Monopolistic Competition, Oligopoly, and Antitrust © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Effects of Market Entry In the absence of substantial economies of scale, it is possible for additional firms to enter the market, driving down prices and profit. Output decisions are based on the marginal principle: Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Effects of Market Entry When a second firm enters the market, the monopoly’s demand and marginal revenue curves shift inward. The firm’s price and output level will have to be adjusted in order to follow the marginal principle. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Effects of Market Entry The monopoly satisfies the marginal principle by producing and selling 300 toothbrushes at $2 each. After entry, each of two firms produces 200 units and charges $1.85 per unit. Entry decreases price. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Effects of Market Entry Before entry, the monopoly produces 300 units, at a cost per unit of $0.90 per toothbrush. After entry, each of two firms produces 200 units at an average cost of $1.00. Entry increases average cost. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Effects of Market Entry Summary: There are three reasons why profit decreases for the individual firm after entry of a second firm: Lower price Lower quantity sold Higher AC of production © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Effects of Market Entry 2.00 e 1.85 d 1.00 Revenue or cost ( $ per tooth brush) c 0.90 AC x n D1 MC1 D2 MR1 MR2 200 300 Toothbrushes per minute © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Monopolistic Competition Monopolistic Competition: A market served by dozens of firms selling slightly different products. Characteristics of Monopolistic Competition: Many firms Differentiated product No artificial barriers to entry © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Meaning of “Monopolistic Competition” Each firm is monopolistic because it sells a unique product. Each firm is a competitive because it sells a product that is a close but not a perfect substitute for the products sold by other firms in the market. The availability of close substitutes makes the firm’s demand very price elastic. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Product Differentiation Firms may differentiate their product in several ways: Physical characteristics Location Services Aura or image © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Short-run and Long-run Equilibrium As long as there is profit to be made, more and more firms will enter the market. As firms enter, each firm’s demand curve shifts to the left, decreasing market price, decreasing the quantity produced per firm, and increasing the average cost of production. Entry will stop once the economic profit of each existing firm reaches zero. In the long run, revenue will be just enough to cover all costs, including the opportunity cost of all inputs, but not enough to cause additional firms to enter. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Long-run Equilibrium Under Monopolistic Competition In this example, the marginal principle is satisfied at 55 thousand toothbrushes per minute, selling at a price of $1.35. The cost of producing each toothbrush is also $1.35. Economic profit equals zero. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Trade-offs with Monopolistic Competition Monopoly Monopolistic Competition © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Trade-offs with Monopolistic Competition Monopolistic competition brings good news and bad news relative to the monopoly outcome: Good news: lower price and greater variety Bad news: higher average cost © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Oligopoly An oligopoly is a market served by a few firms. The key feature of an oligopoly is that firms act strategically. Firms are interdependent—the actions of one firm affect the profits of the other firms in the market. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Oligopoly and Pricing Decisions Economists use concentration ratios to measure the degree of concentration, or just how few firms exist in a market. For example a four firm concentration ratios is the percentage of total output in the market produced by the largest four, i.e., a 93% concentration ratio for cigarettes indicates that the largest 4 firms produced 93% of the total output. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Concentration Ratios in Selected Manufacturing Industries Industry Four-firm Concentration Ratio (%) Eight-firm Concentration Ratio (%) Cigarettes 93 Not available Guided missiles and space vehicles 99 Beer and malt beverages 90 98 Batteries 87 95 Electric bulbs 86 94 Breakfast cereals 85 Motor vehicles and car bodies 84 91 Greeting cards 88 Engines and turbines 79 92 Aircraft and parts © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Barriers to Entry in an Oligopoly Most firms in an oligopoly earn economic profit, yet additional firms do not enter the market, for three reasons: Economies of scale large enough to generate a natural oligopoly but not a natural monopoly Government barriers to entry Substantial investment in an advertising campaign in order to enter the market © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Oligopolistic Firms A duopoly is a market with two firms. A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service. The arrangement under which two or more firms act as one, coordinating their pricing decisions, is also known as price fixing. The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Cartel Pricing In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket. The firms also split the profit. Each firm earns $7,500 = [(400-300) x 150]/2. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Duopoly Pricing When two firms compete against one another, they end up serving 100 passengers each, at a price of $350. Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Duopoly Versus Cartel Pricing The duopoly produces more output and charges a lower price than the cartel. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Game Tree A game tree provides a visual representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Cartel and Duopoly Outcomes in the Game Tree Profits ($000) Jill Jack $7.5 $7.5 Jack: High or Low price? High High price Jill Jack $1 $1 Jill: High or Low price? Low Jill Jack $8.5 $1 High Jack: High or Low price? Low price Jill Jack $5 $5 Low © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Cartel and Duopoly Outcomes in the Game Tree Profits ($000) Jill Jack $7.5 $7.5 Jack: High or Low price? High High price Cartel Outcome Jill: High or Low price? Duopoly Outcome Jack: High or Low price? Low price Jill Jack $5 $5 Low © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Outcome of the Price-Fixing Game Jack captures large share of market Jill captures large share of market Jill: Low Price Jack: High Price Price $350 $400 Quantity 170 10 Average cost $300 Profit per passenger $50 $100 Total profit $8,500 $1,000 © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Dominant Strategy Irrational for Jack to choose high price Jack chooses the low price when Jill chooses the high price. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Dominant Strategy Jack chooses the low price when Jill chooses the low price. Irrational for Jack to choose high price Dominant Strategy: Jack chooses the low price regardless of Jill’s choice. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Duopolists’ Dilemma Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price? Irrational for Jill to be underpriced. Jill will choose the low price, and the trajectory of the game is X to Z to 4. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Duopolists’ Dilemma The duopolists’ dilemma is that although both firms would be better off if they chose the high price, each firm chooses the low price. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Retaliation for Underpricing Schemes to punish Jack if he underprices: Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack. Tit-for-tat: Jill chooses whatever price Jack chose the preceding month. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Tit-for-Tat Response to Underpricing Jill chooses whatever price Jack chose the preceding month. After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Avoiding the Dilemma: Guaranteed Price Matching To eliminate the incentive for underpricing, one firm can guarantee that it will match its competitor’s price. How will Jack respond to Jill’s price-matching policy? Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits. Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Guaranteed Price Matching Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel. Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price! © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Entry Deterrence and Limit Pricing An insecure monopolist fears the entry of a second firm, and could react in one of two ways: A passive strategy: allow the second firm to enter the market An entry-deterrence strategy: try to prevent the firm from entering The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Passive Strategy If Mona adopts a passive strategy, it will allow Doug to enter the market, and each will earn the duopoly profits of $5,000 each (Duopoly Outcome). © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Entry-deterrence Strategy Mona can prevent Doug from entering by incurring a large investment and committing herself to serving a large number of customers at a low price. 400 m: Secure Monopoly Profit = $15,000 370 350 z LRAC 300 Market Demand Passengers per day 150 180 200 250 © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Entry-deterrence Strategy Due to economies of scale, suppose that that the minimum entry quantity is 70 passengers a day, the entry deterring quantity for Mona will be 180 passengers (250-70). If Doug enters serving 70 passengers and Mona serves 180, the price drops to $300, making entry unprofitable to Doug. 400 m: Secure Monopoly 370 i: Insecure Monopoly Deterrence Profit = $12,600 350 d: Duopoly z LRAC 300 Once Mona commits to large load of passengers, the most profitable load will be 180 passengers Market Demand Passengers per day 150 180 200 250 © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

The Entry-deterrence Strategy Mona can prevent Doug from entering by incurring a large investment and committing herself to serving a large number of customers at a low price. What is more profitable, entry deterrence or the passive duopoly outcome? 400 m: Secure Monopoly 370 i: Insecure Monopoly Deterrence Profit = $12,600 350 z LRAC 300 Market Demand Passengers per day 150 180 200 250 © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Antitrust Policy The purpose of antitrust policy is to promote competition among firms. Competition leads to lower prices and better products. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Antitrust Policy Under federal antitrust rules, the government can: Break up of monopolies into several smaller companies. Prevent corporate mergers that would reduce competition. Regulate business practices. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Brief History of Antitrust Legislation 1890 Sherman Act: made it illegal to monopolize a market or to engage in practices that resulted in a restraint of trade. 1914 Clayton Act: outlawed specific practices that discourage competition, including tying contracts, price discrimination for the purpose of reducing competition, and stock-purchase mergers that would substantially reduce competition. Federal Trade Commission: established to enforce antitrust laws. 1936 Robinson-Patman Act: prohibited selling products at “unreasonably low prices” with the intent of reducing competition. 1950 Celler-Kefauver Act: outlawed asset-purchase mergers that would substantially reduce competition. 1980 Hart-Scott-Rodino Act: extended antitrust legislation to proprietorships and partnerships. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Breaking Up Monopolies A trust is an arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees. Firms in a trust act as a single firm. The label “antitrust” comes from early cases involving the breakup of trusts. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Blocking Mergers A merger occurs when two firms combine their operations. Because a merger decreases the number of firms in a market, it is likely to lead to higher prices. A possible benefit from a merger is that the new firm could combine production, marketing, or administrative operations, and thus produce its products at a lower average cost. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Blocking Mergers New guidelines developed by the Justice Department and the Federal Trade Commission allow companies involved in a proposed merger to present evidence that the merger would reduce costs and lead to lower prices, better products, or better service. The analysis of proposed mergers today focuses less on counting the number of firms in a market, and more on how a merger would affect price. © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

Regulating Business Practices The government may intervene when specific business practices increase market concentration. Among those practices are: Price fixing Tying, or forcing consumers of one product to purchase another Price discrimination that reduces competition © 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin