Transcript Economics for Today 2005

Monopolistic
Competition & Oligopoly
• Key Concepts
• Summary
©2005 South-Western College Publishing
1
What will I learn in
this chapter?
This chapter will help you
understand the impact of
monopolistic competition
and oligopoly market
structures on the price
and output decisions of
real-world firms.
2
What is
imperfect competition?
A market structure
between the extremes
of perfect competition
and monopoly
3
What is monopolistic
competition?
• many small sellers
• differentiated product
• easy entry and exit
4
What is
product differentiation?
The process of creating
real or apparent
differences between
goods and services
5
What does many small
sellers mean?
Each firm is so small
relative to the total
market that each firm’s
pricing decisions have a
negligible effect on the
market price
6
What is
nonprice competition?
A firm competes using
advertising, packaging,
product development,
better service, rather
than lower prices
7
How easy is entry and
exit in monopolistic
competition?
Not as easy as in perfect
competition because of
product differentiation
8
Why is a monopolistic
competitive firm a
price maker?
Product differentiation
gives the firm some
control over its price
9
What does the demand
curve for monopolistic
competition look like?
It is less elastic (steeper)
than for a perfectly
competitive firm and
more elastic (flatter)
than for a monopolist
10
What are examples of
monopolistic competition?
• grocery stores
• hair salons
• gas stations
• video rental stores
• restaurants
11
How effective is
advertising?
Somewhat effective in the
short-run but less
effective in the long-run
12
What effect does
advertising have on
average costs?
It raises the long-run
average cost curve
13
P
Cost per unit
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
$1.00
$.50
The effect of Advertising
With advertising
LRAC2
LRAC1
Without advertising
2 4 6 8 10 12 14 16 18
Q
14
How does a firm
decide what price to
charge and how many
units to produce?
MR = MC
15
P
$40
$35
$30
$25
$20
$15
$10
$5
MC
MR=MC
ATC
Profit
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
16
Why is a normal profit
made in the long-run?
The combination of the
leftward shift in the
firm’s demand curve
and the upward shift in
the LRAC curve
17
P
$40
$35
$30
$25
$20
$15
$10
$5
Normal Profit
MC
LRAC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
18
How efficient is
monopolistic
competition?
Less resources are used
and a higher price is
charged than would be
the case under perfect
competition
19
P
$40
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum LRAC
MC
ATC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
20
P
Price & Cost per unit
$40
$35
$30
$25
$20
$15
$10
$5
Perfect Competition
Minimum
LRAC
MC LRAC
MR
1 2 3 4 5 6 7 8 9
Q
21
What is
one way monopolistic
competition compares
to perfect competition?
Price is higher and
quantity is lower in
monopolistic competition
22
Why is
price higher and quantity
lower in monopolistic
competition?
Because of the downward
sloping demand curve and
the MR curve that is
beneath the demand curve
and more steeply sloped
23
How efficient is
monopolistic
competition?
Less resources are used
and a higher price is
charged than would be
the case under perfect
competition
24
What is an oligopoly?
In an oligopolistic
market there are:
• few sellers
• a differential product
• difficulties of market entry
25
How few are a
few sellers?
When the firms are so
large relative to the total
market that they can
affect the market price
26
What is a significant
barrier to entry?
Economies of scale
27
What is
nonprice competition?
Competition in ways
other than pricing
policies
28
What is the
distinguishing
feature of oligopoly?
mutual
interdependence
29
What is mutual
interdependence?
A condition in which an
action by one firm may
cause a reaction on
the part of other firms
30
What does mutual
interdependence do to
the demand curve?
A kinked demand curve
is a possible result of
this characteristic
31
What does a kinked
demand curve show?
It shows that rivals will
match a firm’s price
decrease, but ignore a
price increase
32
Oligopolist’s Kinked Demand Curve
P
$400
$350
$300
$250
$200
$150
$100
$50
5 10 15 20 25 30 35 40 45 Q
33
How do oligopolists
determine price?
They play the game “follow
the leader” that economists
call price leadership
34
What is
price leadership?
A pricing strategy in
which a dominant firm
sets the price for an
industry and the other
firms follow
35
What is a cartel?
A group of firms
formally agreeing to
control the price and
output of a product
36
What are examples
of cartels?
• Organization of Petroleum
Exporting Countries (OPEC)
• International Telephone
Cartel (CCITT)
• International Airline Cartel
(IATA)
37
What is the major
weakness of a cartel?
Member firms cheating
38
$40
$35
$30
$25
$20
$15
$10
$5
Price & Cost per unit
P
Why a Cartel Member Has
an Incentive to Cheat
MC LRAC
MR2
MR1
1 2 3 4 5 6 7 8 9
Q
39
What is Game Theory?
A model of the strategic
moves and
countermoves of rivals.
40
What are two
pricing methods in
Game Theory?
Tit for tat
Price leadership
41
What is tit for tat?
Under this approach, a
player will do whatever
the other player did the
last time.
42
What is price
leadership?
One company follows
whatever price the
leader sets
43
What is formal
collusion?
This is when companies
communicate and
decide what price to
charge customers
44
What is informal
collusion?
This is when companies
find alternative ways to
agree on a price
without any tacit
communication
45
Is formal
collusion legal?
No, it is against the law
for firms to come
together and agree
amongst them what
price to charge
46
What conclusion
can be drawn
from collusion?
As long as the benefits
exceed the costs, cheating
can threaten formal or
informal agreements
among oligopolists to
maximize joint profits
47
What conclusion
can be drawn
from oligopolies?
The price charged for the
product will be higher than
under perfect competition
More money is spent on
forms of nonprice
competition
48
Key Concepts
49
•
•
•
•
•
What is imperfect competition?
What is monopolistic competition?
What is product differentiation?
What is nonprice competition?
Why is a monopolistic competitive firm a price
maker?
• How does a firm decide what price to charge
and how many units to produce?
• Why is a normal profit made in the long-run?
50
•
•
•
•
•
•
•
•
How efficient is monopolistic competition?
What is oligopoly?
What is nonprice competition?
What is the distinguishing feature of
oligopoly?
What does a kinked demand curve show?
How do oligopolists determine price?
What is a cartel?
What is Game Theory?
51
Summary
52
Imperfect competition is the market
structure between the extremes of
perfect competition and monopoly
Monopolistic competition and
oligopoly belong to the imperfect
competition category.
53
Monopolistic competition is a
market structure characterized by
(1) many small sellers, (2) a
differentiated product, and (3) easy
market entry and exit. Given these
characteristics, firms in monopolistic
competition have a negligible effect
on the market price.
54
Product differentiation is a key
characteristic of monopolistic
competition. It is the process of
creating real or apparent
differences between products.
55
Nonprice competition includes
advertising, packaging, product
development, better quality, and
better service. Under imperfect
competition, firms may compete
using nonprice competition,
rather than price competition.
56
Short-run equilibrium for a
monopolistic competitor can yield
economic losses, zero economic
profits, or economic profits. In the
long run, monopolistic competitors
make zero economic profits.
57
P
$40
$35
$30
$25
$20
$15
$10
$5
MC
MR=MC
ATC
Profit
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
58
Comparing monopolistic
competition with perfect
competition, we find that the
monopolistic competitive firm does
not achieve allocative
efficiency,charges a higher price,
restricts output, and does not
produce where average costs are
at a minimum.
59
P
$40
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum LRAC
MC
ATC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
60
P
Price & Cost per unit
$40
$35
$30
$25
$20
$15
$10
$5
Perfect Competition
Minimum
LRAC
MC
LRAC
MR
1 2 3 4 5 6 7 8 9
Q
61
Oligopoly is a market structure
characterized by (1) few sellers, (2)
a homogeneous or differentiated
product, and (3) difficult market
entry. Oligopolies are mutually
interdependent because an action
by one firm may cause a reaction
on the part of other firms.
62
The nonprice competition model is
a theory that might explain
oligopolistic behavior. Under this
theory, firms use advertising and
product differentiation, rather than
price reductions, to compete.
63
The kinked demand curve is a
model that explains why prices
may be rigid in an oligopoly. The
kink is established because an
oligopolist assumes that rivals will
match a price decrease, but ignore
a price increase.
64
Oligopolist’s Kinked Demand Curve
P
$400
$350
$300
$250
$200
$150
$100
$50
5 10 15 20 25 30 35 40 45 Q
65
Price leadership is another theory
of pricing behavior under oligopoly.
When a dominant firm in an
industry raises or lowers price,
other firms follow suit.
66
A cartel is a formal agreement
among firms to set prices and
output quotas. The goal is to
maximize profits, but firms have
an incentive to cheat, which is a
constant threat to a cartel.
67
$40
$35
$30
$25
$20
$15
$10
$5
Price & Cost per unit
P
Why a Cartel Member Has
an Incentive to Cheat
MC LRAC
MR2
MR1
1 2 3 4 5 6 7 8 9
Q
68
Comparing oligopoly with
perfect competition, we find that
the oligopolist allocates
resources inefficiently, charges a
higher price, and restricts output
so that price may exceed
average cost.
69
Oligopoly is much more difficult
to evaluate than other market
structures. None of the models
just presented gives a definite
answer to the question of
efficiency under oligopoly.
Depending on the assumptions
made, an oligopolist can behave
much like a perfectly competitive
firm or more like a monopoly.
70
END
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