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11 Between Competition and Monopoly . . . Neither fish nor fowl. JOHN HEYWOOD (CIRCA 1565) Contents ● Monopolistic Competition ● Oligopoly ● Monopolistic Competition, Oligopoly, and Public Welfare ● A Glance Backward: Comparing the Four Market Forms Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Companies That Are Richer Than Most Nations Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Monopolistic Competition ● Characteristics of Monopolistic Competition ♦ Many sellers ♦ Freedom of entry and exit ♦ Perfect information ♦ Heterogeneous products Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition ● Characteristics of Monopolistic Competition ♦ First three characteristics same as those for perfect competition. ♦ Fourth is an important distinction. ♦ Demand curve facing the firm is negatively sloped. ♦ Majority of U.S. firms are in this type of market structure. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition ● Price and Output Determination under Monopolistic Competition ♦ MR = MC rule applies for setting output. ♦ Long-run equilibrium: the firm’s demand curve must be tangent to its average cost curve. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 11-1 Short-Run Equil. Under Monopolistic Competition FIGURE MC Price per Gallon AC $1.50 1.40 P C E D MR 12,000 Gallons of Gasoline per Week Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 11-2 Long-Run Equil. Under Monopolistic Competition FIGURE MC Price per Gallon AC $1.45 $1.35 P M E D MR 10,000 15,000 Gallons of Gasoline per Week Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Excess Capacity Theorem ● Under monopolistic competition, in the long run the firm will produce an output lower than that which minimizes its unit costs. ● Hence, unit costs will be higher than necessary. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Excess Capacity Theorem ● Achievement of minimum average costs would require fewer but larger firms. ● This inefficiency may, however, be a reasonable price to pay for providing a large range of consumer choice. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● Oligopoly = market dominated by a few sellers, at least several of which are large enough relative to the total market that they can influence the market price ● Oligopoly more intense competition than pure competition Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● Why Oligopolistic Behavior is So Difficult to Analyze ♦ Oligopolistic firms interact with each other in complex ways, and almost anything can and sometimes does happen under oligopoly. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● A Shopping List ♦ Ignore interdependence ♦ Strategic interaction ♦ Cartels ♦ Price leadership and tacit collusion ♦ Sales maximization ♦ Kinked demand curve ♦ Game theory Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● Sales Maximization: An Oligopoly Model with Interdependence Ignored ♦ Firms may attempt to maximize revenue rather than profit if ■control is separated from ownership. ■compensation of managers is related to the size of the firm. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● Sales Maximization: An Oligopoly Model with Interdependence Ignored ♦ Output set where marginal revenue = 0 (rather than marginal cost) ♦ Compared to a profit-maximizer ■Higher output ■Lower price Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 11-3 Sales-Maximization Equilibrium FIGURE MC E $1.00 Price per Box AC .80 F .75 .69 A D B 2.5 3.75 Millions of Boxes per Year MR Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ? The Kinked Demand Curve Model ● Because the managers of a firm think that other firms will match any cut they make in price, but not any increase, they may think they face an inelastic demand curve with respect to price cuts and an elastic curve with respect to price increases. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. ? The Kinked Demand Curve Model ● The demand curve is kinked, and the marginal revenue curve is discontinuous. ● If so, neither price nor output will change in response to moderate shifts in costs. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. FIGURE 11-4 The Kinked Demand Curve Price d D $8 7 A D (Competitors’ prices are fixed) (Competitors d respond to price changes) 0 1,000 1,100 1,400 Quantity per Year Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 11-5 The Kinked Demand Curve and Sticky Prices FIGURE d MC Price D A $8 B D E MR d C 1,000 mr Quantity Supplied per Year Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Oligopoly ● The Game-Theory Approach ♦ Each oligopolist is seen as a competing player in a game of strategy. ♦ Managers act as though their opponents will adopt the most profitable countermove to any move they make. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. TABLE 11-1 A Payoff Matrix Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Oligopoly ● The Game-Theory Approach ♦ Maximin = a strategy in which one seeks the maximum of the minimum payoffs to the available strategies. ♦ “Prisoners’ Dilemma” Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● The Game-Theory Approach ♦ Nash equilibrium = both players adopt moves such that each player’s move is its most profitable response to the other’s move. ♦ Often, no such mutually accommodating solution is possible. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● The Game-Theory Approach ♦ Repeated games ■Most markets feature repeat buyers. ■Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. ■“Tit for tat” Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Oligopoly ● The Game-Theory Approach ♦ Threats and credibility ■Induce rivals to change their behavior ■Threat must be credible Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 11-6 Entry and EntryBlocking Strategy FIGURE Possible Choices of Old Firm Possible Reactions of New Firm Profits (millions $) Old Firm New Firm –2 –2 4 0 2 2 6 0 Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Monopolistic Competition, Oligopoly, & Public Welfare ● Behavior is so varied that it is hard to come to a simple conclusion about welfare implications. ● In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Monopolistic Competition, Oligopoly, & Public Welfare ● When an oligopolistic market is perfectly contestable--if firms can enter and exit without losing the money they have invested--then the performance of the firms is likely to be socially efficient. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ● Perfect competition and pure monopoly are uncommon in reality. ● Many monopolistically competitive firms exist. ● Oligopoly firms account for the largest share of the economy’s output. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ● Profits are zero in long-run equilibrium under perfect competition and monopolistic competition because of free entry and exit. ● Consequently, AC = AR in long-run equilibrium under these two market forms. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ● In equilibrium, MC = MR for the profitmaximizing firm under any market form. ● In the equilibrium of the oligopoly firm, MC may be unequal to MR. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Comparing the Four Market Forms ● Perfectly competitive firm and industry theoretically efficient allocation of resources. ● Monopoly and monopolistic competition are likely inefficient allocation of resources. ● Under oligopoly, almost anything can happen, impossible to generalize about its vices or virtues. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 11-2 Attributes of the Four Market Forms TABLE Copyright© 2003 South-Western/Thomson Learning. All rights reserved.