Monopolistic Competition and Oligopoly

1. Chapter 11 Monopolistic Competition and Oligopoly

2. Chapter Objectives • Characteristics of monopolistic competition • Normal profit in the long run • Characteristics of oligopoly • Game theory • The oligopolist’s kinked demand curve • Collusion among oligopolists • The effects of advertising

3. Monopolistic Competition • Large number of sellers • Small market shares • No collusion • Independent action • Differentiated Products • Product attributes • Service • Location • Brand names and packaging • Some control over price

4. Monopolistic Competition Monopolistic Competition • Easy entry and exit • Need for advertising • Nonprice Competition • Which industries? • Degree of concentration • Four-firm concentration ratio • Herfindahl index

5. Monopolistic Competition Short-Run Profits ATC MC P1 A1 Price and Costs Economic Profit D1 MR = MC MR 0 Q1 Quantity

6. Monopolistic Competition Short-Run Losses ATC MC A2 P2 Loss Price and Costs D2 MR = MC MR 0 Q2 Quantity

7. Monopolistic Competition Long-Run Equilibrium MC ATC P3= A3 Price and Costs D3 MR = MC MR 0 Q3 Quantity

8. Monopolistic Competition • Firm’s demand curve • Highly elastic • Short run profit or loss • Produce where MR=MC • Long run normal profit • Entry and exit • Inefficient • Product variety

9. MC ATC P3= A3 Price and Costs D3 MR = MC MR Quantity 0 Q3 P=MC=Min ATC for pure competition P4 Price is Lower Excess Capacity at Minimum ATC Q4 • P3>lowest ATC A3; therefore, P ≠ MC & minimum ATC. Productive efficiency is not achieved. • P3>MC, meaning underallocation of resources. Allocative efficiency is not achieved

10. Oligopoly • A few large producers • Homogeneous or differentiated products • Control over price • Mutual interdependence • Strategic behavior • Entry barriers • Mergers

11. Four-firm concentration ratio • Needs to be more than 40% • Half of U.S. manufacturing • Localized markets • Interindustry competition • World trade • Import Competition • Herfindahl index

12. Oligopoly Behavior: Game Theory • Mutual interdependence -Pricing policy-Oligopolistic firms can increase their profit, and influence their rivals’ profits by changing their pricing strategies. Each firm’s profit depends on its own pricing strategy and that of its rivals, which is why this relationship between oligopolies is called mutual interdependence. • Collusion -Oligopolists often can benefit from collusion or cooperation with rivals. • Incentive to cheat -After a collusive pricing agreement every oligopolist might be tempted to cheat, because either firm can increase its profit by lowering its price.

13. Oligopoly Behavior: Game Theory Model RareAir’s Price Strategy • 2 competitors • 2 price strategies • Each strategy has a payoff matrix • Greatest combined • profit • Independent actions • stimulate a response High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8

14. Game Theory Model RareAir’s Price Strategy • Independently lowered prices in expectation of greater profit leads to the worst combined outcome • Eventually low outcome make firms return to higher prices High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8

15. Three Oligopoly Models • Kinked-demand curve • Collusive pricing • Price leadership

16. Kinked-Demand Curve • Noncollusive oligopoly • Strategies • Match price changes- when one firm lowers their prices to have a better profit, the other companies match their price so the demand and marginal revenue curve will be steeper. • Ignore price changes-when a firm changes their prices and their rivals ignore this change, the demand curve for this first firm will be more elastic. • Combined strategy • Oligopolistic industries suggest that a firm’s rivals will match price declines below P0, and they will ignore price changes over P0.

17. Kinked Demand Curve • Price Inflexibility • The kinked demand curve gives each oligopolist reason to believe that any change in price will be for the worse. If it raises its price, many of its customers will desert it. If it lowers its price, its sales at best will increase very modestly, since rivals will match the lower prices.

18. Price Price and Costs 0 0 Quantity Quantity Kinked-Demand Curve Competitor 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 MC1 D2 e e P0 P0 MR2 f f D2 MC2 MR2 g Rivals Match Price Decrease g D1 D1 Q0 Q0 MR1 MR1

19. Price and Costs Quantity Cartels and Other Collusion • Price and output • Joint profit maximization Effectively Sharing The Monopoly Profit MC P0 ATC A0 MR=MC Economic Profit D MR Q0

20. Cartels and Other Collusion • Overt collusion • Covert collusion • Tacit understandings • Obstacles to collusion • Demand and cost differences • Number of firms • Cheating • Recession • Potential entry • Legal obstacles: antitrust law

21. The OPEC Cartel Daily oil production (barrels) , November 2008 Saudi Arabia 8,904,000 Iran 3,843,000 Kuwait 2,538,000 Venezuela 2,368,000 Iraq 2,297,000 Nigeria 2,183,000 UAE 2,117,000 Angola 1,804,000 Libya 1,737,000 Algeria 1,417,000 Qatar 848,000 Indonesia 843,000 Ecuador 530,000 Source: A. T. Kearney, Foreign Policy

22. Price Leadership Model • Leadership tactics • Infrequent price changes • Communications • Limit pricing • Breakdowns in price leadership: • Price wars

23. Advertising • Prevalent in monopolistic competition and oligopoly • Capture market share • Better than a price cut • Information for consumers • Manipulation

24. Advertising Spending Millions of $ Company Oligopoly and Advertising The Largest U.S. Advertisers, 2006 Proctor and Gamble AT&T General Motors Time Warner Verizon Ford Motor GlaxoSmithKline Walt Disney Johnson & Johnson Unilever $4898 3345 3296 3089 2822 2577 2444 2320 2291 2098 Source: Advertising Age

25. Oligopoly and Advertising Coca-Cola Microsoft IBM General Electric Nokia Toyota Intel McDonald’s Disney Mercedes-Benz Source: Interbrand World’s Top 10 Brand Names, 2007

26. Oligopoly and Efficiency • Not productively efficient • Not allocatively efficient • Tendency to share the monopoly profit • Qualifications • Increased foreign competition • Limit pricing • Technological advance