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© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 13 Prepared by: Fernando Quijano and Yvonn Quijano Monopolistic.

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Presentation on theme: "© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 13 Prepared by: Fernando Quijano and Yvonn Quijano Monopolistic."— Presentation transcript:

1 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 13 Prepared by: Fernando Quijano and Yvonn Quijano Monopolistic Competition and Oligopoly

2 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition A monopolistically competitive industry has the following characteristics:A monopolistically competitive industry has the following characteristics: A large number of firms A large number of firms No barriers to entry No barriers to entry Product differentiation Product differentiation

3 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition Monopolistic competition is a common form of industry (market) structure in the United States, characterized by a large number of firms, none of which can influence market price by virtue of size alone.Monopolistic competition is a common form of industry (market) structure in the United States, characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products.Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease.New firms can enter and established firms can exit such an industry with ease.

4 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Nine Industries with Characteristics of Monopolistic Competition Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 SIC NO. INDUSTRY DESIGNATION FOUR LARGEST FIRMS EIGHT LARGEST FIRMS TWENTY LARGEST FIRMS NUMBER OF FIRMS 3792 Travel trailers and campers Dolls Wood office furniture Book publishing Curtains and draperies Fresh or frozen seafood Blowers and fans Womens dresses Miscellaneous plastic products Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.

5 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Product Differentiation, Advertising, and Social Welfare Total Advertising Expenditures in 1998 DOLLARS (BILLIONS) Newspapers44.2 Television48.0 Direct mail 39.5 Other31.7 Yellow pages 12.0 Radio14.5 Magazines10.4 Total200.3 Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947.

6 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case for Product Differentiation and Advertising The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power.The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. Product differentiation helps to ensure high quality and efficient production.Product differentiation helps to ensure high quality and efficient production.

7 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case for Product Differentiation and Advertising Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.

8 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case Against Product Differentiation and Advertising Critics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency.Critics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.

9 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Case Against Product Differentiation and Advertising Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance.Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. People exist to satisfy the needs of the economy, not vice versa.People exist to satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.

10 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Product Differentiation Reduces the Elasticity of Demand Facing a Firm Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.

11 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Short Run In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC.In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC. This firm is earning positive profits in the short-run.This firm is earning positive profits in the short-run.

12 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Short-Run Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.

13 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monopolistic Competition in the Long-Run The firms demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.The firms demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.

14 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product. Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product.

15 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity. Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity.

16 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Oligopoly An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated.An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.

17 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Ten Highly Concentrated Industries Percentage of Value of Shipments Accounted for by the Largest Firms in High- Concentration Industries, 1992 SIC NO. INDUSTRY DESIGNATION FOUR LARGEST FIRMS EIGHT LARGEST FIRMS NUMBER OF FIRMS 2823 Cellulosic man-made fiber Primary copper Household laundry equipment Cigarettes Malt beverages (beer) Electric lamp bulbs Cereal breakfast foods Motor vehicles Small arms ammunition Household refrigerators and freezers Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.

18 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Oligopoly Models All kinds of oligopoly have one thing in common:All kinds of oligopoly have one thing in common: The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly. The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly.

19 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Collusion Model A group of firms that gets together and makes price and output decisions jointly is called a cartel.A group of firms that gets together and makes price and output decisions jointly is called a cartel. Collusion occurs when price- and quantity-fixing agreements are explicit.Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit.Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit.

20 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Cournot Model The Cournot model is a model of a two-firm industry (duopoly) in which a series of output-adjustment decisions leads to a final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly.The Cournot model is a model of a two-firm industry (duopoly) in which a series of output-adjustment decisions leads to a final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly.

21 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Kinked Demand Curve Model The kinked demand model is a model of oligopoly in which the demand curve facing each individual firm has a kink in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price.The kinked demand model is a model of oligopoly in which the demand curve facing each individual firm has a kink in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price.

22 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Kinked Demand Curve Model Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firms quantity demanded (demand is elastic).Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firms quantity demanded (demand is elastic). Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).

23 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Price-Leadership Model Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.

24 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Price-Leadership Model Assumptions of the price-leadership model:Assumptions of the price-leadership model: 1. The industry is made up of one large firm and a number of smaller, competitive firms; 2. The dominant firm maximizes profit subject to the constraint of market demand and subject to the behavior of the smaller firms; 3. The dominant firm allows the smaller firms to sell all they want at the price the leader has set.

25 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Price-Leadership Model Outcome of the price-leadership model:Outcome of the price-leadership model: 1. The quantity demanded in the industry is split between the dominant firm and the group of smaller firms. 2. This division of output is determined by the amount of market power that the dominant firm has. 3. The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

26 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Predatory Pricing The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing.The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing. Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.

27 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Game Theory Game theory analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms.Game theory analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms. In game theory, firms are assumed to anticipate rival reactions.In game theory, firms are assumed to anticipate rival reactions.

28 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Payoff Matrix for Advertising Game Bs STRATEGY As STRATEGY Do not advertise Advertise As profit = $50,000 Bs profit = $50,000 As loss = $25,000 Bs profit = $75,000 Advertise As profit = $75,000 Bs loss = $25,000 As profit = $10,000 Bs profit = $10,000 The strategy that firm A will actually choose depends on the information available concerning Bs likely strategy.

29 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Payoff Matrix for Advertising Game Bs STRATEGY As STRATEGY Do not advertise Advertise As profit = $50,000 Bs profit = $50,000 As loss = $25,000 Bs profit = $75,000 Advertise As profit = $75,000 Bs loss = $25,000 As profit = $10,000 Bs profit = $10,000 Regardless of what B does, it pays A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.

30 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Prisoners Dilemma ROCKY GINGER Do not confess Confess Ginger: 1 year Rocky: 1 year Ginger: 7 years Rocky: free Confess Ginger: free Rocky: 7 years Ginger: 5 years Rocky: 5 years Both Ginger and Rocky have dominant strategies: to confess. Both will confess, even though they would be better off if they both kept their mouths shut.

31 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Payoff Matrix for Left/Right-Top/Bottom Strategies Original Game Ds STRATEGY Cs STRATEGY LeftRight Top C wins $100 D wins no $ C wins $100 D wins $100 Bottom C loses $100 D wins no $ C wins $200 D wins $100 Because Ds behavior is predictable (he will play the right-hand strategy), C will play bottom. When all players are playing their best strategy given what their competitors are doing, the result is called Nash equilibrium.

32 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Payoff Matrix for Left/Right-Top/Bottom Strategies C is likely to play top and guarantee herself a $100 profit instead of losing $10,000 to win $200, even if there is just a small chance of Ds choosing left. When uncertainty and risk are introduced, the game changes. A maximin strategy is a strategy chosen to maximize the minimum gain that can be earned. New Game Ds STRATEGY Cs STRATEGY LeftRight Top C wins $100 D wins no $ C wins $100 D wins $100 Bottom C loses $10,000 D wins no $ C wins $200 D wins $100

33 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Contestable Markets A market is perfectly contestable if entry to it and exit from it are costless.A market is perfectly contestable if entry to it and exit from it are costless. In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.

34 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Oligopoly is Consistent with a Variety of Behaviors The only necessary condition of oligopoly is that firms are large enough to have some control over price.The only necessary condition of oligopoly is that firms are large enough to have some control over price. Oligopolies are concentrated industries. At one extreme is the cartel, in essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms.Oligopolies are concentrated industries. At one extreme is the cartel, in essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms.

35 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Oligopoly and Economic Performance Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons:Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons: They are likely to price above marginal cost. This means that there would be underproduction from societys point of view. They are likely to price above marginal cost. This means that there would be underproduction from societys point of view. Strategic behavior can force firms into deadlocks that waste resources. Strategic behavior can force firms into deadlocks that waste resources. Product differentiation and advertising may pose a real danger of waste and inefficiency. Product differentiation and advertising may pose a real danger of waste and inefficiency.

36 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Role of Government The Celler-Kefauver Act of 1950 extended the governments authority to ban vertical and conglomerate mergers.The Celler-Kefauver Act of 1950 extended the governments authority to ban vertical and conglomerate mergers. The Herfindahl-Hirschman Index (HHI) is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.The Herfindahl-Hirschman Index (HHI) is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.

37 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Regulation of Mergers Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms PERCENTAGE SHARE OF: HERFINDAHL- HIRSCHMAN INDEX FIRM 1 FIRM 2 FIRM 3 FIRM 4 Industry A = 5,000 Industry B = 6,600 Industry C = 2,500 Industry D = 2,800

38 © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Department of Justice Merger Guidelines (revised 1984) ANTITRUST DIVISION ACTION HHI1,8001,0000 Concentrated Challenge if Index is raised by more than 50 points by the merger Moderate Concentration Challenge if Index is raised by more than 100 points by the merger Unconcentrated No challenge


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