1. Monopolistic Competition and Oligopoly
Chapter 12
Monopolistic Competition and Oligopoly
DERYA GÜLTEKİN KARAKAŞ 1

2. Topics to be Discussed Monopolistic Competition Oligopoly
Price Competition
Competition Versus Collusion: The Prisoners’ Dilemma
Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Cartels
Chapter 12 2

3. Monopolistic Competition
Characteristics
1) Many firms
2) Differentiated but highly substitutable products
3) Free entry and exit
Chapter 12 4

4. Monopolistic Competition
Examples of this very common market structure include:
Toothpaste
Soap
Shampoo
Chapter 12 5

5. Monopolistic Competition
The amount of monopoly power depends on the degree of differentiation.
Toothpaste
Crest and monopoly power
Procter & Gamble is the sole producer of Crest
Consumers can have a preference for Crest---taste, reputation, decay preventing efficacy
The greater the preference (differentiation) the higher the price.
Question? Does Procter & Gamble have much monopoly power in the market for Crest?
Chapter 12 6

6. A Monopolistically Competitive Firm in the Short and Long Run
$/Q
Short Run
$/Q
Long Run MC AC MC AC
DSR
MRSR
QSR
PSR
DLR
MRLR
QLR
PLR
Quantity
Quantity 12

7. A Monopolistically Competitive Firm in the Short and Long Run
Observations (short-run)
Downward sloping demand--differentiated product
Demand is relatively elastic--good substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits
Chapter 12 13

8. A Monopolistically Competitive Firm in the Short and Long Run
Observations (long-run)
Profits will attract new firms to the industry (no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC -- some monopoly power
Chapter 12 14

9. Monopolistic Competition
Questions
1) If the market became competitive, what would happen to output and price?
2) Should monopolistic competition be regulated?
3) What is the degree of monopoly power?
4) What is the benefit of product diversity?
Chapter 12 20

10. Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium
Perfect Competition
Monopolistic Competition
$/Q
$/Q
Deadweight
loss MC AC MC AC
DLR
MRLR
QMC P QC PC
D = MR
Quantity
Quantity 17

11. Monopolistic Competition
Monopolistic Competition and Economic Efficiency
The monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle.
With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.
Chapter 12 18

12. Oligopoly Characteristics Small number of firms
Product differentiation may or may not exist
Barriers to entry
Chapter 12 24

13. Oligopoly Examples Automobiles Steel Aluminum Petrochemicals
Electrical equipment
Computers
Chapter 12 25

14. Oligopoly The barriers to entry are: Natural Scale economies Patents
Technology
Name recognition
Strategic action
Flooding the market
Controlling an essential input
Chapter 12 26

15. Oligopoly Management Challenges Question Strategic actions
Rival behavior
Question
What are the possible rival responses to a 10% price cut by Ford?
Chapter 12 28

16. Oligopoly Defining Equilibrium:
Firms doing the best they can and have no incentive to change their output or price
Equilibrium in an Oligopolistic Market
In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price.
In oligopoly the producers must consider the response of competitors when choosing output and price.
Chapter 12 29

17. Oligopoly Nash Equilibrium
Each firm is doing the best it can given what its competitors are doing.
Chapter 12 31

18. Oligopoly The Cournot Model Duopoly
Two firms competing with each other
Homogenous good
The output of the other firm is assumed to be fixed
Chapter 12 32

19. Firm 1’s Output Decision
MR1(0)
If Firm 1 thinks Firm 2 will
produce nothing, its demand
curve, D1(0), is the market
demand curve. P1
D1(50)
MR1(50) 25
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(75)
D1(75)
12.5
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MC1 50
What is the output of Firm 1
if Firm 2 produces 100 units? Q1
Chapter 12 38

20. Oligopoly The Reaction Curve
A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2.
Chapter 12 39

21. Reaction Curves and Cournot Equilibrium
Firm 1’s Reaction
Curve Q*1(Q2) x
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model. Q1
100
Firm 2’s Reaction
Curve Q*2(Q2)
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce. 75
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximize its own profits.
Cournot
Equilibrium 50 25 Q2 25 50 75
100
Chapter 12 43

22. Oligopoly
Questions
1) If the firms are not producing at the Cournot equilibrium, will they adjust until the Cournot equilibrium is reached?
2) When is it rational to assume that its competitor’s output is fixed?
Chapter 12 44

23. The Linear Demand Curve
Oligopoly
The Linear Demand Curve
An Example of the Cournot Equilibrium
Duopoly
Market demand is P = 30 - Q where Q = Q1 + Q2
MC1 = MC2 = 0
Chapter 12 4 45

24. The Linear Demand Curve
Oligopoly
The Linear Demand Curve
An Example of the Cournot Equilibrium
Firm 1’s Reaction Curve
Chapter 12 4 46

25. The Linear Demand Curve
Oligopoly
The Linear Demand Curve
An Example of the Cournot Equilibrium
Chapter 12 4 47

26. The Linear Demand Curve
Oligopoly
The Linear Demand Curve
An Example of the Cournot Equilibrium
Chapter 12 4 48

27. The demand curve is P = 30 - Q and both firms have 0 marginal cost.
Duopoly Example Q1
The demand curve is P = 30 - Q and
both firms have 0 marginal cost.
Firm 2’s
Reaction Curve 30 15 10
Cournot Equilibrium
Firm 1’s
Reaction Curve 15 30 Q2
Chapter 12 54

28. Profit Maximization with Collusion
Oligopoly
Profit Maximization with Collusion
Chapter 12 4 55

29. Profit Maximization with Collusion
Oligopoly
Profit Maximization with Collusion
Collusion Curve
Q1 + Q2 = 15
Shows all pairs of output Q1 and Q2 that maximizes total profits
Q1 = Q2 = 7.5
Less output and higher profits than the Cournot equilibrium
Chapter 12 4 56

30. Duopoly Example Q1 30 15 10 7.5 Firm 2’s
Collusion
Curve
7.5
Collusive Equilibrium
For the firm, collusion is the best
outcome followed by the Cournot
Equilibrium and then the
competitive equilibrium
Firm 2’s
Reaction Curve 15
Competitive Equilibrium (P = MC; Profit = 0) 10
Cournot Equilibrium
Firm 1’s
Reaction Curve Q2 30
Chapter 12 54

31. First Mover Advantage-- The Stackelberg Model
Assumptions
One firm can set output first
MC = 0
Market demand is P = 30 - Q where Q = total output
Firm 1 sets output first and Firm 2 then makes an output decision
Chapter 12 58

32. First Mover Advantage-- The Stackelberg Model
Firm 1
Must consider the reaction of Firm 2
Firm 2
Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = /2Q1
Chapter 12 59

33. First Mover Advantage-- The Stackelberg Model
Firm 1
Choose Q1 so that:
Chapter 12 60

34. First Mover Advantage-- The Stackelberg Model
Substituting Firm 2’s Reaction Curve for Q2:
Chapter 12 61

35. First Mover Advantage-- The Stackelberg Model
Conclusion
Firm 1’s output is twice as large as firm 2’s
Firm 1’s profit is twice as large as firm 2’s
Questions
Why is it more profitable to be the first mover?
Which model (Cournot or Shackelberg) is more appropriate?
Chapter 12 62

36. Price Competition
Competition in an oligopolistic industry may occur with price instead of output.
The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods.
Chapter 12 63

37. Price Competition Assumptions Bertrand Model Homogenous good
Market demand is P = 30 - Q where Q = Q1 + Q2
MC = $3 for both firms and MC1 = MC2 = $3
Chapter 12 64

38. Price Competition Assumptions Bertrand Model The Cournot equilibrium:
Assume the firms compete with price, not quantity.
Chapter 12 64

39. Price Competition
Bertrand Model
How will consumers respond to a price differential? (Hint: Consider homogeneity)
The Nash equilibrium:
P = MC; P1 = P2 = $3
Q = 27; Q1 & Q2 = 13.5
Chapter 12 65

40. Price Competition Bertrand Model
Why not charge a higher price to raise profits?
How does the Bertrand outcome compare to the Cournot outcome?
The Bertrand model demonstrates the importance of the strategic variable (price versus output).
Chapter 12 66

41. Price Competition Criticisms Bertrand Model
When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices.
Even if the firms do set prices and choose the same price, what share of total sales will go to each one?
It may not be equally divided.
Chapter 12 69

42. Competition Versus Collusion: The Prisoners’ Dilemma
Why wouldn’t each firm set the collusion price independently and earn the higher profits that occur with explicit collusion?
Chapter 12 84

43. Competition Versus Collusion: The Prisoners’ Dilemma
Assume:
Chapter 12 85

44. Competition Versus Collusion: The Prisoners’ Dilemma
Possible Pricing Outcomes:
Chapter 12 86

45. Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $6
Charge $4
$12, $12
$20, $4
$16, $16
$4, $20
Firm 1
Charge $6
Chapter 12 88

46. Competition Versus Collusion: The Prisoners’ Dilemma
These two firms are playing a noncooperative game.
Each firm independently does the best it can taking its competitor into account.
Question
Why will both firms both choose $4 when $6 will yield higher profits?
Chapter 12 89

47. Competition Versus Collusion: The Prisoners’ Dilemma
An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.
Chapter 12 90

48. Competition Versus Collusion: The Prisoners’ Dilemma
Scenario
Two prisoners have been accused of collaborating in a crime.
They are in separate jail cells and cannot communicate.
Each has been asked to confess to the crime.
Chapter 12 91

49. Payoff Matrix for Prisoners’ Dilemma
Prisoner B
Confess
Don’t confess
Confess
-5, -5
-1, -10
-2, -2
-10, -1
Prisoner A
Would you choose to confess?
Don’t
confess
Chapter 12 92

50. Payoff Matrix for the P & G Prisoners’ Dilemma
Conclusions: Oligipolistic Markets
1) Collusion will lead to greater profits
2) Explicit and implicit collusion is possible
3) Once collusion exists, the profit motive to break and lower price is significant
Chapter 12 95

51. Payoff Matrix for the P&G Pricing Problem
Unilever and Kao
Charge $1.40
Charge $1.50
Charge
$1.40
$12, $12
$29, $11
$3, $21
$20, $20
P&G
What price should P & G choose?
Charge
$1.50
Chapter 12 97

52. Implications of the Prisoners’ Dilemma for Oligipolistic Pricing
Observations of Oligopoly Behavior
1) In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur.
Chapter 12 99

53. Implications of the Prisoners’ Dilemma for Oligipolistic Pricing
Observations of Oligopoly Behavior
2) In other oligopoly markets, the firms are very aggressive and collusion is not possible.
Firms are reluctant to change price because of the likely response of their competitors.
In this case prices tend to be relatively rigid.
Chapter 12
100

54. The Kinked Demand Curve
$/Q
If the producer raises price the
competitors will not and the
demand will be elastic. MR D
If the producer lowers price the
competitors will follow and the
demand will be inelastic.
Quantity
Chapter 12
109

55. The Kinked Demand Curve
$/Q MC
MC’
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant. D P* Q*
Quantity
Chapter 12 MR
109

56. Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership
Price Signaling
Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit
Chapter 12
110

57. Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership
Price Leadership
Pattern of pricing in which one firm regularly announces price changes that other firms then match
Chapter 12
110

58. Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
The Dominant Firm Model
In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market.
The large firm might then act as the dominant firm, setting a price that maximized its own profits.
Chapter 12
110

59. Price Setting by a Dominant Firm
MCD
MRD SF
The dominant firm’s demand
curve is the difference between
market demand (D) and the supply
of the fringe firms (SF).
Price D DD
At this price, fringe firms
sell QF, so that total
sales are QT. P1 QF QT P2 QD P*
Quantity
Chapter 12
115

60. Cartels Characteristics 1) Explicit agreements to set output and price
2) May not include all firms
Chapter 12
116

61. Cartels Characteristics 3) Most often international
Examples of unsuccessful cartels
Copper
Tin
Coffee
Tea
Cocoa
Examples of successful cartels
OPEC
International Bauxite Association
Mercurio Europeo
Chapter 12
117

62. Cartels Characteristics 4) Conditions for success
Competitive alternative sufficiently deters cheating
Potential of monopoly power--inelastic demand
Chapter 12
119

63. Cartels Comparing OPEC to CIPEC
Most cartels involve a portion of the market which then behaves as the dominant firm
Chapter 12
120

64. The OPEC Oil Cartel Price P* QOPEC TD SC MCOPEC MROPEC DOPEC Quantity
TD is the total world demand
curve for oil, and SC is the
competitive supply. OPEC’s
demand is the difference
between the two.
Price
MROPEC
DOPEC
QOPEC P*
OPEC’s profits maximizing
quantity is found at the
intersection of its MR and
MC curves. At this quantity
OPEC charges price P*.
Quantity
Chapter 12
124

65. Cartels About OPEC Very low MC TD is inelastic
Non-OPEC supply is inelastic
DOPEC is relatively inelastic
Chapter 12
125

66. The OPEC Oil Cartel Price QC QT P* Pc QOPEC TD SC MCOPEC
The price without the cartel:
Competitive price (PC) where
DOPEC = MCOPEC QC QT
MROPEC
DOPEC P* Pc
QOPEC
Quantity
Chapter 12
124

67. The CIPEC Copper Cartel
QCIPEC P* PC QC QT
TD and SC are relatively elastic
DCIPEC is elastic
CIPEC has little monopoly power
P* is closer to PC
Price
MRCIPEC TD
DCIPEC SC
MCCIPEC
Quantity
Chapter 12
130

68. Cartels Observations To be successful:
Total demand must not be very price elastic
Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic
Chapter 12
131

69. Summary
In a monopolistically competitive market, firms compete by selling differentiated products, which are highly substitutable.
In an oligopolistic market, only a few firms account for most or all of production.
Chapter 12
134

70. Summary
In the Cournot model of oligopoly, firms make their output decisions at the same time, each taking the other’s output as fixed.
In the Stackelberg model, one firm sets its output first.
Chapter 12
135

71. Summary
The Nash equilibrium concept can also be applied to markets in which firms produce substitute goods and compete by setting price.
Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this.
Chapter 12
136

72. Summary
The Prisoners’ Dilemma creates price rigidity in oligopolistic markets.
Price leadership is a form of implicit collusion that sometimes gets around the Prisoners Dilemma.
In a cartel, producers explicitly collude in setting prices and output levels.
Chapter 12
137

73. Monopolistic Competition and Oligopoly
End of Chapter 12
Monopolistic Competition and Oligopoly 1