Transcript 12.4 game theory

Monopolistic Competition
and Oligopoly
CHAPTER
12
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Explain how price and quantity are determined in
monopolistic competition.
2
Explain why selling costs are in monopolistic
competition.
3
Explain the dilemma faced by firms in oligopoly.
4
Use game theory to explain how price and
quantity are determined in oligopoly.
12.1 MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure in
which
• A large number of firms compete.
• Each firm produces a differentiated product.
• Firms compete on price, product quality, and
marketing.
• Firms are free to enter and exit.
12.1 MONOPOLISTIC COMPETITION
Large Number of Firms
Like perfect competition, the market has a large number
of firms. Three implications are
• Small market share
• No market dominance
• Collusion impossible
12.1 MONOPOLISTIC COMPETITION
Product Differentation
Product differentiation is making a product that is
slightly different from the products of competing firms.
A differentiated product has close substitutes but it does
not have perfect substitutes.
When the price of one firm’s product rises, the quantity
demanded of that firm’s product decreases.
12.1 MONOPOLISTIC COMPETITION
Competing on Quality, Price, and Marketing
Quality
Design, reliability, after-sales service, and buyer’s ease
of access to the product.
Price
Because of product differentiation, the demand curve for
the firms’ product is downward sloping.
Marketing
Advertising and packaging
12.1 MONOPOLISTIC COMPETITION
 Entry and Exit
No barriers to entry.
So the firm cannot make economic profit in the long run.
 Identifying Monopolistic Competition
Two indexes:
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index
12.1 MONOPOLISTIC COMPETITION
The Four-Firm Concentration Ratio
The four-firm concentration ratio is the percentage
of the value of sales accounted for by the four largest
firms in the industry.
The range of concentration ratio is from almost zero for
perfect competition to 100 percent for monopoly.
• A ratio that exceeds 60 percent is an indication of
oligopoly.
• A ratio of less than 40 percent is an indication of a
competitive market—monopolistic competition.
12.1 MONOPOLISTIC COMPETITION
The Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is the square
of the percentage market share of each firm summed
over the largest 50 firms in a market.
Example, four firms with market shares as 50 percent,
25 percent, 15 percent, and 10 percent.
HHI = 502 + 252 + 152 + 102 = 3,450
A market with an HHI less than 1,000 is regarded as
competitive and between 1,000 and 1,800 is moderately
competitive.
12.1 MONOPOLISTIC COMPETITION
How, given its costs and the demand for its jeans, does
Tommy Hilfiger decide the quantity of jeans to produce
and the price at which to sell them?
The Firm’s Profit-Maximizing Decision
The firm in monopolistic competition makes its output
and price decision just like a monopoly firm does.
Figure 12.1 on the next slide illustrates this decision.
12.1 MONOPOLISTIC COMPETITION
1. Profit is maximized
when MR = MC.
2. The profit-maximizing
output is 125 pairs of
Tommy jeans per day.
3. The profit-maximizing
price is $75 per pair.
ATC is $25 per pair, so
4. The firm makes an
economic profit of
$6,250 a day.
12.1 MONOPOLISTIC COMPETITION
Long Run: Zero Economic Profit
Economic profit induces entry and economic loss
induces exit, as in perfect competition.
Entry decreases the demand for the product of each
firm.
Exit increases the demand for the product of each firm.
In the long run, economic profit is competed away and
firms earn normal profit.
Figure 12.2 on the next slide illustrates long-run
equilibrium.
12.1 MONOPOLISTIC COMPETITION
1. The output that
maximizes profit is 75
pairs of Tommy jeans a
day.
2. The price is $50 per
pair. Average total cost
is also $50 per pair.
3. Economic profit is zero.
12.1 MONOPOLISTIC COMPETITION
Monopolistic Competition and Efficiency
Efficiency requires that marginal benefit (price) equal
marginal cost.
In monopolistic competition, price exceeds marginal
cost—a sign of inefficiency.
But this inefficiency arises from product differentiation—
variety—that consumers value and for which they are
willing to pay.
So in a broader view, monopolistic competition brings
gains to consumers.
12.1 MONOPOLISTIC COMPETITION
Firms in monopolistic competition always have excess
capacity in the long run.
Excess Capacity
A firm has excess capacity if the quantity it produces
is less that the quantity at which average total cost is a
minimum.
A firm’s efficient scale is the quantity of production at
which average total cost is a minimum.
Figure 12.3 on the next slide shows the firm’s excess
capacity in the long-run equilibrium.
12.1 MONOPOLISTIC COMPETITION
1. The efficient scale is 100
pairs of jeans a day.
2. In the long run, the firm
produces less than the
efficient scale and has
excess capacity.
3. Price exceeds 4. marginal
cost.
5. Deadweight loss arise.
12.2 DEVELOPMENT AND MARKETING
 Innovation and Product Development
Wherever economic profits are earned, imitators
emerge.
To maintain economic profit, a firm must seek out new
products.
Cost Versus Benefit of Product Innovation
The firm must balance the cost and benefit at the
margin.
12.2 DEVELOPMENT AND MARKETING
Efficiency and Product Innovation
Regardless of whether a product improvement is real or
imagined, its value to the consumer is its marginal
benefit, which equals the amount the consumer is
willing to pay.
The marginal benefit to the producer is the marginal
revenue, which in equilibrium equals marginal cost.
Because price exceeds marginal cost, product
improvement is not pushed to its efficient level.
12.2 DEVELOPMENT AND MARKETING
Marketing
Firms in monopolistic competition spend a large amount
on advertising and packaging their products.
Marketing Expenditures
A large proportion of the prices that we pay cover the
cost of selling a good.
Figure 12.4 on the next slide shows some estimates of
marketing expenditures for some familiar markets.
12.2 DEVELOPMENT AND MARKETING
12.2 DEVELOPMENT AND MARKETING
Selling Costs and Total Costs
Selling costs such as advertising costs increase the
costs of a monopolistically competitive firm above those
of a perfectly competitive firm or a monopoly.
Advertising costs are fixed costs.
Advertising costs per unit decrease as production
increases.
Figure 12.5 on the next slide illustrates the effects of
selling costs on total cost.
12.2 DEVELOPMENT AND MARKETING
1. When advertising
costs are added to
2. The average total
cost of production,
3. Average total cost
increases by a
greater amount at
small outputs than
at large outputs.
12.2 DEVELOPMENT AND MARKETING
4. If advertising enables
sales to increase
from 25 pairs of jeans
a day to 100 pairs a
day, it lowers the
average total cost
from $60 a pair to
$40 a pair.
12.2 DEVELOPMENT AND MARKETING
Selling Costs and Demand
Advertising and other selling efforts change the demand
for a firm’s product.
The effects are complex:
• A firm’s own advertising increases the demand for
its product.
• Advertising by all firms might decrease the
demand for any one firm’s product and make
demand more elastic.
The price might fall.
12.2 DEVELOPMENT AND MARKETING
Efficiency: The Bottom Line
Because price exceeds marginal cost, monopolistic
competition creates deadweight loss—an indicator of
inefficiency.
Price exceeds marginal cost because of product
differentiation. But product variety is valued.
The bottom line is ambiguous. But compared to the
alternative, monopolistic competition looks efficient.
12.3 OLIGOPOLY
Another market type that stands between perfect
competition and monopoly.
Oligopoly is a market type in which
• A small number of firms compete.
• Natural or legal barriers prevent the entry of new
firms.
12.3 OLIGOPOLY
In contrast to monopolistic competition and perfect
competition, an oligopoly consists of a small number of
firms.
• Each firm has a large market share
• The firms are interdependent
• The firms have an incentive to collude
12.3 OLIGOPOLY
Collusion
A cartel is a group of firms acting together to limit
output, raise price, and increase economic profit.
Cartels are illegal but they do operate in some markets.
To study oligopoly, we look at the special case of
duopoly.
A duopoly is a market in which there are only two
producers.
12.3 OLIGOPOLY
Duopoly in Airplanes
Airbus and Boeing are the only makers of large
commercial jets.
Monopoly Outcome
If this industry had only one firm, it would operate as a
single-price monopoly.
Figure 12.6 on the next slide shows the monopoly
outcome.
12.3 OLIGOPOLY
12.3 OLIGOPOLY
The Duopolists’ Dilemma
To achieve the
monopoly profit, Airbus
and Boeing might
attempt to form a cartel.
If the firms can agree to
produce the monopoly
output of 6 airplanes a
week, joint profits will
be $72 million .
12.3 OLIGOPOLY
Would it be in the self-interest of Airbus and Boeing to
stick to the agreement and limit production to 3 planes a
week each?
With price exceeding marginal cost, one firm can an
increase its profit by increasing its output.
If both firms increased output when price exceeds
marginal cost, the end of the process would be the
same as perfect competition.
12.3 OLIGOPOLY
Perfect Competition
Equilibrium occurs where the marginal revenue curve
intersects the demand curve.
The quantity produced is 12 planes a week and the
price would be $1 million a plane.
Figure 12.6 shows the perfect competition outcome and
the range of possible oligopoly outcomes.
12.3 OLIGOPOLY
12.3 OLIGOPOLY
Boeing Increases Output
to 4 Airplanes a Week
Boeing can increase its
economic profit by $4
million, from $36 million
to $40 million.
And cause the economic
profit of Airbus to fall by $6
million, from $36 million to
$30 million.
12.3 OLIGOPOLY
Airbus Increases
Output to 4 Airplanes
a Week
For Airbus, this outcome
is an improvement on the
previous one by $2 million
a week.
For Boeing, the outcome
is worse than the previous
one by $8 million a week.
12.3 OLIGOPOLY
Boeing Increases
Output to 5 Airplanes
a Week
If Boeing increases
output to 5 airplanes a
week, its economic profit
falls.
Similarly, if Airbus
increases output to 5
airplanes a week, its
economic profit falls.
12.3 OLIGOPOLY
The Dilemma
• If both firms stick to the monopoly output, they
each produce 3 airplanes and make $36 million.
• If they both increase production to 4 airplanes a
week, they make $32 million each.
• If only one firm increases production to 4 airplanes
a week, that firm makes $40 million.
• What do they do?
Game theory provides an answer.
12.4 GAME THEORY
Game theory
The tool used to analyze strategic behavior—behavior
that recognizes mutual interdependence and takes
account of the expected behavior of others.
12.4 GAME THEORY
What Is a Game?
All games involve three features:
• Rules
• Strategies
• Payoffs
Prisoners’ dilemma
A game between two prisoners that shows why it is hard
to cooperate, even when it would be beneficial to both
players to do so.
12.4 GAME THEORY
The Prisoners’ Dilemma
Art and Bob been caught stealing a car: sentence is 2
years in jail.
DA wants to convict them of a big bank robbery:
sentence is 10 years in jail.
DA has no evidence and to get the conviction, the DA
makes the prisoners play a game.
12.4 GAME THEORY
Rules
Players cannot communicate with one another.
• If both confess to the larger crime, each will
receive a sentence of 3 years for both crimes.
• If one confesses and the accomplice does not,
the one who confesses will receive a 1-year
sentence, while the accomplice receives a
10-year sentence.
• If neither confesses, both receive a 2-year
sentence.
12.4 GAME THEORY
Strategies
The strategies of a game are all the possible
outcomes of each player.
The strategies in the prisoners’ dilemma are
• Confess to the bank robbery.
• Deny the bank robbery.
12.4 GAME THEORY
Payoffs
Four outcomes:
• Both confess.
• Both deny.
• Art confesses and Bob denies.
• Bob confesses and Art denies.
A payoff matrix is a table that shows the payoffs for
every possible action by each player given every
possible action by the other player.
12.4 GAME THEORY
Table 12.5 shows
the prisoners’
dilemma payoff
matrix for Art and
Bob.
12.4 GAME THEORY
Equilibrium
Occurs when each player takes the best possible action
given the action of the other player.
Nash equilibrium
An equilibrium in which each player takes the best
possible action given the action of the other player.
12.4 GAME THEORY
The Nash equilibrium for Art and Bob is to confess.
Not the Best Outcome
The equilibrium of the prisoners’ dilemma is not the best
outcome.
12.4 GAME THEORY
The Duopolists’ Dilemma as a Game
Each firm has two strategies. It can produce airplanes
at the rate of:
• 3 a week
• 4 a week
12.4 GAME THEORY
Because each firm has two strategies, there are four
possible combinations of actions:
• Both firms produce 3 a week (monopoly outcome).
• Both firms produce 4 a week.
• Airbus produces 3 a week and Boeing produces 4
a week.
• Boeing produces 3 a week and Airbus produces 4
a week.
12.4 GAME THEORY
The Payoff Matrix
Table 12.6 shows the
payoff matrix as the
economic profits for
each firm in each
possible outcome.
12.4 GAME THEORY
Equilibrium of the
Duopolists’ Dilemma
Both firms produce 4
a week.
Like the prisoners, the
duopolists fail to
cooperate and get a
worse outcome than
the one that
cooperation would
deliver.
12.4 GAME THEORY
Collusion is Profitable but Difficult to Achieve
The duopolists’ dilemma explains why it is difficult for
firms to collude and achieve the maximum monopoly
profit.
Even if collusion were legal, it would be individually
rational for each firm to cheat on a collusive agreement
and increase output.
In an international oil cartel, OPEC, countries frequently
break the cartel agreement and overproduce.
12.4 GAME THEORY
Advertising and Research Games in
Oligopoly
Advertising campaigns by Coke and Pepsi, and
research and development (R&D) competition between
Procter & Gamble and Kimberly-Clark are like the
prisoners’ dilemma game.
12.4 GAME THEORY
Advertising Game
Coke and Pepsi have
two strategies: advertise
or not advertise.
Table 16.8 shows the
payoff matrix as the
economic profits for each
firm in each possible
outcome.
12.4 GAME THEORY
The Nash equilibrium
for this game is for
both firms advertise.
But they could earn a
larger joint profit if they
could collude and not
advertise.
12.4 GAME THEORY
Research and Development Game
P&G and KimberlyClark have two
strategies: spend on
R&D or do no R&D.
Table 16.9 shows the
payoff matrix as the
economic profits for
each firm in each
possible outcome.
12.4 GAME THEORY
The Nash equilibrium
for this game is for
both firms to
undertake R&D.
But they could earn a
larger joint profit if
they could collude and
not do R&D.
12.4 GAME THEORY
Repeated Games
Most real-world games get played repeatedly.
Repeated games have a larger number of strategies
because a player can be punished for not cooperating.
This suggests that real-world duopolists might find a
way of learning to cooperate so that they can enjoy
monopoly profit.
The next slide shows the payoffs with a “tit-for-tat”
response.
12.4 GAME THEORY
Week 1: Suppose Boeing
contemplates producing 4
planes a week.
Boeing’s profit will increase
from $36 million to $40
million and Airbus’s profit will
decrease from $36 million to
$30 million.
Week 2: Airbus punishes
Boeing and produces 4
planes a week.
12.4 GAME THEORY
But Boeing must go back to 3
planes a week to induce Airbus
to cooperate in week 3.
In week 2, Airbus’s profit is $40
million and Boeing’s profit is
$30 million.
Over the two weeks, Boeing’s
profit would have been $72
million if it cooperated but only
$70 million with Airbus’s tit-fortat response.
12.4 GAME THEORY
In reality, where a duopoly works like a one-play game
or a repeated game depends on the number of players
and the ease of detecting and punishing
overproduction.
The larger the number of players, the harder it is to
maintain the monopoly outcome.
12.4 GAME THEORY
Is Oligopoly Efficient?
In oligopoly, price usually exceeds marginal cost.
So the quantity produced is less than the efficient
quantity.
Oligopoly suffers from the same source and type of
inefficiency as monopoly.
Because oligopoly is inefficient, antitrust laws and
regulations are used to try to reduce market power and
move the outcome closer to that of competition and
efficiency.
A Game in YOUR Life
The payoff matrix here
describes a game that might
be familiar to you: the lovers’
dilemma.
Jane and Jim like to do
things together. But Jane
likes the movies more than
the ball game, and Jim
likes the ball game more
than movies.
What do they do?
A Game in YOUR Life
You can figure out that Jim
never goes to the movies
alone and Jane never goes
to the game alone.
So they out together. To the
movies or the ball game?
This game, unlike the
prisoners’ dilemma, has no
unique equilibrium.
What do the payoffs tell
you?