Chapter 25

Chapter 25 – Monopolist Competition and Oligopoly

Monopolistic competition – a) relatively large number of sellers b) Differentiated products c) Easy entrance and exit from the economy

Relatively large number of sellers – maybe 25 – 70 but not the thousands as in complete competition

No Collusion – enough firms that price setting/collusion is improbable

Independent action – No feel of interdependence, if one firm lowers prices, another one wouldn’t feel much of an effect

Differentiated Products – unlike pure competition, the products differ slightly by…Product Attributes, Service, Location (of purchase), Brand names and packaging – advertising and brand loyalty, Some Control over price – Sellers may pay a little more to choose a brand they think is better so not completely price takers

Easy Entry and Exit – because the firms are relatively smaller, it is not as hard to raise capital or achieve economy of scale

Advertisements – the goal of advertising is to differentiate products and encourage non-price competition – to make price less of a factor

Price and Output in Monopolistic Competition

The firms demand curve – Elasticity of demand faced by a monopolistically competitive firm is highly elastic but not perfectly elastic. Elasticity of demand depends on the number of rivals and the degree of product differentiation

The short run: Profit or Loss – mazimize profit/minimize loss by making MC = MR

The Long Run: Only a Normal Profit – In the long run, a monopolistically competitive industry will earn only a normal profit

Profits: Firms enter – Economic profit attracts new rivals, because entry to the industry is relatively easy, as more firms join, the demand curve will fall until it is tangent to the ATC curve, at this point the firms only produce a normal profit so there is no incentive for new firms to enter the business

Losses: Firms leave – Short term losses will push some firms out of the business, this will shift the demand curve (of the individual firm) to the right and thus restore normal profits

Complications – if a firm has sufficient product differentiation such that they cannot be copied, then they may be able to sustain modest economic profits in the long run or it might not be quite as free to enter the market due to product differentiation

Monopolistic Competition and Efficiency – the equality of price and marginal cost yields allocative efficiency

Neither Productive nor allocative efficiency – neither productive nor allocative efficiency occurs in long-run equilibrium. Profit maximizing price exceeds the lowest averacte total cost, therefore, the firms ATC is higher than optimal from society’s perspective. Also the Profit maximizing price exceeds marginal cost meaning that monopolistic competition causes an underallocation of resources, therefore it is not allocatively efficient either. Monopolistic competitors must charge a higher than competitive price in the long run to achieve a normal profit

Excess Capability – the difference between the minimum-ATC and the profit-maximizing ATC

Product Variety

Benefits of Product Variety – Product variety and product improvement of monopolistic competition may offset the inefficiency

Further Complexity – Graph 25.1 assumes no product development/fixed level of advertising, Competitive firm juggles price, product and advertising – In practice, this is determined by trial and error

Oligopoly

A Few Large Producers – when only a few companies 3-5 are in competition

Homogenous or Differentiated Products – May be a homogenous oligopoly or a differentiated oligopoly depending on whether or not the products are differentiated

Control over Price, but Mutual Interdependence – Price maker but must be careful that rivals wont undercut them significantly.

Strategic behavior – self-interested behavior

Mutual interdependence – each firms profit also depends on the prices/advertising of the other firms

Entry Barriers

Hard to enter because of often high capital requirements and need for economy of scale

Mergers – while sometimes firms grow into a oligopoly, often it is done by mergers. Beneficial because it makes the firm more monopolist in nature

Measures of Industry Concentration

Concentration Ration – percentage of total output controlled by the largest firm, when the largest four firms control over 40% of a market, it is considered an oligopoly

Localized Markets – CR’s are for the whole nation, but you can have oligopolies on a smaller level

Interindustry Competition – Sometimes industries compete with each other; for example motorcycle market competes with car market

World Trade – Import competition from foreign markets

Herfindahl Index – It could be possible if 4 companies controlled the whole industry that the four-firm CR was equal to a monopolized industry, the H index is the squared percentage market shares of all firms in the industry

The greater the H I, the greater the market power in the industry

Oligopoly and game theory

The study of how people behave in strategic systems is called game theory

Mutual Interdependence – Each firms profit depends on their pricing strategies and those of their rivals, one rivals high price strategy will only be profitable if the other one employs a high price strategy and vice versa

Collusive Tendencies – Collusion – cooperation with rivals (ie keep prices up for both firms)

Incentive to cheat – incentive to break price setting because then they could dominate the market

Three Oligopoly Models

Diversity of oligopolies – Tight Oligopolies – 3 or 4 control almost all, or Loose – 6-7 control 70% or so

Complications of interdependence – Firms cannot predict reactions so they cannot predict profit maximizing prices

Kinkead-Demand Thory: Non collusive Oligopoly

Match Price changes – If Company B and C react to Company As price decrease by matching A’s prices exactly then Arch’s demand and marginal revenue curves will look like straight lines

Ignore price change – Demand and MR curves faced by A will be straight lines, A would gain sales at the expensive of the other two companies, if it raised prices, A would lose many customers but not all of them because of product loyalty

A combined strategy

It is rational that B and C would lower their prices – but not raise them if Price was raised

Noncollusive oligopolies face the kinked-demand curve

Price Inflexibility

Either raising or lowering the price will result in smaller profits

Criticism of the Model – explains why price is pretty inflexible not what prices are set, When the macroeconomy is unstable, prices are instable. Price reductions lead to a price war

Cartels and other collusion – it would be profitable to collude and fix prices and create barriers to entry. Price and Output – each firm’s demand curve is indeterminate unless we know how the other firms will react. We will assume that they will match the price leaders price, so each demand curve is straight – therefore the same graph represents all three firms

If company A chooses where MC = MR = P (like a monopoly) the other firms will keep the same price and A’s demand curve will shift to the Left as customers shift loyalty

Each firm finds it profitable to charge where MC = MR, so they should collude to charge that price

Overt Collusions – the OPEC Cartel – cartel – a group of producers that typically creates a formal written agreement specifying how much each member will produce and forgo

Output must be controlled and divided up to maintain the agreed on price

OPEC controls 60% of oil traded internationally so they are able to drive prices up/lower them

Covert Collusion – also Tacit understandings – informal agreements about collusion

Obstacles to Collusion – Demand and Cost differences – difficult to agree on a price, Number of firms – The larger the number of firms, the harder it is to have a Cartel

Cheating – There is still a tendency to offer a lower price to steal competition

Recession – Slumping markets increase ATC

Potential Entry – Higher prices attract more firms

Legal Obstacles: Antitrust Law : prohibit cartels and price fixing

Price Leadership Model – Dominant firm initiates price changes and everyone else follows the leader

Leadership Tactics –

Infrequent price changes – Price is changed only when demand and cost has been changed significantly,

Communications – communicates the need to raise/lower prices so other firms can react,

Limit pricing – Set prices below profit-maximizing level in order to discourage other companies from entering the industry,

Breakdowns in Price Leadership: Price Wars – Price leadership usually ends when one company undercuts the other companies and a price war results

Oligopoly and Advertising – each firms share of the total market is best determined by product development and advertising

Product development and advertising are less easily duplicated then price cuts and therefore can produce longer lasting gains

Oligopolists generally have capital to put into product development

Advertising is prevalent in monopolistic and Oligopolistic competition

Positive effects of advertisements – Spreding info about products helps people make rational discussions and break up monopolies, enhances competition – greater economic efficiency

Negative effects of advertising – some ads convey little about product attributes, two costly advertising campaigns can be canceling

Oligopoly and efficiency

Productive and Allocative efficiency – P – minimum ATC