chapter 10: monopolistic competition and oligopoly econ 101: microeconomics

Chapter 10:

Monopolistic Competition

And Oligopoly

Econ 101: Microeconomics

Hall & Leiberman; Economics: Principles And Applications, 2004

2

Monopolistic Competition And Oligopoly

On any given day, you are probably exposed to hundreds of advertisements• Advertising is everywhere in the economy

So far in this book not much has been said about advertising• There is a good reason for this

• In perfect competition and monopoly firms do little, if any, advertising

Where, then, is all the advertising coming from?• We must consider firms that are neither perfect

competitors nor monopolists


3

The Concept of Imperfect Competition

Refers to market structures between perfect competition and monopoly• In imperfectly competitive markets, there is more than

one seller, but too few to create a perfectly competitive market

• Imperfectly competitive markets often violate other conditions of perfect competition• Such as the requirement of a standardized product or

free entry and exit Types of imperfectly competitive markets

• Monopolistic competition • Oligopoly


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Monopolistic Competition

Hybrid of perfect competition and monopoly, sharing some of features of each• A monopolistically competitive market has

three fundamental characteristics• Many buyers and sellers

• Sellers offer a differentiated product

• Sellers can easily enter or exit the market


5

Many Buyers and Sellers Under monopolistic competition, an individual

buyer is unable to influence price he pays• But an individual seller, in spite of having many

competitors, decides what price to charge Our assumption of many sellers, however, has

another purpose• To ensure that no strategic games will be played

among firms in market• There are so many firms, each supplying such a small

part of the market• That no one of them needs to worry that its actions will be

noticed—and reacted to—by others


6

Sellers Offer a Differentiated Product

Each seller produces a somewhat different product from the others

Faces a downward-sloping demand curve • In this sense is more like a monopolist than a

perfect competitor

• When it raises its price a modest amount, quantity demanded will decline (but not all the way to zero)


7

Sellers Offer a Differentiated Product

What makes a product differentiated?• Quality of product

• Difference in location Product differentiation is a subjective matter

• A product is different whenever people think that it is• Whether their perception is accurate or not

Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated• This perception may be real or illusory, but economic

implications are the same in either case• Firm chooses its price


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Easy Entry and Exit

This feature is shared by monopolistic competition and perfect competition• Plays the same role in both

• Ensures firms earn zero economic profit in long-run

In monopolistic competition, however, assumption about easy entry goes further• No barrier stops any firm from copying the

successful business of other firms


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Monopolistic Competition in the Short-Run

Individual monopolistic competitor behaves very much like a monopoly

Key difference is this• While a monopoly is the only seller in its

market, a monopolistic competitor is one of many sellers

• When a monopolistic competitor raises its price, its customers have one additional option• Can buy similar good from some other firm


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Figure 1: A Monopolistically Competitive Firm in the Short Run

MR1

$70

30

250

d1

A MCATC

Dollars

Homes Serviced per Month

2. and charges $70 per home.

4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle.

1. Kafka services 250 homes per month, where MC and MR intersect . . .

3. ATC at 250 units is less than price, so profit per unit is positive.


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Monopolistic Competition in the Long-Run

Under monopolistic competition—in which there are no barriers to entry and exit—the firm will not enjoy its profit for long• Entry will continue to occur, and demand curve will continue

to shift leftward Under monopolistic competition, firms can earn positive

or negative economic profit in short-run• But in long-run, free entry and exit will ensure that each firm

earns zero economic profit just as under perfect competition In real world, monopolistic competitors often earn

economic profit or loss in the short-run• But—given enough time—profits attract new entrants, and

losses result in an industry shakeout• Until firms are earning zero economic profit


12

Figure 2: A Monopolistically Competitive Firm in the Long Run

d2MR2

E

MC

$40

100 250

Dollars

Homes Serviced per Month

ATC

MR1

In the long run, profit attracts entry, which shifts the firm's demand curve leftward.

The typical firm produces where its new MR crosses MC.

d1

Entry continues until P = ATC at the best output level, and economic profit is zero.


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Excess Capacity Under Monopolistic Competition

In long-run, a monopolistic competitor will operate with excess capacity• Will produce too little output to achieve minimum cost per

unit Excess capacity suggests that monopolistic

competition is costly to consumers May tempt you to leap to a conclusion

• Consumers are better off under perfect competition; however• In order to get beneficial results of perfect competition, all

firms must produce identical output

• Consumers usually benefit from product differentiation


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Non-price Competition If monopolistic competitor wants to increase its output it can

cut its price• Move along its demand curve

Any action a firm takes to increase demand for its output—other than cutting its price—is called non-price competition• Examples include better service, product guarantees, free home

delivery, more attractive packaging Non-price competition is another reason why monopolistic

competitors earn zero economic profit in long-run All this non-price competition is costly

• Must pay for advertising, for product guarantees, for better staff training

• Costs must be included in each firm’s ATC curve, shifting it upward

None of this changes conclusion that monopolistic competitors will earn zero economic profit in long-run


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Oligopoly

When just a few large firms dominate a market• So that actions of each one have an important impact

on the others

• Would be foolish for any one firm to ignore its competitors’ reactions

• In such a market, each firm recognizes its strategic interdependence with others

An oligopoly is a market dominated by a small number of strategically interdependent firms


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Market Domination and Economies of Scale

Strategic interdependence requires that a few firms—whatever their number—dominate the market • Their share of market is large

When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market• A large firm—supplying a large share of the market—will

have lower cost per unit than a small firm• Since small firms can’t compete, only a few large firms survive

• Market becomes an oligopoly

• Tends to happen on its own unless there is government intervention

• Such a market is often called a natural oligopoly—analogous to natural monopoly


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Reputation as a Barrier A new entrant may suffer just from being new

• Established oligopolists are likely to have favorable reputations

In some cases, where potential profits are great, investors may decide it is worth the risk and accept initial losses in order to enter industry

In other industries, the initial losses may be too great and probability of success too low for investors to risk their money starting a new firm


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Strategic Barriers

Oligopoly firms often pursue strategies designed to keep out potential competitors• Maintain excess production capacity as a signal to a

potential entrant that they could easily saturate market and leave new entrant with little or no revenue

• Make special deals with distributors to receive best shelf space in retail stores

• Make long-term arrangements with customers to ensure that their products are not displaced quickly by those of a new entrant

• Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product


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Legal Barriers

Patents and copyrights—which can be responsible for monopoly—can also create oligopolies

Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination

Government barriers can operate against domestic entrants, too


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The Game Theory Approach Oligopoly presents the greatest challenge to economists Economist have had to modify tools used to analyze other market

structures and to develop entirely new tools as well to analyze oligopoly behavior

Game theory• An approach to modeling strategic interaction of oligopolists in terms of

moves and countermoves In all games—except those of pure chance, such as roulette—a

player’s strategy must take account of the strategies followed by other players

Game theory analyzes oligopoly decisions as if they were games by • Looking at the rules players must follow

• Payoffs they are trying to achieve

• Strategies they can use to achieve them


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The Prisoner’s Dilemma Easiest way to understand how game theory works is to

start with a simple, non-economic example—the prisoner’s dilemma• Explains why a technique for obtaining confessions,

commonly used by police, is so often successful Each of four boxes in payoff matrix represents one of four

possible strategy combinations that might be selected in this game• Upper left box: Both Rose and Colin confess

• Lower left box: Colin confesses and Rose doesn’t

• Upper right box: Rose confesses and Colin doesn’t

• Lower right box: Neither Rose nor Colin confesses


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Figure 3: The Prisoner’s Dilemma

Confess

Confess

Don’t Confess

Rose’s Actions

Colin gets 20 years

Rosegets 20years

Colin gets30 years

Colin gets 3 years

Colin gets5 years

Rosegets 20years

Rosegets 20years

Rosegets 20years

Colin’s Actions

Don’t Confess


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The Prisoner’s Dilemma Regardless of Rose’s strategy Colin’s best choice is to

confess

• In this game, the strategy “confess” is an example of a dominant strategy

• Strategy that is best for a player regardless of strategy of other player

Outcome of this game is an example of a Nash equilibrium—appropriately named after the mathematician John Nash, who originated the concept

• Exists when each player is taking the best action—given actions taken by other players

As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them


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Simple Oligopoly Games Same method used to understand behavior of Rose and Colin

in prisoner’s dilemma can be applied to a simple oligopoly market

Duopoly• Oligopoly market with only two sellers

Assume that Gus and Filip must make their decisions independently• Without knowing in advance what the other will do

No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy

Notice that outcome is a Nash equilibrium• Equilibrium price in market is the low price


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Figure 4: A Duopoly Game

Low Price

Low Price

High Price

Filip’s Actions

Gus’s profit = $25,000

Filip’sProfit =$25,000

Gus’s profit= –$10,000

Gus’s profit= $75,000

Gus’s profit= $50,000

Filip’sProfit =$–10,000



Gus’s Actions

High Price


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Oligopoly Games in the Real World

Will typically be more than two strategies from which to choose

Will usually be more than two players In some games, one or more players may not

have a dominant strategy• A game with two players will have a Nash equilibrium

as long as at least one player has a dominant strategy• Whether the other has a dominant strategy or not

• When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game


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Oligopoly Games in the Real World

We’ve limited the players to one play of the game• In reality, for gas stations and almost all other

oligopolies, there is repeated play• Where both players select a strategy

• Observe the outcome of the trial

• Play the game again and again, as long as they remain rivals

One possible result of repeated trials is cooperative behavior


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Cooperative Behavior in Oligopoly

In real world, oligopolists will usually get more than one chance to choose their prices

The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once• Often, firms will evolve some form of

cooperation in the long run


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Explicit Collusion Simplest form of cooperation is explicit collusion

• Managers meet face-to-face to decide how to set prices Most extreme form of explicit collusion is creation of a

cartel• Group of firms that tries to maximize total profits of the

group as a whole If explicit collusion to raise prices is such a good thing for

oligopolists, why don’t they all do it?• Usually illegal

• Penalties, if the oligopolists are caught, can be severe But oligopolists can collude in other, implicit ways


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Tacit Collusion

Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion

Tit for tat• A game-theoretic strategy of doing to another player

this period what he has done to you in previous period

However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion• Oligopolist will sometimes go further

• Attempting to punish a firm that threatens to destroy tacit cooperation


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Tacit Collusion Another form of tacit collusion is price leadership

• One firm—the price leader—sets its price and other sellers copy that price

With price leadership, there is no formal agreement• Rather the decisions come about because firms realize

—without formal discussion—that system benefits all of them

• Decisions include• Choice of leader

• Criteria it uses to set its price

• Willingness of other firms to follow


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The Limits to Collusion

Oligopoly power—even with collusion—has its limits• Even colluding firms are constrained by

market demand curve

• Collusion—even when it is tacit—may be illegal

• Collusion is limited by powerful incentives to cheat on any agreement


33

The Incentive to Cheat Go back to Gus and Filip for a moment

• One way or another they arrive at high-price cooperative solution

• Will the market stay there? Maybe, and maybe not

• Problem—each player may conclude that he can do even better by cheating

• Two players would be back to noncooperative outcome based on their dominant strategies

• May be in each player’s interest to cheat occasionally Analyzing this sort of behavior requires some rather

sophisticated game theory models

• Economists are actively engaged in building them


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When is Cheating Likely?

While no firm wants to completely destroy a collusive agreement by cheating• Since this would mean a return to the noncooperative

equilibrium wherein each firm earns lower profit

• Some firms may be willing to risk destroying agreement if benefits are great enough

• Suggests that cheating is most likely to occur—and collusion will be least successful—under the following conditions

• Difficulty observing other firms’ prices

• Unstable market demand

• Large number of sellers


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The Future of Oligopoly

Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure• In 1932, two economists—Adolf Berle and Gardiner

Means—noted trend toward big business • Predicted the 200 largest U.S. firms would control

nation’s entire economy by 1970• Unless something were done to stop it

Prediction has not come true• Today, there are hundreds and thousands of ongoing

businesses in United States


36

Antitrust Legislation and Enforcement Antitrust enforcement has focused on three types of actions

• Preventing collusive agreements among firms

• Such as price-fixing agreements

• Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers

• Preventing mergers that would lead to harmful market domination

Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws

While thrust of these policies is to preserve competition

• Type of competition preserved—and zeal with which policies are applied—can shift


37

The Globalization of Markets By enlarging markets from national ones to global ones,

international trade can increase the number of firms in a market

• Decreasing market dominance by a few, and increasing competition Although oligopolists often try to prevent it, they face increasingly

stiff competition from foreign producers Entry of U.S. producers has helped to increase competition in

foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods

While consumers in each nation may have access to more firms, these may be larger and more powerful firms

• Creating greater likelihood of strategic interaction and danger of collusion


38

Technological Change Technological change works to increase competition by

creating new substitute goods Can reduce barriers to entry in much the same way that

globalization does• By increasing size of market

Technology—the internet—has enabled residents in many smaller towns to choose among a dozen or more online sellers of the same merchandize• Trend can also be seen as encouraging oligopoly• Result could be strategic interaction, or collusion, among

large national players Finally, some technologies actually increase MES of

typical firm• Thereby encouraging formation of oligopolies


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Figure 5a: Advertising in Monopolistic Competition

1,000

C

A60

100

$120

2,0006,000

B

1.Before advertising, long-run economic profit is zero.

2. In the short run, the first firms to advertise earn economic profit.

dads

dno ads

ATCads

ATCno ads

dall advertise

Dollars

Bottles of Perfume per Month

3. But in the long run, imitation and entry bring economic profit back to zero.

4. Advertising can lead to a higher price in the long run, as in this panel . . .


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Figure 5b: Advertising in Monopolistic Competition

Dollars

Bottles of Perfume per Month

1,000

A60

dall advertise

dno ads

B$120

6,000

C50

2,000

dads

ATCads

ATCno ads

5. or to a lower price in the long run, as in this panel.


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Figure 6: An Advertising Game

Run Safety Ads

Run Safety Ads

Don't Run Ads

United's Actions

American's Actions

Don't Run Ads

American earns low

profit

American earns high

profit

United earns very low profit

United earns low profit

American earns very

low profit

American earns

medium profitUnited

earns medium profit

United earns high profit


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Problem #8 In Promaine Flats, Nevada there are two restaurants: Sal Monella

and Road Kill Café. Current profit =$7000 each. If clean up will attract more

customers, but profit becomes $5000 each. However, if clean up and doesn’t clean up then $12000 and

$3000.a. What is the payoff matrix?b. What is each player’s dominant strategy?

c. What will be the outcome of the game?d. Suppose the two restaurants will face the decision repeatedly. How might the outcome differ?e. Suppose the clean restaurant earns $6000 when one clean up and one stays dirty. What is the outcome?

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