LECTRUE NOTES XIII
Chapter 13
Monopolistic Competition, Oligopoly, and Strategic Pricing
I.
Monopolistic Competition
A.
CHARACTERISTICS:
1)
2)
Numerous rival firms
Free entry and exit
SO PROFIT MAY NOT BE SUSATAINED IN THE LONG RUN
Firms act independently
Firms don’t consider the response of other firms when setting their price.
3)
4)
Products are differentiated (HETEROGENOUS)
This implies that
a)
There are no perfect substitutes
b)
Firms are price searcher
c)
Firms face a downward sloping demand curve
(but there are many firms and close substitutes so it is very flat)
Firms have some market power and they are trying to gain a market niche.
5)
Firms engage in multiple dimensions of competition
Non-price Competition
B.
GRAPHICALLY
GRAPH
SAME SHUT DOWN RULE (Shut down if P < AVC)
In short run, these firms can have profits and losses, but this induces entry and exit- thus
no long run profits.
Similar to Perfect Competition:
1) no profit in the long run due to free entry and exit
2) Relatively elastic demand although not perfectly elastic (some steepness due to no
perfect substitutes, but relatively elastic due to many close substitutes).
3) Produce where MR = MC (however MR = P in this case).
Similar to monopoly:
1) Faces a downward sloping demand curve because no perfect substitutes
2) Allocative inefficiency
P = MC
Deadweight Loss
3) Productive inefficiency – do not produce at low point of ATC curve.
Usually due to expense of product differentiation
II.
OLIGOPOLY
A.
CHARACTERISTIC
1) Few sellers
There may actually be a few or many, but if many, there are a few dominant firms with a
competitive fringe
2) Mutual Interdependence of firms
Conjectural dependence – firms make conjectures about the reactions of other firms to there plans
3) Price searchers – demand curve is downward sloping
4) Products may be differentiated or homogeneous
5) Barriers to entry
B. GRAPHICALLY
Market for oligopoly firms
GRAPH
Two possible outcomes:
i) COOPERATIVE
ACT AS A JOINT MONOPOLY, Pm and Qm.
Move closer to producing where MR = MC
COLLUSION OR PRICE FIXING - typically illegal
ii)
NON COOPERATIVE
FIRMS COMPETE BY LOWERING PRICE
Move closer or to producing where MC = D
Pc and Qc, COMPETITIVE OUTCOME
There are short-term gains from cheating, but not long-lived
Cooperative solution - collusion
Shared monopoly – maximizing joint profits
CARTEL – when firms act jointly as a monopoly
Explicit or overt collusion
Tacit or covert collusion (try to keep a secret since it’s illegal)
C. Factors that affect the stability of a collusive agreement
1) Number of sellers
2) Product differentiation
3) Less non-price competition, easier to collude
4) Easier to collude if market is expanding rather than contracting
5) (Un)stable demand conditions hurt collusion
6) Easier to collude if dominant firm exists a price leader
7) The more barriers to entry, the easier it is to collude. No new entrants to hurt agreement
8) Legal barriers to collusion like antitrust laws make collusion difficult – cartels are illegal
9) Ability to detect and eliminate price cuts
D. GAME THEORY
Oligopoly market structures have more than one possible equilibrium. Also, one firm
must take into account the reaction of its rivals when it determines its pricing policy. Therefore,
the firms behave strategically and they choose pricing strategies. Since they are choosing among
different strategies, to analyze the choices and outcomes we can look at it as a game, where the
players are all trying to win (maximize profit), but they face some uncertainty about what the
other players will do. The branch of economics that looks at these situations called “Game Theory
Economics”. We will look at a simple game to see how the theory works and what it tells us
about behavior of firms in an oligopoly market.
The Prisoner’s Dilemma:
Payoff Matrix
Strategies for person A
Do Not Confess
Strategies
for person B
Do Not Confess
6 months A
Confess
0 months A
6 months B
9 years A
9 years B
5 years A
Confess
0 months B
5 years B
If they both confess, this is the noncooperative – competitive solution and the profit is
driven to zero. In this case – a longer prison term for each.
E. THE CONCENTRATION RATIO
Tells you if market power is concentrated in the hands of a few firms or spread out over
many firms.
(Measures level of competitiveness in an industry)
EXAMPLE:
Calculate a Four Firm Concentration Ratio – sum of market share of four largest firms in
each industry
INDUSTRY 1
Five firms
Firm % Market share
1
20%
2
20%
3
18%
4
15%
INDUSTRY 2
50 Firms
Firm % Market share
1
5%
2
2%
3
2%
4
1%
Concentration ratio in industry 1 is 73%
Concentration ratio in industry 2 is 10%
1 is more like monopoly and 2 is more like perfect competition
Problems with the Concentration Ratio:
1) does not account for the number of firms
2) say there are four firms in each two different industries
Firm % Market share
Firm % Market share
1
85%
1
25%
2
5%
2
25%
3
5%
3
25%
4
5%
4
25%
These would both have a four firm concentration ratio of 100 but they are very different.
So we use The Herfindahl Index: this adds market share squared of all firms in the
industry, not just top four or top eight
Industry 1: (assuming each just has four firms)
H = 852 + 52 + 52 + 52 = 7,225 + 25 + 25 + 25 = 7,300
Industry 2:
H = 252 + 252 + 252 + 252 = 625 + 625 + 625 + 625 = 2,500
The H weights a firm with a larger share more heavily.
Market power is evenly distributed in industry 2 so the h has a lower value – more
competitive