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
• Implications of the Prisoners Dilemma for
  Oligopolistic Pricing
• Cartels

3
Monopolistic Competition

• Characteristics
• Many firms
• Free entry and exit
• Differentiated product

4
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

5
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

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Monopolistic Competition

• Two important characteristics
• Differentiated but highly substitutable products
• Free entry and exit

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

• 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

9
A Monopolistically CompetitiveFirm in the Short
and Long Run

• 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

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Monopolistically and Perfectly Competitive
Equilibrium (LR)
Monopolistic Competition
Perfect Competition
/Q
/Q
Quantity
Quantity
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Monopolistic Competition and Economic Efficiency

• The monopoly power 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 deadweight
  loss.
• With no economic profits in the long run, the
  firm is still not producing at minimum AC and
  excess capacity exists.

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Monopolistic Competition and Economic Efficiency

• Firm faces downward sloping demand so zero profit
  point is to the left of minimum average cost
• Excess capacity is inefficient because average
  cost would be lower with fewer firms
• Inefficiencies would make consumers worse off

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Monopolistic Competition

• If inefficiency is bad for consumers, should
  monopolistic competition be regulated?
• Market power is relatively small. Usually there
  are enough firms to compete with enough
  substitutability between firms deadweight loss
  small.
• Inefficiency is balanced by benefit of increased
  product diversity may easily outweigh
  deadweight loss.

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The Market for Colas and Coffee

• Each market has much differentiation in products
  and tries to gain consumers through that
  differentiation
• Coke vs. Pepsi
• Maxwell House vs. Folgers
• How much monopoly power do each of these
  producers have?
• How elastic is demand for each brand?

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Elasticities of Demand forBrands of Colas and
Coffee
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The Market for Colas and Coffee

• The demand for Royal Crown is more price
  inelastic than for Coke
• There is significant monopoly power in these two
  markets
• The greater the elasticity, the less monopoly
  power and vice versa

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Oligopoly Characteristics

• Small number of firms
• Product differentiation may or may not exist
• Barriers to entry
• Scale economies
• Patents
• Technology
• Name recognition
• Strategic action

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Oligopoly

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

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Oligopoly

• Management Challenges
• Strategic actions to deter entry
• Threaten to decrease price against new
  competitors by keeping excess capacity
• Rival behavior
• Because only a few firms, each must consider how
  its actions will affect its rivals and in turn
  how their rivals will react

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Oligopoly Equilibrium

• If one firm decides to cut their price, they must
  consider what the other firms in the industry
  will do
• Could cut price some, the same amount, or more
  than firm
• Could lead to price war and drastic fall in
  profits for all
• Actions and reactions are dynamic, evolving over
  time

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Oligopoly Equilibrium

• Defining Equilibrium
• Firms are 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
• Nash Equilibrium
• Each firm is doing the best it can given what its
  competitors are doing
• We will focus on duopoly
• Markets in which two firms compete

22
Oligopoly

• The Cournot Model
• Oligopoly model in which firms produce a
  homogeneous good, each firm treats the output of
  its competitors as fixed, and all firms decide
  simultaneously how much to produce
• Firm will adjust its output based on what it
  thinks the other firm will produce

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Firm 1s Output Decision
P1
Q1
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Oligopoly

• The Reaction Curve
• The relationship between a firms
  profit-maximizing output and the amount it thinks
  its competitor will produce
• A firms profit-maximizing output is a decreasing
  schedule of the expected output of Firm 2

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Reaction Curves and Cournot Equilibrium
Q1
Firm 1s reaction curve shows how much it will
produce as a function of how much it thinks Firm
2 will produce. The xs correspond to the
previous model.
100
75
Firm 2s reaction curve shows how much it will
produce as a function of how much it thinks Firm
1 will produce.
50
x
x
25
x
x
Q2
25
50
75
100
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Reaction Curves and Cournot Equilibrium
Q1
100
In Cournot equilibrium, each firm correctly
assumes how much its competitors will produce and
thereby maximizes its own profits.
75
50
x
x
25
x
x
Q2
25
50
75
100
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Cournot Equilibrium

• Each firms reaction curve tells it how much to
  produce given the output of its competitor
• Equilibrium in the Cournot model, in which each
  firm correctly assumes how much its competitor
  will produce and sets its own production level
  accordingly

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Oligopoly

• Cournot equilibrium is an example of a Nash
  equilibrium (Cournot-Nash Equilibrium)
• The Cournot equilibrium says nothing about the
  dynamics of the adjustment process
• Since both firms adjust their output, neither
  output would be fixed

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The Linear Demand Curve

• An Example of the Cournot Equilibrium
• Two firms face linear market demand curve
• We can compare competitive equilibrium and the
  equilibrium resulting from collusion
• Market demand is P 30 - Q
• Q is total production of both firms
• Q Q1 Q2
• Both firms have MC1 MC2 0

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Oligopoly Example

• Firm 1s Reaction Curve ? MR MC

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Oligopoly Example

• An Example of the Cournot Equilibrium

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Oligopoly Example

• An Example of the Cournot Equilibrium

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Duopoly Example
Q1
The demand curve is P 30 - Q and both firms
have 0 marginal cost.
Q2
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Oligopoly Example

• Profit Maximization with Collusion

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Profit Maximization w/ Collusion

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

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Duopoly Example
Q1
For the firm, collusion is the best outcome
followed by the Cournot Equilibrium and then the
competitive equilibrium
30
Q2
30
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First Mover Advantage The Stackelberg Model

• Oligopoly model in which one firm sets its output
  before other firms do
• Assumptions
• One firm can set output first
• MC 0
• Market demand is P 30 - Q where Q is total
  output
• Firm 1 sets output first and Firm 2 then makes an
  output decision seeing Firm 1s output

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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 - ½(Q1)

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First Mover Advantage The Stackelberg Model

• Firm 1
• Choose Q1 so that
• Firm 1 knows Firm 2 will choose output based on
  its reaction curve. We can use Firm 2s reaction
  curve as Q2 .

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First Mover Advantage The Stackelberg Model

• Using Firm 2s Reaction Curve for Q2

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First Mover Advantage The Stackelberg Model

• Conclusion
• Going first gives Firm 1 the advantage
• Firm 1s output is twice as large as Firm 2s
• Firm 1s profit is twice as large as Firm 2s
• Going first allows Firm 1 to produce a large
  quantity. Firm 2 must take that into account and
  produce less unless it wants to reduce profits
  for everyone.

42
Price Competition

• Competition in an oligopolistic industry may
  occur with price instead of output
• The Bertrand Model is used
• Oligopoly model in which firms produce a
  homogeneous good, each firm treats the price of
  its competitors as fixed, and all firms decide
  simultaneously what price to charge

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Price Competition Bertrand Model

• Assumptions
• Homogenous good
• Market demand is P 30 - Q where
  Q Q1 Q2
• MC1 MC2 3
• Can show the Cournot equilibrium if Q1 Q2 9
  and market price is 12, giving each firm a
  profit of 81.

44
Price Competition Bertrand Model

• Assume here that the firms compete with price,
  not quantity
• Since good is homogeneous, consumers will buy
  from lowest price seller
• If firms charge different prices, consumers buy
  from lowest priced firm only
• If firms charge same price, consumers are
  indifferent who they buy from

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Price Competition Bertrand Model

• Nash equilibrium is competitive output since have
  incentive to cut prices
• Both firms set price equal to MC
• P MC P1 P2 3
• Q 27 Q1 Q2 13.5
• Both firms earn zero profit

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Price Competition Bertrand Model

• Why not charge a different price?
• If charge more, sell nothing
• If charge less, lose money on each unit sold
• The Bertrand model demonstrates the importance of
  the strategic variable
• Price versus output

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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

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Price Competition Differentiated Products

• Market shares are now determined not just by
  prices, but by differences in the design,
  performance, and durability of each firms
  product
• In these markets, more likely to compete using
  price instead of quantity

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Price Competition Differentiated Products

• Example
• Duopoly with fixed costs of 20 but zero variable
  costs
• Firms face the same demand curves
• Firm 1s demand Q1 12 - 2P1 P2
• Firm 2s demand Q2 12 - 2P1 P2
• Quantity that each firm can sell decreases when
  it raises its own price but increases when its
  competitor charges a higher price

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Price Competition Differentiated Products

• Firms set prices at the same time

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Price Competition Differentiated Products

• If P2 is fixed

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Nash Equilibrium in Prices

• What if both firms collude?
• They both decide to charge the same price that
  maximizes both of their profits
• Firms will charge 6 and will be better off
  colluding since they will earn a profit of 16

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Nash Equilibrium in Prices
P1
Equilibrium at price of 4 and profits of 12
P2
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Nash Equilibrium in Prices

• If Firm 1 sets price first and then Firm 2 makes
  pricing decision
• Firm 1 would be at a distinct disadvantage by
  moving first
• The firm that moves second has an opportunity to
  undercut slightly and capture a larger market
  share

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A Pricing Problem Procter Gamble

• Procter Gamble, Kao Soap, Ltd., and Unilever,
  Ltd. were entering the market for Gypsy Moth Tape
• All three would be choosing their prices at the
  same time
• Each firm was using same technology so had same
  production costs
• FC 480,000/month VC 1/unit

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A Pricing Problem Procter Gamble

• Procter Gamble had to consider competitors
  prices when setting their price
• PGs demand curve was
• Q 3,375P-3.5(PU)0.25(PK)0.25
• Where P, PU, PK are PGs, Unilevers, and Kaos
  prices respectively

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A Pricing Problem Procter Gamble

• What price should PG choose and what is the
  expected profit?
• Can calculate profits by taking different
  possibilities of prices you and the other
  companies could charge
• Nash equilibrium is at 1.40 the point where
  competitors are doing the best they can as well

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PGs Profit (in thousands of per month)
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A Pricing Problem for Procter Gamble

• Collusion with competitors will give larger
  profits
• If all agree to charge 1.50, each earn profit of
  20,000
• Collusion agreements are hard to enforce

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Competition Versus CollusionThe Prisoners
Dilemma

• Nash equilibrium is a noncooperative equilibrium
  each firm makes decision that gives greatest
  profit, given actions of competitors
• Although collusion is illegal, why dont firms
  cooperate without explicitly colluding?
• Why not set profit maximizing collusion price and
  hope others follow?

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Competition Versus CollusionThe Prisoners
Dilemma

• Competitor is not likely to follow
• Competitor can do better by choosing a lower
  price, even if they know you will set the
  collusive level price
• We can use example from before to better
  understand the firms choices

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Competition Versus CollusionThe Prisoners
Dilemma

• Assume

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Competition Versus CollusionThe Prisoners
Dilemma

• Possible Pricing Outcomes

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

• We can now answer the question of why firm does
  not choose cooperative price
• Cooperating means both firms charging 6 instead
  of 4 and earning 16 instead of 12
• Each firm always makes more money by charging 4,
  no matter what its competitor does
• Unless enforceable agreement to charge 6, will
  be better off charging 4

66
Competition Versus CollusionThe Prisoners
Dilemma

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

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Payoff Matrix for Prisoners Dilemma
Prisoner B
Confess
Dont confess
Confess
Prisoner A
Would you choose to confess?
Dont confess
68
Oligopolistic Markets

• Conclusions
• Collusion will lead to greater profits
• Explicit and implicit collusion is possible
• Once collusion exists, the profit motive to break
  and lower price is significant

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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
70
Observations of Oligopoly Behavior

• In some oligopoly markets, pricing behavior in
  time can create a predictable pricing environment
  and implied collusion may occur
• In other oligopoly markets, the firms are very
  aggressive and collusion is not possible

71
Observations of Oligopoly Behavior

• 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

72
Price Rigidity

• Firms have strong desire for stability
• Price rigidity characteristic of oligopolistic
  markets by which firms are reluctant to change
  prices even if costs or demands change
• Fear lower prices will send wrong message to
  competitors, leading to price war
• Higher prices may cause competitors to raise
  theirs

73
Price Rigidity

• Basis of kinked demand curve model of oligopoly
• Each firm faces a demand curve kinked at the
  current prevailing price, P
• Above P, demand is very elastic
• If P gt P, other firms will not follow
• Below P, demand is very inelastic
• If P lt P, other firms will follow suit

74
Price Rigidity

• With a kinked demand curve, marginal revenue
  curve is discontinuous
• Firms costs can change without resulting in a
  change in price
• Kinked demand curve does not really explain
  oligopolistic pricing
• Description of price rigidity rather than an
  explanation of it

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The Kinked Demand Curve
/Q
Quantity
76
The Kinked Demand Curve
/Q
Quantity
MR
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Price Signaling and Price Leadership

• 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

78
Price Signaling and Price Leadership

• 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 maximizes its own
  profits

79
The Dominant Firm Model

• Dominant firm must determine its demand curve, DD
• Difference between market demand and supply of
  fringe firms
• To maximize profits, dominant firm produces QD
  where MRD and MCD cross
• At P, fringe firms sell QF and total quantity
  sold is QT QD QF

80
Price Setting by a Dominant Firm
Price
Quantity
81
Cartels

• Producers in a cartel explicitly agree to
  cooperate in setting prices and output
• Typically only a subset of producers are part of
  the cartel and others benefit from the choices of
  the cartel
• If demand is sufficiently inelastic and cartel is
  enforceable, prices may be well above competitive
  levels

82
Cartels

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

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

83
Cartels Conditions for Success

• Stable cartel organization must be formed price
  and quantity settled on and adhered to
• Members have different costs, assessments of
  demand and objectives
• Tempting to cheat by lowering price to capture
  larger market share

84
Cartels Conditions for Success

• Potential for monopoly power
• Even if cartel can succeed, there might be little
  room to raise prices if it faces highly elastic
  demand
• If potential gains from cooperation are large,
  cartel members will have more incentive to make
  the cartel work

85
Analysis of Cartel Pricing

• Members of cartel must take into account the
  actions of non-members when making pricing
  decisions
• Cartel pricing can be analyzed using the dominant
  firm model
• OPEC oil cartel successful
• CIPEC copper cartel unsuccessful

86
The OPEC Oil Cartel
Price
Quantity
87
Cartels

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

88
The OPEC Oil Cartel
Price
P
QOPEC
Quantity
89
The CIPEC Copper Cartel
Price
Quantity
90
Cartels

• 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

91
The Cartelization of Intercollegiate Athletics

• Large number of firms (colleges)
• Large number of consumers (fans)
• Very high profits

92
The Cartelization of Intercollegiate Athletics

• NCAA is the cartel
• Restricts competition
• Reduces bargaining power by athletes enforces
  rules regarding eligibility and terms of
  compensation
• Reduces competition by universities limits
  number of games played each season, number of
  teams per division, etc.
• Limits price competition sole negotiator for
  all football television contracts

93
The Cartelization of Intercollegiate Athletics

• Although members have occasionally broken rules
  and regulations, has been a successful cartel
• In 1984, Supreme Court ruled that the NCAAs
  monopolization of football TV contracts was
  illegal
• Competition led to drop in contract fees
• More college football on TV, but lower revenues
  to schools