Imperfect Competition: Monopolistic Competitive and Oligopoly · • Definition: Monopolistic...

Imperfect Competition: Monopolistic Competitive and Oligopoly

Lecture Week 6 Mamta Chowdhury

Learning Objectives • Market structure and control over the market • Monopolistically competitive • Non price competition • Product differentiation and advertisement • Short and long run equilibrium and inefficiency • Oligopoly and market power • Collusion and market share • Non collusive oligopoly and Kinked demand curve • Game theory, Prisoner’s dilemma and Nash equilibrium • Price discrimination

Market Structure and Control over the market

Monopolistic Competition • Definition: Monopolistic Competition (MCM) is the

market structure where many firms selling differentiated products. Soft drinks

• Example of an imperfect competition. Has characteristics of both perfect competition and monopoly

• Products are close but not perfect substitutes for each other, however, product differentiation is the key distinction between perfect competition and monopolistic competition.

• Non price competition • Advertisement • MCM faces downward sloping demand curve as a

monopoly. Demand curve is highly but not perfectly elastic

Assumptions of monopolistic competition

• Large number of firms

• Large number of buyers

• Interdependence: price policy and faces a fairly elastic demand curve

• Freedom of entry

• Product differentiation.

• Factor prices and technology are constant

Examples in Australia:

• Petrol stations, hairdressers, restaurants, shampoos

Extreme Australian Examples

• Market-share of single largest company: • Instant coffee market: Nestlé • Cola market: Coca-Cola Amatil • Lighter market: Bic • Sauce market: Heinz • Chewing gum market: Wrigley

Short run Equilibrium • MC=MR → not efficient price but P ≠ MC • AR and MR are more elastic • Can earn Short run super normal profit

• In the long run, super normal profit attract new firms

• Never operates at its minimum AC • Only normal profits

Market Structure Sellers Product Knowledge Barriers Monopolistic competition Many Differentiated Complete None

Over 95% market share

$

Q 0 Qs

AR = D

MC

AC

Ps

ACs

Monopolistic competition Short-run equilibrium of the firm

Economic profit

MR 9

Copyright ©2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –

9781486005581/Sloman/Principles of Economics/4e

AR = D

MR Q 0 QL

PL

LRAC

LRMC

Monopolistic competition Long-run equilibrium of the firm

$

10 Copyright ©2014 Pearson Australia (a division of

Pearson Australia Group Pty Ltd) –9781486005581/Sloman/Principles of Economics/4e

Non-price competition

● Tend to increase sales and profit through product differentiation and advertisement instead of lowering price and capture market share.

● Product development: in high or potentially high demand inelastic demand due to lack of close substitutes.

● Promotional program or Advertising: increase demand make demand less elastic.

Q2 Q 0

P1

LRAC

DL monopolistic competition

Q1

Perfect and monopolistic competition Long-run equilibrium of the firm contrasted

$

P2 DL perfect competition

Long-run equilibrium under perfect competition

Long-run equilibrium under monopolistic competition



Monopolistic and Perfect Competition • Perfectly competitive markets have no barriers of entry or

exit. Monopolistically competitive markets have a few barriers of entry and exit.

• Perfect competition faces horizontal demand curve (infinitely elastic) whereas demand curve for Monopolistic competition is downward sloping.

• Both types make only normal profit in the long run • Monopolistic competition sales less at higher price compared

to perfect competition • Monopolistic competition price is not the socially optimal, i.e.,

P ≠ MC • Not producing at the least-cost point, i.e., at the lowest AC,

excess capacity • Monopolistic competition offers greater variety of products • greater economies of scale and more funds for investment

and R&D under monopoly.

Oligopoly • Key features: Barriers to entry and Interdependence of the

firms. • Oligopoly is a market structure dominated by a few large

sellers selling an identical or differentiated product or service. Supermarkets, banking industry, Car industry, petroleum industry, mining

• Oligopolies can result from various forms of collusion which reduce competition in the market and lead to higher prices for consumers.

• Oligopolists apply strategic decision while choosing the output and price level. Since the number of firms in oligopoly market is small, each firm must act strategically as its profit depends on price and output decisions by the other firms in the market.

Features of Oligopoly • Interdependence of firms, firms will be affected by how other

firms set price and output. • Barriers to entry, but less than monopoly. • Differentiated products, advertising is often important • Non-price competition • Mergers and collusion • Most common market structure in modern economic

landscape: Motor vehicle industry, banking industry, supermarket retailers.

• Firms in an oligopoly choose production to max profit and their output and price decision most often dependent on the rival firm’s decision. However, oligopoly firm choose output lower than perfect competition but higher than monopoly, but price higher than perfect competition and lower than monopoly price.

Two largest supermarkets

Moody’s estimates Aldi holds 8% of the local market, whereas Woolworths has 37% and Coles has 26%. Metcash is estimated to have 11% of the market, with another 18% made up of “other”

retailers. March 2015

Australian Groceries

CR 62% to 76% 82% to 98%

Top 2, sales Top 4, sales

Top 2 Sellers: Coles, Woolworths Top 4 Sellers: Coles, Woolworths, Aldi, IGA

Top 5 Mining Corporations

Australian finance

Life insurance 40

70% 93%

Banks etc 251

Insurance 143 35% 58%

No. of companies Top 4, assets Top 10, assets

Top 4 Banks: CBA, NAB, ANZ, Westpac

Top 4 Insurers: QBE, IAG, Suncorp, Allianz Top 4 Life Insurers: AMP, AXA, MLC, ING

Debate over oligopolisation The negative case: More concentration collusion, higher prices, less consumer sovereignty, higher inequality of income

& wealth.

21

1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” The Wealth of Nations

Collusion • Two types of oligopoly: Collusive and non-collusive • Oligopolies/doupolists may collude together and act as a

monopoly • Collusion: An agreement among firms about price and

quantities setting • Cartel: group of firms acting in unison. • Although oligopolists would like to form cartels and earn

monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

• non-collusive: May compete fiercely with their rival, drive competitors out of the market for the bigger share of the market and higher profit. Australian airlines market

Collusive Oligopoly ● Firms agree on prices, market share, advertising expenditure and so on. ● Collusion reduces uncertainty, and the fear of engaging in competitive price cutting or retaliatory

advertising.

Tacit collusion: is where firms keep to the price that is set by an established firm

• Dominant firm price leadership: follow the price set by a dominant firm

• Barometric firm price leadership: where the price leader the firm whose prices are believed to reflect market condition in the most satisfactory way.

• Other forms of tacit collusion (rules of thumb):

average cost pricing: price is set by adding a certain percentage for profit on the top of average cost price benchmark: price is typically changed from one benchmark to another benchmark when cost rises.

● Firms may form cartel such as OPEC:

the cartel’s MC curve is the horizontal sum of the MC curves of its members producing an output where MC=MR non-price competition quota illegal in many countries.



Q 0

Oligopolistic price leader aims to maximise profits for a given market share (III)

$

D market = AR

market

D leader = AR leader

PL

Q L

MC leader

MR leader

Q M

EL EM

Price leader has major market share and sets market price Market follows price

leader



Factors favouring collusion: • Few firms

• Open with each other about costs • Similar production methods and average costs • Similar products • There is a dominant firm • Significant entry barriers • The market is stable • No government measures to curb collusion.

• Breakdown of collusion ● Temptation to cheat by cutting prices or selling more than allotted

quota ● Retaliation and price war.

Q 0

Oligopolistic price leader aims to maximise profits for a given market share

$

D market = AR

market

D leader = AR leader

Q L

MC leader

MR leader

Q M

EL EM PL (=M)

PL1

Q L1

EL1

Leader drops price

Market may retaliate - price war!

Leader increases market share



Non-collusive oligopoly • Kinked demand curve : A kinked-demand curve has two distinct segments

with different elasticities that join to form a kink. The primary use of the

kinked-demand curve is to explain price rigidity (stability) in oligopoly.

Oligopoly and the consumer • Assumptions of the model (kinked demand curve):

If an oligopolist cuts its price, its rivals will feel forced to follow suit and cut theirs, to prevent losing customers to the first firm.

If an oligopolist raises its price, however, its rivals will not follow suit since, by keeping their prices the same, they will gain customers from the first firm.

Oligopoly and the consumer Disadvantages: ● Depending on the size of the individual oligopolists, there may be less scope for

economies of scale to mitigate the effects of market power. ● Oligopolists are likely to engage in more extensive advertising than a monopolist. Advantages: ● Oligopolists can use part of their supernormal profit for research and

development. ● Non-price competition through product differentiation may result in greater choice

for the consumer. more concentration economies of scale lower costs lower prices. and larger profits R&D technological and product innovations (“creative destruction”).

Game Theory • Game theory is the study of how people behave in strategic situations. • Game theory is the study of decisions when payoff of player X depends on actions

of player Y • Game theory illustrates the concerns by the competitors (competing businesses)

in predicting the games of strategy in which they have incomplete information about each others’ price and output decision.

von Neuman and Morgenstern, Theory of Games and Economic Behavior (1944) — Nash, Non-cooperative Games (1951) ; Nobel Prize to Nash, Harsanyi (Berkeley), Selten (1994) • Single-move games: single move by each firm involved. Lowest bidder – highest

price and lowest interest for T-bonds and T-notes. • Simple dominant strategy games: ● Maximin: worst possible outcome is the least bad ● Maximax: strategy of choosing the policy that has the best possible outcome ● Dominant strategy game: where the same policy is suggested by different

strategies ● Nash equilibrium: everyone making their optimal assumptions about their rivals’

decisions. ● Prisoners’ dilemma: independently choosing the best strategy for whatever the

rivals are likely to do.

Game theory

Profits for firms X and Y at different prices



Copyright©2003 Southwestern/Thomson Learning

Eve’ s Decision

Confess

Confess

Eve gets 8 years

Adam gets 8 years

Eve gets 20 years

Adam goes free

Eve goes free

Adam gets 20 years

gets 1 year Eve

Adam gets 1 year

Remain Silent

Remain Silent

Adam’s Decision

Prisoners’ dilemma

Prisoners’ dilemma • The prisoners’ dilemma is a particular “game” between

two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

• The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.

• Dominant strategies in Prisoners’ dilemma: _ Eve: Confess _ Adam: Confess

Nash Equilibrium • Nash Equilibrium (self-interest): _ Adam: Confess & Eve: Confess • Best Outcome (cooperation): _ Adam: Silent & Eve: Silent • Cooperation is difficult to maintain, because

cooperation is not in the best interest of the individual player.

• Game Example: OPEC • Iraq and Iran: Members of OPEC • Their decisions on oil production. • Decisions: High Production or Low Production • Best Outcome (cooperation): _ Iran: low production & Iraq: low production

Copyright©2003 Southwestern/Thomson Learning

Iraq ’ s Decision

High Production

High Production Iraq gets $40 billion

Iran gets $40 billion

Iraq gets $30 billion






Low Production

Low Production

Iran ’ s Decision

Price discrimination • Price discrimination is the practice of charging a different price for the

same good or service. • For different facilities or time of service: student vs adult fares • Example: air line fares (Business class vs Economic class), peak period

train fare and off pick period fare • There are three types of price discrimination – first-degree, second-

degree, and third-degree price discrimination. • First degree discrimination, alternatively known as perfect price

discrimination, occurs when a firm charges a different price for every unit consumed.

• Second-degree price discrimination means charging a different price for different quantities, such as quantity discounts for bulk purchases. Electricity or gas consumption when charge is based on the unit of consumption.

• Third-degree price discrimination means charging a different price to different consumer groups. For example, rail and tube travellers can be subdivided into commuter and casual travellers, and cinema goers can be subdivide into adults and children.

Price discrimination Conditions necessary for price discrimination to operate ● The firms must be able to set their price. ● The market must be separate, either by time, physical distance and nature of use,

such as Microsoft Office ‘Schools’ edition which is only available to educational institutions, at a lower price.

● The firm must be able to identify different market segments, such as domestic users and industrial users.

● Demand elasticity must differ in each market. Different segments must have different price elasticities (PEDs).

● Non transferrable price, which means that a consumer cannot purchase at the low price in the elastic sub-market, and then re-sell to other consumers in the inelastic sub-market, at a higher price.

Advantages to the firm ● Higher revenue ● Driving competitors out of business (predatory pricing). Price discrimination and the consumer ● No clear-cut decision ● Some benefit, some lose.



http://www.economicsonline.co.uk/Competitive_markets/Price_elasticity_of_demand.html

Price discrimination

Figure 6.6 Price discrimination

37 Copyright ©2014 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –9781486005581/Sloman/Principles of Economics/4e

If we assume marginal cost (MC) is constant across all markets, whether or not the market is divided, it will equal average total cost (ATC). Profit maximisation will occur at the price and output where MC = MR =$5. If

the market can be separated, the price and output in the relatively inelastic sub-market will be PX=$9 and QX=1000 and PY=$7 and QY=2000 in the relatively elastic sub-market.

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