Monopolistic Competition and Oligopoly

Characteristics of Monopolistic Competition • Characteristics • Many producers offer products that are either close substitutes but are not viewed as identical • Each supplier has some power over the price it charges  are price makers • Low barriers to entry  firms in the long run can enter or leave the market with ease  enough sellers that they behave competitively • Sellers act independently of each other

Product Differentiation • Sellers differentiate their products in four basic ways • Physical differences and qualities • Location • Accompanying services • Product image

Short-Run Profit Maximization or Loss Minimization • Because products are a somewhat different product, each has some control over price  each firm’s demand curve slopes downward • Since many firms are selling close substitutes, any firm that raises its price can expect to lose some customers, but not all, to rivals  demand is more elastic than a monopolist’s but less elastic than a perfect competitors

Price Elasticity of Demand • The price elasticity of the monopolistic competitor’s demand depends on • The number of rival firms that produce similar products • The firm’s ability to differentiate its product from those of its rivals • A firm’s demand curve will be more elastic the greater the number of competing firms and the less differentiated its product

Marginal Revenue Equals Marginal Cost • The downward-sloping demand curve means that the marginal revenue curve also slopes downward and lies beneath the demand curve • The cost curves are similar to those developed in perfect competition and monopoly

Zero Economic Profit in the Long Run • Since there are low barriers to entry in monopolistic competition, short-run economic profit will attract new entrants in the long run • Because new entrants offer products that are similar to those offered by existing firms, they draw some customers away from existing firms  the demand facing each firm declines and becomes more elastic since there are more substitutes for each firm’s product

Zero Economic Profit in the Long Run • Because of the ease of entry, monopolistically competitive firms earn zero economic profit in the long run • In the cases of losses that persist, some monopolistic competitors will leave the industry  their customers will switch to the remaining firms  increasing the demand for each remaining firm’s demand curve and making it less elastic

Comparison • How does monopolistic competition compare with perfect competition in terms of efficiency? • In the long run, neither can earn economic profit • However, a difference arises because of the different demand curves facing individual firms in each of two market structures

Comparison • Firms in monopolistic competition are said to have excess capacity, since production is lower than the rate that would be associated with the lowest average cost • Alternatively, excess capacity means that each producer could easily produce more and in the process would lower the average cost  the marginal value of increased output would exceed its marginal cost  greater output would increase economic welfare

Comparison • Another differences is that although the cost curves in the previous exhibit are identical, firms in monopolistic competition spend more on advertising and other promotional expenses to differentiate their products • These higher costs shift up their average cost curves

Comparison • Some argue that monopolistic competition results in too many suppliers and in product differentiation that is often artificial • The counterargument is that consumers are willing to pay a higher price for greater selection • That is, consumers are willing to pay a higher price for greater selection • Consumers benefit from the wider choice

Oligopoly • Oligopoly refers to a market structure that is dominated by just a few firms • Because an oligopoly has only a few firms, each must consider the effect of its own actions on competitors’ behavior  the firms in an oligopoly are interdependent • There are a variety of oligopolies

Varieties of Oligopoly • The product can be homogeneous across producers or differentiated across producers • The more homogeneous the products, the greater the interdependence among the few dominant firms in the industry • Products can be differentiated by physical qualities, sales locations, services provided with the product and the image of the product

Varieties of Oligopoly • Because of interdependence among firms in an industry, the behavior of any particular firm is difficult to analyze • Each firm knows that any changes in its product quality, price, output, or advertising policy may prompt a reaction from its rivals • Domination by a few firms can often be traced to some form of barrier to entry

Economies of Scale • Perhaps the most significant barrier to entry is economies of scale • Recall that the minimum efficient scale is the lowest rate of output at which the firm takes full advantage of economies of scale • If a firm’s minimum efficient scale is relatively large compared to industry output, then only one or a few firms are needed to produce the total output demanded in the market

High Cost of Entry • The total investment needed to reach the minimum size is often gigantic which may pose another problem for potential entrants into oligopolistic industries • Advertising a new product enough to compete with established brands may also require enormous outlays • High start-up costs and established brand names can create substantial barriers to entry, especially since the fortunes of a new product are so uncertain

High Cost of Entry • Product differentiation expenditures create barriers to entry • Oligopolists often compete with existing rivals and try to block new entry by offering a variety of models and products • Firms often spend billions trying to differentiate their products • Some of these expenditures have the beneficial effects of providing valuable information to consumers and offering them a wide variety of products

Models of Oligopolies • The interdependence of firms in an oligopoly makes analyzing their behavior complicated  no one model or approach explains the outcomes • At one extreme, the firms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartel • At the other extreme, they may compete so fiercely that price wars erupt

Models of Oligopoly • While there are many theories, we will focus our attention on three of the better-known approaches • Collusion • Price Leadership • Game Theory • Each approach has some relevance, although none is entirely satisfactory as a general theory • Each is based on the diversity of observed behavior in an interdependent market

Collusion • Collusion is an agreement among firms in the industry to divide the market and fix the price • A cartel is a group of firms that agree to collude so they can act as a monopolist and earn monopoly profits • Colluding firms usually reduce output, increase price, and block the entry of new firms

Collusion • Collusion and cartels are illegal in the United States; some other countries are more tolerant and some countries even promote cartels  OPEC

Cartel Model • To maximize cartel profit, output must be allocated so that the marginal cost for the final unit produced by each firm is identical • Any other allocation would lower cartel profits • However, this is much easier said than done in practice

Differences in Cost • If all firms have identical costs, output and profit are easily allocated across firms  each firm produces the same quantity • However, if costs differ, as is normally the case, problems arise • The greater the differences in average costs across firms, the greater will be the differences in economic profits among firms

Differences in Cost • If cartel members try to equalize each firm’s total profit, a high-cost firm would need to sell more than a low-cost firm • But this allocation scheme violates the cartel’s profit-maximizing condition of finding the output for each firm that results in identical marginal costs across firms  if average costs differ across firms, the output allocation that maximizes cartel profit will yield unequal profit across cartel members

Number of Firms in the Cartel • The more firms in the industry, the more difficult it is to negotiate an acceptable allocation of output among them • Consensus becomes harder to achieve as the number of firms grows  the greater the chances are that one or more will become dissatisfied with the cartel and break the agreement

New Entry Into the Industry • If a cartel cannot block the entry of new firms into the industry, new entry will eventually force prices down, squeezing economic profit and undermining the cartel • The profit of the cartel attracts entry, entry increases market supply  market price is forced down

Cheating • Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement • By offering a price slightly below the established price, a firm can usually increase its sales and economic profit • Because oligopolists usually operate with excess capacity, some cheat on the established price

Summary • Establishing and maintaining an effective cartel will be more difficult • If the product is differentiated among firms • If costs differ among firms • If there are many suppliers in the industry • If entry barriers are low, and • If cheating on the agreement becomes widespread

Price Leadership • An informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry • A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition • Price leader also initiates price changes

Price Leadership • Obstacles in price leadership industries • The practice usually violates U.S. antitrust laws • The greater the product differentiation among sellers, the less effective price leadership will be as a means of collusion • There is no guarantee that other firms will follow the leader  if other firms do not follow, the leader risks losing sales • Some firms will try to cheat on the agreement by cutting price to increase sales and profits • Unless there are barriers to entry, a profitable price will attract entrants

Game Theory • Game theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms • It analyzes the behavior of decision-makers, or players, whose choices affect one another • Provides a general approach that allows us to focus on each player’s incentives to cooperate or not

Prisoner’s Dilemma • Two thieves, Ben and Jerry, are caught near the scene of a robbery • The police believe they are guilty but they need a confession • Each thief faces a choice of confessing or denying any knowledge of the crime • If only one confesses he is granted immunity and goes free  other gets the maximum of 10 years • If both deny the crime, each gets a 1-year sentence and if both confess, each gets 5 years

Prisoner’s Dilemma • What will each do? • The answer depends on the assumptions about their behavior  that is, what strategy each pursues • A strategy reflects a player’s game plan • In the prisoner’s dilemma, each player tries to save his own skin by minimizing his time in jail, regardless of what happens to the other • Exhibit 6 shows the payoff matrix for the game

Payoff Matrix • Payoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues • Each prisoner pursues one of two strategies, confessing or clamming up • Ben’s strategies are shown along the left margin and Jerry’s across the top • The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies

Payoff Matrix • The number above the diagonal shows Ben’s sentence in years and the number below the diagonal show Jerry’s sentence • What strategies are rational assuming that each player tries to minimize jail time? • Ben’s perspective: you know that Jerry will either confess or clam up. Suppose Jerry confesses, if you confess also, you both get 5 years, but if you deny involvement you get 10 years while Jerry walks  if Ben thinks Jerry will confess, he should also

Price Setting Game • The prisoner’s dilemma applies to a broad range of economic phenomena such as pricing policy and advertising strategy • Consider the market for gasoline in a rural community with only two gas stations  a duopoly • Suppose customers are indifferent between the two brands and consider only the price

Price Setting Game • Each station sets its daily price early in the morning before knowing the price set by the other • Suppose only two prices are possible  a low price and a high price • If both charge the low price, they split the market and each earns a profit of $500 per day • If both charge the high price, they also split the market and earn $700 profit • If one charges the high price but the other the low one, the low price station earns a profit of $1,000 and the other $200

Price Setting Game • If each firm thinks other firms in the cartel will stick with their quotas, they can increase their profits by cutting price and increasing quantities • If you think other firms will cheat and overproduce, they you should too • Either way your incentive as a cartel member is to cheat on the quota

One-Shot versus Repeated Games • The outcome of a game often depends on whether it is a one-shot game or the repeated game • The classic prisoner’s dilemma is a one-shot game  the game is to be played only once • However, if the same players repeat the prisoner’s dilemma, as would likely occur in the price setting game, other possibilities unfold

One-Shot versus Repeated Games • In a repeated-game setting, each player has a chance to establish a reputation for cooperation and thereby can encourage the other player to do the same • The cooperative solution makes both players better off than if they fail to cooperate

Tit-for-Tat Strategy • Experiments show that the strategy with the highest payoff in repeated games turns out to be the tit-for-tat strategy • You begin by cooperating in the first round of play • On every round thereafter you cooperate if the other player cooperated in the previous round, and you cheat if your opponent cheated in the previous round

Oligopoly and Perfect Competition • Since there is no typical model of oligopoly, no direct comparison with perfect competition is available • However, we can imagine an experiment in which we took the many firms in a competitive industry and, through a series of mergers, combine them to form, say, four firms • How would the behavior of firms in this industry differ before and after the merger

Oligopoly and Perfect Competition • Price is usually higher under oligopoly • With fewer competitors after the merger, remaining firms would become more interdependent  they will try to coordinate pricing policies  if they engage in some sort of implicit or explicit collusion, industry output would be lower and price would be higher than under perfect competition • Higher profits under oligopoly • If there are barriers to entry into the oligopoly, profits will be higher than under perfect competition in the long run

Monopolistic Competition and Oligopoly