chap013 oligopoly, monopolistic competition & price strategy

8/8/2019 Chap013 Oligopoly, Monopolistic Competition & Price Strategy

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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., AllRights Reserved.

MonopolisticMonopolistic

Competition, Oligopoly,Competition, Oligopoly,and Strategic Pricingand Strategic Pricing

Chapter 13


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Laugher CurveLaugher Curve

In Canada, there is a small radical group

that refuses to speak English and no one

can understand them.

They are called separatists.


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Laugher CurveLaugher Curve

In the United States we have the same

kind of group.

They are called economists.

Nations Business


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IntroductionIntroduction

s Market structure is the focus real-world

competition.

s Market structure refers to the physical

characteristics of the market within which

firms interact.


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s Market structure involves the number of

firms in the market and the barriers to

entry.


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s Perfect competition, with an infinite

number of firms, and monopoly, with a

single firm, are polar opposites.s Monopolistic competition and oligopoly lie

between these two extremes.


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Rights Reserved.


s Monopolistic competition is a market

structure in which there are many firms

selling differentiated products.s There are few barriers to entry.



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s Oligopolyis a market structure in which

there are a few interdependent firms.

s There are often significant barriers toentry.



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Problems DeterminingProblems Determining

Market StructureMarket Structures Defining a market has problems:

qWhat is an industry and what is its

geographic market -- local, national, orinternational?

qWhat products are to be included in thedefinition of an industry?



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Classifying IndustriesClassifying Industries

s One of the ways in which economists

classify markets is by cross-price

elasticities.qCross-price elasticitymeasures the

responsiveness of the change in demand

for a good to change in the price of arelated good.


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s Industries are classified by government

using the North American Industry

Classification System (NAICS).qThe North American Industry Classification

System (NAICS) is a classification system ofindustries adopted by Canada, Mexico, and the U.S.

in 1997.


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s When economists talk about industry

structure the general practice is to refer to

three-digit industries.qUnder the NAICS, a two-digit industry is

a broadly based industry.

q

A three-digit industry is a specific typeof industry within a broadly defined two-digit industry.


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Two- and Four- DigitTwo- and Four- Digit

Industry GroupsIndustry Groups


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Determining IndustryDetermining Industry

StructureStructures Economists use one of two methods to

measure industry structure:

qThe concentration ratio.qThe Herfindahl index.


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Concentration RatioConcentration Ratio

s The concentration ratio is the value of

sales by the top firms of an industry stated

as a percentage of total industry sales.


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Concentration RatioConcentration Ratio

s The most commonly used concentration

ratio is the four-firm concentration ratio.

s The higher the ratio, the closer to anoligopolistic or monopolistic type of market

structure.


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The Herfindahl IndexThe Herfindahl Index

s The Herfindahl indexisan index of

market concentration calculated by adding

the squared value of the individual marketshares of all firms in the industry.


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s The Herfindahl index gives higher weights

to the largest firms in the industry because

it squares market shares.


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s The Herfindahl Index is used as a rule of

thumb by the Justice Department to

determine whether a merger be allowed totake place.q If the index is less than 1,000, the industry

is considered competitive thus allowing themerger to take place.


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Concentration Ratios andConcentration Ratios and

the Herfindahl Indexthe Herfindahl Index


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Conglomerate Firms andConglomerate Firms and

BignessBignesss Neither the four-firm concentration ratio or

the Herfindahl index gives a complete

picture of corporations bigness.


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Conglomerate Firms andConglomerate Firms and

BignessBignesss This is because many firms are

conglomerates huge corporations

whose activities span various unrelatedindustries.


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The Importance ofThe Importance ofClassifying IndustryClassifying IndustryStructureStructures The less concentrated industries are more

likely to resemble perfectly competitive

markets.


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The Importance ofThe Importance ofClassifying IndustryClassifying IndustryStructureStructures The number of firms in an industry play a

role in determining whether firms explicitly

take other firms actions into account.


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The Importance ofThe Importance ofClassifying IndustryClassifying IndustryStructureStructures It is unlikely that an monopolistically

competitive firm will explicitly take into

account rival firms responses to itsdecisions.


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The Importance ofThe Importance ofClassifying IndustryClassifying IndustryStructureStructures In oligopoly, with fewer firms, each firm

explicitly engages in strategic decision

making.s Strategic decision making taking

explicit account of a rivals expected

response to a decision you are making.


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Monopolistic CompetitionMonopolistic Competition

s The four distinguishing characteristics of

monopolistic competition are:

qMany sellers.qDifferentiated products.

qMultiple dimensions of competition.

q Easy entry of new firms in the long run.


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Many SellersMany Sellers

s When there are many sellers, they do not

take into account rivals reactions.

s The existence of many sellers makescollusion difficult.

s Monopolistically competitive firms act

independently.


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Differentiated ProductsDifferentiated Products

s The many sellers characteristic gives

monopolistic competition its competitive

aspect.s Product differentiation gives monopolistic

competition its monopolistic aspect.


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Differentiated ProductsDifferentiated Products

s Differentiation exists so long as advertising

convinces buyers that it exists.

s Firms will continue to advertise as long asthe marginal benefits of advertising exceed

its marginal costs.


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Multiple Dimensions ofMultiple Dimensions of

CompetitionCompetitions One dimension of competition is product

differentiation.

s Another is competing on perceived quality.s Competitive advertising is another.

s Others include service and distribution

outlets.


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Easy Entry of New FirmsEasy Entry of New Firms

in the Long Runin the Long Runs There are no significant barriers to entry.

s Barriers to entry prevent competitive

pressures.s Ease of entry limits long-run profit.


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Output, Price, and ProfitOutput, Price, and Profitof a Monopolisticof a MonopolisticCompetitorCompetitors A monopolistically competitive firm prices

in the same manner as a monopolist

where MC = MR.s But the monopolistic competitor is not only

a monopolist but a competitor as well.


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Output, Price, and ProfitOutput, Price, and Profitof a Monopolisticof a MonopolisticCompetitorCompetitors At equilibrium,ATCequals price and

economic profits are zero.

s This occurs at the point of tangency of theATCand demand curve at the output

chosen by the firm.


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MC

ATC

MR D

QM

PM

Price

0 Quantity


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Comparing Perfect andComparing Perfect and

Monopolistic CompetitionMonopolistic Competitions Both the monopolistic competitor and the

perfect competitor make zero economic

profit in the long run.


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Monopolistic CompetitionMonopolistic Competitions The perfect competitors demand curve as

perfectly elastic.

s Zero economic profit means that itproduces at the minimum of the ATC

curve.


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Monopolistic CompetitionMonopolistic Competitions A monopolistic competitor faces a

downward sloping demand curve, and

produces where MC = MR.s TheATCcurve is tangent to the demand

curve at that level, which is not at the

minimum point of theATCcurve.


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Monopolistic CompetitionMonopolistic Competitions Increasing market share is a relevant

concern for a monopolistic competitor but

not for a perfect competitor.


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Perfect competition Monopolistic competition



MC

PC

D

QC

Price

0 Quantity

ATC

PM

MC

ATC

DMR

QM

Quantity0

Price

QC

PC



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Comparing MonopolisticComparing MonopolisticCompetition withCompetition withMonopolyMonopolys It is possible for the monopolist to make

economic profit in the long-run.

s No long-run economic profit is possible inmonopolistic competition.


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Advertising andAdvertising and

Monopolistic CompetitionMonopolistic Competitions Firms in a perfectly competitive market

have no incentive to advertise

s Monopolistic competitors have a strongincentive to do so.


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Goals of AdvertisingGoals of Advertising

s The goals of advertising include shifting

the demand curve to the right and making

it more inelastic.s Advertising shifts theATCcurve up.


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Does Advertising Help orDoes Advertising Help or

Hurt Society?Hurt Society?s There is a sense of trust in buying brands

we know.

s If consumers are willing to pay fordifferentness, its a benefit to them.


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Characteristics OligopolyCharacteristics Oligopoly

s Oligopolies are made up of a small number

of mutually interdependent firms.

s Each firm must take into account theexpected reaction of other firms.


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Models of OligopolyModels of Oligopoly

BehaviorBehaviors No single general model of oligopoly

behavior exists.

s Two models of oligopoly behavior are thecartel model and the contestable market

model.


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The Cartel ModelThe Cartel Model

s A cartelis a combination of firms that acts

as it were a single firm.

s A cartel is a shared monopoly.s In the cartel model, an oligopoly sets a

monopoly price.


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s If oligopolies can limit the entry of other

firms and form a cartel, they can increase

the profits going to the firms in the cartel.


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s The cartel model of oligopoly:qOligopolies act as if they were monopolists,

qThat have assigned output quotas toindividual member firms,

q So that total output is consistent with jointprofit maximization.


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Implicit Price CollusionImplicit Price Collusion

s Formal collusion is illegal in the U.S. while

informal collusion is permitted.

s Implicit price collusion exists whenmultiple firms make the same pricing

decisions even though they have not

consulted with one another.


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Implicit Price CollusionImplicit Price Collusion

s Sometimes the largest or most dominant

firm takes the lead in setting prices and the

others follow.


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Cartels andCartels and

Technological ChangeTechnological Changes Cartels can be destroyed by an outsider

with technological superiority.

s Thus, cartels with high profits will provideincentives for significant technological

change.


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Why Are Prices Sticky?Why Are Prices Sticky?

s Informal collusion is an important reason

why prices are sticky.

s Another is the kinked demand curve.


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Why Are Prices Sticky?Why Are Prices Sticky?

s When there is a kink in the demand curve,

there has to be a gap in the marginal

revenue curve.s The kinked demand curve is not a theory

of oligopoly but a theory of sticky prices.


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D2

The Kinked DemandThe Kinked Demand

CurveCurve

D1

MR2

MR1

Price

Quantity0 Q

P

ab

c

d

MC0

MC1


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The Contestable MarketThe Contestable Market

ModelModels According to the contestable market

model, barriers to entry and barriers to exit

determine a firms price and outputdecisions.q Even if the industry contains only one

firm, it could still be a competitivemarket if entry is open.


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The Contestable MarketThe Contestable Market

ModelModels In the contestable market model, an

oligopoly with no barriers to entry sets a

competitive price.

C i hC i th


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Comparing theComparing theContestable Market andContestable Market andCartel ModelsCartel Modelss The stronger the ability of oligopolists to

collude and prevent market entry, the

closer it is to a monopolistic situation.s The weaker the ability to collude is, the

more competitive it is.

s Oligopoly markets lie between these twoextremes.


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Strategic Pricing andStrategic Pricing and

OligopolyOligopolys Both the cartel and contestable market

models use strategic pricing decisions

firms set their price based on the expectedreactions of other firms.

N E t Li itN E t Li it


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New Entry as a Limit onNew Entry as a Limit onthe Cartelizationthe Cartelization

StrategyStrategys The threat from outside competition limits

oligopolies from acting as a cartel.

s The newcomer may not want to cooperatewith the other firms.


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Price WarsPrice Wars

s Price wars are the result of strategic

pricing decisions gone wild.

s Sometimes a firm engages in this activitybecause it hates its competitor.


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Price WarsPrice Wars

s A firm may develop a predatory pricing

strategy as a matter of policy.

s Apredatory pricing strategyinvolves temporarily pushing theprice down in order to drive a competitor out of business.

G Th dG Th d


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Game Theory andGame Theory andStrategic DecisionStrategic Decision

MakingMakings Most oligopolistic strategic decision

making is carried out with explicit or

implicit use of game theory.s Game theoryis the application of

economic principles to interdependent

situations.

G Th dG Th d


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MakingMakings Theprisoners dilemma is a well-known

game that demonstrates the difficulty of

cooperative behavior in certaincircumstances.

G Th dG Th d


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MakingMakings In the prisoners dilemma, where mutual

trust gets each one out of the dilemma,

confessing is the rational choice.


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Prisoners Dilemma and aPrisoners Dilemma and a

Duopoly ExampleDuopoly Examples The prisoners dilemma has its simplest

application when the oligopoly consists of

only two firmsa duopoly.


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Prisoners Dilemma and aPrisoners Dilemma and a

Duopoly ExampleDuopoly Examples By analyzing the strategies of both firms

under all situations, all possibilities are

placed in a payoffmatrix.s Apayoff matrixis a box that contains

the outcomes of a strategic game under

various circumstances.


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Firm and Industry DuopolyFirm and Industry Duopoly

Cooperative EquilibriumCooperative Equilibrium

Pr

ice

Pr

ice

575

$800

700

600

500

400

300

200

100

0

(a) Firm's cost curves

1 2 3 4 5 6 7 8

Quantity (in thousands)

MCATC

$800

700

600

500

400

300

200

100

01 2 3 4 5 6 7 8 9 10 11

Monopolistsolution

MR

D

Competitivesolution

MC

(b) Industry: Competitive and monopolist solution



Fi d I d t D lFi d I d t D l


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Firm and Industry DuopolyFirm and Industry DuopolyEquilibrium When One FirmEquilibrium When One Firm

CheatsCheats

Pr

ice

Pr

ice

Pr

ice

$800

700

600

500

400

300

200

100

0

$800

700

600

500

400

300

200

100

0

$900

800

700

600

500

400

300

200

100

0

550 550 550

1 2 3 4 5 6 7 1 2 3 4 5 6 7

A

MCATC


(a) Noncheating firms loss

A

MCATC


(b) Cheating firms profit

AB

C

1 2 3 4 5 6 7 8


(c) Cheating solution

Non-cheating

firmsoutput

Cheatingfirms

output



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Duopoly and a PayoffDuopoly and a Payoff

MatrixMatrixs The duopoly is a variation of the prisoner's

dilemma game.

s The results can be presented in a payoffmatrix that captures the essence of the

prisoner's dilemma.


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B Cheats

B Does notcheat

A Does not cheat A Cheats

B +$200,000 B 0

A 0

A +$200,000

B $75,000

A $75,000

A $75,000

B $75,000

The Payoff Matrix ofThe Payoff Matrix of

Strategic Pricing DuopolyStrategic Pricing Duopoly

Oligopoly ModelsOligopoly Models


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Oligopoly Models,Oligopoly Models,Structure, andStructure, and

PerformancePerformances Oligopoly models are based either on

structure or performance.

qThe four-fold division of marketsconsidered so far are based on marketstructure.

qStructure means the number, size, andinterrelationship of firms in the industry.



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PerformancePerformances A monopoly is the least competitive,

perfectly competitive industries are the

most competitive.


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PerformancePerformances There is a similarity in the two approaches.

qOften barriers to entry are the reason thereare only a few firms in an industry.

qWhen there are many firms, that suggests thatthere are few barriers to entry.

q In the majority of cases, the two approachescome to the same conclusion.


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MonopolisticMonopolisticCompetition, Oligopoly,Competition, Oligopoly,and Strategic Pricingand Strategic Pricing

End of Chapter 13

chap013 oligopoly, monopolistic competition & price strategy

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