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.

6
Monopolistic Competition

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

7
A Monopolistically CompetitiveFirm in the Short
and Long Run
/Q
/Q
Short Run
Long Run
Quantity
Quantity
8
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

10
Monopolistically and Perfectly Competitive
Equilibrium (LR)
Monopolistic Competition
Perfect Competition
/Q
/Q
Quantity
Quantity
11
Monopolistic Competition 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.

12
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

13
Monopolistic Competition

• If inefficiency bad for consumers, should
  monopolistic competition be regulated?
• Market power relatively small. Usually 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

14
The Market for Colas and Coffee

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

15
Elasticities of Demand forBrands of Colas and
Coffee
16
The Market for Colas and Coffee

• The demand for Royal Crown 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.

17
Oligopoly Characteristics

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

18
Oligopoly

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

19
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.

20
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

21
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

23
Firm 1s Output Decision
P1
Q1
24
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.

25
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
26
Reaction Curves and Cournot Equilibrium
Q1
100
In Cournot equilibrium, each firm correctly
assumes how much its competitors will produce and
thereby maximize its own profits.
75
50
x
x
25
x
x
Q2
25
50
75
100
27
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.

28
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

29
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

30
Oligopoly Example

• Firm 1s Reaction Curve ? MRMC

31
Oligopoly Example

• An Example of the Cournot Equilibrium

32
Oligopoly Example

• An Example of the Cournot Equilibrium

33
Duopoly Example
Q1
The demand curve is P 30 - Q and both firms
have 0 marginal cost.
Q2
34
Oligopoly Example

• Profit Maximization with Collusion

35
Profit Maximization w/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

36
Duopoly Example
Q1
For the firm, collusion is the best outcome
followed by the Cournot Equilibrium and then the
competitive equilibrium
30
Q2
30
37
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 1 output

38
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)

39
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

40
First Mover Advantage The Stackelberg Model

• Using Firm 2s Reaction Curve for Q2

41
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 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

43
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
  profits 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

45
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

46
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

47
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.

48
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

49
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 P1
• Quantity that each firm can sell decreases when
  it raises its own price but increases when its
  competitor charges a higher price

50
Price Competition Differentiated Products

• Firms set prices at the same time

51
Price Competition Differentiated Products

• If P2 is fixed

52
Nash Equilibrium in Prices

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

53
Nash Equilibrium in Prices
P1
Equilibrium at price of 4 and profits of 12
P2
54
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

55
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

56
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).25(PK).25
• Where P, PU, PK are PGs, Unilevers, and Kaos
  prices respectively

57
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

58
PGs Profit (in thousands of per month)
59
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
• Collusions agreement hard to enforce

60
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?

61
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

62
Competition Versus CollusionThe Prisoners
Dilemma

• Assume

63
Competition Versus CollusionThe Prisoners
Dilemma

• Possible Pricing Outcomes

64
Payoff Matrix for Pricing Game
Firm 2
Charge 4
Charge 6
Charge 4
Firm 1
Charge 6
65
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.

67
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

69
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

1. In some oligopoly markets, pricing behavior in
   time can create a predictable pricing environment
   and implied collusion may occur.
2. 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
  currently prevailing price, P
• Above P, demand is very elastic
• If PgtP, other firms will not follow
• Below P, demand is very inelastic
• If PltP, 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

75
The Kinked Demand Curve
/Q
Quantity
76
The Kinked Demand Curve
/Q
Quantity
MR
77
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 price if 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

1. Large number of firms (colleges)
2. Large number of consumers (fans)
3. 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