monopolistic competition and...

Monopolistic Competition and Oligopoly 16

Monopolistic Competition and Oligopoly

Competition, you know, is a lot like

chastity. It is widely praised, but alas,

too little practiced.

— Carol Tucker

CHAPTER 16

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


Monopolistic Competition

• A market structure in which there are many firms selling differentiated products with few barriers to entry

McGraw-Hill/Irwin Colander, Economics 2


Characteristics of Monopolistic Competition

1. Many sellers

• Do not take into account the reaction of competitors

2. Product differentiation

•Goods are NOT identical

16-3


Characteristics of Monopolistic Competition

3. Multiple dimensions of competition

• Since these products have substitutes, firms use non-price competition such as advertising, brand names and packaging, service, etc.

4. Easy entry and exit of firms in the long run

• There are no significant barriers to entry



“Monopoly” + ”Competition”= Monopolistic Competition

Monopolistic Qualities

• Control over price of own good due to differentiated product

• D greater than MR

• Plenty of advertising

• Not efficient

Perfect Competition Qualities

• Large number of smaller firms

• Relatively easy entry and exit

• Zero economic profit in long-run since firms can enter



Advertising and Monopolistic Competition

• Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do

• The goals of advertising are to increase demand and make demand more inelastic

16-6


Advertising and Monopolistic Competition

• Advertising increases ATC

• The increase in cost of a monopolistically competitive product is the cost of “differentness”



Monopolistic Competition

• A monopolistic firm can earn profits, losses, or break even in the short run

• At its profit maximizing output, marginal cost will be less than price


Monopolistic Competition and Oligopoly 16Drawing the Graph

Monopolistic Competition Earning a Profitin the Short run

• Draw a downward sloping demand curve

• The MR curve starts at the same point on the price axis as does P

• It bisects the demand curve

• Draw your MC curve



Drawing the Graph Monopolistic Competition Earning a Profit

in the Short run• Find the point where MC=MR

• Take this point down to the quantity axis to determine profit maximizing quantity

• Take this point up the demand curve and over to the price axis to determine price



Drawing the Graph Monopolistic Competition Earning a Profit

in the Short run

• Now, add your ATC to show a profit

• ATC should be below price

• Take price off the demand curve down to ATC to find the profit

• Shade the area of profit



Q

P

Q1

MC

D

MR

Draw the Graph Monopolistic Competition Earning a Profit

in the Short run

P1

ATC

16-12

Profit


Drawing the Graph Monopolistic Competition Earning a Loss

in the Short run

• In this graph, ATC will be above price

• Take the price off the demand curve up to the ATC to determine the area of loss

• Shade the area of loss



Q

P

Q1

MC

D

MR

Draw the Graph Monopolistic Competition Earning a Loss

in the Short run

P1

ATC

16-14

Loss

Monopolistic Competition and Oligopoly 16Drawing the Graph

Monopolistic Competition in the Long Run: Zero Economic Profit

• In this graph the ATC will be tangent to the demand curve at the output the firm produces but NOT at its minimum

• For a monopolistic competitor in long-run equilibrium, (P = ATC) ≥ (MC = MR)



Q

P

ATC

Q1

MC

D

MR

Draw the Graph Monopolistic Competition in the Long Run:

Zero Economic Profit

P1

16-16


Are Monopolistically Competitive Firms Efficient?

• Socially optimal/allocatively efficient level (SO/AE): where D=MC (or supply=demand)• Not allocatively efficient because P MC

• Productively efficient level: minimum ATC; using the least combination of inputs to produce maximum output for minimum cost• Not productively efficient because not

producing at minimum ATC



Are Monopolistically Competitive Firms Efficient?

• Firms have excess capacity: firm could be producing at the lowest cost but is producing less (not allocatively efficient)



Q

P

Q1

MC

D

MR

Draw the Graph: Monopolistic Competition Earning a Profit in the Short run with SO and PE

P1

ATC

16-19

PE

SO/AE

QPEQso

PPE

Pso

•Socially optimal/allocatively efficient level: where D=MC

•Productively efficient level: minimum ATC


Monopolistic Competition Graph Compared with a Perfect Competition Graph

• In monopolistic competition in the long run,

P > min ATC

• In perfect competition in the long run, P = min ATC

• Outcome: monopolistic competition output is lower and price is higher than perfect competition



Monopolistic Competition compared to Perfect Competition

16-21

Q

P

QMC

MC

D

MR

PMC

ATC

QC

PC

DWL

Because a monopolistically competitive firm produces at a higher price and a lower output than a perfectly competitive firm there is DWL


Comparing Monopolistic Competition with a Monopoly

• It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry

• No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry

• For a monopolistic competitor in long-run equilibrium, (P = ATC) ≥ (MC = MR)

16-22


Oligopolies



Characteristics of Oligopolies

• A market in which there are only a few firms in an industry that have a large market share

• Examples: car industry, cell phone industry, cereal industry)

• May produced standardized products or differentiated products




• In any decision a firm makes, it must take into account the expected reaction of other firms

• Firms are mutually interdependent

• Can be collusive or noncollusive




• Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making

• High barriers to entry

• Generally, there are high start-up costs and costs of raw materials



Models of Oligopoly Behavior: The Cartel Model

• The cartel model is when a combination of firms acts as if it were a single firm and amonopoly price is set

• Assumes that oligopolies act as if they

were a monopoly and set a price to

maximize profit

• If oligopolies can limit the entry of other

firms, they can increase profits

16-27


Implicit Price Collusion

• Explicit (formal) collusion is illegal in the U.S.

while implicit (informal) collusion is permitted

• Implicit price collusion exists when multiple

firms make the same pricing decisions even

though they have not consulted with one

another

• Sometimes the largest or most dominant firm

takes the lead in setting prices and the others

follow16-28


Why Are Prices Sticky?

• Sticky prices are prices that don’t change

frequently

• Caused by informal collusion

• Look at the kinked demand curve (not

tested)

16-29


Models of Oligopoly Behavior: The Contestable Market Model

• Where barriers to entry and exit, not market structure, determines a firms’ price and output decisions

• An oligopoly with no barriers to entry sets a competitive price

16-30


Comparing Contestable Market and Cartel Models

• The cartel model is appropriate for

oligopolists that collude, set a monopoly

price, and prevent market entry

• The contestable market model describes

oligopolies that set a competitive price and

have no barriers to entry

16-31


Comparing Contestable Market and Cartel Models

• Both models use strategic pricing decisions where firms set their price based on the expected reactions of other firms



New Entry as a Limit on the Cartelization Strategy and Price Wars

• Price wars are the result of strategic pricing decisions gone wild—sometimes the goal is to drive the competitor out of business even if it hurts the firm itself

• A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business



Comparison of Market Structures

Monopoly OligopolyMonopolistic Competition

Perfect Competition

No. of firms One Few Many Almost infinite

Barriers to entry Significant Significant Few None

Pricing decisions MC = MR Strategic pricing MC = MR MC = MR = P

Output decisionsMost output

restrictionOutput

restricted

Outputrestricted,

product differentiation

No outputrestriction

InterdependenceNo

competitorsInterdependent

decisions Each firm

independentEach firm

independent

LR profit Possible Possible None None

P and MC P > MC P > MC P > MC P = MC

16-34


Classifying Industries and Markets in Practice

• An industry rarely fits neatly into one

category or another

• One way to classify markets is by its cross-

price elasticity

• Goods with a cross-price elasticity of 3 or

more are in the same industry

16-35


Empirical Measures of Industry Structure

• The concentration ratio is the value of sales

by the top firms of an industry stated as a

percentage of total industry sales

• The Herfindahl index is the sum of the

squared value of the individual market shares

of all firms in the industry (on the chapter

test)

16-36


Empirical Measures of Industry Structure

• Because it squares market shares, the Herfindahl index gives more weight to firms with large market shares than does the concentration ratio measure



Chapter Summary

• Monopolistic competition is characterized by:

• Many sellers

• Differentiated products

• Multiple dimensions of competition

• Ease of entry of new firms

• The central characteristic of oligopoly is that there are a small number of interdependent firms

• Monopolistic competitors differ from perfect competitors in that the former face a downward sloping demand curve

16-38


Chapter Summary

• Monopolistic competitors differ from monopolists in that monopolistic competitors make zero long-run profit

• In monopolistic competition firms act independently; in an oligopoly they take account of each other’s actions

• An oligopolist’s price will be somewhere between the competitive price and the monopolistic price

• A contestable market theory of oligopoly judges an industry’s competitiveness more by performance and barriers to entry than by structure

16-39


Chapter Summary

• Cartel models of oligopoly concentrate on market structure

• Industries are classified by economic activity in the North American Industry Classification System (NAICS)

• Industry structures are measured by concentration ratios and Herfindahl indexes

• A concentration ratio is the sum of market shares of the largest firms in an industry

• A Herfindahl index is the sum of the squares of the market shares of all firms in an industry

16-40

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