Monopolistic Competition and
Product Differentiation
Krugman Wells, Chap. 16
Monopolistic Competition
• Most firms produce a good that is (to a
certain extent) unique. No other good has
the exact same properties.
– Coke, Pepsi, President’s Choice
• To the extent that you are a unique
producer, you will have some market power.
• Price elasticity of individual products are
larger than total category. But not infinite as
in the case of commodity goods.
Monopolistic Competition:
Short-term
Price
MC
ATC
P*
D
MR
Q*
Output
Characteristics of Monopolistically
Competitive Markets
•
•
•
•
Differentiated Products
Free Entry into very similar markets.
Fixed costs of setting up production
Individual firms face downward sloping
demand curve and a falling average total
cost curve.
– They would sell more if they could at the
going rate but lowering their prices to sell
more would lead to losses.
No Barriers to Entry
• What happens if new firms can enter?
• If there are profits to be had,
entrepreneurs will enter markets to provide
close substitutes for profit making goods.
• New goods splitting the market and better
substitutes means lower, flatter demand
curve.
Monopolistic Competition:
Entry of Competitors
MC
Price
ATC
D
D′
MR′
Q*
MR
Output
Monopolistic Competition vs.
Perfect Competition
• On a market-by-market basis, perfect
competition will offer greater efficiency
both in terms of minimizing deadweight
losses and encouraging an efficient
production scale.
• Monopolistic Competition only occurs with
differentiated products.
– Greater variety generated by this market may
compensate for loss of efficiency.
Monopolistic Competition:
Long-term
Price
MC
ATC
P*
MR
Q*
D
Output
Monopolistic Competition and
Entrepreneurship
• New markets are frequently developed.
• For many goods, the only barriers to entry
is imagination.
• Entrepreneurs develop new ideas for new
goods. The pay-off for entrepreneurship
are short-run monopoly profits. (Ted
Turner and CNN). Only in rare cases will
firms be able to make long-term
monopolistic profits.
Consequences of Market Power
• One clear consequence of the existence of
market power is that prices are higher than
marginal cost and output is smaller than
perfect competition.
• Additional consequences of the presence of
market power may be:
– Complacency by firms managers (i.e. standard
corporate governance measures do not
generate efficiency)
– Rent-seeking: Firms may put effort into
constructing artificial barriers to entry rather
than producing goods.
Oligopoly
KW Chap. 15
Oligopoly
• Many industries are dominated by a small
number of firms: Airlines, airplane
manufacturing, supermarkets, drugstores.
• In theory, even a small number of firms may
compete, driving down prices to the level of
costs.
– Airplane manufacturing: Boeing vs. Airbus
• Oligopolists may also collude!
– OPEC
– Sotheby’s and Christie’s
Concentration Ratios are often used
to measure market competition
Concentration Ratios
Scheduled passenger air transportation
Trucking Industry
Share or
Top 4 Firms
Top 8 Firms
Top 20 Firms
Top 50 Firms
33.7
50.8
73.1
89.9
7.6
12.6
21.2
28.9
Four Firm Concentration Ratio: Sales of Top
4 Firms Divided by Total Sales
Conditions of Cartel
• Small number of firms
• Barriers to Entry
• Ineffective or Non-existent government
regulation.
• Way to Stop Cheating
–Enforcer
–Capacity Constraints (California
Electricity Market)
Duopolists
• Two companies can agree on a price at which they could
make profits.
• If the other firm keeps its word, you can win whole
market by undercutting their price.
• If the other firm doesn’t keep its word, you must undercut
the agreed upon price or lose everything.
• Either way, best strategy is to cheat on agreement.
Q
P
50
Revenue MR
550
27500
Cost
ATC
MC
18750
375
475
75
525
39375
500
28125
50000
475
375
450
67500
11250
5625
12500
12500
6250
12500
12500
6250
11250
11250
5625
8750
375
46875
375
325
150
Cheat
4375
11250
375
37500
59375
8750
375
375
125
Split
375
425
100
Profit
375
56250
375
Payoff Matrix
• Two firms
• Each one could choose to
collude and charge a
price of 475.
• Or each could decide to
cheat, steal the market
for themselves and
charge a price of 450
• The matrix describes the
payoff of each firm given
the strategies of another.
Red Firm 1
Collude
Blue
Firm
2
Cheat
Collude 6250,
6250
0,
11,250
Cheat
5625
5625
11,250,
0
Game Theory & Beautiful Mind
• Game Theory is a branch of math that describes
strategic interactions.
• Nash describes a game that is in equilibrium as
one in which no player has an incentive to
change their strategy given the strategy of the
other player.
• Nash equilibrium in the above game is for both
to cheat even though they both players would be
better off if they could collude.
California, 2000
• In 1998, utilities in California’s deregulated
wholesale power market were paying between
$30 and $40 per MWH. By summer and fall of
2000, prices skyrocketed to $140.
• Five firms producing wholesale electricity
(Enron, Dynegy,…). When there is excess
capacity, five firm market behaved relatively
competitively.
• When capacity constraints hit, firms could
exercise significant pricing power and raise
prices above marginal cost.
Sotheby’s and Christies
Prior to 1995, Sotheby's and Christie's, the world's largest auction houses,
were in fierce competition for consignments from sellers. ,… . In March 1995,
this competition abruptly ended. Christie's … would charge sellers a fixed,
non-negotiable commission … and a month later Sotheby's announced the
same policies. Detailed documents kept by …, Christie's former chief
executive, show that the abrupt change was due to a price-fixing conspiracy.
Why were these firms able to
successfully form a cartel?
Anatomy of the Rise and Fall of a PriceFixing Conspiracy: Auctions at Sotheby's
and Christie's
Orley Ashenfelter and Kathryn Graddy *
Firms may compare future profits from staying
in cartel relative to current profits from
cheating. In lean markets, the benefits from
cheating may be less than the future benefits
from staying in a cartel.
Boeing vs. Airbus.
• Why might it be difficult for two airlines to
collude.
• There is a large stock of existing aircraft
available for sale in used market.
• Durable goods producers have to compete
with their own past.
• Some economists claim that Alcoa did not
have a monopoly because the broad
supply of recycled Aluminum.
Price Discrimination
• What if you don’t have to charge the same price
to everyone?
• If you have perfect knowledge of the valuation
applied to your product by each customer, you
might tailor your price for each one.
• Since lowering your price for each customer
doesn’t affect the price obtained from higher
value customers, you gain by selling at a price
above marginal cost.
P
P1
P2
11
10
9
9
8
P3
7
P4
6
P5
Total profit
earned by firm
10
8
7
6
5
5
4
P6
4
3
3
MC = 3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
Perfect Price
Discrimination will
generate same output as
perfect competion, but
monopolist will take all
surplus as profit.
10
9
8
7
6
5
P
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
Learning Outcomes
Students should be able to:
• Characterize the relationship between price, marginal
revenue, marginal cost, average total cost, and profits in
a monopolistically competitive market in the short and
long run.
• Describe the conditions that characterize markets with
oligopoly.
• Define price discrimination and discuss the costs and
benefits to the firm and society.
• Evaluate the difficulties of maintaining collusion.
• Measure oligopolistic conditions with concentration
ratios.
Contestable Markets
and Strategies to Deter Entry
• A monopoly firm may not set profit maximizing
prices because they want to keep the price low
enough to keep other firms out.
• A market in which the possibility of market entry
tempers the behaviors of monopolists is called a
contestable market.
– A pricing strategy to prevent entry is called limit
pricing.
• Firms may also use other strategies to deter
entry which are less beneficial than lowering
prices and increasing production.
Strategies of Entry Deterrence
• A firm may deter entry by competitors by
threatening them with :
– Engaging in predatory pricing.
• Price below marginal cost to drive another firm out
of the market.
– Building excess capacity (promise predatory
pricing)
Surplus
• The demand curve represents how much
consumers are willing to pay for one more unit of a
good, if they have already bought a certain number
of goods.
• There are diminishing returns to any given product.
As people consume more of that product, the benefit
they get from consuming another one declines, and
they are only willing to pay a lower price.
• Difference between the price people are willing to
pay for a good (i.e. the position of the price
schedule) and the actual price is the consumer
surplus (net benefit to the consumer) generated by
that purchase.
P
11
10
Surplus
generated
by buying
first good
=6
10
9
9
8
8
7
7
6
6
5
5
4
P=3
4
3
3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
10
Surplus
generated
by buying
second
good = 5
10
9
9
8
8
7
7
6
6
5
5
4
P=3
4
3
3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
10
Total consumer
surplus is the
sum of surplus
of each good
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
P=3
2
2
1
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
P
11
When goods adjust
continuously, total
consumer surplus is
a triangle created by
price line and
demand curve
10
9
8
7
6
5
P
4
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Q
Producer Surplus
• Producers achieve profits whenever they
sell an extra goods at a price above the
cost of producing the extra good.
• Sum of profits for each good is the total
producer surplus, the area in the triangle
below the price line and above the supply
curve.
Competitive Market
Supply and Demand
P
Producer
Surplus
S
P*
D
Q*
Q
Competitive Equilibrium is Efficient
• Economic efficiency means that there are no
gains to be had at the level of society from
additional trades.
• If the price is higher or lower, the sum of the
areas of the consumer & producer surplus
triangles will be less than at the equilibrium
price.
• Economic efficiency does not guarantee that the
split of the surplus will coincide with any notion
of fairness.
Efficient Equilibrium Market
P 12
Consumer
Surplus
10
8
S
6
Producer
Surplus
P*
4
D
2
0
0
2
4
6
8
10
12
Q
Monopoly Price
P 12
D
10
S
8
P*6
Ceiling
4
2
0
0
2
Q*
4
6
8
10
12
Q
Total Societal Surplus is lower
under monopoly
P 12
Consumer
Surplus
10
Deadweight
Loss
S
8
6
4
Ceiling
Producer
Surplus
2
0
0
2
4
Q*
6
D
8
10
12
Q