Monopolistic Competition & Oligopoly

Unit Objectives Describe the characteristics of monopolistic competition and oligopoly Discover how monopolistic competitors can earn a normal profit in the long run Apply game theory to oligopolies

Monopolistic Competition Relatively large number of sellers Each with small market shares No collusion Independent action Differentiated products Reliance on advertising Nonprice competition Ease of entry and exit

Product Differentiation Variations on a particular product Product attribute Service Location Brand names and packaging Some control over price

Four Firm Concentration Ratio Four Firm Concentration Ratio: Output of the 4 largest firms Total industry output Ratio is very low in purely competitive industries Ratios above 40% are considered oligopolies Ratios below 40% are considered monopolistic competitive industries

Monopolistic Competitive Industries Industry concentration: the degree to which the largest firms account for the bulk of the industry’s output

Herfindahl Index The sum of the squared percentage market shares of all firms In the industry Takes into consideration highly localized industries Gives more weight to larger firms An index approaching 0 is purely competitive An index of 10,000 (100 2 ) is a monopoly

The Firm’s Demand Curve Demand curve is highly but not perfectly elastic – Close substitutability of goods – Not perfect substitutes Elasticity depends on number of rivals and degree of product differentiation

Oligopoly A few large producers Homogeneous or differentiated products Control over price, but mutual interdependence Strategic behavior Barriers to entry Economies of scale Role of mergers

Oligopolistic Industries Shortcomings of concentration ratios: – Localized markets, interindustry competition, import competition, & dominant firms (Herfindahl index)

Short Run: Profit or Loss Graphs

Short Run: Profit or Loss Same profit maximizing (loss minimizing) criteria: MR=MC Price is determined on the demand curve Compare price with ATC to determine short term profit or loss

Long Run: Normal Profit Only In the long run, firms enter a profitable industry and may exit industries with losses In the real world: – Sufficient product differentiation creates “unique” opportunities and barriers to entry

Monopolistic Competition and Efficiency P=MC=minimum ATC – P=min. ATC is productive efficiency – P=MC is allocative efficiency Neither occurs in long-run equilibrium for this market structure Firm’s ATC at profit max. is higher than “optimal” Profit max. price is higher than marginal cost – Under allocation of resources

Efficiency Graphs

Oligopolistic Behavior: Game Theory The study of how people behave in strategic situations – Pattern behavior according to actions and expected reactions of rivals Duopoly – two firm industry Payoff matrix – shows the payoff that results from each combination of strategies Collusion- cooperation between rivals Incentive to cheat

The Payoff Matrix

The One Time Game Firms select their optimal strategies in a single time period without regard to possible interactions in subsequent time periods Simultaneous game – both firms pick their strategies at the same time Positive sum game – Sum of outcomes in >0 Zero-sum game, negative-sum game

Strategies and Equilibrium Dominant strategy: an option that is better than any alternative option regardless of what the other firm does Nash equilibrium (did you see A Beautiful Mind?) is an outcome from which neither rival wants to deviate Strategy is optimal given the other firm’s strategic choice Stable solution

Textbook Example

Three Oligopoly Models Diversity of oligopolies Tight and loose Interdependence makes determining profit maximizing decisions difficult Kinked demand Collusive pricing Cartels are most extreme case Price leadership

Oligopoly and Efficiency P=MC=Minimum ATC Oligopolies can earn economic profits year after year – Output is where P>MC and min. ATC Neither productive nor allocative efficiencies occur – At least monopolies are regulated Caveats: increased foreign competition, limit pricing, and technological advance

Oligopoly Efficiency Graph