1. MONOPOLISTIC COMPETITION AND OLIGOPOLY 13 CHAPTER

2. Objectives  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 After studying this chapter, you will able to

3. Objectives  Explain why the price might be sticky in oligopoly  Explain how price and output are determined when there is one dominant firm and several smaller firms in a market  Use game theory to make predictions about price wars and competition among a small number of firms After studying this chapter, you will able to

4. PC War Games Each PC maker tells us that they have the best product at the best price. Just two big chip makers produce almost all the processor and memory chips in our PCs. Firms in these markets are neither price takers like those in perfect competition, nor are they protected from competition by barriers to entry like a monopoly. How do such firms choose the quantity to produce and price?

5. 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.

6. Monopolistic Competition Large Number of Firms The presence of a large number of firms in the market implies:  Each firm has only a small market share and therefore has limited market power to influence the price of its product.  Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firm’s actions directly affect the actions of other firms.  Collusion, or conspiring to fix prices, is impossible.

7. 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.

8. 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. But there is a tradeoff between price and quality. Differentiated products must be marketed using advertising and packaging.

9. 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.

10. 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.

11. Output and Price in Monopolistic Competition Short-Run Economic Profit 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). Price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.

12. Output and Price in Monopolistic Competition Figure 13.2(a) shows a short-run equilibrium for a firm in monopolistic competition. It operates much like a single-price monopolist.

13. 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.

14. 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.

15. 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.

16. Output and Price in Monopolistic Competition This figure shows a firm in monopolistic competition moving from short-run equilibrium to long-run equilibrium. If firms incur an economic loss, firms exit to restore the long-run equilibrium just described.

17. Output and Price in Monopolistic Competition Monopolistic Competition and Efficiency Firms in monopolistic competition are inefficient and operate with excess capacity. Figure 13.3 on the next slide illustrates these propositions.

18. Output and Price in Monopolistic Competition Because they product- differentiate and face a downward-sloping demand curve for their products, firms in monopolistic competition receive a marginal revenue that is less than price for all levels of output.

19. Output and Price in Monopolistic Competition Firms maximize profit by setting marginal revenue equal to marginal cost, so with marginal revenue less than price, marginal cost is also less than price.

20. Output and Price in Monopolistic Competition Because price equals the marginal benefit, marginal cost is less than marginal benefit. Underproduction in monopolistic competition creates deadweight loss.

21. Output and Price in Monopolistic Competition A firm’s capacity output is the output at which average total cost is at its minimum. At the long-run profit maximizing output, price equals average total cost. But recall that MR < P, which means that MC < ATC.

22. Output and Price in Monopolistic Competition If MC < ATC, then the ATC curve is falling. With output in the range of falling ATC, output is less than capacity output. Goods are not produced at the minimum unit cost of production in the long run.

23. 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, if only temporarily, before competitors imitate the innovation.

24. 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 create the appearance of a change in product quality. Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which is the amount the consumer is willing to pay for it.

25. Product Development and Marketing Marketing A firm’s marketing program uses advertising and packaging as the two principal methods to market its differentiated products to consumers. Firms in monopolistic competition incur heavy marketing and advertising expenditures to enhance the perception of quality differences between their product and rival products. These costs make up a large portion of the price for the product.

26. ATCAFCAVC Manufacturer (Asia) Materials9.00 Cost of labor2.75 Cost of capital3.00 Profit1.75 Shipping0.50 Import duties3.00 Nike (Beaverton, Oregon) Sales, distribution, and administration5.00 Advertising4.00 Research and development0.25 Nike’s profit6.25 Retailer (your town) Sales clerks’ wages9.50 Shop rent9.00 Retailer’s other costs7.00 Retailer’s profit9.00 Totals$70.00$6.50$63.50

27. Product Development and Marketing Figure 13.4 shows estimates of the percentage of sale price for different monopolistic competition markets. Cleaning supplies and toys top the list at almost 15 percent.

28. Product Development and Marketing Selling Costs and Total Costs Selling costs, like advertising expenditures, fancy retail buildings, etc. are fixed costs. Average fixed costs decrease as production increases, so selling costs increase average total costs at any given level of output but do not affect the marginal cost of production. Selling efforts such as advertising are successful if they increase the demand for the firm’s product.

29. Product Development and Marketing Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced. Here, with no advertising, the firm produces 25 units of output at an average total cost of $170.

30. Product Development and Marketing With advertising, the firm produces 130 units of output at an average total cost of $160. 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.

31. Product Development and Marketing But advertising can increase a firm’s demand and profits in the short run only. Economic profit leads to entry, which decreases the demand for each firm’s product in the long run. To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are efficient.

32. Oligopoly Oligopoly is a market in which a small number of firms compete. In oligopoly, the quantity sold by one firm depends on the firm’s own price and the prices and quantities sold by the other firms. The response of other firms to a firm’s price and output influence the firm’s profit-maximizing decision.

33. Oligopoly 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.

34. Oligopoly Figure 13.6 shows the kinked demand curve model. The demand curve that a firm believes it faces has a kink at the current price and quantity.

35. Oligopoly 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.

36. Oligopoly The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by the gap AB in the figure.

37. Oligopoly This slide helps to envisage why the kink in the demand curve puts a break in the marginal revenue curve.

38. Oligopoly 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 MC 0 to MC 1, the profit- maximizing price and quantity would not change.

39. Oligopoly The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesn’t maximize profit.

40. Oligopoly 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.

41. Oligopoly Figure 13.7 shows a dominant firm industry. On the left are 10 small firms and on the right is one large firm. S 10

42. Oligopoly The demand curve, D, is the market demand curve and the supply curve S 10 is the supply curve of the 10 small firms. S 10

43. Oligopoly At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing. S 10

44. Oligopoly But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm.

45. Oligopoly The demand curve for the large firm’s output is the curve XD on the right.

46. Oligopoly The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.

47. Oligopoly The large firm maximizes profit by setting MR = MC. Let’s suppose that the marginal cost curve is MC in the figure.

48. Oligopoly The profit-maximizing quantity for the large firm is 10 units. The price charged is $1.00.

49. Oligopoly The small firms take this price and supply the rest of the quantity demanded.

50. Oligopoly A dominant firm oligopoly can arise only if one firm has lower costs than the others.

51. Oligopoly In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.

52. 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

53. 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) have been caught committing a petty crime. Each is held in a separate cell and cannot communicate with the other.

54. Oligopoly Games Each is told that both are suspected of committing a more serious crime. If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes. If both confess to the more serious crime, each receives 3 years in jail for both crimes. If neither confesses, each receives a 2-year sentence for the minor crime only.

55. Oligopoly Games In game theory, strategies are all the possible actions of each player. Art and Bob each have two possible actions:  Confess to the larger crime  Deny having committed the larger crime Because there are two players and two actions for each player, there are four possible outcomes:  Both confess  Both deny  Art confesses and Bob denies  Bob confesses and Art denies

56. Oligopoly Games Each prisoner can work out what happens to him—can work out his payoff—in each of the four possible outcomes. We can tabulate these outcomes in a payoff matrix. A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player. The next slide shows the payoff matrix for this prisoners’ dilemma game.

57. Oligopoly Games Payoff Matrix

58. Oligopoly Games If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player. If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibrium—first proposed by John Nash. The following slides show how to find the Nash equilibrium.

59. Bob’s view of the world

61. Art’s view of the world

63. Equilibrium

64. Oligopoly Games An Oligopoly Price-Fixing Game A game like the prisoners’ dilemma is played in duopoly. A duopoly is a market in which there are only two producers that compete. Duopoly captures the essence of oligopoly. Figure 13.8 on the next slide describes the demand and cost situation in a natural duopoly.

65. Oligopoly Games Part (a) shows each firm’s cost curves. Part (b) shows the market demand curve.

66. Oligopoly Games This industry is a natural duopoly. Two firms can meet the market demand at the least cost.

67. Oligopoly Games How does this market work? What is the price and quantity produced in equilibrium?

68. Oligopoly Games Suppose that the two firms enter into a collusive agreement. A collusive agreement is an agreement between two (or more) firms to restrict output, raise price, and increase profits. Such agreements are illegal in the United States and are undertaken in secret. Firms in a collusive agreement operate a cartel.

69. Oligopoly Games The possible strategies are:  Comply  Cheat Because each firm has two strategies, there are four possible outcomes:  Both comply  Both cheat  Trick complies and Gear cheats  Gear complies and Trick cheats

70. Oligopoly Games The first possible outcome—both comply—earns the maximum economic profit, which is the same as a monopoly would earn.

71. Oligopoly Games To find that profit, we set marginal cost for the cartel equal to marginal revenue for the cartel. Figure 13.9 shows this outcome.

72. Oligopoly Games The cartel’s marginal cost curve is the horizontal sum of the MC curves of the two firms and the marginal revenue curve is like that of a monopoly.

73. Oligopoly Games The firms maximize economic profit by producing the quantity at which MC I = MR.

74. Oligopoly Games Each firm agrees to produce 2,000 units and each firm shares the maximum economic profit.

75. Oligopoly Games When each firm produces 2,000 units, the price is greater than the firm’s marginal cost, so if one firm increased output, its profit would increase.

76. Oligopoly Games Figure 13.10 shows what happens when one firm cheats and increases its output to 3,000 units. Industry output rises to 5,000 and the price falls.

77. Oligopoly Games For the complier, ATC now exceeds price. For the cheat, price exceeds ATC.

78. Oligopoly Games The complier incurs an economic loss. The cheat earns an increased economic profit.

79. Oligopoly Games Either firm could cheat, so this figure shows two of the possible outcomes. Next, let’s see the effects of both firms cheating.

80. Oligopoly Games Figure 13.11 shows the outcome if both firms cheat and increase their output to 3,000 units.

81. Oligopoly Games Industry output is 6,000 units, the price falls, and both firms earn zero economic profit—the same as in perfect competition.

82. Oligopoly Games You’ve now seen the four possible outcomes:  If both comply, they make $2 million a week each.  If both cheat, they earn zero economic profit.  If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million.  If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million. The next slide shows the payoff matrix for the duopoly game.

83. Payoff Matrix

84. Trick’s view of the world

86. Gear’s view of the world

88. Equilibrium

89. Oligopoly Games The Nash equilibrium is where both firms cheat. The quantity and price are those of a competitive market, and the firms earn normal profit. Other Oligopoly Games Advertising and R & D games are also prisoners’ dilemmas. An R & D Game Procter & Gamble and Kimberley Clark play an R & D game in the market for disposable diapers.

90. Repeated Games and Sequential Games A Repeated Duopoly Game If a game is played repeatedly, it is possible for duopolists to successfully collude and earn a monopoly profit. If the players take turns and move sequentially (rather than simultaneously as in the prisoner’s dilemma), many outcomes are possible. In a repeated prisoners’ dilemma duopoly game, additional punishment strategies enable the firms to comply and achieve a cooperative equilibrium, in which the firms make and share the monopoly profit.

91. Repeated Games and Sequential Games One possible punishment strategy is a tit-for-tat strategy, in which one player cooperates this period if the other player cooperated in the previous period but cheats in the current period if the other player cheated in the previous period. A more severe punishment strategy is a trigger strategy in which a player cooperates if the other player cooperates but plays the Nash equilibrium strategy forever thereafter if the other player cheats.

92. Repeated Games and Sequential Games Table 13.4 (page 297) shows that a tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game. Price wars might result from a tit-for-tat strategy where there is an additional complication—uncertainty about changes in demand. A fall in demand might lower the price and bring forth a round of tit-for-tat punishment.

93. Repeated Games and Sequential Games A Sequential Entry Game in a Contestable Market In a contestable market—a market in which firms can enter and leave so easily that firms in the market face competition from potential entrants—firms play a sequential entry game.

94. Repeated Games and Sequential Games Figure 13.12 shows the game tree for a sequential entry game in a contestable market.

95. Repeated Games and Sequential Games In the first stage, Agile decides whether to set the monopoly price or the competitive price.

96. Repeated Games and Sequential Games In the second stage, Wanabe decides whether to enter or stay out.

97. Repeated Games and Sequential Games In the equilibrium of this entry game, Agile sets a competitive price and earns a normal profit to keep Wanabe out. A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out.

98. 13 CHAPTER THE END MONOPOLISTIC COMPETITION AND OLIGOPOLY