Monopolistic Competition and Oligopoly

1
Chapter 12

• Monopolistic Competition and Oligopoly

2
Topics to be Discussed

• Monopolistic Competition
• Oligopoly
• Price Competition
• Competition Versus Collusion The Prisoners
  Dilemma

3
Topics to be Discussed

• Implications of the Prisoners Dilemma for
  Oligopolistic Pricing
• Cartels

4
Monopolistic Competition

• Characteristics
• 1) Many firms
• 2) Free entry and exit
• 3) Differentiated product

5
Monopolistic Competition

• The amount of monopoly power depends on the
  degree of differentiation.
• Examples of this very common market structure
  include
• Toothpaste
• Soap
• Cold remedies

6
Monopolistic Competition

• Toothpaste
• Crest and monopoly power
• Procter Gamble is the sole producer of Crest
• Consumers can have a preference for
  Crest---taste, reputation, decay preventing
  efficacy
• The greater the preference (differentiation) the
  higher the price.

7
Monopolistic Competition

• Question
• Does Procter Gamble have much monopoly power in
  the market for Crest?

8
Monopolistic Competition

• The Makings of Monopolistic Competition
• Two important characteristics
• Differentiated but highly substitutable products
• Free entry and exit

9
A Monopolistically CompetitiveFirm in the Short
and Long Run
/Q
/Q
Short Run
Long Run
Quantity
Quantity
10
A Monopolistically CompetitiveFirm in the Short
and Long Run

• Observations (short-run)
• Downward sloping demand--differentiated product
• Demand is relatively elastic--good substitutes
• MR lt P
• Profits are maximized when MR MC
• This firm is making economic profits

11
A Monopolistically CompetitiveFirm in the Short
and Long Run

• Observations (long-run)
• Profits will attract new firms to the industry
  (no barriers to entry)
• The old firms demand will decrease to DLR
• Firms output and price will fall
• Industry output will rise
• No economic profit (P AC)
• P gt MC -- some monopoly power

12
Comparison of Monopolistically CompetitiveEquilib
rium and Perfectly Competitive Equilibrium
Monopolistic Competition
Perfect Competition
/Q
/Q
Quantity
Quantity
13
Monopolistic Competition

• Monopolistic Competition and Economic Efficiency
• The monopoly power (differentiation) yields a
  higher price than perfect competition. If price
  was lowered to the point where MC D,
  consumer surplus would increase by the yellow
  triangle.

14
Monopolistic Competition

• Monopolistic Competition and Economic Efficiency
• With no economic profits in the long run, the
  firm is still not producing at minimum AC and
  excess capacity exists.

15
Monopolistic Competition

• Questions
• 1) If the market became competitive, what would
  happen to output and price?
• 2) Should monopolistic competition be regulated?

16
Monopolistic Competition

• Questions
• 3) What is the degree of monopoly power?
• 4) What is the benefit of product diversity?

17
Monopolistic Competitionin the Market for Colas
and Coffee

• The markets for soft drinks and coffee illustrate
  the characteristics of monopolistic competition.

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Elasticities of Demand forBrands of Colas and
Coffee
Brand Elasticity of Demand

• Colas Royal Crown -2.4
• Coke -5.2 to -5.7
• Ground Coffee Hills Brothers -7.1
• Maxwell House -8.9
• Chase and Sanborn -5.6

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Elasticities of Demand forBrands of Colas and
Coffee

• Questions
• 1) Why is the demand for Royal Crown more price
  inelastic than for Coke?
• 2) Is there much monopoly power in these two
  markets?
• 3) Define the relationship between elasticity
  and monopoly power.

20
Oligopoly

• Characteristics
• Small number of firms
• Product differentiation may or may not exist
• Barriers to entry

21
Oligopoly

• Examples
• Automobiles
• Steel
• Aluminum
• Petrochemicals
• Electrical equipment
• Computers

22
Oligopoly

• The barriers to entry are
• Natural
• Scale economies
• Patents
• Technology
• Name recognition

23
Oligopoly

• The barriers to entry are
• Strategic action
• Flooding the market
• Controlling an essential input

24
Oligopoly

• Management Challenges
• Strategic actions
• Rival behavior
• Question
• What are the possible rival responses to a 10
  price cut by Ford?

25
Oligopoly

• Equilibrium in an Oligopolistic Market
• In perfect competition, monopoly, and
  monopolistic competition the producers did not
  have to consider a rivals response when choosing
  output and price.
• In oligopoly the producers must consider the
  response of competitors when choosing output and
  price.

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Oligopoly

• Equilibrium in an Oligopolistic Market
• Defining Equilibrium
• Firms doing the best they can and have no
  incentive to change their output or price
• All firms assume competitors are taking rival
  decisions into account.

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Oligopoly

• Nash Equilibrium
• Each firm is doing the best it can given what its
  competitors are doing.

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Oligopoly

• The Cournot Model
• Duopoly
• Two firms competing with each other
• Homogenous good
• The output of the other firm is assumed to be
  fixed

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Firm 1s Output Decision
P1
What is the output of Firm 1 if Firm 2 produces
100 units?
Q1
30
Oligopoly

• The Reaction Curve
• A firms profit-maximizing output is a decreasing
  schedule of the expected output of Firm 2.

31
Reaction Curves and Cournot Equilibrium
Q1
100
75
50
25
Q2
25
50
75
100
32
Oligopoly

• Questions
• 1) If the firms are not producing at the
  Cournot equilibrium, will they adjust until the
  Cournot equilibrium is reached?
• 2) When is it rational to assume that its
  competitors output is fixed?

33
Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium
• Duopoly
• Market demand is P 30 - Q where Q Q1 Q2
• MC1 MC2 0

34
Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium
• Firm 1s Reaction Curve

35
Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium

36
Oligopoly
The Linear Demand Curve

• An Example of the Cournot Equilibrium

37
Duopoly Example
Q1
The demand curve is P 30 - Q and both firms
have 0 marginal cost.
Q2
38
Oligopoly
Profit Maximization with Collusion
39
Oligopoly
Profit Maximization with Collusion

• Contract Curve
• Q1 Q2 15
• Shows all pairs of output Q1 and Q2 that
  maximizes total profits
• Q1 Q2 7.5
• Less output and higher profits than the Cournot
  equilibrium

40
Duopoly Example
Q1
30
Q2
30
41
First Mover Advantage--The Stackelberg Model

• Assumptions
• One firm can set output first
• MC 0
• Market demand is P 30 - Q where Q total
  output
• Firm 1 sets output first and Firm 2 then makes an
  output decision

42
First Mover Advantage--The Stackelberg Model

• Firm 1
• Must consider the reaction of Firm 2
• Firm 2
• Takes Firm 1s output as fixed and therefore
  determines output with the Cournot reaction
  curve Q2 15 - 1/2Q1

43
First Mover Advantage--The Stackelberg Model

• Firm 1
• Choose Q1 so that

44
First Mover Advantage--The Stackelberg Model

• Substituting Firm 2s Reaction Curve for Q2

45
First Mover Advantage--The Stackelberg Model

• Conclusion
• Firm 1s output is twice as large as firm 2s
• Firm 1s profit is twice as large as firm 2s
• Questions
• Why is it more profitable to be the first mover?
• Which model (Cournot or Shackelberg) is more
  appropriate?

46
Price Competition

• 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.

47
Price Competition
Bertrand Model

• Assumptions
• Homogenous good
• Market demand is P 30 - Q where
  Q Q1 Q2
• MC 3 for both firms and MC1 MC2 3

48
Price Competition
Bertrand Model

• Assumptions
• The Cournot equilibrium
• Assume the firms compete with price, not quantity.

49
Price Competition
Bertrand Model

• How will consumers respond to a price
  differential? (Hint Consider homogeneity)
• The Nash equilibrium
• P MC P1 P2 3
• Q 27 Q1 Q2 13.5

50
Price Competition
Bertrand Model

• 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).

51
Price Competition
Bertrand Model

• Criticisms
• When firms produce a homogenous good, it is more
  natural to compete by setting quantities rather
  than prices.
• Even if the firms do set prices and choose the
  same price, what share of total sales will go to
  each one?
• It may not be equally divided.

52
Price Competition

• Price Competition with Differentiated Products
• Market shares are now determined not just by
  prices, but by differences in the design,
  performance, and durability of each firms
  product.

53
Price Competition
Differentiated Products

• Assumptions
• Duopoly
• FC 20
• VC 0

54
Price Competition
Differentiated Products

• Assumptions
• Firm 1s demand is Q1 12 - 2P1 P2
• Firm 2s demand is Q2 12 - 2P1 P1
• P1 and P2 are prices firms 1 and 2 charge
  respectively
• Q1 and Q2 are the resulting quantities they sell

55
Price Competition
Differentiated Products

• Determining Prices and Output
• Set prices at the same time

56
Price Competition
Differentiated Products

• Determining Prices and Output
• Firm 1 If P2 is fixed

57
Nash Equilibrium in Prices
P1
P2
58
Nash Equilibrium in Prices

• Does the Stackelberg model prediction for first
  mover hold when price is the variable instead of
  quantity?
• Hint Would you want to set price first?

59
A Pricing Problem for Procter Gamble
Differentiated Products

• Scenario
• 1) Procter Gamble, Kao Soap, Ltd., and
  Unilever, Ltd were entering the market for Gypsy
  Moth Tape.
• 2) All three would be choosing their prices at
  the same time.

60
A Pricing Problem for Procter Gamble
Differentiated Products

• Scenario
• 3) Procter Gamble had to consider
  competitors prices when setting their price.
• 4) FC 480,000/month and VC 1/unit
  for all firms

61
A Pricing Problem for Procter Gamble
Differentiated Products

• Scenario
• 5) PGs demand curve was
• Q 3,375P-3.5(PU).25(PK).25
• Where P, PU , PK are PGs, Unilevers, and Kaos
  prices respectively

62
A Pricing Problem for Procter Gamble
Differentiated Products

• Problem
• What price should PG choose and what is the
  expected profit?

63
PGs Profit (in thousands of per month)
Competitors (Equal) Prices ()
PGs Price () 1.10 1.20 1.30 1.40 1.50 1.60 1.7
0 1.80

• 1.10 -226 -215 -204 -194 -183 -174 -165 -155
• 1.20 -106 -89 -73 -58 -43 -28 -15 -2
• 1.30 -56 -37 -19 2 15 31 47 62
• 1.40 -44 -25 -6 12 29 46 62 78
• 1.50 -52 -32 -15 3 20 36 52 68
• 1.60 -70 -51 -34 -18 -1 14 30 44
• 1.70 -93 -76 -59 -44 -28 -13 1 15
• 1.80 -118 -102 -87 -72 -57 -44 -30 -17

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A Pricing Problem for Procter Gamble

• What Do You Think?
• 1) Why would each firm choose a price of 1.40?
  Hint Think Nash Equilibrium
• 2) What is the profit maximizing price with
  collusion?

65
Competition Versus CollusionThe Prisoners
Dilemma

• Why wouldnt each firm set the collusion price
  independently and earn the higher profits that
  occur with explicit collusion?

66
Competition Versus CollusionThe Prisoners
Dilemma

• Assume

67
Competition Versus CollusionThe Prisoners
Dilemma

• Possible Pricing Outcomes

68
Payoff Matrix for Pricing Game
Firm 2
Charge 4
Charge 6
Charge 4
Firm 1
Charge 6
69
Competition Versus CollusionThe Prisoners
Dilemma

• These two firms are playing a noncooperative
  game.
• Each firm independently does the best it can
  taking its competitor into account.
• Question
• Why will both firms both choose 4 when 6 will
  yield higher profits?

70
Competition Versus CollusionThe Prisoners
Dilemma

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

71
Competition Versus CollusionThe Prisoners
Dilemma

• Scenario
• Two 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.

72
Payoff Matrix for Prisoners Dilemma
Prisoner B
Confess
Dont confess
Confess
Prisoner A
Would you choose to confess?
Dont confess
73
Payoff Matrix forthe P G Prisoners Dilemma

• Conclusions Oligipolistic 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

74
Payoff Matrix for the PG Pricing Problem
Unilever and Kao
Charge 1.40
Charge 1.50
Charge 1.40
PG
What price should P G choose?
Charge 1.50
75
Implications of the PrisonersDilemma for
Oligipolistic Pricing

• Observations of Oligopoly Behavior
• 1) In some oligopoly markets, pricing behavior
  in time can create a predictable pricing
  environment and implied collusion may occur.

76
Implications of the PrisonersDilemma for
Oligipolistic Pricing

• Observations of Oligopoly Behavior
• 2) In other oligopoly markets, the firms are
  very aggressive and collusion is not possible.
• Firms are reluctant to change price because of
  the likely response of their competitors.
• In this case prices tend to be relatively rigid.

77
The Kinked Demand Curve
/Q
Quantity
78
The Kinked Demand Curve
/Q
Quantity
MR
79
Implications of the PrisonersDilemma for
Oligopolistic Pricing
Price Signaling Price Leadership

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

80
Implications of the PrisonersDilemma for
Oligopolistic Pricing
Price Signaling Price Leadership

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

81
Implications of the PrisonersDilemma for
Oligopolistic Pricing

• The Dominant Firm Model
• In some oligopolistic markets, one large firm has
  a major share of total sales, and a group of
  smaller firms supplies the remainder of the
  market.
• The large firm might then act as the dominant
  firm, setting a price that maximized its own
  profits.

82
Price Setting by a Dominant Firm
Price
Quantity
83
Cartels

• Characteristics
• 1) Explicit agreements to set output and price
• 2) May not include all firms

84
Cartels

• Characteristics
• 3) Most often international

• Examples of unsuccessful cartels
• Copper
• Tin
• Coffee
• Tea
• Cocoa

• Examples of successful cartels
• OPEC
• International Bauxite Association
• Mercurio Europeo

85
Cartels

• Characteristics
• 4) Conditions for success
• Competitive alternative sufficiently deters
  cheating
• Potential of monopoly power--inelastic demand

86
Cartels

• Comparing OPEC to CIPEC
• Most cartels involve a portion of the market
  which then behaves as the dominant firm

87
The OPEC Oil Cartel
Price
Quantity
88
Cartels

• About OPEC
• Very low MC
• TD is inelastic
• Non-OPEC supply is inelastic
• DOPEC is relatively inelastic

89
The OPEC Oil Cartel
Price
P
QOPEC
Quantity
90
The CIPEC Copper Cartel
Price
Quantity
91
Cartels

• Observations
• To be successful
• Total demand must not be very price elastic
• Either the cartel must control nearly all of the
  worlds supply or the supply of noncartel
  producers must not be price elastic

92
The Cartelizationof Intercollegiate Athletics

• Observations
• 1) Large number of firms (colleges)
• 2) Large number of consumers (fans)
• 3) Very high profits

93
The Cartelizationof Intercollegiate Athletics

• Question
• How can we explain high profits in a competitive
  market? (Hint Think cartel and the NCAA)

94
The Milk Cartel

• 1990s with less government support, the price of
  milk fluctuated more widely
• In response, the government permitted six New
  England states to form a milk cartel (Northeast
  Interstate Dairy Compact -- NIDC)

95
The Milk Cartel

• 1999 legislation allowed dairy farmers in
  Northeastern states surrounding NIDC to join
  NIDC, 7 in 16 Southern states to form a new
  regional cartel.
• Soy milk may become more popular.

96
Summary

• In a monopolistically competitive market, firms
  compete by selling differentiated products, which
  are highly substitutable.
• In an oligopolistic market, only a few firms
  account for most or all of production.

97
Summary

• In the Cournot model of oligopoly, firms make
  their output decisions at the same time, each
  taking the others output as fixed.
• In the Stackelberg model, one firm sets its
  output first.

98
Summary

• The Nash equilibrium concept can also be applied
  to markets in which firms produce substitute
  goods and compete by setting price.
• Firms would earn higher profits by collusively
  agreeing to raise prices, but the antitrust laws
  usually prohibit this.

99
Summary

• The Prisoners Dilemma creates price rigidity in
  oligopolistic markets.
• Price leadership is a form of implicit collusion
  that sometimes gets around the Prisoners Dilemma.
• In a cartel, producers explicitly collude in
  setting prices and output levels.

100
End of Chapter 12

• Monopolistic Competition and Oligopoly