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Prepared by: Jamal Husein C H A P T E R 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monopolistic Competition,

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Presentation on theme: "Prepared by: Jamal Husein C H A P T E R 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monopolistic Competition,"— Presentation transcript:

1 Prepared by: Jamal Husein C H A P T E R 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monopolistic Competition, Oligopoly, and Antitrust

2 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  In the absence of substantial economies of scale, it is possible for additional firms to enter the market, driving down prices and profit.  Output decisions are based on the marginal principle: Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

3 3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  When a second firm enters the market, the monopoly’s demand and marginal revenue curves shift inward.  The firm’s price and output level will have to be adjusted in order to follow the marginal principle.

4 4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  The monopoly satisfies the marginal principle by producing and selling 300 toothbrushes at $2 each.  After entry, each of two firms produces 200 units and charges $1.85 per unit. Entry decreases price.

5 5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  Before entry, the monopoly produces 300 units, at a cost per unit of $0.90 per toothbrush.  After entry, each of two firms produces 200 units at an average cost of $1.00. Entry increases average cost.

6 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Effects of Market Entry  There are three reasons why profit decreases for the individual firm after entry of a second firm:  Lower price  Lower quantity sold  Higher AC of production Summary:

7 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Effects of Market Entry Revenue or cost ( $ per tooth brush) n m c MC 1 D1D1 MR 1 300 2.00 Toothbrushes per minute 0.90 D2D2 MR 2 AC 1.00 200 e d 1.85 x

8 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monopolistic Competition Characteristics of Monopolistic Competition:  Many firms  Differentiated product  No artificial barriers to entry Monopolistic Competition: A market served by dozens of firms selling slightly different products.

9 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Meaning of “Monopolistic Competition”  Each firm is monopolistic because it sells a unique product.  The availability of close substitutes makes the firm’s demand very price elastic.  Each firm is a competitive because it sells a product that is a close but not a perfect substitute for the products sold by other firms in the market.

10 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Product Differentiation  Physical characteristics  Location  Services  Aura or image Firms may differentiate their product in several ways:

11 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Short-run and Long-run Equilibrium  As firms enter, each firm’s demand curve shifts to the left, decreasing market price, decreasing the quantity produced per firm, and increasing the average cost of production.  As long as there is profit to be made, more and more firms will enter the market.  Entry will stop once the economic profit of each existing firm reaches zero. In the long run, revenue will be just enough to cover all costs, including the opportunity cost of all inputs, but not enough to cause additional firms to enter.

12 12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Long-run Equilibrium Under Monopolistic Competition  In this example, the marginal principle is satisfied at 55 thousand toothbrushes per minute, selling at a price of $1.35. The cost of producing each toothbrush is also $1.35. Economic profit equals zero.

13 13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Trade-offs with Monopolistic Competition Monopolistic CompetitionMonopoly

14 14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Trade-offs with Monopolistic Competition Monopolistic competition brings good news and bad news relative to the monopoly outcome:  Good news: lower price and greater variety  Bad news: higher average cost

15 15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin OligopolyOligopoly  An oligopoly is a market served by a few firms.  The key feature of an oligopoly is that firms act strategically. Firms are interdependent—the actions of one firm affect the profits of the other firms in the market.

16 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Oligopoly and Pricing Decisions  Economists use concentration ratios to measure the degree of concentration, or just how few firms exist in a market.  For example a four firm concentration ratios is the percentage of total output in the market produced by the largest four, i.e., a 93% concentration ratio for cigarettes indicates that the largest 4 firms produced 93% of the total output.

17 17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Concentration Ratios in Selected Manufacturing Industries Industry Four-firm Concentration Ratio (%) Eight-firm Concentration Ratio (%) Cigarettes93Not available Guided missiles and space vehicles9399 Beer and malt beverages9098 Batteries8795 Electric bulbs8694 Breakfast cereals8598 Motor vehicles and car bodies8491 Greeting cards8488 Engines and turbines7992 Aircraft and parts7993

18 18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Barriers to Entry in an Oligopoly  Economies of scale large enough to generate a natural oligopoly but not a natural monopoly  Government barriers to entry  Substantial investment in an advertising campaign in order to enter the market Most firms in an oligopoly earn economic profit, yet additional firms do not enter the market, for three reasons:

19 19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Oligopolistic Firms  A duopoly is a market with two firms.  A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service.  The arrangement under which two or more firms act as one, coordinating their pricing decisions, is also known as price fixing.  The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly.

20 20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Cartel Pricing  In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket.  The firms also split the profit. Each firm earns $7,500 = [(400-300) x 150]/2.

21 21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Duopoly Pricing  When two firms compete against one another, they end up serving 100 passengers each, at a price of $350.  Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm.

22 22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Duopoly Versus Cartel Pricing  The duopoly produces more output and charges a lower price than the cartel.

23 23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Game Tree  A game tree provides a visual representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies.

24 24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Jill: High or Low price? Jill: High or Low price? Jack: High or Low price? Jack: High or Low price? Jack: High or Low price? Jack: High or Low price? Jill Jack $7.5 $7.5 Jill Jack $1 $1 Jill Jack $8.5 $1 Jill Jack $5 Jill Jack $5 High High price High Low price Low Profits ($000) Cartel and Duopoly Outcomes in the Game Tree

25 25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Jill: High or Low price? Jill: High or Low price? Jack: High or Low price? Jack: High or Low price? Jack: High or Low price? Jack: High or Low price? Jill Jack $7.5 $7.5 Cartel Outcome Cartel Outcome Jill Jack $5 Jill Jack $5 High High price Low price Low Profits ($000) Cartel and Duopoly Outcomes in the Game Tree Duopoly Outcome Duopoly Outcome

26 26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Outcome of the Price-Fixing Game Jill captures large share of market Jack captures large share of market Jill: Low Price Jack: High Price Price$350$400 Quantity17010 Average cost$300 Profit per passenger$50$100 Total profit$8,500$1,000

27 27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Dominant Strategy Irrational for Jack to choose high price  Jack chooses the low price when Jill chooses the high price.

28 28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Dominant Strategy  Jack chooses the low price when Jill chooses the low price. Irrational for Jack to choose high price  Dominant Strategy: Jack chooses the low price regardless of Jill’s choice.

29 29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Duopolists’ Dilemma  Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price?  Jill will choose the low price, and the trajectory of the game is X to Z to 4. Irrational for Jill to be underpriced.

30 30 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Duopolists’ Dilemma  The duopolists’ dilemma is that although both firms would be better off if they chose the high price, each firm chooses the low price.

31 31 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Retaliation for Underpricing  Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack.  Tit-for-tat: Jill chooses whatever price Jack chose the preceding month. Schemes to punish Jack if he underprices:

32 32 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Tit-for-Tat Response to Underpricing  After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month.  Jill chooses whatever price Jack chose the preceding month.

33 33 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Avoiding the Dilemma: Guaranteed Price Matching  To eliminate the incentive for underpricing, one firm can guarantee that it will match its competitor’s price.  How will Jack respond to Jill’s price-matching policy? Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits. Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price.

34 34 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Guaranteed Price Matching  Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel.  Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price!

35 35 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Entry Deterrence and Limit Pricing  An insecure monopolist fears the entry of a second firm, and could react in one of two ways: A passive strategy: allow the second firm to enter the market An entry-deterrence strategy: try to prevent the firm from entering  The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit.

36 36 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Passive Strategy  If Mona adopts a passive strategy, it will allow Doug to enter the market, and each will earn the duopoly profits of $5,000 each (Duopoly Outcome).

37 37 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Profit = $15,000 The Entry-deterrence Strategy Mona can prevent Doug from entering by incurring a large investment and committing herself to serving a large number of customers at a low price. z Market Demand 250 400 LRAC Passengers per day m: Secure Monopoly 200 180 150 370 350 300

38 38 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Entry-deterrence Strategy Due to economies of scale, suppose that that the minimum entry quantity is 70 passengers a day, the entry deterring quantity for Mona will be 180 passengers (250- 70). If Doug enters serving 70 passengers and Mona serves 180, the price drops to $300, making entry unprofitable to Doug. z Market Demand 250 400 LRAC Passengers per day m: Secure Monopoly i: Insecure Monopoly d: Duopoly 200 180 150 370 350 300 Deterrence Profit = $12,600 Once Mona commits to large load of passengers, the most profitable load will be 180 passengers

39 39 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Deterrence Profit = $12,600 The Entry-deterrence Strategy  Mona can prevent Doug from entering by incurring a large investment and committing herself to serving a large number of customers at a low price.  What is more profitable, entry deterrence or the passive duopoly outcome? z Market Demand 250 400 LRAC Passengers per day m: Secure Monopoly i: Insecure Monopoly 200 180 150 370 350 300

40 40 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Antitrust Policy  The purpose of antitrust policy is to promote competition among firms. Competition leads to lower prices and better products.

41 41 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Antitrust Policy  Break up of monopolies into several smaller companies.  Prevent corporate mergers that would reduce competition.  Regulate business practices. Under federal antitrust rules, the government can:

42 42 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Brief History of Antitrust Legislation 1890Sherman Act: made it illegal to monopolize a market or to engage in practices that resulted in a restraint of trade. 1914Clayton Act: outlawed specific practices that discourage competition, including tying contracts, price discrimination for the purpose of reducing competition, and stock-purchase mergers that would substantially reduce competition. 1914Federal Trade Commission: established to enforce antitrust laws. 1936Robinson-Patman Act: prohibited selling products at “unreasonably low prices” with the intent of reducing competition. 1950Celler-Kefauver Act: outlawed asset-purchase mergers that would substantially reduce competition. 1980Hart-Scott-Rodino Act: extended antitrust legislation to proprietorships and partnerships.

43 43 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Breaking Up Monopolies  A trust is an arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees. Firms in a trust act as a single firm.  The label “antitrust” comes from early cases involving the breakup of trusts.

44 44 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Blocking Mergers  A merger occurs when two firms combine their operations.  Because a merger decreases the number of firms in a market, it is likely to lead to higher prices.  A possible benefit from a merger is that the new firm could combine production, marketing, or administrative operations, and thus produce its products at a lower average cost.

45 45 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Blocking Mergers  New guidelines developed by the Justice Department and the Federal Trade Commission allow companies involved in a proposed merger to present evidence that the merger would reduce costs and lead to lower prices, better products, or better service.  The analysis of proposed mergers today focuses less on counting the number of firms in a market, and more on how a merger would affect price.

46 46 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Regulating Business Practices  The government may intervene when specific business practices increase market concentration.  Among those practices are: Price fixing Tying, or forcing consumers of one product to purchase another Price discrimination that reduces competition


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