© 2003 mcgraw-hill ryerson limited. monopolistic competition, oligopoly, and strategic pricing...
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© 2003 McGraw-Hill Ryerson Limited.
Monopolistic Monopolistic Competition, Competition,
Oligopoly, and Oligopoly, and Strategic PricingStrategic Pricing
Chapter 13Chapter 13
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IntroductionIntroduction
In discussing real-world competition, the focus quickly becomes market structure.
Market structure refers to the physical characteristics of the market within which firms interact.
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IntroductionIntroduction
Market structure involves the number of firms in the market and the barriers to entry.
Perfect competition, with an infinite number of firms, and monopoly, with a single firm, are polar opposites.
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IntroductionIntroduction
Monopolistic competition and oligopoly lie between these two extremes. Monopolistic competition is a market
structure in which there are many firms selling differentiated products.
Oligopoly is a market structure in which there are a few interdependent firms.
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13 - 5Introduction to Introduction to Monopolistic Monopolistic Competition and Competition and OligopolyOligopoly The number of firms in an industry plays
an important role in determining whether firms explicitly take other firms’ actions into account. Oligopolies take into account the
reactions of other firms; monopolistic competitors do not.
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13 - 6Introduction to Introduction to Monopolistic Monopolistic Competition and Competition and OligopolyOligopoly In monopolistic competition, there are
so many firms that firms do not take into account their rivals’ responses to their decisions.
Collusion is difficult due to a large number of firms.
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13 - 7Introduction to Introduction to Monopolistic Monopolistic Competition and Competition and OligopolyOligopoly In oligopoly, there are only a few firms
and each firm is more likely to engage in strategic decision making.
Strategic decision making – taking explicit account of a rival’s expected response to a decision one is making.
In oligopoly, few firms can collude relatively easily.
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Monopolistic Monopolistic CompetitionCompetition The four distinguishing characteristics of
monopolistic competition are: Many sellers. Differentiated products. Multiple dimensions of competition. Easy entry of new firms in the long
run.
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Many SellersMany Sellers
There are many sellers in monopolistic competition, but each of them is able to identify its own small market segment.
Monopolistically competitive firms act independently of its rivals.
The existence of many sellers also makes collusion difficult.
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Differentiated ProductsDifferentiated Products
The “many sellers” characteristic gives monopolistic competition its competitive aspect.
Its monopolistic aspect comes from product differentiation.
In a monopolistically competitive market competitors produce many close substitutes.
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Differentiated ProductsDifferentiated Products
Differentiation may be based on real differences in product characteristics, or can be based on consumers’ perceptions about product differences.
Generally, monopolistic competition is characterized by significant expenditures on advertising, which acts as an important barrier to entry.
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Differentiated ProductsDifferentiated Products
Any industry where brand proliferation is present is likely to be monopolistically competitive. Some examples are soap, jeans,
cookies and games.
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Multiple Dimensions of Multiple Dimensions of CompetitionCompetition Competition takes many forms in a
monopolistically competitive industry: Product differentiation. Perceived quality. Competitive advertising. Service and distribution outlets.
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Easy Entry of New Firms Easy Entry of New Firms in the Long Runin the Long Run There are no significant barriers to entry
in monopolistic competition. The existence of economic profits
induces other firms to enter, bringing long-run profit down to zero.
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Output, Price, and Profit Output, Price, and Profit of a Monopolistic of a Monopolistic CompetitorCompetitor A monopolistically competitive firm
produces in the same manner as a monopolist—to maximize profit, it chooses the quantity where MC = MR.
Having determined output, the firm will charge what consumers are willing to pay (determined by the demand curve).
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Output, Price, and Profit Output, Price, and Profit of a Monopolistic of a Monopolistic CompetitorCompetitor If price exceeds ATC, the firm will earn
positive economic profits.
These profits attract entry. Some customers of the existing firms
switch to become customers of the new firm.
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Output, Price, and Profit Output, Price, and Profit of a Monopolistic of a Monopolistic CompetitorCompetitor Entry causes the existing firm’s demand
curve to shift left (decrease) as it loses customers.
Competition, therefore, implies zero economic profit in the long run.
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Output, Price, and Profit Output, Price, and Profit of a Monopolistic of a Monopolistic CompetitorCompetitor At the long run equilibrium, ATC equals
price and economic profits are zero. This occurs at the point of tangency of
the ATC and demand curve at the output chosen by the firm.
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Monopolistic Monopolistic Competition, Competition, Fig. 13-1a, p 283Fig. 13-1a, p 283
MR D1
Q1
P1
Price
0 Quantity
ATC1
MC
C1
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Monopolistic Monopolistic Competition, Competition, Fig. 13-1b, p 283 Fig. 13-1b, p 283
MR1 D1Q1
Price
0 Quantity
P1
ATC1
MC
C1
ATC2
MR2
D2
P2C2
Q2
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Monopolistic Monopolistic Competition, Competition, Fig. 13-1c, p 283 Fig. 13-1c, p 283
MR3 D3
Q3
P3 =C3
Price
0 Quantity
MC
ATC3
C1
C2
P1
P2
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with Perfect CompetitionPerfect Competition Both the monopolistic competitor and
the perfect competitor make zero economic profit in the long run.
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with Perfect CompetitionPerfect Competition The perfect competitor’s demand curve
is perfectly elastic. Zero economic profit means that it
produces at the minimum of the ATC curve.
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with Perfect CompetitionPerfect Competition A monopolistic competitor faces a downward
sloping demand curve It produces where MC = MR, and not where
MC =P. The ATC curve is tangent to the demand curve in
the zero-profit long run equilibrium, so the firm does not produce at the minimum point of the ATC curve.
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with Perfect CompetitionPerfect Competition A monopolistic competitor produces
less than a perfect competitor. For a monopolistic competitor,
increasing market share is a relevant concern, since it can decrease the average cost by increasing output.
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Perfect competition Monopolistic competition
Comparing Perfect and Comparing Perfect and Monopolistic Monopolistic Competition,Competition,Fig.13-2, p 284Fig.13-2, p 284
MC
PC D
QC
Price
0 Quantity
ATC
PMC
MCATC
QMC Quantity0
Price
QC
PC
MR
D
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with MonopolyMonopoly The difference between a monopolist
and a monopolistic competitor is in the position of the average total cost curve in long-run equilibrium.
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with MonopolyMonopoly The monopolist makes a long-run
economic profit since entry is prevented by significant barriers to entry.
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Comparing Monopolistic Comparing Monopolistic Competition with Competition with MonopolyMonopoly For a monopolistic competitor, barriers
to entry are low, and entry means that no long run economic profit is possible.
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Advertising and Advertising and Monopolistic Monopolistic CompetitionCompetition Firms in a perfectly competitive market
have no incentive to advertise Monopolistic competitors have a strong
incentive to do so.
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Characteristics Characteristics OligopolyOligopoly Oligopolies are made up of a small
number of very large firms. Products may be homogeneous or
differentiated Firms are mutually interdependent. Each firm must take into account the
expected reaction of other firms.
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Models of Oligopoly Models of Oligopoly BehaviorBehavior Oligopolistic industries are difficult to
characterize. There is no single general model of
oligopoly because each oligopolistic industry is different.
Two (out of many) models of oligopoly behavior are the cartel model and the contestable market model.
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Models of Oligopoly Models of Oligopoly BehaviorBehavior In the cartel model, an oligopoly sets a
monopoly price. In the contestable market model, an
oligopoly with no barriers to entry sets a competitive price.
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The Cartel ModelThe Cartel Model
A cartel is a combination of firms that acts as if it were a single firm.
If oligopolies can limit entry, they have a strong incentive to collude.
To collude is to get together with other firms to set price or allocate market share.
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The Cartel ModelThe Cartel Model
The cartel model of oligopoly assumes that oligopolies act as if they were monopolists that have assigned output quotas to individual member firms so that total output is consistent with joint profit maximization.
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Implicit Price CollusionImplicit Price Collusion
Formal collusion is against the law in Canada, but informal collusion is allowed.
Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another.
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Implicit Price CollusionImplicit Price Collusion
Sometimes the largest or most dominant firm takes the lead in pricing and output decisions, and the others follow.
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Cartels and Cartels and Technological ChangeTechnological Change Cartels can be destroyed by an outsider
with technological superiority. Thus, cartels with high profits will
provide incentives for significant technological change.
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Kinked Demand: Why Kinked Demand: Why Are Prices Sticky?Are Prices Sticky? Informal collusion is an important
reason why prices are sticky. Another is the kinked demand curve.
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Kinked Demand Kinked Demand
When there is a kink in the demand curve, there has to be a gap in the marginal revenue curve.
The kinked demand curve is not a theory of oligopoly but a theory of sticky prices.
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D2
The Kinked Demand The Kinked Demand Curve,Curve, Fig. 13-3, p 289 Fig. 13-3, p 289
D1
MR2
MR1
Price
Quantity0 Q
Pa
b
c
d
MC0
MC1
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The Contestable Market The Contestable Market ModelModel According to the contestable market
model, barriers to entry and barriers to exit determine a firm’s price and output decisions. Even if the industry contains a very
small number of firms, it could still behave as a competitive market if entry is open.
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The Contestable Market The Contestable Market ModelModel The stronger the ability of the
oligopolists to collude and prevent market entry, the closer it is to a monopolist solution.
The weaker the ability to collude, the more competitive will be the market.
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Strategic Pricing and Strategic Pricing and OligopolyOligopoly Both the cartel and contestable market
models use strategic pricing decisions—they set their prices based on the expected reactions of other firms.
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Strategic Pricing and Strategic Pricing and OligopolyOligopoly Creation of cartels is limited by threat of
outside competition. In many industries the outside
competition comes from international firms.
For a cartel with few barriers to entry, the long run demand curve is very elastic.
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Price WarsPrice Wars
Price wars are the result of strategic pricing decisions breaking down.
If prices fall below average total cost, firms may enter into a price war in any oligopoly.
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Price WarsPrice Wars
A firm may develop a predatory pricing strategy as a matter of policy A predatory pricing strategy involves
temporarily pushing the price down below cost in order to drive a competitor out of business.
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Game Theory and Game Theory and Strategic Decision Strategic Decision MakingMaking Game theory is the application of
economic principles to interdependent situations.
One example is the “prisoners’ dilemma” game.
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The Prisoner’s Dilemma The Prisoner’s Dilemma and a Duopoly Exampleand a Duopoly Example The prisoner’s dilemma is one well-
known game that demonstrates the difficulty of cooperative behavior in certain circumstances.
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The Prisoner’s Dilemma The Prisoner’s Dilemma and a Duopoly Exampleand a Duopoly Example The prisoners dilemma has its simplest
application when the oligopoly consists of only two firms—a duopoly.
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The Prisoner’s Dilemma The Prisoner’s Dilemma and a Duopoly Exampleand a Duopoly Example By analyzing the strategies of both firms
under all situations, all possibilities are placed in a payoff matrix.
A payoff matrix is a box that contains the outcomes of a strategic game under various circumstances.
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Firm and Industry Duopoly Firm and Industry Duopoly Cooperative Equilibrium, Cooperative Equilibrium, Fig. Fig. 13-4, p 29113-4, p 291
575
$800
700
600
500
400
300
200
100
0
(a) Firm's cost curves
1 2 3 4 5 6 7 8
Quantity (in thousands)
MC ATC$800
700
600
500
400
300
200
100
0 1 2 3 4 5 6 7 8 9 10 11
Monopolist solution
MR
D
Competitive solution
MC
(b) Industry: Competitive and monopolist solution
Quantity (in thousands)
Price Price
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Firm and Industry Duopoly Firm and Industry Duopoly Equilibrium When One Firm Equilibrium When One Firm Cheats, Cheats, Fig. 13-5, p 292Fig. 13-5, p 292
Pri
ce
Pri
ce
Pri
ce
$800
700
600
500
400
300
200
100
0
$800
700
600
500
400
300
200
100
0
$900
800
700
600
500
400
300
200
100
0
550 550 550
1 2 3 4 5 6 7 1 2 3 4 5 6 7
A
MC ATC
Quantity (in thousands)
(a) Noncheating firm’s loss
A
MC ATC
Quantity (in thousands)
(b) Cheating firm’s profit
AB
C
1 2 3 4 5 6 7 8
Quantity (in thousands)
(c) The market
Non-cheating
firm’s output
Cheating firm’s
output
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Duopoly and a Payoff Duopoly and a Payoff MatrixMatrix The duopoly is a variation of the
prisoner's dilemma game. The results can be presented in a payoff
matrix that captures the essence of the prisoner's dilemma.
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B Cheats
B Does not cheat
A Does not cheat A Cheats
B +$200,000 B 0
A 0
A +$200,000
B $75,000
A $75,000
A – $75,000
B – $75,000
The Payoff Matrix of The Payoff Matrix of Strategic Pricing Strategic Pricing Duopoly, Duopoly, Fig. 13-6, p 293Fig. 13-6, p 293
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Oligopoly Models, Oligopoly Models, Structure, and Structure, and PerformancePerformance Oligopoly models are based either on
structure or performance. The four-fold division of markets
considered so far are based on market structure.
Structure means the number, size, and interrelationship of firms in the industry.
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Oligopoly Models, Oligopoly Models, Structure, and Structure, and PerformancePerformance A monopoly is considered the least
competitive, perfectly competitive industries are considered the most competitive.
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Oligopoly Models, Oligopoly Models, Structure, and Structure, and PerformancePerformance The contestable market model gives
less weight to market structure. Markets in this model are judged by
performance, not structure. Performance includes such results as ratio
of price to marginal cost, output, allocative and productive efficiency, product variety, innovation rate, and profits.
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Oligopoly Models, Oligopoly Models, Structure, and Structure, and PerformancePerformance There is a similarity in the two
approaches, structure versus performance Often barriers to entry are the reason
there are only a few firms in an industry. When there are many firms, that’s usually
because there are few barriers to entry. In most situations the two approaches
come to the same conclusion regarding competitiveness.
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Monopolistic Monopolistic Competition, Oligopoly, Competition, Oligopoly, and Strategic Pricingand Strategic Pricing
End of Chapter 13End of Chapter 13