Chap7

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Chap7

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