) large higher expected rates of return, 3) large scalescale spread costs out spread costs out lower prices, 4) lower prices, 4) range of R+D: hits>misses; BUT: range of R+D: hits>misses; BUT: complacency, obsolescence of capitalcomplacency, obsolescence of capital

►Monopoly: least conducive to R+DMonopoly: least conducive to R+D defensive R+D and suppress new products defensive R+D and suppress new products (oil industry and wind?)(oil industry and wind?)

Inverted-U TheoryInverted-U Theory

Concentration Ratio

R+D Expenditure as % sales

50%

Efficiency and Creative Efficiency and Creative DestructionDestruction

►Process innovationProcess innovation productive productive efficiencyefficiency

►Product innovationProduct innovation allocative allocative efficiencyefficiency

►Creative Destruction: Joseph Creative Destruction: Joseph SchumpeterSchumpeter