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Hall & Leiberman; Economics: Principles And Applications, 2004
1
Monopolistic Competition And Oligopoly
• On any given day, you are probably exposed to hundreds of advertisements
• In perfect competition and monopoly firms do little, if any, advertising
• Where, then, is all the advertising coming from?
Hall & Leiberman; Economics: Principles And Applications, 2004
2
The Concept of Imperfect Competition
• Refers to market structures between perfect competition and monopoly
• Types of imperfectly competitive markets– Monopolistic competition – Oligopoly
Hall & Leiberman; Economics: Principles And Applications, 2004
3
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
4
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
Hall & Leiberman; Economics: Principles And Applications, 2004
5
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
6
Sellers Offer a Differentiated Product
• What makes a product differentiated?
• Product differentiation is a subjective matter
• Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated
Hall & Leiberman; Economics: Principles And Applications, 2004
7
Easy Entry and Exit
• Same as in perfect competition– 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
8
Monopolistic Competition in the Short-Run
• Individual monopolistic competitor behaves very much like a monopoly
• Key difference is this– When a monopolistic competitor raises its
price, its customers have one additional option – to buy from another seller
Hall & Leiberman; Economics: Principles And Applications, 2004
9
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
10
The Long-Run• No barriers to entry and exit—the firm will
not enjoy its profit for long
• 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
Hall & Leiberman; Economics: Principles And Applications, 2004
11
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
12
Excess Capacity Under Monopolistic Competition
• In long-run, a monopolistic competitor will operate with excess capacity
• Excess capacity suggests that monopolistic competition is costly to consumers
• Does that mean consumers prefer perfect competition to monopolistic competition?
Hall & Leiberman; Economics: Principles And Applications, 2004
13
Nonprice Competition• Any action a firm takes to increase
demand for its output—other than cutting its price—is called nonprice competition
• Nonprice competition is another reason why monopolistic competitors earn zero economic profit in long-run
• All this nonprice competition is costly
Hall & Leiberman; Economics: Principles And Applications, 2004
14
Oligopoly
• An oligopoly is a market dominated by a small number of strategically interdependent firms
• In such a market, each firm recognizes its strategic interdependence with others
Hall & Leiberman; Economics: Principles And Applications, 2004
15
Number of Firms
• Oligopoly requires that a few firms dominate the market
• No absolute number at which oligopoly ends and monopolistic competition begins
Hall & Leiberman; Economics: Principles And Applications, 2004
16
Market Domination
• Strategic interdependence requires that a few firms dominate the market
• As combined market share shrinks, strategic interdependence becomes weaker
• Oligopoly is a matter of degree– Not an absolute classification
Hall & Leiberman; Economics: Principles And Applications, 2004
17
Economies of Scale: Natural Oligopolies
• When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market – A large firm will have lower cost per unit than
a small firm
• Does it remind you of monopoly? How is this different?
Hall & Leiberman; Economics: Principles And Applications, 2004
18
Barriers to entry• Reputation - A new entrant may suffer just
from being new
• Strategic barriers - Oligopoly firms often pursue strategies designed to keep out potential competitors
• Legal barriers - Patents and copyrights, Govt. legislation
Hall & Leiberman; Economics: Principles And Applications, 2004
19
Oligopoly vs. Other Market Structures
• Oligopoly presents the greatest challenge to economists
• Essence of oligopoly is strategic interdependence
• Need new tools of modeling
• One approach—game theory—has yielded rich insights into oligopoly behavior
Hall & Leiberman; Economics: Principles And Applications, 2004
20
The Game Theory Approach• Game theory
• In all games, except those of pure chance, a player’s strategy must take account of the strategies followed by other players
• Game theory analyzes oligopoly decisions as if they were games
Hall & Leiberman; Economics: Principles And Applications, 2004
21
The Prisoner’s Dilemma• 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
22
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 ActionsDon’t Confess
Hall & Leiberman; Economics: Principles And Applications, 2004
23
The Prisoner’s Dilemma• Regardless of Rose’s strategy Colin’s best choice is to
confess
• “Confess” is the dominant strategy for both
• Outcome of this game is an example of a Nash equilibrium
• 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• To apply the same method to a simple oligopoly
market• Duopoly - Oligopoly market with only two sellers• Assume that Gus and Filip must make their
decisions independently• No matter what Filip does, Gus’s best move is to
charge a low price—his dominant strategy• The same holds for Filip• The outcome is a Nash equilibrium
Hall & Leiberman; Economics: Principles And Applications, 2004
25
Figure 4: A Duopoly Game
Confess
Confess
Don’t Confess
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 ActionsDon’t Confess
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
– 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
28
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
Hall & Leiberman; Economics: Principles And Applications, 2004
29
Explicit Collusion• Simplest form of cooperation is explicit collusion
• Most extreme form of explicit collusion is creation of a cartel
• If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it?
• 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
Hall & Leiberman; Economics: Principles And Applications, 2004
31
Tacit Collusion
• Another form of tacit collusion is price leadership
• With price leadership, there is no formal agreement
Hall & Leiberman; Economics: Principles And Applications, 2004
32
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?• Each player has an incentive to cheat
• Analyzing this sort of behavior requires some rather sophisticated game theory models
Hall & Leiberman; Economics: Principles And Applications, 2004
34
When is Cheating Likely?• 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
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
36
Figure 5b: Advertising in Monopolistic Competition
Dollars
Bottles of Perfume per Month1,000
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
37
Using the Theory: Advertising in Monopolistic Competition and Oligopoly• Perfect competitors never advertise and
monopolies advertise relatively little– But advertising is almost always found under
monopolistic competition and very often in oligopoly• Why?
– All monopolistic competitors, and many oligopolists, produce differentiated products
• Since other firms will take advantage of opportunity to advertise, any firm that doesn’t advertise will be lost in shuffle
Hall & Leiberman; Economics: Principles And Applications, 2004
38
Advertising and Collusion in Oligopoly
• Oligopolists have a strong incentive to engage in tacit collusion
• Take airline industry as an example• In theory, any airline should be able to
claim superior safety– Yet no airline has ever run an advertisement
with information about its security policies or attacked those of a competitor
Hall & Leiberman; Economics: Principles And Applications, 2004
39
Figure 6: An Advertising Game
Run Safety Ads
Run Safety Ads
Don't Run Ads
United's Actions
American's ActionsDon'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
40
The Four Market Structures: A Postscript
• Different market structures– Perfect competition– Monopoly– Monopolistic competition– Oligopoly
• Market structure models help us organize and understand apparent chaos of real-world markets