lecture 10 monopolistic competition

Hall & Leiberman; Economics: Principles And Applications, 2004

1

Monopolistic Competition And Oligopoly

• On any given day, you are probably exposed to hundreds of advertisements

• In perfect competition and monopoly firms do little, if any, advertising

• Where, then, is all the advertising coming from?


2

The Concept of Imperfect Competition

• Refers to market structures between perfect competition and monopoly

• Types of imperfectly competitive markets– Monopolistic competition – Oligopoly


3

Monopolistic Competition

• Hybrid of perfect competition and monopoly, sharing some of features of each– A monopolistically competitive market has

three fundamental characteristics• Many buyers and sellers• Sellers offer a differentiated product• Sellers can easily enter or exit the market


4

Many Buyers and Sellers• Under monopolistic competition, an individual

buyer is unable to influence price he pays

• But an individual seller, in spite of having many competitors, decides what price to charge


5

Sellers Offer a Differentiated Product

• Each seller produces a somewhat different product from the others

• Faces a downward-sloping demand curve – In this sense is more like a monopolist than a

perfect competitor– When it raises its price a modest amount,

quantity demanded will decline (but not all the way to zero)


6

Sellers Offer a Differentiated Product

• What makes a product differentiated?

• Product differentiation is a subjective matter

• Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated


7

Easy Entry and Exit

• Same as in perfect competition– Ensures firms earn zero economic profit in

long-run• In monopolistic competition, however,

assumption about easy entry goes further– No barrier stops any firm from copying the

successful business of other firms


8

Monopolistic Competition in the Short-Run

• Individual monopolistic competitor behaves very much like a monopoly

• Key difference is this– When a monopolistic competitor raises its

price, its customers have one additional option – to buy from another seller


9

Figure 1: A Monopolistically Competitive Firm in the Short Run

MR1

$70

30

250

d1

A MCATC

Dollars

Homes Serviced per Month

2. and charges $70 per home.

4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle.

1. Kafka services 250 homes per month, where MC and MR intersect . . .

3. ATC at 250 units is less than price, so profit per unit is positive.


10

The Long-Run• No barriers to entry and exit—the firm will

not enjoy its profit for long

• Under monopolistic competition, firms can earn positive or negative economic profit in short-run

• But in long-run, free entry and exit will ensure that each firm earns zero economic profit just as under perfect competition


11

Figure 2: A Monopolistically Competitive Firm in the Long Run

d2MR2

E

MC

$40

100 250

Dollars

Homes Serviced per Month

ATC

MR1

In the long run, profit attracts entry, which shifts the firm's demand curve leftward.

The typical firm produces where its new MR crosses MC.

d1

Entry continues until P = ATC at the best output level, and economic profit is zero.


12

Excess Capacity Under Monopolistic Competition

• In long-run, a monopolistic competitor will operate with excess capacity

• Excess capacity suggests that monopolistic competition is costly to consumers

• Does that mean consumers prefer perfect competition to monopolistic competition?


13

Nonprice Competition• Any action a firm takes to increase

demand for its output—other than cutting its price—is called nonprice competition

• Nonprice competition is another reason why monopolistic competitors earn zero economic profit in long-run

• All this nonprice competition is costly


14

Oligopoly

• An oligopoly is a market dominated by a small number of strategically interdependent firms

• In such a market, each firm recognizes its strategic interdependence with others


15

Number of Firms

• Oligopoly requires that a few firms dominate the market

• No absolute number at which oligopoly ends and monopolistic competition begins


16

Market Domination

• Strategic interdependence requires that a few firms dominate the market

• As combined market share shrinks, strategic interdependence becomes weaker

• Oligopoly is a matter of degree– Not an absolute classification


17

Economies of Scale: Natural Oligopolies

• When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market – A large firm will have lower cost per unit than

a small firm

• Does it remind you of monopoly? How is this different?


18

Barriers to entry• Reputation - A new entrant may suffer just

from being new

• Strategic barriers - Oligopoly firms often pursue strategies designed to keep out potential competitors

• Legal barriers - Patents and copyrights, Govt. legislation


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Oligopoly vs. Other Market Structures

• Oligopoly presents the greatest challenge to economists

• Essence of oligopoly is strategic interdependence

• Need new tools of modeling

• One approach—game theory—has yielded rich insights into oligopoly behavior


20

The Game Theory Approach• Game theory

• In all games, except those of pure chance, a player’s strategy must take account of the strategies followed by other players

• Game theory analyzes oligopoly decisions as if they were games


21

The Prisoner’s Dilemma• Each of four boxes in payoff matrix represents

one of four possible strategy combinations that might be selected in this game– Upper left box: Both Rose and Colin confess– Lower left box: Colin confesses and Rose

doesn’t– Upper right box: Rose confesses and Colin

doesn’t– Lower right box: Neither Rose nor Colin

confesses


22

Figure 3: The Prisoner’s Dilemma

Confess

Confess

Don’t Confess

Rose’s Actions

Colin gets 20 years

Rosegets 20years

Colin gets30 years

Colin gets 3 years

Colin gets5 years

Rosegets 20years

Rosegets 20years

Rosegets 20years

Colin’s ActionsDon’t Confess


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The Prisoner’s Dilemma• Regardless of Rose’s strategy Colin’s best choice is to

confess

• “Confess” is the dominant strategy for both

• Outcome of this game is an example of a Nash equilibrium

• As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them


24

Simple Oligopoly Games• To apply the same method to a simple oligopoly

market• Duopoly - Oligopoly market with only two sellers• Assume that Gus and Filip must make their

decisions independently• No matter what Filip does, Gus’s best move is to

charge a low price—his dominant strategy• The same holds for Filip• The outcome is a Nash equilibrium


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Figure 4: A Duopoly Game

Confess

Confess

Don’t Confess

Filip’s Actions

Gus’s profit = $25,000

Filip’sProfit =$25,000

Gus’s profit= –$10,000

Gus’s profit= $75,000

Gus’s profit= $50,000

Filip’sProfit =$–10,000



Gus’s ActionsDon’t Confess


26

Oligopoly Games in the Real World• Will typically be more than two strategies from

which to choose• Will usually be more than two players• In some games, one or more players may not

have a dominant strategy– A game with two players will have a Nash equilibrium

as long as at least one player has a dominant strategy

– When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game


27

Oligopoly Games in the Real World

• We’ve limited the players to one play of the game– In reality, for gas stations and almost all other

oligopolies, there is repeated play• Where both players select a strategy• Observe the outcome of the trial• Play the game again and again, as long as they

remain rivals

• One possible result of repeated trials is cooperative behavior


28

Cooperative Behavior in Oligopoly

• In real world, oligopolists will usually get more than one chance to choose their prices

• The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once


29

Explicit Collusion• Simplest form of cooperation is explicit collusion

• Most extreme form of explicit collusion is creation of a cartel

• If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it?

• But oligopolists can collude in other, implicit ways


30

Tacit Collusion

• Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion

• Tit for tat– A game-theoretic strategy of doing to another player

this period what he has done to you in previous period• However, gentle reminder of tit-for-tat is not

always effective in maintaining tacit collusion


31

Tacit Collusion

• Another form of tacit collusion is price leadership

• With price leadership, there is no formal agreement


32

The Limits to Collusion

• Oligopoly power—even with collusion—has its limits– Even colluding firms are constrained by

market demand curve– Collusion—even when it is tacit—may be

illegal– Collusion is limited by powerful incentives to

cheat on any agreement


33

The Incentive to Cheat• Go back to Gus and Filip for a moment

– One way or another they arrive at high-price cooperative solution

– Will the market stay there?• Each player has an incentive to cheat

• Analyzing this sort of behavior requires some rather sophisticated game theory models


34

When is Cheating Likely?• Cheating is most likely to occur—and collusion

will be least successful—under the following conditions– Difficulty observing other firms’ prices– Unstable market demand– Large number of sellers


35

Figure 5a: Advertising in Monopolistic Competition

1,000

C

A60

100

$120

2,0006,000

B

1.Before advertising, long-run economic profit is zero.

2. In the short run, the first firms to advertise earn economic profit.

dads

dno ads

ATCads

ATCno ads

dall advertise

Dollars

Bottles of Perfume per Month

3. But in the long run, imitation and entry bring economic profit back to zero.

4. Advertising can lead to a higher price in the long run, as in this panel . . .


36

Figure 5b: Advertising in Monopolistic Competition

Dollars

Bottles of Perfume per Month1,000

A60

dall advertise

dno ads

B$120

6,000

C50

2,000

dads

ATCads

ATCno ads

5. or to a lower price in the long run, as in this panel.


37

Using the Theory: Advertising in Monopolistic Competition and Oligopoly• Perfect competitors never advertise and

monopolies advertise relatively little– But advertising is almost always found under

monopolistic competition and very often in oligopoly• Why?

– All monopolistic competitors, and many oligopolists, produce differentiated products

• Since other firms will take advantage of opportunity to advertise, any firm that doesn’t advertise will be lost in shuffle


38

Advertising and Collusion in Oligopoly

• Oligopolists have a strong incentive to engage in tacit collusion

• Take airline industry as an example• In theory, any airline should be able to

claim superior safety– Yet no airline has ever run an advertisement

with information about its security policies or attacked those of a competitor


39

Figure 6: An Advertising Game

Run Safety Ads

Run Safety Ads

Don't Run Ads

United's Actions

American's ActionsDon't Run Ads

American earns low

profit

American earns high

profit

United earns very low profit

United earns low profit

American earns very

low profit

American earns

medium profitUnited

earns medium profit

United earns high profit


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The Four Market Structures: A Postscript

• Different market structures– Perfect competition– Monopoly– Monopolistic competition– Oligopoly

• Market structure models help us organize and understand apparent chaos of real-world markets

lecture 10 monopolistic competition

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