ECONOMICS 5e
Michael Parkin
CHAPTER
14
Monopolistic
Competition and
Oligopoly
Learning Objectives
• Explain how price and output are
determined
in
a
competitive industry
monopolistically
• Explain why advertising costs are high in a
monopolistically competitive industry
• Explain why the price might be sticky in an
oligopoly industry
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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
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TM 14-3
Learning Objectives
• Explain how price and output are
determined
in
a
competitive industry
monopolistically
• Explain why advertising costs are high in a
monopolistically competitive industry
• Explain why the price might be sticky in an
oligopoly industry
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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.
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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.
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TM 14-6
Monopolistic Competition
Monopolistic competition (cont.)
Consequently, a firm in monopolistic competition
cannot make an economic profit in the long-run.
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TM 14-7
Examples of Monopolistic
Competition
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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.
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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.
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TM 14-10
Monopolistic Competition
Short-run
Price (dollars per
jacket)
220
MC
ATC
190
160
Economic
profit
D
140
120
MR
0
50
100
150
200
250
300
Quantity (jackets per day)
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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.
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TM 14-12
Price (dollars per jacket)
Monopolistic Competition
Long-run
220
MC
180
Zero
economic
profit
160
ATC
145
120
MR
0
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50
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.
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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 in
monopolistic competition always have
excess capacity in long-run equilibrium.
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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.
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TM 14-16
Price (dollars per jacket)
Excess Capacity
180
MC
ATC
160
145
Excess
capacity
Profit
120
maximizing
output
0
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Capacity
output
MR
D
50
100
150
Quantity (jackets per day)
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
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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.
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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.
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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.
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Product Development and
Marketing
Marketing Expenditures
Advertising expenditures affect the profits
in two ways:
• Increase costs
• Change demand
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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.
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TM 14-23
Advertising Expenditures
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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.
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TM 14-25
Price (dollars per jacket)
Selling Cost and Total Costs
Advertising
cost
200
Average total cost
with advertising
180
170
160
By increasing
the
140
quantity bought,
advertising
can
120
decrease ATC
Average total cost
with no advertising
MR
0
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25
130
200
300
Quantity (jackets per day)
TM 14-26
Efficiency: The Bottom Line
The bottom line on the question of
efficiency of monopolistic competition is
ambiguous.
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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
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TM 14-28
Oligopoly
Price and quantity of a producer depends upon that
of the other producers’.
Models developed to explain the prices and
quantities in oligopoly markets:
• Traditional
• Kinked Demand Curve Model
• Dominant Firm Model
• Game Theory
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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.
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TM 14-30
Price and cost (dollars)
The Kinked Demand
Curve Model
MC1
MC0
P
a
b
D
0
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MR
Q
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.
• This may result in the firm incurring an
economic loss.
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TM 14-32
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
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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.
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TM 14-34
Dominant Firm Oligopoly
Let’s use Big-G as an example.
Big-G is the dominant gas station in a
city.
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TM 14-35
Dominant Firm Oligopoly
Price (dollars per gallon)
Ten small firms and market demand
Big-G’s price and output decision
S10
1.50
1.00
MC
1.50
a
b
1.00
a
b
D
0.50
0.50
XD
MR
0
10
20
Quantity (thous. of gal./week)
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0
10
20
Quantity (thous. of gal./week)
TM 14-36
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
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TM 14-37
Game Theory
Invented by John von Neumann in 1937.
We will use it to help understand oligopoly.
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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.
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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.
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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.
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The Prisoners’ Dilemma
Strategies (possible actions)
They can each:
• Confess to the robbery
• Deny having committed the robbery
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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.
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TM 14-43
Prisoners’ Dilemma Payoff Matrix
Arts strategies
Confess
Deny
3 years
10 years
Confess
Bob’s
strategies
3 years
1 year
1 year
2 years
Deny
10 years
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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.
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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.
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TM 14-46
An Oligopoly Price-Fixing Game
A cartel is a group of firms that enter into a
collusive agreement.
The firms in the cartel can:
• Comply
• Cheat
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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.
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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.
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TM 14-49
Individual Firm
MC
10
ATC
6
Price and cost (thous. of $/ unit)
Price and cost (thous. of $/ unit)
Costs and Demand
Industry
10
6
D
Minimum
ATC
0
1
2
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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.
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TM 14-51
Individual Firm
MC ATC
10
9
8
6
Economic
Profit
Price and cost (thous. of $/ unit)
Price and cost (thous. of $/ unit)
Colluding to Make Monopoly Profits
Industry
10
9
MC1
Collusion achieves
monopoly outcome
6
D
MR
0
1
2
3
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4
5
Quantity (thous. of
switchgears/week)
0
1
2
3
4
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.
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TM 14-53
One Firm Cheats
Complier
Cheater
ATC
8.0
7.5
Economic
loss
0
1
2
ATC
10.0
10.0
Price & cost
Price & cost
Price & cost
10.0
7.5
6.0
4
5
Quantity (thousands
of switchgears/week)
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0
1
2
3
8.0
7.5
Complier’s
output
Economic
profit
3
Industry
4
5
Quantity (thousands
of switchgears/week)
D
Cheat’s
output
0 1 2 3 4 5 6 7
Quantity (thousands
of switchgears/week)
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.
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TM 14-55
Individual Firm
MC ATC
10
6
0
1
2
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3
4
5
Price and cost (thous. of $/ unit)
Price and cost (thous. of $/ unit)
Both Firms Cheat
Quantity (thous. of
switchgears/week)
Industry
10
MC1
6
Both cheating achieves
competitive outcome
0
1
2
3
4
D
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.
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TM 14-57
Duopoly Payoff Matrix
Gear’s strategies
Cheat
Comply
$0
-$1.0m
Cheat
Trick’s
strategies
$0
+$4.5m
+$4.5m
+$2m
Comply
–$1.0m
Copyright © 1998 Addison Wesley Longman, Inc.
+$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?
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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.
• tit-for-tat strategy
• trigger strategy
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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.
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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?
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TM 14-62
Pampers Versus Huggies: An R&D Game
Procter & Gambles strategies
R&D
No R&D
+$45m
R&D
+$5m
-$10m
+$85m
KimberlyClark’s
strategies
+$85m
+$70m
No R&D
-$10m
Copyright © 1998 Addison Wesley Longman, Inc.
+$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
entrants is a contestable market.
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TM 14-64
Entry-Deterrence Game
Let’s see what happens when a
firm attempts to enter a market
dominated by a single firm.
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TM 14-65
Duopoly Payoff Matrix
Agile’s strategies
Monopoly price
Enter and set
price below
Agile’s price
Wannabe’s
strategies
Economic
loss
Economic
profit
Monopoly
profit
Competitive price
Economic
loss
Economic
loss
Normal
profit
Not enter
Normal
profit
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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.
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TM 14-67