Copyright 2002, Pearson Education Canada1 Monopolistic Competition and Oligopoly Chapter 14

Copyright 2002, Pearson Education Canada2 Monopolistic Competition zMonopolistic competition is a common form of industry structure in Canada, characterized by: ya large number of firms, none of which can influence market price by virtue of size alone ysome degree of market power achieved through the production of differentiated products yno barriers to entry or exit

Copyright 2002, Pearson Education Canada3 Concentration Ratios in Selected Industries, 1988 (Table 14.1) CR4 and CR8 refer to the percentage of revenue controlled by the largest 4 and the largest 8 enterprises.

Copyright 2002, Pearson Education Canada4 Product Differentiation zProduct differentiation refers to a strategy that firms use to achieve market power. z Achieved by producing products that have distinct positive identities in the minds of consumers

Copyright 2002, Pearson Education Canada5 The Case for Product Differentiation & Advertising zProvides consumers with variety in markets zEnsures that the quality of products remains high zSatisfies a wide range of consumer tastes zProvides for product innovation zEncourages competition among firms, providing for efficiency zAdvertising provides information for consumers

Copyright 2002, Pearson Education Canada6 The Case Against Product Differentiation & Advertising zSociety’s scarce resources are wasted as firms attempt to make small changes in products zInformation content of advertising is minimal and often misleading zHigh advertising costs may serve as a barrier to entry in some industries zAdvertising imposes costs on society because it is bothersome

Copyright 2002, Pearson Education Canada7 Product Differentiation Reduces the Elasticity of Demand Facing a Firm (Figure 14.1)

Copyright 2002, Pearson Education Canada8 Price / Output Determination in the Short Run zTo maximize profit, the monopolistically competitive firm will increase production until the marginal revenue from increasing output and selling it, no longer exceeds the marginal cost of producing it. This occurs at the point where MC = MR. zIt is therefore possible for the monopolistically competitive firm to earn short-run profits or suffer short-run losses.

Copyright 2002, Pearson Education Canada9 A Monopolistically Competitive Firm Earning Short-Run Profits (Figure 14.2a)

Copyright 2002, Pearson Education Canada10 A Monopolistically Competitive Firm Suffering Short-Run Losses (Figure 14.2b)

Copyright 2002, Pearson Education Canada11 Monopolistically Competitive Firm at Long-Run Equilibrium (Figure 14.3) zAs new firms enter the monopolistically competitive industry the demand curves of profit-making firms begin to shift left. zThe process continues until profits are eliminated and the demand curve is just tangent to the average total cost curve.

Copyright 2002, Pearson Education Canada12 Economic Efficiency and Resource Allocation for Monopolistic Competition zPrice is greater than marginal cost, greater than the perfectly competitive solution. zThe long-run equilibrium quantity of output is to the left of the minimum of ATC.

Copyright 2002, Pearson Education Canada13 Oligopoly zOligopoly is a form of industry structure characterized by: ya few firms, each large enough to influence market price ydifferentiated or homogeneous products yfirms behaving in a way that depends to a great extent on the behaviour of other firms

Copyright 2002, Pearson Education Canada14 Concentration Ratios in Selected Industries, 1988 (Table 14.5)

Copyright 2002, Pearson Education Canada15 Oligopoly Models zThe Collusion Model zThe Cournot Model zThe Kinked Demand Model zThe Price Leadership Model zGame Theoretic Models

Copyright 2002, Pearson Education Canada16 Collusion Model zCartel refers to a group of firms that gets together and makes joint price and output decisions in order to maximize joint profits. zA modern example is OPEC. zCollusion occurs when price and quantity fixing agreements among producers are explicit. zTacit collusion occurs when such agreements are implicit.

Copyright 2002, Pearson Education Canada17 Assumptions of the Cournot Model zThere are two firms in the industry - a duopoly. zEach firm takes the output of the other firm as given. zBoth firms maximize profits.

Copyright 2002, Pearson Education Canada18 Cournot Model zThe Cournot Model is model of a two-firm industry (duopoly) in which a series of output adjustment decisions leads to a final level of output that is between that which would prevail if the market were organized competitively and that which would be set by a monopoly.

Copyright 2002, Pearson Education Canada19 The Kinked Demand Curve Model zThe kinked demand curve model is a model of oligopoly in which the demand curve facing each individual firm has a kink in it. zThe kink follows from the assumption that competitive firms will follow suit if a single firm cuts price, but will not follow suit it a single firm raises price.

Copyright 2002, Pearson Education Canada20 The Kinked Demand Curve Oligopoly Model (Figure 14.4) zIf the firm increases its price the demand will fall off quite quickly. zIf the firm drops its price the other firms follow and quantity demanded does not change as much. zDemand is elastic above P* and inelastic below P*.

Copyright 2002, Pearson Education Canada21 The Price Leadership Model zThe price leadership model is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.

Copyright 2002, Pearson Education Canada22 The Price Leadership Model (Figure 14.5) The leading firm maximizes profits by assuming that the demand it will face is the total market demand minus the amount supplied by the firms that are expected to follow its leadership.

Copyright 2002, Pearson Education Canada23 Results of the Price Leadership Model zThe quantity demanded in the industry is split between the dominant firm and the group of smaller firms. zThis division of output is determined by the amount of market power that the dominant firm has. zThe dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

Copyright 2002, Pearson Education Canada24 Game Theory zGame theory analyzes oligopolistic behaviour as a complex series of strategic moves and reactive countermoves among rival firms. zIn game theory, firms are assumed to anticipate rival reactions.

Copyright 2002, Pearson Education Canada25 Dominant Strategy and Nash Equilibrium zA dominant strategy in game theory is a strategy that is best no matter what the opposition does. zNash equilibrium is the result in game theory, when all players play their best strategy given what their competitors are doing.

Copyright 2002, Pearson Education Canada26 Payoff Matrix for an Advertising Game (Figure 14.6) The dominant strategy for A and B is to advertise.

Copyright 2002, Pearson Education Canada27 The Prisoner’s Dilemma (Figure 14.7) The dominant strategy is for both Rocky and Ginger to confess.

Copyright 2002, Pearson Education Canada28 Payoff Matrixes for Left / Right - Top / Bottom Strategies (Figure 14.8a) zIn this game C does not have a dominant strategy but D does, right. zSince D’s behaviour is predictable C will play accordingly, in this case bottom.

Copyright 2002, Pearson Education Canada29 Payoff Matrixes for Left / Right - Top / Bottom Strategies (Figure 14.8b) zIn this game C does not have a dominant strategy but D does, right. zSince C stands to lose such a large amount, uncertainty and risk will probably cause C to choose top rather than risk bottom, despite knowledge of D’s dominant strategy.

Copyright 2002, Pearson Education Canada30 Maximin Strategy zA maximin strategy in game theory is a strategy chosen to maximize the minimum gain that can be earned.

Copyright 2002, Pearson Education Canada31 Contestable Markets zA market in which entry and exit are costless. zBecause entry is cheap, firms are continually faced with competition or the threat of competition. zIn contestable markets, firms behave like perfectly competitive firms.

Copyright 2002, Pearson Education Canada32 Oligopoly and Economic Performance zMarket concentration leads to pricing above marginal cost and output below the efficient level. zEntry barriers prevent the efficient flow of resources between firms and industries. zProduct differentiation may lead to efficiency losses.

Copyright 2002, Pearson Education Canada33 Review Terms & Concepts zcartel zcournot model zdominant strategy zgame theory zkinked demand curve model zmaximin strategy zmonopolistic competition zNash equilibrium zoligopoly zperfectly contestable market zprice leadership zproduct differentiation ztacit collusion