13 • MONOPOLISTIC COMPETITION AND OLIGOPOLY CHAPTER
Objectives • After studying this chapter, you will able to • Define and identify monopolistic competition • Explain how output and price are determined in a monopolistically competitive industry • Explain why advertising costs are high in a monopolistically competitive industry
Objectives • After studying this chapter, you will able to • Define and identify oligopoly • Explain two traditional oligopoly models • Use game theory to explain how price and output are determined in oligopoly • Use game theory to explain other strategic decisions
Monopolistic Competition • Monopolistic competition is a market with the following characteristics: • A large number of firms. • Each firm produces a differentiated product. • Firms compete on product quality, price, and marketing. • Firms are free to enter and exit the industry.
Monopolistic Competition • Large Number of Firms • The presence of a large number of firms in the market implies: • Small market. • Ignore other firms. • Collusion impossible.
Monopolistic Competition • Product Differentiation • Firms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms.
Monopolistic Competition • Competing on Quality, Price, and Marketing • Product differentiation enables firms to compete in three areas: quality, price, and marketing. • Quality includes design, reliability, and service. • Because firms produce differentiated products, each firm has a downward-sloping demand curve for its own product. • Differentiated products must be marketed using advertising and packaging.
Monopolistic Competition • Entry and Exit • There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. • Examples of Monopolistic Competition • Figure 13.1 on the next slide shows market share of the largest four firms and the HHI for each of ten industries that operate in monopolistic competition.
Monopolistic Competition • The red bars refer to the 4 largest firms. • Green is the next 4. • Blue is the next 12. • The numbers are the HHI.
Output and Price in Monopolistic Competition • The Firm’s Short-Run Output and Price Decision • A firm that has decided the quality of its product and its marketing program produces the profit maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC).
Output and Price in Monopolistic Competition • Figure 13.2 shows a short-run equilibrium for a firm in monopolistic competition. • It operates much like a single-price monopolist.
Output and Price in Monopolistic Competition • The firm produces the quantity at which price equals marginal cost and sells that quantity for the highest possible price. • It earns an economic profit (as in this example) when P > ATC.
Output and Price in Monopolistic Competition • Profit Maximizing Might be Loss Minimizing • A firm might incur an economic loss in the short run. • Here is an example. • In this case, P < ATC.
Output and Price in Monopolistic Competition • Long Run: Zero Economic Profit • In the long run, economic profit induces entry. • And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC). • In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.
Output and Price in Monopolistic Competition • As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward. • The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity. • Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.
Output and Price in Monopolistic Competition • Figure 13.4 shows a firm in monopolistic competition in long-run equilibrium. • If firms incur an economic loss, firms exit to achieve the long-run equilibrium.
Output and Price in Monopolistic Competition • Monopolistic Competition and Perfect Competition • Two key differences between monopolistic competition and perfect competition are: • Excess capacity • Markup • A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. • A firm’s markup is the amount by which its price exceeds its marginal cost.
Output and Price in Monopolistic Competition • Firms in monopolistic competition operate with excess capacity in long-run equilibrium. • The downward-sloping demand curve for their products drives this result.
Output and Price in Monopolistic Competition • Firms in monopolistic competition operate with positive mark up. • Again, the downward-sloping demand curve for their products drives this result.
Output and Price in Monopolistic Competition • In contrast, firms in perfect competition have no excess capacity and no markup. • The perfectly elastic demand curve for their products drives this result.
Output and Price in Monopolistic Competition • Is Monopolistic Competition Efficient? • Because in monopolistic competition P > MC, marginal benefit exceeds marginal cost. • So monopolistic competition seems to be inefficient.
Product Development and Marketing • Innovation and Product Development • We’ve looked at a firm’s profit maximizing output decision in the short run and the long run of a given product and with given marketing effort. • To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development. • New product development allows a firm to gain a competitive edge.
Product Development and Marketing • Innovation is costly, but it increases total revenue. • Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation. • Production development may benefit the consumer by providing an improved product, or it may only the appearance of a change in product quality.
Product Development and Marketing • Advertising • Firms in monopolistic competition incur heavy advertising expenditures. • Figure 13.6 shows estimates of the percentage of sale price for different monopolistic competition markets. • Cleaning supplies and toys top the list at almost 15 percent.
Product Development and Marketing • With advertising, the firm produces 100 units of output at an average total cost of $40. • The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.
Product Development and Marketing • Advertising might also decrease the markup. • In Figure 13.8(a), with no advertising, demand is not very elastic and the markup is large. • In Figure 13.8(b), advertising makes demand more elastic, increases the quantity and lowers the price and markup.
What is Oligopoly? • The distinguishing features of oligopoly are: • Natural or legal barriers that prevent entry of new firms • A small number of firms compete
What is Oligopoly? • Barriers to Entry • Either natural or legal barriers to entry can create oligopoly. • Figure 13.9 shows two oligopoly situations. • In part (a), there is a natural duopoly—a market with two firms.
What is Oligopoly? • In part (b), there is a natural oligopoly market with three firms.
What is Oligopoly? • Small Number of Firms • Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. • Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions. • Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit. • Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.
What is Oligopoly? • Examples of Oligopoly • Figure 13.10 shows some examples of oligopoly. • An HHI that exceeds 1800 is generally regarded as an oligopoly. • An HHI below 1800 is generally regarded as monopolistic competition.
Two Traditional Oligopoly Models • The Kinked Demand Curve Model • In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.
Two Traditional Oligopoly Models • Figure 13.11 shows the kinked demand curve model. • The demand curve that a firm believes it faces has a kink at the current price and quantity.
Two Traditional Oligopoly Models • Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. • Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.
Two Traditional Oligopoly Models • The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by that gap AB in the figure.
Two Traditional Oligopoly Models • Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged. • For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit maximizing price and quantity would not change.
Two Traditional Oligopoly Models • Dominant Firm Oligopoly • In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. • The large firm operates as a monopoly, setting its price and output to maximize its profit. • The small firms act as perfect competitors, taking as given the market price set by the dominant firm.
Two Traditional Oligopoly Models • Figure 13.12 shows a dominant firm industry. On the left are 10 small firms and on the right is one large firm.
Two Traditional Oligopoly Models • The demand curve, D, is the market demand curve and the supply curve S10 is the supply curve of the 10 small firms. S10
Two Traditional Oligopoly Models • At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing.
Two Traditional Oligopoly Models • But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm.
Two Traditional Oligopoly Models • The demand curve for the large firm’s output is the curve XD on the right.
Two Traditional Oligopoly Models • The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.
Two Traditional Oligopoly Models • The large firm maximizes profit by setting MR = MC. Let’s suppose that the marginal cost curve is MC in the figure.
Two Traditional Oligopoly Models • The profit maximizing quantity for the large firm is 10 units. The price charged is $1.00.
Two Traditional Oligopoly Models • The small firms take this price and supply the rest of the quantity demanded.
Two Traditional Oligopoly Models • A dominant firm oligopoly can arise only if one firm has lower costs than the others.
Two Traditional Oligopoly Models • In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.
Oligopoly Games • Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. • What Is a Game? • All games share four features: • Rules • Strategies • Payoffs • Outcome.
Oligopoly Games • The Prisoners’ Dilemma • The prisoners’ dilemma game illustrates the four features of a game. • The rules describe the setting of the game, the actions the players may take, and the consequences of those actions. • In the prisoners’ dilemma game, two prisoners (Art and Bob). • Each is held in a separate cell and cannot communicate with each other.