Monopolistic Competition Chapter 25: Monopolistic Competition And Oligopoly

Monopolistic Competition Relatively Large Number of Sellers Small Market Shares No Collusion (collusion needs few producers) Independent Action (each firm sets its price without considering the possibility of rival reactions) 2) Differentiated Products Product Attributes, Service, Location (accessibility), Brand Names and Packaging, Some Control Over Price 3) Role of Advertising To differentiate their products (Non-price competition) 4) Easy Entry and Exit (relative to monopoly) Relatively small, don’t heavily rely on economies of scale.

Price and Output in Monopolistic Competition The firm’s demand curve The firm faces a highly, but not perfectly, elastic demand curve. Reasons: The seller has many competitors. Close substitutes to its product. Elasticity of demand for the producer depends on: The number of rivals (+) The degree of product differentiation (-)

Optimal Output: The Short Run Rule: MC = MR There are tow possibilities: Profit Losses Optimal Output: The long run: Only a Normal Profit (i.e. economic profit = zero)

Profits: Firms enter. In the short run economic profits attract new entrants. Demand facing the firm shifts to the left Profits decline Demand curve is tangent to ATC No further incentive for entry

Losses: Firms leave In the short run economic losses force some firms to leave Demand facing the firm shifts to the right losses disappear Demand curve is tangent to ATC No further incentive to exit

PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION Economic Profits MC ATC P1 A1 Price and Costs Economic Profits D New competition drives down the price level – leading to economic losses in the short run MR Q1 Quantity

PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC ATC A2 P2 Economic Losses Price and Costs D MR With economic losses, firms will exit the market – Stability occurs when economic profits are zero Q2 Quantity

MONOPOLISTIC COMPETITION PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION MC Long-Run Equilibrium Normal Profit Only ATC P3 = A3 Price and Costs D MR Q3 Quantity

MONOPOLISTIC COMPETITION AND EFFICIENCY In Pure Competition only Economic Efficiency: P = MC = Minimum ATC Productive Efficiency: P = ATC Goods are produced in the least costly way. Price is just efficient to cover total costs including a normal profit Allocative Efficiency: P = MC The right amount of output is being produced. The right amount of the society’s scarce resources is being devoted to this specific use.

MONOPOLISTIC COMPETITION AND EFFICIENCY In Monopolistic Competition Not Productively Efficient: price  Minimum ATC P > Minimum ATC Not Allocatively Efficient: Price  MC

Monopolistic competition results in underallocation of the society’s resources. Monopolistic competition is not allocatively efficient. Consumers pay a higher than the competitive price and obtain a less than optimal output. Monopolistic competition producers must charge a higher than the competitive price in the long run in order to achieve a normal profit. The price-marginal cost gap experienced by each firm creates an industrywide efficiency loss.

Excess Capacity Optimal capacity is to produce at minimum ATC. The gap between minimum ATC and the profit maximizing price identifies excess capacity: Plant and equipment are underused because production is at less than minimum ATC.

MONOPOLISTIC COMPETITION AND EFFICIENCY MC Long-Run Equilibrium Price is Not = Minmum ATC ATC P3 = A3 Price  MC Price and Costs D MR Excess capacity Q3 Q4 Quantity

Oligopoly Oligopoly exists where a few large firms producing a homogeneous or differentiated product dominate a market. There are few enough firms in the industry that firms are mutually interdependent—each must consider its rivals’ reactions in response to its decisions about prices, output, and advertising. Some oligopolistic industries produce standardized products (steel, zinc, copper, cement), whereas others produce differentiated products (automobiles, detergents, greeting cards).

1. Economies of scale may exist due to technology and market share. Barriers to entry 1. Economies of scale may exist due to technology and market share. 2. The capital investment requirement may be very large. 3. Other barriers to entry may exist, such as patents, control of raw materials, preemptive and retaliatory pricing, substantial advertising budgets, and traditional brand loyalty.

Cartels and collusion agreements constitute another oligopoly model 1. Collusion reduces uncertainty, increases profits, and may prohibit the entry of new rivals. 2. A cartel may reduce the chance of a price war breaking out particularly during a general business recession. 3. A cartel is a group of producers that creates a formal written agreement specifying how much each member will produce and charge. 4. Cartels are illegal in the U.S., thus any collusion that exists is covert and secret.

There are many obstacles to collusion: a. Differing demand and cost conditions among firms in the industry; b. A large number of firms in the industry; c. The incentive to cheat; d. Recession and declining demand (increasing ATC); e. The attraction of potential entry of new firms if prices are too high; and f. Antitrust laws that prohibit collusion.

Oligopoly and Advertising A. Product development and advertising campaigns are more difficult to combat and match than lower prices. B. Oligopolists have substantial financial resources with which to support advertising and product development. C. By providing information about competing goods, advertising diminishes monopoly power, resulting in greater economic efficiency. D. By facilitating the introduction of new products, advertising speeds up technological progress. E. If advertising is successful in boosting demand, increased output may reduce long run average total cost, enabling firms to enjoy economies of scale.

Oligopoly and Efficiency The economic efficiency of an oligopolistic industry is hard to evaluate. Allocative and productive efficiency are not realized because price will exceed marginal cost and, therefore, output will be less than minimum average-cost output level. Informal collusion among oligopolists may lead to price and output decisions that are similar to that of a pure monopolist while appearing to involve some competition.

Economic inefficiency may be lessened because: 1. Foreign competition has made many oligopolistic industries much more competitive when viewed on a global scale. 2. Oligopolistic firms may keep prices lower in the short run to deter entry of new firms. 3. Over time, oligopolistic industries may foster more rapid product development and greater improvement of production techniques than would be possible if they were purely competitive.