1. Roger LeRoy Miller Economics Today Chapter 25 Monopolistic Competition, Oligopoly, and Strategic Behavior

2. Slide 25-2 Introduction Shoppers at the Web site of the apparel manufacturer Eddie Bauer can use a “virtual dressing room” to click and drag clothes together for a closer look. By making its Web site interesting and useful Eddie Bauer seeks to differentiate its brand name and attract customers. To understand the actions of firms that sell similar but differentiated goods, you must learn about monopolistic competition.

3. Slide 25-3 Learning Objectives Discuss the key characteristics of a monopolistically competitive industry Contrast the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms

4. Slide 25-4 Learning Objectives Outline the fundamental characteristics of oligopoly Understand how to apply game theory to evaluate the pricing strategies of oligopolistic firms

5. Slide 25-5 Learning Objectives Explain the kinked demand curve theory of oligopolistic price rigidity Describe theories of how firms may deter market entry by potential rivals

6. Slide 25-6 Chapter Outline Monopolistic Competition Price and Output for the Monopolistic Competitor Price and Output for the Monopolistic Competitor Comparing Perfect Competition with Monopolistic Competition Comparing Perfect Competition with Monopolistic Competition Oligopoly

7. Slide 25-7 Chapter Outline Strategic Behavior and Game Theory Price Rigidity and the Kinked Demand Curve Price Rigidity and the Kinked Demand Curve Strategic Behavior with Implicit Collusion: A Model of Price Leadership Strategic Behavior with Implicit Collusion: A Model of Price Leadership Deterring Entry into an Industry Comparing Market Structures

8. Slide 25-8 Did You Know That... 80 percent of initial customer contacts for General Motors Saturn division now originate on the Internet? GM and other businesses leave no stone unturned to inform people about what they sell, where people can buy it, and at what price?

9. Slide 25-9 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

10. Slide 25-10 Monopolistic Competition Characteristics of monopolistic competition –Significant number of sellers in a highly competitive market –Differentiated products –Sales promotion and advertising –Easy entry of new firms in the long run

11. Slide 25-11 Monopolistic Competition Implications of the large number of firms –Small market share –Lack of collusion –Independence

12. Slide 25-12 Monopolistic Competition Product Differentiation –The distinguishing of products by brand name, color, and other minor attributes

13. Slide 25-13 Monopolistic Competition Product differentiation and price –Differentiate perfectly Producer is a monopoly –Significant influence on price –Differentiation is not perfect Producer is a monopolistic competitor –The more successful it is at differentiation the more control over price

14. Slide 25-14 Monopolistic Competition Ease of entry –Threat of a more efficient competitor is always present

15. Slide 25-15 Monopolistic Competition Sales promotion and advertising –Can increase demand for a firm –Can differentiate a firm’s product –Should be continued to the point at which the additional revenue from one more dollar of advertising just equals that one dollar of marginal cost

16. Slide 25-16 Monopolistic Competition Advertising as signaling behavior –Advertising over a long period of time is a signal that a firm wants repeat business

17. Slide 25-17 Monopolistic Competition 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?

18. Slide 25-18 Short-Run and Long-Run Equilibrium with Monopolistic Competition Figure 25-1, Panel (a) Price (P 1 ) > ATC Economic profit

19. Slide 25-19 Short-Run and Long-Run Equilibrium with Monopolistic Competition Figure 25-1, Panel (b) -Price (P 1 ) < ATC -Economic loss

20. Slide 25-20 Figure 25-1, Panel (c) Short-Run and Long-Run Equilibrium with Monopolistic Competition -Price (P 1 ) = ATC -Normal rate of return

21. Slide 25-21 Perfect competitors and monopolistic competitors earn zero economic profit. How are they different? Comparing Perfect Competition with Monopolistic Competition

22. Slide 25-22 Comparison of the Perfect Competitor with the Monopolistic Competitor Figure 25-2, Panels (a) and (b)

23. Slide 25-23 What do you think? –Would you want to live in a perfectly competitive world with homogenous products? Comparing Perfect Competition with Monopolistic Competition

24. Slide 25-24 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

25. Slide 25-25 Oligopoly Characteristics of oligopoly –Small number of firms –Interdependence Strategic dependence

26. Slide 25-26 Oligopoly 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

27. Slide 25-27 Oligopoly Why oligopoly occurs –Economies of scale –Barriers to entry –Mergers Vertical mergers Horizontal mergers

28. Slide 25-28 Oligopoly 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

29. Slide 25-29 Oligopoly Measuring industry concentration –Concentration Ratio The percentage of all sales contributed by the leading four or leading eight firms in an industry

30. Slide 25-30 Computing the Four-Firm Concentration Ratio Annual Sales Firm($ Millions) 1150 2100 380 470 5 through 2550 Total450 Total number of firms in Industry = 25 Four-firm concentration ratio = 450 400 88.9% 

31. Slide 25-31 Computing the Four-Firm Concentration Ratio Percentage of Value of Total Domestic Shipments Accounted IndustryFor By the Top Four Firms % Domestic motor vehicles84 Breakfast cereals85 Soft drinks69 Tobacco products93 Primary aluminum59 Household vacuum cleaners59 Electronic computers45 Printing and publishing23 Source: U.S. Bureau of the Census

32. Slide 25-32 Oligopoly What do you think? –Are oligopolies inefficient?

33. Slide 25-33 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

34. Slide 25-34 Strategic Behavior and Game Theory 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

35. Slide 25-35 Strategic Behavior and Game Theory Cooperative Game –A game in which the players explicitly cooperate to make themselves better off

36. Slide 25-36 Strategic Behavior and Game Theory Noncooperative Game –A game in which the players neither negotiate nor cooperate in any way

37. Slide 25-37 Strategic Behavior and Game Theory Zero-Sum Game –A game in which any gains within the group are exactly offset by equal losses by the end of the game

38. Slide 25-38 Strategic Behavior and Game Theory Negative-Sum Game –A game in which players as a group lose at the end of the game

39. Slide 25-39 Strategic Behavior and Game Theory Positive-Sum Game –A game in which players as a group are better off at the end of the game

40. Slide 25-40 Strategic Behavior and Game Theory Strategies in noncooperative games –Strategy Any rule that is used to make a choice Any potential choice that can be made by players in a game –Dominant Strategies Strategies that always yield the highest benefit

41. Slide 25-41 Prisoner’s Dilemma You and your partner rob a bank and get caught.

42. Slide 25-42 Prisoner’s Dilemma You are separated and given these options: –Both confess and get 5 years in jail –Neither confess and get 2 years –One confess and the other does not Confessor goes free One who does not confess get 10 years

43. Slide 25-43 Prisoner’s Dilemma What would you do? –Remember No cooperation

44. Slide 25-44 The Prisoners’ Dilemma Payoff Matrix Figure 25-3

45. Slide 25-45 Strategic Behavior and Game Theory Applying game theory to pricing strategies –Would you choose a high price or a low price? Remember –No collusion

46. Slide 25-46 Strategic Behavior and Game Theory Figure 25-4

47. Slide 25-47 Strategic Behavior and Game Theory Opportunistic Behavior –Actions that ignore the possible long-run benefits of cooperation and focus solely on short-run gains

48. Slide 25-48 Strategic Behavior and Game Theory Opportunistic behavior –Implies a noncooperative game –Not realistic We make repeat transactions

49. Slide 25-49 Strategic Behavior and Game Theory Tit-for-Tat Strategic Behavior –In game theory, cooperation that continues so long as the other players continue to cooperate

50. Slide 25-50 Pakistan agreed to certain conditions for an IMF loan –In 1999, the IMF discovered that Pakistan had spent much of this loan on the development of nuclear weapons –Soon, Pakistan had to default on its debt Why would Pakistan engage in this behavior with the IMF? International Example: Strategically Relating Subsidies to Nuclear Weapons

51. Slide 25-51 d 1 is relatively elastic if one firm raises its price the others will not and it will lose market share d 2 is relatively inelastic if one firm lowers its price the others lower their price so gain in sales is small Price Rigidity and the Kinked Demand Curve Figure 25-5, Panel (a)

52. Slide 25-52 The kinked demand curve indicates the possibility of price rigidity Price Rigidity and the Kinked Demand Curve Figure 25-5, Panel (b)

53. Slide 25-53 Price Rigidity and the Kinked Demand Curve Figure 25-6 Changes in cost do not impact output and prices as long as MC remains in the vertical portion of MR

54. Slide 25-54 d1d1 d2d2 MR 2 P0P0 q0q0 Criticisms of the Kinked Demand Curve Quantity per Time Period Price and Marginal Revenue per Unit MR 1 Cannot determine P 0 Empirical evidence does not confirm the kinked demand theory

55. Slide 25-55 Strategic Behavior Do pet products have nine lives? –H.J. Heinz’s Pet Products Company Dropped its price of 9-Lives cat food by 22% to meet increased competition from Nestle, Quaker, Grand Metropolitan, and Mars Heinz then decided to raise prices Its competition did not and Heinz’s market share dropped from 23 to 15 percent

56. Slide 25-56 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 Strategic Behavior with Implicit Collusion: A Model of Price Leadership

57. Slide 25-57 Price War –A pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices Strategic Behavior with Implicit Collusion: A Model of Price Leadership

58. Slide 25-58 Markets where price wars are common –Cigarettes –Long-distance telephone companies –Airlines Strategic Behavior with Implicit Collusion: A Model of Price Leadership

59. Slide 25-59 Markets where price wars are common –Diapers –Frozen foods –PC hardware and software Strategic Behavior with Implicit Collusion: A Model of Price Leadership

60. Slide 25-60 Cigarette price wars –Philip Morris cut Marlboro by 40 cents a pack –RJR Nabisco matched the cut for Camel –Marlboro’s market share rose from 22.1% to 27.3% –Profits and stock prices fell Strategic Behavior with Implicit Collusion: A Model of Price Leadership

61. Slide 25-61 Cigarette price wars –Phillip Morris reduced prices by 18% and sales went up by only 12.5% Profits fell by 25% Strategic Behavior with Implicit Collusion: A Model of Price Leadership

62. Slide 25-62 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 Deterring Entry Into an Industry

63. Slide 25-63 Increasing entry cost –Threat of price wars –Government regulations Environmental regulation Safety standards Deterring Entry Into an Industry

64. Slide 25-64 Limit-Pricing Strategies –A model that hypothesizes that a group of colluding sellers will set the highest common price that they believe they can charge without new firms seeking to enter that industry in search of relatively high profits Deterring Entry Into an Industry

65. Slide 25-65 Raising customer’s switching cost –Examples Non-compatible software Non-transferability of college courses Deterring Entry Into an Industry

66. Slide 25-66 Comparing Market Structures Long-Run NumberUnrestrictedAbilityEconomic MarketofEntry andto SetProfitsProductNonprice StructureSellersExitPricePossibleDifferentiationCompetitionExamples PerfectNumerousYesNoneNoNoneNoneAgriculture, competitioncoal MonopolisticManyYesSome NoConsiderableYesToothpaste competitiontoilet paper, soap, retail trade OligopolyFewPartialSomeYesFrequentYesCigarettes, steel Pure OneNo (forConsider-YesNoneYesSome electric monopoly entry) able (product is companies, unique) some local telephone companies

67. Slide 25-67 Issues and Applications: Product Differentiation on the Web Some Internet-based companies such as Yahoo and AOL are now in the top echelons of American business because they forged a recognized brand name. New companies copy the strategies of successful companies –Barnes and Noble and Books.com copied Amazon.com

68. Slide 25-68 Web Links The following Web link appears in the margin of this chapter in the textbook: –http://www.csgb.ubc.ca/ccpp/simulationhttp://www.csgb.ubc.ca/ccpp/simulation

69. Slide 25-69 Summary Discussion of Learning Objectives Key characteristics of monopolistic competition –Large number of small firms –Differentiated products –Easy entry and exit –Advertising and sales promotion

70. Slide 25-70 Summary Discussion of Learning Objectives Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms –Monopolistically competitive firm MR = MC determines output Price set on demand curve P > MC P = ATC in the long-run

71. Slide 25-71 Summary Discussion of Learning Objectives Contrasting the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms –Perfectly competitive firm MR = MC determines output P = MR = MC P = minimum ATC in the long-run

72. Slide 25-72 Summary Discussion of Learning Objectives The fundamental characteristics of oligopoly –Economies of scale –Barriers to entry –Strategic dependence Applying game theory to evaluate the pricing strategies of oligopolistic firms –Game theory looks at competition for payoffs That depends on the strategies that others employ

73. Slide 25-73 Summary Discussion of Learning Objectives The kinked demand theory of oligopolistic price rigidity –If a firm believes that rivals will follow price cuts but not price increases, it will be reluctant to change price. How firms may deter market entry by potential rivals –Raise entry costs –Limit pricing –Switching policies

74. End of Chapter Chapter 25 Monopolistic Competition, Oligopoly, and Strategic Behavior