Monopolistic Competition and Oligopoly Chapter 11

Monopolistic Competition Large number of sellers –Small market shares –No collusion –Independent action Differentiated Products –Product attributes –Service –Location –Brand names and packaging –Some control over price 11-2

Easy entry and exit Need for advertising –Nonprice Competition Which industries? –Degree of concentration –Four-firm concentration ratio –Herfindahl index Monopolistic Competition 11-3

Firm’s demand curve –Highly elastic, differentiating it from monopoly and pure competition Short run profit or loss –Produce where MR=MC Monopolistic Competition 11-4

Short-Run Profits Quantity Price and Costs MR = MC MC MR D1D1 ATC Economic Profit Q1Q1 A1A1 P1P1 0 Monopolistic Competition 11-5

Short-Run Losses Quantity Price and Costs MR = MC MC MR D2D2 ATC Loss Q2Q2 A2A2 P2P2 0 Monopolistic Competition 11-6

Long run normal profit –Entry and exit –As firms enter, the demand faced by individual firm falls until it is tangential to ATC Monopolistic Competition 11-7

Long-Run Equilibrium Quantity Price and Costs MR = MC MC MR D3D3 ATC Q3Q3 P 3 = A 3 0 Monopolistic Competition 11-8

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 Monopolistic Competition 11-9

Inefficient –Neither allocative nor productive efficiency achieved Product variety –Can maintain profits by maintaining product differentiation Monopolistic Competition 11-10

Oligopoly A few large producers Homogeneous or differentiated products Control over price –Mutual interdependence –Strategic behavior Entry barriers Mergers 11-11

Oligopoly Four-firm concentration ratio –Needs to be more than 40% Shortcomings: 1.Localized markets 2.Inter-industry competition –substitutes 11-12

Oligopoly 3. World trade –Import Competition 4. Dominant firms –A firm may have close to 100% share and operate as a monopoly while others operate as oligopoly Solution: Herfindahl index 11-13

Game Theory 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 11-14

Game Theory 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 the worst combined outcome Eventually low outcomes make firms return to higher prices 11-15

Game Theory Mutual interdependence –Pricing policy Collusion –Enhances profit by agreeing to a high price policy Incentive to cheat Prisoner’s dilemma –Fearful that other will cheat, both firms will probably cheat 11-16

Three Oligopoly Models 1. Kinked-demand curve 2. Collusive pricing 3. Price leadership Why three models? –Diversity of oligopolies –Complications of interdependence 11-17

Kinked-Demand Curve Noncollusive oligopoly What does D look like? –Will depend on how rivals react to a price change 1.Match price changes –Steep D and MR because if P cut, sales will increase modestly as other firms also cut P 11-18

Kinked-Demand Curve 2. Ignore price changes –Flatter D and MR –P cut will ensure significant gain in sales –As P rises, all sales will not be lost due to product differentiation 11-19

Price Quantity 0 MR 2 D2D2 D1D1 MR 1 g Competitor and rivals strategize versus each other Kinked-Demand Curve

Combined strategy Which assumption should the firm make about its rivals? –Depends on direction of price change Match price decline below P 0 as they act to prevent price cutter from taking their customers Ignore price increases above P 0

Price Price and Costs Quantity 0 0 P0P0 MR 2 D2D2 D1D1 MR 1 e f g Rivals Ignore Price Increase Rivals Match Price Decrease Q0Q0 Competitor and rivals strategize versus each other Consumers effectively have 2 partial demand curves and each part has its own marginal revenue part MR 2 D2D2 D1D1 MR 1 Q0Q0 MC 1 MC 2 P0P0 Resulting in a kinked-demand curve to the consumer – price and output are optimized at the kink e f g Kinked-Demand Curve 11-22

Price inflexibility On the D side, any change in P will be for the worse If it raises P, many customers will desert it If it lowers P, sales will only improve modestly as rivals also lower P On the cost side, all positions of MC between MC 1 and MC 2 will result in same decision

Criticisms of the model: 1.Explains inflexibility not how does price get to P 0 2.Prices are not that rigid when macroeconomy is unstable resulting in price wars Kinked-Demand Curve 11-24

Price and Costs Quantity Cartels and Other Collusion Price and output –Joint profit maximization D MR=MC ATC MC MR P0P0 A0A0 Q0Q0 Economic Profit Effectively Sharing The Monopoly Profit 11-25

Cartels and Other Collusion Covert collusion –Tacit understandings Obstacles to collusion –Demand and cost differences –Number of firms –Cheating –Recession –Potential entry –Legal obstacles: antitrust law 11-26

Price Leadership Model One dominant firm sets price Infrequent price changes –Risk that rivals might not follow Communications Limit pricing –May lower prices to discourage entry Breakdowns in price leadership: –Price wars 11-27

Oligopoly and Efficiency Not productively efficient Not allocatively efficient Tendency to share the monopoly profit Qualifications –Increased foreign competition –Limit pricing –Technological advance 11-28