Monopolistic Competition and Oligopoly
Monopolistic Competition is characterized:
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Relatively large number of sellers
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differentiated products (promoted by heavy advertising)
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Easy entry and exist from the industry
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Large number of seller (like 25, 35, 60, 70)
*Not in the hundreds or thousands of firms like in pure competition
Types of monopolistic Competition
Small market share: Each firm has comparative small percentage of the total market and consequently has limited
control of marker price.
No collusion: the presence of relatively large number of firms ensures that collusion by a group of firm to restrict output
and set prices is unlikely.
Independent action: with numerous firms in an industry there is no feeling of interdependence among them
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Firm can determine its own pricing policy without considering the possible rival firms.
Differentiated Products
Products Differentiated when firms turn out variation of a particular product, these product are slightly different physical
characteristics and varying degree of customer service providing varying amount of location convenience, or proclaim
special qualities.
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Product attributes physical or qualitative differences in the product difference in functional features material
design and workmanship.
Example: MP3 player may differ in storage capacity, speed, Graphic and displays
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Service the prestige appeal of the store the courteousness and helpfulness of the staff and the firms’ reputation for
servicing or exchanging its product and credit it make available.
Example: Store greeter, customer service and repair time
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Location products may also be differentiated through location and accessibility of store that sell them
Example: Motels on the interstate highway
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Brand name and packaging differentiate products from each other through trademark and package, celebrity
connection.
Example: Apple and its white apple logo or celebrity endorsed product like Tiger Woods and Nike
Control over price firms control price because of product differentiation.
Easy entry and exits because the monopolistic is made up of small firms both absolutely and relatively, economies of
scales are few and capital requirements are low.
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Advertising the goal of product differentiation and advertising is nonprice competition is to make price less of a
factor in a consumer purchase and make product difference a greater factor. ( if the firm is successful then
demand curve will shift to the right and will become less elastic )
The Short Run: Profit or Loss
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Competitive firm maximizes its profit or minimizes its loss in the short run by producing the output at which
marginal revenue equal marginal cost (MR = MC)
[=(P₁- A₁)×Q₁]
The Long Run: Only a Normal Profit
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Firm will earn normal profits or break even (the cost curve includes both explicit cost and implicit cost
and normal profits
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Profits: Firms Enters “New rivals” the demand curve will shift to the left
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Losses: Firms Leaves some firms will exit in the long run faced with fewer substitute products, the
demand curve will shift to the right giving way to normal profits.
Monopolistic Competition and Efficiency
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Remember economic efficiency requires the triple equality P=MC=minimum ATC.
Productive efficiency P=minium ATC. The good is being produced in the least costly way; it is enough to cover
ATC.
Allocative efficiency P=MC. The right amount of output is being produced, and the right amount of socicety’s
scarce resources is being devoted to this specific use.
Neither Productive nor Allocative Efficiency
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In monopolist competition, neither productive nor allocative efficiency occurs in the long run equilibrium.
P3>lowest ATC A3; therefore, P ≠ MC & minimum ATC. Productive efficiency is not achieved.
P3>MC, meaning underallocation of resources. Allocative efficiency is not achieved.
Consumers pay a higher-than-competitive price and obtain a less-than-optimal output.
Monopolistic competitors must charge a higher-than-competitive price in the long run to achieve a normal profit.
Excess capacity: plant and equipment that are underused because firms are producing less than the minimum ATC
output. For example, the situation created by the abundance of small motel in a city.
Product variety
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Each firm has a product that is distinguishable in some way from those of other producer.
The firm can attempt to stay ahead of competitors and sustain its profit through further product differentiation and
better advertising.
Product differentiation and advertising will add to the firm’s cost, but they can also increase the demand for its
product.
Successful product improvement by one firm obligates rivals to imitate or improve their products or else lose
business.
Product differentiation creates a trade-off between cosumer choice and productive efficiency. The greater the
product differentiation, the greater the excess capacity and, therefore, the greater is the productive inefficiency.
The efficiency loss associated with monopolistic competition is greatly muted by the benefits consumers receive
from product variety.
The monopolistically competitive firm takes into account three factors – price, product, and advertising – to
maximize its profit.
Each combination of price, product, and advertising poses a different demand and cost for the firm.
OLIGOPOLY
It is a market dominated by a few large producers of a homogeneous or differentiated product.
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Oligopolists have considerable control over their prices, but each must consider the possible reaction of rivals to
its pricing, output, and advertising decisions.
Oligopoly encompasses the U.S. aluminum industry, in which three huge firms dominate an entire national
market, and the situation in which four or five much smaller auto-parts stores enjoy roughly equal shares of the
market in a medium size town.
Generally, terms such as “Big Three,” Big Four,” or “Big Six,” refer to an oligopolistic industry.
Homogenous or Differentiated Products
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Many industrial products (steel, zinc, copper, aluminum, lead, cement, industrial alcohol) are virtually
standardized or homogenous products that are produced in oligopolies.
Consumer goods industries (automobiles, tires, households appliances, electronics equipment, breakfast cereals,
cigarettes, and many sporting goods) are differentiated oligopolies.
Control over price, but Mutual Interdependence
In oligopoly industries, each firm is a “Price Maker”. It can set its prices and output levels to maximize its profit.
The ogilopolists must consider how its rivals will react to any change in its price, output, product characteristics,
or advertising.
Strategic behavior: self-interested behavior that takes into account the reactions of others.
Mutual interdependence: each firm’s profit depends not entirely on its own price and sales strategies but also on those of
the other firms. So oligopolistic firms make their decision based on how they think their rivals will react to those
decisions.
Entry barriers
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The same barriers to entry that create pure monopoly also contribute to the creation of oligopoly (economies of
scale, patents and licenses, ownership or control over essential resources).
Large expenditure of capital required for entering the certain industries (jet engine, automobile, and petroleum
refining industries).
Mergers
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The merging, or combining, of two or more competing firms may substantially increase their market share, and
this in turn may allow the new firm to achieve greater economy of scale.
Another motive underlying the “urge to merge” is the desire for monopoly power. The large firm that results from
a merger has greater control over market supply and thus the price of its product.
Oligopolistic Industries
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When the largest four firms in an industry control over the 40% or more of the market, that industry is considered
oligopolistic.
Although concentration ratios help indentify oligopoly they have four shortcoming
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Localized markets: concentration ratios applied to the nation as a whole, but the market for some products are
highly localized because of high transportation costs.
Interindustry competition: competition between two products associated with different industries (aluminum and
copper compete in many applications)
World trade: the ration concentration table is only for products in the United States and may overstate
concentration because they do not account for import competition of foreign suppliers. Many of the world’s
largest corporations are foreign, and many of them do business in the United States.
Dominant firms: the four-firm concentration ratio does not reveal the extent to which one or two firms dominate
an industry.
Oligopoly Behavior: A Game-Theory Overview
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Oligopolists must pattern their actions according to the actions and expected reactions of rivals. To analyze the
behavior of oligopolists we will use a game-theory model.
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Mutual Interdependence Revisited
Oligopolistic firms can increase their profit, and influence their rivals’ profits by changing their pricing strategies.
Each firm’s profit depends on its own pricing strategy and that of its rivals, which is why this relationship
between oligopolies is called mutual interdependence.
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Collusive Tendencies
Oligopolists often can benefit from collusion or cooperation with rivals.
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Incentive to Cheat
After a collusive pricing agreement every oligopolist might be tempted to cheat, because either firm can increase
its profit by lowering its price.
Three Oligopoly Models
An Oligopoly has three distinct pricing models: the kinked demand curve, the collusive pricing, and the price
leadership.
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Kinked –Demand Theory
Suppose we have three firms that have equal shares in the market and that are independent between one another.
Obviously the location and shape of the demand curve of each firm will be depending on the prices of their
competence. If firm 1 lowers the price to earn more money the other two firms will have to: match price changes
or ignore price changes.
The price inflexibility in the kinked-demand curve gives each oligopolist reason to believe that any change in price
will be for the worse. If it raises its price, they lose customers, and if they lower its price, its sales at best will increase
modestly, since rivals will match the lower price.
On the cost side, the broken marginal-revenue curve suggests that even if an oligopolist’s costs change
substantially, the firm may have no reason to change its price.
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Collusive Pricing
Collusion occurs whenever firms in an industry reach an agreement to fix prices, divide up the market, or
otherwise restrict competition among themselves. By controlling their prices, oligopolists are able to reduce
uncertainty, increase profits, and perhaps even prohibit the entry of new rivals.
The most comprehensive form of collusion is the cartel, which is a group of producers that creates a formal written
agreement specifying how much members will produce and charge. Output must be controlled, the market must be
divided up in order to maintain the agreed upon price.
Overt Collusion:
The most comprehensive for of collusion is a cartel, which is a group of producers that typically creates a formal written
agreement specifying how much each member will produce and charge. Output must be controlled ; the market must be
divided up, in order to maintain the agreed-upon price. The collusion is overt, or open to view.
The most significant international carte is the Organization of Petroleum Exporting Counties (OPEC), comprising 13 oilproducing nations. It produces 40 percent of the world’s oil and supplies 60 percent of all oil traded internationally. OPEC
has the market power to hold the price of oil substantially above its marginal cost of production.
Covert Collusion:
Cartels are illegal in the United States, and hence any collusion that exists is covert or secret. Yet there are numerous
examples , as shown by evidence from antitrust (antimonopoly) cases.
In 1993 food companies plead guilty of rigging bids on the prices of milk products sold to schools and military bases.
They would meet at luncheons or by phone.
In 1996 American agribusiness Archer Daniels Midland and three Japanese and South Korean firms were found to have
conspired to fix the worldwide price and sales volume of a livestock feed additive. Executives secretly met in different
countries to discuss their plans.
In other instances collusion is much subtler. Unwritten, informal understandings (known as “gentlemen agreement”) are
frequently made in cocktails, golf courses or through phone. Executives reach a verbal or even tactic understandings on
product price leaving market shares to be decided by non-price competition. These agreements also violate the antitrust
laws, the elusive character of informal understandings make them difficult to detect.
Obstacles to collusion:
Demand an Cost Differences:
When Oligopolists face different costs and demand curves, it is difficult for them to agree on a price. This is a particularly
the case in industries where products are differentiated and change frequently. Even when highly standardized products,
firms usually have somewhat different market shares and operate with differing degrees of productive efficiency. Thus it
is unlikely that even homogeneous oligopolists would have the same demand and cost curves.
Price collusion depends on compromises and concessions that are not always easy to obtain and hence act as an obstacle
to collusion.
Number of firms:
The larger the number of firms, the more difficult it is to create a cartel or some other type of price collusion. Agreement
on price by three of four producers that control the entire market may be relatively easy to accomplish.
Cheating:
As the game theory model makes clear, collusive oligopolists are tempted to engage in secret price cutting to increase
sales and profits. The difficulty of such cheating is that buyers who are paying a high price for a product may become
aware of the lower-priced sales and demand similar treatment. Or buyers receiving a concession from one producer may
use the concession as a wedge to get even larger price concessions from rival producer. Collusion is more likely to
succeed when cheating is easy to detect and punish. Then the conspirators are less likely to cheat on the price agreement.
Recession:
Long-lasting recession usually serves as an enemy of collusion because slumping markets increase average total cost.
Shifting Demand and marginal revenue curves to the left. In response to recession, each firm moves leftward and upward
to a higher operating point on its average total cost curve. Under such conditions, businesses may feel they can avoid
serious profit reduction by cutting price and thus gaining sales at the expense of rivals.
Potential Entry:
The greater prices and profits that result from collusion may attract new entrants, but this increases the market supply and
reduce prices and profits, successful colluding oligopolists block the entry of new producers.
Legal Obstacles : Antitrust Law:
U.S. Antitrust laws prohibit cartels and price-fixing collusion. So less obvious means of price control have evolved in this
country.
Price Leadership Model
A price evolves whereby the “dominant firm” ( the largest or most efficient firm in the industry) initiates price changes
and all the other firms “more or less” follow.
Leadership Tactics
Infrequent Price Change:
Price changes always carry the risk of rivals not following the lead firm, price adjustments are only made infrequently. In
the automotive industry price change is only made when new models are introduced each fall.
Communication:
The price leader often communicates impeding price adjustments to the industry through speeches by major executives,
trade publication interviews, or press releases.
Limit Pricing:
The price leader does not always choose the price that maximizes short-run profits for the industry because the industry
may want to discourage new firms from entering. The strategy os establishing a price that blocks the entry of new firms is
called limit pricing.
Breakdowns in Price leadership: Price wars.
Price leadership in oligopoly occasionally breaks down, and sometimes result in a price war. Most price wars run their
course. When all firms recognize that low prices are severely reducing their profits, they again yield price leadership to
one of the industry’s leading firm. That firm then begins to raise preices, and the other firms willingly follow suit.
Oligopoly and Advertising:
Each firm share of the total market is typically determined through product development and advertising for two reasons:
-Product developments and advertising campaigns are less easily duplicated than price cuts.
-Oligopolists have sufficient financial resources to engage in product development and advertising. Profits in the past help
finance current advertising and product development.
Positive Effects of Advertising.
In order to make rational decisions, consumers need information about the product characteristics and prices. Media
advertising may be a low-cost means for consumers to obtain that information.
-Enhances competition, advertising results in greater economic efficiency.
-Facilitates the introduction of new products, advertising speeds up technological progress.
-Increases sales and output, advertising can reduce lon-run ATC by enabling firms to obtain economies of scales.
Potential Negative Effects of Advertising.
Advertising is designed simply to manipulate or persuade consumers. It is also sometimes based on misleading and
extravagant claims that confuse the consumers rather than enlighten them.
-Firms establish substantial bran-name loyalty and thus achieve monopoly power via their advertising. As consequence
they increase their sales, expand their market and enjoy greater profits. In time consumers may lose the advantages of
competitive markets and face the disadvantages of monopolized markets. It may also fall into a barrier to entry the
industry.
-Self-canceling, because of advertising, all firms will experience higher costs and either their profits will fall or, through
successful price leadership, their product prices will rise.
Productive and allocative Efficiency.
Oligopolist’s production occurs where price exceeds MC and ATC. Moreover production is below the output at which
ATC is minimized. So, neither productive efficiency (P=minimum ATC) nor allocative efficiency (P=MC) is likely to
occur under oligopoly.
Qualifications:
Increased foreign competition. This helps to break down such cozy arrangements as price leadership and to stimulate
much more competitive pricing.
Limit pricing. Consumers and society may get some of the benefits of competition (prices closer to MC and minimum
ATC) even without the competition that free entry would provide.
Technological advance. Over time oligopolistic industries may foster more rapid product development and greater
improvement of production techniques than would be possible if they were purely competitive.