The Monopolistic Competition MarketStructure• A market structure characterized by: ▫ Many small sellers ▫ A differentiated product ▫ Easy market entry & exit• This market structure fits many real-world industries
Many Small Sellers• The exact number cannot be stated.• This structure is one where the seller can set prices slightly higher or improve services independently without fear that competitors will react by changing their prices or giving better service.
Differentiated Product• This is the key difference between perfect competition and monopolistic competition ▫ Def: Production differentiation is the process creating real or apparent differences between goods and services
Examples of Differentiated Products• Design• Reliability• Location• Costly information
How do they compete• They often compete on non-price competition ▫ Advertising ▫ Packaging ▫ Product development ▫ Better quality ▫ Better services
Easy Entry & Exit• They face low barriers to entry, but it is not as easy to enter as perfect competition.• Because there are differentiated products it is hard for firms to get established in these markets. ▫ Example: new restaurants in town
Monopolistically Competitive Firms arePrice Makers• They are not price takers, meaning they let the market set the price.• Thus the demand curve is less elastic than the perfectly competitive firm, but more elastic than the monopolist.
What do the Demand and MarginalRevenue Curve look like • Demand and marginal revenue are negatively- sloped ▫ Negatively-sloped demand curve⇒marginal revenue is less than price at each quantity. ▫ Marginal revenue curve is negatively-sloped and lies below the demand curve.
Short-Run• The monopolistically competitive firm will maximize profit at MR=MC.• If short-run economic losses occur, then the firm will exit the market.
Long-Run• The firms will not earn a profit, like perfect competition. ▫ Long-run equilibrium: Sellers earn zero economic profit (or a normal accounting profit).
13 Monopolistic Competition and OligopolyShort-Run EquilibriumThe profit-maximizing quantitywhere marginal revenue equalsmarginal cost . . .is 150 pairs of jeans per day.The maximum price consumersare willing to pay for 150 pairs is$70 per pair.The average total cost to produce150 pairs is $20 per pair, . . .so economic profit is $50 perpair or $7,500 a day.
14 Monopolistic Competition and OligopolyAdjustment from Short Run toLong RunShort-run economic profitcreates an incentive for entry ofnew resources.With increased competition,demand decreases to D andmarginal revenue decreases toMR.
How does it Compare to Perfect Competition• The monopolistically competitive firm also fails the efficiency test, P>MC.• The value to consumers is greater than the cost of producing it.• The L-R equilibrium output is lower than the perfect competitive firm and the price is higher.• What does this mean?
The Oligopoly Market Structure• An imperfectly competitive market structure in which a few large firms dominate the market• How to define an oligopoly? ▫ Few sellers ▫ Either a homogenous or a differentiated product ▫ Difficult market entry
Few Sellers• Again, there is no specific number that must dominate an industry before it is an oligopoly.• The components of an oligopoly are the mutual interdependence . ▫ Def: Mutual interdependence in which an action by one firm may cause a reaction from other firms.• Being there are only a few firms in the market, it is easy to collude in the market
Homogenous or DifferentiatedProduct• The goods produced may be identical or may not be identical.
Difficult Entry• Some barriers: ▫ Exclusive financial requirements ▫ Control over an essential resource ▫ Patent rights ▫ Other legal barriers ▫ Economies of Scale- this is the major one
Examples of Oligopolies• Characteristics of Oligopoly ▫ Examples• Do sellers in these markets behave competitively or monopolistically? • Beverages (soft drinks) • Music (CD’s) • Tobacco • Automobiles
• Characteristics of Oligopoly• In 2007 (after 2008, “the Big Three” went from 70% of the market to 50%): U.S. Market Share of Largest Sellers in Market Beverages Tobacco Cars Seller Share Seller Share Seller Share Phillip Coke 44.5% Morris 49.4% GM 29.3% R.J. Pepsi 31.4% 24.0% Ford 24.9% Reynolds Brown andCadbury 14.4% Williamson 15.0% Chrysler 16.1% Total 90.3% Total 88.4% Total 70.3%
Price and Output for an Oligopolist• The maximize price is not as simple at MR=MC. One player’s move depends on the anticipated reactions of the opposing player.• The oligopoly can compete on several different levels. ▫ Non-price competition ▫ Price Leadership ▫ The Cartel ▫ Game Theory
Non-price Competition• They often compete using advertising & product differentiation• This is why research & development is so important in these type of firms.
Price Leadership• They play a game of follow the leader. ▫ Def: Price leadership is a pricing strategy in which a dominant firm sets the price for an industry and the other firms follow
Collusion• An agreement among firms in the industry to divide the market and fix the prices
The Cartel• Firms may decide to avoid price wars and they may openly or secretly conspire to form a monopoly called a “cartel.” ▫ Def: A cartel is a group of firms that formally agree to control the price and the output of a product
CARTELSAnatomy of a Cartel:OPECIn the 1970’s, OPEC succeededin limiting the supply of crudeoil produced by membercountries so as to increase theprice.After 1980, however, the marketimploded. Price fell almost asmuch as it had risen.What happened? Why was thecartel’s success so short-lived? Monopolistic Competition and Oligopoly 28
Monopolistic Competition and 29 OligopolyCARTELS• Anatomy of a Cartel: OPEC ▫ Reaching agreement
Monopolistic Competition and 30 OligopolyCARTELS• Anatomy of a Cartel: OPEC ▫ New sources of supply
Monopolistic Competition and• Anatomy of a Cartel: OPEC 31 Oligopoly ▫ Greater energy efficiency and consumer substitution
Monopolistic Competition and• Anatomy of a Cartel: OPEC 32 Oligopoly ▫ Detecting and preventing cheating
Monopolistic Competition and 33 OligopolyCARTELS• Anatomy of a Cartel: OPEC ▫ Enforcing the agreement
Game Theory• Def: Game theory is a model of strategic moves and countermoves of rivals ▫ They are mutually interdependence because an action by one firm may cause a reaction from the other firm.
Game Theory• In an oligopoly structure, a few firms compete for their customers. One firm may gain customers by decreasing the price at the expense of the other firms or they may increase advertising.• In an oligopoly, the important element is those firms that do not follow suit will lose customers. However, if the other firms react competitively by doing the same, then all the firms lose. Thus, each firm finds itself on the horns of a dilemma- this example is known as the classic “prisoner’s dilemma.”
Game Theory• Economists have increasingly used game theory (like the example of the prisoner’s dilemma) to analyze strategic choices made by competitors.
Example of Game Theory• To see how this works, think about two touring Americans who just met at a train station in a small foreign country : Joe and William.• The two are taken into the local police station under the suspicion of being involved in a local robbery of the bakery.• The two are told that it will make the polices’ job easier if they confess immediately, giving them 6 months of jail time each. But they are also told that if one confesses and the other does not, then the one who confesses will get 6 months of jail time, but the one who does not confess will get 12 months.
Example of Game Theory• If neither confesses, both will be held for three months while the investigation continues. William and Joe are not allowed to communicate with each other. Will they confess? ▫ In order to figure this out, we must lay out the alternative outcomes and show how they would relate to the choices made by the players of the game. This is done in a matrix form.
Example of Game Theory Joe’s Choice Confess Not Confess Confess 6 months each Joe: 12 monthsWilliam’s William: 6 monthsChoice Not Confess Joe: 6 months 3 months each William: 12 months
Example of Game Theory• For both Joe and William, the best choice depends on what the other does. If Joe confesses, then William can save 6 months of jail time by also confessing. The same will hold for William if he thinks that Joe is going to confess. But if neither confesses then they both will only receive 3 months of jail time. Joe and William must each decide, without communicating with each other, whether to confess.
Example of Game Theory• Joe knows that if William does not confess, then he can either confess and spend 6 months in jail, or not confess and spend 3 months. But if William does confess, then Joe’s failure to confess will cost him an additional 6 months in jail. The story for William is the same… Thus, each man has an incentive to confess if he thinks the other one will, but an incentive not to confess if he thinks the other will also remain silent.
How does this apply to Oligopoly?• The firms must make decisions in this same way, they are dependent on what the other firm is going to do. For instance, if one firm cuts its price, then how do the other firms react? Do they choice to advertise or not? ▫ There is always a trade-off for the individual firms.