Monopolistic Competition and Oligopoly Chapter 11 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Characteristics of monopolistic competition Normal profit in the long run Characteristics of oligopoly Game theory The oligopolist’s kinked demand curve Collusion among oligopolists The effects of advertising 11-2

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 11-3

Easy entry and exit Need for advertising –Nonprice Competition Which industries? –Degree of concentration –Four-firm concentration ratio –Herfindahl index Monopolistic Competition 11-4

Firm’s demand curve –Highly elastic Short run profit or loss –Produce where MR=MC Long run normal profit –Entry and exit Inefficient Product variety Monopolistic Competition 11-5

Short-Run Profits Quantity Price and Costs MR = MC MC MR D1D1 ATC Economic Profit Q1Q1 A1A1 P1P1 0 Monopolistic Competition 11-6

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

Oligopoly A few large producers Homogeneous or differentiated products Control over price –Mutual interdependence –Strategic behavior Entry barriers Mergers 11-10

Oligopoly Four-firm concentration ratio –Needs to be more than 40% –Half of U.S. manufacturing Localized markets Interindustry competition World trade –Import Competition Herfindahl index 11-11

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 11-12

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 11-13

Game Theory Mutual interdependence –Pricing policy Collusion –Enhances profit Incentive to cheat Prisoner’s dilemma 11-14

Three Oligopoly Models Kinked-demand curve Collusive pricing Price leadership Why three models? –Diversity of oligopolies –Complications of interdependence 11-15

Kinked-Demand Curve Noncollusive oligopoly Strategies –Match price changes –Ignore price changes Combined strategy Price inflexibility The kinked-demand curve 11-16

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 11-17

Criticisms of the model –How does price get to P 0 –Explains inflexibility, not price –Prices are not that rigid –Price wars Kinked-Demand Curve 11-18

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 11-19

The OPEC Cartel Source: A. T. Kearney, Foreign Policy Iran3,843,000 Kuwait2,538,000 Venezuela2,368,000 Iraq2,297,000 Nigeria2,183,000 UAE2,117,000 Angola1,804,000 Libya1,737,000 Algeria1,417,000 Qatar 848,000 Indonesia 843,000 Ecuador 530,000 Daily oil production (barrels), November 2008 Saudi Arabia8,904,

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 11-21

Price Leadership Model Leadership tactics Infrequent price changes Communications Limit pricing Breakdowns in price leadership: –Price wars 11-22

Advertising Prevalent in monopolistic competition and oligopoly Capture market share Better than a price cut Information for consumers Manipulation 11-23

Oligopoly and Advertising The Largest U.S. Advertisers, 2006 Company Advertising Spending Millions of $ Proctor and Gamble AT&T General Motors Time Warner Verizon Ford Motor GlaxoSmithKline Walt Disney Johnson & Johnson Unilever $ Source: Advertising Age 11-24

World’s Top 10 Brand Names, 2007 Source: Interbrand Coca-Cola Microsoft IBM General Electric Nokia Toyota Intel McDonald’s Disney Mercedes-Benz Oligopoly and Advertising 11-25

Oligopoly and Efficiency Not productively efficient Not allocatively efficient Tendency to share the monopoly profit Qualifications –Increased foreign competition –Limit pricing –Technological advance 11-26

Oligopoly in the Beer Industry From hundreds to a few firms Demand side changes –Taste shifts to lighter beers –Shift from tap to cans or bottles Supply side changes –Technological change increased minimum efficient scale –National brands enjoy cost advantages Consolidation into oligopoly 11-27

Key Terms monopolistic competition product differentiation nonprice competition four-firm concentration ratio Herfindahl index excess capacity oligopoly homogeneous oligopoly differentiated oligopoly strategic behavior mutual interdependence interindustry competition import competition game theory collusion kinked-demand curve price war cartel price leadership 11-28

Next Chapter Preview… Technology, R&D, And Efficiency 11-29