Transcript Monopolistic Competition, Oligopoly, And Strategic Pricing

Monopolistic
Competition, Oligopoly,
and Strategic Pricing
Chapter 13
© 2003 McGraw-Hill Ryerson Limited.
13 - 2
Introduction
 In
discussing real-world competition, the
focus quickly becomes market structure.
 Market structure refers to the physical
characteristics of the market within
which firms interact.
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Introduction
 Market
structure involves the number of
firms in the market and the barriers to
entry.
 Perfect competition, with an infinite
number of firms, and monopoly, with a
single firm, are polar opposites.
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Introduction
 Monopolistic
competition and oligopoly
lie between these two extremes.
Monopolistic competition is a market
structure in which there are many firms
selling differentiated products.
 Oligopoly is a market structure in which
there are a few interdependent firms.

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Introduction to Monopolistic
Competition and Oligopoly
 The
number of firms in an industry plays
an important role in determining
whether firms explicitly take other firms’
actions into account.

Oligopolies take into account the reactions
of other firms; monopolistic competitors do
not.
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Introduction to Monopolistic
Competition and Oligopoly
 In
monopolistic competition, there are
so many firms that firms do not take into
account their rivals’ responses to their
decisions.
 Collusion is difficult due to a large
number of firms.
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Introduction to Monopolistic
Competition and Oligopoly
 In
oligopoly, there are only a few firms
and each firm is more likely to engage
in strategic decision making.
 Strategic decision making – taking
explicit account of a rival’s expected
response to a decision one is making.
 In oligopoly, few firms can collude
relatively easily.
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Monopolistic Competition
 The
four distinguishing characteristics of
monopolistic competition are:
Many sellers.
 Differentiated products.
 Multiple dimensions of competition.
 Easy entry of new firms in the long run.

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Many Sellers
 There
are many sellers in monopolistic
competition, but each of them is able to
identify its own small market segment.
 Monopolistically competitive firms act
independently of its rivals.
 The existence of many sellers also
makes collusion difficult.
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Differentiated Products
 The
“many sellers” characteristic gives
monopolistic competition its competitive
aspect.
 Its monopolistic aspect comes from
product differentiation.
 In a monopolistically competitive market
competitors produce many close
substitutes.
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Differentiated Products
 Differentiation
may be based on real
differences in product characteristics, or
can be based on consumers’
perceptions about product differences.
 Generally, monopolistic competition is
characterized by significant
expenditures on advertising, which acts
as an important barrier to entry.
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Differentiated Products
 Any
industry where brand proliferation is
present is likely to be monopolistically
competitive.

Some examples are soap, jeans, cookies and
games.
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Multiple Dimensions of
Competition
 Competition
takes many forms in a
monopolistically competitive industry:
Product differentiation.
 Perceived quality.
 Competitive advertising.
 Service and distribution outlets.

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Easy Entry of New Firms in
the Long Run
 There
are no significant barriers to entry
in monopolistic competition.
 The existence of economic profits
induces other firms to enter, bringing
long-run profit down to zero.
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Output, Price, and Profit of a
Monopolistic Competitor
 A monopolistically
competitive firm
produces in the same manner as a
monopolist—to maximize profit, it
chooses the quantity where MC = MR.
 Having determined output, the firm will
charge what consumers are willing to
pay (determined by the demand curve).
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Output, Price, and Profit of a
Monopolistic Competitor
 If
price exceeds ATC, the firm will earn
positive economic profits.
 These
profits attract entry.
 Some customers of the existing firms
switch to become customers of the new
firm.
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Output, Price, and Profit of a
Monopolistic Competitor
 Entry
causes the existing firm’s demand
curve to shift left (decrease) as it loses
customers.
 Competition, therefore, implies zero
economic profit in the long run.
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Output, Price, and Profit of a
Monopolistic Competitor
 At
the long run equilibrium, ATC equals
price and economic profits are zero.
 This occurs at the point of tangency of
the ATC and demand curve at the
output chosen by the firm.
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Monopolistic Competition, Fig. 131a, p 283
Price
P1
C1
MC

MR
0
Q1
D1
Quantity
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Monopolistic Competition, Fig. 131b, p 283
Price
MC
P1
P2
C2
C1
0
Q2 Q1
MR1
D2
D1
Quantity
MR2
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Monopolistic Competition, Fig. 131c, p 283
Price
MC
P1
P2
P3 =C3
C2
C1
ATC3
MR3
0
Q3
D3
Quantity
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Comparing Monopolistic
Competition with Perfect
Competition
 Both
the monopolistic competitor and
the perfect competitor make zero
economic profit in the long run.
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Comparing Monopolistic
Competition with Perfect
Competition
 The
perfect competitor’s demand curve
is perfectly elastic.
 Zero economic profit means that it
produces at the minimum of the ATC
curve.
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Comparing Monopolistic
Competition with Perfect
Competition
A monopolistic competitor faces a downward
sloping demand curve
 It produces where MC = MR, and not where
MC =P.
 The ATC curve is tangent to the demand
curve in the zero-profit long run equilibrium,
so the firm does not produce at the minimum
point of the ATC curve.

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Comparing Monopolistic
Competition with Perfect
Competition
 A monopolistic
competitor produces less
than a perfect competitor.
 For a monopolistic competitor,
increasing market share is a relevant
concern, since it can decrease the
average cost by increasing output.
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Comparing Perfect and
Monopolistic Competition,Fig.13-2,
p 284
Perfect competition
Price
Monopolistic competition
Price
MC
ATC
D
PC
MC
ATC
PMC
PC
D
0
QC
Quantity
0
MR
QMC QC Quantity
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Comparing Monopolistic
Competition with Monopoly
 The
difference between a monopolist
and a monopolistic competitor is in the
position of the average total cost curve
in long-run equilibrium.
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Comparing Monopolistic
Competition with Monopoly
 The
monopolist makes a long-run
economic profit since entry is prevented
by significant barriers to entry.
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Comparing Monopolistic
Competition with Monopoly
 For
a monopolistic competitor, barriers
to entry are low, and entry means that
no long run economic profit is possible.
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Advertising and Monopolistic
Competition
 Firms
in a perfectly competitive market
have no incentive to advertise
 Monopolistic competitors have a strong
incentive to do so.
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Characteristics Oligopoly
 Oligopolies
are made up of a small
number of very large firms.
 Products may be homogeneous or
differentiated
 Firms are mutually interdependent.
 Each firm must take into account the
expected reaction of other firms.
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Models of Oligopoly Behavior
 Oligopolistic
industries are difficult to
characterize.
 There is no single general model of
oligopoly because each oligopolistic
industry is different.
 Two (out of many) models of oligopoly
behavior are the cartel model and the
contestable market model.
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Models of Oligopoly Behavior
 In
the cartel model, an oligopoly sets a
monopoly price.
 In the contestable market model, an
oligopoly with no barriers to entry sets a
competitive price.
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The Cartel Model
 A cartel
is a combination of firms that
acts as if it were a single firm.
 If oligopolies can limit entry, they have a
strong incentive to collude.
 To collude is to get together with other
firms to set price or allocate market
share.
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The Cartel Model
 The
cartel model of oligopoly assumes
that oligopolies act as if they were
monopolists that have assigned output
quotas to individual member firms so
that total output is consistent with joint
profit maximization.
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Implicit Price Collusion
 Formal
collusion is against the law in
Canada, but informal collusion is
allowed.
 Implicit price collusion exists when
multiple firms make the same pricing
decisions even though they have not
consulted with one another.
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Implicit Price Collusion
 Sometimes
the largest or most
dominant firm takes the lead in pricing
and output decisions, and the others
follow.
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Cartels and Technological
Change
 Cartels
can be destroyed by an outsider
with technological superiority.
 Thus, cartels with high profits will
provide incentives for significant
technological change.
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Kinked Demand: Why Are
Prices Sticky?
 Informal
collusion is an important
reason why prices are sticky.
 Another is the kinked demand curve.
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Kinked Demand
 When
there is a kink in the demand
curve, there has to be a gap in the
marginal revenue curve.
 The kinked demand curve is not a
theory of oligopoly but a theory of sticky
prices.
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The Kinked Demand Curve, Fig.
13-3, p 289
Price
a
P
b
MC0
c
MC1
D1
d
MR1
D2
0
Q
MR2
Quantity
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The Contestable Market
Model
 According
to the contestable market
model, barriers to entry and barriers to
exit determine a firm’s price and output
decisions.

Even if the industry contains a very small
number of firms, it could still behave as a
competitive market if entry is open.
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The Contestable Market
Model
 The
stronger the ability of the
oligopolists to collude and prevent
market entry, the closer it is to a
monopolist solution.
 The weaker the ability to collude, the
more competitive will be the market.
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Strategic Pricing and
Oligopoly
 Both
the cartel and contestable market
models use strategic pricing decisions—
they set their prices based on the
expected reactions of other firms.
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Strategic Pricing and
Oligopoly
 Creation
of cartels is limited by threat of
outside competition.
 In many industries the outside
competition comes from international
firms.
 For a cartel with few barriers to entry,
the long run demand curve is very
elastic.
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Price Wars
 Price
wars are the result of strategic
pricing decisions breaking down.
 If prices fall below average total cost,
firms may enter into a price war in any
oligopoly.
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Price Wars
 A firm
may develop a predatory pricing
strategy as a matter of policy

A predatory pricing strategy involves
temporarily pushing the price down below
cost in order to drive a competitor out of
business.
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Game Theory and Strategic
Decision Making
 Game
theory is the application of
economic principles to interdependent
situations.
 One example is the “prisoners’
dilemma” game.
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The Prisoner’s Dilemma and a
Duopoly Example
prisoner’s dilemma is one wellknown game that demonstrates the
difficulty of cooperative behavior in
certain circumstances.
 The
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The Prisoner’s Dilemma and a
Duopoly Example
 The
prisoners dilemma has its simplest
application when the oligopoly consists
of only two firms—a duopoly.
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The Prisoner’s Dilemma and a
Duopoly Example
 By
analyzing the strategies of both firms
under all situations, all possibilities are
placed in a payoff matrix.
 A payoff matrix is a box that contains
the outcomes of a strategic game under
various circumstances.
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Firm and Industry Duopoly
Cooperative Equilibrium, Fig. 13-4, p 291
Price
Price
MC ATC
$800
$800
700
700
600
600
500
500
400
400
300
300
200
200
100
100
575
Monopolist
solution
MC
Competitive
solution
D
0
1
2
3
4
5
6
7
8
Quantity (in thousands)
(a) Firm's cost curves
0
MR
1
2
3
4
5
6
7
8
9 10 11
Quantity (in thousands)
(b) Industry: Competitive and monopolist solution
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Firm and Industry Duopoly
Equilibrium When One Firm Cheats,
Fig. 13-5, p 292
$900
$800
$800
800
700
700
700
600
550
500
600
550
500
600
550
500
400
300
A
400
Price
A
Price
Price
MC ATC
MC ATC
300
200
200
100
100
100
1
2 3 4
5 6 7
Quantity (in thousands)
(a) Noncheating firm’s loss
0
1
2 3 4
5
6 7
Quantity (in thousands)
(b) Cheating firm’s profit
B
A
NonCheating
400 cheating
firm’s
firm’s
output
300 output
200
0
C
0
1
2 3
4 5 6
7 8
Quantity (in thousands)
(c) The market
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Duopoly and a Payoff Matrix
 The
duopoly is a variation of the
prisoner's dilemma game.
 The results can be presented in a payoff
matrix that captures the essence of the
prisoner's dilemma.
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The Payoff Matrix of Strategic
Pricing Duopoly, Fig. 13-6, p 293
A Does not cheat
A Cheats
A +$200,000
A $75,000
B Does not
cheat
B $75,000
B – $75,000
A – $75,000
A0
B Cheats
B +$200,000
B0
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Oligopoly Models, Structure,
and Performance
 Oligopoly
models are based either on
structure or performance.
The four-fold division of markets
considered so far are based on market
structure.
 Structure means the number, size, and
interrelationship of firms in the industry.

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Oligopoly Models, Structure,
and Performance
 A monopoly
is considered the least
competitive, perfectly competitive
industries are considered the most
competitive.
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Oligopoly Models, Structure,
and Performance
 The
contestable market model gives
less weight to market structure.
Markets in this model are judged by
performance, not structure.
 Performance includes such results as ratio
of price to marginal cost, output, allocative
and productive efficiency, product variety,
innovation rate, and profits.

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Oligopoly Models, Structure,
and Performance
 There
is a similarity in the two
approaches, structure versus
performance
Often barriers to entry are the reason there
are only a few firms in an industry.
 When there are many firms, that’s usually
because there are few barriers to entry.
 In most situations the two approaches
come to the same conclusion regarding
competitiveness.

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Monopolistic Competition,
Oligopoly, and Strategic
Pricing
End of Chapter 13
© 2003 McGraw-Hill Ryerson Limited.