Chapter 12 Slide 1

Monopolistic Competition Characteristics

1) Many firms

2) Free entry and exit

3) Differentiated product (but high degree of substitutability)

The amount of monopoly power depends on the degree of differentiation.

Examples of this common market structure include:Toothpaste; Soap; Cold remedies; Soft Drinks;

Coffee

A Monopolistically CompetitiveFirm in the Short and Long Run

Quantity

$/Q

Quantity

$/QMC

AC

MC

AC

DSR

MRSR

DLR

MRLR

QSR

PSR

QLR

PLR

Short Run Long Run

Chapter 12 Slide 3

Observations (short-run)Downward sloping demand - differentiated

product

Demand is relatively elastic - good substitutes

MR < P

Profits are maximized when MR = MC

This firm is making economic profits

Monopolistic Competition in the SR

Chapter 12 Slide 4

Observations (long-run)Profits will attract new firms to the industry

(no barriers to entry)

The old firm’s demand will decrease to DLR

Firm’s output and price will fallIndustry output will riseNo economic profit (P = AC)P > MC -- some monopoly power

Monopolistic Competition in the LR

Deadweight lossMC AC

Comparison of Monopolistically CompetitiveEquilibrium and Perfectly Competitive Equilibrium

$/Q

Quantity

$/Q

D = MR

QC

PC

MC AC

DLR

MRLR

QMC

P

Quantity

Perfect Competition Monopolistic Competition

Chapter 12 Slide 6

Monopolistic Competition

Reduction in Economic EfficiencyThe monopoly power (differentiation) yields

a higher price than perfect competition. If price was lowered to the point where MC = D, total surplus would increase by the yellow triangle.

Although there are no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.

Chapter 12 Slide 7

Oligopoly

Characteristics

Small number of firms

Product differentiation may or may not exist

Barriers to entry

Examples: Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers

Chapter 12 Slide 8

Oligopoly

Barriers to entry include:Scale economies; Patents; Technology; Name

recognition

Strategic action: Flooding the market; Controlling an essential input

Management ChallengesStrategic actions

Rival behavior

Chapter 12 Slide 9

Oligopoly

Equilibrium in an Oligopolistic MarketIn perfect competition, monopoly, and

monopolistic competition the producers did not have to consider a rival’s response when choosing output and price.

In oligopoly the producers must consider the response of competitors when choosing output and price.

Chapter 12 Slide 10

Oligopoly

Equilibrium in an Oligopolistic MarketDefining Equilibrium

Firms do the best they can and have no incentive to change their output or price

All firms assume competitors are taking rival decisions into account.

Nash EquilibriumEach firm is doing the best it can given what its

competitors are doing.

Chapter 12 Slide 11

Quantity Competition: Cournot

The Cournot ModelDuopoly

Two firms competing with each otherHomogeneous goodThe output of the other firm is assumed

to be fixed

Chapter 12 Slide 12

MC1

50

MR1(75)

D1(75)

12.5

If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is

shifted to the left by this amount.

Firm 1’s Output Decision

Q1

P1

D1(0)

MR1(0)

If Firm 1 thinks Firm 2 will produce nothing, its demand

curve, D1(0), is the market demand curve.

D1(50)MR1(50)

25

If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is

shifted to the left by this amount.

Chapter 12 Slide 13

Firm 2’s ReactionCurve Q2*(Q1)

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Reaction Curves and Cournot Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

Firm 1’s reaction curve shows how much itwill produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous example.

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximizes its own profits.

CournotEquilibrium

Chapter 12 Slide 14

Price Competition: Bertrand

Competition in an oligopolistic industry may occur with price instead of output.

The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods.

How will consumers respond to a price differential? (Hint: Consider homogeneity)

Chapter 12 Slide 15

Price Competition

Why not charge a higher price to raise profits?

How does the Bertrand outcome compare to the Cournot outcome?

The Bertrand model demonstrates the importance of the strategic variable (price versus output).

Bertrand ModelBertrand Model

Chapter 12 Slide 16

Price Competition

Price Competition with Differentiated ProductsMarket shares are now determined not just

by prices, but by differences in the design, performance, and durability of each firm’s product.

Chapter 12 Slide 17

Firm 1’s Reaction Curve

Nash Equilibrium in Prices

P1

P2

Firm 2’s Reaction Curve

$4

$4

Nash Equilibrium

Chapter 12 Slide 18

Competition Versus Collusion:Payoff Matrix for Pricing Game

Firm 2

Firm 1

Charge $4 Charge $6

Charge $4

Charge $6

$12, $12 $20, $4

$16, $16$4, $20

Chapter 12 Slide 19

These two firms are playing a noncooperative game.Each firm independently does the best it can

taking its competitor into account.

QuestionWhy will both firms both choose $4 when $6 will

yield higher profits?

An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.

Competition Versus Collusion:The Prisoners’ Dilemma

Chapter 12 Slide 20

ScenarioTwo prisoners have been accused of

collaborating in a crime.

They are in separate jail cells and cannot communicate.

Each has been asked to confess to the crime.

Competition Versus Collusion:The Prisoners’ Dilemma

Chapter 12 Slide 21

-5, -5 -1, -10

-2, -2-10, -1

Payoff Matrix for Prisoners’ Dilemma

Prisoner A

Confess Don’t confess

Confess

Don’tconfess

Prisoner B

Would you choose to confess?

Chapter 12 Slide 22

Payoff Matrix for the Prisoners’ Dilemma

Conclusions: Oligopolistic Markets

1) Collusion will lead to greater profits

2) Explicit and implicit collusion is possible

3) Once collusion exists, the profit motive to break and lower price is significant

Chapter 12 Slide 23

Charge $1.40 Charge $1.50

Charge$1.40

Unilever and Kao

Charge$1.50

P&G

$12, $12 $29, $11

$3, $21 $20, $20

Payoff Matrix for the P&G Pricing Problem

What price should P & G choose?

Chapter 12 Slide 24

Implications of the Prisoners’Dilemma for Oligopolistic Pricing

Price Signaling: Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit.

Price Leadership: Pattern of pricing in which one firm regularly announces price changes that other firms then match.

Price Signaling & Price LeadershipPrice Signaling & Price Leadership