1. Chapter Eleven Product Differentiation, Monopolistic Competition, and Oligopoly

2. 11 | 2 Copyright © Houghton Mifflin Company. All rights reserved. Monopolistic Competition Monopolistic Competition – A market structure characterized by many firms selling differentiated products in an industry in which there is free entry and exit. Oligopoly – A market structure characterized by a few firms selling the same product with limited entry of other firms.

3. 11 | 3 Copyright © Houghton Mifflin Company. All rights reserved. Four Types of Industries Figure 11.1 identifies the four different types of market structure and summarizes the similarities and differences between them. In the figure, monopoly and competition are the two extremes, while oligopoly and monopolistic competition are in between them.

4. 11 | 4 Copyright © Houghton Mifflin Company. All rights reserved. Four Types of Industries (cont’d) Figure 11.1

5. 11 | 5 Copyright © Houghton Mifflin Company. All rights reserved. Product Differentiation Product differentiation – The effort by firms to produce goods that are slightly different from other types of goods. Homogeneous Products – Goods that have no product differentiation; goods that are indistinguishably similar from the point of view of the buyer.

6. 11 | 6 Copyright © Houghton Mifflin Company. All rights reserved. Variety of Goods in the Market Economy Heterogeneous products – Goods that have product differentiation; goods that are not similar in the view of the buyer. Table 11.1 illustrates the wide variety of different types of goods in the market.

7. 11 | 7 Copyright © Houghton Mifflin Company. All rights reserved. Variety of Goods in the Market Economy (cont’d)

8. 11 | 8 Copyright © Houghton Mifflin Company. All rights reserved. One interesting fact to note from Table 11.1 is that even bottled water has 50 different brands. How can companies manage to make 50 different brands of bottled water and try to make their brand differentiated? Variety of Goods in the Market Economy (cont’d)

9. 11 | 9 Copyright © Houghton Mifflin Company. All rights reserved. Product Differentiation in the 1950’s David Ogilvy’s advertising for Shell in the 1950s is probably the best example of differentiating a homogeneous product. Shell’s successful marketing campaign “The New Shell with Platformate” moved Shell into the big leagues in gasoline manufacturing. Platformate, however, was an additive found in all gasoline back then; it was not even possible to buy gasoline without Platformate.

10. 11 | 10 Copyright © Houghton Mifflin Company. All rights reserved. Intraindustry Trade When countries trade with each other, trade may be for goods that are from different industries (interindustry trade), or it may be for goods from similar industries (intraindustry trade). Product differentiation can explain why countries conduct interindustry and intraindustry trade.

11. 11 | 11 Copyright © Houghton Mifflin Company. All rights reserved. Intraindustry Trade (cont’d) Intraindustry Trade – Trade between countries for goods from the same or similar industries. (For example: the US buys Toyotas from Japan, and sells Fords to Japan). Interindustry Trade – Trade between countries for goods from different industries. (For example: the US buys Toyotas from Japan and sells computers to Japan).

12. 11 | 12 Copyright © Houghton Mifflin Company. All rights reserved. Advertising Product differentiation leads to advertising. If a firm has a new differentiated product, then the only way to let everyone know more about the product is through advertising. Advertising sometimes leads to product differentiation by creating a perception that a product is different.

13. 11 | 13 Copyright © Houghton Mifflin Company. All rights reserved. How are Products Differentiated? Ways to differentiate products: 1)Altering a product’s physical characteristics, such as making the legroom in a car longer or making a knife sharper. 2)Location – A McDonald’s restaurant 10 miles away has the same menu and the same product as the one down the street. However, the location makes it more likely for you to buy from the nearer one.

14. 11 | 14 Copyright © Houghton Mifflin Company. All rights reserved. 3)Time – A flight from Los Angeles to New York that leaves at 10 a.m. is a different product than one that leaves at 6 p.m. 4)Convenience – Your local supermarket sells mushrooms that are whole and mushrooms that are sliced. These products are no longer the same and are sold for different prices. How are Products Differentiated? (cont’d)

15. 11 | 15 Copyright © Houghton Mifflin Company. All rights reserved. The Optimal Amount of Product Differentiation Since product differentiation entails cost, finding the optimal level of product differentiation is similar to finding the equilibrium in a supply and demand model. Figure 11.2 illustrates how firms determine the optimal amount of product differentiation.

16. 11 | 16 Copyright © Houghton Mifflin Company. All rights reserved. The Optimal Amount of Product Differentiation (cont’d) Figure 11.2

17. 11 | 17 Copyright © Houghton Mifflin Company. All rights reserved. In Figure 11.2, the optimal amount of production differentiation is found by comparing the additional revenue from product differentiation with the additional cost of product differentiation. A firm will choose to increase the amount of product differentiation until the point where the additional revenue from differentiation equals the additional cost. The Optimal Amount of Product Differentiation (cont’d)

18. 11 | 18 Copyright © Houghton Mifflin Company. All rights reserved. While it is easy to model the optimal amount of product differentiation, applying the model in reality may be difficult because revenue gains are difficult to judge. How much more a firm makes from product differentiation is also affected by the actions of other firms. The Optimal Amount of Product Differentiation (cont’d)

19. 11 | 19 Copyright © Houghton Mifflin Company. All rights reserved. Monopolistic Competition Recall Monopolistic Competition – A market structure characterized by many firms selling differentiated products in an industry in which there is free entry and exit.

20. 11 | 20 Copyright © Houghton Mifflin Company. All rights reserved. Since monopolistically competitive firms sell a differentiated product, their demand curves slope downward, similar to a monopoly. However, unlike a monopoly, the monopolistic firm faces competition, as other firms are free to enter and exit the industry. Monopolistic Competition (cont’d)

21. 11 | 21 Copyright © Houghton Mifflin Company. All rights reserved. Figure 11.3 illustrates the key features of the model of monopolistic competition. The top left graph shows a typical monopolistically competitive firm that is generating positive profits, while the graph on the top right shows one with negative profits. The bottom graph shows a monopolistically competitive firm with zero profits. Monopolistic Competition (cont’d)

22. 11 | 22 Copyright © Houghton Mifflin Company. All rights reserved. Figure 11.3 showcases some similarities between a monopolistically competitive firm and a monopoly: 1)The demand curve and the marginal cost curves that they face are downward sloping. 2)The profit maximization requires that the quantity be determined at the intersection of MR and MC. 3)Profits of both firms can be positive and negative in the short run. Monopolistic Competition (cont’d)

23. 11 | 23 Copyright © Houghton Mifflin Company. All rights reserved. Monopolistic Competition Figure 11.3

24. 11 | 24 Copyright © Houghton Mifflin Company. All rights reserved. Differences between a monopolistically competitive firm and a monopoly: 1)The demand curve faced by the monopolistically competitive firm is not the market demand curve. 2)In the long run, a monopolistically competitive firm will earn zero (economic) profits, as a result of free entry and exit. Monopolistic Competition (cont’d)

25. 11 | 25 Copyright © Houghton Mifflin Company. All rights reserved. Hence, while any of the three graphs in Figure 11.3 may depict a monopolistically competitive firm in the short run, only the bottom graph is consistent with the profits of the firm in the long run. Monopolistic Competition (cont’d)

26. 11 | 26 Copyright © Houghton Mifflin Company. All rights reserved. Why does entry and exit result to zero profits in the long run? When positive profits are made, new firms enter the industry, taking some of the demand from existing firms and watering down each firm’s profits. When negative profits are made, some firms exit the industry, increasing the demand for remaining firms and raising each firm’s profits to zero. Monopolistic Competition (cont’d)

27. 11 | 27 Copyright © Houghton Mifflin Company. All rights reserved. Comparing the long run equilibrium of a competitive and a monopolistically competitive market, we identify two differences: 1)Price is greater than marginal cost in a monopolistically competitive firm, because the firm restricts output below the competitive equilibrium. 2)The firm could lower excess cost and eliminate excess capacity if it increased production. The Long Run Monopolistically Competitive Equilibrium

28. 11 | 28 Copyright © Houghton Mifflin Company. All rights reserved. Excess costs: Costs of production that are higher than the minimum average total cost. Excess Capacity: A situation in which a firm produces below the level that gives the minimum average total cost (minimum efficient scale). The Long Run Monopolistically Competitive Equilibrium (cont’d)

29. 11 | 29 Copyright © Houghton Mifflin Company. All rights reserved. Figure 11.4 illustrates excess cost and excess capacity brought about with monopolistic competition in the long run. As stated earlier, the monopolistically competitive firm earns zero profits in the long run. This is illustrated with the long run average total cost tangent to the demand curve at the profit maximizing quantity. The Long Run Monopolistically Competitive Equilibrium (cont’d)

30. 11 | 30 Copyright © Houghton Mifflin Company. All rights reserved. Figure 11.4

31. 11 | 31 Copyright © Houghton Mifflin Company. All rights reserved. In Figure 11.4, excess cost is shown as the distance between the monopolistically competitive price and the minimum of the average total cost. Excess capacity is shown as the distance between the monopolistically competitive quantity produced and the quantity consistent with the minimum efficient scale. The Long Run Monopolistically Competitive Equilibrium (cont’d)

32. 11 | 32 Copyright © Houghton Mifflin Company. All rights reserved. Comparing Monopoly, Competition and Monopolistic Competition Table 11.2 compares the different effects of competition, monopoly, and monopolistic competition with regards to price, deadweight loss generated, profits in the long run, and the ability to minimize average total cost.

33. 11 | 33 Copyright © Houghton Mifflin Company. All rights reserved. Comparing Monopoly, Competition and Monopolistic Competition (cont’d)

34. 11 | 34 Copyright © Houghton Mifflin Company. All rights reserved. From Table 11.2. we can see that a monopoly and a monopolistically competitive firm are similar except in the ability to generate profits in the long run. A competitive firm and a monopolistically competitive firm’s similarity is that both have zero profits in the long run. Comparing Monopoly, Competition and Monopolistic Competition (cont’d)

35. 11 | 35 Copyright © Houghton Mifflin Company. All rights reserved. Oligopoly Recall Oligopoly – A market structure characterized by few firms selling the same product with limited entry of other firms. Because there are only a few firms in the industry, firm managers need to understand the situation within their own firm and those of other firms. This awareness and consideration of other firms’ reactions is called strategic behavior.

36. 11 | 36 Copyright © Houghton Mifflin Company. All rights reserved. Strategic Behavior – Firm behavior that takes into account the market power and reactions of other firms in the industry. One common approach to understanding strategic behavior is through game theory. Oligopoly (cont’d)

37. 11 | 37 Copyright © Houghton Mifflin Company. All rights reserved. Game Theory: A branch of applied mathematics that studies games of strategy like poker or chess. Game theory has many uses in economics, including the analysis of the interaction of firms that take each other’s actions into account. Oligopoly (cont’d)

38. 11 | 38 Copyright © Houghton Mifflin Company. All rights reserved. A Oligopoly Game Theory Example: Sequential Games U.S. airlines drop plans to raise rates By Kevin Allison Updated: 8:22 p.m. ET June 20, 2005 NEW YORK - Several big U.S. airlines have abandoned their most recent attempts to raise prices for last-minute business travelers, it emerged on Monday. Continental, Northwest, United and a handful of other legacy carriers raised prices for one-way walk-up fares, commonly used by business travelers, on certain routes by $10 to $509 late last week. But they retreated at the weekend after Delta, which imposed a $499 cap on walk-up fares in January, failed to match its rivals' price increases on all but a handful of flights. Source:Excerpted from http://www.msnbc.msn.com/id/7279844/did/8294496http://www.msnbc.msn.com/id/7279844/did/8294496

39. 11 | 39 Copyright © Houghton Mifflin Company. All rights reserved. One example in game theory is the game called prisoner’s dilemma. Prisoner’s Dilemma Game – A game in which individual incentives lead to a non- optimal (or non-cooperative) outcome. If players can credibly commit to cooperate, then they achieve the best (cooperative) outcome. Oligopoly (cont’d)

40. 11 | 40 Copyright © Houghton Mifflin Company. All rights reserved. The game is between Anna and Pete, two prisoners arrested for a crime that they committed. The police already have enough evidence to get a conviction for a lesser crime, one that would yield a prison sentence of 3 years each for Anna and Pete. Prisoner’s Dilemma

41. 11 | 41 Copyright © Houghton Mifflin Company. All rights reserved. Anna and Pete have the option to “confess” or “remain silent” to the more serious crime. The reward for confessing when the other does not is a reduced penalty of 1 year, which is not as severe as the 3 years they would get for the lesser crime. The penalty of conviction without a confession is 7 years. Both Anna and Pete will get 5 years each if both confess. Prisoner’s Dilemma (cont’d)

42. 11 | 42 Copyright © Houghton Mifflin Company. All rights reserved. Figure 11.5 illustrates the payoff matrix for the prisoner’s dilemma game. Payoff Matrix – a table that contains the strategies and payoffs for two players in a game. Prisoner’s Dilemma (cont’d)

43. 11 | 43 Copyright © Houghton Mifflin Company. All rights reserved. Prisoner’s Dilemma (cont’d) Figure 11.5

44. 11 | 44 Copyright © Houghton Mifflin Company. All rights reserved. In the payoff matrix, the case where both remain silent is the cooperative outcome. The case where both choose to follow individual incentives is the non-cooperative outcome. Notice that the cooperative outcome is more preferred (less prison time) than the non-cooperative outcome. Unfortunately, Pete and Ann will find themselves in the case where both confess (the non- cooperative outcome). Prisoner’s Dilemma (cont’d)

45. 11 | 45 Copyright © Houghton Mifflin Company. All rights reserved. Mathematician and Nobel laureate in economics John Nash defined the noncooperative equilibrium (a.k.a. the Nash equilibrium) as a set of strategies that no player would deviate from unilaterally. In a Nash equilibrium, no player would see an increase in their payoff by changing their strategy when the other keeps their strategy constant. Prisoner’s Dilemma (cont’d)

46. 11 | 46 Copyright © Houghton Mifflin Company. All rights reserved. In the case of the two prisoners, Anna and Pete would be better off with a cooperative behavior. However, the payoffs of each prisoner is always higher when each chooses to confess. Prisoner’s Dilemma (cont’d)

47. 11 | 47 Copyright © Houghton Mifflin Company. All rights reserved. One simple application of the Prisoner’s Dilemma is with duopoly games (2 firms in the market). Duopolies, like the one illustrated in Figure 11.6, can increase profits when they cooperate and decrease the quantities that they sell. Prisoner’s Dilemma: Application

48. 11 | 48 Copyright © Houghton Mifflin Company. All rights reserved. Prisoner’s Dilemma: Application (cont’d) Figure 11.6

49. 11 | 49 Copyright © Houghton Mifflin Company. All rights reserved. Unfortunately, the lure of higher profits achieved by increasing output once the other player commits to a lower output can result to the noncooperative outcome. In Figure 11.6, the noncooperative outcome is when both Jack and Jill sells 60 pumpkins each, and their profits both equal zero. Prisoner’s Dilemma: Application (cont’d)

50. 11 | 50 Copyright © Houghton Mifflin Company. All rights reserved. While firms can compete by varying quantities, they can also compete through pricing. In economics, Cournot competition (named after French economist Augustin Cournot) is the competition in quantities, while the Bertrand competition (named after Joseph Louis Francois Bertrand, a French mathematician) is the competition in prices. Prisoner’s Dilemma: Application (cont’d)

51. 11 | 51 Copyright © Houghton Mifflin Company. All rights reserved. Collusion Explicit collusion - Open cooperation of firms to make mutually beneficial pricing of production decisions. In explicit collusion, managers communicate directly with each other and agree to fix prices or cut back production. Explicit collusion in the US is illegal.

52. 11 | 52 Copyright © Houghton Mifflin Company. All rights reserved. Cartel – A group of producers in the same industry who coordinate pricing and production decisions. –Example: OPEC (Organization of Petroleum Exporting Countries). Collusion (cont’d)

53. 11 | 53 Copyright © Houghton Mifflin Company. All rights reserved. Collusion (cont’d) Tacit Collusion – Implicit or unstated cooperation of firms to make mutually beneficial pricing and production decisions. The dominant firm in a tacit collusion is the price leader. Price leader – The price setting firm in a collusive industry that other firms follow.

54. 11 | 54 Copyright © Houghton Mifflin Company. All rights reserved. Incentives to Cooperate Although the Prisoner’s Dilemma and the Cournot duopoly suggest that there is a tendency for a noncooperative outcome, there is an incentive to cooperate if the game is to be repeated over for a long period of time. Ann and Pete may cooperate if the payoffs involve small monetary rewards (instead of jail time) and the game can be played again in the future.

55. 11 | 55 Copyright © Houghton Mifflin Company. All rights reserved. The incentive to cheat on an agreement will depend on the likelihood of detection. For example, OPEC member nations may choose not to honor its quota if it can secretly sell oil to other countries (China, for example). Once a country chooses to cheat (or defect), its profits will increase at the expense of lower profits for all other member nations. Incentives to Cooperate (cont’d)

56. 11 | 56 Copyright © Houghton Mifflin Company. All rights reserved. Key Terms Monopolistic competition Oligopoly Product differentiation Intraindustry and interindustry rate Excess costs and excess capacities Strategic behavior Game theory Prisoner’s dilemma

57. 11 | 57 Copyright © Houghton Mifflin Company. All rights reserved. Key Terms (cont’d) Payoff matrix Cooperative outcome Noncooperative outcome Nash equilibrium Explicit collusion Cartel Tacit collusion Price leader