Monopolistic Competition and Oligopoly

Monopolistic Competition Edward Chamberlin & Joan Robinson (1933) A monopolistically competitive industry has the following characteristics: A large number of firms No barriers to entry Product differentiation

Monopolistic Competition Monopolistic competition is a common form of industry (market) structure in the United States, characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease.

Product Differentiation and Advertising Product differentiation helps to ensure high quality and efficient production. Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place. Nothing more than waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.

Product Differentiation and Advertising Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. People exist to satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.

Monopolistic Competition in the Short Run In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC. This firm is earning positive profits in the short-run.

Monopolistic Competition in the Short-Run Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.

Monopolistic Competition in the Long-Run The firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry. As new firms enter a monopolistically competitive industry in search of profits, the demand curves of profit-making existing firms begin to shift to the left, pushing marginal revenue with them as consumers switch to the new close substitutes. This process continues until profits are eliminated, which occurs for a firm when its demand curve is just tangent to its average cost curve.

Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product.

Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity.

Oligopoly An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.

Oligopoly Models The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly (Interdependence) So, firms are acting strategically.

Measuring Market Shares Concentration Ratio (CR) = Herfindahl-Hirschman Index (HHI) = Merger Standard Post-Merger HHI below 1000 Post-merger HHI between 1000 and 1800 Post-Merger HHI above 1800

The Collusion Model A group of firms that gets together and makes price and output decisions jointly is called a cartel. Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit.

The Cournot Model The Cournot model is a model of a two-firm industry (duopoly) in which a series of output-adjustment decisions leads to a final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly.

The Kinked Demand Curve Model The kinked demand model is a model of oligopoly in which the demand curve facing each individual firm has a “kink” in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price.

The Kinked Demand Curve Model Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firm’s quantity demanded (demand is elastic). Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).

The Price-Leadership Model Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.

The Price-Leadership Model Assumptions of the price-leadership model: The industry is made up of one large firm and a number of smaller, competitive firms; The dominant firm maximizes profit subject to the constraint of market demand and subject to the behavior of the smaller firms; The dominant firm allows the smaller firms to sell all they want at the price the leader has set.

The Price-Leadership Model Outcome of the price-leadership model: The quantity demanded in the industry is split between the dominant firm and the group of smaller firms. This division of output is determined by the amount of market power that the dominant firm has. The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

Predatory Pricing The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing. Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.

Game Theory Game theory analyzes economic behavior as a complex series of strategic moves and reactive countermoves among rival firms. Von Neumann and Morgenstern “Theory of Games and Economic Behaviors” (1944) Game theory aims to help us understand situations in which decision-makers interact. Game is “a competitive activity in which players contend with each other according to a set of rules.” But, the main focus is to illustrate economic, political, and even biological phenomena.

Basic Elements of a Game Players: Identity of those playing the game N ≥ 2 Rules: the timing of all players’ move; the actions available to a player at each of her moves; the information that a player has at each move. Strategies: Players employ to attain their objectives in the game. Payoffs: It represents the players’ preferences over the outcomes of the game.

Equilibrium Concepts We want to focus on how to solve games. An equilibrium concept is a solution to a game. By this we mean that equilibrium concept identifies the strategies that players are actually likely to play. Solving for equilibrium is similar to making a prediction about how the game will be played. Dominant Strategy: A strategy that is the best for a player, no matter what strategies other players use. Nash Equilibrium: A situation where each player chooses the best strategy, given the strategies chose by other players (A Beautiful Mind).

Fundamental Assumptions Rationality: Players are interested in maximizing their payoffs. Common Knowledge: All players know the structure of the game and that their opponents are rational, that all players know that all players know the structure of the game and that their opponents are rational, and so on.

Price Competition between Two Stores Target Wal-Mart $200 $150 Wal-Mart: $10,000 Target: $10,000 Wal-Mart: $5,000 Target: $15,000 Wal-Mart: $15,000 Target: $5,000 Wal-Mart: $7,500 Target: $7,500 The strategy that Target (Wal-Mart) will actually choose depends on the information available concerning Wal-Mart’s (Target’s) likely strategy.

Firm Behavior and Prisoners’ Dilemma Cooperative Equilibrium: An equilibrium in a game in which players cooperate to increase their mutual payoffs (Collusion, game of chicken). Non-cooperative Equilibrium: An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoners’ Dilemma: A game where pursuing dominant strategies results in non-cooperation that leaves everyone worse off.

Payoff Matrix for Advertising Game PEPSI COCA-COLA Do not advertise Advertise Coke earns $750 mil Pepsi earns $750 mil Coke earns $400 mil Pepsi earns $900 mil Coke earns $900 mil Pepsi earns $400 mil Coke earns $500 mil Pepsi earns $500 mil Coca-Cola and Pepsi would be better more profitable if they both refrained from advertising, thereby saving the enormous expense of TV and radio commercials and newspaper and magazine ads. Each firm’s dominant strategy is to advertise.

The Prisoners’ Dilemma Bonnie Clyde Do not confess Confess Clyde: 1 year Bonnie: 1 year Clyde: 7 years Bonnie: free Clyde: free Bonnie: 7 years Clyde: 5 years Bonnie: 5 years Both Bonnie and Clyde have dominant strategies: to confess. Both will confess, even though they would be better off if they both kept their mouths shut.

Can Firms Escape the Prisoners’ Dilemma? Implicit Collusion or Retaliation in Repeated Game. Enforcement Mechanism (matching price) Target Wal-Mart $200 $150 Wal-Mart: $10,000 Target: $10,000 Wal-Mart: $7,500 Target: $7,500

Case Studies American Airlines vs. Northwest Airlines (2002) OPEC (Cartel)

Payoff Matrix for Left/Right-Top/Bottom Strategies Original Game D’s STRATEGY C’s STRATEGY Left Right Top C wins $100 D wins no $ C wins $100 D wins $100 Bottom C loses $100 D wins no $ C wins $200 D wins $100 Because D’s behavior is predictable (he will play the right-hand strategy), C will play bottom. When all players are playing their best strategy given what their competitors are doing, the result is called Nash equilibrium.

Payoff Matrix for Left/Right-Top/Bottom Strategies New Game D’s STRATEGY C’s STRATEGY Left Right Top C wins $100 D wins no $ C wins $100 D wins $100 Bottom C loses $10,000 D wins no $ C wins $200 D wins $100 C is likely to play top and guarantee herself a $100 profit instead of losing $10,000 to win $200, even if there is just a small chance of D’s choosing left. When uncertainty and risk are introduced, the game changes. A maximin strategy is a strategy chosen to maximize the minimum gain that can be earned.

Contestable Markets A market is perfectly contestable if entry to it and exit from it are costless. In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.

Oligopoly is Consistent with a Variety of Behaviors The only necessary condition of oligopoly is that firms are large enough to have some control over price. Oligopolies are concentrated industries. At one extreme is the cartel, in essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms.

Oligopoly and Economic Performance Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons: They are likely to price above marginal cost. This means that there would be underproduction from society’s point of view. Strategic behavior can force firms into deadlocks that waste resources. Product differentiation and advertising may pose a real danger of waste and inefficiency.

The Role of Government The Celler-Kefauver Act of 1950 extended the government’s authority to ban vertical and conglomerate mergers. The Herfindahl-Hirschman Index (HHI) is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.

HERFINDAHL- HIRSCHMAN INDEX Regulation of Mergers Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms PERCENTAGE SHARE OF: HERFINDAHL- HIRSCHMAN INDEX FIRM 1 FIRM 2 FIRM 3 FIRM 4 Industry A 50 - 502 + 502 = 5,000 Industry B 80 10 802 + 102 + 102 = 6,600 Industry C 25 252 + 252 + 252 + 252 = 2,500 Industry D 40 20 402 + 202 + 202 + 202 = 2,800