1. Monopolistic Competition And Oligopoly

2. Monopolistic Competition And Oligopoly
On any given day, you are probably exposed to hundreds of advertisements
Advertising is everywhere in the economy
So far in this book not much has been said about advertising
There is a good reason for this
In perfect competition and monopoly firms do little, if any, advertising
Where, then, is all the advertising coming from?
We must consider firms that are neither perfect competitors nor monopolists

3. The Concept of Imperfect Competition
Refers to market structures between perfect competition and monopoly
In imperfectly competitive markets, there is more than one seller, but too few to create a perfectly competitive market
Imperfectly competitive markets often violate other conditions of perfect competition
Such as the requirement of a standardized product or free entry and exit
Types of imperfectly competitive markets
Monopolistic competition
Oligopoly

4. Monopolistic Competition
Hybrid of perfect competition and monopoly, sharing some of features of each
A monopolistically competitive market has three fundamental characteristics
Many buyers and sellers
Sellers offer a differentiated product
Sellers can easily enter or exit the market

5. Many Buyers and Sellers
Under monopolistic competition, an individual buyer is unable to influence price he pays
But an individual seller, in spite of having many competitors, decides what price to charge
Our assumption of many sellers, however, has another purpose
To ensure that no strategic games will be played among firms in market
There are so many firms, each supplying such a small part of the market
That no one of them needs to worry that its actions will be noticed—and reacted to—by others

6. Sellers Offer a Differentiated Product
Each seller produces a somewhat different product from the others
Faces a downward-sloping demand curve
In this sense is more like a monopolist than a perfect competitor
When it raises its price a modest amount, quantity demanded will decline (but not all the way to zero)

7. Sellers Offer a Differentiated Product
What makes a product differentiated?
Quality of product
Difference in location
Product differentiation is a subjective matter
A product is different whenever people think that it is
Whether their perception is accurate or not
Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated
This perception may be real or illusory, but economic implications are the same in either case
Firm chooses its price

8. Easy Entry and Exit
This feature is shared by monopolistic competition and perfect competition
Plays the same role in both
Ensures firms earn zero economic profit in long-run
In monopolistic competition, however, assumption about easy entry goes further
No barrier stops any firm from copying the successful business of other firms

9. Monopolistic Competition in the Short-Run
Individual monopolistic competitor behaves very much like a monopoly
Key difference is this
While a monopoly is the only seller in its market, a monopolistic competitor is one of many sellers
When a monopolistic competitor raises its price, its customers have one additional option
Can buy similar good from some other firm

10. A Monopolistically Competitive Firm in the Short Run

11. Monopolistic Competition in the Long-Run
Under monopolistic competition—in which there are no barriers to entry and exit—the firm will not enjoy its profit for long
Entry will continue to occur, and demand curve will continue to shift leftward
Under monopolistic competition, firms can earn positive or negative economic profit in short-run
But in long-run, free entry and exit will ensure that each firm earns zero economic profit just as under perfect competition
In real world, monopolistic competitors often earn economic profit or loss in the short-run
But—given enough time—profits attract new entrants, and losses result in an industry shakeout
Until firms are earning zero economic profit

12. A Monopolistically Competitive Firm in the Long Run

13. Excess Capacity Under Monopolistic Competition
In long-run, a monopolistic competitor will operate with excess capacity
Will produce too little output to achieve minimum cost per unit
Excess capacity suggests that monopolistic competition is costly to consumers
May tempt you to leap to a conclusion
Consumers are better off under perfect competition; however
In order to get beneficial results of perfect competition, all firms must produce identical output
Consumers usually benefit from product differentiation

14. Nonprice Competition
If monopolistic competitor wants to increase its output it can cut its price
Move along its demand curve
Any action a firm takes to increase demand for its output—other than cutting its price—is called nonprice competition
Examples include better service, product guarantees, free home delivery, more attractive packaging
Nonprice competition is another reason why monopolistic competitors earn zero economic profit in long-run
All this nonprice competition is costly
Must pay for advertising, for product guarantees, for better staff training
Costs must be included in each firm’s ATC curve, shifting it upward
None of this changes conclusion that monopolistic competitors will earn zero economic profit in long-run

15. Oligopoly When just a few large firms dominate a market
So that actions of each one have an important impact on the others
Would be foolish for any one firm to ignore its competitors’ reactions
In such a market, each firm recognizes its strategic interdependence with others
An oligopoly is a market dominated by a small number of strategically interdependent firms

16. Market Definition In oligopoly, a few large firms dominate market
In many cases, common sense provides a sufficient guideline
Should broaden market definition just enough to include all reasonably close substitutes
In some cases, common sense isn’t definitive

17. Number of Firms
Oligopoly requires that a few firms dominate the market
Even if we can agree on a market’s definition, what number qualifies as “a few”?
At some point, number of firms is large enough—and interdependence weak enough—that oligopoly becomes a poor description
Monopolistic competition would fit better
No absolute number at which oligopoly ends and monopolistic competition begins

18. Market Domination
Strategic interdependence requires that a few firms—whatever their number—dominate the market
Their share of market is large
As combined market share shrinks, strategic interdependence becomes weaker
Oligopoly is a matter of degree
Not an absolute classification

19. Economies of Scale: Natural Oligopolies
When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market
A large firm—supplying a large share of the market—will have lower cost per unit than a small firm
Since small firms can’t compete, only a few large firms survive
Market becomes an oligopoly
Tends to happen on its own unless there is government intervention
Such a market is often called a natural oligopoly—analogous to natural monopoly

20. Reputation as a Barrier
A new entrant may suffer just from being new
Established oligopolists are likely to have favorable reputations
In some cases, where potential profits are great, investors may decide it is worth the risk and accept initial losses in order to enter industry
In other industries, the initial losses may be too great and probability of success too low for investors to risk their money starting a new firm

21. Strategic Barriers
Oligopoly firms often pursue strategies designed to keep out potential competitors
Maintain excess production capacity as a signal to a potential entrant that they could easily saturate market and leave new entrant with little or no revenue
Make special deals with distributors to receive best shelf space in retail stores
Make long-term arrangements with customers to ensure that their products are not displaced quickly by those of a new entrant
Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product

22. Legal Barriers
Patents and copyrights—which can be responsible for monopoly—can also create oligopolies
Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination
Government barriers can operate against domestic entrants, too

23. Oligopoly vs. Other Market Structures
Oligopoly presents the greatest challenge to economists
Essence of oligopoly is strategic interdependence
Wherein each firm anticipates actions of its rivals when making decisions
In order to understand and predict behavior in oligopoly markets
Economists have had to modify the tools used to analyze other market structures and to develop entirely new tools as well
One approach—game theory—has yielded rich insights into oligopoly behavior

24. The Game Theory Approach
An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves
In all games—except those of pure chance, such as roulette—a player’s strategy must take account of the strategies followed by other players
Game theory analyzes oligopoly decisions as if they were games by
Looking at the rules players must follow
Payoffs they are trying to achieve
Strategies they can use to achieve them

25. The Prisoner’s Dilemma
Easiest way to understand how game theory works is to start with a simple, noneconomic example—the prisoner’s dilemma
Explains why a technique for obtaining confessions, commonly used by police, is so often successful
Each of four boxes in payoff matrix represents one of four possible strategy combinations that might be selected in this game
Upper left box: Both Rose and Colin confess
Lower left box: Colin confesses and Rose doesn’t
Upper right box: Rose confesses and Colin doesn’t
Lower right box: Neither Rose nor Colin confesses

26. The Prisoner’s Dilemma

27. The Prisoner’s Dilemma
Regardless of Rose’s strategy Colin’s best choice is to confess
In this game, the strategy “confess” is an example of a dominant strategy
Strategy that is best for a player regardless of strategy of other player
Outcome of this game is an example of a Nash equilibrium—appropriately named after the mathematician John Nash, who originated the concept
Exists when each player is taking the best action—given actions taken by other players
As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them

28. Simple Oligopoly Games
Same method used to understand behavior of Rose and Colin in prisoner’s dilemma can be applied to a simple oligopoly market
Duopoly
Oligopoly market with only two sellers
Assume that Gus and Filip must make their decisions independently
Without knowing in advance what the other will do
No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy
A similar analysis from Filip’s point of view, using the red-shaded entries of Figure 4, would tell us that his dominant strategy is the same: a low price
Notice that outcome is a Nash equilibrium
Equilibrium price in market is the low price

29. A Duopoly Game

30. Oligopoly Games in the Real World
Will typically be more than two strategies from which to choose
Will usually be more than two players
In some games, one or more players may not have a dominant strategy
A game with two players will have a Nash equilibrium as long as at least one player has a dominant strategy
Whether the other has a dominant strategy or not
When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

31. Oligopoly Games in the Real World
We’ve limited the players to one play of the game
In reality, for gas stations and almost all other oligopolies, there is repeated play
Where both players select a strategy
Observe the outcome of the trial
Play the game again and again, as long as they remain rivals
One possible result of repeated trials is cooperative behavior

32. Cooperative Behavior in Oligopoly
In real world, oligopolists will usually get more than one chance to choose their prices
The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once
Often, firms will evolve some form of cooperation in the long run

33. Explicit Collusion Simplest form of cooperation is explicit collusion
Managers meet face-to-face to decide how to set prices
Most extreme form of explicit collusion is creation of a cartel
Group of firms that tries to maximize total profits of the group as a whole
If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it?
Usually illegal
Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways

34. Tacit Collusion
Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion
Tit for tat
A game-theoretic strategy of doing to another player this period what he has done to you in previous period
However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion
Oligopolist will sometimes go further
Attempting to punish a firm that threatens to destroy tacit cooperation

35. Tacit Collusion Another form of tacit collusion is price leadership
One firm—the price leader—sets its price and other sellers copy that price
With price leadership, there is no formal agreement
Rather the decisions come about because firms realize—without formal discussion—that system benefits all of them
Decisions include
Choice of leader
Criteria it uses to set its price
Willingness of other firms to follow

36. The Limits to Collusion
Oligopoly power—even with collusion—has its limits
Even colluding firms are constrained by market demand curve
Collusion—even when it is tacit—may be illegal
Collusion is limited by powerful incentives to cheat on any agreement

37. The Incentive to Cheat Go back to Gus and Filip for a moment
One way or another they arrive at high-price cooperative solution
Will the market stay there?
Maybe, and maybe not
Problem—each player may conclude that he can do even better by cheating
Two players would be back to noncooperative outcome based on their dominant strategies
May be in each player’s interest to cheat occasionally
Analyzing this sort of behavior requires some rather sophisticated game theory models
Economists are actively engaged in building them

38. When is Cheating Likely?
While no firm wants to completely destroy a collusive agreement by cheating
Since this would mean a return to the noncooperative equilibrium wherein each firm earns lower profit
Some firms may be willing to risk destroying agreement if benefits are great enough
Suggests that cheating is most likely to occur—and collusion will be least successful—under the following conditions
Difficulty observing other firms’ prices
Unstable market demand
Large number of sellers

39. The Future of Oligopoly
Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure
In 1932, two economists—Adolf Berle and Gardiner Means—noted trend toward big business
Predicted the 200 largest U.S. firms would control nation’s entire economy by 1970
Unless something were done to stop it
Prediction has not come true
Today, there are hundreds and thousands of ongoing businesses in United States

40. Antitrust Legislation and Enforcement
Antitrust enforcement has focused on three types of actions
Preventing collusive agreements among firms
Such as price-fixing agreements
Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers
Preventing mergers that would lead to harmful market domination
Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws
While thrust of these policies is to preserve competition
Type of competition preserved—and zeal with which policies are applied—can shift

41. The Globalization of Markets
By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market
Decreasing market dominance by a few, and increasing competition
Although oligopolists often try to prevent it, they face increasingly stiff competition from foreign producers
Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods
While consumers in each nation may have access to more firms, these may be larger and more powerful firms
Creating greater likelihood of strategic interaction and danger of collusion

42. Technological Change
Technological change works to increase competition by creating new substitute goods
Can reduce barriers to entry in much the same way that globalization does
By increasing size of market
Technology—the internet—has enabled residents in many smaller towns to choose among a dozen or more online sellers of the same merchandize
Trend can also be seen as encouraging oligopoly
Result could be strategic interaction, or collusion, among large national players
Finally, some technologies actually increase MES of typical firm
Thereby encouraging formation of oligopolies

43. Advertising in Monopolistic Competition

44. Using the Theory: Advertising in Monopolistic Competition and Oligopoly
Perfect competitors never advertise and monopolies advertise relatively little
But advertising is almost always found under monopolistic competition and very often in oligopoly
Why?
All monopolistic competitors, and many oligopolists, produce differentiated products
Since other firms will take advantage of opportunity to advertise, any firm that doesn’t advertise will be lost in shuffle

45. Using the Theory: Advertising and Market Equilibrium Under Monopolistic Competition
A monopolistic competitor advertises for two reasons
To shift its demand curve rightward (greater quantity demanded at each price)
To make demand for its output less elastic
So it can raise price and suffer a smaller decrease in quantity demanded
Can summarize impact of advertising as illustrated in panel (a)
Since each firm must pay costs of advertising, and more competitors have entered the market, Narcissus and its competitors are each earning normal economic profit—just as they were originally
Advertising has raised the price from $60 to $100 in long- run
But this is not the only possible result

46. Using the Theory: Advertising and Market Equilibrium Under Monopolistic Competition
Because you and I and everyone else is buying more perfume
Each producer can operate closer to capacity output, with lower costs per unit
In long-run, entry will force each firm to pass cost savings on to us
Analysis suggests the following conclusion
Under monopolistic competition, advertising may increase size of market, so that more units are sold
But in long-run, each firm earns zero economic profit, just as it would if no firm were advertising
Price to consumer, however, may either rise or fall

47. Advertising and Collusion in Oligopoly
Oligopolists have a strong incentive to engage in tacit collusion
But in some cases can use a simple game theory model to show that collusion is almost certainly taking place
Take airline industry as an example
In theory, any airline should be able to claim superior safety
Yet no airline has ever run an advertisement with information about its security policies or attacked those of a competitor
Airlines are playing against each other repeatedly and reach the kind of cooperative equilibrium we discussed earlier

48. An Advertising Game

49. The Four Market Structures: A Postscript
Different market structures
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Market structure models help us organize and understand apparent chaos of real-world markets