1. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology Chapter 12: Monopolistic Competition, Oligopoly, and Strategic Pricing

2. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Introduction Market structure is the focus of real-world competition. Market structure refers to the physical characteristics of the market within which firms interact.

3. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Introduction Market structure involves the number of firms in the market and the barriers to entry.

4. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Introduction Perfect competition, with an infinite number of firms, and monopoly, with a single firm, are polar opposites. Monopolistic competition and oligopoly lie between these two extremes.

5. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Introduction Monopolistic competition is a market structure in which there are many firms selling differentiated products. There are few barriers to entry.

6. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Introduction Oligopoly is a market structure in which there are a few interdependent firms. There are often significant barriers to entry.

7. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Defining a Market Defining a market has problems: What is an industry and what is its geographic market?  Local, national, or international? What products are to be included in the definition of an industry?

8. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Classifying Industries One of the ways in which economists classify markets is by cross-price elasticities. Cross-price elasticity measures the responsiveness of the change in demand for a good to change in the price of a related good.

9. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Classifying Industries Industries are classified by government using the North American Industry Classification System (NAICS). The North American Industry Classification System (NAICS) is a classification system of industries adopted by Canada, Mexico, and the U.S. in 1997.

10. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Classifying Industries Under the NAICS, all firms are placed into 20 broadly defined two-digit sectors. Two-digit sectors are further subdivided into three-digit subsectors, four-digit industry groupings, five-digit industries and six-digit national industry groupings.

11. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Classifying Industries When economists talk about industry structure the general practice is to refer to three-digit industries.  Under the NAICS, a two-digit industry is a broadly based industry.  A three-digit industry is a specific type of industry within a broadly defined two-digit industry.

12. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Classifying Industries

13. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Determining Industry Structure Economists use one of two methods to measure industry structure:  The concentration ratio.  The Herfindahl index.

14. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Concentration Ratio The concentration ratio is the percentage of industry sales by the top few firms.

15. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Concentration Ratio The most commonly used concentration ratio is the four-firm concentration ratio, the CR4. The higher the ratio, the closer to an oligopolistic or monopolistic type of market structure.

16. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Herfindahl Index The Herfindahl index is an index of market concentration calculated by adding the squared values of the individual market shares of all the firms in the industry.

17. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Herfindahl Index Two advantages of the Herfindahl index is that it takes into account all firms in an industry, and that it gives extra weight to a single firm that has an especially large market share.

18. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Herfindahl Index The Herfindahl Index is important because it is used as a rule of thumb in determining whether an industry is sufficiently competitive to allow a merger between two large firms in the industry.  If the index is less than 1,000, the industry is considered to be sufficiently competitive.

19. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Conglomerate Firms and Bigness Neither the four-firm concentration ratio nor the Herfindahl index gives a complete picture of corporations’ bigness. This is because many firms are conglomerates.

20. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Conglomerate Firms and Bigness Conglomerates are huge corporations whose activities span various unrelated industries.

21. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Importance of Industry Structure The less concentrated industries are more likely to resemble perfectly competitive markets.

22. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Importance of Industry Structure The number of firms in an industry plays an important role in determining whether firms explicitly take other firms’ actions into account. Oligopolies take into account the reactions of other firms; monopolistic competitors do not.

23. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Importance of Industry Structure In monopolistic competition, there are so many firms that firms do not take into account their rivals’ responses to their decisions. Collusion is difficult due to a large number of firms.

24. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Importance of Industry Structure In oligopoly, with fewer firms, each firm is more likely to engage in strategic decision making. Strategic decision making – taking explicit account of a rival’s expected response to a decision you are making.

25. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Monopolistic Competition The four distinguishing characteristics of monopolistic competition are:  Many sellers.  Differentiated products.  Multiple dimensions of competition.  Easy entry of new firms in the long run.

26. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Many Sellers There are many sellers in monopolistic competition, but each of them is able to identify its own small market segment. Monopolistically competitive firms act independently of their rivals. The existence of many sellers also makes collusion difficult.

27. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Differentiated Products The “many sellers” characteristic gives monopolistic competition its competitive aspect. Product differentiation gives monopolistic competition its monopolistic aspect. Competitors produce many close substitutes.

28. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Differentiated Products Differentiation may be based on real differences in product characteristics, or can be based on consumers’ perceptions about product differences. Generally, monopolistic competition is characterized by significant expenditures on advertising, which acts as an important barrier to entry.

29. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Differentiated Products Differentiation exists so long as advertising convinces buyers that it exists. Firms will continue to advertise as long as the marginal benefits of advertising exceed its marginal costs.

30. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Differentiated Products Any industry where brand proliferation is present is likely to be monopolistically competitive.  Some examples are soap, jeans, cookies and games.

31. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Multiple Dimensions of Competition Competition takes many forms in a monopolistically competitive industry:  Product differentiation.  Perceived quality.  Competitive advertising.  Service and distribution outlets.

32. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Easy Entry The existence of economic profits induces other firms to enter, bringing long-run profit down to zero.

33. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Output, Price, and Profit A monopolistically competitive firm produces in the same manner as a monopolist—to maximize profit, it chooses the quantity where MC = MR. Having determined output, the firm will charge what consumers are willing to pay (determined by the demand curve).

34. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Output, Price, and Profit If price exceeds ATC, the firm will earn positive economic profits. These profits attract entry. Some customers of the existing firms switch to become customers of the new firm.

35. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Output, Price, and Profit Entry causes the existing firms’ demand curve to shift left (decrease) as they lose customers. Competition, therefore, implies zero economic profit in the long run.

36. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Output, Price, and Profit At the long-run equilibrium, ATC equals price and economic profits are zero. This occurs at the point of tangency of the ATC and demand curve at the output chosen by the firm.

37. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Monopolistic Competition: Short Run MRD1D1 Q1Q1 P1P1 Price 0Quantity ATC 1 MC C1C1 

38. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Monopolistic Competition: Short Run Q1Q1 Price 0Quantity P1P1 MC C1C1 P2P2 Q2Q2 MR 2 D2D2 ATC 2 ATC 1 C2C2 MR 1 D1D1

39. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Monopolistic Competition: Long Run MR 3 D3D3 Q3Q3 P 3 =C 3 Price 0Quantity ATC 3 C1C1 C2C2 P1P1 P2P2 ATC 2 D2 MR 2 MC

40. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Comparing Monopolistic Competition and Perfect Competition Both the monopolistic competitor and the perfect competitor make zero economic profit in the long run.

41. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 The perfect competitor’s demand curve is perfectly elastic. Zero economic profit means that it produces at the minimum of the ATC curve. Comparing Monopolistic Competition and Perfect Competition

42. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 A monopolistic competitor faces a downward sloping demand curve, and produces where MC = MR, not where MC = P. The ATC curve is tangent to the demand curve at that level, which is not at the minimum point of the ATC curve. Comparing Monopolistic Competition and Perfect Competition

43. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 A monopolistic competitor produces less than a perfect competitor. Comparing Monopolistic Competition and Perfect Competition

44. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Perfect CompetitionMonopolistic Competition MC PCPC D QCQC Price 0 Quantity ATC PMPM MC ATC DMR QMQM Quantity 0 Price QCQC PCPC Comparing Monopolistic Competition and Perfect Competition

45. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Excess Capacity The Excess Capacity theorem indicates that a monopolistically competitive firm will have excess capacity in long-run equilibrium. It occurs because of product differentiation.

46. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Monopolistic Competition and Advertising Firms in a perfectly competitive market have no incentive to advertise Monopolistic competitors have a strong incentive to do so.

47. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Monopolistic Competition and Advertising The goals of advertising are to increase demand for the firm’s product and to increase customer loyalty to the product. The firm’s demand increases, and becomes more inelastic.

48. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48 Monopolistic Competition and Advertising Advertising shifts the demand curve to the right, and it increases firm’s costs, shifting the ATC up.

49. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 Does Advertising Help or Hurt Society? There is a sense of trust in buying brands we know. If consumers are willing to pay for “differentness,” it’s a benefit to them.

50. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Comparing Monopolistic Competition and Monopoly It is possible for the monopolist to make economic profit in the long-run. No long-run economic profit is possible in monopolistic competition.

51. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Characteristics of Oligopoly Oligopolies are made up of a small number of very large firms. Products may be homogeneous or differentiated Firms are mutually interdependent. Each firm must take into account the expected reaction of other firms.

52. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Models of Oligopoly Behaviour No single general model of oligopoly behaviour exists because each oligopolistic industry is different. Two models of oligopoly behaviour are the cartel model and the contestable market model.

53. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Models of Oligopoly Behaviour In the cartel model, an oligopoly sets a monopoly price. In the contestable market model, an oligopoly with no barriers to entry sets a competitive price.

54. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Cartel Model A cartel is a combination of firms that acts as it were a single firm. A cartel is a shared monopoly. In the cartel model, an oligopoly sets a monopoly price.

55. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 Cartel Model If oligopolies can limit entry, they have a strong incentive to collude. To collude is to get together with other firms to set price or allocate market share.

56. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 Cartel Model In the cartel model of oligopoly,  Oligopolies act as if they were monopolists  That have assigned output quotas to individual member firms  So that total output is consistent with joint profit maximization.

57. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 Implicit Price Collusion Formal collusion is illegal in Canada, but informal collusion is permitted. Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another.

58. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Implicit Price Collusion Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.

59. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Cartels and Technological Change Cartels can be destroyed by an outsider with technological superiority. Thus, cartels with high profits will provide incentives for significant technological change.

60. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Why Are Prices Sticky? Sticky prices are prices that don’t change very much. Informal collusion is an important reason why prices are sticky. Another is the kinked demand curve.

61. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Kinked Demand Curve Model of Oligopoly Firms have expectations about how the other firms in the industry will behave. A firm’s assumptions about the other firm’s behaviour creates the kink in the demand curve.

62. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Assumption 1: If a firm raises its price, no other firms will raise their prices. This make the firm’s own demand curve very elastic. Kinked Demand Curve Model

63. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Assumption 2: If a firm lowers its price, all the other firms will lower their prices too. This make the firm’s own demand curve very inelastic. Kinked Demand Curve Model

64. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 When there is a kink in the demand curve, there has to be a gap in the marginal revenue curve. The kinked demand curve is not a theory of oligopoly but a theory of sticky prices. Kinked Demand Curve Model

65. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 D1D1 MR 1 Price Quantity 0 Q P a b c d MC 0 MC 1 Kinked Demand Curve Model No-one follows a price increase. All firms lower price. D2D2 MR 2

66. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 If a firm’s MC curve crosses MR in the vertical portion between c and d, it will produce the quantity Q and charge a price equal to P. Kinked Demand Curve Model

67. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 A high-cost firm and a low-cost firm will both produce the same quantity and charge the same price. If a firm’s costs decrease, consumers will not see any change.  Price will not decrease. The firm’s profits will increase. Kinked Demand Curve Model

68. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Contestable Market Model According to the contestable market model, barriers to entry and barriers to exit determine a firm’s price and output decisions.  Even if the industry contains a very small number of firms, it could still be a competitive market if entry is open.

69. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Contestable Market Model In the contestable market model, an oligopoly with no barriers to entry sets a competitive price.

70. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 70 Comparing the Contestable Market and Cartel Models The stronger the ability of oligopolists to collude and prevent market entry, the closer it is to a monopolistic situation. The weaker the ability to collude is, the more competitive it is. Oligopoly markets lie between these two extremes.

71. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 71 Strategic Pricing and Oligopoly Both the cartel and contestable market models use strategic pricing decisions – firms set their prices based on the expected reactions of other firms.

72. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 72 Creation of cartels is limited by threat of outside competition. In many industries the outside competition comes from international firms. For a cartel with few barriers to entry, the long run demand curve is very elastic. New Entry Limits Cartelization

73. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 73 Price Wars Price wars are the result of strategic pricing decisions breaking down.

74. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 74 Price Wars A firm may develop predatory pricing strategy, which involves temporarily pushing the price down below cost in order to drive a competitor out of business.

75. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 75 Game Theory and Strategic Decision Making Most oligopolistic strategic decision making is carried out with explicit or implicit use of game theory. Game theory is the application of economic principles to interdependent situations.

76. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 76 Game Theory and Strategic Decision Making The prisoner’s dilemma is a well-known game that demonstrates the difficulty of cooperative behaviour in certain circumstances.

77. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 77 Game Theory and Strategic Decision Making In the prisoner’s dilemma, it’s mutual trust that gets each one out of the dilemma, however, confessing is the rational choice.

78. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 78 Prisoner’s Dilemma and Duopoly The prisoners dilemma has its simplest application when the oligopoly consists of only two firms—a duopoly.

79. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 79 Prisoner’s Dilemma and Duopoly By analyzing the strategies of both firms under all situations, all possibilities are placed in a payoff matrix. A payoff matrix is a box that contains the outcomes of a strategic game under various circumstances.

80. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 80 Cooperative Equilibrium

81. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 81 One Firm Cheats

82. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 82 Duopoly and a Payoff Matrix The duopoly is a variation of the prisoner's dilemma game. The results can be presented in a payoff matrix that captures the essence of the prisoner's dilemma.

83. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 83 B Cheats B Does not cheat A Does not cheatA Cheats B +$200,000 B $0 A $0 A +$200,000 B $75,000 A $75,000 A – $75,000 B – $75,000 Payoff Matrix

84. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 84 If both firms cooperate, they can both get higher profits.  $75,000 each. However, both firms have an incentive to cheat on their agreement.  $200,000 for the one that cheats. Payoff Matrix

85. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 85 A dominant strategy is one which always yields the highest payoff, no matter what the other player does. The dominant strategy is to not cooperate.  i.e. to cheat. Payoff Matrix

86. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 86 If both firms choose to cheat on their agreement, the outcome will be a Nash equilibrium, a non-cooperative equilibrium in which no player can achieve a better outcome by switching strategies, given the strategy of the other player. Payoff Matrix

87. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 87 Oligopoly, Structure, and Performance Oligopoly models are based either on structure or performance.  The four types of markets considered so far are based on market structure.  Structure means the number, size, and interrelationship of firms in the industry.

88. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 88 Oligopoly, Structure, and Performance A monopoly is the least competitive, while perfectly competitive industries are the most competitive.

89. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 89 Oligopoly, Structure, and Performance The contestable market model gives less weight to market structure. Markets are judged by performance, not structure.

90. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 90 Oligopoly, Structure, and Performance Performance includes: ratio of price to marginal cost output allocative and productive efficiency product variety innovation rate profits

91. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 91 Oligopoly, Structure, and Performance There is a similarity in the two approaches. Often barriers to entry are the reason there are only a few firms in an industry. When there are many firms, that suggests that there are few barriers to entry. In the majority of cases, the two approaches come to the same conclusion.

92. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 92

93. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.93 Monopolistic Competition, Oligopoly, and Strategic Pricing End of Chapter 12