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  • 1. CHAPTER 7: MARKET STRUCTURE: MONOPOLISTIC COMPETITION & OLIGOPOLY
  • 2. 7.1 Characteristic of Monopolistic Competition 7.2 Short-run Decision: Profit Maximization 7.3 Short-run Decision: Minimizing Loss 7.4 Long-run Equilibrium 7.5 E conomic E fficiency and R esource A llocation Chapter Outline
  • 3.
    • 7. 6 Characteristic of Oligopoly
    • 7.7 Oligopoly Model
    • 7.8 Games Theory
    Chapter Outline
  • 4.
    • Definition:
      • A common form of industry (market) structure characterized by a large number of small firms, none of which can influence market price by virtue of size alone.
      • Some degree of market power is achieved by firms producing differentiated products.
      • New firms can enter and established firms can exit such an industry with ease.
      • For example: an individual restaurant
    MONOPILSTIC COMPETITION
  • 5.
    • Large number of sellers
      • A large number of firms but it is less than perfect competition.
      • The size of each firm is small and therefore, no individual firm can influence the market price.
    • Product differentiation
      • The firms produce goods which are differentiated, that is, they are not identical.
      • Each seller will use various methods to differentiate their products from other sellers.
      • Differentiation of the product may be through the packaging, design, labeling, advertising and brand names.
  • 6.
    • characteristic..
    • Free entry & exit
      • There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.
    • Advertising
      • Each firm tries to promote its product by using different types of advertisements include banners, media advertisements, pamphlets etc.
      • provides consumers with the valuable information on product availability, quality, and price.
  • 7. characteristic..
    • Non-price competition
      • Monopolistic do not compete base on price as they are price takers.
      • They create a sense of brand consciousness among customers.
      • Types of non-price competition are advertisements, promotions, discounts, free gifts and so on.
  • 8.
    • When MR = MC;
      • The profit-maximizing quantity occurs while the price is found up on the demand curve at that quantity .
      • The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.
  • 9. Profit ??? SUPERNORMAL PROFIT
  • 10. Loss ??? SUBNORMAL PROFIT
  • 11. NORMAL PROFIT?
  • 12.
    • There is not guaranteed an economic profit in the market.
    • When ATC > demand curve, no quantity allows the firm to escape a loss.
      • Firm must decide whether to produce at a loss or choose to shut down.
    • Keep production:
      • As long as price exceeds AVC.
    • Shut down:
      • If the price cannot cover the AVC.
    7.3 SHORT-RUN DECISION: MINIMIZING LOSS
  • 13.
    • Firm will continue to produce in the short run if the price exceeds AVC.
    SHORT-RUN DECISION: MINIMIZING LOSS
  • 14.
    • Free entry :
    • If the firms are making supernormal profit in the short-run, they will attract more firms to enter the market.
    • Decrease the demand for existing firms , so the demand curve will shift leftward.
    • The process will continue until all profits are eliminated and (P = ATC).
    • In the long-run, a monopolistic firm will earn normal profit .
    7.4 LONG-RUN EQUILIBRIUM
  • 15.
    • Free entry :
    LONG-RUN EQUILIBRIUM Quantity Price MC ATC DD 0 DD 1 MR P 0 P 1 = ATC Q
  • 16.
    • Free exit :
    • If the firms are making subnormal profit in the short-run, the existing firms will exit from the market.
    • Increase the demand for existing firms , so the demand curve will shift rightward.
    • The process will continue until all losses are eliminated and (P = ATC).
    • In the long-run, a monopolistic firm will earn normal profit .
    LONG-RUN EQUILIBRIUM
  • 17.
    • LONG-RUN EQUILIBRIUM
    • Free exit ?
  • 18.
    • There are two noteworthy differences between monopolistic and perfect competition
      • excess capacity and markup over MC .
    • Excess Capacity
      • Free entry results in competitive firms producing at the point where ATC is minimized, which is the efficient scale of the firm.
      • In monopolistic competition, the firm has excess capacity if its output is less than the efficient scale of perfect competition.
    7.5 ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION
  • 19.
    • Mark up over marginal cost
      • F or a competitive firm , price equal marginal cost.
      • For a monopolistically competitive firm, price exceeds marginal cost because the firm has some market power.
      • Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically firm.
  • 20.
    • Monopolistic versus perfect competition
    D Quantity Price MC ATC MR P Q MC Price Quantity MC ATC P=MR P=MC Q PC (efficient scale) a) Monopolistic b) Perfect Competition MC
  • 21.
  • 22. OLIGOPOLY
    • Definition:
      • A form of industry (market) structure characterized by a few dominant firms .
      • Products may be homogenous or differentiated .
      • The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others (interdependent) .
      • For example: automobile industry/ petroleum
  • 23.
    • Few in number but large in size
      • The market share of each firm is large enough to dominate the market and its controlled by a few firms.
    • Interdependent
      • The behavior of oligopoly firms depend on the behavior of other firms in the industry before making the decision.
    • Homogeneous or differentiated product
      • The products sold may be homogeneous or differentiated.
      • Example: Petroleum (homogenous) and automobiles (differentiated).
  • 24. characteristic
    • Barriers to entry
      • Advertising a new product enough to compete with established brands.
    • Incentive to collude
      • Colluding firms usually reduce output, increase price, and block the entry of new firms to achieve the monopoly power.
  • 25.
    • Price Rigidity and Kinked Demand Curve
      • Price rigidity explain the behavior of an oligopoly firm which has no incentive to either increase or decrease the price of its products.
      • The theory of a kinked demand curve is based on two assumptions :
        • If an oligopoly reduces the price of his product, his rivals will follow and reduces their price too, so as to avoid losing customers.
        • If an oligopolist increase the price of his products, his rival will not increase their price but instead maintain the same prices, thereby gaining customers from which firms which increase their price.
  • 26.
    • Price Rigidity and Kinked Demand Curve (continue..)
    • Based on this two assumptions, oligopoly will face a kinked demand curve.
    • It assumes that rivals will match a price cut but ignore a price increase.
    • The kinked demand curve creates a gap in the MR curve, illustrates the price rigidity of a firm in an oligopoly.
    • Equilibrium price and quantity occur at P* and Q*, when MR = MC.
    • As long as MR intersect with MC curve in the gap, price and output will remain constant.
  • 27.
    • Demand is elastic above the kink, where an increase in price to more than P* will lead to a large drop in quantity as more customers switch to the rival’s lower priced product.
    • Demand is inelastic below the kink where decreasing the price will only reflect a small increase in quantity since all the other firms have reduced their price to below P*.
    Kinked Demand Curve elastic inelastic
  • 28.
    • Definition :
      • Analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms.
      • In game theory, firms are assumed to anticipate rival reactions.
    • Types :
      • Dominant strategies
      • Nash equilibrium
      • Prisoners’ dilemma
  • 29.
    • “ If I believe that my competitors are rational and act to maximize their own profits, how should I take their behavior into account when making my own profit-maximizing decisions?”
  • 30.
    • Definition :
      • Dominant Strategy is one that is optimal no matter what an opposition does.
    • Example:
      • A & B sell competing products
      • They are deciding whether to undertake advertising campaigns.
      • Their decision is interdependence on other firm decision.
  • 31. Payoff Matrix for Advertising Game: (A,B) Firm A Advertise Not Advertise Advertise Not Advertise Firm B Dominant Strategies A A B A A A What strategy should each firm choose? Game Theory A B A B A B 10 , 5 15 , 0 10 , 2 6 , 8
  • 32.
    • Firm A:
    • If firm B does advertise, Firm A will earn a profit of 10 if it also advertise and 6 if it doesn’t.
    • Thus, firm A should advertise if firm B advertise.
    • If firm B doesn’t advertise, firm A would earn profit of 15 if it advertise and 10 if it doesn’t.
    • Thus, firm A should advertise whether firm B advertise or not.
    • Firm A has dominant strategy!
  • 33.
    • Firm B:
    • If firm A does advertise, Firm B will earn a profit of 5 if it also advertise and 0 if it doesn’t.
    • Thus, firm B should advertise if firm A advertise.
    • If firm A doesn’t advertise, firm B would earn profit of 8 if it advertise and 2 if it doesn’t.
    • Thus, firm B should advertise whether firm A advertise or not
    • Firm B has dominant strategy!
  • 34.
    • Observations
      • Dominant strategy for A & B is to advertise
      • Do not worry about the other player
      • Equilibrium in dominant strategy
    Both firms with advertise. Firm A Advertise Not Advertise Advertise Not Advertise Firm B 10, 5 15, 0 10, 2 6, 8
  • 35.
    • Equilibrium in dominant strategies
      • Outcome of a game in which each firm is doing the best it can regardless of what its competitors are doing.
      • Optimal strategy is determined without worrying about actions of other players.
    • However, not every game has a dominant strategy for each player
  • 36.
    • Definition:
      • When all players are playing their best strategy given what their competitors are doing.
    • Game Without Dominant Strategy
      • The optimal decision of a player without a dominant strategy will depend on what the other player does.
      • Revising the payoff matrix we can see a situation where no dominant strategy exists.
  • 37. Firm A Advertise Not Advertise Advertise Not Advertise Firm B Nash Equilibrium A A A A B B B B What strategy should each firm choose? 10 , 5 15 , 0 20 , 2 6 , 8
  • 38.
    • Observations
      • A: No dominant strategy; depends on B’s actions
      • B: Dominant strategy is to Advertise
      • Firm A determines B’s dominant strategy and makes its decision accordingly
    10 , 5 15 , 0 20 , 2 6 , 8 Firm A Advertise Don’t Advertise Advertise Don’t Advertise Firm B
  • 39.
    • In order for firm A to determine whether to advertise, firm A must first try to determine what firm B will do.
    • If firm B advertises, firm A earns a profit of 10 if it advertises and 6 if it does not.
    • If firm B does not advertise, firm A earns a profit of 15 if it advertises and 20 if it does not.
    • Thus, firm A should advertise if firm B advertise , and it should not advertise if firm B doesn’t .
    10, 5 15, 0 20, 2 6, 8 Firm A Advertise Not Advertise Advertise Not Advertise Firm B
  • 40.
    • Firm A has to determines B’s dominant strategy and makes its decision accordingly.
    • Firm B’s dominant strategy is to advertise , therefore, the optimal strategy for firm A is also to advertise. This is Nash equilibrium.
      • Only when each player has chose its optimal strategy given the strategy of the other player do we have Nash equilibrium .
    10, 5 15, 0 20, 2 6, 8 Firm A Advertise Not Advertise Advertise Not Advertise Firm B
  • 41.
    • Definition:
      • The players are prevented from cooperating with each other;
      • Each player in isolation has a dominant strategy;
      • The dominant strategy makes each player worse off than in the case in which they could cooperate.
  • 42. Prisoners’ Dilemma Firm A Low Price High Price Low Price High Price Firm B What strategy should each firm choose? 2 , 2 5 , 1 3 , 3 1 , 5
  • 43.
    • Firm A:
    • If firm B charged a low price, firm A would earn a profit of 2 if it also charged the low price and 1 if it charge a high price.
    • If firm B charged the high price ,firm A would earn a profit of 5 if it charged the low price and 3 if it charged the high price.
    • Thus, firm A should adopt its dominant strategy of charging the low price .
  • 44.
    • Firm B:
    • If firm A charged a low price, firm B would earn a profit of 2 if it also charged the low price and 1 if it charge a high price.
    • If firm A charged the high price, firm B would earn a profit of 5 if it charged the low price and 3 if it charged the high price.
    • Thus, firm B should adopt its dominant strategy of charging the low price.
  • 45.
    • However, both firms could do better (i.e., earn higher profit of 3) if they cooperated and both charged the higher price (the bottom right cell).
    • Thus, both firms are in a prisoners’ dilemma:
      • Each firm will charge the lower price and earn a smaller profit because if it charges the high price, it cannot trust its rival to also charge the high price.
  • 46.
    • Suppose that firm A charged the high price with the expectation that firm B would also charge the high piece (so that each firm would earn a profit of 3).
    • Given that firm A has charged the higher, however, firm B now has an incentive to charge the low price, because by doing so it can increase its profits to 5.
  • 47.
    • Suppose that firm B charged the high price with the expectation that firm A would also charge the high piece (so that each firm would earn a profit of 3).
    • Given that firm B has charged the higher, however, firm A now has an incentive to charge the low price, because by doing so it can increase its profits to 5.
  • 48.
    • The net result is that each firm charges the low price and earns a profit of only 2.
    • Only if the two firms cooperate and both charge the high price will they earn the highest profit of 3 (and overcome their dilemma)
  • 49.
    • Conclusion:
      • The concept of the prisoner’s dilemma can be used to analyze price and non-price competition in oligopolistic markets, as well as the incentive to cheat in a cartel (i.e., the tendency to secretly cut prices or to sell more than the allocated quota.
  • 50. Game Theory
    • Ginger and Rocky have dominant strategies to confess even though they would be better off if they both kept their mouths shut.
  • 51. Comparison for Market Structure Characteristics of Different Market Organizations
  • 52. THANK YOU