Prepared by: Jamal Husein C H A P T E R 7 © 2005 Prentice Hall Business PublishingSurvey of...

© 2005 Prentice Hall Business Publishing© 2005 Prentice Hall Business Publishing Survey of Economics, 2/eSurvey of Economics, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Prepared by: Jamal Husein

C H A P T E R

77Monopolistic Competition, Oligopoly, and Antitrust

© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

The Effects of Market EntryThe Effects of Market EntryThe Effects of Market EntryThe Effects of Market Entry In the absence of substantial economies of scale,

it is possible for additional firms to enter the market, driving down prices and profit.

Output decisions are based on the marginal principle:

Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.


The Effects of Market EntryThe Effects of Market EntryThe Effects of Market EntryThe Effects of Market Entry

When a second firm enters the market, the monopoly’s demand and marginal revenue curves shift inward.

The firm’s price and output level will have to be adjusted in order to follow the marginal principle.



The monopoly satisfies the marginal principle by producing and selling 300 toothbrushes at $2 each.

After entry, each of two firms produces 200 units and charges $1.85 per unit.

Entry decreases price.



Before entry, the monopoly produces 300 units, at a cost per unit of $0.90 per toothbrush.

After entry, each of two firms produces 200 units at an average cost

of $1.00. Entry increases average cost.



There are three reasons why profit decreases for the individual firm after entry of a second firm: Lower price Lower quantity sold Higher AC of production

Summary:


The Effects of Market EntryThe Effects of Market EntryThe Effects of Market EntryThe Effects of Market EntryR

even

ue

or c

ost

( $

per

too

th

bru

sh)

n

m

c

MC1D1

MR1

300

2.00

Toothbrushes per minute

0.90

D2

MR2

AC

1.00

200

e

d

1.85

x


Monopolistic CompetitionMonopolistic CompetitionMonopolistic CompetitionMonopolistic Competition

Characteristics of Monopolistic Competition: Many firms Differentiated product No artificial barriers to entry

Monopolistic Competition: A market served by dozens of firms selling slightly different products.


The Meaning of “Monopolistic The Meaning of “Monopolistic Competition”Competition”The Meaning of “Monopolistic The Meaning of “Monopolistic Competition”Competition”

Each firm is monopolistic because it sells a unique product.

The availability of close substitutes makes the firm’s demand very price elastic.

Each firm is a competitive because it sells a product that is a close but not a perfect substitute for the products sold by other firms in the market.


Product DifferentiationProduct DifferentiationProduct DifferentiationProduct Differentiation

Physical characteristics Location Services Aura or image

Firms may differentiate their product in several ways:


Short-run and Long-run EquilibriumShort-run and Long-run EquilibriumShort-run and Long-run EquilibriumShort-run and Long-run Equilibrium

As firms enter, each firm’s demand curve shifts to the left, decreasing market price, decreasing the quantity produced per firm, and increasing the average cost of production.

As long as there is profit to be made, more and more firms will enter the market.

Entry will stop once the economic profit of each existing firm reaches zero. In the long run, revenue will be just enough to cover all costs, including the opportunity cost of all inputs, but not enough to cause additional firms to enter.


Long-run Equilibrium Under Long-run Equilibrium Under Monopolistic CompetitionMonopolistic CompetitionLong-run Equilibrium Under Long-run Equilibrium Under Monopolistic CompetitionMonopolistic Competition

In this example, the marginal principle is satisfied at 55 thousand toothbrushes per minute, selling at a price of $1.35. The cost of producing each toothbrush is also $1.35. Economic profit equals zero.


Trade-offs with Monopolistic Trade-offs with Monopolistic CompetitionCompetitionTrade-offs with Monopolistic Trade-offs with Monopolistic CompetitionCompetition

Monopolistic CompetitionMonopoly


Trade-offs with Monopolistic CompetitionTrade-offs with Monopolistic CompetitionTrade-offs with Monopolistic CompetitionTrade-offs with Monopolistic Competition

Monopolistic competition brings good news and bad news relative to the monopoly outcome:

Good news: lower price and greater variety

Bad news: higher average cost


Oligopoly Oligopoly Oligopoly Oligopoly

An oligopoly is a market served by a few firms.

The key feature of an oligopoly is that firms act strategically. Firms are interdependent—the actions of one firm affect the profits of the other firms in the market.


Oligopoly and Pricing DecisionsOligopoly and Pricing DecisionsOligopoly and Pricing DecisionsOligopoly and Pricing Decisions

Economists use concentration ratios to measure the degree of concentration, or just how few firms exist in a market.

For example a four firm concentration ratios is the percentage of total output in the market produced by the largest four, i.e., a 93% concentration ratio for cigarettes indicates that the largest 4 firms produced 93% of the total output.


Concentration Ratios in Selected Concentration Ratios in Selected Manufacturing IndustriesManufacturing IndustriesConcentration Ratios in Selected Concentration Ratios in Selected Manufacturing IndustriesManufacturing Industries

IndustryFour-firm Concentration Ratio (%)

Eight-firm Concentration Ratio (%)

Cigarettes 93 Not available

Guided missiles and space vehicles 93 99

Beer and malt beverages 90 98

Batteries 87 95

Electric bulbs 86 94

Breakfast cereals 85 98

Motor vehicles and car bodies 84 91

Greeting cards 84 88

Engines and turbines 79 92

Aircraft and parts 79 93


Barriers to Entry in an OligopolyBarriers to Entry in an OligopolyBarriers to Entry in an OligopolyBarriers to Entry in an Oligopoly

Economies of scale large enough to generate a natural oligopoly but not a natural monopoly

Government barriers to entry

Substantial investment in an advertising campaign in order to enter the market

Most firms in an oligopoly earn economic profit, yet additional firms do not enter the market, for three reasons:


Oligopolistic FirmsOligopolistic FirmsOligopolistic FirmsOligopolistic Firms

A duopoly is a market with two firms.

A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service.

The arrangement under which two or more firms act as one, coordinating their pricing decisions, is also known as price fixing.

The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly.


Cartel PricingCartel PricingCartel PricingCartel Pricing

In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket.

The firms also split the profit. Each firm earns$7,500 = [(400-300) x 150]/2.


Duopoly PricingDuopoly PricingDuopoly PricingDuopoly Pricing

When two firms compete against one another, they end up serving 100 passengers each, at a price of $350.

Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm.


Duopoly Versus Cartel PricingDuopoly Versus Cartel PricingDuopoly Versus Cartel PricingDuopoly Versus Cartel Pricing

The duopoly produces more output and charges a lower price than the cartel.


The Game TreeThe Game TreeThe Game TreeThe Game Tree

A game tree provides a visual representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies.


Jill:

High or

Low price?

Jill:

High or

Low price?

Jack:

High or

Low price?

Jack:

High or

Low price?

Jack:

High or

Low price?

Jack:

High or

Low price?

Jill Jack$7.5 $7.5Jill Jack$7.5 $7.5

Jill Jack$1 $1Jill Jack$1 $1

Jill Jack$8.5 $1Jill Jack$8.5 $1

Jill Jack

$5 $5

Jill Jack

$5 $5

High

High price

HighLow price

Low

Low

Profits ($000)Profits ($000)

Cartel and Duopoly Outcomes in the Game TreeCartel and Duopoly Outcomes in the Game TreeCartel and Duopoly Outcomes in the Game TreeCartel and Duopoly Outcomes in the Game Tree


Jill:

High or

Low price?

Jill:

High or

Low price?

Jack:

High or

Low price?

Jack:

High or

Low price?

Jack:

High or

Low price?

Jack:

High or

Low price?

Jill Jack$7.5 $7.5Jill Jack$7.5 $7.5

Cartel

Outcome

Cartel

Outcome

Jill Jack

$5 $5

Jill Jack

$5 $5

High

High price

Low priceLow

Profits Profits ($000)($000)

Cartel and Duopoly Outcomes in the Game TreeCartel and Duopoly Outcomes in the Game TreeCartel and Duopoly Outcomes in the Game TreeCartel and Duopoly Outcomes in the Game Tree

Duopoly

Outcome

Duopoly

Outcome


The Outcome of the Price-Fixing GameThe Outcome of the Price-Fixing GameThe Outcome of the Price-Fixing GameThe Outcome of the Price-Fixing Game

Jill captures large share of market

Jack captures large share of market

Jill: Low PriceJack: High Price

Price $350 $400

Quantity 170 10

Average cost $300 $300

Profit per passenger $50 $100

Total profit $8,500 $1,000


The Dominant StrategyThe Dominant StrategyThe Dominant StrategyThe Dominant Strategy

Irrational for Jack to choose high price

Jack chooses the low price when Jill chooses the high price.


The Dominant StrategyThe Dominant StrategyThe Dominant StrategyThe Dominant Strategy

Jack chooses the low price when Jill chooses the low price.

Irrational for Jack to choose high price

Dominant Strategy: Jack chooses the low price regardless of Jill’s choice.


The Duopolists’ DilemmaThe Duopolists’ DilemmaThe Duopolists’ DilemmaThe Duopolists’ Dilemma

Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price?

Jill will choose the low price, and the trajectory of the game is X to Z to 4.

Irrational for Jill to be underpriced.


The Duopolists’ DilemmaThe Duopolists’ DilemmaThe Duopolists’ DilemmaThe Duopolists’ Dilemma

The duopolists’ dilemma is that although both firms would be better off if they chose the high price, each firm chooses the low price.


Retaliation for UnderpricingRetaliation for UnderpricingRetaliation for UnderpricingRetaliation for Underpricing

Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack.

Tit-for-tat: Jill chooses whatever price Jack chose the preceding month.

Schemes to punish Jack if he underprices:


Tit-for-Tat Response to UnderpricingTit-for-Tat Response to UnderpricingTit-for-Tat Response to UnderpricingTit-for-Tat Response to Underpricing

After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month.

Jill chooses whatever price Jack chose the preceding month.


Avoiding the Dilemma: Guaranteed Avoiding the Dilemma: Guaranteed Price MatchingPrice MatchingAvoiding the Dilemma: Guaranteed Avoiding the Dilemma: Guaranteed Price MatchingPrice Matching

To eliminate the incentive for underpricing, one firm can guarantee that it will match its competitor’s price.

How will Jack respond to Jill’s price-matching policy?

Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits.

Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price.


Guaranteed Price MatchingGuaranteed Price MatchingGuaranteed Price MatchingGuaranteed Price Matching

Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel.

Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price!


Entry Deterrence and Limit PricingEntry Deterrence and Limit PricingEntry Deterrence and Limit PricingEntry Deterrence and Limit Pricing

An insecure monopolist fears the entry of a second firm, and could react in one of two ways:

A passive strategy: allow the second firm to enter the market

An entry-deterrence strategy: try to prevent the firm from entering

The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit.


The Passive StrategyThe Passive StrategyThe Passive StrategyThe Passive Strategy

If Mona adopts a passive strategy, it will allow Doug to enter the market, and each will earn the duopoly profits of $5,000 each (Duopoly Outcome).


Profit = $15,000Profit = $15,000

The Entry-deterrence StrategyThe Entry-deterrence StrategyThe Entry-deterrence StrategyThe Entry-deterrence Strategy

Mona can prevent Doug from entering by incurring a

large investment and committing herself to serving a large number of customers

at a low price.

Mona can prevent Doug from entering by incurring a

large investment and committing herself to serving a large number of customers

at a low price.

z

MarketDemand

250

400

LRAC

Passengersper day

m: Secure Monopoly

200180150

370

350

300


The Entry-deterrence StrategyThe Entry-deterrence StrategyThe Entry-deterrence StrategyThe Entry-deterrence StrategyDue to economies of scale,

suppose that that the minimum entry quantity is 70

passengers a day, the entry deterring quantity for Mona will be 180 passengers (250-

70). If Doug enters serving 70 passengers and Mona serves 180, the price drops to $300, making entry unprofitable to

Doug.

Due to economies of scale, suppose that that the

minimum entry quantity is 70 passengers a day, the entry

deterring quantity for Mona will be 180 passengers (250-

70). If Doug enters serving 70 passengers and Mona serves 180, the price drops to $300, making entry unprofitable to

Doug.z

MarketDemand

250

400

LRAC

Passengersper day

m: Secure Monopoly

i: Insecure Monopoly

d: Duopoly

200180150

370

350

300

Deterrence Profit =$12,600

Once Mona commits to large

load of passengers, the most profitable load will be 180

passengers

Once Mona commits to large

load of passengers, the most profitable load will be 180

passengers


Deterrence Profit =$12,600

The Entry-deterrence StrategyThe Entry-deterrence StrategyThe Entry-deterrence StrategyThe Entry-deterrence Strategy Mona can prevent Doug from entering by incurring a

large investment and committing herself to serving a large number of customers at a low price.

What is more profitable, entry deterrence or the passive duopoly outcome?

z

MarketDemand

250

400

LRAC

Passengersper day

m: Secure Monopoly

i: Insecure Monopoly

200180150

370

350

300


Antitrust PolicyAntitrust PolicyAntitrust PolicyAntitrust Policy

The purpose of antitrust policy is to promote competition among firms. Competition leads to lower prices and better products.


Antitrust PolicyAntitrust PolicyAntitrust PolicyAntitrust Policy

Break up of monopolies into several smaller companies.

Prevent corporate mergers that would reduce competition.

Regulate business practices.

Under federal antitrust rules, the government can:


Brief History of Antitrust LegislationBrief History of Antitrust LegislationBrief History of Antitrust LegislationBrief History of Antitrust Legislation

1890 Sherman Act: made it illegal to monopolize a market or to engage in practices that resulted in a restraint of trade.

1914 Clayton Act: outlawed specific practices that discourage competition, including tying contracts, price discrimination for the purpose of reducing competition, and stock-purchase mergers that would substantially reduce competition.

1914 Federal Trade Commission: established to enforce antitrust laws.

1936 Robinson-Patman Act: prohibited selling products at “unreasonably low prices” with the intent of reducing competition.

1950 Celler-Kefauver Act: outlawed asset-purchase mergers that would substantially reduce competition.

1980 Hart-Scott-Rodino Act: extended antitrust legislation to proprietorships and partnerships.


Breaking Up MonopoliesBreaking Up MonopoliesBreaking Up MonopoliesBreaking Up Monopolies

A trust is an arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees. Firms in a trust act as a single firm.

The label “antitrust” comes from early cases involving the breakup of trusts.


Blocking MergersBlocking MergersBlocking MergersBlocking Mergers

A merger occurs when two firms combine their operations.

Because a merger decreases the number of firms in a market, it is likely to lead to higher prices.

A possible benefit from a merger is that the new firm could combine production, marketing, or administrative operations, and thus produce its products at a lower average cost.


Blocking MergersBlocking MergersBlocking MergersBlocking Mergers

New guidelines developed by the Justice Department and the Federal Trade Commission allow companies involved in a proposed merger to present evidence that the merger would reduce costs and lead to lower prices, better products, or better service.

The analysis of proposed mergers today focuses less on counting the number of firms in a market, and more on how a merger would affect price.


Regulating Business PracticesRegulating Business PracticesRegulating Business PracticesRegulating Business Practices

The government may intervene when specific business practices increase market concentration.

Among those practices are: Price fixing Tying, or forcing consumers of one product to

purchase another Price discrimination that reduces competition

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Prepared by: Jamal Husein C H A P T E R 7 © 2005 Prentice Hall Business PublishingSurvey of...

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