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© 2009 South-Western, a part of Cengage Learning, all rights reserved

C H A P T E R

Monopolistic Competition

EconomicsP R I N C I P L E S O F

N. Gregory Mankiw

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by Ron Cronovich

16

MONOPOLISTIC COMPETITION 1

Introduction: Between Monopoly and Competition

Two extremes

Perfect competition: many firms, identical

products

Monopoly: one firm

In between these extremes: imperfect competition

Oligopoly: only a few sellers offer similar or

identical products.

Monopolistic competition: many firms sell

similar but not identical products. (differentiated)

../../../../../Program Files/TurningPoint/2003/Questions.html


Characteristics & Examples of Monopolistic Competition

Characteristics:

Many sellers

Product differentiation

Free entry and exit

Examples:

apartments

books

bottled water

clothing

fast food

night clubs



Comparing Perfect & Monop. Competition

yesnone, price-takerfirm has market power?

downward-

slopinghorizontalD curve facing firm

differentiatedidenticalthe products firms sell

zerozerolong-run econ. profits

yesyesfree entry/exit

manymanynumber of sellers

Monopolistic

competition

Perfect

competition



Comparing Monopoly & Monop. Competition

yesyesfirm has market power?

downward-

sloping

downward-

sloping

(market demand)

D curve facing firm

manynoneclose substitutes

zeropositivelong-run econ. profits

yesnofree entry/exit

manyonenumber of sellers

Monopolistic

competitionMonopoly



profit

ATC

P

A Monopolistically Competitive Firm Earning Profits in the Short Run

The firm faces a

downward-sloping

D curve.

At each Q, MR < P.

To maximize profit,

firm produces Q

where MR = MC.

The firm uses the

D curve to set P. Quantity

Price

ATC

D

MR

MC

Q



losses

A Monopolistically Competitive Firm With Losses in the Short Run

For this firm,

P < ATC

at the output where

MR = MC.

The best this firm

can do is to

minimize its losses.

Quantity

Price

ATC

Q

P

ATC

MC

D

MR


Entry and Normal Profit


Monopolistic Competition and Monopoly

Short run: Under monopolistic competition,

firm behavior is very similar to monopoly.

Long run: In monopolistic competition,

entry and exit drive economic profit to zero.

If profits in the short run:

New firms enter market,

taking some demand away from existing firms,

prices and profits fall.

If losses in the short run:

Some firms exit the market,

remaining firms enjoy higher demand and prices.



A Monopolistic Competitor in the Long Run

Entry and exit

occurs until

P = ATC and

profit = zero.

Notice that the

firm charges a

markup of price

over marginal cost

and does not

produce at

minimum ATC. Quantity

Price

ATC

D

MR

Q

MC

MC

P = ATC

markup



Why Monopolistic Competition Is Less Efficient than Perfect Competition

1.

The monopolistic competitor operates on the

downward-sloping part of its ATC curve,

produces less than the cost-minimizing output.

Under perfect competition, firms produce the

quantity that minimizes ATC.

2.

Under monopolistic competition, P > MC.

Under perfect competition, P = MC.



Monopolistic Competition and Welfare

Monopolistically competitive markets do not

have all the desirable welfare properties of

perfectly competitive markets.

Because P > MC, the market quantity is below

the socially efficient quantity.

Yet, not easy for policymakers to fix this problem:

Firms earn zero profits, so cannot require them

to reduce prices.


1. So far, we have studied three market

structures: perfect competition, monopoly, and

monopolistic competition. In each of these,

would you expect to see firms spending money

to advertise their products? Why or why not?

2. Is advertising good or bad from society’s

viewpoint? Try to think of at least one “pro”

and “con.”

A C T I V E L E A R N I N G 1

Advertising

12


Advertising

In monopolistically competitive industries,

product differentiation and markup pricing

lead naturally to the use of advertising.

In general, the more differentiated the products,

the more advertising firms buy.



Advertising as a Signal of Quality

A firm’s willingness to spend huge amounts

on advertising may signal the quality of its product

to consumers, regardless of the content of ads.

Ads may convince buyers to try a product once,

but the product must be of high quality for people

to become repeat buyers.


Advertising as a Signal of Quality The most expensive ads are not worthwhile

unless they lead to repeat buyers.

When consumers see expensive ads,

they think the product must be good if the

company

is willing to spend so much on advertising.



Brand Names

In many markets, brand name products coexist

with generic ones.

Firms with brand names usually spend more on

advertising, charge higher prices for the products.

As with advertising, there is disagreement about

the economics of brand names…



The Defense of Brand Names

Defenders of brand names believe:

Brand names provide information about quality

to consumers.

Companies with brand names have incentive

to maintain quality, to protect the reputation of

their brand names.



CONCLUSION

Differentiated products are everywhere;

examples of monopolistic competition abound.


CHAPTER SUMMARY

A monopolistically competitive market has

many firms, differentiated products, and free entry.

Each firm in a monopolistically competitive market

has excess capacity – produces less than the

quantity that minimizes ATC. Each firm charges a

price above marginal cost.

19

© 2009 South-Western, a part of Cengage Learning, all rights reserved

C H A P T E R

Oligopoly

EconomicsP R I N C I P L E S O F

N. Gregory Mankiw

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by Ron Cronovich

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OLIGOPOLY 21

Measuring Market Concentration

Concentration ratio: the percentage of the

market’s total output supplied by its four largest

firms.

The higher the concentration ratio,

the less competition.

This chapter focuses on oligopoly,

a market structure with high concentration ratios.


Concentration Ratios in Selected U.S. Industries

Industry Concentration ratio

Video game consoles 100%

Tennis balls 100%

Credit cards 99%

Batteries 94%

Soft drinks 93%

Web search engines 92%

Breakfast cereal 92%

Cigarettes 89%

Greeting cards 88%

Beer 85%

Cell phone service 82%

Autos 79%


OLIGOPOLY 23

Oligopoly

Oligopoly: a market structure in which only a

few sellers offer similar or identical products.

Strategic behavior in oligopoly:

A firm’s decisions about P or Q can affect other

firms and cause them to react. The firm will

consider these reactions when making decisions.

Game theory: the study of how people behave

in strategic situations.

OLIGOPOLY 24

A Comparison of Market Outcomes

When firms in an oligopoly individually choose

production to maximize profit,

oligopoly Q is greater than monopoly Q

but smaller than competitive Q.

oligopoly P is greater than competitive P

but less than monopoly P.


OLIGOPOLY 25

Game Theory

Game theory helps us understand oligopoly and

other situations where “players” interact and

behave strategically.

Dominant strategy: a strategy that is best

for a player in a game regardless of the

strategies chosen by the other players

Prisoners’ dilemma: a “game” between

two captured criminals that illustrates

why cooperation is difficult even when it is

mutually beneficial


OLIGOPOLY 26

Prisoners’ Dilemma Example

The police have caught Bonnie and Clyde,

two suspected bank robbers, but only have

enough evidence to imprison each for 1 year.

The police question each in separate rooms,

offer each the following deal:

If you confess and implicate your partner,

you go free.

If you do not confess but your partner implicates

you, you get 20 years in prison.

If you both confess, each gets 8 years in prison.


OLIGOPOLY 27


Confess Remain silent

Confess

Remain

silent

Bonnie’s decision

Clyde’s

decision

Bonnie gets

8 years

Clyde

gets 8 years

Bonnie gets

20 years

Bonnie gets

1 year

Bonnie goes

free

Clyde

goes free

Clyde

gets 1 yearClyde

gets 20 years

Confessing is the dominant strategy for both players.

Nash equilibrium:

both confess


OLIGOPOLY 28


Outcome: Bonnie and Clyde both confess,

each gets 8 years in prison.

Both would have been better off if both remained

silent.

But even if Bonnie and Clyde had agreed before

being caught to remain silent, the logic of self-

interest takes over and leads them to confess.


OLIGOPOLY 29

Oligopolies as a Prisoners’ Dilemma

When oligopolies form a cartel in hopes

of reaching the monopoly outcome,

they become players in a prisoners’ dilemma.

Our earlier example:

T-Mobile and Verizon are duopolists in

Smalltown.

The cartel outcome maximizes profits:

Each firm agrees to serve Q = 30 customers.

Here is the “payoff matrix” for this example…


OLIGOPOLY 30

T-Mobile & Verizon in the Prisoners’ Dilemma

Q = 30 Q = 40

Q = 30

Q = 40

T-Mobile

Verizon

T-Mobile’s

profit = $900

Verizon’s

profit = $900

T-Mobile’s

profit = $1000

T-Mobile’s

profit = $800

T-Mobile’s

profit = $750

Verizon’s

profit = $750

Verizon’s

profit = $800Verizon’s profit

= $1000

Each firm’s dominant strategy: renege on agreement,

produce Q = 40.


The players: American Airlines and United Airlines

The choice: cut fares by 50% or leave fares alone

If both airlines cut fares,

each airline’s profit = $400 million

If neither airline cuts fares,

each airline’s profit = $600 million

If only one airline cuts its fares,

its profit = $800 million

the other airline’s profits = $200 million

Draw the payoff matrix, find the Nash equilibrium.


The “fare wars” game

31


Answers

32

Nash equilibrium:

both firms cut fares

Cut fares Don’t cut fares

Cut fares

Don’t cut

fares

American Airlines

United

Airlines$600 million

$600 million

$200 million

$800 million

$800 million

$200 million

$400 million

$400 million

../../../Program Files/TurningPoint/2003/Questions.html

OLIGOPOLY 33

Other Examples of the Prisoners’ Dilemma

Ad Wars

Two firms spend millions on TV ads to steal

business from each other. Each firm’s ad

cancels out the effects of the other,

and both firms’ profits fall by the cost of the ads.

Organization of Petroleum Exporting Countries

Member countries try to act like a cartel, agree to

limit oil production to boost prices & profits.

But agreements sometimes break down

when individual countries renege.


OLIGOPOLY 34

Other Examples of the Prisoners’ Dilemma

Arms race between military superpowers

Each country would be better off if both disarm,

but each has a dominant strategy of arming.

Common resources

All would be better off if everyone conserved

common resources, but each person’s dominant

strategy is overusing the resources.


OLIGOPOLY 35

Another Example: Negative Campaign Ads

Election with two candidates, “R” and “D.”

If R runs a negative ad attacking D,

3000 fewer people will vote for D:

1000 of these people vote for R, the rest abstain.

If D runs a negative ad attacking R,

R loses 3000 votes, D gains 1000, 2000 abstain.

R and D agree to refrain from running attack ads.

Will each one stick to the agreement?

OLIGOPOLY 36

Another Example: Negative Campaign Ads

Do not run attack

ads (cooperate)

R’s decision

D’s decision

no votes lost

or gained

no votes

lost or gained

R gains 1000

votes

R loses

2000 votes

R loses 3000

votes

D loses

3000 votes

D loses

2000 votesD gains

1000 votes

Each candidate’s

dominant strategy:

run attack ads.Run attack ads

(defect)

Do not run

attack ads

(cooperate)

Run

attack ads

(defect)


Cooperation and Cartels

If the firms in an oligopoly cooperate, they may earn

more profits than if they act independently.

Collusion, which leads to secret cooperative

agreements, is illegal in the U.S., although it is legal and

acceptable in many other countries.

Price-Leadership Cartels may form in which firms

simply do whatever a single leading firm in the industry

does. This avoids strategic behavior and requires no

illegal collusion.

Cartels

A cartel is an organization of independent firms whose purpose is to control and limit production and maintain or increase prices and profits.

Like collusion, cartels are illegal in the United States.

Conditions necessary for a cartel to be stable (maintainable): There are few firms in the industry.

There are significant barriers to entry.

An identical product is produced.

There are few opportunities to keep actions secret.

There are no legal barriers to sharing agreements.

OPEC as an Example of a Cartel

OPEC: Organization of Petroleum Exporting Countries.

Attempts to set prices high enough to earn member countries significant profits, but not so high as to encourage dramatic increases in oil exploration or the pursuit of alternative energy sources.

Controls prices by setting production quotas for member countries.

Such cartels are difficult to sustain because members have large incentives to cheat, exceeding their quotas.

The Diamond Cartel

In 1870 huge diamond mines in South Africa flooded the gem

market with diamonds.

Investors at the time wanted to control production and created

De Beers Consolidated Mines, Ltd., which quickly took control

of all aspects of the world diamond trade.

The Diamond Cartel, headed by DeBeers, has been

extremely successful. While other commodities’ prices, such

as gold and silver respond to economic conditions, diamonds’

prices have increased every year since the Depression.

This success has been achieved by DeBeers’ influence on the

supply of diamonds, but also via the cartel’s influence on

demand.

In the 1940s DeBeers’ instigated an advertising campaign

making the diamond a symbol of status and romance.

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