Transcript Document

A Lecture Presentation
to accompany
Exploring Economics
3rd Edition
by Robert L. Sexton
Copyright © 2005 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0-324-26086-5
Copyright © 2002 by Thomson Learning, Inc.
Chapter 13
Monopolistic Competition
and Oligopoly
Copyright © 2002 by Thomson Learning, Inc.
13.1 Monopolistic Competition


Many goods and services are traded
in circumstances that contain
elements of both monopoly and
perfect competition.
Theories of monopolistic competition
and oligopoly deal with markets that
lie between the extreme cases of
perfect competition and monopoly.
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What is Monopolistic Competition?

Monopolistic competition is a
market structure where many
producers of somewhat different
products compete with one another.
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
Monopolistic competition has
features in common with both
monopoly and perfect competition.


Like monopoly, individual sellers believe
that they have some market power.
Unlike monopoly, there are many close
substitutes coming from other
monopolistically competitive firms.
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

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Firms in monopolistically competitive
markets recognize the existence of
competitors.
They impose a limit on the prices they
can charge and still sell a particular
level of output.
But they do not consider competitors
as rivals who are watching them
closely.
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
Monopolistic competition is similar to
perfect competition.

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
relatively free entry of new firms
long-run price and output behavior
zero long-run economic profits
However, the monopolistically
competitive firm produces a
differentiated product, which leads to
some degree of monopoly power.
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

In a sense, each seller in a market of
monopolistic competition may be
regarded as a “monopolist” of its own
particular brand of the commodity.
Unlike a firm in the monopoly model,
there is competition by many firms
selling similar (but not identical)
brands.
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The Three Basic Characteristics
of Monopolistic Competition

The theory of monopolistic
competition is based on three
characteristics:
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

product differentiation
many sellers
free entry
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

Product differentiation is the
accentuation of unique product
qualities, real or perceived, to
develop a specific product identity.
With differentiation, buyers believe
that the products of the various
sellers are not the same, whether the
products are actually physically
different or not.
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

Product differentiation leads to
preferences among buyers to deal
with particular sellers or to purchase
the products of particular sellers.
Sources of differentiation

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

physical differences
prestige considerations
location
service considerations
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
When many firms compete for the
same customers, any particular firm
has little control over or interest in
what other firms do.
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
Entry in monopolistic competition is
relatively unrestricted.


New firms may easily start the
production of close substitutes for
existing products.
Economic profits tend to be eliminated in
the long run, as is the case in perfect
competition.
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13.2 Price and Output Determination
in Monopolistic Competition


Monopolistically competitive sellers
are price searchers; they do not
regard price as a given by market
conditions.
Because each firm sells a slightly
different product, each firm’s
demand curve is downward sloping,
but quite flat (elastic) because of
many close substitutes.
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Determining Short-Run
Equilibrium

In perfect competition, each firm’s
demand curve is horizontal because
each firm, one of a great many
sellers, sells the same homogenous
product.
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

Given the position of an individual
firm’s demand curve, we can
determine short-run equilibrium output
and price using a method similar to
that used to determine monopoly
output and price.
The intersection of MR and MC curves
indicates the short-run equilibrium
output under monopolistic competition.
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
By observing the price on the
demand curve at which that output
can be sold, we then find the shortrun equilibrium price.
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Three Step Method for
Monopolistic Competition

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
Find q* where MR= MC.
Go up to the demand curve then to
the left to find the market price.
Go up from the profit-maximizing
quantity to ATC.


if TR > TC (P is greater than ATC), the
firm is generating profits
if TR < TC (P is less than ATC), the firm
is generating losses
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Short-Run Profits and Losses
in Monopolistic Competition


The short-run equilibrium situation,
whether involving profits or losses, will
probably not last long because there is
entry and exit in the long run.
If market entry and exit are sufficiently
free,


new firms will enter when there are economic
profits
some firms will exit when there are economic
losses
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Determining Long-Run Equilibrium

If existing firms are earning
economic profits,

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new firms enter to take advantage of
the economic profits
the demand curves for each of the
existing firms will fall and become more
elastic due to increasing substitutes
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
This decline in demand continues
until ATC becomes tangent with the
demand curve, and economic profits
are reduced to zero.
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
When monopolistically competitive
firms are making economic losses,

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some firms will exit the industry
the demand curves for the remaining
firms shift to the right and makes them
more inelastic due to reduced
substitutes
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
The higher demand results in
smaller losses for the existing firms
until the losses disappear where the
ATC curve is tangent to the demand
curve.
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
Long-run equilibrium will occur when
demand is equal to average total
cost for each firm at a level of
output at which each firm’s demand
curve is just tangent to its ATC
curve.
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

The point of tangency will always
occur at the same level of output as
where MR = MC.
At this equilibrium point, there are


zero economic profits
no incentives for firms to either enter or
exit the industry
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13.3 Monopolistic Competition
versus Perfect Competition


Both monopolistic competition and
perfect competition have many
buyers and sellers and relatively free
entry.
However, product differentiation
allows a monopolistic competitor the
ability to have some influence over
price.
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
A monopolistic competitive firm has
a downward-sloping demand curve,
but it tends to be more elastic than
the demand curve for a monopolist
because of the large number of good
substitutes for its product.
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The Significance of Excess
Capacity


Because of the downward slope of the
demand curve, its point of tangency
with ATC will not and cannot be at the
lowest level of average cost.
Therefore, even when long-run
adjustments are complete, firms will not
be operating at a level that permits the
lowest average cost of productionthe
efficient scale of the firm.
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

The existing plant, even though
optimal for the equilibrium volume of
output, will not be used to capacity.
That is, excess capacity will exist
at that level of output.
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
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Unlike a perfectly competitive firm, a
monopolistically competitive firm could
increase output and lower its average
total costs.
However, increasing output to attain
lower average costs would be
unprofitable. The price reduction
necessary to sell the greater output would
cause MR to fall below MC of the
increased output.
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

Consequently, in monopolistic
competition, there is a tendency toward
too many firms in the industry, each
producing a volume of output less than
that which would allow lowest cost.
Economists call this failing to reach
productive efficiency—output
production is not minimizing average
total costs.
Copyright © 2002 by Thomson Learning, Inc.
Failing to Meet Allocative
Efficiency, Too

In monopolistic competition, firms are not
operating where P = MC.

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At the intersection of MC and MR, P > MC.
This means that society is willing to pay more
for the product (the price) than it costs society
to produce it.
The firm is not allocatively efficient,
(where P = MC).

Too many firms are producing at output levels
that are less than full capacity.
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
Perfectly competitive firms reach

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productive efficiency (P = ATC at the
minimum point on the ATC curve)
allocative efficiency (P = MC)
However, these drawbacks in the
monopolistically competitive market
would be far greater in monopoly,
where the demand curve is more
inelastic (steeper).
Copyright © 2002 by Thomson Learning, Inc.


In monopolistic competition, the higher
average costs and the slightly higher
price and lower output may just be the
price we pay for differentiated
productsvariety.
Just because we have not met the
conditions of productive and allocative
efficiencies, it is difficult to say whether
or not society is better off.
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What are the Real Costs of
Monopolistic Competition?

Perfect competition meets the test of
allocative and productive efficiency
and monopolistic competition does
not.
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Are the Differences Between Monopolistic
and Perfect Competition Exaggerated?


The significance of the difference
between the relationship of long-run
marginal cost to price in monopolistic
competition and in perfect competition
can easily be exaggerated.
As long as preferences for various
brands are not extremely strong, the
demand for the products of firms will
be highly elastic.
Copyright © 2002 by Thomson Learning, Inc.


Accordingly, the points of tangency
with the ATC curves are not likely to
be far above the point of lowest cost,
and excess capacity will be small.
Only if differentiation is very strong
will the difference between the
long-run price level and that which
would prevail under perfectly
competitive conditions be significant.
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

Remember: The theory of the firm is like
a road map that does not provide every
possible detail, but gives us directions to
get from one point to another.
Any particular theory of the firm may
not tell us precisely how an individual
firm will operate, but rather will give us
valuable insight into the tendencies of
how firms will react to changing
economic conditions.
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13.4 Advertising


Advertising is an important non-price
method of competition that is
commonly used in monopolistic
competition.
By advertising, firms hope to increase
the demand and create a less elastic
demand curve for their products, thus
enhancing revenues and profits.
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Advertising Can Change the Shape
and Position of the Demand Curve

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
A successful advertising campaign
can increase demand and decrease its
elasticity by convincing buyers that a
firm’s product is truly different.
The result would be greater profits.
The degree to which advertising
impacts demand varies from market
to market.
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Is Advertising “Good” or “Bad”
from Society’s Perspective?

Some have argued that advertising
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

manipulates consumer tastes and wastes
billions of dollars annually creating
“needs” for trivial products
is sometimes based on misleading claims
in itself, requires resources, which raises
average costs.
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
On the other hand, if one believes
that people are rational and should
be permitted freedom of expression,
the argument against advertising
loses some of its force.
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
While it is true that advertising can
raise average total costs, it is possible
that in situations where substantial
economies of scale exist, average
production costs may decline more
than the amount of per-unit costs of
advertising, by allowing firms to
operate closer to the point of
minimum cost on their ATC curve.
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
If the increase in demand resulting
from advertising is significant,
economies of scale from higher
output levels may offset the
advertising costs, allowing the firm
to sell at a lower price.

Toys R Us is an example.
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

Firms in monopolistic competition
are not likely to experience
substantial cost reductions as output
increases.
Therefore, they probably will not be
able to offset advertising costs with
lower production costs.
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
Even if advertising does add to total
cost, it does convey information.


Customers become aware of options in
terms of product choice.
It informs price-conscious customers
about the cost of the product.
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

Advertising reduces information costs,
so customers know about more
substitutes.
Consequently, this leads to
increasingly competitive markets.

Studies in the eyeglass, toy, and drug
industries have shown that advertising
has increased competition and led to
lower prices in these markets.
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13.5 Oligopoly

Oligopolies exist where relatively few
firms control all or most of the
production and sale of a product
(oligopoly = few sellers).

The products may be homogeneous or
differentiated, but the barriers to entry
are often very high, which makes it
very difficult for firms to enter into the
industry. Firms in the industry may earn
long-run economic profits.
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Mutual Interdependence


Oligopoly is characterized by mutual
interdependence among firms; each
firm shapes its policy with an eye to
the policies of competing firms.
Oligopolists must strategize, much
like good chess or bridge players,
constantly observing and anticipating
the moves of their rivals.
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
Oligopoly occurs when the number
of firms in an industry is so small
that any change in output or price
by one firm appreciably impacts the
sales of competing firms, so
competitors respond directly to
these actions in determining their
own policy.
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Why Do Oligopolies Exist?

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
Primarily, oligopoly is a result of the
relationship between technological
conditions of production and potential
sales volumes.
For many products, a reasonably low cost
of production cannot be obtained unless a
firm is producing a large fraction of the
market output.
In other words, substantial economies of
scale are present.
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Measuring Industry Concentration


Oligopolies exist, by definition, when
a relatively few firms control most of
the production and sale of a given
product or class of products.
A way of measuring the extent of
oligopoly power in various industries
is by using concentration ratios.
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
A concentration ratio indicates the
proportion of total industry
shipments (sales) of goods that a
specified number of the largest firms
in the industry produced, or the
proportion of total industry assets
held by those largest firms.
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
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The extent of oligopoly power is
indicated by the four-firm
concentration ratio for the U.S.
Concentration ratios of 70 to 100
percent are common oligopolies.
That is, a high concentration ratio
means that a few sellers dominate
the market.
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
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However, concentration ratios are
not a perfect guide to industry
concentration.
One problem is that they do not take
into consideration foreign
competition.
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Economies of Scale as a
Barrier to Entry

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Economies of large-scale production
make operation on a small scale
during a new firm’s early years
extremely unprofitable.
A firm cannot build up a large market
overnight; in the interim, ATC is so
high that losses are heavy.
Recognition of this fact discourages
new firms from entering the market.
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Equilibrium Price and Quantity
in Oligopoly

With mutual interdependence, an
oligopolist generally faces
considerable uncertainty as to the
shape of its demand and marginal
revenue curves because in order to
know anything about its demand
curve, a firm must know how other
firms will react to its prices and other
policies.
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

Thus, in the absence of additional
assumptions, equating marginal
revenue and marginal cost is
relegated to guesswork.
Thus, it is difficult for an oligopolist to
determine its profit-maximizing price
and output.
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13.6 Collusion and Cartels


The uncertainties of pricing decisions
are substantial in oligopoly, so the
implications of misjudging the behavior
of competitors could prove to be
disastrous.
Because of this uncertainty, some
believe that oligopolists change their
prices less frequently than perfect
competitors, whose prices may change
almost continuously.
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Uncertainty and Pricing
Decisions

The empirical evidence, however,
does not clearly indicate that prices
are in fact always slow to change in
oligopoly situations.
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Collusion

Because the actions and profits of
oligopolists are so dominated by
mutual interdependence, the
temptation is great for firms to
colludeto get together and agree
to act jointly in pricing and other
matters.
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

If firms believe they can increase
their prices by coordinating their
actions, they will be tempted to
collude.
Collusion reduces uncertainty and
increases the potential for monopoly
profits.
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
From society’s point of view, collusion
has the same disadvantages
monopoly does.

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
Goods are overpriced.
Goods are underproduced.
Consumers lose out from a misallocation
of resources.
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Is Collusion Like a Monopoly?


A truly collusive oligopoly that involves
all firms in an industry could act as the
equivalent of one firm with several
“plants” from the standpoint of pricing
and output decisions.
Acting in this matter, the economic
effect of the collusive oligopolist is
exactly the same as a monopolist; a
single demand curve exists for the
group of companies.
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
Once the profit-maximization price
is determined, they can agree on
how much output each firm in the
group will offer for sale.
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Joint Profit Maximization


Agreements between firms on sale, pricing,
and other decisions are usually called
cartels.
Cartels may lead to joint profit
maximization, which requires the
determination of price on the basis of the
marginal revenue function derived from the
total (or market) demand schedule for the
product and the marginal cost schedules of
the various firms.
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
With outright agreements
necessarily secret because of
antitrust lawsfirms that make up
the market will attempt to estimate
demand and cost schedules, and will
set optimum price and output levels
accordingly.
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
If prices are set by one firm and
followed by all others, the price
setter will act on the basis of total
cost schedules rather than its own
situation, and other firms will abide
by the decision.
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
When collusive action is absent, joint
maximum profits can be obtained
only if each firm, acting
independently, correctly estimates
the price that is optimal from the
standpoint of the group.
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
Equilibrium quantity and price for a
collusive oligopoly, like those of a
monopoly, are determined


according to the intersection of the
marginal revenue curve derived from
the market demand curve
and the horizontal sum of the short-run
marginal cost curves for the
oligopolists.
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

Collusion facilitates joint profit
maximization for an oligopoly.
Like monopoly, if the oligopoly is
maintained in the long run,



it charges a higher price
produces less output
fails to maximize social welfare, relative
to perfect competition
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
The manner in which total profits are
shared among firms in the industry
depends in part upon the relative
costs and sales of the various firms.
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
Firms with low costs and large supply
capability will obtain the largest
profits because they have great
bargaining power. With outright
collusion, firms may agree upon
market shares and the division of
profits.
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
Division of total profits depends on
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relative bargaining strength of the firms
relative financial strength
ability to inflict damage (through price wars)
on other firms
ability to withstand similar action on the part
of other firms
relative costs
consumer preferences
bargaining skills
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
The OPEC nations were successful with
their pricing policies between 1973 and
1981 for several reasons: worldwide
demand was highly inelastic in the short
run, OPEC’s share of total world oil output
had increased, and the supply of oil was
inelastic in the short run—ability to
increase production from existing wells is
limited and it takes times to drill new
ones.
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Copyright © 2002 by Thomson Learning, Inc.
Why are Most Collusive
Oligopolies Short Lived?

Fortunately, most strong collusive
oligopolies are rather short lived, for
two reasons.
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
First, in the United States and in some
other nations, collusive oligopolies are
strictly illegal under antitrust laws.
Second, for collusion to work, firms must
agree to restrict output to a level that
will support the profit-maximizing price.
Copyright © 2002 by Thomson Learning, Inc.

At profit-maximizing price, firms can
earn positive economic profits.


Yet there is a great temptation for firms
to cheat on the agreement of the
collusive oligopoly.
And because collusive agreements are
illegal, the other parties have no way to
punish the offender.
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
Why do oligopolists have a strong
incentive to cheat?
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
Any individual firm could lower its price
slightly and increase sales and profits, as
long as it is undetected.
Undetected price cuts could bring in new
customers, including rivals’ customers.
In addition, there are non-price forms of
defection.
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13.7 Other Oligopoly Models



Prices in some oligopolistic industries
tend to be quite stable, or rigid.
Even if demand or cost changes, firms
will be reluctant to change their price.
If demand or cost were to increase,
firms might be tempted to increase their
prices, but may not because of the fear
that rivals will not raise their prices and
they will lose customer sales.
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The Kinked Demand Curve
Model—Price Rigidity

The idea that there is price rigidity in
oligopoly is the basis of the kinked
demand curve model.

Each firm faces a demand curve that is
kinked at the market price because of
the greater tendency of competitors to
follow price reductions than price
increases.
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
They may also be reluctant to lower
their prices because it might set off
a price war.
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Copyright © 2002 by Thomson Learning, Inc.


A price reduction takes business away
from other firms and forces them to
cut prices to protect their sales, while
an increase does not necessitate a
readjustment, since other firms gain
customers if one increases its price.
In the kinked demand curve mode, at
the point of the kink, the MR curve is
discontinuous.
Copyright © 2002 by Thomson Learning, Inc.

The profit-maximizing price is indicated by the
point at which the demand curve changes
slope.
 For higher prices, the demand curve is
elastic; the firm will lose sales and market
share to others who fail to follow the price
increase.
 For lower prices, the demand curve is
relatively inelastic; rival firms match the
price reduction to maintain their market
share.
Copyright © 2002 by Thomson Learning, Inc.

Consequences of the kink in the
demand curve



The firm may be slow to adjust price in
response to cost changes.
The marginal revenue curve is
discontinuous.
The MC curve can move up or down over
a substantial range without affecting the
optimal level of price.
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

While the kinked demand curve may
be useful for explaining sellers’
reactions to various changes, it does
little to explain how the price came
to be where it is.
At the same time, the notion that
the shape of the firm’s demand
curve is dependent on the actions of
competing firms is valid.
Copyright © 2002 by Thomson Learning, Inc.


In the real world, when a firm raises its
price, but other firms do not, the priceraising firm will face the prospect of a
major sales decline. The firm will usually
retreat from the price increase originally
announced.
The explanation for the price rigidity
comes from the idea that firms do not
want to engage in destructive price
competition.
Copyright © 2002 by Thomson Learning, Inc.


Not all oligopolies experience price
rigidity.
It is more likely when there is excess
capacity, like during a recession,
because firms are likely to match a
price cut but not a price hike.
Copyright © 2002 by Thomson Learning, Inc.
Price Leadership


Over time, an implied understanding
may develop in an oligopoly market
that a large firm is the price leader.
Competitors that go along with the
pricing decisions of the price leader
are called price followers.
Copyright © 2002 by Thomson Learning, Inc.
What Happens in the Long
Run if Entry is Easy?


Mutual interdependence in itself is
no guarantee of economic profits,
even if the firms in the industry
succeed in maximizing joint profits.
The extent to which economic profits
disappear depends on the ease with
which new firms can enter the
industry.
Copyright © 2002 by Thomson Learning, Inc.

When entry is easy, excess profits
attract newcomers.

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
New firms may break down existing price
agreements by cutting prices in an
attempt to establish themselves in the
industry.
Older firms may reduce prices to avoid
excessive sales losses.
As a result, the general level of prices
will begin to approach average total cost.
Copyright © 2002 by Thomson Learning, Inc.
How Do Oligopolists Deter
Market Entry?
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
The profit-maximizing level of profits in
oligopoly could be quite high, which
would encourage entry.
But oligopolists often initiate pricing
policies that reduce the entry incentive
for new firms, holding prices below the
maximum-profit point.
This lower-than-profit-maximizing price
may discourage newcomers from
entering.
Copyright © 2002 by Thomson Learning, Inc.


Because new firms would likely have
higher costs than existing firms, the
lower price may not be high enough
to cover their costs.
However, once the threat of entry
subsides, the market price may
return to the profit-maximizing
price.
Copyright © 2002 by Thomson Learning, Inc.


If the price is deliberately kept low
(below AVC) to drive a competitor
out of the market, it is called
predatory pricing.
It is difficult to distinguish predatory
pricing from vigorous competition.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
13.8 Game Theory and
Strategic Behavior


Noncollusive oligopoly resembles a
military campaign or a poker game.
Firms take certain actions not
because they are necessarily
advantageous in themselves but
because they improve the position of
the oligopolist relative to its
competitors and may ultimately
improve its financial position.
Copyright © 2002 by Thomson Learning, Inc.

Examples


deliberately cutting prices
sacrificing profits either to drive
competitors out of business or to
discourage them from undertaking
actions contrary to the interests of the
other firms.
Copyright © 2002 by Thomson Learning, Inc.
What is Game Theory?


Some have suggested examining
firm behavior in terms of a strategic
game.
Game theory stresses the tendency
of various parties in such
circumstances to act in such a way
that minimizes damage from
opponents.
Copyright © 2002 by Thomson Learning, Inc.

With the game theory approach,
there is a set of alternative actions,
and the action that would be taken in
a particular case depends on the
specific policies followed by each firm.

The firm may try to figure out its
competitors’ most likely countermoves
to its own policies and then formulate
alternative defense measures.
Copyright © 2002 by Thomson Learning, Inc.
Cooperative and
Noncooperative Games

Interactions can either be cooperative
or noncooperative.


A cooperative game would be two
firms that decide to collude in order to
improve their profit maximization
position.
Consequently, most games are
noncooperative games in which each
firm sets its own price without consulting
other firms.
Copyright © 2002 by Thomson Learning, Inc.

The primary difference between
cooperative and noncooperative
games is the contract.


Players in a cooperative game can talk
and set binding contracts.
Those in noncooperative games are
assumed to act independently, with no
communication and no binding contracts.
Copyright © 2002 by Thomson Learning, Inc.

Because antitrust laws forbid firms
to collude, we will assume that most
strategic behavior in the
marketplace is noncooperative.
Copyright © 2002 by Thomson Learning, Inc.
The Prisoners’ Dilemma


A firm’s decision-makers must map
out a pricing strategy based on a
wide range of information.
They also must decide whether their
strategy will be effective only under
certain conditions regarding the
actions of competitors or if the
strategy will work regardless of the
competitors’ actions.
Copyright © 2002 by Thomson Learning, Inc.

A strategy that will be optimal
regardless of the opponents’ actions
is called a dominant strategy.
Copyright © 2002 by Thomson Learning, Inc.

The prisoners’ dilemma is a famous
game that has a dominant strategy
and demonstrates the basic problem
confronting noncolluding oligopolists.


Two bank robbery suspects are caught.
The suspects are placed in separate jail
cells and are not allowed to talk with
each other.
Copyright © 2002 by Thomson Learning, Inc.

There are four possible results in this
situation




both prisoners confess
neither confesses
Prisoner A confesses but Prisoner B
doesn’t
Prisoner B confesses but Prisoner A
doesn’t
Copyright © 2002 by Thomson Learning, Inc.

The payoff matrix summarizes these
possibilities.



If each prisoner confesses they will each
serve two years in jail.
If neither confesses, each prisoner may
only get one year because of insufficient
evidence.
If one prisoner confesses and the other
does not, the confessor gets six months
and the other prisoner gets six years.
Copyright © 2002 by Thomson Learning, Inc.



Looking at the payoff matrix, if one
prisoner confesses, it is in the best
interest of the other prisoner to confess.
Since both know the temptation of the
other to confess, the dominant strategy
is to confess.
That is, the prisoners know that
confessing is the way to make the best
of a bad situation.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.

Firms in oligopoly often behave like
the prisoners in the prisoners’
dilemma, carefully anticipating the
moves of their rivals in an uncertain
environment.
Copyright © 2002 by Thomson Learning, Inc.
Profits Under Different Pricing
Strategies


To demonstrate how the prisoners’
dilemma can shed light on oligopoly
theory, let us consider the pricing
strategy of two firms.
In Exhibit 2, we present the payoff
matrix—the possible profits that
each firm would earn under different
pricing strategies.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.


At a Nash equilibrium, each firm is
doing as well as it can, given the
actions of its competitor. Each will
make the choice that minimizes the
risk of the worst scenario.
The Nash equilibrium is also the
dominant strategy.
Copyright © 2002 by Thomson Learning, Inc.

The Nash equilibrium takes on
particular importance because it is a
self-enforcing equilibrium.

Once this equilibrium is established,
there is no incentive for either firm to
move.
Copyright © 2002 by Thomson Learning, Inc.


If two firms were to collude, it would
be in their best interest.
However, each firm has a strong
incentive to lower its price if this
pricing strategy goes undetected by
its competitor.
Copyright © 2002 by Thomson Learning, Inc.


However, if both firms defect by
lowering their prices from the jointprofit-maximization level, both will be
worse off than if they had colluded, but
at least each will have minimized its
potential loss if it cannot trust its
competitor.
This is the oligopolist’s dilemma, which
can also be played out over other
strategic variables, such as advertising.
Copyright © 2002 by Thomson Learning, Inc.
Advertising


Advertising can lead to a situation
like the prisoners’ dilemma.
Perhaps the decision makers of a
large firm are deciding whether or
not to launch an advertising
campaign against a rival firm.
Copyright © 2002 by Thomson Learning, Inc.

According to the payoff matrix in
Exhibit 3, if neither company
advertises, the two companies split
the market, each making $100
million in profits.
Copyright © 2002 by Thomson Learning, Inc.

They also split the market if they
both advertise, but their net profits
are smaller, $75 million, because
they would both incur advertising
costs that are greater than any gains
in additional revenues from
advertising.
Copyright © 2002 by Thomson Learning, Inc.


However, if one advertises and the
other does not, the company that
advertises takes customers away
from the rival.
The dominant strategy—the optimal
strategy regardless of the rival’s
actions—is to advertise.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Reviewing the Market Structures

We have now studied four market
structures in which firms operate:




Perfect competition
Monopoly
Monopolisitc competition
Oligopoly
Copyright © 2002 by Thomson Learning, Inc.

In practice it is sometimes difficult to
decide precisely which structure a
given firm or industry most
appropriately fits, because the
dividing line between the structures
is not always crystal clear.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.