Monopolistic Competition and Oligopoly 11 Monopolistic Competition and Oligopoly Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Monopolistic Competition Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice competition Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities LO1 11-2

Monopolistic Competition Relatively large number of sellers Differentiated products Easy entry and exit Advertising LO1 11-3

Monopolistically Competitive Industry concentration Measured by: Four-firm concentration ratios Percentage of 4 largest firms Herfindahl index Sum of squared market shares Output of four largest firms Total output in the industry 4-Firm CR = HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2 LO1 11-4

Price and Output in Monopolistic Comp Demand is highly elastic Short run profit or loss Produce where MR=MC Long run normal profit Entry and exit Inefficient Product variety LO2 11-5

The Short Run: Profit or Loss ATC MC P1 A1 Price and Costs Economic Profit D1 MR = MC MR Q1 Quantity LO2 11-6

The Short Run: Profit or Loss ATC MC A2 P2 Loss Price and Costs D2 MR = MC MR Q2 Quantity LO2 11-7

The Long Run: Only a Normal Profit MC ATC P3= A3 Price and Costs D3 MR = MC MR Q3 Quantity LO2 11-8

Monopolistic Competition: Efficiency Inefficient Productive inefficiency P > ATC Allocative inefficiency P > MC LO2 11-9

Monopolistic Competition: Efficiency P=MC=Min ATC for pure competition (recall) Quantity Price and Costs MR = MC MC MR D3 ATC Q3 P3= A3 P4 Price is Lower Excess Capacity at Minimum ATC Q4 Monopolistic competition is not efficient LO2 11-10

The firm constantly manages price, product, and advertising Product Variety The firm constantly manages price, product, and advertising Better product differentiation Better advertising The consumer benefits by greater array of choices and better products Types and styles Brands and quality LO2 11-11

Homogeneous or differentiated products Limited control over price Oligopoly A few large producers Homogeneous or differentiated products Limited control over price Mutual interdependence Strategic behavior Entry barriers Mergers LO3 11-12

Oligopolistic Industries Four-firm concentration ratio 40% or more to be oligopoly Shortcomings Localized markets Inter-industry competition World price Dominant firms LO3 11-13

Oligopolies display strategic pricing behavior Mutual interdependence Game Theory Overview Oligopolies display strategic pricing behavior Mutual interdependence Collusion Incentive to cheat Prisoner’s dilemma LO4 11-14

Game Theory Overview 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 LO4 11-15

Game Theory Overview RareAir’s Price Strategy Independently lowered prices in expectation of greater profit leads to 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 LO4 11-16

Three Oligopoly Models Kinked-demand curve Collusive pricing Price leadership Reasons for 3 models Diversity of oligopolies Complications of interdependence LO5 11-17

Kinked-Demand Curve Rivals Ignore Price Increase D2 MC1 Price e Price MR2 f f D2 MC2 MR2 Rivals Match Price Decrease g g D1 D1 Q0 MR1 Q0 MR1 Quantity Quantity LO5 11-18

Explains inflexibility, not price Prices are not that rigid Price wars Kinked-Demand Curve Criticisms Explains inflexibility, not price Prices are not that rigid Price wars LO6 11-19

Cartels and Other Collusion Price and Costs Quantity MC P0 ATC A0 MR=MC Economic Profit D MR Q0 LO6 11-20

Cartels - a group of firms or nations that collude Overt Collusion Cartels - a group of firms or nations that collude Formally agreeing to the price Sets output levels for members Collusion is illegal in the United States OPEC LO6 11-21

Obstacles to Collusion Demand and cost differences Number of firms Cheating Recession New entrants Legal obstacles LO6 11-22

Price Leadership Model Dominant firm initiates price changes Other firms follow the leader Use limit pricing to block entry of new firms Possible price war LO6 11-23

Oligopoly and Advertising Prevalent to compete with product development and advertising Less easily duplicated than a price change Financially able to advertise LO7 11-24

Advertising Positive Effects Negative Effects Low-cost way of providing information to consumers Can be manipulative Enhances competition Contains misleading claims that confuse consumers Speeds up technological progress Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product Can help firms obtain economies of scale LO7 11-25

Oligopoly and Efficiency Oligopolies are inefficient Productively inefficient P > minATC Allocatively inefficient P > MC Qualifications Increased foreign competition Limit pricing Technological advance LO7 11-26