Monopolistic Competition and Oligopoly

1. Monopolistic Competition and Oligopoly

2. Monopolistic Competition • Monopolistic competition • Many producers • Low barriers to entry • Slightly different products • A firm that raises prices: lose some customers to rivals • Some control over price ‘Price makers’ • Downward sloping demand curve • Act independently or interdependently

3. Monopolistic Competition • Product differentiation • Physical differences • Appearance; quality • Location • Spatial differentiation • Services • Product image • Promotion; advertising

4. Short-Run Profit or Loss • Curves • Demand curve, D • Slopes downward • Marginal revenue, MR • Below the demand curve • Slopes downward • Average total cost, ATC • Average variable cost, AVC • Marginal cost, MC

5. Short-Run Profit or Loss • Maximize profit: MR=MC • Price: on D curve • If p>ATC • Economic profit • If ATC>p>AVC • Economic loss; Produce in short run • If p<AVC: AVC curve above D curve • Economic loss; Shut down in short run

6. Exhibit 1 Monopolistic Competitor in the Short Run (a) Maximizing short-run profit (b) Minimizing short-run loss MC MC Loss c Profit p p ATC ATC AVC D D Dollars per unit Dollars per unit c MR MR b c c b e e The monopolistically competitive firm produces the level of output at which marginal revenue equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping demand curve. In panel (a), the firm produces q units, sells them at price p, and earns a short-run economic profit equal to (p-c) multiplied by q, shown by the blue rectangle. In panel (b), the average total cost exceeds the price at the output where marginal revenue equals marginal cost. Thus, the firm suffers a short-run loss equal to (c p) multiplied by q, shown by the pink rectangle. Quantity per period 0 0 q q Quantity per period

7. Profit in the Long-Run • Short run economic profit • New firms enter the market • Draw customers away from other firms • Reduce demand facing other firms • Profit disappears in long run • Zero economic profit

8. Profit in the Long-Run • Short run economic loss • Some firms exit the market • Their customers switch to other firms • Increase demand facing the remaining firms • Loss is erased in the long run • Zero economic profit

9. Exhibit 2 Long-Run Equilibrium in Monopolistic Competition If existing firms earn economic profit in the short run, new firms will enter the industry in the long run. This entry reduces the demand facing each firm. In the long run, each firm’s demand curve shifts leftward until marginal revenue equals marginal cost (point a) and the demand curve is tangent to the average total cost curve (point b). Economic profit is zero at output q. With zero economic profit, no more firms will enter, so the industry is in long-run equilibrium. The same long-run outcome occurs if firms suffer a short-run loss. Firms leave until remaining firms earn just a normal profit. Dollars per unit MC ATC a b p D MR Quantity per period q 0

10. Fast forward to creative destruction • 1970s, videocassette recorders • Expensive • Increased demand for videotaped movies • Video rental stores • Security deposits • Membership fees ($100) • Little competition • Short run economic profit

11. Fast forward to creative destruction • Supply of rental stores increased • Faster than demand • Rental rates: $0.99; • No fees or deposits • Latest substitutes • On-demand movies (broadband cable) • Downloads from the Internet • Grab-and-go rental kiosks • Online rental services that mail DVDs

12. Fast forward to creative destruction • Creative destruction • ‘Out with the old, in with the new’ • Technological change • Some producers lose • Consumers benefit • Wider choice • More competitive prices

13. Comparison • Monopolistic competition and perfect competition • Zero economic profit in long run • MR=MC for quantity • Where demand curve is tangent to average total cost curve

14. Comparison • Perfect competition • Firm’s demand: horizontal line • Produces at minimum average cost • Productive and allocative efficiency

15. Comparison • Monopolistic competition • Downward sloping demand curve • Not producing at minimum average cost • Excess capacity • Produces less, charges more • Than perfect competitor • In the long run • Spend more to differentiate their products

16. Comparison • Excess capacity • Difference between a firm’s profit-maximizing quantity • And the quantity that minimizes average cost • Firms with excess capacity • Could reduce average cost • By increasing quantity

17. Exhibit 3 Perfect Competition Versus Monopolistic Competition in Long-Run Equilibrium (a) Perfect competition (b) Monopolistic competition MC MC d=MR=AR ATC ATC D MR p Dollars per unit p’ Dollars per unit Cost curves are assumed to be the same in each panel. The perfectly competitive firm of panel (a) faces a demand curve that is horizontal at market price p. Long-run equilibrium occurs at output q, where the demand curve is tangent to the average total cost curve at its lowest point. The monopolistically competitive firm of panel (b) is in long-run equilibrium at output q’, where demand is tangent to the average total cost curve. Because the demand curve slopes downward in panel (b), the tangency does not occur at the minimum point of average total cost. Thus, the monopolistically competitive firm produces less output and charges a higher price than does a perfectly competitive firm with the same cost curves. Neither firm earns economic profit in the long run. The firm in monopolistic competition has excess capacity, meaning that it could reduce average cost by increasing its rate of output. Quantity per period Quantity per period 0 q’ 0 q

18. Introduction to Oligopoly • Oligopoly • Few firms • Each behaves interdependently • The more similar the products • The greater interdependence • Undifferentiated oligopoly • Oligopoly that sells a commodity

19. Introduction to Oligopoly • Differentiated oligopoly • Oligopoly that sells products that differ across suppliers • Product differentiation • Physical qualities • Sales location • Services • Product image

20. Introduction to Oligopoly • Barriers to entry • Economies of scale • Legal restrictions • Brand names • Control over an essential resource • High cost of entry • Start-up costs; advertising • Crowding out the competition

21. Exhibit 4 Economies of Scale as a Barrier to Entry ca a b Dollars per unit Long-run average cost cb At point b, an existing firm can produce M or more automobiles at an average cost of cb. A new entrant able to sell only S automobiles would incur a much higher average cost of ca at point a. If automobile prices are below ca, a new entrant would suffer a loss. In this case, economies of scale serve as a barrier to entry, insulating firms that have achieved minimum efficient scale from new competitors. Autos per year 0 S M

22. Models of Oligopoly • Interdependence • Cooperation or • Fierce competition • Collusion • Price leadership • Game theory

23. Collusion and Cartels • Collusion • Agreement among firms to • Increase economic profit by • Dividing the market • Fixing the price • Cartel • Group of firms that agree to coordinate their production and pricing decisions • To reap monopoly profit • Illegal in U.S.

24. Exhibit 5 Cartel as a Monopolist MC A cartel acts like a monopolist. Here, D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel). Cartel profits are maximized when the industry produces quantity Q and charges price p. p D Dollars per unit MR c Q Quantity per period 0

25. Collusion and Cartels • Maximize profit • Allocate output among cartel members • Same MC of the final unit produced • Difficulties to maintain a cartel: • Differentiated product • Differences in average cost • Many firms in the cartel • Low barriers to entry • Cheating

26. Price Leadership • Price leadership • Informal, tacit collusion • Price leader • Sets the price for the industry • Initiate price changes • Followed by the other firms

27. Price Leadership • Obstacles • U.S. antitrust laws • Product differentiation • No guarantee others will follow • Barriers to entry • Cheating

28. Game Theory • Game theory • Approach that analyzes oligopolistic behavior • Series of strategic moves and countermoves by rival firms • General approach • Focus: each player’s incentives to cooperate or compete

29. Game Theory • Prisoner’s dilemma • Game that shows why players have difficulty cooperating • Even though they would benefit from cooperation • Strategy • Operational plan pursued by a player

30. Game Theory • Payoff matrix • Table listing the payoffs • That each player can expect from each move • Based on the actions of the other player • Dominant-strategy equilibrium • Outcome achieved when each player’s choice does not depend on what the other player does

31. Exhibit 6 The Prisoner’s Dilemma Payoff Matrix (years in jail) 5 0 5 10 1 10 0 1 This matrix shows the years each prisoner can expect to spend in jail based on his actions and the actions of the other prisoner. Ben’s payoff is in red and Jerry’s in blue.

32. Game Theory • Duopoly • Market with only two producers • Nash equilibrium • A player chooses the best strategy given the strategies chosen by others • No participant can improve his or her outcome by changing strategies • Even after learning of the strategies selected by other participants

33. Exhibit 7 Price-Setting Payoff Matrix (profit per day) $500 $1,000 $500 $200 $200 $700 $700 $1,000 This matrix shows the daily profit each gas station can expect to earn based on the price each charges. Texaco’s price is in red and Exxon’s is in blue.

34. Exhibit 8 Cola War Payoff Matrix (annual profit in billions) $4 $2 $2 $1 $1 $3 $3 $4 This matrix shows annual profit each soft-drink company can expect to earn based on the promotional budget each adopts. Pepsi’s profit is in red and Coke’s is in blue.

35. Game Theory • One-shot versus repeated games • One-shot game • Game is played just once • Repeated games • Establish reputation for cooperation • Tit-for-tat strategy • Highest payoff

36. Game Theory • Tit-for-tat • Strategy in repeated games • A player in one round of the game mimics the other player’s behavior in the previous round • Optimal strategy for getting the other player to cooperate

37. Game Theory • Coordination game • Game in which a Nash equilibrium occurs when each player chooses the same strategy • Neither player can do better than matching the other player’s strategy

38. Comparison • Oligopoly • If firms collude or operate with excess capacity • Higher price • Lower output • If price wars • Lower price • Higher profits in the long run

39. Exhibit 9 Comparison of Market Structures