Chap 009

Chapter 9: Monopolistic Competition and Oligopoly

Characteristics of Monopolistic Competition • L a r g e n u m b e r o f s e l le rs :   • Small market shares • No collusion • Independent action

• D i f f er e n t i at e d p r o d u c t s : • Firms have some control over prices. • Products may differ in • • • •

attributes services location brand name and packaging

• E as y e n t r y a n d e x i t LO: 9-1

Examples: • furniture • jewelry • leather goods • grocery stores • gas stations • restaurants • clothing stores • medical care

Pricing and Output in Monopolistic Competition • Monopolistically competitive firms engage in non-price competition (such as advertising) in order to differentiate their products. • Because products are differentiated, the demand curve of a monopolistically competitive firm is not perfectly elastic (although it is more elastic than a pure monopolist’s demand). • The price elasticity of a firm’s demand is higher  • The larger the number of rival firms • The weaker the product differentiation LO: 9-2

Profits and Losses in Monopolistic Competition Short run •

•

The monopolistically competitive firm uses the MC = MR Rule to maximize profit or minimize loss in the short run. It produces a quantity Q at which MR = MC and charges a price P  based on its demand curve. • When P > ATC, the firm earns an economic profit. • When P < ATC, the firm incurs a loss. LO: 9-2

Long run • Because entry and exit are easy, • Economic profits attract new firms, which lowers profits of existing firms, until P=ATC. • Economic losses make firms exit until P=ATC. •  As a result, a monopolistic competitor will earn only a normal profit in the long run.

Short-Run Profits in Monopolistic Competition MC   s    t   s P    o AT C     C    d   n   a   e   c    i   r    P

Economic Profit

ATC

D in SR MR = MC

MR 0

Q 

Quantity LO: 9-2

Long-Run Profits in Monopolistic Competition MC   s    t   s P    o AT C  P=    C    dAT C    n   a   e   c    i   r    P

Economic Profit

MR = MC

ATC

D in SR D in LR

MR 0

Q 

Quantity LO: 9-2

Monopolistic Competition vs. Pure Competition MC   s    t   s   o P MC    C P PC    d   n   a   e   c    i   r    P

ATC

Price is Higher D3 MR = MC

Excess Capacity at M i n i m u m A TC 0 LO: 9-2

MR Q MC

Q PC

Quantity M o n o p o l i s t i c c o m p e t i ti o n i s n o t ef f ic i en t

Characteristics of Oligopoly • A f e w l a rg e p r o d u c e r s : • Firms are price markers • Firms engage in strategic behavior • Firms’ profits depend on the actions of other firms

• H o m o g e n e o u s o r d i f f er en t i a te d products:

• If products are differentiated, firms engage in advertising

• B l o c k e d en t r y LO: 9-3

Examples: • tires • beer • cigarettes • copper • greeting cards • automobiles • breakfast cereals • airlines

Oligopoly and Game Theory • Behavior of firms in the oligopoly can be analyzed using g a m e t h e o r y . • Consider an example where two firms (a duopoly) decide whether to set their price high or low. •  A payoff matrix  can be constructed to show the payoffs (profit) to each firm that result from each combination of strategies. G am e t h e o r y    is the study of how people or firms

behave in strategic situations. LO: 9-3

Oligopoly and Game Theory: Example RareAir’s Price Strategy

• 2 competitors • 2 price strategies • Each strategy has a payoff • Greatest combined profit • Independent actions stimulate a response

LO: 9-4

High   y   g   e    t   a   r High    t    S   e   c    i   r    P   s    ’   n   w Low   o    t   p    U

A

$12

Low

B

$12

C $15

$15 $6

$6

D

$8

$8

Oligopoly and Game Theory: Example • Independently lowered prices in expectation of greater profit leads to the worst combined outcome • Eventually low outcomes make firms return to higher prices • There is a gain from collusion LO: 9-4

RareAir’s Price Strategy High   y   g   e    t   a   r High    t    S   e   c    i   r    P   s    ’   n   w Low   o    t   p    U

A

$12

Low

B

$12

C $15

$15 $6

$6

D

$8

$8

Kinked-Demand Model of Oligopoly • In the k i n k ed -d e m a n d m o d el  , oligopolists face a demand curve based on the assumption that rivals will ignore a price increase and follow a price decrease. • An oligopolist’s rivals will ignore a price increase above the going price but will follow a price decrease below the going price. • The demand curve is kinked at this price and the marginal-revenue curve has a vertical gap. • Price and output are optimized at the kink.

• This model helps explain why prices are generally stable in noncollusive oligopolistic industries. LO: 9-5

Kinked-Demand Model of Oligopoly • Competitors and rivals strategize versus each other • Consumers effectively have 2 partial demand curves and each part has its own marginal revenue part Rivals Ignore Price Increase   e   c    i   r    P

e

P0 f

D2

Rivals Match g Price Decrease 0

LO: 9-5

Q0

MR1 Quantity

MR2

  s    t   s   o    CP0    d   n   a   e   c    i   r    P

MC1

D2 e

MR2

f

MC2

g

D1

D1 0

Q0 Quantity

MR1

Collusion • Collusion, through price control, may allow oligopolists to reduce uncertainty, increase profits, and possibly block potential entry. • If oligopolistic firms produce an identical product and have identical cost, demand, and marginal-revenue curves, then each firm can maximize profit using the MR = MC Rule. • Firms will choose the price and quantity according to the MR = MC Rule, because it is the most profitable price-output combination. • One form of collusion is the cartel  .  A Cartel   is a formal agreement among producers to set the price and the individual firm’s output levels of a product. One example is OPEC. LO: 9-6

Profit Maximization by a Cartel MC   s    t   s   o    C    d   n   a   e   c    i   r    P

E f f ec t i v e l y S h a r in g The Mono po ly Profit

P0

ATC

A0 MR=MC

Economic Profit

D

MR Q0

Quantity LO: 9-6

C ar t e l -t y p e o l i g o p o l y i s i n e ff i c i e n t

Obstacles to Collusion • • • •

 Anti-trust law prevents cartels from forming Demand and costs may be different across firms There may be too many firms to coordinate There are strong incentives to cheat • If rivals charge prices lower than P o, then the demand curve of the firm charging P o will shift to the left as its customers turn to its rivals, and its profits will fall. • The firm can retaliate and cut its price, too. However, all firms’ profits would eventually fall.

• Recessions increase excess capacity and strengthen incentives to cheat • High profits attract potential entry. LO: 9-6

Oligopoly and Advertising Oligopolists have sufficient financial resources to engage in product differentiation through product development and advertising. Positive Effects of Advertising • Enhances competition • Reduces consumers’ search time, direct costs, and indirect costs • Facilitates the introduction of new products

LO: 9-7

Negative Effects of Advertising • Alters consumers’ preferences in favor of the advertiser’s product • Brand-loyalty promotes monopoly power