# Between Competition and Monopoly

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Between Competition and Monopoly
9 Between Competition and Monopoly

Outline Monopolistic Competition Oligopoly
Monopolistic Competition, Oligopoly, and Public Welfare A Glance Backward: Comparing the Four Market Forms

Three Real World Puzzles
Why are there so many retailers? E.g., intersections with 4 gas stations which is more than # of cars warrants. Why and how do they all stay open? Why do oligopolists advertise more than competitive firms? E.g., many big Co. use ads to battle for customers and ad budgets account for a huge portion of TC. Vs. farmers where few if any farms spend \$ on ads. Why do oligopolists seem to ∆P so infrequently? E.g., ∆P commodities hourly but ∆P cars or refrigerators only a few times a year.

Characteristics of Monopolistic Competition
Many small buyers and sellers Freedom of entry and exit Perfect information Heterogeneous products: each seller’s product differs somewhat from every other seller’s product. E.g., Diff. in packaging, services, or consumers’ perceptions. Only characteristic that differs from perfect competition.

Monopolistic Competition
D curve facing firm has (-) slope. Each seller’s product is different –they are not perfect substitutes. ↑P will drive away some but not all of firm’s customers. Or ↓P will attract some but not all customers from rival firms. Freedom of entry and exit → firms cannot earn econ Π in LR. SR Π > 0 → new firms enter and ↓P until P = AC. Most U.S. firms are in this market structure.

Determination of Price and Output under Monopolistic Competition
Recall when D has (-) slope → P > MR. Profit-max Q is where MR = MC. Analysis looks like pure monopoly, but monop. comp. firm (with rivals producing close substitutes) has a much flatter D curve. LR: Π = 0 → each firm produces where P = AC. So firm’s D curve must be tangent to its AC curve. Zero econ. Π in LR is seen in real world. E.g., Gas station owners do not earn higher Π than small farmers under perfect competition.

FIGURE 1. Short-Run Equilibrium Under Monopolistic Competition
Π-max Q =12,000 and P = \$3.50 Per unit Π = \$0.10 → total Π = \$1,200. MC AC D MR \$3.80 P \$3.50 Price per Gallon 3.40 C \$3.00 E 12,000 Gallons of Gasoline per Week

FIGURE 2. Long-Run Equilibrium Under Monopolistic Competition
SR profits in Fig. 1 → new firms enter which shifts each firm’s D curve down until P = AC. Compared with SR profits in Fig. 1: a. P is lower in LR b. more firms in industry; each produces a smaller Q with higher AC. MC AC D MR P \$3.45 M Price per Gallon \$3.35 E 10,000 15,000 Gallons of Gasoline per Week

The Excess Capacity Theorem
In Fig. 2, AC at LR Q of firm (pt P) > min AC (pt M). Pt M is where LR Q of a perf. comp. firm would be. In LR, monop. comp. firm is producing where ↓AC but has not yet reached its min. Monopolistic competition leads to firms that have unused or wasted capacity. Resolve puzzle 1 –abundance of retailers: intersection with 4 gas stations where 2 would suffice and operate at lower AC is real world ex. of excess capacity.

The Excess Capacity Theorem
Fewer firms in a monop. comp. market → each firm could ↑Q and ↓AC. Yet, fewer firms with larger quantities means there is less variety of product. Greater efficiency would be achieved at the cost of greater standardization. Not clear society would be better off with fewer firms.

Oligopoly Defined Oligopoly = market dominated by a few sellers, where several are large enough to affect market P. Great rivalry among firms with new product intros, free samples, and agro marketing campaigns. Degree of product differentiation varies by industry: none in steel plates but lots in cars. Some industries also contain large # of smaller firms (e.g., soft drinks) but they are dominated by a few large firms that get bulk of industry sales.

Oligopoly Defined Firms strive to create unique products (in terms of features, location, or appeal) to shield themselves from competition that ↓P and ↓sales. More intense competition than pure competition. E.g., A corn farmer doesn’t make tough P decisions. He accepts market P and reacts by picking Q. A farmer doesn’t need to advertise. He can sell as much as he likes at current market P. A farmer doesn’t worry about P policies his rivals are planning.

Oligopoly Defined Oligopolists have some influence over market P, so they must consider rivals’ P; spend a fortune on ads; and try to predict their rivals’ actions. Resolve puzzle 2 –why oligopolists advertise and perfectly competitive firms do not. Comp. firms can sell as much as they want at current P, so why advertise? Vs. Toyota faces a (-) sloped D curve, so it must ↓P or ↑ads (try to shift D out) to sell more cars. Products are identical, so farm A’s ads might ↑ sales of farm B. Vs. Toyota’s ads may ↑ its sales and ↓ sales of rival carmakers.

Why Oligopolistic Behavior is So Difficult to Analyze
Largest firms can impact P and all firms must watch rivals’ actions. Analysis is difficult as firms’ decisions are inter-dependent and oligopolists know that outcomes of their decisions depend on rivals’ responses. E.g., Toyota’s managers know that their actions will cause reactions by Honda which may require Toyota to adjust its plans. Oligopolies have a variety of behavior patterns which requires different models to understand their behavior.

Models of Oligopoly Different models to understand Oligopoly behavior:
Ignore interdependence Strategic interaction Cartels Price leadership and tacit collusion Sales maximization Kinked demand curve Game theory

Ignoring Interdependence
Simplest model Firms behave as if their actions will not spark reactions from rivals. Each firm seeks to max profits and assumes its P-Q decision will not affect its rivals’ strategy. Analyze oligopoly in the same way as pure monopoly. This doesn’t explain most oligopoly behavior!

Strategic Interaction
Consider 2 soap makers: X and Y. X ↓P to \$4.05 and assumes Y will continue its P = \$4.12 Say Qx = 5m and X spends \$1m on ads. X may be surprised when Y cuts P to \$4.00; ↑Qy to 8m and sponsors the Super Bowl. This ↓Πx and X wishes it didn’t cut P in first place. X cannot afford to ignore how Y will react.

Cartels All firms agree to set P and Q → act as pure monopolist.
OPEC began making joint decisions in 1970’s and has been successful over time at ↓Q oil and ↑P oil. Cartels are difficult to organize and hard to enforce. Each member must produce small Q assigned by group. But once high P is established, every firm is tempted to cheat by ↑Qs. When cheating is suspected, cartel quickly falls apart as others ↑Qs which ↓P. Considered worse than monopoly. Cartel charges monopoly P without the cost savings from large scale production.

Overt collusion (where firms meet to pick P-Q) is illegal in the U.S. and rare. But tacit collusion is common. Each tacitly colluding firm hopes that if it does not rock the boat (via ↓P or ↑ads), then rivals will do same. Price leadership = 1 firm makes P decisions for group. Other firms are expected to adopt P of leader without any explicit agreement. P leader is often largest firm in industry.

Sales Maximization: Model with Interdependence Ignored
Firms may attempt to max revenue rather than profit if: control is separated from ownership compensation of managers is related to size of the firm Q set where MR = 0 (rather than MR = MC) Recall: MR is slope of TR curve. So TR is max when MR = 0. If MR > 0 → ↑Q to ↑TR and if MR < 0 → ↓Q to ↑TR. Compared to profit-max firm: Higher Q Lower P

FIGURE 3. Sales-Max Equilibrium
Π-max Q = 2.5m where MR = MC. P = \$4.00 and total Π = \$0.20 x 2.5 m = \$500,000. Sales-max Q = 3.75m where MR = 0. P = \$3.75 and total Π = \$0.06 x 3.75 m = \$225,000. Total Π (TR) is lower (higher) at point F than point E. MR D MC AC E \$4.00 3.80 F Price per Box 3.75 3.69 A B 2.5 3.75 Millions of Boxes per Year

The Kinked Demand Curve Model
? The Kinked Demand Curve Model Resolve puzzle 3 –why do P in oligopolistic markets (cars or appliances) change less often than P of commodities (wheat or gold)? Firms think that other firms will match any P cut, but not any P increase. If true, firms face an inelastic D curve with P cuts and an elastic curve with P increases.

The Kinked Demand Curve Model
? The Kinked Demand Curve Model In Fig. 4, pt A is firm’s initial P = \$8. 2 D curves pass through pt A. DD is more elastic → rivals’ P are fixed dd is less elastic → rivals match ∆P If firm ↓P to \$7 (and rivals don’t match ↓P) → large ↑customers, so new Qd = 1,400. If rivals match ↓P → ↑Qd is small, so new Qd = 1,100. If firm ↑P (and rivals don’t match ↑P) → large ↓Qd.

The Kinked Demand Curve Model
? The Kinked Demand Curve Model The firm’s true demand curve in Fig. 4 is DAd –a kinked demand curve. P tend to “stick” to their original level because ↑P → lose many customers and ↓P → gain very few customers. Firm will only ∆P if costs change enormously.

FIGURE 4. The Kinked Demand Curve
Typical oligopoly fears the worst. If firm cuts P then rivals will match P cut → relevant demand curve is dd. But if firm raises P then rival will not match the P increase → relevant demand curve is DD. Thus, the firm’s true demand curve is the red line “DAd.” (Competitors respond to price changes) d D (Competitors’ prices are fixed) A Price \$8 7 1,000 1,100 1,400 Quantity per Year

The Kinked Demand Curve Model
? The Kinked Demand Curve Model MR is associated with DD and mr is associated with dd. Overall marginal revenue curve is DBCmr. MC = MR at pt E which shows Π-max Q for oligopolist. Since relevant MR curve is kinked, even a moderate shift in MC will leave Q and thereby P unchanged. Oligopoly prices are “sticky” and do not respond to minor cost changes.

FIGURE 5. The Kinked Demand Curve and Sticky Prices
MC mr D MR A Price \$8 E B C 1,000 Quantity Supplied per Year

The Game-Theory Approach
Most widely used approach to analyze oligopoly behavior. Each oligopolist is seen as a competing player in a game of strategy. Optimal strategies are determined by examining a payoff matrix showing Π of each firm depending on P strategy that each firm follows.

Games with Dominant Strategies
Dominant strategy = one that gives the bigger payoff to the firm that selects it, no matter which of the two strategies the competitor selects. E.g., Table 1., both firms have an incentive to pick low P strategy regardless of what other firm does. If B picks high P, then A receives largest payoff choosing low P. Or if B picks low P, then A receives the largest payoff by choosing low P. “Low Price” is the dominant strategy for both firms, so both charge a low P and each earns \$3m.

TABLE 1. Payoff Matrix with Dominant Strategies
Firm B Strategy High Price Low Price A gets \$10m B gets \$10m A gets -\$2m B gets \$12m A gets \$12m B gets -\$2m A gets \$3m B gets \$3m High Price Firm A Strategy Low Price

Games with Dominant Strategies
A market with a duopoly serves public interest better than a monopoly because of the competition created between two firms. Both firms would be better off if they could charge high P. But the presence of a competitor, forces each firm to protect itself by charging low P. It is damaging to the public to allow rival firms to collude on what prices to charge for their products. E.g., if two firms collude in Table 1, then we end up with high P and each earning \$10m.

Games without Dominant Strategies
Maximin = select the strategy that yields the max payoff assuming your rival does as much damage to you as he can. In Table 2, A’s maximin strategy is to pick low P and earn \$5m. Firm A thinks: if I chose a high P → worst outcome is B picks a low P and I get \$3m. If I chose a low P → worst outcome is B picks a low P and I get \$5m. Firm A picks the strategy that offers the best of those bad outcomes.

TABLE 2. A Payoff Matrix without a Dominant Strategy
Firm B Strategy High Price Low Price A gets \$10m A gets \$3m A gets \$8m A gets \$5m High Price Firm A Strategy Low Price

Repeated Games Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. Table 1 shows a single round of the game. Each firm picked low P. But if games are repeated, players can escape this trap. E.g., Firm A could cultivate a reputation of “tit for tat.” Each time B charges a high P → A would charge a high P. After a few repetitions, B learns that A always matches its P decisions. So B will see that it’s better to stick with a high P.

Threats and Credibility
Use threats to induce rivals to change their behavior. E.g., retailer could threaten to double Q and ↓P to \$0 if a rival imitates its product. But this is not credible, because it hurts the retailer who is making the threat. A credible threat is a threat that does not harm the threatener if it is carried out. Old firms often use credible threats to prevent new firms from entering the industry. E.g., old firm will build a larger factory than it would otherwise want. Large factory lowers cost of ↑Q –even at low P.

FIGURE 6. Entry and Entry-Blocking Strategy
Possible Choices of Old Firm Possible Reactions of New Firm Profits (millions \$) Old Firm New Firm –2 Enter Big Factory Don’t Enter 4 Small Factory 2 Enter Don’t Enter 6

Threats and Credibility
In Fig. 6, best outcome for old firm is to have a small factory and no rivals. But if old firm builds a small factory, it can count on new firm entering to earn \$2m. So old firm’s ↓Π to \$2m. If old firm builds a big factory, its ↑Q will ↓P and ↓Π. Old firm now earns \$4m if new firm stays out. Clearly, new firm will stay out to avoid loses of \$2m. Thus, old firm should build big factory to keep rivals out.

Monopolistic Competition, Oligopoly, & Public Welfare
Oligopolistic behavior is so varied that it is hard to come to a simple conclusion about welfare implications. In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum. Excess capacity theorem suggests monopolistic competition can lead to inefficiently high production costs. Oligopolists may organize into successful cartels to ↓Q and ↑P.

Monopolistic Competition, Oligopoly, & Public Welfare
When an oligopolistic market is perfectly contestable –if firms can enter and exit without losing \$ they invested –then (P,Q) of firms is likely to be socially efficient. E.g., airplanes, trucks, and barges can easily be moved. Constant threat of entry forces oligopolists to keep their prices down and their costs low.

Comparing the Four Market Forms
Perfect competition and pure monopoly are rare. Most firms are monopolistically competitive, but oligopoly firms account for largest share of economy’s output. Π = 0 in LR under perfect competition and monopolistic competition because of free entry and exit. Thus, P = AC in LR under these 2 market forms. Π-max firm under any market form selects Q by setting MR = MC. However, oligopolists may not set MC = MR when choosing Q –e.g., if firm max sales.

Comparing the Four Market Forms
Perfectly competitive firm and industry  efficient allocation of resources. Monopoly  inefficient allocation of resources by ↓Q and ↑P. Monopolistic competition  inefficient allocation of resources through excess capacity. Under oligopoly, almost anything can happen,  impossible to generalize about its vices or virtues.

TABLE 3. Attributes of the Four Market Forms