Monopolistic Competition and Oligopoly

© 2015 Pearson

Which cell phone? Are two cell phone makers

two too few?

© 2015 Pearson

Monopolistic Competitionand Oligopoly

13When you have completed your study of this chapter, you will be able to

1 Explain how price and quantity are determined in monopolistic competition.

2 Explain why selling costs are high in monopolistic competition.

3 Explain the dilemma faced by firms in oligopoly.

4 Use game theory to explain how price and quantity are determined in oligopoly.

CHAPTER CHECKLIST

© 2015 Pearson

13.1 MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure in which

• A large number of firms compete.• Each firm produces a differentiated product.• Firms compete on price, product quality, and

marketing.• Firms are free to enter and exit.

© 2015 Pearson


Large Number of Firms

Like perfect competition, the market has a large number of firms. Three implications are

• Small market share

• No market dominance

• Collusion impossible

© 2015 Pearson


Product Differentation

Product differentiation is making a product that is slightly different from the products of competing firms.

A differentiated product has close substitutes but it does not have perfect substitutes.

When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases.

© 2015 Pearson


Competing on Quality, Price, and Marketing

QualityDesign, reliability, after-sales service, and buyer’s ease of access to the product.

PriceBecause of product differentiation, the demand curve for the firms’ product is downward sloping.

MarketingMarketing has two main forms: Advertising and packaging.

© 2015 Pearson


Entry and Exit

No barriers to entry.

So the firm cannot make economic profit in the long run.

Identifying Monopolistic Competition

Two indexes:

• The four-firm concentration ratio

• The Herfindahl-Hirschman Index

© 2015 Pearson


The Four-Firm Concentration Ratio

The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry.

The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly.

• A ratio that exceeds 60 percent is an indication of oligopoly.

• A ratio of less than 40 percent is an indication of a competitive market—monopolistic competition.

© 2015 Pearson


The Herfindahl-Hirschman Index

The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms in a market.

Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent.

HHI = 502 + 252 + 152 + 102 = 3,450

A market with an HHI less than 1,000 is regarded as competitive and between 1,000 and 1,800 is moderately competitive.

© 2015 Pearson


How, given its costs and the demand for its jeans, does Lucky Brands decide the quantity of jeans to produce and the price at which to sell them?

The Firm’s Profit-Maximizing Decision

The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.

Figure 13.1 on the next slide illustrates this decision.

© 2015 Pearson

1. Profit is maximized when MR = MC.

3. The profit-maximizing price is $100 per pair.

4. The firm makes an economic profit of $6,250 a day.

2. The profit-maximizing output is 125 pairs of Lucky jeans per day.

ATC is $50 per pair, so...


© 2015 Pearson


Long Run: Zero Economic ProfitEconomic profit induces entry and economic loss induces exit, as in perfect competition.

Entry decreases the demand for the product of each firm.

Exit increases the demand for the product of each firm.

In the long run, economic profit is competed away and firms make zero economic profit.

Figure 13.2 on the next slide illustrates long-run equilibrium.

© 2015 Pearson

1. The output that maximizes profit is 75 pairs of Lucky jeans a day.

2. The price is $70 per pair. Average total cost is also $70 per pair.

3. Economic profit is zero.


© 2015 Pearson


Monopolistic Competition and Perfect Competition

The two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there is

• Excess capacity

• Price exceeds marginal cost

© 2015 Pearson


Excess Capacity

A firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum.

A firm’s efficient scale is the quantity of production at which average total cost is a minimum.

© 2015 Pearson

1. The efficient scale is 100 pairs of Lucky jeans a day.

2. The firm produces less than the efficient scale and has excess capacity.

3. Price exceeds 4. marginal cost.

5. Deadweight loss is created.


© 2015 Pearson

13.2 PRODUCT DEVELOPMENT AND MARKETING

Innovation and Product Development

Wherever economic profits are earned, imitators emerge.

To maintain economic profit, a firm must seek out new products.

Cost Versus Benefit of Product Innovation

The firm must balance the cost and benefit at the margin.

© 2015 Pearson


Efficiency and Product Innovation

Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which equals the amount the consumer is willing to pay.

The marginal benefit to the producer is the marginal revenue, which in equilibrium equals marginal cost.

Because price exceeds marginal cost, product improvement is not pushed to its efficient level.

© 2015 Pearson


Marketing

Firms in monopolistic competition spend a large amount on advertising and packaging their products.

Marketing Expenditures

A large proportion of the prices that we pay cover the cost of selling a good.

Eye On Your Life shows the selling costs that you pay when you buy a new pair of running shoes.

© 2015 Pearson


Selling Costs and Total Costs

Marketing expenditures increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly.

Selling costs such as advertising costs are fixed costs.

Advertising costs per unit decrease as production increases.

Figure 13.4 on the next slide illustrates the effects of selling costs on total cost.

© 2015 Pearson

2. The average total cost of production,

3. Average total cost increases by a greater amount at small outputs than at large outputs.


1. When advertising costs are added to

© 2015 Pearson


4. If advertising enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, …

the average total cost falls from $60 a pair to $40 a pair.

© 2015 Pearson


Selling Costs and Demand

Advertising and other selling efforts change the demand for a firm’s product.

The effects are complex:

• A firm’s own advertising increases the demand for its product.

• Advertising by all firms might decrease the demand for any one firm’s product and might make demand more elastic.

The price and markup might fall.

© 2015 Pearson


Efficiency: The Bottom Line

The bottom line on the question of efficiency of monopolistic competition is ambiguous.

Do the gains from extra product variety offset the selling costs and the extra cost arising from excess capacity?

© 2015 Pearson

There is a lot of product differentiation in cell phones:

Samsung makes 38 versions; HTC makes 35; Nokia makes 30; and Sony makes 25.

In the three months from April through June 2013, dozens of new varieties of cell phones were announced by the top 20 firms in this market.

Why is there so much variety in cell phones?

The answer is that preferences are diverse and the cost of matching the diversity of preference is low.

© 2015 Pearson

Think about the ways in which cell phones differ.

Just a few examples are its dimensions, weight, navigation tools, talk time, standby time, screen, camera features, audio features, memory, connectivity, processor speed, storage, and network capability.

Each one of these features comes in dozens of varieties.

How many possible designs?

For example, if a phone had 10 features and each feature comes in 6 varieties, there are 1 million different possible cell-phone designs.

© 2015 Pearson

Firms produce variety only when the marginal cost of doing so is less than the marginal benefit.

The marginal cost of some cell-phone variety is not large.

But a technology exists for adding variety at almost zero cost that increases product differentiation to make each cell phone unique to the preferences of each individual.

This technology is the app.

Apple has only six versions of the iPhone, but with a large and growing number of apps, each iPhone owner can load their phone with exactly the apps they want.

© 2015 Pearson

In the long-run equilibrium, entry and innovation by each competitor will drive the economic profit toward zero.

Each cell-phone maker will offer a degree of product differentiation that equates the marginal cost of variety with its marginal benefit.

But the pursuit of economic profit will spur ever more innovation.

Consumers will be confronted with ever wider choice.

© 2015 Pearson

13.3 OLIGOPOLY

Oligopoly is another market type that stands between perfect competition and monopoly.

In oligopoly:

• A small number of firms compete.

• Natural or legal barriers prevent the entry of new firms.

Because oligopoly consists of a small number of firms:

• Each firm has a large market share.

• The firms are interdependent.

• The firms have an incentive to collude.

© 2015 Pearson

13.3 OLIGOPOLY

Collusion

When a small number of firms share a market, they can increase their profit by forming a cartel and acting like a monopoly.

A cartel is a group of firms acting together to limit output, raise price, and increase economic profit.

A duopoly is a market in which there are only two producers.

© 2015 Pearson

13.3 OLIGOPOLY

Cartels are illegal but they do operate in some markets.

Despite the temptation to collude, cartels tend to collapse.

Oligopoly might operate like monopoly, like perfect competition, or somewhere between these two extremes.

Monopoly Outcome

The firm would operate as a single-price monopoly.

Figure 13.5 on the next slide shows the monopoly outcome.

© 2015 Pearson

13.3 OLIGOPOLY

With the market demand, D, marginal revenue curve, MR, and marginal cost, MC, …

a monopoly airplane maker maximizes profit by producing 6 airplanes a week and selling them for $13 million an airplane.

© 2015 Pearson

13.3 OLIGOPOLY

The Duopolist’s Dilemma

To achieve the monopoly profit Airbus and Boeing might attempt to form a cartel.

If the firms can agree to produce the monopoly output of 6 airplanes a week, joint profits will be $72 million .

© 2015 Pearson

13.3 OLIGOPOLY

Would it be in the self-interest of Airbus and Boeing to stick to the agreement and limit production to 3 planes a week each?

With price exceeding marginal cost, one firm can an increase its profit by increasing its output.

If both firms increased output when price exceeds marginal cost, the end of the process would be the same as perfect competition.

© 2015 Pearson

13.3 OLIGOPOLY

Perfect Competition

Equilibrium occurs where the marginal revenue curve intersects the demand curve.

The quantity produced is 12 planes a week and the price would be $1 million a plane.

© 2015 Pearson

Boeing can increase its economic profit by $4 million and cause the economic profit of Airbus to fall by $6 million to $30 million.

Boeing Increases Output to 4 Airplanes a Week

13.3 OLIGOPOLY

© 2015 Pearson

Airbus Increases Output to 4 Airplanes a Week

For Airbus, this outcomeis an improvement on the previous one by $2 milliona week (up from $30 million).

For Boeing, the outcomeis worse than the previous one by $8 million a week (down from $40 million).

13.3 OLIGOPOLY

© 2015 Pearson

13.3 OLIGOPOLY

Boeing Increases Output to 5 Airplanes a Week

If Boeing increases output to 5 airplanes a week, its economic profit falls.Similarly, if Airbus increases output to 5 airplanes a week, its economic profit falls.

© 2015 Pearson

13.3 OLIGOPOLY

A cartel might achieve the monopoly equilibrium, break down and result in the perfect competition equilibrium,

or operate somewhere between these two extreme outcomes.

© 2015 Pearson

13.3 OLIGOPOLY

• If both firms stick to the monopoly output, they each produce 3 airplanes and make $36 million.

• If they both increase production to 4 airplanes a week, they make $32 million each.

• If only one firm increases production to 4 airplanes a week, that firm makes $40 million.

• What do they do?

Game theory provides an answer.

© 2015 Pearson

13.4 GAME THEORY

Game theory is the tool used to analyze strategic behavior—behavior that recognizes mutual interdependence and takes account of the expected behavior of others.

© 2015 Pearson

13.4 GAME THEORY

What Is a Game?

All games involve three features:• Rules• Strategies• Payoffs

Prisoners’ dilemma is a game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.

© 2015 Pearson

13.4 GAME THEORY

The Prisoners’ Dilemma

Art and Bob been caught stealing a car: sentence is 2 years in jail.

DA wants to convict them of a big bank robbery: sentence is 10 years in jail.

DA has no evidence and to get the conviction, he makes the prisoners play a game.

© 2015 Pearson

13.4 GAME THEORY

Rules

Players cannot communicate with one another.

• If both confess to the larger crime, each will receive a sentence of 3 years for both crimes.

• If one confesses and the accomplice does not,the one who confesses will receive a 1-year sentence, while the accomplice receives a10-year sentence.

• If neither confesses, both receive a 2-year sentence.

© 2015 Pearson

13.4 GAME THEORY

Strategies

The strategies of a game are all the possible actions of each player.

The strategies in the prisoners’ dilemma are

• Confess to the bank robbery.

• Deny the bank robbery.

© 2015 Pearson

13.4 GAME THEORY

Payoffs

Four outcomes:

• Both confess.

• Both deny.

• Art confesses and Bob denies.

• Bob confesses and Art denies.

A payoff matrix is a table that shows the payoffs for every possible action by each player given every possible action by the other player.

© 2015 Pearson

Table 13.5 shows the prisoners’ dilemma payoff matrix for Art and Bob.

13.4 GAME THEORY

© 2015 Pearson

13.4 GAME THEORY

Equilibrium

Occurs when each player takes the best possible action given the action of the other player.

Nash equilibrium is an equilibrium in which each player takes the best possible action given the action of the other player.

The Nash equilibrium for Art and Bob is to confess.

The equilibrium of the prisoners’ dilemma is not the best outcome for the players.

© 2015 Pearson

13.4 GAME THEORY

The Duopolists’ Dilemma

The dilemma of Boeing and Airbus is similar to that of Art and Bob.

Each firm has two strategies. It can produce airplanes at the rate of:

• 3 a week

• 4 a week

© 2015 Pearson

13.4 GAME THEORY

Because each firm has two strategies, there are four possible combinations of actions:

• Both firms produce 3 a week (monopoly outcome).

• Both firms produce 4 a week.

• Airbus produces 3 a week and Boeing produces 4 a week.

• Boeing produces 3 a week and Airbus produces 4 a week.

© 2015 Pearson

The Payoff Matrix

Table 13.6 shows the payoff matrix as the economic profits for each firm in each possible outcome.

13.4 GAME THEORY

© 2015 Pearson

Equilibrium of the Duopolists’ Dilemma

Both firms produce 4 a week.

Like the prisoners, the duopolists fail to cooperate and get a worse outcome than the one that cooperation would deliver.

13.4 GAME THEORY

© 2015 Pearson

13.4 GAME THEORY

Collusion Is Profitable but Difficult to Achieve

The duopolists’ dilemma explains why it is difficult for firms to collude and achieve the maximum monopoly profit.

Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output.

In an international oil cartel, OPEC, countries frequently break the cartel agreement and overproduce.

© 2015 Pearson

13.4 GAME THEORY

Advertising and Research Games in Oligopoly

Advertising campaigns by Coke and Pepsi, and research and development (R&D) competition between Procter & Gamble and Kimberly-Clark are like the prisoners’ dilemma game.

© 2015 Pearson

The Nash equilibrium for this game is for both firms advertise.

But they could earn a larger joint profit if they could collude and not advertise.

13.4 GAME THEORY

© 2015 Pearson

P&G and Kimberly-Clark have two strategies: spend on R&D or do no R&D.


Research and Development Game

13.4 GAME THEORY

© 2015 Pearson

The Nash equilibrium for this game is for both firms to undertake R&D.

But they could earn a larger joint profit if they could collude and not do R&D.

13.4 GAME THEORY

© 2015 Pearson

13.4 GAME THEORY

Repeated Games

Most real-world games get played repeatedly.

Repeated games have a larger number of strategies because a player can be punished for not cooperating.

This suggests that real-world duopolists might find a way of learning to cooperate so they can enjoy monopoly profit.

The next slide shows the payoffs with a “tit-for-tat” response.

© 2015 Pearson

Week 1: Suppose Boeing contemplates producing 4 planes instead of the agreed 3 planes.

Boeing’s profit will increase from $36 million to $40 million, and Airbus’s profit will decrease from $36 million to $30 million.

13.4 GAME THEORY

© 2015 Pearson

13.4 GAME THEORY

Week 2: Airbus punishes Boeing and produces 4 planes.

But Boeing must go back to producing 3 planes to induce Airbus to cooperate in week 3.

In week 2, Boeing’s profit falls to $30 million and Airbus’s profit increases to $40 million.

© 2015 Pearson

13.4 GAME THEORY

Over the two-week period,

Boeing’s profit would have been $72 million if it had cooperated, but it was only $70 million with Airbus’s tit-for-tat response.

© 2015 Pearson

13.4 GAME THEORY

In reality, whether a duopoly works like a one-play game or a repeated game depends on the number of players and the ease of detecting and punishing overproduction.

The larger the number of players, the harder it is to maintain the monopoly outcome.

© 2015 Pearson

13.4 GAME THEORY

Is Oligopoly Efficient?

In oligopoly, price usually exceeds marginal cost.

So the quantity produced is less than the efficient quantity.

Oligopoly suffers from the same source and type of inefficiency as monopoly.

Because oligopoly is inefficient, antitrust laws and regulations are used to try to reduce market power and move the outcome closer to that of competition and efficiency.

© 2015 Pearson

The cell phone combines two products: hardware and software.

Two firms dominate the cell-phone market: Apple and Samsung.

Apple powers its iPhone with its own operating system whereas Samsung installs the Android operating system.

© 2015 Pearson

© 2015 Pearson

Figure 1 shows that Android is the most popular operating system with 75 percent share.

Figure 2 shows that Samsung competes with other Android smart-phone producers.

© 2015 Pearson

© 2015 Pearson

Is the cell-phone market efficient?

Profit is one test of efficiency.

The large profit made suggest that the market is closer to monopoly than perfect competition.

Producer surplus is maximized.

Consumer surplus is less than it would be in a competitive market.

There is underproduction and a deadweight loss.

© 2015 Pearson

© 2015 Pearson

Some firms (Apple, Microsoft, Google) seek maximum profit by controlling both hardware and software.

Others ( Samsung, LG and other) focus on hardware only.

In either case, hardware is the key to profit.

Economies of scale in the design and production of hardware mean that this market is likely to remain a highly concentrated oligopoly.

© 2015 Pearson

Monopolistic Competition and Oligopoly

Business

Transcript of Monopolistic Competition and Oligopoly