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Monopolistic Competition and Oligopoly

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© 2003 South-Western/Thomson Learning

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Characteristics of Monopolistic Competition

CharacteristicsMany producers offer products that are either close substitutes but are not viewed as identicalEach supplier has some power over the price it charges are price makersLow barriers to entry firms in the long run can enter or leave the market with ease enough sellers that they behave competitivelySellers act independently of each other

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Product Differentiation

Sellers differentiate their products in four basic ways

Physical differences and qualitiesLocationAccompanying servicesProduct image

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Short-Run Profit Maximization or Loss Minimization

Because products are a somewhat different product, each has some control over price each firm’s demand curve slopes downward

Since many firms are selling close substitutes, any firm that raises its price can expect to lose some customers, but not all, to rivals demand is more elastic than a monopolist’s but less elastic than a perfect competitors

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Price Elasticity of DemandThe price elasticity of the monopolistic competitor’s demand depends on

The number of rival firms that produce similar productsThe firm’s ability to differentiate its product from those of its rivals

A firm’s demand curve will be more elastic the greater the number of competing firms and the less differentiated its product

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Marginal Revenue Equals Marginal Cost

The downward-sloping demand curve means that the marginal revenue curve also slopes downward and lies beneath the demand curve

The cost curves are similar to those developed in perfect competition and monopoly

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Zero Economic Profit in the Long Run

Since there are low barriers to entry in monopolistic competition, short-run economic profit will attract new entrants in the long run

Because new entrants offer products that are similar to those offered by existing firms, they draw some customers away from existing firms the demand facing each firm declines and becomes more elastic since there are more substitutes for each firm’s product

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Zero Economic Profit in the Long RunBecause of the ease of entry, monopolistically competitive firms earn zero economic profit in the long run

In the cases of losses that persist, some monopolistic competitors will leave the industry their customers will switch to the remaining firms increasing the demand for each remaining firm’s demand curve and making it less elastic

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ComparisonHow does monopolistic competition compare with perfect competition in terms of efficiency?In the long run, neither can earn economic profitHowever, a difference arises because of the different demand curves facing individual firms in each of two market structures

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ComparisonFirms in monopolistic competition are said to have excess capacity, since production is lower than the rate that would be associated with the lowest average costAlternatively, excess capacity means that each producer could easily produce more and in the process would lower the average cost the marginal value of increased output would exceed its marginal cost greater output would increase economic welfare

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Comparison

Another differences is that although the cost curves in the previous exhibit are identical, firms in monopolistic competition spend more on advertising and other promotional expenses to differentiate their products

These higher costs shift up their average cost curves

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ComparisonSome argue that monopolistic competition results in too many suppliers and in product differentiation that is often artificial

The counterargument is that consumers are willing to pay a higher price for greater selection

That is, consumers are willing to pay a higher price for greater selectionConsumers benefit from the wider choice

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OligopolyOligopoly refers to a market structure that is dominated by just a few firms

Because an oligopoly has only a few firms, each must consider the effect of its own actions on competitors’ behavior the firms in an oligopoly are interdependent

There are a variety of oligopolies

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Varieties of OligopolyThe product can be homogeneous across producers or differentiated across producers

The more homogeneous the products, the greater the interdependence among the few dominant firms in the industry

Products can be differentiated by physical qualities, sales locations, services provided with the product and the image of the product

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Varieties of OligopolyBecause of interdependence among firms in an industry, the behavior of any particular firm is difficult to analyze

Each firm knows that any changes in its product quality, price, output, or advertising policy may prompt a reaction from its rivals

Domination by a few firms can often be traced to some form of barrier to entry

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Economies of ScalePerhaps the most significant barrier to entry is economies of scaleRecall that the minimum efficient scale is the lowest rate of output at which the firm takes full advantage of economies of scaleIf a firm’s minimum efficient scale is relatively large compared to industry output, then only one or a few firms are needed to produce the total output demanded in the market

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High Cost of EntryThe total investment needed to reach the minimum size is often gigantic which may pose another problem for potential entrants into oligopolistic industries Advertising a new product enough to compete with established brands may also require enormous outlaysHigh start-up costs and established brand names can create substantial barriers to entry, especially since the fortunes of a new product are so uncertain

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High Cost of EntryProduct differentiation expenditures create barriers to entry

Oligopolists often compete with existing rivals and try to block new entry by offering a variety of models and products

Firms often spend billions trying to differentiate their productsSome of these expenditures have the beneficial effects of providing valuable information to consumers and offering them a wide variety of products

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Models of OligopoliesThe interdependence of firms in an oligopoly makes analyzing their behavior complicated no one model or approach explains the outcomes

At one extreme, the firms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartelAt the other extreme, they may compete so fiercely that price wars erupt

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Models of OligopolyWhile there are many theories, we will focus our attention on three of the better-known approaches

CollusionPrice LeadershipGame Theory

Each approach has some relevance, although none is entirely satisfactory as a general theory

Each is based on the diversity of observed behavior in an interdependent market

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Collusion

Collusion is an agreement among firms in the industry to divide the market and fix the price

A cartel is a group of firms that agree to collude so they can act as a monopolist and earn monopoly profits

Colluding firms usually reduce output, increase price, and block the entry of new firms

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Collusion

Collusion and cartels are illegal in the United States; some other countries are more tolerant and some countries even promote cartels OPEC

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Cartel ModelTo maximize cartel profit, output must be allocated so that the marginal cost for the final unit produced by each firm is identical

Any other allocation would lower cartel profits

However, this is much easier said than done in practice

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Differences in CostIf all firms have identical costs, output and profit are easily allocated across firms each firm produces the same quantity

However, if costs differ, as is normally the case, problems arise

The greater the differences in average costs across firms, the greater will be the differences in economic profits among firms

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Differences in CostIf cartel members try to equalize each firm’s total profit, a high-cost firm would need to sell more than a low-cost firmBut this allocation scheme violates the cartel’s profit-maximizing condition of finding the output for each firm that results in identical marginal costs across firms if average costs differ across firms, the output allocation that maximizes cartel profit will yield unequal profit across cartel members

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Number of Firms in the CartelThe more firms in the industry, the more difficult it is to negotiate an acceptable allocation of output among them

Consensus becomes harder to achieve as the number of firms grows the greater the chances are that one or more will become dissatisfied with the cartel and break the agreement

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New Entry Into the Industry

If a cartel cannot block the entry of new firms into the industry, new entry will eventually force prices down, squeezing economic profit and undermining the cartel

The profit of the cartel attracts entry, entry increases market supply market price is forced down

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CheatingPerhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement

By offering a price slightly below the established price, a firm can usually increase its sales and economic profit

Because oligopolists usually operate with excess capacity, some cheat on the established price

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Summary

Establishing and maintaining an effective cartel will be more difficult

If the product is differentiated among firmsIf costs differ among firmsIf there are many suppliers in the industryIf entry barriers are low, and If cheating on the agreement becomes widespread

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Price LeadershipAn informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry

A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition

Price leader also initiates price changes

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Price LeadershipObstacles in price leadership industries

The practice usually violates U.S. antitrust lawsThe greater the product differentiation among sellers, the less effective price leadership will be as a means of collusionThere is no guarantee that other firms will follow the leader if other firms do not follow, the leader risks losing salesSome firms will try to cheat on the agreement by cutting price to increase sales and profitsUnless there are barriers to entry, a profitable price will attract entrants

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Game TheoryGame theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms

It analyzes the behavior of decision-makers, or players, whose choices affect one another

Provides a general approach that allows us to focus on each player’s incentives to cooperate or not

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Prisoner’s Dilemma

Two thieves, Ben and Jerry, are caught near the scene of a robberyThe police believe they are guilty but they need a confessionEach thief faces a choice of confessing or denying any knowledge of the crimeIf only one confesses he is granted immunity and goes free other gets the maximum of 10 yearsIf both deny the crime, each gets a 1-year sentence and if both confess, each gets 5 years

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Prisoner’s DilemmaWhat will each do?The answer depends on the assumptions about their behavior that is, what strategy each pursuesA strategy reflects a player’s game planIn the prisoner’s dilemma, each player tries to save his own skin by minimizing his time in jail, regardless of what happens to the otherExhibit 6 shows the payoff matrix for the game

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Payoff MatrixPayoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues

Each prisoner pursues one of two strategies, confessing or clamming up

Ben’s strategies are shown along the left margin and Jerry’s across the top

The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies

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Payoff MatrixThe number above the diagonal shows Ben’s sentence in years and the number below the diagonal show Jerry’s sentence

What strategies are rational assuming that each player tries to minimize jail time?

Ben’s perspective: you know that Jerry will either confess or clam up. Suppose Jerry confesses, if you confess also, you both get 5 years, but if you deny involvement you get 10 years while Jerry walks if Ben thinks Jerry will confess, he should also

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Price Setting GameThe prisoner’s dilemma applies to a broad range of economic phenomena such as pricing policy and advertising strategy

Consider the market for gasoline in a rural community with only two gas stations a duopoly

Suppose customers are indifferent between the two brands and consider only the price

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Price Setting GameEach station sets its daily price early in the morning before knowing the price set by the otherSuppose only two prices are possible a low price and a high price

If both charge the low price, they split the market and each earns a profit of $500 per dayIf both charge the high price, they also split the market and earn $700 profitIf one charges the high price but the other the low one, the low price station earns a profit of $1,000 and the other $200

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Price Setting Game

If each firm thinks other firms in the cartel will stick with their quotas, they can increase their profits by cutting price and increasing quantities

If you think other firms will cheat and overproduce, they you should too

Either way your incentive as a cartel member is to cheat on the quota

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One-Shot versus Repeated GamesThe outcome of a game often depends on whether it is a one-shot game or the repeated game

The classic prisoner’s dilemma is a one-shot game the game is to be played only once

However, if the same players repeat the prisoner’s dilemma, as would likely occur in the price setting game, other possibilities unfold

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One-Shot versus Repeated Games

In a repeated-game setting, each player has a chance to establish a reputation for cooperation and thereby can encourage the other player to do the same

The cooperative solution makes both players better off than if they fail to cooperate

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Tit-for-Tat StrategyExperiments show that the strategy with the highest payoff in repeated games turns out to be the tit-for-tat strategy

You begin by cooperating in the first round of playOn every round thereafter you cooperate if the other player cooperated in the previous round, and you cheat if your opponent cheated in the previous round

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Oligopoly and Perfect Competition

Since there is no typical model of oligopoly, no direct comparison with perfect competition is available

However, we can imagine an experiment in which we took the many firms in a competitive industry and, through a series of mergers, combine them to form, say, four firmsHow would the behavior of firms in this industry differ before and after the merger

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Oligopoly and Perfect CompetitionPrice is usually higher under oligopoly

With fewer competitors after the merger, remaining firms would become more interdependent they will try to coordinate pricing policies if they engage in some sort of implicit or explicit collusion, industry output would be lower and price would be higher than under perfect competition

Higher profits under oligopolyIf there are barriers to entry into the oligopoly, profits will be higher than under perfect competition in the long run