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

Copyright©2003 Southwestern/Thomson Learning

Quantity 0

Price

Profit-

maximizing

quantity

Price

Demand

MR

ATC

(a) Firm Makes Profit

Average

total cost Profit

MC

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

Price

Price

Loss-

minimizing

quantity

Average

total cost

(b) Firm Makes Losses

MR

Losses ATC

MC

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

Price

0

Demand MR

ATC

MC

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

Price

Demand

(a) Monopolistically Competitive Firm

Quantity 0

Price

P = MC P = MR (demand

curve)

(b) Perfectly Competitive Firm

MC ATC

MC ATC

MR

Efficient scale

P

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

Pri

ce

an

d C

osts

MR = MC

MC

MR

D3

ATC

Q3 0

P3= A3

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

P4

Q4

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

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 (profit) matrix •Greatest combined

profit •Independent actions

stimulate a response

Game theory

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 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

it.

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.

Pri

ce

Pri

ce

an

d C

osts

Quantity Quantity

0 0

P0

MR2

D2

D1

MR1

e

f

g

Rivals Ignore Price Increase

Rivals Match Price Decrease

Q0

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

and each part has its own marginal revenue part

MR2

D2

D1

MR1 Q0

MC1

MC2

P0

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

e

f

g

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.

Pri

ce

an

d C

osts

Quantity


• Price and output – The oligopolistic firms face identical demand

and cost conditions – Joint profit maximization (common price)

D

MR=MC

ATC

MC

MR

P0

A0

Q0

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

Technology

Ch11 monopolistic competition_and_oligopoly[1]