Chapter 14

Transcript Chapter 14

ECONOMICS 5e

Michael Parkin CHAPTER

14 Monopolistic Competition and Oligopoly

Learning Objectives

• Explain determined how in price a competitive industry and output are monopolistically • Explain why advertising costs are high in a monopolistically competitive industry • Explain why the price might be sticky in an oligopoly industry Copyright © 1998 Addison Wesley Longman, Inc.

TM 14-2

Learning Objectives (cont.)

• Explain how price and output are determined when an industry has one dominant firm and several small firms • Use game theory to make predictions about price wars and competition among a small number of firms Copyright © 1998 Addison Wesley Longman, Inc.

TM 14-3

Learning Objectives

TM 14-4

Monopolistic Competition

Monopolistic competition A large number of firms compete.

• • • Small market share Ignore other firms Collusion Impossible Each firm produces a differentiated product.

• A product slightly different from the products of competing firms.

TM 14-5

Monopolistic Competition

Monopolistic competition (cont.) Firms compete on product quality, price, and marketing.

• Quality - design, reliability, service, ease of access to the product.

• • Price - downward sloping demand curve.

• A tradeoff between price and quality.

Marketing - advertising and packaging.

Firms are free to enter and exit.

TM 14-6

Monopolistic Competition

Monopolistic competition (cont.) Consequently, a firm in monopolistic competition cannot make an economic profit in the long-run.

TM 14-7

Examples of Monopolistic Competition

TM 14-8

Monopolistic Competition

As a result of the characteristics of monopolistic competition: • No one firm can effectively influence what other firms do.

• The firm faces a downward sloping demand curve.

• Firms cannot earn long-run economic profit.

TM 14-9

Output and Price in Monopolistic Competition

Short-Run: Economic Profit • The firm in monopolistic competition looks just like a single price monopoly.

• The key difference between monopoly and monopolistic competition lies in the long-run .

TM 14-10

Monopolistic Competition

220 Short-run 190 MC ATC 160

Economic profit

TM 14-11

Output and Price in Monopolistic Competition

Long-Run: Zero Economic Profit • Economic profit attracts new entrants.

• As new firms enter the industry, the firm’s demand curve and marginal revenue start to shift leftward.

• The profit-maximizing quantity and price fall.

TM 14-12

Monopolistic Competition

50 MR 100 D 150 200 250 300 Quantity (jackets per day)

TM 14-13

Monopolistic Competition and Efficiency

Marginal benefit exceeds marginal cost and production is less than its efficient level.

Therefore, the market structure is inefficient.

TM 14-14

Monopolistic Competition and Efficiency

The monopolistically competitive industry produces an output at which price equals average total cost but exceeds marginal cost.

This outcome means that firms monopolistic competition always have excess capacity in long-run equilibrium .

TM 14-15

Excess Capacity

A firm’s capacity output is the output at which average total cost is a minimum - the output at the bottom of the U-shaped

ATC

curve.

The firm produces a smaller output than that which minimizes average total cost.

TM 14-16

Excess Capacity

TM 14-17

Learning Objectives

• Explain how price and output are determined in a monopolistically competitive industry • Explain why advertising costs are high in a monopolistically competitive industry • Explain why the price might be sticky in an oligopoly industry Copyright © 1998 Addison Wesley Longman, Inc.

TM 14-18

Product Development and Marketing

Innovation and Product Development To maintain its economic profit, a firm must seek out new products that will provide it with a competitive edge, even if temporarily.

TM 14-19

Product Development and Marketing

Efficiency and Product Innovation Two views • Improved products that bring great benefits to the consumer.

• But many so-called improvements amount to little more than changing the appearance of a product.

TM 14-20

Product Development and Marketing

Marketing Advertising and packaging are the principle means used by firms to attempt to create a consumer perception of product differentiation even when actual differences are small.

TM 14-21

Product Development and Marketing

TM 14-22

Product Development and Marketing

Selling Costs and Total Costs Advertising expenditures increase the costs of a monopolistically competitive firm above those of a competitive firm or monopoly.

Selling costs are fixed costs.

TM 14-23

Advertising Expenditures

TM 14-24

Product Development and Marketing

Selling Costs and Demand Advertising increases competition .

To the extent that advertising increases competition, it

decreases

the demand faced by any one firm.

TM 14-25

Selling Cost and Total Costs

200 Advertising cost Average total cost with advertising 180 170 160 140 quantity bought, 120 decrease ATC Average total cost with no advertising 0 25 130 MR 200 300 Quantity (jackets per day) Copyright © 1998 Addison Wesley Longman, Inc.

TM 14-26

Efficiency: The Bottom Line

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

TM 14-27

Learning Objectives

• Define monopolistic competition and oligopoly • Explain how price and output are determined in a monopolistically competitive industry • Explain why the price might be sticky in an oligopoly industry Copyright © 1998 Addison Wesley Longman, Inc.

TM 14-28

Oligopoly

Price and quantity of a producer depends upon that of the other producers’.

TM 14-29

The Kinked Demand Curve Model

Assumption • If a firm raises its price, others will not follow.

• more elastic response • If a firm cuts its price, so will the other firms.

• less elastic response This assumption results in the kinked demand curve.

TM 14-30

The Kinked Demand Curve Model

MC 1 MC 0

Q MR D Quantity

TM 14-31

The Kinked Demand Curve Model

Problems • Beliefs about the demand curve are not always correct.

• Other firms may, in fact, follow a price increase.

TM 14-32

Learning Objectives (cont.)

TM 14-33

Dominant Firm Oligopoly

A dominant firm oligopoly may exist if one firm: • Has a big cost advantage over the other firms.

• Sells a large part of the industry output.

• Sets the market price.

• Other firms are price takers.

TM 14-34

Dominant Firm Oligopoly

Let’s use Big-G as an example .

Big-G is the dominant gas station in a city.

TM 14-35

Dominant Firm Oligopoly

Ten small firms and market demand Big-G’s price and output decision S 10 MC 1.50

1.50

a b

1.00

0.50

1.00

D 0.50

0 XD MR 10 20 Quantity (thous. of gal./week)

TM 14-36

Learning Objectives (cont.)

TM 14-37

Game Theory

Invented by John von Neumann in 1937.

We will use it to help understand oligopoly.

TM 14-38

Game Theory

What is a game?

Games have 3 features: • • • Rules Strategies Payoffs “The Prisoners Dilemma” is a game that is used to generate predictions.

TM 14-39

The Prisoners’ Dilemma

Art & Bob are caught stealing a car.

The D.A. feels they are responsible for a robbery months earlier.

The D.A. decides to make them play a game.

TM 14-40

The Prisoners’ Dilemma

Rules of the game • Prisoners are put in separate rooms and cannot communicate with the other.

• They are told that they are a suspect in the earlier crime.

• If both confess, they will get 3 years.

• If one confesses and the other does not, the confessor will get 1 year while the other gets 10.

TM 14-41

The Prisoners’ Dilemma

TM 14-42

The Prisoners’ Dilemma

Payoffs Four outcomes are possible: • • • • Both confess.

Both deny.

Art confesses and the Bob denies.

Bob confesses and Art denies.

TM 14-43

Prisoners’ Dilemma Payoff Matrix Confess

Arts strategies

Deny

3 years 10 years

Confess Bob’s strategies

3 years 1 year 1 year 2 years

Deny

10 years 2 years

TM 14-44

The Prisoners’ Dilemma

A dominant strategy emerges.

Art and Bob should both deny because: • • • • If they both deny, they will only get 2 years—but they don’t know if the other will deny.

If Art denies, but Bob does not, Art will only get 1 year.

If Art denies, but Bob confesses, Art will get 10 years.

They both eventually decide it is best to confess — Nash equilibrium .

TM 14-45

An Oligopoly Price-Fixing Game

Duopoly A market structure with two firms.

We will use Trick and Gear as our two firms.

They agree with each other to restrict output in order to raise prices and profits — a collusive agreement .

TM 14-46

An Oligopoly Price-Fixing Game

A cartel is a group of firms that enter into a collusive agreement.

TM 14-47

An Oligopoly Price-Fixing Game

Four outcomes are possible • Both firms comply • Both firms cheat • Trick complies and Gear cheats • Gear complies and Trick cheats.

TM 14-48

Costs and Demand Conditions

The conditions are: • Trick and Gear face identical costs.

• The switchgears they produce are identical.

They are a natural duopoly.

TM 14-49

Costs and Demand

3 4 5 Quantity (thous. of switchgears/week) 0 1 2 3 4 5 6 7 Quantity (thous. of switchgears/week)

TM 14-50

Colluding to Maximize Profits

• These firms may benefit from colluding.

• They attempt to behave like a monopoly.

• They agree to restrict output to a level that makes marginal revenue and marginal cost equal.

TM 14-51

Colluding to Make Monopoly Profits

3 4 5 Quantity (thous. of switchgears/week) 0 1 2 3 4 MR 5 6 7 Quantity (thous. of switchgears/week)

TM 14-52

One Firm Cheats on a Collusive Agreement

Previous example • Each firm produced 2,000 units and earned $2 million in economic profit.

Now, Trick convinces Gear that it cannot sell 2,000 units a week and must cut its price to be able to do so.

• Gear cuts its price, but it does not change output.

• Trick lies and cheats on their agreement — it increases output.

TM 14-53

One Firm Cheats

Complier Cheater Industry 10.0

8.0

7.5

Economic loss

ATC

10.0

7.5

6.0

Economic profit

ATC

10.0

8.0

7.5

Complier’s output Cheat’s output

0 1 2 3 4 5 Quantity (thousands of switchgears/week) 0 1 2 3 4 5 Quantity (thousands of switchgears/week) 0 1 2 3 4 5 6 7 Quantity (thousands of switchgears/week) Copyright © 1998 Addison Wesley Longman, Inc.

TM 14-54

Both Firms Cheat

Both firms will cheat as long as price exceeds marginal cost.

When price equals marginal cost they will no longer have an incentive to cheat.

TM 14-55

6 10

Both Firms Cheat

Individual Firm Industry

MC ATC

MC 1

Both cheating achieves competitive outcome D

0 1 2

3 4 5

Quantity (thous. of switchgears/week)

0 1 2 3 4 5 6 7

Quantity (thous. of switchgears/week)

TM 14-56

The Payoff Matrix

Now, let’s illustrate these possibilities using a duopoly payoff matrix.

TM 14-57

Duopoly Payoff Matrix Cheat

Gear’s strategies

Comply

Cheat Trick’s strategies

Comply

+$4.5m

–$1.0m

-$1.0m

+$4.5m

+$2m +$2m

TM 14-58

Equilibrium of the Duopolists Dilemma

At equilibrium, it pays both firms to cheat.

What if this game is repeated over and over again? Will the outcome differ?

TM 14-59

Repeated Games

If this is repeated, one firm has the opportunity to penalize the other.

A cooperative equilibrium may occur.

• This occurs when the firms make and share the monopoly profit.

• Must be penalized for cheating.

TM 14-60

Games and Price Wars

Some price wars resemble the tit-for-tat strategy.

Price wars sometimes result from new firms entering a monopoly industry.

TM 14-61

Other Oligopoly Games

An R&D Game Firms spend large sums of money in R&D in the attempt to: • • • develop the most highly valued product develop the least-cost technology gain a competitive edge to increase market share and profit Should a firm spend money in R&D?

TM 14-62

Pampers Versus Huggies: An R&D Game

Procter & Gambles strategies

R&D No R&D

+$45m

R&D Kimberly Clark’s strategies

+$5m +$85m

No R&D

-$10m -$10m +$85m +$70m +$30m

TM 14-63

Contestable Markets

A market in which one firm (or a small number of firms) operates, but in which both entry and exit are free, so the firm(s) in the market faces competition from

potential

TM 14-64

Entry-Deterrence Game

Let’s see what happens when a firm attempts to enter a market dominated by a single firm.

TM 14-65

Enter and set price below Agile’s price

Wannabe’s strategies Duopoly Payoff Matrix

Agile’s strategies Monopoly price Competitive price Economic loss Economic loss Economic profit Economic loss Monopoly profit Normal profit Not enter Normal profit Normal profit

TM 14-66

Entry-Deterrence Game

The practice of charging a price below the monopoly profit-maximizing price and producing a quantity greater than that at which marginal revenue equals marginal cost in order to deter entry is limit pricing.

TM 14-67