Oligopoly, Duopoly & Monopolistic Competition

1. Chapter 25 Oligopoly, Duopoly& Monopolistic Competition

2. I. Oligopoly & Duopoly • Oligopolyis a market in which a few firms produce all or most of the market supply of a particular good or service. • Ex: Automobile industry • Duopolyis a market in which a two firms produce all or most of the market supply of a particular good or service. • Ex: Coke & Pepsi Chapter 25 2

3. Oligopoly & Duopoly Characteristics • Some firms – 2 or more • Each firm has some market power • depends on the relative size of the company • High barriers to entry • Price takers • Differentiated products • Somewhat similar substitutes • Advertising has big role • Informative • Persuasive • Cost competitive • Quality competitive Chapter 25 3

4. Advertising’s Primary Purpose • To differentiate your product • artificially creating a monopoly by convincing the customer’s that there is no substitute. Chapter 25 4

5. Measuring Market Power • The standard measure of market power is the concentration ratio. • The concentration ratiois the proportion of total industry output produced by the largest firms (usually the four largest). • The concentration ratio is a measure of market power that relates the size of firms to the size of the market. Chapter 25 5

6. The Battle for Market Share • Increased sales on the part of one firm will be: • Noticed immediately by the other firms. • The competitors will respond by: • Step up marketing efforts. • Cut prices on their products. • An attempt by one firm to increase its market share by cutting prices will lead to a general reduction in the market price for all. Chapter 25 6

7. Game Theory • Each firm has to consider the potential responses of rivals when formulating price or output strategies. • The payoff to a firm’s price cut depends on how its rivals respond. Chapter 25 7

8. Game Theory • Game theoryis the study of decision making in situations where strategic interaction (moves and countermoves) between rivals occurs. • Each firm is uncertain about its rival’s behavior. • The collective interests of the oligopoly are protected if no one cuts the market price. • But an individual firm could lose if it holds the line on price when rivals reduce price. Chapter 25 8

9. The Payoff Matrix • The payoff to a price cut depends on how rivals respond. • Coke & Pepsi both reduce price • Both take small loss • Coke reduces price, Pepsi doesn’t • Coke sales soars, Pepsi takes big losses • Pepsi reduces price, Coke doesn’t • Pepsi sales soar, Coke takes big losses • Neither lowers price • No change Chapter 25 9

10. Price and Output • Price discounting can destroy oligopoly profits. • When it occurs, rival firms seek to end it as quickly as possible. Chapter 25 10

11. Price and Output • An oligopoly will want to behave like a monopoly, choosing a rate of industry output that maximizes total industry profit. • To maximize industry profit, the firms in an oligopoly must agree on a monopoly price and agree to maintain it by limiting production and allocating market shares. Chapter 25 11

12. Oligopoly vs. Competition • There is an incentive for firms to cooperate to try to keep prices high. Chapter 25 12

13. Cooperation Among Competitors • Is illegal • Example: a cartel • A cartelis a group of firms with an explicit agreement to fix prices and output shares in a particular market • Wouldn’t last long anyway • There is a strong incentive to cheat Chapter 25 13

14. Coordination Problems • There is an inherent conflict in the joint and individual interests of oligopolists. • Each firm wants industry profits to be maximized. • Each firm wants to maximize it’s own market share. Chapter 25 14

15. Price Leadership • Some firms use price leadership rather than explicit agreements to coordinate their prices. • Price leadershipis an oligopolistic pricing pattern that allows one firm to establish the market price for all firms in the industry. Chapter 25 15

16. Allocation of Market Shares • When firms raise their prices, they have to deal with how the loss of output will be distributed among them. • A firm may resort to predatory pricing when market shares are not being divided in a satisfactory manner. • Predatory pricing- temporary price reductions designed to alter market shares or drive out competition Chapter 25 16

17. II. Monopolistic Competition Chapter 25 17

18. Monopolistic Competition • Monopolistic competitionis a market in which many firms produce similar goods or services but each maintains some independent control of its own price. • Examples: banks, radio stations, health spas, restaurants, apparel stores, auto dealerships and convenience stores. Chapter 25 18

19. Monopolistic Competition Characteristics • Many firms • Differentiated products • Low barriers to entry • Each firm has some market power in it’s area, but not over the entire industry • Price Setter – within reason • Advertising has a role – mostly non-price • Informative • Persuasive • Quality competitive Chapter 25 19

20. Differences • The main differences between Monopolistic Competition & Oligopolies is: • More producers • Lower entry barriers • Often cover smaller geographic areas Chapter 25 20

21. Brand Image • Each firm has a distinct identity – a brand image. • Consumers perceive its output to be somewhat different than others in the industry. Chapter 25 21

22. Brand Loyalty • By differentiating their products, monopolistic competitors establish brand loyalty. • Brand loyalty gives producers greater control over the price of their products. • Each firm only has a monopoly on its brand image. • Brand loyalty makes the demand curve facing the firm less price-elastic. Chapter 25 22

23. Short-Run Price and Output • The production decision is similar to that of a monopolist. • The profit-maximizing rate of output is the quantity where MR = MC. Chapter 25 23

24. Entry and Exit • With low barriers to entry, new firms will enter the market if there is economic profit. • When firms enter a monopolistically competitive industry: • The market supply curve shifts to the right. • The demand curves facing individual firms shift to the left • No Long-Run Profits Chapter 25 24

25. Effects of Entry on Industry and Firm • Tends to be less efficient in the long run than a perfectly competitive industry. • Because of the industry-wide excess capacity, each firm produces a rate of output that is less than its minimum ATC. Chapter 25 25

26. Flawed Price Signals • The monopolistically competitive firm will always price its output above the level of marginal cost. • Monopolistic competition results in both production inefficiency (above-minimum average cost) and allocative inefficiency (wrong mix of output). Chapter 25 26