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CHAPTER 14 Monopolistic Competition and Oligopoly Michael Parkin ECONOMICS 5e.

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Presentation on theme: "CHAPTER 14 Monopolistic Competition and Oligopoly Michael Parkin ECONOMICS 5e."— Presentation transcript:

1 CHAPTER 14 Monopolistic Competition and Oligopoly Michael Parkin ECONOMICS 5e

2 TM 14-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price and output are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry

3 TM 14-3 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain how price and output are determined when an industry has one dominant firm and several small firms Use game theory to make predictions about price wars and competition among a small number of firms

4 TM 14-4 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price and output are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry

5 TM 14-5 Copyright © 1998 Addison Wesley Longman, Inc. Monopolistic Competition Monopolistic competition A large number of firms compete. Small market share Ignore other firms Collusion Impossible Each firm produces a differentiated product. A product slightly different from the products of competing firms.

6 TM 14-6 Copyright © 1998 Addison Wesley Longman, Inc. Monopolistic Competition Monopolistic competition (cont.) Firms compete on product quality, price, and marketing. Quality - design, reliability, service, ease of access to the product. Price - downward sloping demand curve. A tradeoff between price and quality. Marketing - advertising and packaging. Firms are free to enter and exit.

7 TM 14-7 Copyright © 1998 Addison Wesley Longman, Inc. Monopolistic Competition Monopolistic competition (cont.) Consequently, a firm in monopolistic competition cannot make an economic profit in the long-run.

8 TM 14-8 Copyright © 1998 Addison Wesley Longman, Inc. Examples of Monopolistic Competition

9 TM 14-9 Copyright © 1998 Addison Wesley Longman, Inc. Monopolistic Competition As a result of the characteristics of monopolistic competition: No one firm can effectively influence what other firms do. The firm faces a downward sloping demand curve. Firms cannot earn long-run economic profit.

10 TM Copyright © 1998 Addison Wesley Longman, Inc. Output and Price in Monopolistic Competition Short-Run: Economic Profit The firm in monopolistic competition looks just like a single price monopoly. The key difference between monopoly and monopolistic competition lies in the long-run.

11 TM Copyright © 1998 Addison Wesley Longman, Inc. Economic profit MC Price (dollars per jacket) Monopolistic Competition 0 D MR ATC Short-run Quantity (jackets per day)

12 TM Copyright © 1998 Addison Wesley Longman, Inc. Output and Price in Monopolistic Competition Long-Run: Zero Economic Profit Economic profit attracts new entrants. As new firms enter the industry, the firm’s demand curve and marginal revenue start to shift leftward. The profit-maximizing quantity and price fall.

13 TM Copyright © 1998 Addison Wesley Longman, Inc. MC Price (dollars per jacket) Monopolistic Competition 0 D MR ATC Quantity (jackets per day) Long-run Zero economic profit

14 TM Copyright © 1998 Addison Wesley Longman, Inc. Monopolistic Competition and Efficiency Marginal benefit exceeds marginal cost and production is less than its efficient level. Therefore, the market structure is inefficient.

15 TM Copyright © 1998 Addison Wesley Longman, Inc. Monopolistic Competition and Efficiency The monopolistically competitive industry produces an output at which price equals average total cost but exceeds marginal cost. This outcome means that firms in monopolistic competition always have excess capacity in long-run equilibrium.

16 TM Copyright © 1998 Addison Wesley Longman, Inc. Excess Capacity A firm’s capacity output is the output at which average total cost is a minimum - the output at the bottom of the U-shaped ATC curve. The firm produces a smaller output than that which minimizes average total cost.

17 TM Copyright © 1998 Addison Wesley Longman, Inc. Excess Capacity MC Price (dollars per jacket) 0 D MR ATC Quantity (jackets per day) Excess capacity Capacity output Profit maximizing output

18 TM Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain how price and output are determined in a monopolistically competitive industry Explain why advertising costs are high in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry

19 TM Copyright © 1998 Addison Wesley Longman, Inc. Product Development and Marketing Innovation and Product Development To maintain its economic profit, a firm must seek out new products that will provide it with a competitive edge, even if temporarily.

20 TM Copyright © 1998 Addison Wesley Longman, Inc. Product Development and Marketing Efficiency and Product Innovation Two views Improved products that bring great benefits to the consumer. But many so-called improvements amount to little more than changing the appearance of a product.

21 TM Copyright © 1998 Addison Wesley Longman, Inc. Product Development and Marketing Marketing Advertising and packaging are the principle means used by firms to attempt to create a consumer perception of product differentiation even when actual differences are small.

22 TM Copyright © 1998 Addison Wesley Longman, Inc. Product Development and Marketing Marketing Expenditures Advertising expenditures affect the profits in two ways: Increase costs Change demand

23 TM Copyright © 1998 Addison Wesley Longman, Inc. Product Development and Marketing Selling Costs and Total Costs Advertising expenditures increase the costs of a monopolistically competitive firm above those of a competitive firm or monopoly. Selling costs are fixed costs.

24 TM Copyright © 1998 Addison Wesley Longman, Inc. Advertising Expenditures

25 TM Copyright © 1998 Addison Wesley Longman, Inc. Product Development and Marketing Selling Costs and Demand Advertising increases competition. To the extent that advertising increases competition, it decreases the demand faced by any one firm.

26 TM Copyright © 1998 Addison Wesley Longman, Inc. Selling Cost and Total Costs Price (dollars per jacket) 0 MR Quantity (jackets per day) Advertising cost Average total cost with advertising Average total cost with no advertising By increasing the quantity bought, advertising can decrease ATC

27 TM Copyright © 1998 Addison Wesley Longman, Inc. Efficiency: The Bottom Line The bottom line on the question of efficiency of monopolistic competition is ambiguous.

28 TM Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define monopolistic competition and oligopoly Explain how price and output are determined in a monopolistically competitive industry Explain why the price might be sticky in an oligopoly industry

29 TM Copyright © 1998 Addison Wesley Longman, Inc. Oligopoly Price and quantity of a producer depends upon that of the other producers’. Models developed to explain the prices and quantities in oligopoly markets: Traditional Kinked Demand Curve Model Dominant Firm Model Game Theory

30 TM Copyright © 1998 Addison Wesley Longman, Inc. The Kinked Demand Curve Model Assumption If a firm raises its price, others will not follow. more elastic response If a firm cuts its price, so will the other firms. less elastic response This assumption results in the kinked demand curve.

31 TM Copyright © 1998 Addison Wesley Longman, Inc. Quantity Price and cost (dollars) The Kinked Demand Curve Model D Q a MR b 0 MC 1 P MC 0

32 TM Copyright © 1998 Addison Wesley Longman, Inc. The Kinked Demand Curve Model Problems Beliefs about the demand curve are not always correct. Other firms may, in fact, follow a price increase. This may result in the firm incurring an economic loss.

33 TM Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain how price and output are determined when an industry has one dominant firm and several small firms Use game theory to make predictions about price wars and competition among a small number of firms

34 TM Copyright © 1998 Addison Wesley Longman, Inc. Dominant Firm Oligopoly A dominant firm oligopoly may exist if one firm: Has a big cost advantage over the other firms. Sells a large part of the industry output. Sets the market price. Other firms are price takers.

35 TM Copyright © 1998 Addison Wesley Longman, Inc. Dominant Firm Oligopoly Let’s use Big-G as an example. Big-G is the dominant gas station in a city.

36 TM Copyright © 1998 Addison Wesley Longman, Inc. MR XD S 10 D Dominant Firm Oligopoly Quantity (thous. of gal./week) Price (dollars per gallon) Quantity (thous. of gal./week) b 10 a MC a b Ten small firms and market demandBig-G’s price and output decision

37 TM Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain how price and output are determined when an industry has one dominant firm and several small firms Use game theory to make predictions about price wars and competition among a small number of firms

38 TM Copyright © 1998 Addison Wesley Longman, Inc. Game Theory Invented by John von Neumann in We will use it to help understand oligopoly.

39 TM Copyright © 1998 Addison Wesley Longman, Inc. Game Theory What is a game? Games have 3 features: Rules Strategies Payoffs “The Prisoners Dilemma” is a game that is used to generate predictions.

40 TM Copyright © 1998 Addison Wesley Longman, Inc. The Prisoners’ Dilemma Art & Bob are caught stealing a car. The D.A. feels they are responsible for a robbery months earlier. The D.A. decides to make them play a game.

41 TM Copyright © 1998 Addison Wesley Longman, Inc. The Prisoners’ Dilemma Rules of the game Prisoners are put in separate rooms and cannot communicate with the other. They are told that they are a suspect in the earlier crime. If both confess, they will get 3 years. If one confesses and the other does not, the confessor will get 1 year while the other gets 10.

42 TM Copyright © 1998 Addison Wesley Longman, Inc. The Prisoners’ Dilemma Strategies (possible actions) They can each: Confess to the robbery Deny having committed the robbery

43 TM Copyright © 1998 Addison Wesley Longman, Inc. The Prisoners’ Dilemma Payoffs Four outcomes are possible: Both confess. Both deny. Art confesses and the Bob denies. Bob confesses and Art denies.

44 TM Copyright © 1998 Addison Wesley Longman, Inc. Prisoners’ Dilemma Payoff Matrix Arts strategies ConfessDeny Bob’s strategies Confess Deny 3 years 2 years 1 year 10 years 1 year 10 years

45 TM Copyright © 1998 Addison Wesley Longman, Inc. The Prisoners’ Dilemma A dominant strategy emerges. Art and Bob should both deny because: If they both deny, they will only get 2 years—but they don’t know if the other will deny. If Art denies, but Bob does not, Art will only get 1 year. If Art denies, but Bob confesses, Art will get 10 years. They both eventually decide it is best to confess — Nash equilibrium.

46 TM Copyright © 1998 Addison Wesley Longman, Inc. An Oligopoly Price-Fixing Game Duopoly A market structure with two firms. We will use Trick and Gear as our two firms. They agree with each other to restrict output in order to raise prices and profits — a collusive agreement.

47 TM Copyright © 1998 Addison Wesley Longman, Inc. An Oligopoly Price-Fixing Game A cartel is a group of firms that enter into a collusive agreement. The firms in the cartel can: Comply Cheat

48 TM Copyright © 1998 Addison Wesley Longman, Inc. An Oligopoly Price-Fixing Game Four outcomes are possible Both firms comply Both firms cheat Trick complies and Gear cheats Gear complies and Trick cheats.

49 TM Copyright © 1998 Addison Wesley Longman, Inc. Costs and Demand Conditions The conditions are: Trick and Gear face identical costs. The switchgears they produce are identical. They are a natural duopoly.

50 TM Copyright © 1998 Addison Wesley Longman, Inc. MC D ATC Quantity (thous. of switchgears/week) Price and cost (thous. of $/ unit ) Costs and Demand Quantity (thous. of switchgears/week) Price and cost (thous. of $/ unit ) Minimum ATC Individual FirmIndustry

51 TM Copyright © 1998 Addison Wesley Longman, Inc. Colluding to Maximize Profits These firms may benefit from colluding. They attempt to behave like a monopoly. They agree to restrict output to a level that makes marginal revenue and marginal cost equal.

52 TM Copyright © 1998 Addison Wesley Longman, Inc. Quantity (thous. of switchgears/week) Price and cost (thous. of $/ unit ) Colluding to Make Monopoly Profits Quantity (thous. of switchgears/week) Price and cost (thous. of $/ unit ) MCATC D Individual FirmIndustry 99 8 MR MC 1 Collusion achieves monopoly outcome Economic Profit

53 TM Copyright © 1998 Addison Wesley Longman, Inc. One Firm Cheats on a Collusive Agreement Previous example Each firm produced 2,000 units and earned $2 million in economic profit. Now, Trick convinces Gear that it cannot sell 2,000 units a week and must cut its price to be able to do so. Gear cuts its price, but it does not change output. Trick lies and cheats on their agreement — it increases output.

54 TM Copyright © 1998 Addison Wesley Longman, Inc. One Firm Cheats Quantity (thousands of switchgears/week) Price & cost 10.0 Quantity (thousands of switchgears/week) Quantity (thousands of switchgears/week) Price & cost ATC ComplierCheaterIndustry D Economic loss Economic profit Complier’s output Cheat’s output

55 TM Copyright © 1998 Addison Wesley Longman, Inc. Both Firms Cheat Both firms will cheat as long as price exceeds marginal cost. When price equals marginal cost they will no longer have an incentive to cheat.

56 TM Copyright © 1998 Addison Wesley Longman, Inc. MC 1 D Quantity (thous. of switchgears/week) Price and cost (thous. of $/ unit ) Both Firms Cheat Quantity (thous. of switchgears/week) Price and cost (thous. of $/ unit ) MC ATC Individual FirmIndustry Both cheating achieves competitive outcome

57 TM Copyright © 1998 Addison Wesley Longman, Inc. The Payoff Matrix Now, let’s illustrate these possibilities using a duopoly payoff matrix.

58 TM Copyright © 1998 Addison Wesley Longman, Inc. Duopoly Payoff Matrix Gear’s strategies CheatComply Trick’s strategies Cheat Comply $0 +$4.5m –$1.0m -$1.0m +$4.5m +$2m

59 TM Copyright © 1998 Addison Wesley Longman, Inc. Equilibrium of the Duopolists Dilemma At equilibrium, it pays both firms to cheat. What if this game is repeated over and over again? Will the outcome differ?

60 TM Copyright © 1998 Addison Wesley Longman, Inc. Repeated Games If this is repeated, one firm has the opportunity to penalize the other. A cooperative equilibrium may occur. This occurs when the firms make and share the monopoly profit. Must be penalized for cheating. tit-for-tat strategy trigger strategy

61 TM Copyright © 1998 Addison Wesley Longman, Inc. Games and Price Wars Some price wars resemble the tit-for-tat strategy. Price wars sometimes result from new firms entering a monopoly industry.

62 TM Copyright © 1998 Addison Wesley Longman, Inc. Other Oligopoly Games An R&D Game Firms spend large sums of money in R&D in the attempt to: develop the most highly valued product develop the least-cost technology gain a competitive edge to increase market share and profit Should a firm spend money in R&D?

63 TM Copyright © 1998 Addison Wesley Longman, Inc. Pampers Versus Huggies: An R&D Game Procter & Gambles strategies R&DNo R&D Kimberly- Clark’s strategies R&D No R&D +$45m +$5m +$85m -$10m +$70m +$30m -$10m +$85m

64 TM Copyright © 1998 Addison Wesley Longman, Inc. Contestable Markets A market in which one firm (or a small number of firms) operates, but in which both entry and exit are free, so the firm(s) in the market faces competition from potential entrants is a contestable market.

65 TM Copyright © 1998 Addison Wesley Longman, Inc. Entry-Deterrence Game Let’s see what happens when a firm attempts to enter a market dominated by a single firm.

66 TM Copyright © 1998 Addison Wesley Longman, Inc. Duopoly Payoff Matrix Agile’s strategies Monopoly priceCompetitive price Wannabe’s strategies Enter and set price below Agile’s price Not enter Economic loss Economic profit Economic loss Economic loss Monopoly profit Normal profit Normal profit Normal profit

67 TM Copyright © 1998 Addison Wesley Longman, Inc. Entry-Deterrence Game The practice of charging a price below the monopoly profit-maximizing price and producing a quantity greater than that at which marginal revenue equals marginal cost in order to deter entry is limit pricing.


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