Chapter 7 In Between the Extremes: Imperfect Competition

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-2 Learning Objectives List the five conditions that must be met for the existence of monopolistic competition. Describe the methods that firms can use to signal to consumers that their products are of high quality. List the four characteristics of oligopoly. Explain opportunistic behavior and why most firms (and consumers) do not engage in it consistently. Describe one form of tacit collusion among firms in an oligopolistic industry.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-3 Monopolistic Competition The most common form of market structure in the United States is monopolistic competition, in which a large number of sellers offer similar, but slightly differentiated products. Examples of monopolistically competitive industries are brand-name items such as toothpaste, cosmetics, and designer clothes.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-4 Characteristics of Monopolistic Competition 1.Numerous Sellers 2.Relatively Easy Entry: Entry into the market is easier than in an industry with just a few dominant firms. 3.Differentiated Products: Each supplier sells a slightly different product to attract customers.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-5 Characteristics of Monopolistic Competition (cont.) 4.Non-price Competition: Businesses compete, at least in part, by using product differentiation and by advertising. 5.Some Control Over Price: By building a loyal customer base through product differentiation, each firm has some control over the price it charges.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-6 Comparing Demand Curves The demand curve facing a perfect competitor is perfectly elastic. The demand curve facing a monopolist is the entire market demand curve. The demand curve facing a firm in a monopolistically competitive industry is somewhere in between the two extremes.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-7 Figure 7-1: Comparing Demand Curves

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-8 The Long Run for the Monopolistically Competitive Firm In the long run, because so many firms produce substitutes for the product in question, any economic profits will disappear through competition. In the long run, the price that firm can charge will just equal its average total cost. It will be making a normal rate of return and zero economic profits.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-9 Figure 7-2(a): Comparison of the Perfect Competitor with the Monopolistic Competitor

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-10 Figure 7-2(b): Comparison of the Perfect Competitor with the Monopolistic Competitor (cont.)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-11 Monopolistic Competition May Lead to Waste It has been argued that monopolistic competition involves waste because minimum average total costs are not achieved and price exceeds marginal cost. There are too many firms, each with excess capacity, producing too little output. Therefore, according to critics, society’s resources are being wasted.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-12 Sale Promotion and Advertising Advertising is used to increase demand and to differentiate one’s product. How much advertising should be undertaken? It should be carried to the point at which the additional revenue resulting from one more dollar of advertising just equals one dollar.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-13 Oligopoly Is an industry structure consisting of a small number of interdependent sellers. Each firm in the industry knows that other firms will react to its changes in prices, quantities, and qualities. An oligopoly market structure can exist for either a homogeneous or a differentiated product.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-14 Characteristics of Oligopoly 1.Few Sellers: Several large firms are responsible for 60 to 80 percent of the market. 2.Identical or Slightly Different Products: The goods and services provided by oligopolists are very similar.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-15 Characteristics of Oligopoly (cont.) 3.Non-price Competition: Advertising emphasizes minor differences and attempts to build customer loyalty. 4.Interdependence: Any change in competitive practices on the part of one firm will cause a reaction on the part of other firms in the oligopolistic industry.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-16 Industry Concentration There is no one way to determine whether an industry is oligopolistic. Economists have chosen industry concentration ratio statistics in order to talk about oligopolies. Industry concentration ratio— measures the percentage of total sales accounted for by the top four firms.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-17 Figure 7-4: Selected Potential Oligopolies

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-18 Are Oligopolies Harmful to Consumers? To the extent that oligopolists have market power, they lead to resource misallocations. Oligopolists charge prices that exceed marginal cost. However, if an oligopoly occurs because of economies of scale, consumers might actually end up paying lower prices than if the industry were composed of numerous smaller firms.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-19 Duopoly It is possible to have only two firms in one market. This is called a duopoly. There are very few duopoly markets in the world today. When they exist, it is relatively easy for the two members of the duopoly to collude on prices and perhaps market share.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-20 How to Make Higher Profits Through Price Discrimination An imperfect competitor (including a monopolist) may be able to charge different people different prices. When there is not a cost difference, this strategy is called price discrimination. A firm will engage in price discrimination whenever feasible to increase profits.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-21 How to Make Higher Profits Through Price Discrimination (cont.) Profitable price discrimination involves charging a higher price to customers who have a relatively low price elasticity of demand. At the same time, customers with high price elasticity of demand are charged lower prices.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-22 Interdependence and Strategic Dependence All markets and all firms are, in a sense, interdependent. Only when a few large firms account for a majority of sales in an industry does the question of strategic dependence of one on the others’ actions arise.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-23 Interdependence and Strategic Dependence (cont.) The firms must, and do, recognize that they are interdependent. In an oligopolistic market structure, the managers of firms are like generals in a war: They must attempt to predict the reaction of rival firms. This is a strategic game.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-24 Opportunistic Behavior and Cheating Oligopolists prefer higher to lower profits, so you might think they would want to “cheat”—they might try to fool their rivals. In another context, an oligopolist could advertise a product with lots of features at a specific price, knowing that some of those features do not exist. This is called opportunistic behavior.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-25 Results of Opportunistic Behavior If all of us engaged in opportunistic behavior all of the time, the world would be a mess. The reality is that this is not the world in which most of us live. Why not? Because most of engage in repeat transactions. Sellers would like us to keep coming back to their stores. Each of us would like to keep our jobs, get promotions, etc.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-26 Price Leadership and Price Wars Most oligopolists do not explicitly engage in collusion—they don’t have meetings to get together to split up the market or fix prices. However, oligopolists can figure out ways to implicitly determine prices together. This is called tacit collusion. One example of this is the model of price leadership.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-27 Price Leadership In the model of price leadership, the basic assumption is that there is one dominant firm. It is usually the biggest firm. The dominant firm sets the price that it thinks is profit maximizing. Then it allows other firms to sell all they can at that price. The dominant firm sells the remainder.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-28 Price Wars Price leadership may not always work. If the price leader ends up much better off than the firms that follow, the followers may choose not to set prices according to those set by that dominant firm. The result may be a price war—the dominant firm lowers its prices a little bit, but the other firms lower theirs even more.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.7-29 Key Terms and Concepts collusion duopoly industry concentration ratio monopolistic competition oligopoly opportunistic behavior price discrimination price leadership price war strategic dependence tacit collusion