Chapter 25 Monopolistic Competition and Oligopoly

Key characteristics of Monopolistic Competition:

1. Large number of sellers – individual firms have relatively small market share – no collusion – independent action (i.e. not significant interdependence)

2. Differentiated Products– Product Attributes – Service – location– Branding / Merchandising / significant advertising expenditures

product differentiation provides some control over price

3. Easy entry and exit

Monopolistic Competition:Price and Output

The firm faces highly elastic demand.• many rivals producing close substitutes• product differentiation means

demand is not perfectly elastic

Short run: ‑MR = MC maximizes profits (or minimizes losses)

Long run: ‑the firm will tend to earn a normal profit only, but no economic profits• Easy entry/exit

Complicating factors (theory v. practice):• Product differentiation can be strong (branding, location, etc.); some firms are able to sustain long run profits• Always some restriction to entry (e.g. start-up costs); economic profits may linger into the long run

Monopolistic Competition and Economic EfficiencyReview:Allocative efficiency: P = MC (at MC = D) price = marginal cost - the right amount of resources are allocated to the product

Productive efficiency: P = min. ATC (at ATC = D) price = minimum average total cost- production occurs using the lowest cost combination of resources

MONOPOLISTIC COMPETITION IS NOT EFFICIENT:

Allocative Efficiency not achieved• Long run P > MC• consumers want additional units not being produced

Productive Efficiency not achieved• although long run P = ATC at the given level of output, firms do not produce the

output that coincides with the lowest ATC• costs associated with product differentiation (not incurred in pure competition)

Monopolistic Competition (cont.)A producer may be able to postpone the long-run outcome of zero economic profit

- new product development, current product improvement, merchandising

Although the consumer pays a higher price in monopolistic competition (and the producers don’t supply “enough”), one consumer benefit exists:

-- additional product choice (close but not exact substitutes)

The monopolistically competitive firm juggles three factors in seeking maximum profit.• product attributes• product price• advertising

Theory v. Practice:Every possible combination of price, product, and advertising poses a different demand and cost situation for the individual firm.

The optimal combination cannot be easily predicted.

A monopolistically competitive firm uses trial and error to maximize profits.

#1. Explain how the entry of firms into its industry affects the demand curve facing a monopolistic competitor and how that, in turn, affects its economic profit.

Economic profits attract competing firms to enter:- putting downward pressure on prices - decreasing the portion of market demand held by the individual firm.

This reduces economic profit for the individual firm.

http://www.youtube.com/watch?v=6c0VtOdibcI&feature=relmfu

Spurlock on branding/advertising

OligopolyKey characteristics:• a “few” large producers• differentiated or homogeneous product• some monopoly power over price, but…

limited by mutual interdependence• strong barriers to entry Economies of scale, initial costs of capital,

control/ownership of resources

Mergers may lead to and are prevalent in oligoply. increase monopoly power

Determining the Market Structure of an Industry

Concentration Ratio:-- a measure of the total output produced in an industry by a given number of firms in the industry.-- a four firm concentration ratio is the most commonly used-- a high concentration ratio is associated with less competition

Assume Industry A, with 10 producers that have market shares (%) of:

30% 23% 15% 10% 8% 6% 4% 2% 1% 1%

The four firm concentration ratio is: 78%

Assume Industry B, with 10 producers that have market shares (%) of:

12% 11% 10% 10% 10% 10% 10% 10% 9% 8%

The four firm concentration ratio is: 43%

Industry B appears much more competitive than Industry A.

0 – 50%: Industry ranges from perfect competition to oligopoly50 – 80%: Industry is likely oligopoly80 – 100%: Industry ranges from oligopoly to monopoly (or near monopoly).

Determining the Market Structure of an Industry

Herfindahl Index:-- a measure of the size of firms in relation to the industry -- an indicator of the amount of competition in an industry. -- named after economist Orris C. Herfindahl -- widely applied in competition law and antitrust inquiry-- a relatively high Herfindahl Index is associated with low competition

-- defined as the sum of the squares of the market shares of all the firms in the industry

Assume Industry A, with 10 producers that have market shares (%) of:

30% 23% 15% 10% 8% 6% 4% 2% 1% 1%

The Herfindahl Index is:

Assume Industry B, with 10 producers that have market shares (%) of:

12% 11% 10% 10% 10% 10% 10% 10% 9% 8%

The Herfindahl Index is:

Industry B appears much more competitive than Industry A.

Oligopoly & Game Theory

Dominant Strategy:• No matter what the opponent does, a

strategy that earns a player a payoff better than any other strategy.

• Does not mean player gets the best possible payoff.

Nash Equilibrium:- set of strategies, one for each player, such that

no player has incentive to unilaterally change his strategy- does not mean either player gets the best possible payoff- one example of equilibrium is if both players have a dominant strategy- players are in Nash equilibrium if each one is making the best decision that he can,

taking into account the potential decisions of the other

Prisoner’s Dilemma:- situation in which both players could improve the Equilibrium outcome by collusion

Price Fixinghttp://www.youtube.com/watch?v=DPXTsPS-hyw http://www.youtube.com/watch?v=u6VHDJ4x0sI

1. Does either firm have a dominant strategy?

2. Is there a Nash Equilibrium?

3. Can you predict a likely outcome (no collusion)?

4. Is it a Prisoner’s Dilemma game?

5. Is there an incentive for collusive strategy? If so, what is the likely result of binding collusion?

same prices lower prices

sameprices

lowerprices

Questions for each matrix:1. Does either firm have a dominant strategy?

2. Is there a Nash Equilibrium?

3. Can you predict a likely outcome (no collusion)?

4. Is it a Prisoner’s Dilemma game?

5. Is there an incentive for collusive strategy? If so, what is the likely result of binding collusion?

Questions for each matrix:1. Does either firm have a

dominant strategy?

2. Is there a Nash Equilibrium?

3. Can you predict a likely outcome (no collusion)?

4. Is it a Prisoner’s Dilemma game?

5. Is there an incentive for collusive strategy? If so, what is the likely result of binding collusion?

airlines Coke & Pepsi McD’s & BKboth maintain fare

Yes; bothmaintain fare

Yes; bothmaintain fare

Yes

Yes; bothraise fare

both advertise

Yes; bothadvertise

Yes; bothadvertise

No

No

No

No

No

No

Perhaps

same prices lower prices

sameprices

lowerprices

#1. How does monopolistic competition differ from pure competition? Pure Competition Monopolistic Competition

very large number of firms many firmsstandardized product differentiated productno control over price little control over price

no entry barriers very small barriers to entryno non-price comp. significant non-price comp.

Explain fully what product differentiation involves.

Product differentiation – whether based on real or perceived differences – is what the monopolistic competitor needs to gain some monopoly power in the market.

The real differences can be in quality, in services, in location, or in marketing.

To the extent that product differentiation exists in fact or in the mind of the consumer, monopolistic competitors have some control over price, because they have built up some loyalty to their brand.

From pure monopoly?Pure Monopoly

one firmUnique product; no close subs.

Price makerBlocked entry

little/no nonprice comp.

#5. Critically evaluate and explain:“In monopolistically competitive industries economic profits are competed away in the long run; hence, there is no valid reason to criticize the performance and efficiency of such industries.”

The first part of the statement is TRUE (theoretically) . The second part of the statement is FALSE.

The inefficiency of monopolistic competition is not related to the profit level but to the fact that the firms do not produce at the point of minimum ATC (not productively efficient) and do not equate price and MC (not allocatively efficient).

This is an inevitable consequence of imperfect competition.

“In the long run monopolistic competition leads to a monopolistic price but not to monopolistic profits.”TRUE.

Competition of close substitutes tends to move price of the average firm down to equality with ATC. Thus, there is no economic profit.

However, price is higher than in pure competition (and therefore “monopolistic”) because while the P = ATC it does not equal minimum ATC.

#6. Why do oligopolies exist?

• economies of scale (automobiles, steel industry)• ownership/control of resources (cigarettes, mining industries)• Mergers (banking)

Worcester County National, Shawmut, Fleet, Banknorth, TD Banknorth, TD Bank

List five or six oligopolists whose products you own or regularly purchase. Coca-Cola, Chrysler, General Electric, Whirlpool, Sanford.

What distinguishes oligopoly from monopolistic competition?Oligopoly Monopolistic Competitionfew firms many firms

standard or diff. product differentiated productprice-maker, but… little control over price

strong entry barriers very small barriers to entry significant non-price comp significant non-price comp.

#7a. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent?

A four-firm concentration ratio states the percentage of sales that the largest four firms in an industry generate.

A ratio of 60 percent means the largest four firms in the industry account for 60 percent of sales; a four-firm concentration ratio of 90 percent means the largest four firms account for 90 percent of sales.

What are the shortcomings of concentration ratios as measures of monopoly power?

• definition of industry regarding geography (regional v. national v. international)• do not account for inter-industry competition (theater v. ballpark… entertainment)• do not reveal the dispersion of size among the top four firms.

#7b. Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent of total industry sales. For the five firms in industry B the figures are 60, 25, 5, 5, and 5 percent. Calculate the Herfindahl index for each industry…

Herfindahl index for A: 302 + 302 + 202 + 102 + 102

900 + 900 + 400 + 100 + 1002,400

Herfindahl index for B: 602 + 252 + 52 + 52 + 52

3,600 + 625 + 25 + 25 +254,300

…and compare their likely competitiveness.Industry A would likely be more competitive than Industry B, where one firm dominates and two firms control 85 percent of the market.

8. Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit figures are in thousands. Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries.C and D are interdependent because their profits depend not just on their own price, but also on the other firm’s price.

Assuming no collusion between C and D, what is the likely pricing outcome?Both firms will set price at $35. If either charged $40, it would be concerned the other would undercut the price and its profit by charging $35. At $35 for both; C’s profit is $55,000, D’s, $58,000.

In view of your answer to 8b, explain why price collusion is mutually profitable. Why might there be a temptation to cheat on the collusive agreement?Through price collusion—agreeing to charge $40—each firm would achieve higher profits (C = $57,000; D = $60,000). Once both firms agree on $40, each sees it can increase its profit even more by secretly charging $35 while its rival charges $40.

25-11 Why is there so much advertising in monopolistic competition and oligopoly?

Monopolistically competitive firms maintain economic profits through: product development and advertising.

(advertising will increase demand for the product… tastes and preferences)

The oligopolist would rather not compete on a basis of price.Advertising can operate as a barrier to entry

How does such advertising help consumers and promote efficiency? • Advertising provides information about new products and product improvements

to the consumer. • Advertising may result in an increase in competition by promoting new products

and product improvements.

Why might it be excessive at times? • Advertising may result in manipulation and persuasion rather than information. • An increase in brand loyalty through advertising will increase the producer’s

monopoly power. • Excessive advertising may create barriers to entry into the industry … cycle of

advertising/profits/advertising

FTC:http://www.youtube.com/watch?v=NssfPApe5iQ

Bagels price fixing:http://www.youtube.com/watch?v=u6VHDJ4x0sI

Qantas price fixing:http://www.youtube.com/watch?v=o_gnvHKoOX4

Prisoner’s dilemma:http://www.youtube.com/watch?v=ED9gaAb2BEw

Dark Knight: http://www.youtube.com/watch?v=TmUWRJInwhk&feature=related

Split/Steal:http://www.youtube.com/watch?v=InDgRkn04xg