Chapter 11: Monopolistic Competition and Oligopoly Contrast Between Monopolistic Contrast Between Monopolistic

Competition and OligopolyCompetition and Oligopoly Monopolistic Competition in DetailMonopolistic Competition in Detail Oligopoly in DetailOligopoly in Detail Game TheoryGame Theory Market Structure MeasurementMarket Structure Measurement

More Market Structures Needed

Few firms have perfect monopoly or are in Few firms have perfect monopoly or are in a perfectly competitive industrya perfectly competitive industry

Need something closer to observed business Need something closer to observed business realityreality

What can explain this?What can explain this?

Monopolistic Competition

Market structure characterized by a large number Market structure characterized by a large number of sellers of differentiated productsof sellers of differentiated products

Lack of perfect substitutesLack of perfect substitutes Tide, Dockers, Campbell’s Soup?Tide, Dockers, Campbell’s Soup? May be perceived differences?May be perceived differences? Not price takers – some discretion in setting priceNot price takers – some discretion in setting price Competition from imitatorsCompetition from imitators Profits still driven to normal risk-adjusted rate of Profits still driven to normal risk-adjusted rate of

return in the long runreturn in the long run

Oligopoly

Market Structure characterized by few sellers and Market Structure characterized by few sellers and interdependent price/output decisionsinterdependent price/output decisions

Significant barriers to entrySignificant barriers to entry Product could be homogenous (similar) or Product could be homogenous (similar) or

differentiateddifferentiated Potential for economic profits in the long runPotential for economic profits in the long run Incentive for illegal price settingIncentive for illegal price setting Competition can be vigorous among the few firmsCompetition can be vigorous among the few firms

The Changing Nature of Markets

1980’s auto industry considered oligopoly1980’s auto industry considered oligopoly GM, Ford, ChryslerGM, Ford, Chrysler Today monopolistically competitive?Today monopolistically competitive? Adding Toyota, Honda, NissanAdding Toyota, Honda, Nissan

Review: Monopolistic Competition Large number of buyers and sellers: each firm Large number of buyers and sellers: each firm

produces a small portion of the industry output, produces a small portion of the industry output, each customer buys only a small part of the totaleach customer buys only a small part of the total

Product Differentiation: The output of each firm Product Differentiation: The output of each firm is (or is perceived to be) different from, although is (or is perceived to be) different from, although comparable with, the output of other firms in the comparable with, the output of other firms in the industryindustry

Free entry and exit: Firms are not restricted from Free entry and exit: Firms are not restricted from entering or leaving the industryentering or leaving the industry

Close to Reality?

Not as restrictive as perfect competitionNot as restrictive as perfect competition Fairly common in actual marketsFairly common in actual markets Discount and fashion retail, electronics, food Discount and fashion retail, electronics, food

manufacturing?manufacturing? Firms have some control over pricing policyFirms have some control over pricing policy Limited by competitors offering similar productsLimited by competitors offering similar products America’s Choice or Roundy’s Vs Del Monte?America’s Choice or Roundy’s Vs Del Monte?

Monopolistic Competition Continued A price change does not cause competitors A price change does not cause competitors

to change price (oligopoly)to change price (oligopoly) Unique productsUnique products Quality, packaging, advertising, brandingQuality, packaging, advertising, branding Downward sloping demand curve – price Downward sloping demand curve – price

flexibilityflexibility Degree of price flexibility depends on Degree of price flexibility depends on

differentiationdifferentiation

Product Differentiation and Elasticity of Demand

Consumers view product A Consumers view product A as only slightly differentiatedas only slightly differentiated

Close to being a price taker Close to being a price taker (near horizontal)(near horizontal)

Product B is highly Product B is highly differentiateddifferentiated

Consumers less willing to Consumers less willing to accept substitutes for B accept substitutes for B (change in price little change (change in price little change in demand, demand in demand, demand elasticity)elasticity)

Change price of A, large Change price of A, large change in demandchange in demand

Copyright © 2000 by Harcourt, Inc.

Figure 11.1

DADB

Price per unit ($)

Quantity per time period

Price and Output in Monopolistic Competition Elements of both perfect competition and Elements of both perfect competition and

monopolymonopoly Monopoly in the short-runMonopoly in the short-run New product introduction, creative marketing, New product introduction, creative marketing,

branding, etc.branding, etc. Over time monopoly profits attract competitorsOver time monopoly profits attract competitors In long run competitors emerge to offer similar In long run competitors emerge to offer similar

but imperfect substitutes and profits erodebut imperfect substitutes and profits erode Seems close to reality – kids toys for example?Seems close to reality – kids toys for example?

On the Graph

Demand and MR fall in LRDemand and MR fall in LR D1 to D2 and MR1 to MR2 with new D1 to D2 and MR1 to MR2 with new

competitorscompetitors Price falls from P1 to P2 in the long runPrice falls from P1 to P2 in the long run At P2=ATC=D2 so economic profits driven At P2=ATC=D2 so economic profits driven

to zeroto zero

Monopolistic Competition

D2

$ per unitof output

Q2Quantity per time period

D1

D3

MR2 1

Q1 Q3

P3ATC1

P2 = ATC2

P1 L

M

MC ATC

0

MR1

Like MonopolyClose to PC

Even in Long Run not same as PC If new entrants offered perfect substitutes as If new entrants offered perfect substitutes as

opposed to similar products, LR demand opposed to similar products, LR demand curve would be nearly horizontal like PCcurve would be nearly horizontal like PC

See: D3, P3 and Q3 on previous graphSee: D3, P3 and Q3 on previous graph (Q1,P1) is monopoly (Q1,P1) is monopoly (Q3,P3) is perfect competition (Q3,P3) is perfect competition (Q2,P2) is monopolistic competition (Q2,P2) is monopolistic competition

Is Monopolistic Competition Realistic? The case of XeroxThe case of Xerox Introduced Xerox 914 Copier in 1960Introduced Xerox 914 Copier in 1960 Improvement over coated paper copiersImprovement over coated paper copiers Monopoly in 1970Monopoly in 1970 1970 to 1980, domestic and foreign competition1970 to 1980, domestic and foreign competition IBM, Kodak, 3MIBM, Kodak, 3M 1970 to 1978 Xerox market share fell from 98% to 1970 to 1978 Xerox market share fell from 98% to

56%56% Stockholder return fell from 23.6% to 18.2%Stockholder return fell from 23.6% to 18.2% Now a competitive industryNow a competitive industry

Oligopoly

Monopolistic Competition assumed that Monopolistic Competition assumed that price decisions did not consider competitor price decisions did not consider competitor actionsactions

Appropriate for some industries but not Appropriate for some industries but not othersothers

When firm actions cause competitors to When firm actions cause competitors to react, we have oligopolyreact, we have oligopoly

Oligopoly: A Review

Few Sellers – a handful of firms dominate Few Sellers – a handful of firms dominate the industry outputthe industry output

Homogenous or unique product – can be Homogenous or unique product – can be eithereither

Blocked entry and exit – firms restricted Blocked entry and exit – firms restricted from entering or leaving industryfrom entering or leaving industry

Imperfect information – often cost, price, Imperfect information – often cost, price, quality information is not known by buyers quality information is not known by buyers

In the real world?

AluminumAluminum CigarettesCigarettes Electrical EquipmentElectrical Equipment Filmed EntertainmentFilmed Entertainment Ready to eat cerealReady to eat cereal AirlinesAirlines Small number of firms dominate eachSmall number of firms dominate each

Ready to eat cereal in detail

Kellogg, General Mills, General Foods, RJR Kellogg, General Mills, General Foods, RJR Nabisko, Quaker Oats make all of US productionNabisko, Quaker Oats make all of US production

Customer loyalty allows large profit margins Customer loyalty allows large profit margins Corn Flakes, Frosted Flakes, Cheerios, Raisin Corn Flakes, Frosted Flakes, Cheerios, Raisin

Bran, Wheaties dominate industryBran, Wheaties dominate industry New firms have trouble entering marketNew firms have trouble entering market Imperfect information in that people don’t seem to Imperfect information in that people don’t seem to

realize that generic brands are almost identicalrealize that generic brands are almost identical

Airlines

Relatively small number Relatively small number Huge capital costs cause entry and exit Huge capital costs cause entry and exit

barriersbarriers Rate wars – firms clearly react to Rate wars – firms clearly react to

competitorscompetitors

Price and Output in Oligopoly

In oligopoly, if one firm in an industry In oligopoly, if one firm in an industry changes its’ price the other firms reactchanges its’ price the other firms react

This means a shift in the demand curve (not This means a shift in the demand curve (not a change in output or own price)a change in output or own price)

Oligopoly

Initially, Firm 1 produces Initially, Firm 1 produces Q1 at a price P1 (D1 Q1 at a price P1 (D1 demand curve)demand curve)

Firm 1 cuts price to P2 Firm 1 cuts price to P2 and this increases demand and this increases demand for product to Q2for product to Q2

Other firms respond with Other firms respond with price shift so demand price shift so demand curve for Firm 1 shifts in curve for Firm 1 shifts in (less demand) and they (less demand) and they end up at P2 and Q3end up at P2 and Q3

Copyright © 2000 by Harcourt, Inc.

Figure 11.3

D2

D1

Q2Q3

Quantity per time period

P2

P1

(a) Demand curves that do not explicitly recognize reactions

Price per unit ($)

Q1

Oligopoly

If firms actually knew If firms actually knew how their competitors how their competitors would react we could would react we could draw demand curve D3draw demand curve D3

Firms would know that by Firms would know that by cutting price to P2 they cutting price to P2 they would end up at Q3 – real would end up at Q3 – real demand curve for the firm demand curve for the firm is D3is D3

Copyright © 2000 by Harcourt, Inc.

Figure 11.3b

D2

D1

Q2Q3Quantity per time period

P2

P1

(b) Demand curve that recognizes reactions

Price per unit ($)

Q1

D3

Cartel

Cartel: Firms operating with a formal agreement to Cartel: Firms operating with a formal agreement to fix prices and outputfix prices and output

Would benefit all firmsWould benefit all firms They are said to be in They are said to be in collusioncollusion if a covert, informal if a covert, informal

agreement among firms in an industry is made to fix agreement among firms in an industry is made to fix prices and outputprices and output

Both illegal in the United StatesBoth illegal in the United States Some multinational firms do operate like this in Some multinational firms do operate like this in

foreign marketsforeign markets OPEC in the oil marketOPEC in the oil market

Cartel

If a cartel has absolute control over all firms in an industry they can operate as a If a cartel has absolute control over all firms in an industry they can operate as a monopolymonopoly

Summing each firms MC curve gives the industry MCSumming each firms MC curve gives the industry MC Combining this with the industry MR shows the profit maximizing output and Combining this with the industry MR shows the profit maximizing output and

priceprice Like a monopolyLike a monopoly Profits divided among firms by production, market share, etcProfits divided among firms by production, market share, etc ..

Copyright © 2000 by Harcourt, Inc.

Figure 11.4

Firm A Firm B Industry

Price andcost ($)

Price andcost ($)

Price andcost ($)

MCAMCBATC A ATC B

0 0 0

P *

SMC

D

MR

XA XB X

Output Output Output

Cartels are hard to keep together

Long-run problemsLong-run problems New firms entering market New firms entering market Disagreements among membersDisagreements among members One firm often tries to subvert the cartel, One firm often tries to subvert the cartel,

which is extremely profitablewhich is extremely profitable

Game Theory

First applied during WWII to deal with hard First applied during WWII to deal with hard to predict moves of the enemyto predict moves of the enemy

General framework to help decision making General framework to help decision making when firm payoffs depend on actions taken when firm payoffs depend on actions taken by other firmsby other firms

Used extensively in economic researchUsed extensively in economic research

Game Theory Basics

Because competitive firm decisions are important in Because competitive firm decisions are important in oligopoly markets, game theory has many oligopoly markets, game theory has many applicationsapplications

Simultaneous move game – choices are made without Simultaneous move game – choices are made without specific knowledge of competitor counter movesspecific knowledge of competitor counter moves

2 firms set prices without knowledge of each others 2 firms set prices without knowledge of each others decisiondecision

Sequential move game – choices are made after Sequential move game – choices are made after observing competitor movesobserving competitor moves

One firm sets a price after observing their rivalOne firm sets a price after observing their rival

The Prisoner’s Dilemma

Classic conflict of interest situationClassic conflict of interest situation Use to understand game theory before Use to understand game theory before

applying to firms and economicsapplying to firms and economics

The Prisoner’s Dilemma

Bonnie and Clyde are jointly accused of Bonnie and Clyde are jointly accused of committing a bank robberycommitting a bank robbery

Conviction of either cannot be secured Conviction of either cannot be secured without a confession by the one or both without a confession by the one or both suspectssuspects

Held in isolationHeld in isolation The choices for Bonnie and ClydeThe choices for Bonnie and Clyde

Prisoner’s Dilemma Payoff Matrix

Suspect #1: Bonnie (Top)

Not Confess

Confess

Suspect #2: Clyde (bottom)

Not Confess Confess

FREEDOMFREEDOM

LIFE2 YEARS

2 YEARSLIFE

5 YEARS5 YEARS

The Scenarios Each suspect can control the range of sentencing outcomes, but Each suspect can control the range of sentencing outcomes, but

not the ultimate outcome (no dominant strategy)not the ultimate outcome (no dominant strategy) Dominant Strategy: Decision that gives the best result for either Dominant Strategy: Decision that gives the best result for either

party regardless of the action taken by the otherparty regardless of the action taken by the other Both would be better off if they knew the other wouldn’t confessBoth would be better off if they knew the other wouldn’t confess Failing to confess makes them open to the harsh sentenceFailing to confess makes them open to the harsh sentence To confess or not to confess?To confess or not to confess? Secure Strategy: Decision that guarantees the best possible Secure Strategy: Decision that guarantees the best possible

outcome given the worst possible scenariooutcome given the worst possible scenario Secure strategy is to confess – avoid Life – avoids worse possible Secure strategy is to confess – avoid Life – avoids worse possible

scenario which is that the other confesses and you don’tscenario which is that the other confesses and you don’t

A more practical game: Coke Vs Pepsi

Coke and Pepsi face scenarios like this Coke and Pepsi face scenarios like this every dayevery day

Should Coke or Pepsi offer a special Should Coke or Pepsi offer a special discount to a large grocery retailer?discount to a large grocery retailer?

Hypothetical Prisoner’s Dilemma faced by Coke and Pepsi

Coke

Pepsi (right)

Discount Price

Regular Price

Discount Price Regular Price

$4,000, $2,000 $10,000, $1,000

$1,500, $6,500 $12,500, $9,000

(left)

Weekly Profits from Grocery Store

The Choices If neither offers discount, $12,500 for Coke and $9,000 for If neither offers discount, $12,500 for Coke and $9,000 for

Pepsi – best scenarioPepsi – best scenario Only Coke offers discount - $10,000 for Coke and $1,000 Only Coke offers discount - $10,000 for Coke and $1,000

for Pepsifor Pepsi Only Pepsi offers discount -- $6,500 Pepsi and $1,500 for Only Pepsi offers discount -- $6,500 Pepsi and $1,500 for

CokeCoke Only way Coke can avoid the $1,500 is to grant the discountOnly way Coke can avoid the $1,500 is to grant the discount Only way Pepsi can avoid the $1,000 is to grant the discountOnly way Pepsi can avoid the $1,000 is to grant the discount Only secure strategy is for both to offer the discount and Only secure strategy is for both to offer the discount and

getting $4,000 and $2,000getting $4,000 and $2,000

Nash Equilibrium

The previous example where both firms offer the The previous example where both firms offer the discount regardless of the other firms actions is discount regardless of the other firms actions is called Nash Equilibriumcalled Nash Equilibrium

Secure strategy is chosenSecure strategy is chosen Nash Equilibrium: Set of decision strategies in Nash Equilibrium: Set of decision strategies in

which no player can improve through a unilateral which no player can improve through a unilateral change in strategychange in strategy

Given that Coke (Pepsi) offers discount, other Given that Coke (Pepsi) offers discount, other firm’s best option is secure strategy (discount)firm’s best option is secure strategy (discount)

Colluding is the best option if legalColluding is the best option if legal

Market Structure Measurement

Economic Census: Comprehensive statistical Economic Census: Comprehensive statistical profile of the economy, from the national, to the profile of the economy, from the national, to the state, to the local levelstate, to the local level

Every 5 years – 2002 lastEvery 5 years – 2002 last Primary source of detailed facts about the nations Primary source of detailed facts about the nations

economyeconomy Market Share, Market Size, Plans for expansion, Market Share, Market Size, Plans for expansion,

etc.etc.

How the census data are collected and published For the 1997 census forms were mailed to For the 1997 census forms were mailed to

over 5 million companiesover 5 million companies Compliance is required by lawCompliance is required by law Data is classified by NAICSData is classified by NAICS North American Industry Classification North American Industry Classification

System: Method for categorizing System: Method for categorizing establishments by the principal economic establishments by the principal economic activity in which they are engagedactivity in which they are engaged

NAICS

Replacement for Standard Industrial Classification Replacement for Standard Industrial Classification (SIC)(SIC)

6 digits of detail6 digits of detail Example: Broad to narrow definitionExample: Broad to narrow definition

NAICS Level NAICS Code Description

SectorSubsectorIndustry GroupIndustryUS Industry

51513513351332513321

InformationBroadcast and TelecomTelecomWireless telecom no satellitePaging

Problem Set #6 (due next Monday)

P 11.5, P 11.6P 11.5, P 11.6

Group Assignment (due next Monday)

Research and Answer the Research and Answer the following questions for your following questions for your industry (internet searches will industry (internet searches will provide info you need). Be provide info you need). Be prepared to discuss in class prepared to discuss in class next week.next week.

Explain the structure of the Explain the structure of the industry.industry.

What part of the industry was What part of the industry was deregulated (or is being deregulated (or is being considered for deregulation)?considered for deregulation)?

What is/was the motivation to What is/was the motivation to deregulate?deregulate?

Current status of deregulation?Current status of deregulation? Impact on the industry? Impact on the industry?

Successful?Successful?

John Deere – Electric John Deere – Electric UtilitiesUtilities

GE Service – GE Service – TelecommunicationsTelecommunications

AMX1 (Jennifer, Jeremy, AMX1 (Jennifer, Jeremy, etc.) – Railroadsetc.) – Railroads

AMX2 – AirlinesAMX2 – Airlines Harley – TruckingHarley – Trucking Levitra - BankingLevitra - Banking