Monopolistic Competition and Oligopoly Cheryl Carleton Asher Villanova University

Monopolistic Competition and Oligopoly

Cheryl Carleton AsherVillanova University

Chapter 12 2©2005 Pearson Education, Inc.

Monopolistic Competition

Many producers offer products that are either close substitutes but are not viewed as identical

Each supplier has some power over the price it charges : price makers

Low barriers to entry: firms in the long run can enter or leave the market with ease

Act independently of each other Differentiate their products

A Monopolistically CompetitiveFirm in the Short and Long Run

Quantity

$/Q

Quantity

$/QMC

AC

MC

AC

DSR

MRSR

DLR

MRLR

QSR

PSR

QLR

PLR

Short Run Long Run



Short-run Downward sloping demand – differentiated

product Demand is relatively elastic – good

substitutes MR < P Profits are maximized when MR = MC This firm is making economic profits


Exhibit 1a: Maximizing Short-Run Profit

The monopolistically competitive firm produces the level of output at which marginal revenue equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping demand curve. In panel (a), the firm produces q units, sells them at price p, and earns a short-run economic profit equal to (p – c) multiplied by q, shown by the blue rectangle.



Long-run Profits will attract new firms to the industry

(no barriers to entry) The old firm’s demand will decrease to Firm’s output and price will fall Industry output will rise No economic profit (P = AC) P > MC some monopoly power


Exhibit 2: Long-run Equilibrium

p

0 q

MC

ATC

MR

Da

b

Quantity per period

In the long run, entry and exit will shift each firm’s demand curve until economic profit disappears and price equals ATCLong-run outcome occurs where the MR curve intersects the MC curve at point a, where the ATC curve is tangent to the demand curve at point b and there is no economic profitIn the case of short-run losses, some firms will leave the industry and the demand curve shifts to the right, becoming less elastic until the loss disappears and the remaining firms earn a normal profit

Do

llar

s p

er u

nit

Deadweight lossMC AC

Monopolistically and Perfectly Competitive Equilibrium (LR)

$/Q

Quantity

$/Q

D = MR

QC

PC

MC AC

DLR

MRLR

QMC

P

Quantity

Perfect Competition Monopolistic Competition


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.


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


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 balance by benefit of increased product diversity – may easily outweigh deadweight loss


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?


Elasticities of Demand forBrands of Colas and Coffee


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.


Oligopoly – Characteristics

Small number of firmsProduct differentiation may or may not

existBarriers to entry

Scale economies Patents Technology Name recognition Strategic action


Oligopoly

Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment


Exhibit 4: Economies of Scale as a Barrier to Entry

Do

llars

pe

r u

nit

c a

cb

Autos per year S

b

a

Long-runaverage

cost

0

If a new entrant sells only S cars, the average cost per unit, ca, exceeds the average cost, cb, of a manufacturer that sells enough cars to reach the minimum efficiency scale, M.If autos sell for a price less than ca, a potential entrant can expect to lose money.

M


High Costs of Entry

Total investment needed to reach the minimum size

Advertising a new product enough to compete with established brands

High start-up costs and presence of established brand names: the fortunes of a new product are very uncertain


Oligopoly

Management Challenges Strategic actions to deter entry

Threaten to decrease price against new competitors by keeping excess capacity

Rival behaviorBecause only a few firms, each must consider

how its actions will affect its rivals and in turn how their rivals will react.


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


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


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



Procter & Gamble had to consider competitors prices when setting their price.

P&G’s demand curve was:

Q = 3,375P-3.5(PU).25(PK).25

Where P, PU, PK are P&G’s, Unilever’s, and Kao’s

prices respectively

DON’T WORRY ABOUT EXACT DEMAND CURVE…JUST THAT THEY ARE INTERDEPENDENT



What price should P&G 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


PRICING PROBLEM

Remember that competitors have the same info and making the same decision

SUPPOSE that competitors charged $1.50 OR MORE…best for you to do is charge $1.40. Competitors know the same thing, so it is true for them as well.

SUPPOSE that competitors charged $1.30? Lose the least by charging $1.40


P&G’s Profit (in thousands of $ per month)


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


Competition Versus Collusion:The 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 don’t firms cooperate without explicitly colluding? Why not set profit maximizing collusion price

and hope others follow?



Competitor is not likely to followCompetitor 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



Assume:

16$ 6$ :Collusion

12$ 4$ :mEquilibriuNash

212 :demand s2' Firm

212 :demand s1' Firm

0$ and 20$

12

21

P

P

PPQ

PPQ

VCFC



Possible Pricing Outcomes:

4$204)6)(2(12)6(

20

20$206)4)(2(12)4(

20

4$ 6$

$16 6$ :2 Firm 6$ :1 Firm

111

222

QP

QP

PP

PP


Payoff Matrix for Pricing GameFirm 2

Firm 1

Charge $4 Charge $6

Charge $4

Charge $6

$12, $12 $20, $4

$16, $16$4, $20



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



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.


-5, -5 -1, -10

-2, -2-10, -1

Payoff Matrix for Prisoners’ Dilemma

Prisoner A

Confess Don’t confess

Confess

Don’tconfess

Prisoner B

Would you choose to confess?


Oligopolistic Markets

Conclusions

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


Charge $1.40 Charge $1.50

Charge$1.40

Unilever and Kao

Charge$1.50

P&G

$12, $12 $29, $11

$3, $21 $20, $20

Payoff Matrix for the P&G Pricing Problem

What price should P & G choose?


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.


Observations of Oligopoly Behavior

2. In other oligopoly markets, the firms are very aggressive and collusion is not possible.

a. Firms are reluctant to change price because of the likely response of their competitors.

b. In this case prices tend to be relatively rigid.


Price Rigidity

Firms have strong desire for stabilityPrice 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


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


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.


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


Cartels

Examples of successful cartels OPEC International Bauxite

Association Mercurio Europeo

Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa


Cartels – Conditions for Success

1. 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


Cartels – Conditions for Success

2. 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


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


Cartels

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


Cartels

To be successful: Total demand must not be very price elastic Either the cartel must control nearly all of the

world’s supply or the supply of noncartel producers must not be price elastic


The Cartelization of Intercollegiate Athletics

1. Large number of firms (colleges)

2. Large number of consumers (fans)

3. Very high profits



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



Although members have occasionally broken rules and regulations, has been a successful cartel

In 1984, Supreme Court ruled that the NCAA’s monopolization of football TV contracts was illegal Competition led to drop in contract fees More college football on TV, but lower

revenues to schools


Oligopoly and Perfect Competition

Price is usually higher under oligopolyProfits are higher under oligopoly

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


Comparison of Market Structures

Documents

Monopolistic Competition and Oligopoly Cheryl Carleton Asher Villanova University