9
Between Competition
and Monopoly
Outline
● Monopolistic Competition
● Oligopoly
● Monopolistic Competition, Oligopoly, and
Public Welfare
● A Glance Backward: Comparing the Four
Market Forms
Three Real World Puzzles
1.
Why are there so many retailers?
●
2.
E.g., intersections with 4 gas stations which is more than #
of cars warrants. Why and how do they all stay open?
Why do oligopolists advertise more than competitive
firms?
●
E.g., many big Co. use ads to battle for customers and ad
budgets account for a huge portion of TC. Vs. farmers where
few if any farms spend $ on ads.
Why do oligopolists seem to ∆P so infrequently?
3.
●
E.g., ∆P commodities hourly but ∆P cars or refrigerators
only a few times a year.
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Characteristics of
Monopolistic Competition
1.
2.
3.
4.
Many small buyers and sellers
Freedom of entry and exit
Perfect information
Heterogeneous products: each seller’s product differs
somewhat from every other seller’s product.
♦
♦
E.g., Diff. in packaging, services, or consumers’ perceptions.
Only characteristic that differs from perfect competition.
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Monopolistic Competition
● D curve facing firm has (-) slope.
♦ Each seller’s product is different –they are not perfect
substitutes.
♦ ↑P will drive away some but not all of firm’s customers. Or ↓P
will attract some but not all customers from rival firms.
● Freedom of entry and exit → firms cannot earn econ Π
in LR.
♦ SR Π > 0 → new firms enter and ↓P until P = AC.
● Most U.S. firms are in this market structure.
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Determination of Price and Output
under Monopolistic Competition
● Recall when D has (-) slope → P > MR.
● Profit-max Q is where MR = MC.
● Analysis looks like pure monopoly, but monop. comp.
firm (with rivals producing close substitutes) has a much
flatter D curve.
● LR: Π = 0 → each firm produces where P = AC. So
firm’s D curve must be tangent to its AC curve.
● Zero econ. Π in LR is seen in real world.
♦ E.g., Gas station owners do not earn higher Π than small
farmers under perfect competition.
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FIGURE 1. Short-Run Equilibrium
Under Monopolistic Competition
Π-max Q =12,000 and P
= $3.50
MC
Price per Gallon
AC
$3.80
$3.50
3.40
$3.00
P
C
E
D
MR
12,000
Gallons of Gasoline per Week
Per unit Π = $0.10 →
total Π = $1,200.
FIGURE 2. Long-Run Equilibrium
Under Monopolistic Competition
MC
Price per Gallon
AC
SR profits in Fig. 1 → new
firms enter which shifts each
firm’s D curve down until P
= AC.
Compared with SR profits in
Fig. 1:
$3.45
$3.35
P
a. P is lower in LR
M
b. more firms in industry;
each produces a smaller Q
with higher AC.
E
D
MR
10,000
15,000
Gallons of Gasoline per Week
The Excess Capacity Theorem
● In Fig. 2, AC at LR Q of firm (pt P) > min AC (pt M).
● Pt M is where LR Q of a perf. comp. firm would be.
● In LR, monop. comp. firm is producing where ↓AC but
has not yet reached its min.
● Monopolistic competition leads to firms that have
unused or wasted capacity.
● Resolve puzzle 1 –abundance of retailers: intersection
with 4 gas stations where 2 would suffice and operate at
lower AC is real world ex. of excess capacity.
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The Excess Capacity Theorem
● Fewer firms in a monop. comp. market → each firm
could ↑Q and ↓AC.
● Yet, fewer firms with larger quantities means there is less
variety of product.
● Greater efficiency would be achieved at the cost of
greater standardization.
● Not clear society would be better off with fewer firms.
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Oligopoly Defined
● Oligopoly = market dominated by a few sellers, where
several are large enough to affect market P.
● Great rivalry among firms with new product intros, free
samples, and agro marketing campaigns.
● Degree of product differentiation varies by industry:
none in steel plates but lots in cars.
● Some industries also contain large # of smaller firms
(e.g., soft drinks) but they are dominated by a few large
firms that get bulk of industry sales.
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Oligopoly Defined
● Firms strive to create unique products (in terms of
features, location, or appeal) to shield themselves from
competition that ↓P and ↓sales.
● More intense competition than pure competition.
♦ E.g., A corn farmer doesn’t make tough P decisions. He accepts
market P and reacts by picking Q.
♦ A farmer doesn’t need to advertise. He can sell as much as he
likes at current market P.
♦ A farmer doesn’t worry about P policies his rivals are planning.
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Oligopoly Defined
● Oligopolists have some influence over market P, so they
must consider rivals’ P; spend a fortune on ads; and try
to predict their rivals’ actions.
● Resolve puzzle 2 –why oligopolists advertise and
perfectly competitive firms do not.
1. Comp. firms can sell as much as they want at current P, so why
advertise? Vs. Toyota faces a (-) sloped D curve, so it must ↓P or
↑ads (try to shift D out) to sell more cars.
2. Products are identical, so farm A’s ads might ↑ sales of farm B.
Vs. Toyota’s ads may ↑ its sales and ↓ sales of rival carmakers.
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Why Oligopolistic Behavior is
So Difficult to Analyze
● Largest firms can impact P and all firms must watch
rivals’ actions.
● Analysis is difficult as firms’ decisions are interdependent and oligopolists know that outcomes of their
decisions depend on rivals’ responses.
♦ E.g., Toyota’s managers know that their actions will cause
reactions by Honda which may require Toyota to adjust its
plans.
● Oligopolies have a variety of behavior patterns which
requires different models to understand their behavior.
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Models of Oligopoly
● Different models to understand Oligopoly behavior:
♦
♦
♦
♦
♦
♦
♦
Ignore interdependence
Strategic interaction
Cartels
Price leadership and tacit collusion
Sales maximization
Kinked demand curve
Game theory
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Ignoring Interdependence
● Simplest model
● Firms behave as if their actions will not spark reactions
from rivals.
● Each firm seeks to max profits and assumes its P-Q
decision will not affect its rivals’ strategy.
● Analyze oligopoly in the same way as pure monopoly.
● This doesn’t explain most oligopoly behavior!
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Strategic Interaction
●
●
●
●
Consider 2 soap makers: X and Y.
X ↓P to $4.05 and assumes Y will continue its P = $4.12
Say Qx = 5m and X spends $1m on ads.
X may be surprised when Y cuts P to $4.00; ↑Qy to 8m
and sponsors the Super Bowl.
● This ↓Πx and X wishes it didn’t cut P in first place.
● X cannot afford to ignore how Y will react.
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Cartels
● All firms agree to set P and Q → act as pure monopolist.
● OPEC began making joint decisions in 1970’s and has
been successful over time at ↓Q oil and ↑P oil.
● Cartels are difficult to organize and hard to enforce.
♦ Each member must produce small Q assigned by group. But
once high P is established, every firm is tempted to cheat by
↑Qs. When cheating is suspected, cartel quickly falls apart as
others ↑Qs which ↓P.
● Considered worse than monopoly. Cartel charges
monopoly P without the cost savings from large scale
production.
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Price Leadership and Tacit
Collusion
● Overt collusion (where firms meet to pick P-Q) is illegal
in the U.S. and rare. But tacit collusion is common.
● Each tacitly colluding firm hopes that if it does not rock
the boat (via ↓P or ↑ads), then rivals will do same.
● Price leadership = 1 firm makes P decisions for group.
♦ Other firms are expected to adopt P of leader without any
explicit agreement.
♦ P leader is often largest firm in industry.
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Sales Maximization: Model with
Interdependence Ignored
● Firms may attempt to max revenue rather than profit if:
♦ control is separated from ownership
♦ compensation of managers is related to size of the firm
● Q set where MR = 0 (rather than MR = MC)
♦ Recall: MR is slope of TR curve. So TR is max when MR = 0.
If MR > 0 → ↑Q to ↑TR and if MR < 0 → ↓Q to ↑TR.
● Compared to profit-max firm:
♦ Higher Q
♦ Lower P
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FIGURE 3. Sales-Max Equilibrium
Π-max Q = 2.5m where MR =
MC
MC. P = $4.00 and total Π =
$0.20 x 2.5 m = $500,000.
AC
Sales-max Q = 3.75m where
E
Price per Box
$4.00
3.80
MR = 0. P = $3.75 and total Π =
$0.06 x 3.75 m = $225,000.
F
3.75
3.69
Total Π (TR) is lower (higher) at
point F than point E.
A
D
B
2.5
3.75
Millions of Boxes per Year
MR
?
The Kinked Demand Curve
Model
● Resolve puzzle 3 –why do P in oligopolistic markets
(cars or appliances) change less often than P of
commodities (wheat or gold)?
● Firms think that other firms will match any P cut, but not
any P increase. If true, firms face an inelastic D curve
with P cuts and an elastic curve with P increases.
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?
The Kinked Demand Curve
Model
● In Fig. 4, pt A is firm’s initial P = $8.
● 2 D curves pass through pt A.
♦ DD is more elastic → rivals’ P are fixed
♦ dd is less elastic → rivals match ∆P
● If firm ↓P to $7 (and rivals don’t match ↓P) → large
↑customers, so new Qd = 1,400.
● If rivals match ↓P → ↑Qd is small, so new Qd = 1,100.
● If firm ↑P (and rivals don’t match ↑P) → large ↓Qd.
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?
The Kinked Demand Curve
Model
● The firm’s true demand curve in Fig. 4 is DAd –a kinked
demand curve.
● P tend to “stick” to their original level because ↑P → lose
many customers and ↓P → gain very few customers.
● Firm will only ∆P if costs change enormously.
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FIGURE 4. The Kinked Demand
Curve
Price
d
D
$8
7
Typical oligopoly fears the worst. If firm cuts P then
rivals will match P cut → relevant demand curve is
dd. But if firm raises P then rival will not match the P
increase → relevant demand curve is DD. Thus, the
firm’s true demand curve is the red line “DAd.”
A
D (Competitors’
prices are fixed)
(Competitors
d respond to price
changes)
0
1,000
1,100
Quantity per Year
1,400
?
The Kinked Demand Curve
Model
●
●
●
●
MR is associated with DD and mr is associated with dd.
Overall marginal revenue curve is DBCmr.
MC = MR at pt E which shows Π-max Q for oligopolist.
Since relevant MR curve is kinked, even a moderate shift
in MC will leave Q and thereby P unchanged.
● Oligopoly prices are “sticky” and do not respond to
minor cost changes.
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FIGURE 5. The Kinked Demand
Curve and Sticky Prices
d
MC
Price
D
A
$8
B
D
E
MR
C
1,000
Quantity Supplied per Year
mr
d
The Game-Theory Approach
● Most widely used approach to analyze oligopoly
behavior.
● Each oligopolist is seen as a competing player in a game
of strategy.
● Optimal strategies are determined by examining a payoff
matrix showing Π of each firm depending on P strategy
that each firm follows.
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Games with Dominant Strategies
● Dominant strategy = one that gives the bigger payoff to
the firm that selects it, no matter which of the two
strategies the competitor selects.
♦ E.g., Table 1., both firms have an incentive to pick low P
strategy regardless of what other firm does. If B picks high P,
then A receives largest payoff choosing low P. Or if B picks
low P, then A receives the largest payoff by choosing low P.
♦ “Low Price” is the dominant strategy for both firms, so both
charge a low P and each earns $3m.
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TABLE 1. Payoff Matrix with
Dominant Strategies
Firm B Strategy
High Price
Low Price
High Price
A gets $10m
B gets $10m
A gets -$2m
B gets $12m
Low Price
A gets $12m
B gets -$2m
A gets $3m
B gets $3m
Firm A
Strategy
Games with Dominant Strategies
● A market with a duopoly serves public interest better
than a monopoly because of the competition created
between two firms.
♦ Both firms would be better off if they could charge high P. But
the presence of a competitor, forces each firm to protect itself
by charging low P.
● It is damaging to the public to allow rival firms to
collude on what prices to charge for their products.
♦ E.g., if two firms collude in Table 1, then we end up with high
P and each earning $10m.
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Games without Dominant
Strategies
● Maximin = select the strategy that yields the max payoff
assuming your rival does as much damage to you as he
can.
● In Table 2, A’s maximin strategy is to pick low P and
earn $5m.
♦ Firm A thinks: if I chose a high P → worst outcome is B picks
a low P and I get $3m. If I chose a low P → worst outcome is B
picks a low P and I get $5m.
♦ Firm A picks the strategy that offers the best of those bad
outcomes.
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TABLE 2. A Payoff Matrix without a
Dominant Strategy
Firm B Strategy
High Price
Low Price
High Price
A gets $10m
A gets $3m
Low Price
A gets $8m
A gets $5m
Firm A
Strategy
Repeated Games
● Repeated games give players the opportunity to learn
something about each other’s behavior patterns and,
perhaps, to arrive at mutually beneficial arrangements.
● Table 1 shows a single round of the game. Each firm
picked low P. But if games are repeated, players can
escape this trap.
♦ E.g., Firm A could cultivate a reputation of “tit for tat.” Each
time B charges a high P → A would charge a high P. After a
few repetitions, B learns that A always matches its P decisions.
So B will see that it’s better to stick with a high P.
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Threats and Credibility
● Use threats to induce rivals to change their behavior.
♦ E.g., retailer could threaten to double Q and ↓P to $0 if a rival
imitates its product. But this is not credible, because it hurts the
retailer who is making the threat.
● A credible threat is a threat that does not harm the
threatener if it is carried out.
● Old firms often use credible threats to prevent new firms
from entering the industry.
♦ E.g., old firm will build a larger factory than it would otherwise
want. Large factory lowers cost of ↑Q –even at low P.
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FIGURE 6. Entry and Entry-Blocking
Strategy
Possible Choices
of Old Firm
Possible Reactions
of New Firm
Profits (millions $)
Old Firm New Firm
–2
–2
4
0
2
2
6
0
Threats and Credibility
● In Fig. 6, best outcome for old firm is to have a small
factory and no rivals.
♦ But if old firm builds a small factory, it can count on new firm
entering to earn $2m. So old firm’s ↓Π to $2m.
● If old firm builds a big factory, its ↑Q will ↓P and ↓Π.
Old firm now earns $4m if new firm stays out.
♦ Clearly, new firm will stay out to avoid loses of $2m.
● Thus, old firm should build big factory to keep rivals out.
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Monopolistic Competition,
Oligopoly, & Public Welfare
● Oligopolistic behavior is so varied that it is hard to come
to a simple conclusion about welfare implications.
● In many circumstances, the behavior of monopolistic
competitors and oligopolists falls short of the social
optimum.
● Excess capacity theorem suggests monopolistic
competition can lead to inefficiently high production
costs.
● Oligopolists may organize into successful cartels to ↓Q
and ↑P.
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Monopolistic Competition,
Oligopoly, & Public Welfare
●
When an oligopolistic market is perfectly contestable
–if firms can enter and exit without losing $ they
invested –then (P,Q) of firms is likely to be socially
efficient.
♦
●
E.g., airplanes, trucks, and barges can easily be moved.
Constant threat of entry forces oligopolists to keep
their prices down and their costs low.
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Comparing the Four Market
Forms
● Perfect competition and pure monopoly are rare.
● Most firms are monopolistically competitive, but
oligopoly firms account for largest share of economy’s
output.
● Π = 0 in LR under perfect competition and monopolistic
competition because of free entry and exit.
♦ Thus, P = AC in LR under these 2 market forms.
● Π-max firm under any market form selects Q by setting
MR = MC.
♦ However, oligopolists may not set MC = MR when choosing Q
–e.g., if firm max sales.
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Comparing the Four Market
Forms
● Perfectly competitive firm and industry  efficient
allocation of resources.
● Monopoly  inefficient allocation of resources by ↓Q
and ↑P.
● Monopolistic competition  inefficient allocation of
resources through excess capacity.
● Under oligopoly, almost anything can happen, 
impossible to generalize about its vices or virtues.
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TABLE 3. Attributes of the Four
Market Forms