CHAPTER
Monopolistic Competition
and Oligopoly
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Slides prepared
prepared by:
by:
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Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
The Concept of Imperfect Competition
• Imperfect competition
– A market structure in which there is more
than one firm
– But one or more of the requirements of
perfect competition is violated
• Imperfectly competitive markets
– Monopolistic competition
– Oligopoly
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2
Monopolistic Competition
• Monopolistic competition
– A market structure in which there are:
• Many firms
• Selling products that are differentiated
• And in which there is easy entry and exit
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3
Monopolistic Competition
• Sellers offer a differentiated product
– Downward-sloping demand curve
• Sell more by charging less
• Raise its price without losing all of its
customers
– Price setters
• Product differentiation
– Quality or location
– Can be subjective
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4
Monopolistic Competition
• Many buyers and sellers
– No strategic interaction among firms in the
market
• Easy entry and exit
– No significant barriers to entry
– Zero economic profit in the long run
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5
Monopolistic Competition
• Maximize profit
– Producing where MR=MC
• In the short-run
– Economic profit
– Zero economic profit
– Economic loss
• Demand curve facing a firm
– More elastic than under monopoly
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6
Figure 1
A Monopolistically Competitive Firm in the Short Run
Dollars
MC
A
$70
ATC
30
d1
MR1
250
Like any other firm, a
monopolistic competitor
maximizes profit by producing
the level of output where its
MR and MC curves intersect.
Kafka exterminators
maximizes profit by servicing
250 homes per month. The
profit-maximizing price ($70)
is found on the demand curve
at an output level of 250
(point A). Profit per unit of $40
is the difference between the
price ($70) and average total
cost ($30) at output of 250.
Total profit is profit per unit
times output ($40 × 250 =
$10,000), equal to the area of
the shaded rectangle.
Homes Serviced
per Month
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7
Monopolistic Competition
• Economic profit in the short-run; in the
long-run:
– New firms enter the market
– Existing firms: lose some of its customers
– Demand curve shifts left
– Long run: zero economic profit
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8
Figure 2
A Monopolistically Competitive Firm in the Long Run
Dollars
1. In the long run, profit
attracts entry, which
shifts the firm’s demand
curve leftward.
2. Entry continues
until P=ATC at the
best output level,
and economic profit
is zero.
MC
ATC
E
$40
d1
MR1
3. The typical firm
produces where its new
MR crosses MC
d2
MR2
100
250
Homes Serviced
per Month
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9
Monopolistic Competition
• Economic loss in the short-run; in the
long-run:
– Some firms exit the market
– Firms that remain: gain customers
– Demand curve shifts right
– Long run: zero economic profit
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10
Monopolistic Competition
• Excess capacity under monopolistic
competition
– Long-run equilibrium: firm produces on the
downward-sloping portion of its ATC curve
• Never at minimum average cost
– Its long-run output level is always too small
to minimize cost per unit
– The firm operates with excess capacity
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11
Figure 3
Excess Capacity in Monopolistic Competition
Dollars
E
$40
MR2
100
LR equilibrium
output
d2
200
“Capacity
output”
In long-run equilibrium, a
MC
monopolistic competitor
earns zero profit and
operates on the downwardsloping portion of its ATC
curve (100 units, at point
ATC
E). As a result, it does not
use enough of its capacity
to minimize its average
total cost. “Capacity output”
(where ATC is minimized)
is 200 units. But for any
rise in output beyond 100,
MR < MC, so profit would
decrease (the firm would
Homes Serviced
go from zero to negative
per Month
profit).
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12
Monopolistic Competition
• Excess capacity and prices
– In the long-run: P > minimum ATC
• Higher price under monopolistic competition
than under perfect competition
– Because of product differentiation
– Consumers usually benefit from product
differentiation
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13
Monopolistic Competition
• Nonprice competition
– Any action a firm takes to shift the demand
curve for its output to the right
• Better service, product guarantees
• Free home delivery, more attractive
packaging
• Better locations, advertising
– May lead to short run economic profit
– Long run: zero economic profit
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14
Monopolistic Competition
• Nonprice competition
– Zero economic profit in the long-run
because:
• Imitation by others reverses the initial
rightward shift in demand
• The costs of nonprice competition shift the
ATC curve upward
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15
Oligopoly
• Oligopoly
– A market dominated by a small number of
strategically interacting firms
• Strategically interacting firms
– Try to raise their profits by colluding with
each other to raise prices
• To the detriment of consumers
• Strategic interaction
– Is greater when a market is highly
concentrated
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16
Oligopoly
• Measuring market concentration
– Concentration ratios
– The Herfindahl-Hirschman Index
• Concentration ratio
– The percentage of total output or sales by
a given number of the largest firms in the
market
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17
Table
1
Concentration Ratios and HHI Values in Selected Industries, 2007
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18
Oligopoly
• The Herfindahl-Hirschman Index (HHI)
– A measure of market concentration
obtained by summing the squares of each
firm's market share
– Most useful when the firms are not of
equal size
– The fewer the number of firms in the
market, the larger the HHI
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19
Oligopoly
• The Herfindahl-Hirschman Index (HHI)
– Used by the Federal Trade Commission
and the Department of Justice
• Approve or block mergers between firms
• No government scrutiny or opposition if:
– Increase the HHI by less than 100
– Or keep the HHI under 1,500 (“unconcentrated”
market)
• Government opposition: any merger that
raises the HHI by more than 200 to a value of
2,500 or greater
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20
Oligopoly
• Some provisions on the measures of
market concentration (U.S. Census
Bureau)
– May distort the true degree of market
concentration
• U.S. production only (does not include foreign
production)
– The census data is nationwide, while the
relevant markets are sometimes local
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21
How Oligopolies Arise
• Barriers to entry
– Economies of scale
– Reputation
– Strategic barriers
– Legal barriers
• Economies of scale
– Natural oligopolies: minimum efficient
scale is a large fraction of the market
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22
How Oligopolies Arise
• Reputation as a barrier
– Established oligopolists: likely to have
favorable reputations
– Heavy advertising expenditure: build and
maintain brand loyalty
– A new entrant might be able to catch up
• After a substantial period of high advertising
costs, low revenue, and economic loss
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23
How Oligopolies Arise
• Strategic barriers
– Maintain excess production capacity
– Special deals with distributors: best shelf
space
– Long-term arrangements with customers
• Legal barriers
– Patents and copyrights
– Lobbying
– Zoning regulations
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24
Oligopoly vs. Other Market Structures
• Oligopoly
– Strategic interaction
• Impossible to use the “MR=MC” approach
– Firm: anticipate how the competitors
respond to a change in price
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25
Figure 4
An Oligopolist’s Demand Curve Depends on Its Competitors’ Responses
Price
B”
B
B’
$1.29
A
$0.99
2.5
3.25
4
For Apple, the quantity of
downloaded songs demanded at
each price depends on the
response of its rival, Amazon.
Demand curve D1 facing Apple is
drawn assuming that as Apple
changes its price, Amazon
maintains its current price. In that
case, if Apple raises its price from
$0.99 to $1.29 per song, it will
move from point A to point B.
However, if Amazon matches
Apple’s price hike, Apple’s demand
curve will shift rightward, to D2. In
D2
that case, Apple’s price rise will
D1
move it from point A to point B′,
with a smaller decrease in sales.
Finally, if Amazon responds by
D3
lowering its price, Apple’s demand
curve will shift leftward, to D3, and
Millions of Songs
Apple will move to point B″, with a
per Week
much greater decrease in sales.
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26
The Game Theory Approach
• Game theory
– An approach to modeling the strategic
interaction of oligopolists in terms of
moves and countermoves
• The prisoner’s dilemma
– Two players (Colin, Rose)
– Strategies (Confess, Don’t confess)
– Payoff matrix (years in jail)
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27
The Game Theory Approach
• Column: strategy that Colin might choose
• Row: strategy that Rose might select
• Possible strategy combinations:
1. Upper left box: Both confess
2. Lower left box: Colin confesses and Rose
doesn’t
3. Upper right box: Rose confesses and
Colin doesn’t
4. Lower right box: Neither confesses
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28
Figure 5
The Prisoner’s Dilemma
Colin’s Actions
Confess
Don’t Confess
Colin gets
20 years
Confess
Rose gets
20 years
Colin gets
30 years
Rose gets
3 years
Rose’s
Actions
Colin gets
3 years
Don’t
Confess
Rose gets
30 years
Colin gets
5 years
Rose gets
5 years
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29
The Game Theory Approach
• Payoff matrix
– A table showing the payoffs to each of two
players for each pair of strategies they
choose
• Dominant strategy
– Strategy that is best for a player no matter
what strategy the other player chooses
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30
Simple Oligopoly Games
• Duopoly
– An oligopoly market with only two sellers
• Situations duopolists might face
– Both players have dominant strategies
– Only one player has a dominant strategy
– Neither player has a dominant strategy
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31
Simple Oligopoly Games
• Duopoly
– Players: the only two gas stations in town
(Gus and Filip)
– Strategies: charge a low price, charge a
high price
– Payoff matrix: profits or losses
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32
Figure 6
A Duopoly Game: Both Players Have Dominant Strategies
Gus’s Actions
Low Price
High Price
Gus’s profit
= $25,000
Low
Price
Filip’s profit
= $25,000
Gus’s profit =
- $10,000
Filip’s profit
= $75,000
Filip’s
Actions
High
Price
Gus’s profit
= $75,000
Filip’s profit
= - $10,000
Gus’s profit
= $50,000
Filip’s profit
= $50,000
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33
Simple Oligopoly Games
• Both players have dominant strategies
– We can predict the game’s outcome: Both
will choose the dominant strategy
– Gus’s dominant strategy: charge the low
price
– Filip’s dominant strategy: charge the low
price
– Both charge the low price
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34
Figure 7
A Duopoly Game: Only One Player Has a Dominant Strategy
Gus’s Actions
Low Price
High Price
Gus’s profit
= $25,000
Low
Price
Filip’s profit
= $25,000
Gus’s profit =
- $10,000
Filip’s profit
= $75,000
Filip’s
Actions
High
Price
Gus’s profit
= $75,000
$40,000
Filip’s profit
= - $10,000
Gus’s profit
= $50,000
Filip’s profit
= $50,000
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35
Simple Oligopoly Games
• Only one player has a dominant strategy
– We can predict the game’s outcome:
• The player with the dominant strategy will
choose it
• The other player will choose the best strategy
given the dominant strategy played by his/her
competitor
– Gus: no dominant strategy
– Filip’s dominant strategy: the low price
– Both charge the low price
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36
Figure 8
A Duopoly Game: Neither Player Has a Dominant Strategy
Gus’s Actions
Low Price
High Price
Gus’s profit
= $25,000
Low
Price
Filip’s profit
= $25,000
Filip’s profit
= $75,000
$40,000
Filip’s
Actions
High
Price
Gus’s profit =
- $10,000
Gus’s profit
= $75,000
$40,000
Filip’s profit
= - $10,000
Gus’s profit
= $50,000
Filip’s profit
= $50,000
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37
Simple Oligopoly Games
• No player has a dominant strategy
– Gus: no dominant strategy
– Filip: no dominant strategy
– More difficult to predict an outcome to this
game
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38
Simple Oligopoly Games
• Complications
– More than two strategies from which to
choose
– More than two players
– Repeated play
• Players select a strategy, observe the
outcome of that trial, and play the game again
and again
• Strategically interdependent sellers compete
over many time periods
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39
Cooperative Behavior in Oligopoly
• Explicit collusion
– Cooperation involving direct
communication between competing firms
about setting prices
– Cooperative outcome: maximize payoffs
• Cartel (price-fixing agreement)
– A group of firms that selects a common
price that maximizes total industry profits
– The most extreme form of explicit collusion
– Behave as a monopoly
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40
Cooperative Behavior in Oligopoly
• Price-fixing agreements
– OPEC (Organization of Petroleum
Exporting Countries)
• Among governments
– Illegal in the United States, Canada, the
European Union, and many other
developed countries
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41
Table
2
Some Recent U.S. Price-Fixing Cases
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42
Cooperative Behavior in Oligopoly
• Tacit collusion
– Any form of oligopolistic cooperation that
does not involve an explicit agreement
– Depends on adopting strategies that send
the right signals and discouraging other
firms from breaking the agreement
– Tit-for-tat
– Price leadership
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43
Cooperative Behavior in Oligopoly
• Tit-for-tat
– A game-theoretic strategy of doing to
another player this period what he has
done to you in the previous period
• Price leadership
– A form of tacit collusion in which one firm
sets a price that other firms copy
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44
Cooperative Behavior in Oligopoly
• Limits to collusion
– Constrained by the market demand curve
– Weakened by new technologies
– Powerful incentives to cheat
– Government
• Prosecuting managers who participate in
price-fixing agreements
• Blocking mergers that would result in highly
concentrated markets where collusion of all
types is more likely
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45
The Four Market Structures: A Postscript
• Four different market structures
– Perfect competition, monopoly,
monopolistic competition, and oligopoly
– Each has different characteristics
– Each leads to different predictions about
pricing, profit, nonprice competition, and
firms’ responses to changes in their
environments
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46
Table
3
A Summary of Market Structures
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47
Advertising in Monopolistic
Competition and Oligopoly
• Perfect competitors
– Never advertise (standardized product)
• Monopolistic competitors
– Almost always advertise (differentiated
products)
• Oligopolists
– Very often advertise (differentiated
products)
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48
Advertising in Monopolistic
Competition and Oligopoly
• Monopolistic competitor advertises
– To shift its demand curve rightward
– To make demand for its output less elastic
• Long run
– Greater average cost per unit
– Each firm sells more: demand curve shifts
right
– May raise or lower prices
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49
Figure 9
Advertising in Monopolistic Competition (a)
Dollars
1. Before advertising, longrun economic profit is zero.
B
ATCads
$100
3. Advertising
can lead to a
higher price
in the long
run, as in this
panel . . .
60
2. With advertising,
in the long run,
economic profit
returns to zero.
A
ATC no ads
dno ads
1,000 1,750
dads
Bottles of Perfume
per Month
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50
Figure 9
Advertising in Monopolistic Competition (b)
Dollars
$60
50
A
C
4. or to a lower
price in the
long run, as in
this panel.
ATCads
ATC no ads
dno ads
1,000
2,000
dads
Bottles of Perfume
per Month
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51
Advertising in Monopolistic
Competition and Oligopoly
• Strategic decisions about advertising
– Dominant strategy: run the ads
• Earn low profit
– Tacit collusion: don’t run ads
• Earn medium profit
• Tit-for-tat
– Airline industry
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52
Figure 10
An Advertising Game
American’s Actions
Run safety ads
Run
safety
ads
United’s
Actions
Don’t
run
ads
United
earns low
profit
American
earns low
profit
American
earns high
profit
United
earns very
low profit
Don’t run ads
United
earns high
profit
American
earns very
low profit
American
earns medium
profit
United
earns medium
profit
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53
Cartel Pricing
• Two importers of bananas form a cartel
– Market demand curve: demand curve
facing the cartel
– Restricts output
• Each member is allotted a fixed quantity
– Price: higher then the competitive price
– Profit: maximized (cartel)
• As long as the members stick to the
agreement
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54
Figure A.1
The Profit Maximizing Price and Output Level for a Cartel
Dollars
Facing the market demand
curve D, a cartel’s profit is
maximized by the output level
(120 million pounds) where MR
= MC, charging $0.45 per
pound. Total cartel profit is the
area of the blue-shaded
rectangle. The profit is divided
among the members by
allotting a quantity of output for
each firm, such that the sum of
each firm’s quantity is the profitmaximizing total output (120
million pounds).
A
$0.45
D
0.15
MC = ATC
MR
120
Millions of Pounds
per Month
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
55
Cartel Pricing
• The incentive to cheat
– One firm sells more then its allotment
– Market price falls
– Profit per pound falls
– The cheater earns a higher profit
– The other firm earns a smaller profit
• Cheating
– Dominant strategy for both firms
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
56
Figure A.2
Cheating Reduces the Cartel's Total Profit
Dollars
A
$0.45
B
$0.40
D
0.15
MC = ATC
MR
120 140
The cartel members initially
sell 60 million pounds each
(a total of 120 million
pounds) and charging $0.45
per pound at point A. If one
cartel member cheats by
producing an extra 20 million
pounds, total output rises to
140 million, and the market
price falls to $0.40 (point B).
Total cartel profit falls as
well, to the area of the new
shaded rectangle. However
(from separate calculations
described in this appendix),
the cheater’s profit rises,
while the non-cheater’s profit
falls.
Millions of Pounds
per Month
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
57