11 Monopolistic Competition and Oligopoly

Chapter Objectives Characteristics of Monopolistic Competition Why Monopolistic Competitors Earn Only a Normal Profit in the Long-Run Characteristics of Oligopoly How Game Theory Relates to Oligopoly Why the Demand Curve of the Oligopolist May Be Kinked Incentives and Obstacles to Collusion Among Oligopolists Potential Positive and Negative Effects of Advertising

Monopolistic Competition Characteristics Small Market Shares No Collusion Independent Action Differentiated Products Product Attributes Service Location Brand Names and Packaging Some Control Over Price

Monopolistic Competition Easy Entry and Exit Advertising Nonprice Competition Monopolistically Competitive Industries

Price and Output Determination In Monopolistic Competition The Firm’s Demand Curve The Short Run: Profit or Loss The Long Run: Only a Normal Profit Profits: Firms Enter Losses: Firm’s Leave Complications Product Variety G 11.1

Price and Output Determination In Monopolistic Competition Short-Run Profits ATC MC P1 A1 Price and Costs Economic Profit D1 MR = MC MR Q1 Quantity

Price and Output Determination In Monopolistic Competition Short-Run Losses ATC MC A2 P2 Loss Price and Costs D2 MR = MC MR Q2 Quantity

Price and Output Determination In Monopolistic Competition Long-Run Equilibrium MC ATC P3= A3 Price and Costs D3 MR = MC MR Q3 Quantity

Monopolistic Competition and Efficiency Recall: P=MC=Minimum ATC Quantity Price and Costs MR = MC MC MR D3 ATC Q3 P3= A3 P4 Price is Higher Excess Capacity at Minimum ATC Q4 Monopolistic Competition is Not Efficient

Oligopoly Characteristics A Few Large Producers Homogeneous or Differentiated Products Homogeneous Oligopoly Differentiated Oligopoly Control Over Price, But Mutual Interdependence Strategic Behavior Entry Barriers Mergers

Measures of Concentration Concentration Ratio Localized Markets Interindustry Competition World Trade Import Competition Herfindahl Index (%S1)2 + (%S2)2 + (%S3)2 + … + (%Sn)2 W 11.1

Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy 2 Competitors 2 Price Strategies Each Strategy Has a Payoff Matrix Greatest Combined Profit Independent Actions Stimulate a Response High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8 O 11.2

Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy Independently Lowered Prices in Expectation of Greater Profit Leads to the Worst Combined Outcome Eventually Low Outcomes Make Firms Return to Higher Prices High Low A B $12 $15 High $12 $6 Uptown’s Price Strategy C D $6 $8 Low $15 $8 O 11.2

Game Theory Role of Mutual Interdependence Collusive Tendencies Collusion Incentive to Cheat G 11.2

Three Oligopoly Models Kinked Demand Curve Collusive Pricing Price Leadership Diversity of Oligopolies Complications of Interdependence

Kinked-Demand Curve Strategies A Combined Strategy Price Inflexibility Noncollusive Oligopoly Strategies Match Price Changes Ignore Price Changes A Combined Strategy Price Inflexibility The Kinked-Demand Curve Graphically…

Competitor and Rivals Strategize Versus Each Other Kinked-Demand Curve Noncollusive Oligopoly Competitor and Rivals Strategize Versus Each Other Consumers Effectively Have 2 Partial Demand Curves and Each Part Has Its Own Marginal Revenue Part Price Price and Costs Quantity Rivals Ignore Price Increase D2 MC1 e e P0 P0 MR2 f f D2 MC2 MR2 Rivals Match Price Decrease g g D1 D1 Q0 MR1 Q0 MR1 Resulting in a Kinked-Demand Curve to the Consumer – Price and Output Are Optimized at the Kink

Kinked-Demand Curve Criticisms of the Model Noncollusive Oligopoly Criticisms of the Model Doesn’t Explain How Price Gets to the Kink (P0) Oligopoly Prices Are Not As Rigid During Instability as the Model Indicates Possibility of Price Wars

Cartels and Other Collusion Price and Output Collusion and Tendency Toward Joint-Profit Maximization Price and Costs Quantity Effectively Sharing The Monopoly Profit MC P0 ATC A0 MR=MC Economic Profit D MR Q0

Cartels and Other Collusion Overt Collusion Cartels The OPEC Cartel GLOBAL PERSPECTIVE The 11 OPEC Nations Daily Oil Production, May 2006 Saudi Arabia Iran Venezuela UAE Nigeria Kuwait Iraq Libya Indonesia Algeria Qatar Source: OPEC Country Barrels of Oil 9,099,000 4,110,000 3,233,000 2,444,000 2,306,000 2,247,000 1,903,000 1,500,000 1,451,000 894,000 726,000

Cartels and Other Collusion Covert Collusion Tacit Understandings Obstacles to Collusion Demand and Cost Differences Number of Firms Cheating Recession Potential Entry Legal Obstacles: Antitrust Law

Price Leadership Model Leadership Tactics Infrequent Price Changes Communications Limit Pricing Breakdowns in Price Leadership: Price Wars

Oligopoly and Advertising Advertising Prevalent in Monopolistic Competition and Oligopoly Positive Effects of Advertising Potential Negative Effects of Advertising

Oligopoly and Advertising The Largest U.S. Advertisers, 2005 Company Advertising Spending Millions of $ Proctor and Gamble General Motors Time Warner Verizon AT&T Ford Motor Walt Disney Johnson & Johnson GlaxoSmithKline DaimlerChrysler $4609 4353 3494 2484 2471 2398 2279 2209 2194 2179 Source: Advertising Age

Oligopoly and Advertising World’s Top 10 Brand Names GLOBAL PERSPECTIVE Source: Interbrand Coca-Cola Microsoft IBM General Electric Intel Nokia Toyota Disney McDonalds Mercedes-Benz

Oligopoly and Efficiency Productive and Allocative Efficiency P = MC = Minimum ATC Neither Exists Tendency to Share the Monopoly Profit Qualifications Increased Foreign Competition Limit Pricing Technological Advance

Oligopoly in the Beer Industry Last Word Once Hundreds of Firms Now a Very Small Group Demand Side Changes Taste Shifts to Lighter Beers of Large Breweries Shift From Tavern-Tap Consumption to Can or Bottles Supply Side Changes Technology Increased Minimum Efficient Scale Creating a Barrier to Entry National Brands Enjoy Cost Advantages Consolidation of Firms into Oligopoly

Key Terms monopolistic competition product differentiation nonprice competition excess capacity oligopoly homogeneous oligopoly differentiated oligopoly strategic behavior mutual interdependence concentration ratio interindustry competition import competition Herfindahl index game-theory model collusion kinked-demand curve price war cartel tacit understandings price leadership

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