PC. Comparing Monopolistic Competition with Monopoly ..

1
Monopolistic Competition, Oligopoly, and
Strategic Pricing

• Chapter 13

2
Introduction

• In discussing real-world competition, the focus
  quickly becomes market structure.
• Market structure is the physical characteristics
  of the market within which firms interact.

3
Introduction

• Market structure involves the number of firms in
  the market and the barriers to entry.

• Perfect competition, with an infinite number of
  firms, and monopoly, with a single firm, are
  polar opposites.

4
Introduction

• Monopolistic competition and oligopoly lie
  between these two extremes.

• Monopolistic competition is a market structure in
  which there are many firms selling differentiated
  products.
• Oligopoly is a market structure in which there
  are a few interdependent firms.

5
Introduction

• Most U.S. industry structures fall almost
  entirely between monopolistic competition and
  oligopoly.
• Perfectly competitive and monopolistic industries
  are nearly nonexistent.

6
Problems Determining Market Structure

• Defining a market has problems
• What is an industry and what is its geographic
  market -- local, national, or international?
• What products are to be included in the
  definition of an industry?

7
Classifying Industries

• One of the ways in which economists classify
  markets is by cross-price elasticities.
• Cross-price elasticity measures the
  responsiveness of the change in demand for a good
  to change in the price of a related good.

8
Classifying Industries

• Industries are classified by government using the
  North American Industry Classification System
  (NAICS).

• The North American Industry Classification System
  (NAICS) is a classification system of industries
  adopted by Canada, Mexico, and the U.S. in 1997.

9
Classifying Industries

• When economists talk about industry structure the
  general practice is to refer to three-digit
  industries.

• Under the NAICS, a two-digit industry is a
  broadly based industry.
• A three-digit industry is a specific type of
  industry within a broadly defined two-digit
  industry.

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Two- and Four- Digit Industry Groups
11
Determining Industry Structure

• Economists use one of two methods to measure
  industry structure
• The Concentration Ratio
• The Herfindahl Index

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Concentration Ratio

• The concentration ratio is the percentage of
  industry output that a specific number of the
  largest firms have.

13
Concentration Ratio

• The most commonly used concentration ratio is the
  four-firm concentration ratio.

• The higher the ratio, the closer to an
  oligopolistic or monopolistic type of market
  structure.

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The Herfindahl Index

• The Herfindahl index is an alternative method
  used by economists to classify the
  competitiveness of an industry.
• It is calculated by adding the squared value of
  the market shares of all firms in the industry.

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The Herfindahl Index

• Two advantages of the Herfindahl index is that it
  takes into account all firms in an industry as
  well as giving extra weight to a single firm that
  has an especially large market share.

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The Herfindahl Index

• The Herfindahl Index is important because it is
  used as a marker by the Justice Department for
  allowing or disallowing mergers to take place.

• If the index is less than 1,000, the industry is
  considered competitive thus allowing the merger
  to take place.

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Concentration Ratios and the Herfindahl Index
18
Conglomerate Firms and Bigness

• Neither the four-firm concentration ratio or the
  Herfindahl index gives a complete picture of
  corporations size.

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Conglomerate Firms and Bigness

• This is because many firms are conglomerateshuge
  corporations whose activities span various
  unrelated industries.

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The Importance of Classifying Industry Structure

• Classifying industry structure is important
  because structure affects firm behavior.
• The greater the number of sellers, the more the
  likelihood the industry is competitive.

21
The Importance of Classifying Industry Structure

• The number of firms in an industry plays a role
  in determining whether firms explicitly take
  other firms actions into account.
• Oligopolies take into account the reactions of
  other firms monopolistic competitors do not.

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The Importance of Classifying Industry Structure

• In monopolistic competition, the large number of
  firms makes it unlikely that an individual firm
  will explicitly take into account rival firms
  responses to their decisions.

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The Importance of Classifying Industry Structure

• In oligopoly, with fewer firms, each firm
  explicitly engages in strategic decision making.
• Strategic decision making taking explicit
  account of a rivals expected response to a
  decision you are making.

24
Monopolistic Competition

• The four distinguishing characteristics of
  monopolistic competition are
• Many sellers.
• Differentiated products.
• Multiple dimensions of competition.
• Easy entry of new firms in the long run.

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Many Sellers

• When there are many sellers as in monopolistic
  competition, they do not take into account
  rivals reactions.
• The existence of many sellers also makes
  collusion difficult.
• Monopolistically competitive firms act
  independently.

26
Differentiated Products

• The many sellers characteristic gives
  monopolistic competition its competitive aspect.
• Product differentiation gives monopolistic
  competition its monopolistic aspect.

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Differentiated Products

• Differentiation exists so long as advertising
  convinces buyers that it exists.

• Firms will continue to advertise as long as the
  marginal benefits of advertising exceed its
  marginal costs.

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Multiple Dimensions of Competition

• One dimension of competition is product
  differentiation.
• Another is competing on perceived quality.
• Competitive advertising is another.
• Others include service and distribution outlets.

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Easy Entry of New Firms in the Long Run

• There are no significant barriers to entry.
• Barriers to entry prevent competitive pressures.
• Ease of entry limits long-run profit.

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Output, Price, and Profit of a Monopolistic
Competitor

• A monopolistically competitive firm prices in the
  same manner as a monopolistwhere MC MR.
• But the monopolistic competitor is not only a
  monopolist but a competitor as well.

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Output, Price, and Profit of a Monopolistic
Competitor

• At equilibrium, ATC equals price and economic
  profits are zero.

• This occurs at the point of tangency of the ATC
  and demand curve at the output chosen by the firm.

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Monopolistic Competition
33
Comparing Monopolistic Competition with Perfect
Competition

• Both the monopolistic competitor and the perfect
  competitor make zero economic profit in the long
  run.

34
Comparing Monopolistic Competition with Perfect
Competition

• The perfect competitors demand curve is perfectly
  elastic.
• Easy entry, zero economic profits, and a uniform
  product means that the perfect competitor
  produces at the minimum of the ATC curve.

35
Comparing Monopolistic Competition with Perfect
Competition

• A monopolistic competitor faces a downward
  sloping demand curve, and produces where MC MR.

• The ATC curve is tangent to the demand curve at
  that level, which is not at the minimum point of
  the ATC curve.

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Comparing Monopolistic Competition with Perfect
Competition

• Increasing market share is a relevant concern for
  a monopolistic competitor but not for a perfect
  competitor.

37
Comparing Monopolistic Competition with Perfect
Competition

• In the real world of monopolistic competition,
  increasing output and market share lowers average
  total cost.

38
Comparing Perfect and Monopolistic Competition
Perfect competition
Monopolistic competition
39
Comparing Monopolistic Competition with Monopoly

• The difference between a monopolist and a
  monopolistic competitor is in the position of the
  average total cost curve in long-run equilibrium.

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Comparing Monopolistic Competition with Monopoly

• For a monopolist, the average total cost curve
  can be, but need not be, at a position below
  price so that the monopolist makes a long-run
  economic profit.

41
Comparing Monopolistic Competition with Monopoly

• For a monopolistic competitor, the average total
  cost curve is tangent to the demand curve at the
  price and output chose by the monopolistic
  competitor so that there are zero economic
  profits in the long run.

42
Advertising and Monopolistic Competition

• Firms in a perfectly competitive market have no
  incentive to advertise they can sell all they
  produce at the market price.
• Monopolistic competitors have a strong incentive
  to do so.

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Advertising and Monopolistic Competition

• The primary goals of the advertiser is to
• move the demand curve to the right and
• make it more inelastic.

44
Advertising and Monopolistic Competition

• Advertising shifts the demand curve shifts out
  and shifts the ATC curve up.

• That way the firm can sell more, charge more, or
  both.

45
Advertising the Creation of Name Brands

• There is a sense of trust in buying brands we
  know.
• Advertising creates Name Brand Recognition.
• Consumers are sometimes willing to pay more to
  reduce their uncertainty about the quality of the
  product.
• Companies that develop name brands can often
  charge more than for no name homogeneous
  products.

46
Oligopoly

• Oligopoly is a market structure where there are a
  small number of mutually interdependent firms.
• Each firm must take into account the expected
  reaction of other firms to its profit maximizing
  output decision.

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Models of Oligopoly Behavior

• No single general model of oligopoly behavior
  exists.
• Two models of oligopoly behavior are the cartel
  model and the contestable market model.

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Models of Oligopoly Behavior

• In the cartel model, the firms in the industry
  (oligopolies) collude to set a monopoly price.
• In the contestable market model, an oligopolistic
  firm with no barriers to entry sets a competitive
  price.

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The Cartel Model

• A cartel (sometimes called a trust) is a
  combination of firms that acts as it were a
  single firm.
• A cartel is a shared monopoly.

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The Cartel Model

• If oligopolies can limit the entry of other firms
  and form a cartel, they can increase the profits
  going to the combination of firms in the cartel.

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The Cartel Model

• The model assumes that oligopolies act as if they
  were monopolists that have assigned output quotas
  to individual member firms so that total output
  is consistent with joint profit maximization.

52
Implicit Price Collusion

• Formal collusion is illegal in the U.S. while
  informal collusion is permitted.
• Implicit price collusion exists when multiple
  firms make the same pricing decisions even though
  they have not consulted with one another.

53
Implicit Price Collusion

• Sometimes the largest or most dominant firm takes
  the lead in setting prices and the others follow.

54
Cartels and Technological Change

• Cartels can be destroyed by an outsider with
  technological superiority.
• Thus, cartels with high profits will provide
  incentives for significant technological change.

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Why Are Prices Sticky?

• Informal collusion is an important reason why
  prices are sticky.
• Another is the kinked demand curve.

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Why Are Prices Sticky?

• When there is a kink in the demand curve, there
  has to be a gap in the marginal revenue curve.

• The kinked demand curve is not a theory of
  oligopoly but a theory of sticky prices.

57
The Kinked Demand Curve
MC1
58
The Contestable Market Model

• According to the contestable market model,
  barriers to entry and barriers to exit determine
  a firms price and output decisions.
• Even if the industry contains only one firm, it
  could still be a competitive market if entry is
  open.

59
The Contestable Market Model

• The stronger the ability of the oligopolists to
  collude and prevent market entry, the closer it
  is to a monopolistic situation.

• The weaker the ability to collude is, the more
  competitive it is.

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Strategic Pricing and Oligopoly

• Both the cartel and contestable market models use
  strategic pricing decisionsthey set their prices
  based on the expected reactions of other firms.

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Strategic Pricing and Oligopoly

• Cartelization strategy is limited by entry of new
  firms because the newcomer may not want to
  cooperate with the other firms.

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Price Wars

• Price wars are the result of strategic pricing
  decisions gone wild.
• Sometimes a firm engages in this activity because
  it hates its competitor.

63
Price Wars

• A firm may develop a predatory pricing strategy
  as a matter of policy

• A predatory pricing strategy involves temporarily
  pushing the price down in order to drive a
  competitor out of business.

64
Game Theory and Strategic Decision Making

• Most oligopolistic strategic decision making is
  carried out with explicit or implicit use of game
  theory.
• Game theory is the application of economic
  principles to interdependent situations.

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The Prisoners Dilemma and a Duopoly Example

• The prisoner's dilemma can be used to illustrate
  the behavior of a duopoly.
• The prisoners dilemma is one well-known game
  that demonstrates the difficulty of cooperative
  behavior in certain circumstances.

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The Prisoners Dilemma and a Duopoly Example

• The prisoners dilemma has its simplest
  application when the oligopoly consists of only
  two firmsa duopoly.

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The Prisoners Dilemma and a Duopoly Example

• By analyzing the strategies of both firms under
  all situations, all possibilities are placed in a
  payoff matrix.

• A payoff matrix is a box that contains the
  outcomes of a strategic game under various
  circumstances.

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Firm and Industry Duopoly Cooperative Equilibrium
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Firm and Industry Duopoly Equilibrium When One
Firm Cheats
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Duopoly and a Payoff Matrix

• The duopoly is a variation of the prisoner's
  dilemma game.
• The results can be presented in a payoff matrix
  that captures the essence of the prisoner's
  dilemma.

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The Payoff Matrix of Strategic Pricing Duopoly
A Does not cheat
A Cheats
A 200,000
B Does not cheat
B 75,000
B 75,000
A 0
B Cheats
B 200,000
B 0
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Oligopoly Models, Structure, and Performance

• Oligopoly models are based either on structure or
  performance.
• The four-fold division of markets considered so
  far are based on market structure.
• Structure means the number, size, and
  interrelationship of firms in the industry.

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Oligopoly Models, Structure, and Performance

• A monopoly is the least competitive, perfectly
  competitive industries are the most competitive.

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Oligopoly Models, Structure, and Performance

• The contestable market model gives less weight to
  market structure.

• Markets in this model are judged by performance,
  not structure.
• Close relatives of it have previously been called
  the barriers-to-entry model, the stay-out pricing
  model, and the limited-pricing model.

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Oligopoly Models, Structure, and Performance

• There is a similarity in the two approaches.

• Often barriers to entry are the reason there are
  only a few firms in an industry.
• When there are many firms, that suggests that
  there are few barriers to entry.
• In such situations, which make up the majority of
  cases, the two approaches come to the same
  conclusion.

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Monopolistic Competition, Oligopoly, and
Strategic Pricing

• End of Chapter 13