Monopolistic Competition and Oligopoly

11

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Four Market Models

LO1

Characteristics of the Four Basic Market Models

Characteristic

Pure

Competition

Monopolistic

Competition Oligopoly Monopoly

Number of firms A very large

number

Many Few One

Type of product Standardized Differentiated Standardized or

differentiated

Unique; no

close subs.

Control over

price

None Some, but within rather

narrow limits

Limited by mutual

inter-dependence;

considerable with

collusion

Considerable

Conditions of

entry

Very easy, no

obstacles

Relatively easy Significant

obstacles

Blocked

Nonprice

competition

None Considerable emphasis

on advertising, brand

names, trademarks

Typically a great

deal, particularly

with product

differentiation

Mostly public

relation

advertising

Examples Agriculture Retail trade, dresses,

shoes

Steel, auto, farm

implements

Local utilities

11-2

Monopolistic Competition

• Relatively large number of sellers

• Differentiated products

• Easy entry and exit

• Advertising

LO1 11-3

Monopolistically Competitive

• Industry concentration

• Measured by:

• Four-firm concentration ratios

•Percentage of 4 largest firms

• Herfindahl index

• Sum of squared market shares

LO1

4-Firm CR = Output of four largest firms

Total output in the industry

HI = (%S1)2 + (%S2)2 + (%S3)2 + …. +

(%Sn)2 11-4

Price and Output in Monopolistic Comp

• Demand is highly elastic

• Short run profit or loss

• Produce where MR=MC

• Long run normal profit

• Entry and exit

• Inefficient

• Product variety

LO2 11-5

The Short Run: Profit or Loss

LO2

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D1

ATC

Economic

Profit

Q1

A1

P1

0

11-6

The Short Run: Profit or Loss

LO2

Quantity

Pri

ce

an

d C

os

ts

MC

MR

D2

ATC

Loss

Q2

A2

P2

0

MR = MC

11-7

The Long Run: Only a Normal Profit

LO2

Quantity

Pri

ce

an

d C

os

ts

MC

MR

D3

ATC

Q3

P3= A3

0

MR = MC

11-8

Monopolistic Competition: Efficiency

• Inefficient

• Productive inefficiency

•P > ATC

• Allocative inefficiency

•P > MC

LO2 11-9

Monopolistic Competition: Efficiency

LO2

Quantity

Pri

ce a

nd

Co

sts

MR = MC

MC

MR

D3

ATC

Q3 0

P3= A3

P=MC=Min ATC for pure competition (recall)

P4

Q4

Price is Lower

Excess Capacity at

Minimum ATC

Monopolistic competition is not efficient 11-10

Product Variety

• The firm constantly manages price,

product, and advertising

• Better product differentiation

• Better advertising

• The consumer benefits by greater

array of choices and better products

• Types and styles

• Brands and quality

LO2 11-11

Oligopoly

• A few large producers

• Homogeneous or differentiated

products

• Limited control over price

• Mutual interdependence

• Strategic behavior

• Entry barriers

• Mergers

LO3 11-12

Oligopolistic Industries

• Four-firm concentration ratio

• 40% or more to be oligopoly

• Shortcomings

• Localized markets

• Inter-industry competition

• World price

• Dominant firms

LO3 11-13

Game Theory Overview

• Oligopolies display strategic pricing

behavior

• Mutual interdependence

• Collusion

• Incentive to cheat

• Prisoner’s dilemma

LO4 11-14

Game Theory Overview

LO4

RareAir’s Price Strategy

Up

tow

n’s

Pri

ce

Str

ate

gy

A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low •2 competitors

•2 price

strategies

•Each strategy

has a payoff

matrix

•Greatest

combined

profit

• Independent

actions

stimulate a

response

11-15

Game Theory Overview

LO4

RareAir’s Price Strategy

Up

tow

n’s

Pri

ce

Str

ate

gy

A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low • Independently

lowered prices in

expectation of

greater profit

leads to worst

combined

outcome

•Eventually low

outcomes make

firms return to

higher prices.

11-16

Three Oligopoly Models

• Kinked-demand curve

• Collusive pricing

• Price leadership

• Reasons for 3 models

• Diversity of oligopolies

• Complications of interdependence

LO5 11-17

Kinked-Demand Curve

LO5

P0

MR2

D2

D1

MR1

e

f

g

Rivals Ignore Price Increase

Rivals Match Price Decrease

Q0

MR2

D2

D1

MR1 Q0

MC1

MC2

P0

e

f

g

Pri

ce

Pri

ce

Quantity Quantity

0 0

11-18

Kinked-Demand Curve

• Criticisms

• Explains inflexibility, not price

• Prices are not that rigid

• Price wars

LO6 11-19

Cartels and Other Collusion

LO6

Pri

ce

an

d C

os

ts

Quantity

D

MR=MC

ATC

MC

MR

P0

A0

Q0

Economic

Profit

11-20

Overt Collusion

• Cartels - a group of firms or nations

that collude

• Formally agreeing to the price

• Sets output levels for members

• Collusion is illegal in the United

States

• OPEC

LO6 11-21

Obstacles to Collusion

• Demand and cost differences

• Number of firms

• Cheating

• Recession

• New entrants

• Legal obstacles

LO6 11-22

Price Leadership Model

• Price Leadership

• Dominant firm initiates price

changes

• Other firms follow the leader

• Use limit pricing to block entry of new

firms

• Possible price war

LO6 11-23

Oligopoly and Advertising

• Prevalent to compete with product

development and advertising

• Less easily duplicated than a price

change

• Financially able to advertise

LO7 11-24

Advertising

LO7

Positive Effects Negative Effects

Low-cost way of providing

information to consumers

Can be manipulative

Enhances competition

Contains misleading claims that

confuse consumers

Speeds up technological progress

Consumers pay high prices for a

good while forgoing a better, lower

priced, unadvertised version of the

product

Can help firms obtain economies

of scale

11-25

Oligopoly and Efficiency

• Oligopolies are inefficient

• Productively inefficient P > minATC

• Allocatively inefficient P > MC

• Qualifications

• Increased foreign competition

• Limit pricing

• Technological advance

LO7 11-26