2. Monopolistic Competition and Oligopoly 11 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Copyright 2008 The McGraw-Hill Companies 11-2 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Chapter Objectives Characteristics of Monopolistic Competition Why Monopolistic Competitors Earn Only a Normal Profit in the Long-Run Characteristics of Oligopoly How Game Theory Relates to Oligopoly Why the Demand Curve of the Oligopolist May Be Kinked Incentives and Obstacles to Collusion Among Oligopolists Potential Positive and Negative Effects of Advertising

4. Copyright 2008 The McGraw-Hill Companies 11-3 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS Monopolistic Competition: Relatively Large Number of Sellers Differentiated Products Easy Entry and Exit

5. 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 11-4

6. Low Concentration Industries (1) Industry (2) 4-Firm Concentration Ratio (3) Herfindahl Index (1) Industry (2) 4-Firm Concentration Ratio (3) Herfindahl Index Asphalt paving25207 Metal windows and doors14114 Plastic pipe24262Women’s dresses1384 Textile bags24263Ready mix concrete1163 Bolts, nuts, and rivets24205Wood trusses1050 Plastic bags23240Stone products1059 Quick printing22319Metal stamping831 Textile machinery20206Wood pallets724 Sawmills18117Sheet metal work625 Jewelry16117Signs519 Curtains and draperies16111Retail bakeries47 LO1 11-5

7. Copyright 2008 The McGraw-Hill Companies 11-6 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Monopolistic Competition Easy Entry and Exit Advertising –Nonprice Competition Monopolistically Competitive Industries O 11.1

8. Copyright 2008 The McGraw-Hill Companies 11-7 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Monopolistic Competition Characteristics –Small Market Shares –No Collusion –Independent Action Differentiated Products –Product Attributes –Service –Location –Brand Names and Packaging –Some Control Over Price O 11.1

9. Copyright 2008 The McGraw-Hill Companies 11-8 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price and Output Determination The Firm’s Demand Curve – highly elastic The Short Run: –Profit or Loss The Long Run: –Only a Normal Profit –Profits: Firms Enter –Losses: Firm’s Leave Complications –Product Variety In Monopolistic Competition G 11.1

10. Copyright 2008 The McGraw-Hill Companies 11-9 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price and Output Determination In Monopolistic Competition Short-Run Profits Quantity Price and Costs MR = MC MC MR D1D1 ATC Economic Profit Q1Q1 A1A1 P1P1 0

11. Copyright 2008 The McGraw-Hill Companies 11-10 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price and Output Determination In Monopolistic Competition Short-Run Losses Quantity Price and Costs MR = MC MC MR D2D2 ATC Loss Q2Q2 A2A2 P2P2 0

12. Copyright 2008 The McGraw-Hill Companies 11-11 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price and Output Determination In Monopolistic Competition Long-Run Equilibrium Quantity Price and Costs MR = MC MC MR D3D3 ATC Q3Q3 P3=A3P3=A3 0

13. Copyright 2008 The McGraw-Hill Companies 11-12 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Quantity Price and Costs MR = MC MC MR D3D3 ATC Q3Q3 P3=A3P3=A3 0 Monopolistic Competition and Efficiency Recall: P=MC=Minimum ATC P4P4 Q4Q4 Price is Higher Excess Capacity at Minimum ATC Monopolistic Competition is Not Efficient

14. 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 11-13

15. Copyright 2008 The McGraw-Hill Companies 11-14 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS Oligopoly: A Few Large Producers Homogeneous or Differentiated Products Control Over Price, But Mutual Interdependence Strategic Behavior Entry Barriers

16. Copyright 2008 The McGraw-Hill Companies 11-15 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Oligopoly Characteristics –A Few Large Producers –Homogeneous or Differentiated Products Homogeneous Oligopoly Differentiated Oligopoly –Control Over Price, But Mutual Interdependence Strategic Behavior –Entry Barriers –Mergers

17. Oligopolistic Industries Four-firm concentration ratio 40% or more to be oligopoly Shortcomings Localized markets Inter-industry competition World price Dominant firms LO3 11-16

18. High Concentration Industries (1) Industry (2) 4-Firm Concentration Ratio (3) Herfindahl Index (1) Industry (2) 4-Firm Concentration Ratio (3) Herfindahl Index Primary copper99NDPetrochemicals852662 Cane sugar refining99ND Small arms ammunition831901 Cigarettes95NDMotor vehicles812321 Household laundry equipment93ND Men’s slacks and jeans802515 Beer91NDAircraft81ND Electric light bulbs892582Breakfast cereals782521 Glass containers882582 Household vacuum cleaners782096 Turbines and generators88NDPhosphate fertilizers781853 Household refrigerators and freezers851986 Tires77 1807 Electronic computers76 2662 Primary aluminum85NDAlcohol distilleries711609 LO1 11-17

19. Copyright 2008 The McGraw-Hill Companies 11-18 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Measures of Concentration Concentration Ratio Localized Markets Interindustry Competition World Trade –Import Competition Herfindahl Index (%S 1 ) 2 + (%S 2 ) 2 + (%S 3 ) 2 + … + (%S n ) 2 W 11.1

20. Copyright 2008 The McGraw-Hill Companies 11-19 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Game Theory Game Theory Model to Analyze Behavior 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 O 11.2

21. Copyright 2008 The McGraw-Hill Companies 11-20 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Game Theory Game Theory Model to Analyze Behavior 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 O 11.2

22. Copyright 2008 The McGraw-Hill Companies 11-21 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Game Theory Role of Mutual Interdependence Collusive Tendencies –Collusion Incentive to Cheat G 11.2

23. Copyright 2008 The McGraw-Hill Companies 11-22 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Three Oligopoly Models Kinked Demand Curve Collusive Pricing Price Leadership Diversity of Oligopolies Complications of Interdependence

24. Copyright 2008 The McGraw-Hill Companies 11-23 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Kinked-Demand Curve Strategies –Match Price Changes –Ignore Price Changes A Combined Strategy Price Inflexibility The Kinked-Demand Curve Graphically… Noncollusive Oligopoly

25. Copyright 2008 The McGraw-Hill Companies 11-24 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price Price and Costs Quantity 0 0 Kinked-Demand Curve Noncollusive Oligopoly 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

26. Copyright 2008 The McGraw-Hill Companies 11-25 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Kinked-Demand Curve Noncollusive Oligopoly Criticisms of the Model –Doesn’t Explain How Price Gets to the Kink (P 0 ) –Oligopoly Prices Are Not As Rigid During Instability as the Model Indicates –Possibility of Price Wars

27. Copyright 2008 The McGraw-Hill Companies 11-26 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price and Costs Quantity Cartels and Other Collusion Price and Output –Collusion and Tendency Toward Joint-Profit Maximization D MR=MC ATC MC MR P0P0 A0A0 Q0Q0 Economic Profit Effectively Sharing The Monopoly Profit

28. Copyright 2008 The McGraw-Hill Companies 11-27 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Cartels and Other Collusion Overt Collusion –Cartels –The OPEC Cartel GLOBAL PERSPECTIVE The 11 OPEC Nations Daily Oil Production, May 2006 Saudi Arabia Iran Venezuela UAE Nigeria Kuwait Iraq Libya Indonesia Algeria Qatar Source: OPEC Country Barrels of Oil 9,099,000 4,110,000 3,233,000 2,444,000 2,306,000 2,247,000 1,903,000 1,500,000 1,451,000 894,000 726,000

29. 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 Arabia8,904,000 11-28

30. Global Perspective LO6 11-29

31. Copyright 2008 The McGraw-Hill Companies 11-30 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show 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

32. Copyright 2008 The McGraw-Hill Companies 11-31 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Price Leadership Model Leadership Tactics Infrequent Price Changes Communications Limit Pricing Breakdowns in Price Leadership: –Price Wars

33. Copyright 2008 The McGraw-Hill Companies 11-32 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Oligopoly and Advertising Advertising Prevalent in Monopolistic Competition and Oligopoly Positive Effects of Advertising Potential Negative Effects of Advertising

34. Oligopoly and Advertising Prevalent to compete with product development and advertising Less easily duplicated than a price change Financially able to advertise LO7 11-33

35. Positive Effects of Advertising Low-cost way of providing information to consumers Enhances competition Speeds up technological progress Can help firms obtain economies of scale LO7 11-34

36. Negative Effects of Advertising Can be manipulative Contains misleading claims that confuse consumers Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product. LO7 11-35

37. Oligopoly and Advertising LO7 The Largest U.S. Advertisers, 2008 Company Advertising Spending Millions of $ Procter & Gamble$4831 ($4.8 Billion !) Verizon$3700 AT&T$3073 General Motors$2901 Johnson & Johnson$2529 Unilever$2423 Walt Disney$2218 Time Warner$2208 General Electric$2019 Sears$1865 Source: Advertising Age http://www.adage.comhttp://www.adage.com 11-36

38. Global Perspective LO7 11-37

39. Oligopoly and Efficiency Oligopolies are inefficient Productively inefficient P > minATC Allocatively inefficient P > MC Qualifications Increased foreign competition Limit pricing Technological advance LO7 11-38

40. Copyright 2008 The McGraw-Hill Companies 11-39 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Oligopoly in the Beer Industry Once Hundreds of Firms Now a Very Small Group Demand Side Changes –Taste Shifts to Lighter Beers of Large Breweries –Shift From Tavern-Tap Consumption to Can or Bottles Supply Side Changes –Technology Increased Minimum Efficient Scale Creating a Barrier to Entry –National Brands Enjoy Cost Advantages Consolidation of Firms into Oligopoly

41. Copyright 2008 The McGraw-Hill Companies 11-40 Monopolistic Competition Monopolistic Competition and Efficiency Oligopoly Game Theory Three Oligopoly Models Kinked Demand Curve Cartels and Other Collusion Price Leadership Model Oligopoly and Efficiency Last Word Key Terms End Show Key Terms monopolistic competitionmonopolistic competition product differentiationproduct differentiation nonprice competitionnonprice competition excess capacity oligopoly homogeneous oligopolyhomogeneous oligopoly differentiated oligopolydifferentiated oligopoly strategic behavior mutual interdependencemutual interdependence concentration ratio interindustry competitioninterindustry competition import competition Herfindahl index game-theory model collusion kinked-demand curvekinked-demand curve price war cartel tacit understandingstacit understandings price leadership