mbad 5110 - ch 13 revised
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Monopolistic Competitionand Oligopoly
CHAPTER13
Profits, like sausages, are esteemed
most by those that know least
about what goes into them.Alvin Toffler
Futurist, Author (1928 - )
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C H A P T E R C H E C K L I S T
When you have completed your study of thischapter, you will be able to
1 Explain how price and quantity are determined inmonopolistic competition.
2 Explain why selling costs are high in monopolisticcompetition.
3 Explain the dilemma faced by firms in oligopoly.
4 Use game theory to explain how price and quantity aredetermined in oligopoly.
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MARKET CHARACTERISTICS
Perfect Competition
MonopolisticCompetition
Monopoly
Many, many, many, manysellers, none so large that theycan influence price
Relatively many sellers, littleinfluence on price
One seller that likely caninfluence price
Homogeneous product (buyersdon’t care who they by from) Heterogeneous products, withsubstitutes Heterogeneous product,no close substitutes
No barriers to entry or exit (easyto get in and out of market)
Low to no barriers to entry or exit
HIGH barriers to entry or exit
Long run economic profit = zero(only earning normal profit)
Long run economic profit =zero (only earning normal profit)
Long run economic profitis positive
Firms are price takers (nomarket power, so market setssame price for all firms)
Firms have power over their own pricing becauseproducing different, but
similar, products
Firms are price makers(lots of market power,market IS the firm)
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Relatively Large Number of Firms
• Fewer than perfect competition.
• Three implications are:
– Small market share
– No market dominance
– Collusion impossible
13.1 MONOPOLISTIC COMPETITION
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Product Differentation
Product differentiation - making a product that
is slightly different from the products of competing firms.
•A differentiated product has close substitutes, but not
perfect substitutes.•When the price of one firm’s product rises, the quantity
demanded of that firm’s product decreases.
13.1 MONOPOLISTIC COMPETITION
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Competition on Quality, Price, and Marketing
Quality
Design, reliability, after-sales service, and buyer’sease of access to the product.
Price
Because of product differentiation, the demand
curve for the firms’ product is downward sloping.
Marketing
Advertising and packaging.
13.1 MONOPOLISTIC COMPETITION
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Entry and Exit
Low to no barriers to entry, so the firm is
unlikely to make economic profit in the long run.
Examples:
•Restaurants
•Gas stations•Hair salons
•Dry Cleaners
13.1 MONOPOLISTIC COMPETITION
These firms are monopolistic inthat each one has a monopolyon their brand, image, service,
ambience, menu, etc. They arecompetitive in the sense thatthere are many, many of them,and consumers can easily sub
one for another.
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Concentration ratio – percentage of sales accounted for by specified number of top firms in a market.
•Usually reported as 4-firm, 8-firm, or 20-firm.
• The higher the concentration ratio, the greater thedegree of market dominance by small number of firms.
• The range of concentration ratio is from almost zerofor perfect competition to 100 percent for monopoly.
• Can distinguish between market structures byconcentration ratio
Industry Concentration
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CR1 > 90% Effective monopoly 2-3%
CR4
> 60% Tight oligopoly 10%
CR4 between
40% & 60%
Loose oligopoly 12%
CR4 < 40% Effectively competitive
PC and monopolisticcompetition
75%
% of GDP
Industry Concentration
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Herfindahl-Hirschman Index (HHI) – sum of the squaredmarket shares of all firms.
• HHI = s1
2 + s2
2 + . . . .sn
2
• Ranges from 10,000 for pure monopolist to zero for infinite number of small firms.
•The more unequal the market share, the higher the HHIvalue. The greater the number of firms, the lower theHHI.
Industry Concentration
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• Increases in concentration typically yield increasedprices and profits, ceteris paribus.
• Squaring gives greater weight to larger shares.
• Example: If there are five firms in a market with
market shares of 40%, 30%, 16%, 10% and 4%:
HHI = 402 + 302 + 162 + 102 + 42 = 2,872
Industry Concentration
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Level Ratio / Range Firm Structure
Extreme High 10,000 Only one firmHigh 1,800 up High concentration
Medium 1,000-1,800 Moderately competitive
Low 1,000 down Very competitive
Extreme Low Nearly zero Infinite number firms
Industry Concentration
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13.1 MONOPOLISTIC COMPETITION
The Firm’s Profit-Maximizing Decision
The firm in monopolistic competition makes
its output and price decision just like amonopoly firm does (MC=MR).
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1. Profit is maximizedwhen MR = MC.
3. The profit-maximizing
price is $75 per pair.
4. The firm makes aneconomic profit of
$6,250 a day.
2. The profit-maximizing
output is 125 pairs of Tommy jeans per day.
ATC is $25 per pair, so
13.1 MONOPOLISTIC COMPETITION
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Long Run: Zero Economic Profit
• Economic profit induces entry and economic lossinduces exit, as in perfect competition.
• Entry decreases the demand for the product of eachfirm. (demand curve shifts left)
• Exit increases the demand for the product of eachfirm. (demand curve shifts right)
• In the long run, economic profit is competed awayand firms earn normal profit.
13.1 MONOPOLISTIC COMPETITION
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1. In LR, the outputthat maximizes profitis 75 pairs of
Tommy jeans a day.
2. The price is $50 per pair. Average total
cost is also $50 per pair.
3. Economic profit iszero.
13.1 MONOPOLISTIC COMPETITION
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Equilibrium in Monopolistic Competition
Quantity(units per period)
0
ATC
MC
Priceor
Cost(dollars
pe
runit
)
Initialdemand
The long run
Priceor
Cost( d
ollars
pe
runit
)
MR
qa0
pa
F MC
ATC
Quantity (units per period)
Demand
K
The short run
c a
Later MRqg
pg
G
Later demand
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Monopolistic Competition and Efficiency
• Efficiency requires that the MB of the consumer equal
the MC of the producer.• Price measures marginal benefit, so efficiency requires
P=MC.
• In monopolistic competition, P > MR and MR=MC, so P
> MC – a sign of inefficiency.
• Demand curve can’t lie tangent to minimum ATC, so
tangency is at higher ATC – inefficient.
13.1 MONOPOLISTIC COMPETITION
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• But this inefficiency arises from product differentiation
—variety—that consumers value and for which they
are willing to pay.
• So the loss that arises because MB > MC must be
weighed against the gain that arises from greater
product variety.
• In a broader view of efficiency, monopolisticcompetition brings gains for consumers.
• But firms in monopolistic competition always have
excess capacity in long-run equilibrium.
13.1 MONOPOLISTIC COMPETITION
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1. The efficient scale is 100pairs of Tommy jeans aday. (min ATC)
2. The firm produces lessthan the efficient scale andhas excess capacity.
3. Price exceeds 4. marginal
cost.
5. Deadweight loss arise.
13.1 MONOPOLISTIC COMPETITION
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MARKET CHARACTERISTICS
Perfect Competition MonopolisticCompetition Oligopoly Monopoly
Many, many, many, manysellers, none so large thatthey can influence price
Relatively many sellers,little influence on price
Few (usually 3-5)sellers, but little directprice control becauseof rivals
One seller that likelycan influence price
Homogeneous product(buyers don’t care who
they by from)
Heterogeneous products,with substitutes
Heterogeneousproduct, but rivals are
close substitutes
Heterogeneousproduct, no close
substitutes
No barriers to entry or exit(easy to get in and out of market)
Low to no barriers toentry or exit
HIGH barriers to entry HIGH barriers to
Long run economic profit =
zero (only earning normalprofit)
Long run economic profit
= zero (only earning normalprofit)
Long run economic
profit is positive
Long run economic
profit is positive
Firms are price takers (nomarket power, so marketsets same price for allfirms)
Firms have power over their own pricing becauseproducing different, butsimilar, products
Firms are price makersbecause their outputinfluences price
Firms are price makers(lots of market power,market IS the firm)
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13.3 OLIGOPOLY
Tight oligopoly – concentration ratio > 60
• Duopoly - market in which there are only two producers.
Loose oligopoly – concentration ratio between 40 and 60.
Firms in an oligopoly are closely interdependent. Priceand output changes will impact rivals, and likely draw
some reaction from the rival firms.
Examples: airlines, aircraft, soft drinks, cellular service,computer chips, athletic shoes, cigarettes.
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The Battle for Market SharesIncreased sales on the part of one firm will
be noticed immediately by the other firms.
Increases in the market share of one oligopolist will
reduce the shares of the remaining oligopolists. There isn’t any way that a firm can do so without
causing alarms to go off in the industry.
An attempt by one oligopolist to increase its marketshare by cutting prices will lead to a general reduction inthe market price, eventually harming everyone.
This is why oligopolists avoid price competition andinstead pursue non-price competition.
OLIGOPOLY
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OLIGOPOLY
NON-PRICE COMPETITION Product differentiation – Features that make one
product appear different from competing products in thesame market.
Advertising - strengthens brand loyalty, and makes itexpensive for new producers to enter the market
Training - Customers of training-intensive products(computer hardware, software) become familiar with aparticular system. Creates barriers to later competition.
Network Economies - The widespread use of a particular product may heighten its value to consumers, thereby
making potential substitutes less viable.
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The Kinked Demand Curve
Close interdependence between firms
The degree to which sales increase when theprice is reduced depends on the response of rivaloligopolists. We expect oligopolists to match any price
cuts by rival oligopolists.
Rival oligopolists may not match price
increases in order to gain market share.
OLIGOPOLY
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The Kinked Demand Curve
The shape of the demand curve facing an
oligopolist depends on how its rivals
respond to a change in the price of its ownoutput.
The demand curve will be “kinked” if rival
oligopolists match price cuts, but not price
increases.
OLIGOPOLY
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Price Rigidity (Kinked Demand)
• Oligopolistic firms are interdependent – when one firmchanges, others will have to consider whether action isrequired on their part.
• Firms tend to match price cuts and NOT match price
increases.
• When firm cuts price, Q will increase – if other firms alsocut price, increase in Q will be minimal (inelastic)
• When firm raises price, Q will decrease. If other firms do
not raise their price, increase in Q will be moresubstantial (elastic).
• Difference in relative elasticity will cause kink in demandcurve at current price.
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Dnomatch
Dmatch
M R n o m a t c h
M R m a t c h
P1
Q1
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Dnomatch
Dmatch
M R n o m a t c h
M R m a t c h
P1
Q1
Profit max output is
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Profit max output is
where the MR curve
is discontinuous
(where MC runs
thru discontinuity).
Marginal costs can
increase or
decrease without
changing profit max
output as long as
MC stays in gap.
D
M R
P1
Q1
MC3
MC1
MC2
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D
M R
P1
Q1
MC3
MC1
MC2
Response by
other firms tends
to discourage this
firm from
changing price,keeping prices
stable (price
rigidity).
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Oligopoly vs. Competition
Oligopolists may try to coordinate their behavior
in a way that maximizes industry profits.
An oligopoly will want to behave like amonopoly, choosing a rate of industry outputthat maximizes total industry profit.
To maximize industry profit, the firms in anoligopoly must agree on a monopoly price andagree to maintain it by limiting production andallocating market shares.
OLIGOPOLY
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13.3 OLIGOPOLY
Collusion
When a small number of firms share a market,
they can increase their profit by forming a cartel
and acting like a monopoly.Cartel - group of firms acting together to limit
output, raise price, and increase economic
profit.
•Firms would behave collectively like a multi-firm profit-
maximizing monopolist
•Cartels are illegal in U.S., but they can operate covertly in
some markets.
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Price Fixing
• Explicit agreement among producers about price atwhich goods will be sold.
• The most explicit form of coordination amongoligopolists.
• NOT LEGAL.
OLIGOPOLY
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Price Leadership (Dominant Firm Strategy)
• Often one firm in oligopolistic market owns dominantmarket share.
• Dominant firm can establish profit max price based ontheir cost structure, then smaller, or less aggressive,firms behave as price takers.
• Example: Airlines
OLIGOPOLY
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13.4 GAME THEORY
Game theory is the tool used to analyze
strategic behavior—behavior that
recognizes mutual interdependence and
takes account of the expected behavior of
others.
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13.4 GAME THEORY
What Is a Game?
All games involve three features:
• Rules• Strategies
• Payoffs
Prisoners’ dilemma is a game between two
prisoners that shows why it is hard to
cooperate, even when it would be beneficial
to both players to do so.
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13.4 GAME THEORY
The Prisoners’ Dilemma
Art and Bob are caught stealing a car: sentence
is 2 years in jail.DA wants to convict them of a big bank robbery:
sentence is 10 years in jail.
DA has no evidence and to get the conviction,
he makes the prisoners play a game.
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13.4 GAME THEORY
Rules
Players cannot communicate with one another.
• If both confess to the larger crime, each will receive asentence of 3 years for both crimes.
• If one confesses and the accomplice does not,the one who confesses will receive a 1-year sentence,while the accomplice receives a
10-year sentence.• If neither confesses, both receive a 2-year sentence.
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13.4 GAME THEORY
Payoffs
Four outcomes:
• Both confess.
• Both deny.
• Art confesses and Bob denies.
• Bob confesses and Art denies.
A payoff matrix is a table that shows the payoffsfor every possible action by each player given
every possible action by the other player.
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13.4 GAME THEORY
Equilibrium
•Occurs when each player takes the best possible action given
the action of the other player.
•Nash equilibrium is an equilibrium in which each player takesthe best possible action given the action of the other player.
•The Nash equilibrium for Art and Bob is to confess.
•The equilibrium of the prisoners’ dilemma is not the best
outcome possible for the players, but is the best option if playersdon’t know what the other is doing.
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13.4 GAME THEORY
The Duopolists’ Dilemma as a Game
The dilemma of Boeing and Airbus is similar
to that of Art and Bob.Each firm has two strategies. It can produce
airplanes at the rate of:
• 3 a week
• 4 a week
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13.4 GAME THEORY
Because each firm has two strategies, there
are four possible combinations of actions:
• Both firms produce 3 a week (monopoly outcome).
• Both firms produce 4 a week.
• Airbus produces 3 a week and Boeing produces 4a week.
• Boeing produces 3 a week and Airbus produces 4a week.
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The Payoff Matrix
Table 13.6 shows
the payoff matrix
as the economic
profits for each
firm in eachpossible
outcome.
13.4 GAME THEORY
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Equilibrium of the
Duopolists’ Dilemma
Both firms produce 4 a
week.
Like the prisoners, the
duopolists fail to
cooperate and get aworse outcome than
the one that
cooperation would
deliver.
13.4 GAME THEORY
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13.4 GAME THEORY
Collusion Is Profitable but Difficult to Achieve
•The duopolists’ dilemma explains why it is difficult for firms to
collude and achieve the maximum monopoly profit.
•Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output.
•In OPEC, member countries frequently break the cartel agreement
and overproduce (more players = more difficult to prevent
cheating).
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