Monopolistic Competition and Oligopoly 14 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Market Models LO1 Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic CompetitionOligopolyMonopoly Number of firmsA very large number ManyFewOne Type of productStandardizedDifferentiatedStandardized or differentiated Unique; no close subs. Control over price NoneSome, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easySignificant obstacles Blocked Nonprice competition NoneConsiderable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising ExamplesAgricultureRetail trade, dresses, shoes Steel, auto, farm implements Local utilities

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

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

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

The Short Run: Profit or Loss LO2 Quantity Price and Costs MR = MC MC MR D1D1 ATC Economic Profit Q1Q1 A1A1 P1P1 0

The Short Run: Profit or Loss LO2 Quantity Price and Costs MC MR D2D2 ATC Loss Q2Q2 A2A2 P2P2 0 MR = MC

The Long Run: Only a Normal Profit LO2 Quantity Price and Costs MC MR D3D3 ATC Q3Q3 P 3 = A 3 0 MR = MC

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

Monopolistic Competition: Efficiency LO2 Quantity Price and Costs MR = MC MC MR D3D3 ATC Q3Q3 0 P 3 = A 3 P=MC=Min ATC for pure competition (recall) P4P4 Q4Q4 Price is Lower Excess Capacity at Minimum ATC Monopolistic competition is not efficient

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

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

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

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

Game Theory Overview LO4 RareAir’s Price Strategy Uptown’s Price Strategy AB CD $12 $15 $6 $8 $6 $15 High Low 2 competitors 2 price strategies Each strategy has a payoff matrix Greatest combined profit Independent actions stimulate a response

Game Theory Overview LO4 RareAir’s Price Strategy Uptown’s Price Strategy AB CD $12 $15 $6 $8 $6 $15 High Low Independently lowered prices in expectation of greater profit leads to worst combined outcome Eventually low outcomes make firms return to higher prices.

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

Kinked-Demand Curve LO5 P0P0 MR 2 D2D2 D1D1 MR 1 e f g Rivals Ignore Price Increase Rivals Match Price Decrease Q0Q0 MR 2 D2D2 D1D1 MR 1 Q0Q0 MC 1 MC 2 P0P0 e f g Price Quantity 0 0

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

Cartels and Other Collusion LO6 Price and Costs Quantity D MR=MC ATC MC MR P0P0 A0A0 Q0Q0 Economic Profit

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

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

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

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

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

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