MONOPOLISTIC COMPETITION, OLIGOPOLY, AND STRATEGIC PRICING

1. MONOPOLISTIC COMPETITION, OLIGOPOLY, AND STRATEGIC PRICING Chapter 13

2. Today’s lecture will: • Explain two methods of determining market structure. • Discuss the four distinguishing characteristics of monopolistic competition. • Demonstrate graphically the equilibrium of a monopolistic competitor.

3. Today’s lecture will: • Identify the central element of oligopoly. • Explain why decisions in the cartel model depend on market share and decisions in the contestable market model depend on barriers to entry. • Illustrate a strategic decision facing a duopolist using the prisoner’s dilemma.

4. Market Structures • Market structure refers to the physical characteristics of the market within which firms interact, such as the number of firms in the industry and the existence of barriers to entry. • Perfect competition has an almost infinite number of firms and no barriers to entry. • Monopoly is a single firm with barriers to entry. • Monopolistic competition and oligopoly lie between these two extremes.

5. Market Structures • Monopolistic competition is a market structure, with few barriers to entry, in which there are many firms selling differentiated products. • Oligopoly is a market structure, often with significant barriers to entry, in which there are a few interdependent firms.

6. Problems Determining Market Structure • What is an industry and what is its geographic market – local, national, or international? • What products are to be included in the definition of an industry?

7. Classifying Industries • Cross-price elasticity measures the responsiveness of the change in demand for a good to a change in the price of a related good. • Goods with a cross-price elasticity of 3 or more are in the same industry. • North American Industry Classification System (NAICS) is an industry classification system adopted by Canada, Mexico, and the U.S. in 1997.

8. Classifying Industries Under the NAICS • All firms are placed into 20 broadly defined two-digit sectors. • These two-digit sectors are further divided into subgroupings of three to six digits. • Subgroupings with more digits are more narrowly defined.

9. Industry Groupings in NAICS 44-45 Retail Trade 51 Information __ • Broadcasting and telecommunications • 5133 Telecommunications • 51332 Wireless telecommunications carriers, • except satellite • 513321 Paging • Finance and insurance • 53 Real estate and rental and leasing

10. Determining Industry Structure • Economists use one of two methods to measure industry structure: • The concentration ratio – the value of sales by the top firms of an industry as a percentage of total industry sales • The Herfindahl index – the sum of the squared value of the individual market shares of all firms in the industry

11. Concentration Ratio • The most commonly used concentration ratio is the four-firm concentration ratio. • The higher the ratio, the closer the industry is to an oligopolistic or monopolistic type market of market structure.

12. Herfindahl Index • The Herfindahl Index is used as a rule of thumb by the Justice Department to determine whether a merger should be allowed. • If the index is less than 1000, the industry is considered competitive, thus allowing the merger to take place.

13. Four - firm Herfindahl Industry concentration index ratio Meat products 35 393 Breakfast cereal 82 2,445 Book printing 32 364 Greeting card publishing 66 1,619 Soap and detergent 60 1,306 Men’s footwear 50 857 Electronic computer 45 728 Burial caskets 74 2,965 Radio, TV, wireless 49 972 broadcasting Concentration Ratios and the Herfindahl Index

14. Conglomerate Firms and Bigness • Neither the four-firm concentration ratio or the Herfindahl index gives a complete picture of corporations’ bigness because many firms are conglomerates. • Conglomerates – huge corporations whose activities span various unrelated industries.

15. The Importance of Classifying Industry Structure • The number of firms in an industry is important in determining whether firms explicitly take other firms’ actions into account. • In oligopoly, with few firms, each firm engages in strategic decision making – taking explicit account of a rival’s expected response to its decisions. • Monopolistic competitors do not engage in strategic decision making.

16. Characteristics of Monopolistic Competition • Many sellers • Collusion and strategic decision making is difficult, so monopolistically competitive firms act independently. • Gives monopolistic competition its competitive aspect. • Differentiated products • Gives monopolistic competition its monopolistic aspect. • Differentiation exists so long as advertising convinces buyers that it exists.

17. Characteristics of Monopolistic Competition • Multiple dimensions of competition • Product differentiation • Perceived quality • Competitive advertising • Service and distribution outlets • Easy entry of new firms in the long run • There are no significant barriers to entry. • Ease of entry limits long-run profit.

18. QM Equilibrium in Monopolistic Competition Profit maximizing output is where MR=MC. MC Price ATC PM At equilibrium P=ATC and economic profits are zero. MR D 0 Quantity

19. Price PM PC 0 QC Quantity QM QC Comparing Perfect and Monopolistic Competition Perfect competition Monopolistic competition Price MC MC ATC ATC PC D MR D 0 Quantity

20. Comparing Perfect and Monopolistic Competition • The perfect competitor’s demand curve is perfectly elastic, but the monopolistic competitor has a downward sloping demand curve. • Both make zero economic long-run profit. • In perfect competition P = minimum ATC. • In monopolistic competition, P = ATC, but not minimum ATC. • Increasing market share is relevant for a monopolistic competitor, but not for a perfect competitor.

21. Comparing Monopolistic Competition with Monopoly • It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry. • No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry.

22. Advertising and Monopolistic Competition • Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do. • The goals of advertising are to increase demand and make it more inelastic. • Advertising increases ATC.

23. Characteristics of Oligopoly • Oligopolies are made up of a small number of mutually interdependent firms. • Each firm must take into account the expected reaction of other firms. • Oligopolies can be collusive or noncollusive.

24. Models of Oligopoly Behavior • There is no single model of oligopoly behavior. • Two models of oligopoly behavior are: • The cartel model – the combination of firms acts as if it were a monopoly. • The contestable market model – existence of barriers to entry determine price and output decisions.

25. The Cartel Model • Oligopolies act as if they were a monopoly and set a price to maximize profit. • Output quotas are assigned to individual member firms so that total output is consistent with joint profit maximization. • If oligopolies can limit the entry of other firms, they can increase profits.

26. Implicit Price Collusion • Formal collusion is illegal in the U.S. while informal collusion is permitted. • Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another. • Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.

27. Why Are Prices Sticky? • Informal collusion is an important reason why prices are sticky. • Another is the kinked demand curve. • If a firm increases price, others won’t go along, so demand is very elastic for price increases. • If a firm lowers price, other firms match the decrease, so demand is inelastic for price decreases.

28. Price 0 Quantity The Kinked Demand Curve a b MC0 P MR1 c MC1 D1 d D2 Q MR2

29. The Contestable Market Model • According to the contestable market model, barriers to entry and exit determine a firm’s price and output decisions. • Even if the industry contains only one firm, it will set a competitive price if there are no barriers to entry.

30. Comparing the Contestable Market and Cartel Models • The cartel model is appropriate for oligopolists that collude, set a monopoly price, and prevent market entry. • The contestable market model describes oligopolies that sets a competitive price and has no barriers to entry. • Oligopoly markets lie between these two extremes. • Both models use strategic pricing decisions – firms set their price based on the expected reactions of other firms.

31. New Entry and Price Wars • The threat of outside competition limits oligopolies from acting as a cartel. • Price wars are the result of strategic pricing decisions gone wild. • A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business.

32. Game Theory and Strategic Decision Making • Most oligopolistic strategic decision making is carried out with explicit or implicit use of game theory. • Game theory is the application of economic principles in which players make interdependent choices. • The prisoner’s dilemma is a game that demonstrates the difficulty of cooperative behavior in certain circumstances. • The prisoner’s dilemma can be applied to a duopoly – a two firm oligopoly.

33. Firm and Industry Duopoly Cooperative Equilibrium Monopolist solution Price ATC MC MC $800 Price $800 700 700 600 600 Competitive solution 575 500 500 400 400 D 300 300 200 200 MR 100 100 0 0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 9 10 11 Quantity (in thousands) Quantity (in thousands) Firm's cost curves Industry: Competitive and monopolist solution

34. Firm and Industry Duopoly Equilibrium When One Firm Cheats P P P $900 MC MC A TC A TC $800 $800 800 700 700 700 C 600 600 600 B 550 550 550 A 500 500 500 A A Non-cheating firm’s output 400 Cheating firm’s output 400 400 300 300 300 200 200 200 100 100 100 0 0 0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Quantity (in thousands) Quantity (in thousands) Quantity (in thousands) Cheating solution Noncheating firm’s loss Cheating firm’s profit

35. Duopoly and a Payoff Matrix • A payoff matrix is a box that contains the outcomes of a strategic game under various circumstances. • By analyzing the strategies of both firms under all situations, all possibilities are placed in a payoff matrix.

36. A $75,000 A – $75,000 The Payoff Matrix of Strategic Pricing Duopoly A Does not cheat A Cheats A +$200,000 B Does not cheat B $75,000 B – $75,000 A 0 B Cheats B +$200,000 B 0

37. Comparison of Market Structures Structure Characteristics

38. Summary • Industries are classified by economic activity in the North American Industry Classification System (NAICS). Industry structures are measured by concentration ratios and Herfindahl indexes. • A concentration ratio is the sum of market shares of the largest firms in an industry. • A Herfindahl index is the sum of the squares of the market shares of all firms in an industry.

39. Summary • The central characteristic of oligopoly is that there are a small number of interdependent firms. • Monopolistic competition is characterized by: • Many sellers • Differentiated products • Multiple dimensions of competition • Ease of entry of new firms

40. Summary • Monopolistic competitors differ from perfect competitors in that the former face a downward sloping demand curve. • Monopolistic competitors differ from monopolists in that monopolist competitor make zero long-run profit. • In monopolistic competition firms act independently; in an oligopoly they take account of each other’s actions.

41. Summary • An oligopolist’s price will be somewhere between the competitive price and the monopolistic price. • Game theory and the prisoner’s dilemma can shed light on strategic pricing decisions. • A contestable market theory of oligopoly judges an industry’s competitiveness more by performance and barriers to entry than by structure. • Cartel models of oligopoly concentrate on market structure.

42. Review Question 13-1 Explain the difference in short-run and long-run equilibrium for a monopolistic competitor. In the short-run, a monopolistic competitor produces where MR=MC. As long as P>ATC, the firm will make an economic profit. However, other firms enter the industry and decrease the market share of the original firms. The demand curve of these firms shifts to the left until P=ATC and there are no economic profits in long-run equilibrium. Review Question 13-2 Compare long-run equilibrium in oligopoly with respect to price and output with perfect competition and monopoly. Equilibrium output for oligopoly is larger than output for a monopoly, but less than output for a perfectly competitive firm. Prices in oligopoly are lower than those for monopoly, but higher than those in perfect competition.