1. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology Chapter 12: Monopolistic Competition, Oligopoly, and Strategic Pricing

2. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Chapter Objectives 1. Describe two methods of determining market structure. 2. List four distinguishing characteristics of monopolistic competition. 3a. Demonstrate graphically the equilibrium of a monopolistic competitor. 3b. Discuss how differentiated products relate to the excess capacity theorem.

3. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Chapter Objectives 4. State the central element of oligopoly. 5a. Explain sticky prices using the kinked demand model of oligopoly. 5b. Explain why decisions in the cartel model depend on market share and decisions in the contestable market model depend on barriers to entry.

4. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Chapter Objectives 6. Illustrate a strategic decision facing a duopolist using the prisoner’s dilemma payoff matrix.

5. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Introduction Market structure involves the number of firms in the market and the barriers to entry.

6. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Defining a Market Defining a market has problems: What is an industry and what is its geographic market?  Local, national, or international? What products are to be included in the definition of an industry?

7. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Classifying Industries One of the ways in which economists classify markets is by cross-price elasticities. Cross-price elasticity measures the responsiveness of the change in demand for a good to change in the price of a related good.

8. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Classifying Industries Industries are classified by government using the North American Industry Classification System (NAICS). The North American Industry Classification System (NAICS) is a classification system of industries adopted by Canada, Mexico, and the U.S. in 1997.

9. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Concentration Ratio The concentration ratio is the percentage of industry sales by the top few firms.

10. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Herfindahl Index The Herfindahl index is an index of market concentration calculated by adding the squared values of the individual market shares of all the firms in the industry.

11. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Monopolistic Competition The four distinguishing characteristics of monopolistic competition are:  Many sellers.  Differentiated products.  Multiple dimensions of competition.  Easy entry of new firms in the long run.

12. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Output, Price, and Profit A monopolistically competitive firm produces in the same manner as a monopolist—to maximize profit, it chooses the quantity where MC = MR. Having determined output, the firm will charge what consumers are willing to pay (determined by the demand curve).

13. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Output, Price, and Profit If price exceeds ATC, the firm will earn positive economic profits. These profits attract entry. Some customers of the existing firms switch to become customers of the new firm.

14. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Output, Price, and Profit Entry causes the existing firm’s demand curve to shift left (decrease) as they lose customers. Competition, therefore, implies zero economic profit in the long run.

15. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Output, Price, and Profit At the long-run equilibrium, ATC equals price and economic profits are zero. This occurs at the point of tangency of the ATC and demand curve at the output chosen by the firm.

16. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Monopolistic Competition: Short Run MRD1D1 Q1Q1 P1P1 Price 0Quantity ATC 1 MC C1C1 

17. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Monopolistic Competition: Short Run Q1Q1 Price 0Quantity P1P1 MC C1C1 P2P2 Q2Q2 MR 2 D2D2 ATC 2 ATC 1 C2C2 MR 1 D1D1

18. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Monopolistic Competition: Long Run MR 3 D3D3 Q3Q3 P 3 =C 3 Price 0Quantity ATC 3 C1C1 C2C2 P1P1 P2P2 ATC 2 D2 MR 2 MC

19. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Comparing Monopolistic Competition and Perfect Competition Both the monopolistic competitor and the perfect competitor make zero economic profit in the long run. A monopolistic competitor produces less than a perfect competitor.

20. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Perfect CompetitionMonopolistic Competition MC PCPC D QCQC Price 0 Quantity ATC PMPM MC ATC DMR QMQM Quantity 0 Price QCQC PCPC Comparing Monopolistic Competition and Perfect Competition

21. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Excess Capacity The Excess Capacity theorem indicates that a monopolistically competitive firm will have excess capacity in long-run equilibrium. It occurs because of product differentiation.

22. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Characteristics of Oligopoly Oligopolies are made up of a small number of very large firms. Products may be homogeneous or differentiated Firms are mutually interdependent. Each firm must take into account the expected reaction of other firms.

23. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Cartel Model In the cartel model of oligopoly,  Oligopolies act as if they were monopolists  That have assigned output quotas to individual member firms  So that total output is consistent with joint profit maximization.

24. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Implicit Price Collusion Formal collusion is illegal in Canada, but informal collusion is permitted. Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another.

25. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Why Are Prices Sticky? Sticky prices are prices that don’t change very much. Informal collusion is an important reason why prices are sticky. Another is the kinked demand curve.

26. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Assumption 1: If a firm raises its price, no other firms will raise their prices. This make the firm’s own demand curve very elastic. Kinked Demand Curve Model

27. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Assumption 2: If a firm lowers its price, all the other firms will lower their prices too. This make the firm’s own demand curve very inelastic. Kinked Demand Curve Model

28. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 D1D1 MR 1 Price Quantity 0 Q P a b c d MC 0 MC 1 Kinked Demand Curve Model No-one follows a price increase. All firms lower price. D2D2 MR 2

29. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 A high-cost firm and a low-cost firm will both produce the same quantity and charge the same price. If a firm’s costs decrease, consumers will not see any change.  Price will not decrease. The firm’s profits will increase. Kinked Demand Curve Model

30. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Contestable Market Model According to the contestable market model, barriers to entry and barriers to exit determine a firm’s price and output decisions.  Even if the industry contains a very small number of firms, it could still be a competitive market if entry is open.

31. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Strategic Pricing and Oligopoly Both the cartel and contestable market models use strategic pricing decisions – firms set their prices based on the expected reactions of other firms.

32. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Cooperative Equilibrium

33. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 One Firm Cheats

34. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 B Cheats B Does not cheat A Does not cheatA Cheats B +$200,000 B 0 A 0 A +$200,000 B $75,000 A $75,000 A – $75,000 B – $75,000 Payoff Matrix

35. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 If both firms cooperate, they can both get higher profits.  $75,000 each. However, both firms have an incentive to cheat on their agreement.  $200,000 for the one that cheats. Payoff Matrix

36. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 A dominant strategy is one which always yields the highest payoff, no matter what the other player does. The dominant strategy is to not cooperate.  i.e. to cheat. Payoff Matrix

37. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 If both firms choose to cheat on their agreement, the outcome will be a Nash equilibrium, a non-cooperative equilibrium in which no player can achieve a better outcome by switching strategies, given the strategy of the other player. Payoff Matrix

38. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38

39. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.39 Monopolistic Competition, Oligopoly, and Strategic Pricing End of Chapter 12