Monopolistic Competition and Oligopoly

Chapter 11

Chapter Objectives Characteristics of monopolistic

competition Normal profit in the long run Characteristics of oligopoly Game theory The oligopolist’s kinked demand

curve Collusion among oligopolists The effects of advertising

Monopolistic Competition

Large number of sellersSmall market sharesNo collusionIndependent action

Differentiated ProductsProduct attributesServiceLocationBrand names and packagingSome control over price

Easy entry and exit Need for advertising

Nonprice Competition Which industries?

Degree of concentrationFour-firm concentration ratioHerfindahl index

Monopolistic CompetitionMonopolistic Competition

Short-Run Profits

Quantity

Pric

e an

d C

osts

MR = MC

MC

MR

D1

ATC

EconomicProfit

Q1

A1

P1

0

Monopolistic Competition

Short-Run Losses

Quantity

Pric

e an

d C

osts

MR = MC

MC

MR

D2

ATC

Loss

Q2

A2

P2

0

Monopolistic Competition

Long-Run Equilibrium

Quantity

Pric

e an

d C

osts

MR = MC

MC

MR

D3

ATC

Q3

P3= A3

0

Monopolistic Competition

Firm’s demand curveHighly elastic

Short run profit or lossProduce where MR=MC

Long run normal profitEntry and exit

Inefficient Product variety

Monopolistic Competition

Quantity

Pric

e an

d C

osts

MR = MC

MC

MR

D3

ATC

Q30

P3= A3

P=MC=Min ATC for pure competition

P4

Q4

Price is Lower

Excess Capacity atMinimum ATC

P3>lowest ATC A3; therefore, P ≠ MC & minimum ATC. Productive efficiency is not achieved. P3>MC, meaning underallocation of resources. Allocative efficiency is not achieved

Oligopoly A few large producers Homogeneous or

differentiated products Control over price

Mutual interdependenceStrategic behavior

Entry barriers Mergers

Four-firm concentration ratioNeeds to be more than 40%Half of U.S. manufacturing

Localized markets Interindustry competition World trade

Import Competition Herfindahl index

Oligopoly Behavior: Game Theory

Mutual interdependence-Pricing policy-Oligopolistic firms can increase their profit,

and influence their rivals’ profits by changing their pricing strategies. Each firm’s profit depends on its own pricing strategy and that of its rivals, which is why this relationship between oligopolies is called mutual interdependence.

Collusion-Oligopolists often can benefit from collusion or cooperation with rivals.

Incentive to cheat -After a collusive pricing agreement every oligopolist might be tempted to cheat, because either firm can increase its profit by lowering its price.

Oligopoly Behavior: Game Theory Model

RareAir’s Price Strategy

Upt

own’

s P

rice

Stra

tegy

A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low•2 competitors•2 price strategies•Each strategy has a payoff matrix

•Greatest combinedprofit

• Independent actionsstimulate a response

Game Theory ModelRareAir’s Price Strategy

Upt

own’

s P

rice

Stra

tegy

A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low• Independently lowered prices in expectation of greater profit leads to the worst combined outcome

•Eventually low outcome make firms return to higher prices

Three Oligopoly Models

Kinked-demand curve Collusive pricing Price leadership

Kinked-Demand Curve

Noncollusive oligopoly Strategies

Match price changes- when one firm lowers their prices to have a better profit, the other companies match their price so the demand and marginal revenue curve will be steeper.

Ignore price changes-when a firm changes their prices and their rivals ignore this change, the demand curve for this first firm will be more elastic.

Combined strategyOligopolistic industries suggest that a firm’s rivals will match

price declines below P0, and they will ignore price changes over P0.

Kinked Demand Curve

Price InflexibilityThe kinked demand curve gives each

oligopolist reason to believe that any change in price will be for the worse. If it raises its price, many of its customers will desert it. If it lowers its price, its sales at best will increase very modestly, since rivals will match the lower prices.

Pric

e

Pric

e an

d C

osts

Quantity Quantity

0 0

P0

MR2

D2

D1

MR1

e

f

g

Rivals IgnorePrice Increase

Rivals MatchPrice Decrease

Q0

Competitor and rivals strategize versus each otherConsumers effectively have 2 partial demand curves and

each part has its own marginal revenue part

MR2

D2

D1

MR1Q0

MC1

MC2

P0e

f

g

Kinked-Demand Curve

Pric

e an

d C

osts

Quantity

Cartels and Other Collusion Price and output

Joint profit maximization

D

MR=MC

ATC

MC

MR

P0

A0

Q0

EconomicProfit

Effectively SharingThe Monopoly Profit

Cartels and Other Collusion Overt collusion Covert collusion

Tacit understandings Obstacles to collusion

Demand and cost differencesNumber of firmsCheatingRecessionPotential entryLegal obstacles: antitrust law

The OPEC Cartel

Source: A. T. Kearney, Foreign Policy

Iran 3,843,000Kuwait 2,538,000Venezuela 2,368,000Iraq 2,297,000Nigeria 2,183,000UAE 2,117,000Angola 1,804,000Libya 1,737,000Algeria 1,417,000Qatar 848,000Indonesia 843,000Ecuador 530,000

Daily oil production (barrels) , November 2008

Saudi Arabia 8,904,000

Price Leadership Model Leadership tactics Infrequent price changes Communications Limit pricing Breakdowns in price leadership:

Price wars

Advertising Prevalent in monopolistic

competition and oligopoly Capture market share Better than a price cut Information for consumers Manipulation

Oligopoly and AdvertisingThe Largest U.S. Advertisers, 2006

CompanyAdvertising Spending

Millions of $

Proctor and GambleAT&TGeneral MotorsTime WarnerVerizonFord MotorGlaxoSmithKlineWalt DisneyJohnson & JohnsonUnilever

$4898334532963089282225772444232022912098

Source: Advertising Age

World’s Top 10 Brand Names, 2007

Source: Interbrand

Coca-ColaMicrosoftIBMGeneral ElectricNokiaToyotaIntelMcDonald’sDisneyMercedes-Benz

Oligopoly and Advertising

Oligopoly and Efficiency

Not productively efficient Not allocatively efficient Tendency to share the monopoly

profit Qualifications

Increased foreign competitionLimit pricingTechnological advance