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9 9 Between Competition and Monopoly. ●Monopolistic Competition ●Oligopoly ●Monopolistic Competition, Oligopoly, and Public Welfare ●A Glance Backward:

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Presentation on theme: "9 9 Between Competition and Monopoly. ●Monopolistic Competition ●Oligopoly ●Monopolistic Competition, Oligopoly, and Public Welfare ●A Glance Backward:"— Presentation transcript:

1 9 9 Between Competition and Monopoly

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

3 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Three Real World Puzzles 1.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? 2.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. 3.Why do oligopolists seem to ∆P so infrequently? ●E.g., ∆P commodities hourly but ∆P cars or refrigerators only a few times a year. 1.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? 2.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. 3.Why do oligopolists seem to ∆P so infrequently? ●E.g., ∆P commodities hourly but ∆P cars or refrigerators only a few times a year.

4 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Characteristics of Monopolistic Competition 1.Many small buyers and sellers 2.Freedom of entry and exit 3.Perfect information 4.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. 1.Many small buyers and sellers 2.Freedom of entry and exit 3.Perfect information 4.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.

5 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

6 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

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

8 FIGURE 2. Long-Run Equilibrium Under Monopolistic Competition 15,000 $3.35 Price per Gallon Gallons of Gasoline per Week 10,000 $3.45 MR MC AC D E P M 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.

9 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

10 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

11 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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 = 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.

12 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

13 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. 1.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. 2.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. ●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. 1.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. 2.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.

14 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

15 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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 ●Different models to understand Oligopoly behavior: ♦Ignore interdependence ♦Strategic interaction ♦Cartels ♦Price leadership and tacit collusion ♦Sales maximization ♦Kinked demand curve ♦Game theory

16 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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! ●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!

17 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

18 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

19 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Price Leadership and Tacit Collusion ●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. ●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.

20 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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 ●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

21 FIGURE 3. Sales-Max Equilibrium $4.00 MR B D E AC Price per Box Millions of Boxes per Year F MC A 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.

22 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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. ?

23 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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. ?

24 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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. ?

25 FIGURE 4. The Kinked Demand Curve 0 7 Quantity per Year Price $8 D (Competitors’ prices are fixed) D 1,4001,1001,000 (Competitors respond to price changes) d d A 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.”

26 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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. ?

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

28 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

29 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

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

31 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

32 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

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

34 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

35 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

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

37 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

38 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

39 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

40 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

41 Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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. ●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.

42 TABLE 3. Attributes of the Four Market Forms


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