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Monopolistic and Oligopoly

Chapter 10

© 2006 Thomson/South-Western

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Monopolistic Competition

Many producers offer products that are either close substitutes but are not viewed as identical

Each supplier has some power over the price it charges : price makers

Low barriers to entry: firms in the long run can enter or leave the market with ease

Act independently of each otherDifferentiate their products

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Exhibit 1a: Maximizing Short-Run Profit

The monopolistically competitive firm produces the level of output at which marginal revenue equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping demand curve. In panel (a), the firm produces q units, sells them at price p, and earns a short-run economic profit equal to (p – c) multiplied by q, shown by the blue rectangle.

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Exhibit 1b: Minimizing Short-Run Loss

In panel (b), the average total cost exceeds the price at the output where marginal revenue equals marginal cost. Thus, the firm suffers a short-run loss equal to (c – p) multiplied by q, shown by the pink rectangle.

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Zero Economic Profit in the Long Run

Low barriers to entry in monopolistic competition: short-run economic profit will attract new entrants in the long run

With losses some competitors will leave the industryTheir customers will switch to the

remaining firms, increasing the demand for each remaining firm’s demand curve and making it less elastic

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Exhibit 2: Long-run Equilibrium

p

0 q

MC

ATC

MR

Da

b

Quantity per period

In the long run, entry and exit will shift each firm’s demand curve until economic profit disappears and price equals ATCLong-run outcome occurs where the MR curve intersects the MC curve at point a, where the ATC curve is tangent to the demand curve at point b and there is no economic profitIn the case of short-run losses, some firms will leave the industry and the demand curve shifts to the right, becoming less elastic until the loss disappears and the remaining firms earn a normal profit

Do

llar

s p

er u

nit

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Exhibit 3: Perfect Competition versus Monopolistic Competition

Point of tangency between d, MC and ATC in perfect competition means firm is producing at lowest possible average cost in the long runIn monopolistic competition, the price and average cost exceed those in pure competition – there is excess capacity

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Comparison

Firms in perfect competition are not producing at minimum average cost and are said to have excess capacity, because production falls short of the quantity that would achieve the lowest average cost.

Excess capacity means that each producer could easily serve more customers and in the process would lower average cost.

The marginal value of increased output would exceed its marginal cost, so greater output would increase social welfare.

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Comparison

Some argue that monopolistic competition results in too many suppliers and in product differentiation that is often artificial

Counterargument is that consumers are willing to pay a higher price for greater selection

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Oligopoly

Market structure that is dominated by just a few firms

Each must consider the effect of its own actions on competitors’ behavior the firms in an oligopoly are interdependent

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Varieties of Oligopoly

Homogeneous or differentiated products

Interdependence: the behavior of any particular firm is difficult to analyze

Domination by a few firms can often be traced to some form of barrier to entry

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Exhibit 4: Economies of Scale as a Barrier to Entry

Do

llars

pe

r u

nit

c a

cb

Autos per year S

b

a

Long-runaverage

cost

0

If a new entrant sells only S cars, the average cost per unit, ca, exceeds the average cost, cb, of a manufacturer that sells enough cars to reach the minimum efficiency scale, M.If autos sell for a price less than ca, a potential entrant can expect to lose money.

M

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High Costs of Entry

Total investment needed to reach the minimum size

Advertising a new product enough to compete with established brands

High start-up costs and presence of established brand names: the fortunes of a new product are very uncertain

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Models of Oligopolies

Interdependence: no one model or approach explains the outcomes

At one extreme, the firms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartel

At the other extreme, they may compete so fiercely that price wars erupt

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Collusion

Collusion: an agreement among firms in the industry to divide the market and fix the price

Cartel: a group of firms that agree to collude so they can act as a monopolist and earn monopoly profits

Colluding firms usually reduce output, increase price, and block the entry of new firms

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Exhibit 5: Cartel as a Monopolist

D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel). Cartel profits are maximized when the industry produces quantity Q and charges price p.

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Differences in Cost

The greater the differences in average costs across firms, the greater will be the differences in economic profits among firms

If cartel members try to equalize each firm’s total profit, a high-cost firm would need to sell more than a low-cost firm

This allocation scheme violates the cartel’s profit-maximizing condition of finding the output for each firm that results in identical marginal costs across firms

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Number of Firms in the Cartel

The more firms in the industry, the more difficult it is to negotiate an acceptable allocation of output among them

Consensus becomes harder to achieve as the number of firms grows

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New Entry Into the Industry

If a cartel cannot block the entry of new firms into the industry, new entry will eventually force prices down, squeezing economic profit and undermining the cartel

The profit of the cartel attracts entry, entry increases market supply and market price is forced down

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Cheating

Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement

By offering a price slightly below the established price, a firm can usually increase its sales and economic profit

Because oligopolists usually operate with excess capacity, some cheat on the established price

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Price Leadership

An informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry

A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition

Price leader also initiates price changes

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Price Leadership

Violates U.S. antitrust lawsThe greater the product differentiation among

sellers, the less effective price leadership will be as a means of collusion

There is no guarantee that other firms will follow the leader

Some firms will try to cheat on the agreement by cutting price to increase sales and profits

Unless there are barriers to entry, a profitable price will attract entrants

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Game Theory

Game theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms

It analyzes the behavior of decision-makers, or players, whose choices affect one another

Provides a general approach that allows us to focus on each player’s incentives to cooperate or not

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Payoff Matrix

Payoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues

Each prisoner pursues one of two strategies, confessing or clamming up

The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies

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Exhibit 6: Payoff Matrix

Ben’s payoff is in red and Jerry’s in blue. The incentive for both to confess is the dominant-strategy equilibrium of the game because each player’s strategy does not depend on what the other does.

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Price Setting Game

The prisoner’s dilemma applies to a broad range of economic phenomena such as pricing policy and advertising strategy

Consider the market for gasoline in a rural community with only two gas stations: a duopoly

Suppose customers are indifferent between the two brands and consider only the price

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Price Setting Game

Each station sets its daily price early in the morning before knowing the price set by the other

Suppose only two prices are possible: a low price and a high price If both charge the low price, they split the market

and each earns a profit of $500 per day If both charge the high price, they also split the

market and earn $700 profit If one charges the high price but the other the low

one, the low-price station earns a profit of $1,000 and the high-price station earns $200

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Exhibit 7: Price-Setting Payoff MatrixWhat price for each would maximize profits?Texaco: If Exxon charges the low price, Texaco earns $500 by charging the low price, but only $200 by charging the high price: better off charging the low price.If Exxon charges the high price, Texaco earns $1,000 by charging the low price and $700 by charging the high price: Texaco earns more by charging the low price.Exxon faces the same incentives

Each seller will charge the low price, regardless of what the other does: each earns $500 a day.

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One-Shot versus Repeated Games

The outcome of a game often depends on whether it is a one-shot game or the repeated game

The classic prisoner’s dilemma is a one-shot game: the game is to be played only once

However, if the same players repeat the prisoner’s dilemma, as would likely occur in the price setting game, other possibilities unfold

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One-Shot versus Repeated Games

In a repeated-game setting, each player has a chance to establish a reputation for cooperation and thereby can encourage the other player to do the same

The cooperative solution makes both players better off than if they fail to cooperate

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Exhibit 8: Cola War Payoff Matrix

Pepsi’s profit appears in red and Coke’s in bluePepsi’s decision: If Coke adopts a big promotional budget, Pepsi earns $2 billion by doing the same, but only $1 billion by adopting a moderate budget: Pepsi should adopt big budgetCoke faces the same incentivesBoth will adopt the big budget

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Tit-for-Tat Strategy

Experiments show that the strategy with the highest payoff in repeated games turns out to be the tit-for-tat strategy

You begin by cooperating in the first round of playEvery round thereafter, you cooperate if your

opponent cooperated in the previous round, and

You cheat if your opponent cheated in the previous round

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Oligopoly and Perfect Competition

Price is usually higher under oligopolyProfits are higher under oligopoly

If there are barriers to entry into the oligopoly, profits will be higher than under perfect competition, in the long run

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Comparison of Market Structures