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Chapter 10:
Monopolistic Competition
And Oligopoly
Econ 101: Microeconomics
Hall & Leiberman; Economics: Principles And Applications, 2004
2
Monopolistic Competition And Oligopoly
On any given day, you are probably exposed to hundreds of advertisements• Advertising is everywhere in the economy
So far in this book not much has been said about advertising• There is a good reason for this
• In perfect competition and monopoly firms do little, if any, advertising
Where, then, is all the advertising coming from?• We must consider firms that are neither perfect
competitors nor monopolists
Hall & Leiberman; Economics: Principles And Applications, 2004
3
The Concept of Imperfect Competition
Refers to market structures between perfect competition and monopoly• In imperfectly competitive markets, there is more than
one seller, but too few to create a perfectly competitive market
• Imperfectly competitive markets often violate other conditions of perfect competition• Such as the requirement of a standardized product or
free entry and exit Types of imperfectly competitive markets
• Monopolistic competition • Oligopoly
Hall & Leiberman; Economics: Principles And Applications, 2004
4
Monopolistic Competition
Hybrid of perfect competition and monopoly, sharing some of features of each• A monopolistically competitive market has
three fundamental characteristics• Many buyers and sellers
• Sellers offer a differentiated product
• Sellers can easily enter or exit the market
Hall & Leiberman; Economics: Principles And Applications, 2004
5
Many Buyers and Sellers Under monopolistic competition, an individual
buyer is unable to influence price he pays• But an individual seller, in spite of having many
competitors, decides what price to charge Our assumption of many sellers, however, has
another purpose• To ensure that no strategic games will be played
among firms in market• There are so many firms, each supplying such a small
part of the market• That no one of them needs to worry that its actions will be
noticed—and reacted to—by others
Hall & Leiberman; Economics: Principles And Applications, 2004
6
Sellers Offer a Differentiated Product
Each seller produces a somewhat different product from the others
Faces a downward-sloping demand curve • In this sense is more like a monopolist than a
perfect competitor
• When it raises its price a modest amount, quantity demanded will decline (but not all the way to zero)
Hall & Leiberman; Economics: Principles And Applications, 2004
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Sellers Offer a Differentiated Product
What makes a product differentiated?• Quality of product
• Difference in location Product differentiation is a subjective matter
• A product is different whenever people think that it is• Whether their perception is accurate or not
Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated• This perception may be real or illusory, but economic
implications are the same in either case• Firm chooses its price
Hall & Leiberman; Economics: Principles And Applications, 2004
8
Easy Entry and Exit
This feature is shared by monopolistic competition and perfect competition• Plays the same role in both
• Ensures firms earn zero economic profit in long-run
In monopolistic competition, however, assumption about easy entry goes further• No barrier stops any firm from copying the
successful business of other firms
Hall & Leiberman; Economics: Principles And Applications, 2004
9
Monopolistic Competition in the Short-Run
Individual monopolistic competitor behaves very much like a monopoly
Key difference is this• While a monopoly is the only seller in its
market, a monopolistic competitor is one of many sellers
• When a monopolistic competitor raises its price, its customers have one additional option• Can buy similar good from some other firm
Hall & Leiberman; Economics: Principles And Applications, 2004
10
Figure 1: A Monopolistically Competitive Firm in the Short Run
MR1
$70
30
250
d1
A MCATC
Dollars
Homes Serviced per Month
2. and charges $70 per home.
4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle.
1. Kafka services 250 homes per month, where MC and MR intersect . . .
3. ATC at 250 units is less than price, so profit per unit is positive.
Hall & Leiberman; Economics: Principles And Applications, 2004
11
Monopolistic Competition in the Long-Run
Under monopolistic competition—in which there are no barriers to entry and exit—the firm will not enjoy its profit for long• Entry will continue to occur, and demand curve will continue
to shift leftward Under monopolistic competition, firms can earn positive
or negative economic profit in short-run• But in long-run, free entry and exit will ensure that each firm
earns zero economic profit just as under perfect competition In real world, monopolistic competitors often earn
economic profit or loss in the short-run• But—given enough time—profits attract new entrants, and
losses result in an industry shakeout• Until firms are earning zero economic profit
Hall & Leiberman; Economics: Principles And Applications, 2004
12
Figure 2: A Monopolistically Competitive Firm in the Long Run
d2MR2
E
MC
$40
100 250
Dollars
Homes Serviced per Month
ATC
MR1
In the long run, profit attracts entry, which shifts the firm's demand curve leftward.
The typical firm produces where its new MR crosses MC.
d1
Entry continues until P = ATC at the best output level, and economic profit is zero.
Hall & Leiberman; Economics: Principles And Applications, 2004
13
Excess Capacity Under Monopolistic Competition
In long-run, a monopolistic competitor will operate with excess capacity• Will produce too little output to achieve minimum cost per
unit Excess capacity suggests that monopolistic
competition is costly to consumers May tempt you to leap to a conclusion
• Consumers are better off under perfect competition; however• In order to get beneficial results of perfect competition, all
firms must produce identical output
• Consumers usually benefit from product differentiation
Hall & Leiberman; Economics: Principles And Applications, 2004
14
Non-price Competition If monopolistic competitor wants to increase its output it can
cut its price• Move along its demand curve
Any action a firm takes to increase demand for its output—other than cutting its price—is called non-price competition• Examples include better service, product guarantees, free home
delivery, more attractive packaging Non-price competition is another reason why monopolistic
competitors earn zero economic profit in long-run All this non-price competition is costly
• Must pay for advertising, for product guarantees, for better staff training
• Costs must be included in each firm’s ATC curve, shifting it upward
None of this changes conclusion that monopolistic competitors will earn zero economic profit in long-run
Hall & Leiberman; Economics: Principles And Applications, 2004
15
Oligopoly
When just a few large firms dominate a market• So that actions of each one have an important impact
on the others
• Would be foolish for any one firm to ignore its competitors’ reactions
• In such a market, each firm recognizes its strategic interdependence with others
An oligopoly is a market dominated by a small number of strategically interdependent firms
Hall & Leiberman; Economics: Principles And Applications, 2004
16
Market Domination and Economies of Scale
Strategic interdependence requires that a few firms—whatever their number—dominate the market • Their share of market is large
When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market• A large firm—supplying a large share of the market—will
have lower cost per unit than a small firm• Since small firms can’t compete, only a few large firms survive
• Market becomes an oligopoly
• Tends to happen on its own unless there is government intervention
• Such a market is often called a natural oligopoly—analogous to natural monopoly
Hall & Leiberman; Economics: Principles And Applications, 2004
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Reputation as a Barrier A new entrant may suffer just from being new
• Established oligopolists are likely to have favorable reputations
In some cases, where potential profits are great, investors may decide it is worth the risk and accept initial losses in order to enter industry
In other industries, the initial losses may be too great and probability of success too low for investors to risk their money starting a new firm
Hall & Leiberman; Economics: Principles And Applications, 2004
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Strategic Barriers
Oligopoly firms often pursue strategies designed to keep out potential competitors• Maintain excess production capacity as a signal to a
potential entrant that they could easily saturate market and leave new entrant with little or no revenue
• Make special deals with distributors to receive best shelf space in retail stores
• Make long-term arrangements with customers to ensure that their products are not displaced quickly by those of a new entrant
• Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product
Hall & Leiberman; Economics: Principles And Applications, 2004
19
Legal Barriers
Patents and copyrights—which can be responsible for monopoly—can also create oligopolies
Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination
Government barriers can operate against domestic entrants, too
Hall & Leiberman; Economics: Principles And Applications, 2004
20
The Game Theory Approach Oligopoly presents the greatest challenge to economists Economist have had to modify tools used to analyze other market
structures and to develop entirely new tools as well to analyze oligopoly behavior
Game theory• An approach to modeling strategic interaction of oligopolists in terms of
moves and countermoves In all games—except those of pure chance, such as roulette—a
player’s strategy must take account of the strategies followed by other players
Game theory analyzes oligopoly decisions as if they were games by • Looking at the rules players must follow
• Payoffs they are trying to achieve
• Strategies they can use to achieve them
Hall & Leiberman; Economics: Principles And Applications, 2004
21
The Prisoner’s Dilemma Easiest way to understand how game theory works is to
start with a simple, non-economic example—the prisoner’s dilemma• Explains why a technique for obtaining confessions,
commonly used by police, is so often successful Each of four boxes in payoff matrix represents one of four
possible strategy combinations that might be selected in this game• Upper left box: Both Rose and Colin confess
• Lower left box: Colin confesses and Rose doesn’t
• Upper right box: Rose confesses and Colin doesn’t
• Lower right box: Neither Rose nor Colin confesses
Hall & Leiberman; Economics: Principles And Applications, 2004
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Figure 3: The Prisoner’s Dilemma
Confess
Confess
Don’t Confess
Rose’s Actions
Colin gets 20 years
Rosegets 20years
Colin gets30 years
Colin gets 3 years
Colin gets5 years
Rosegets 20years
Rosegets 20years
Rosegets 20years
Colin’s Actions
Don’t Confess
Hall & Leiberman; Economics: Principles And Applications, 2004
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The Prisoner’s Dilemma Regardless of Rose’s strategy Colin’s best choice is to
confess
• In this game, the strategy “confess” is an example of a dominant strategy
• Strategy that is best for a player regardless of strategy of other player
Outcome of this game is an example of a Nash equilibrium—appropriately named after the mathematician John Nash, who originated the concept
• Exists when each player is taking the best action—given actions taken by other players
As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them
Hall & Leiberman; Economics: Principles And Applications, 2004
24
Simple Oligopoly Games Same method used to understand behavior of Rose and Colin
in prisoner’s dilemma can be applied to a simple oligopoly market
Duopoly• Oligopoly market with only two sellers
Assume that Gus and Filip must make their decisions independently• Without knowing in advance what the other will do
No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy
Notice that outcome is a Nash equilibrium• Equilibrium price in market is the low price
Hall & Leiberman; Economics: Principles And Applications, 2004
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Figure 4: A Duopoly Game
Low Price
Low Price
High Price
Filip’s Actions
Gus’s profit = $25,000
Filip’sProfit =$25,000
Gus’s profit= –$10,000
Gus’s profit= $75,000
Gus’s profit= $50,000
Filip’sProfit =$–10,000
Filip’sProfit =$75,000
Filip’sProfit =$50,000
Gus’s Actions
High Price
Hall & Leiberman; Economics: Principles And Applications, 2004
26
Oligopoly Games in the Real World
Will typically be more than two strategies from which to choose
Will usually be more than two players In some games, one or more players may not
have a dominant strategy• A game with two players will have a Nash equilibrium
as long as at least one player has a dominant strategy• Whether the other has a dominant strategy or not
• When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game
Hall & Leiberman; Economics: Principles And Applications, 2004
27
Oligopoly Games in the Real World
We’ve limited the players to one play of the game• In reality, for gas stations and almost all other
oligopolies, there is repeated play• Where both players select a strategy
• Observe the outcome of the trial
• Play the game again and again, as long as they remain rivals
One possible result of repeated trials is cooperative behavior
Hall & Leiberman; Economics: Principles And Applications, 2004
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Cooperative Behavior in Oligopoly
In real world, oligopolists will usually get more than one chance to choose their prices
The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once• Often, firms will evolve some form of
cooperation in the long run
Hall & Leiberman; Economics: Principles And Applications, 2004
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Explicit Collusion Simplest form of cooperation is explicit collusion
• Managers meet face-to-face to decide how to set prices Most extreme form of explicit collusion is creation of a
cartel• Group of firms that tries to maximize total profits of the
group as a whole If explicit collusion to raise prices is such a good thing for
oligopolists, why don’t they all do it?• Usually illegal
• Penalties, if the oligopolists are caught, can be severe But oligopolists can collude in other, implicit ways
Hall & Leiberman; Economics: Principles And Applications, 2004
30
Tacit Collusion
Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion
Tit for tat• A game-theoretic strategy of doing to another player
this period what he has done to you in previous period
However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion• Oligopolist will sometimes go further
• Attempting to punish a firm that threatens to destroy tacit cooperation
Hall & Leiberman; Economics: Principles And Applications, 2004
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Tacit Collusion Another form of tacit collusion is price leadership
• One firm—the price leader—sets its price and other sellers copy that price
With price leadership, there is no formal agreement• Rather the decisions come about because firms realize
—without formal discussion—that system benefits all of them
• Decisions include• Choice of leader
• Criteria it uses to set its price
• Willingness of other firms to follow
Hall & Leiberman; Economics: Principles And Applications, 2004
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The Limits to Collusion
Oligopoly power—even with collusion—has its limits• Even colluding firms are constrained by
market demand curve
• Collusion—even when it is tacit—may be illegal
• Collusion is limited by powerful incentives to cheat on any agreement
Hall & Leiberman; Economics: Principles And Applications, 2004
33
The Incentive to Cheat Go back to Gus and Filip for a moment
• One way or another they arrive at high-price cooperative solution
• Will the market stay there? Maybe, and maybe not
• Problem—each player may conclude that he can do even better by cheating
• Two players would be back to noncooperative outcome based on their dominant strategies
• May be in each player’s interest to cheat occasionally Analyzing this sort of behavior requires some rather
sophisticated game theory models
• Economists are actively engaged in building them
Hall & Leiberman; Economics: Principles And Applications, 2004
34
When is Cheating Likely?
While no firm wants to completely destroy a collusive agreement by cheating• Since this would mean a return to the noncooperative
equilibrium wherein each firm earns lower profit
• Some firms may be willing to risk destroying agreement if benefits are great enough
• Suggests that cheating is most likely to occur—and collusion will be least successful—under the following conditions
• Difficulty observing other firms’ prices
• Unstable market demand
• Large number of sellers
Hall & Leiberman; Economics: Principles And Applications, 2004
35
The Future of Oligopoly
Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure• In 1932, two economists—Adolf Berle and Gardiner
Means—noted trend toward big business • Predicted the 200 largest U.S. firms would control
nation’s entire economy by 1970• Unless something were done to stop it
Prediction has not come true• Today, there are hundreds and thousands of ongoing
businesses in United States
Hall & Leiberman; Economics: Principles And Applications, 2004
36
Antitrust Legislation and Enforcement Antitrust enforcement has focused on three types of actions
• Preventing collusive agreements among firms
• Such as price-fixing agreements
• Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers
• Preventing mergers that would lead to harmful market domination
Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws
While thrust of these policies is to preserve competition
• Type of competition preserved—and zeal with which policies are applied—can shift
Hall & Leiberman; Economics: Principles And Applications, 2004
37
The Globalization of Markets By enlarging markets from national ones to global ones,
international trade can increase the number of firms in a market
• Decreasing market dominance by a few, and increasing competition Although oligopolists often try to prevent it, they face increasingly
stiff competition from foreign producers Entry of U.S. producers has helped to increase competition in
foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods
While consumers in each nation may have access to more firms, these may be larger and more powerful firms
• Creating greater likelihood of strategic interaction and danger of collusion
Hall & Leiberman; Economics: Principles And Applications, 2004
38
Technological Change Technological change works to increase competition by
creating new substitute goods Can reduce barriers to entry in much the same way that
globalization does• By increasing size of market
Technology—the internet—has enabled residents in many smaller towns to choose among a dozen or more online sellers of the same merchandize• Trend can also be seen as encouraging oligopoly• Result could be strategic interaction, or collusion, among
large national players Finally, some technologies actually increase MES of
typical firm• Thereby encouraging formation of oligopolies
Hall & Leiberman; Economics: Principles And Applications, 2004
39
Figure 5a: Advertising in Monopolistic Competition
1,000
C
A60
100
$120
2,0006,000
B
1.Before advertising, long-run economic profit is zero.
2. In the short run, the first firms to advertise earn economic profit.
dads
dno ads
ATCads
ATCno ads
dall advertise
Dollars
Bottles of Perfume per Month
3. But in the long run, imitation and entry bring economic profit back to zero.
4. Advertising can lead to a higher price in the long run, as in this panel . . .
Hall & Leiberman; Economics: Principles And Applications, 2004
40
Figure 5b: Advertising in Monopolistic Competition
Dollars
Bottles of Perfume per Month
1,000
A60
dall advertise
dno ads
B$120
6,000
C50
2,000
dads
ATCads
ATCno ads
5. or to a lower price in the long run, as in this panel.
Hall & Leiberman; Economics: Principles And Applications, 2004
41
Figure 6: An Advertising Game
Run Safety Ads
Run Safety Ads
Don't Run Ads
United's Actions
American's Actions
Don't Run Ads
American earns low
profit
American earns high
profit
United earns very low profit
United earns low profit
American earns very
low profit
American earns
medium profitUnited
earns medium profit
United earns high profit
Hall & Leiberman; Economics: Principles And Applications, 2004
42
Problem #8 In Promaine Flats, Nevada there are two restaurants: Sal Monella
and Road Kill Café. Current profit =$7000 each. If clean up will attract more
customers, but profit becomes $5000 each. However, if clean up and doesn’t clean up then $12000 and
$3000.a. What is the payoff matrix?b. What is each player’s dominant strategy?
c. What will be the outcome of the game?d. Suppose the two restaurants will face the decision repeatedly. How might the outcome differ?e. Suppose the clean restaurant earns $6000 when one clean up and one stays dirty. What is the outcome?