1. Chapter 7 In Between the Extremes: Imperfect Competition

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-2 Monopolistic Competition In the 1920s and 1930s, economists were aware of industries that did not fit under perfect competition or pure monopoly. Theoretical and empirical research was instituted to develop some sort of middle ground.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-3 Monopolistic Competition (cont'd) Two separately developed models of monopolistic competition resulted. At Harvard, Edward Chamberlin published Theory of Monopolistic Competition in 1933. That same year, Joan Robinson of Cambridge published The Economics of Imperfect Competition.

4. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-4 Monopolistic Competition (cont'd) Monopolistic Competition  A market situation in which a large number of firms produce similar but not identical products  Entry into the industry is relatively easy.

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-5 Monopolistic Competition (cont'd) Characteristics of monopolistic competition 1. Significant number of sellers in a highly competitive market 2. Differentiated products 3. Sales promotion and advertising 4. Easy entry of new firms in the long run

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-6 Monopolistic Competition (cont'd) Implications of the large number of firms 1. Small market share 2. Lack of collusion 3. Independence

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-7 Monopolistic Competition (cont'd) Product Differentiation  The distinguishing of products by brand name, color, and other minor attributes

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-8 Monopolistic Competition (cont'd) Product differentiation and price  Firm has some control over the price it charges.  Unlike perfect competitor, it faces a downward sloping demand curve.  Consider the abundance of brand names for many products.  The more successful the firm is at differentiation, the more control it has over price.

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-9 Example: What Else Besides a Tart Taste do Cranberries Have to Offer? Making cranberries taste like other fruits and berries presented cranberry producers the problem of how to differentiate their product. Producers have promoted taste and the healthful properties of cranberry juice. Sellers emphasize the distinctive experience associated with eating the fruit and its curative properties.

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-10 Monopolistic Competition (cont'd) What do you think?  Would a perfect competitor have any incentive to advertise?  Why would a monopolistically competitive firm advertise?  Can advertising lead to efficiency?

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-11 Monopolistic Competition (cont'd) Sales promotion and advertising  Can increase demand for a firm  Can differentiate a firm’s product  Can result in increased profits

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-12 Monopolistic Competition (cont'd) Question  How much advertising should be undertaken? Answer  It should be carried to the point at which the additional revenue from one more dollar of advertising just equals that one dollar of additional cost.

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-13 Monopolistic Competition (cont'd) Ease of entry  For any current monopolistic competitor, potential competition is always lurking in the background.  The easier—that is, the less costly—entry is, the more a current competitor must worry about losing business.

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-14 Price and Output for the Monopolistic Competitor The individual firm’s demand and cost curves  Demand curve slopes downward  Profit maximized where MC intersects MR from below

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-15 Price and Output for the Monopolistic Competitor (cont'd) Short-run equilibrium  In the short run, it is possible for a monopolistic competitor to make economic profits—profits over and above the normal rate of return, or beyond what is necessary to keep that firm in the industry.  Losses in the short run are clearly also possible.

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-16 Price and Output for the Monopolistic Competitor (cont'd) The long run: zero economic profits  The rate of return will tend toward normal.  Economic profits will tend toward zero.  So many firms produce substitutes, any economic profits will disappear with competition.  Reduced to zero either through entry of new firms seeking to earn a higher rate or return, or by changes in product quality and advertising outlays by existing firms

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-17 Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (a) Price (P 1 ) > ATC Economic profit

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-18 Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (b) Price (P 1 ) < ATC Economic loss

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-19 Figure 26-1 Short-Run and Long-Run Equilibrium with Monopolistic Competition, Panel (c) Price (P 1 ) = ATC Normal rate of return

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-20 Comparing Perfect Competition with Monopolistic Competition Question  If both a monopolistic and perfect competitor make zero economic profit in the long run, how are they different? Answer  Demand curve for individual perfect competitor is perfectly elastic.

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-21 Figure 26-2 Comparison of the Perfect Competitor with the Monopolistic Competitor

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-22 Comparing Perfect Competition with Monopolistic Competition (cont'd) In perfect competition, the long-run equilibrium occurs where average total cost is minimized (this does not occur in monopolistic competition). Some have argued that this is not necessarily a waste of resources—as the added cost arises from product differentiation. Chamberlin argued it is rational for consumers to have a taste for differentiation; consumers willingly accept the resultant increased production costs in return for more choice and variety of output.

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-23 Brand Names and Advertising Because “differentness” has value for consumers, monopolistically competitive firms regard their brand names as valuable private (intellectual) property.  Use trademarks, words, symbols, and logos to distinguish their product brands from goods or services sold by other firms  A successful brand image contributes to a firm’s profitability.

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-24 Brand Names and Advertising (cont'd) Brand names and trademarks  A company’s value in the marketplace depends largely on current perceptions of future profitability.  We can see it in the market value of the world’s most valuable product brands.  Valuation depends on the market prices of shares of stock of a company times the number of shares traded.

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-25 Table 26-1 Values of the Top Ten Brands

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-26 Methods of Advertising Direct Marketing  Advertising targeted at specific consumers: e-mail, regular mail Mass Marketing  Advertising intended to reach as many customers as possible: radio, TV, newspaper Interactive Marketing  Permits consumer to follow up directly by searching for more information

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-27 Figure 26-3 Distribution of U.S. Advertising Expenses

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-28 Informational Versus Persuasive Advertising Search Good  A product with characteristics that enable an individual to evaluate the product’s quality in advance of a purchase Experience Good  A product that an individual must consume before the product’s quality can be established Credence Good  A product with qualities that consumers lack the expertise to assess without assistance

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-29 Brand Names and Advertising Search goods  Clothing and music evaluated prior to purchase Experience goods  Soft-drinks, restaurants, movies Credence goods  Health care, legal advice

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-30 Brand Names and Advertising (cont'd) Informational Advertising  Advertising that emphasizes transmitting knowledge about the features of a product Persuasive Advertising  Advertising that is intended to induce a consumer to purchase a particular product and discover a previously unknown taste for an item

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-31 Brand Names and Advertising (cont'd) Advertising as a signaling behavior  Individual companies can explicitly engage in signaling behavior.  They do so by establishing brand names or trademarks and promoting them.

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-32 Information Products and Monopolistic Competition Information products, such as computer operating systems, software, and digital music and videos, have a unique cost structure. Product development entails high fixed costs, but the marginal cost of producing a copy for one more customer is low.

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-33 Information Products and Monopolistic Competition (cont'd) Information Product  An item that is produced using information- intensive inputs at a relatively high fixed cost but distributed for sale at a relatively low marginal cost

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-34 Figure 26-4 Cost Curves for a Producer of an Information Product TFC is $250,000 Producer sells 5,000 copies AFC falls to $50 per copy What is AFC if producer sells 50,000 copies?

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-35 Information Products and Monopolistic Competition (cont'd) Short-Run Economies of Operation  A distinguishing characteristic of an information product arising from declining short-run average total cost as more units of the product are sold

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-36 Information Products and Monopolistic Competition (cont'd) Computer game manufacturers operate in a monopolistically competitive market. In monopolistic competition, marginal cost pricing results in losses for the firm, even though it creates efficiencies for the economy as a whole.

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26-37 Figure 26-5 The Infeasibility of Marginal Cost Pricing of an Information Product Firm cannot behave as if it were a perfect competitor setting price at $2.50

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-38 Oligopoly An important market structure that we have yet to discuss involves a situation in which a few large firms comprise an entire industry. They are not perfectly competitive, nor even monopolistically competitive, and because there are several of them a pure monopoly doesn’t exist.

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-39 Oligopoly (cont'd) Oligopoly  A market situation in which there are very few sellers  Each seller knows that the other sellers will react to its changes in prices and quantities.

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-40 Oligopoly (cont'd) Characteristics of oligopoly  Small number of firms  Interdependence  Strategic dependence

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-41 Oligopoly (cont'd) Strategic Dependence  A situation in which one firm’s actions with respect to price, quality, advertising, and related changes may be strategically countered by the reactions of one or more other firms in the industry  Such dependence can exist only when there are a limited number of firms in an industry.

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-42 Oligopoly (cont'd) Why oligopoly occurs  Economies of scale  Barriers to entry  Mergers  Vertical mergers  Horizontal mergers

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-43 Oligopoly (cont'd) Vertical Merger  The joining of a firm with another to which it sells an output or from which it buys an input Horizontal Merger  The joining of firms that are producing or selling a similar product

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-44 Oligopoly (cont'd) Measuring industry concentration  Concentration Ratio  The percentage of all sales contributed by the leading four or leading eight firms in an industry  Sometimes called the industry concentration ratio

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-45 Table 27-1 Computing the Four-Firm Concentration Ratio

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-46 Table 27-2 Four-Firm Domestic Concentration Ratios for Selected U.S. Industries

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-47 E-Commerce Example: Market Concentration in the Computer Printer Industry The computer printer industry generated $50 billion in revenues in a recent year, and four firms had a high market share. Of the four: Hewlett-Packard earned $24 billion, Lexmark $9.7 billion, Dell $6.9 billion and Epson $5.2 billion. These figures imply a concentration ratio of 91.6%. Thus, the printer industry is very concentrated.

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-48 Oligopoly, Inefficiency, and Resource Allocation To the extent oligopolists have market power—the ability to individually affect the market price for the industry’s output—they lead to resource misallocations, just as monopolies do. But if oligopolies occur because of economies of scale, consumers might actually end up paying lower prices. All in all, there is no definite evidence of serious resource misallocation in the United States because of oligopolies.

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-49 Oligopoly, Inefficiency, and Resource Allocation (cont'd) The more U.S. firms face competition from the rest of the world, the less any current oligopoly will be able to exercise market power.

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-50 Strategic Behavior and Game Theory Explaining the pricing and output behavior of oligopoly markets  Reaction Function  The manner in which one oligopolist reacts to a change in price, output, or quality made by another oligopolist in the industry

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-51 Strategic Behavior and Game Theory (cont'd) Game Theory  A way of describing the various possible outcomes in any situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly  The plans made by these individuals are known as game strategies.

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-52 Strategic Behavior and Game Theory (cont'd) Cooperative Game  A game in which the players explicitly cooperate to make themselves better off  Firms collude for higher than competitive rates of return Noncooperative Game  A game in which the players neither negotiate nor cooperate in any way  Relatively few firms with some ability to change price

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-53 Strategic Behavior and Game Theory (cont'd) Zero-Sum Game  A game in which any gains within the group are exactly offset by equal losses by the end of the game

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-54 Strategic Behavior and Game Theory (cont'd) Negative-Sum Game  A game in which players as a group lose at the end of the game Positive-Sum Game  A game in which players as a group are better off at the end of the game

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-55 Strategic Behavior and Game Theory (cont'd) Strategies in noncooperative games  Strategy  Any rule that is used to make a choice such as “always pick heads”  Dominant Strategies  Strategies that always yield the highest benefit

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-56 Example: The Prisoners’ Dilemma Two people involved in a bank robbery are caught. What should they do when questioned by police? The result has been called the prisoners’ dilemma.

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-57 Example: The Prisoners’ Dilemma (cont'd) The two are interrogated separately and their interrogator indicates the following: 1. If both confess, they each get five years in jail for the crime. 2. If neither confesses, they each get two years based on a lesser charge. 3. If only one confesses, that person will go free, but the other receives ten years.

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-58 Example: The Prisoners’ Dilemma (cont'd) Question  What would you do in this situation, keeping in mind no cooperation is involved between Sam and Carol?

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-59 Example: The Prisoners’ Dilemma (cont'd) The prisoners’ alternatives are shown in a payoff matrix. There are four possibilities: 1. Both confess. 2. Neither confesses. 3. Sam confesses; Carol doesn’t. 4. Carol confesses; Sam doesn’t.

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-60 Figure 27-1 The Prisoners’ Dilemma Payoff Matrix

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-61 The Prisoners’ Dilemma Payoff Matrix Regardless of what the other prisoner does, each person is better off if she or he confesses. So confessing is the dominant strategy, and each ends up behind bars for five years.

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-62 Strategic Behavior and Game Theory (cont'd) Applying game theory to pricing strategies  Would you choose a high price or a low price?  Remember  No collusion

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-63 Figure 27-2 Game Theory and Pricing Strategies

64. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-64 Strategic Behavior and Game Theory (cont'd) Opportunistic Behavior  Actions that, because long-run benefits of cooperation are perceived to be smaller, focus on short-run gains  An example might be writing a check that you know will bounce.  Implies a noncooperative game which is not realistic—we make repeat transactions

65. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-65 Strategic Behavior and Game Theory (cont'd) Tit-for-Tat Strategic Behavior  In game theory, cooperation that continues so long as the other players continue to cooperate

66. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-66 Strategic Behavior with Implicit Collusion: A Model of Price Leadership Price Leadership  A practice in many oligopolistic industries in which the largest firm publishes its price list ahead of its competitors, who then match those announced prices  Also called parallel pricing

67. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-67 Strategic Behavior with Implicit Collusion: A Model of Price Leadership (cont'd) Price War  A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices

68. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-68 Strategic Behavior with Implicit Collusion: A Model of Price Leadership (cont'd) Markets where price wars are common  Cigarettes  Long-distance telephone companies  Airlines

69. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-69 Strategic Behavior with Implicit Collusion: A Model of Price Leadership (cont'd) Markets where price wars are common  Diapers  Frozen foods  PC hardware and software

70. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-70 Deterring Entry Into an Industry Entry Deterrence Strategy  Any strategy undertaken by firms in an industry, either individually or together, with the intent or effect of raising the cost of entry into the industry by a new firm

71. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-71 Deterring Entry Into an Industry (cont'd) Increasing entry cost  Threat of price wars  Government regulations  Environmental regulation  Safety standards

72. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-72 Deterring Entry Into an Industry (cont'd) Limit-Pricing Model  A model that hypothesizes that a group of colluding sellers will set the highest common price they believe they can charge, without new firms seeking to enter the industry in search of relatively high profits

73. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-73 Example: Switching Costs Keep the HDTV Market on a Dim Setting Consumers are not the only ones who face switching costs in the market for HDTVs. Indeed, the complications that consumers face arise in part from the fact producers have also been struggling with switching costs of their own.

74. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-74 Example: Switching Costs Keep the HDTV Market on a Dim Setting (cont'd) The substantial switching costs have slowed sales in the market for HDTVs. At present, sales of HDTVs account for only slightly more than 10% of total television sales.

75. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-75 Network Effects Network Effect  A situation in which a consumer’s willingness to purchase a good or service is influenced by how many others also buy or have bought the item

76. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-76 Network Effects (cont'd) Positive Market Feedback  Potential for a network effect to arise when an industry’s product catches on Negative Market Feedback  The tendency for industry sales to spiral downward rapidly when the product falls out of favor

77. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-77 E-Commerce Example: Jumping on the “i” Bandwagon Apple simultaneously developed iTunes and the iPod knowing something about market economics. A key feature that helped iTunes catch on with consumers is its ability to store audio data in binary format. Positive market feedback and network effects have boosted Apple’s market share in music downloads to 70%, and digital music players to 60% of the industry.

78. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-78 Network Effects and Industry Concentration In some industries, a few firms can potentially reap most of the benefits of positive market feedback. There is a network effect present in the online auction industry, in which eBay, Amazon and Yahoo account for more than 80% of sales. When a small number of firms secure the bulk of payoffs resulting from positive market feedback, oligopoly is likely to emerge as the prevailing market structure.

79. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-79 Comparing Market Structures We have looked at perfect competition, pure monopoly, monopolistic competition and oligopoly. We are in a position to compare the attributes of these four different market structures.

80. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-80 Table 27-3 Comparing Market Structures

81. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-81 Issues and Applications: The Network Effects of Languages The use of language is a classic situation in which network effects apply. Network effects can generate both positive and negative market feedback. Half of the world’s population uses ten languages as a first or second language.

82. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27-82 Figure 27-5 The Top Ten Languages Used as First or Second Languages

83. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7-83 Key Terms and Concepts collusion duopoly industry concentration ratio monopolistic competition oligopoly opportunistic behavior price discrimination price leadership price war strategic dependence tacit collusion