Monopolistic Competition And Oligopoly On any given

Monopolistic Competition And Oligopoly • On any given day, we are exposed to hundreds of advertisements – Advertising is everywhere in the economy • In perfect competition and monopoly firms do little, if any, advertising – We must consider firms that are neither perfect competitors nor monopolists • Types of imperfectly competitive markets – Monopolistic competition – Oligopoly 1

Monopolistic Competition Monopolistic competition is a market with the following characteristics: • A large number of firms. • Each firm produces a differentiated product. • Firms compete on product quality, price, and marketing. • Firms are free to enter and exit the industry. 2

Monopolistic Competition • Large Number of Firms – The presence of a large number of firms in the market implies: • Each firm has only a small market share and therefore has limited market power to influence the price of its product. • Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firm’s actions directly affect the actions of other firms. • Collusion, or conspiring to fix prices, is impossible. 3

Monopolistic Competition • Product Differentiation – Firms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms. • Product differentiation enables firms to compete in three areas: quality, price, and marketing. – Quality includes design, reliability, and service. – Because firms produce differentiated products, each firm has a downward-sloping demand curve for its own product. – But there is a tradeoff between price and quality. – Differentiated products must be marketed using advertising and packaging. 4

Monopolistic Competition • Entry and Exit – There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. 5

Assessment of Competitiveness Level The total volume of market: Ym = Yp+ Yim - Yex, where Ym - volume of market; Yp - local production of the product; Yim – volume of import on a market; Yex – volume of export on a market. • The subject’s share (Di) is a ratio of its volume (Yi) over market volume (Ym). Di = Yi/Ym x 100% • 6

Market Concentration • Coefficient of market concentration (CR) – ratio of product amount supplied by particular number of biggest suppliers over total volume of the product on the market • Herfindahl-Hirschman index of market concentration (НН) is calculated as a sum of squared shares of all suppliers on the market. 7

Market Concentration Three types of market: I type – highly concentrated markets: 70%

Monopolistic Competition • The red bars refer to the 4 largest firms. • Green is the next 4. • Blue is the next 12. • The numbers are the HHI . 9

Output and Price in Monopolistic Competition • The firm produces the quantity at which price equals marginal cost and sells that quantity for the highest possible price. • It earns an economic profit when P > ATC. 10

Output and Price in Monopolistic Competition • Profit Maximizing Might be Loss Minimizing – A firm might incur an economic loss in the short run. – In this case, P < ATC. 11

Example The profit maximizing level of output is ____ bagels per day at a price of ____each. At the profit- maximizing output and price, the shop’s profit or loss equals___. Given the profit- maximizing choice of output and price, the shop is making______profit, which means there are _____in the industry relative to the long-run equilibrium. 12

Output and Price in Monopolistic Competition • Long Run: Zero Economic Profit – In the long run, economic profit induces entry. – And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC). – In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC. – As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward. – The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity. – Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit. 13

A Monopolistically Competitive Firm in the Long Run In the long run, profit attracts entry, which shifts the firm's demand curve leftward. Dollars MC $40 E The typical firm produces where its new MR crosses MC. Entry continues until P = ATC at the best output level, and economic profit is zero. d 1 MR 2 100 ATC d 2 250 MR 1 Homes Serviced per Month 14

Example Because this market is a monopolistically competitive market, the firm’s average total cost in long- run equilibrium is _______ the minimum unit cost. 15

Output and Price in Monopolistic Competition • Monopolistic Competition and Perfect Competition – Two key differences between monopolistic competition and perfect competition are: • Excess capacity • Markup – A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. – A firm’s markup is the amount by which its price exceeds its marginal cost. 16

Output and Price in Monopolistic Competition • Firms in monopolistic competition operate with excess capacity in long-run equilibrium. 17

Output and Price in Monopolistic Competition • Firms in monopolistic competition operate with positive mark up. 18

Output and Price in Monopolistic Competition • In contrast, firms in perfect competition have no excess capacity and no markup. • The perfectly elastic demand curve for their products drives this result. 19

Output and Price in Monopolistic Competition • Is Monopolistic Competition Efficient – Because in monopolistic competition P > MC, marginal benefit exceeds marginal cost. – So monopolistic competition seems to be inefficient. – But the markup of price above marginal cost arises from product differentiation. • People value variety but variety is costly. • Monopolistic competition brings the profitable and possibly efficient amount of variety to market. 20

Nonprice Competition • If monopolistic competitor wants to increase its output it can cut its price • Any action a firm takes to increase demand for its output— other than cutting its price—is called nonprice competition – better service, product guarantees, free home delivery, more attractive packaging 21

Product Development and Marketing • All nonprice competition is costly – Costs must be included in each firm’s ATC curve, shifting it upward – Advertising • to signal the high quality of products • Brand Names • to provide information about quality and consistency. • Innovation and Product Development 22

Example Which of the following can occur as a result of advertising in a monopolistically competitive market? Check all that apply. q Positive long- run profit q Zero long-run profit q Lower product price q Bigger size of the market 23

Oligopoly • When just a few large firms dominate a market – So that actions of each one have an important impact on the others – Would be foolish for any one firm to ignore its competitors’ reactions – In such a market, each firm recognizes its strategic interdependence with others • An oligopoly is a market dominated by a small number of strategically interdependent firms 24

Oligopoly • Economies of Scale: Natural Oligopolies – When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market • Reputation as a Barrier – Established oligopolists are likely to have favorable reputations • Strategic Barriers – Oligopoly firms often pursue strategies designed to keep out potential competitors • Legal Barriers – Patents and copyrights, lobbying government 25

What is Oligopoly? 26

Two Traditional Oligopoly Models • The Kinked Demand Curve Model – In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow. 27

Two Traditional Oligopoly Models • Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. • Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm • The kink in the demand curve means that the MR curve is discontinuous at the current quantity. 28

Two Traditional Oligopoly Models • Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged. 29

Two Traditional Oligopoly Models • Dominant Firm Oligopoly – In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. – The large firm operates as a monopoly, setting its price and output to maximize its profit. – The small firms act as perfect competitors, taking as given the market price set by the dominant firm. 30

Two Traditional Oligopoly Models 31

Two Traditional Oligopoly Models 32

Oligopoly Games • Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. • All games share four features: – Rules – Strategies – Payoffs – Outcome. 33

The Prisoners’ Dilemma • In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. – Each is held in a separate cell and cannot communicate with each other. – Each is told that both are suspected of committing a more serious crime. – If one of them confesses, he will get a 1 -year sentence for cooperating while his accomplice get a 10 -year sentence for both crimes. – If both confess to the more serious crime, each receives 3 years in jail for both crimes. – If neither confesses, each receives a 2 -year sentence for the minor crime only. 34

Oligopoly Games In game theory, strategies are all the possible actions of each player. Art and Bob each have two possible actions: – Confess to the larger crime – Deny having committed the larger crime. Because there are two players and two actions for each player, there are four possible outcomes: – Both confess – Both deny – Art confesses and Bob denies – Bob confesses and Art denies 35

Oligopoly Games 36

Oligopoly Games • If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player. • If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibrium—first proposed by John Nash. 37

Oligopoly Games Bob’s view of the world 38

Oligopoly Games Bob’s view of the world 39

Oligopoly Games Art’s view of the world 40

Oligopoly Games Art’s view of the world 41

Oligopoly Games Equilibrium 42

Oligopoly Games • A game like the prisoners’ dilemma is played in duopoly. • A duopoly is a market in which there are only two producers that compete. • Duopoly captures the essence of oligopoly. • A collusive agreement is an agreement between two (or more) firms to restrict output, raise price, and increase profits. • Such agreements are illegal and are undertaken in secret. • Firms in a collusive agreement operate a cartel. 43

Oligopoly Games 44

Example Pop Hop Advertise Fizzo Don’t Advertise 8, 8 18, 4 Don’t Advertise 4, 18 12, 12 If Fizzo decides to advertise, it will earn a profit of ______ if Pop Hop advertises and a profit of ______ if Pop Hop does not advertise. If Fizzo decides not to advertise, it will earn a profit of _____ if Pop Hop advertises and a profit of _____ if Pop Hop does not advertise. If Pop Hop advertises, Fizzo makes a higher profit if it chooses_______. If Pop Hop doesn’t advertise, Fizzo makes a higher profit if it chooses_______. Suppose that both firms start off not advertising. If the firms act independently, what strategies will they end up choosing? 45

Example Pictone High Price Flashtech Low Price 7, 7 5, 9 Low Price 9, 5 6, 6 If Flashtech prices high, Pictone makes more profit if it chooses a _____ , and if Flashtech prices low, Pictone makes more profits if it chooses a _______. If Pictone prices high, Flashtech makes more profit if it chooses a_____ , and if Pictone prices low, Flashtech makes more profit if it chooses a _____. Given all of the information above, pricing high______ a dominant strategy for both Flashtech and Pictone. If the firms do not collude, what strategies will they end up choosing? o Both Flashtech and Pictone will choose a high price. o Both Flashtech and Pictone will choose a low price. o Flashtech will choose a low price and Pictone will choose a high price. o Flashtech will choose a high price and Pictone will choose a low price. 46