Managerial economics

1. Monopolistic CompetitionMonopolistic Competition
and Oligopolyand Oligopoly

2. Monopolistic CompetitionMonopolistic Competition
 CharacteristicsCharacteristics
1.1. Many firmsMany firms
2.2. Free entry and exitFree entry and exit
3.3. Differentiated productDifferentiated product
Two important characteristics:Two important characteristics:
• Differentiated but highly substitutable productsDifferentiated but highly substitutable products
• Free entry and exitFree entry and exit

3. Monopolistic CompetitionMonopolistic Competition
 The amount of monopoly powerThe amount of monopoly power
depends on the degree ofdepends on the degree of
differentiationdifferentiation
 Examples of this very commonExamples of this very common
market structure include:market structure include:
– ToothpasteToothpaste
– SoapSoap

4. A Monopolistically CompetitiveA Monopolistically Competitive
Firm in the Short and Long RunFirm in the Short and Long Run
Quantity
$/Q
Quantity
$/Q
MC
AC
MC
AC
DSR
MRSR
DLR
MRLR
QSR
PSR
QLR
PLR
Short Run Long Run

5. A Monopolistically CompetitiveA Monopolistically Competitive
Firm in the Short and Long RunFirm in the Short and Long Run
 Short runShort run
– Downward sloping demand –Downward sloping demand –
differentiated productdifferentiated product
– Demand is relatively elastic – goodDemand is relatively elastic – good
substitutessubstitutes
– MR < PMR < P
– Profits are maximized when MR = MCProfits are maximized when MR = MC
– This firm is making economic profitsThis firm is making economic profits

6. A Monopolistically CompetitiveA Monopolistically Competitive
Firm in the Short and Long RunFirm in the Short and Long Run
 Long runLong run
– Profits will attract new firms to theProfits will attract new firms to the
industry (no barriers to entry)industry (no barriers to entry)
– The old firm’s demand will decrease toThe old firm’s demand will decrease to
DDLRLR
– Firm’s output and price will fallFirm’s output and price will fall
– Industry output will riseIndustry output will rise
– No economic profit (P = AC)No economic profit (P = AC)
– P > MCP > MC  some monopoly powersome monopoly power

7. Oligopoly – CharacteristicsOligopoly – Characteristics
 Product differentiation may or may notProduct differentiation may or may not
existexist
 Interdependence-decisions areInterdependence-decisions are
interdependentinterdependent
 Barriers to entryBarriers to entry
– PatentsPatents
– TechnologyTechnology
– Strategic actionStrategic action
 Small number of firmsSmall number of firms

8. OligopolyOligopoly
 ExamplesExamples
– AutomobilesAutomobiles
– SteelSteel
– AluminumAluminum
– Electrical equipmentElectrical equipment

9. OligopolyOligopoly
 Management ChallengesManagement Challenges
– Strategic actions to deter entryStrategic actions to deter entry
Threaten to decrease price against newThreaten to decrease price against new
competitors by keeping excess capacitycompetitors by keeping excess capacity
– Rival behaviorRival behavior
Because only a few firms, each mustBecause only a few firms, each must
consider how its actions will affect its rivalsconsider how its actions will affect its rivals
and in turn how their rivals will reactand in turn how their rivals will react

10. Oligopoly – EquilibriumOligopoly – Equilibrium
 If one firm decides to cut their price,If one firm decides to cut their price,
they must consider what the otherthey must consider what the other
firms in the industry will dofirms in the industry will do
 Actions and reactions are dynamic,Actions and reactions are dynamic,
evolving over timeevolving over time

11. Price RigidityPrice Rigidity
 Firms have strong desire for stabilityFirms have strong desire for stability
 Price rigidity – characteristic ofPrice rigidity – characteristic of
oligopolistic markets by which firmsoligopolistic markets by which firms
are reluctant to change prices even ifare reluctant to change prices even if
costs or demands changecosts or demands change
– Fear lower prices will send wrongFear lower prices will send wrong
message to competitors, leading to pricemessage to competitors, leading to price
warwar
– Higher prices may cause competitors toHigher prices may cause competitors to
raise theirsraise theirs

12. Price RigidityPrice Rigidity
 Basis ofBasis of kinked demand curvekinked demand curve
modelmodel of oligopolyof oligopoly
– Each firm faces a demand curve kinkedEach firm faces a demand curve kinked
at the current prevailing price, P*at the current prevailing price, P*
– Above P*, demand is very elasticAbove P*, demand is very elastic
If P > P*, other firmsIf P > P*, other firms will notwill not followfollow
– Below P*, demand is very inelasticBelow P*, demand is very inelastic
If P < P*, other firmsIf P < P*, other firms willwill followfollow

13. Price RigidityPrice Rigidity
 With a kinked demand curve,With a kinked demand curve,
marginal revenue curve ismarginal revenue curve is
discontinuousdiscontinuous
 Firm’s costs can change withoutFirm’s costs can change without
resulting in a change in priceresulting in a change in price
 Kinked demand curve does not reallyKinked demand curve does not really
explain oligopolistic pricingexplain oligopolistic pricing
– Description of price rigidity rather thanDescription of price rigidity rather than
an explanation of itan explanation of it

14. The Kinked Demand CurveThe Kinked Demand Curve
$/Q
Quantity
MR
D
If the producer lowers price, the
competitors will follow and the
demand will be inelastic.
If the producer raises price, the
competitors will not and the
demand will be elastic.
P*

15. The Kinked Demand CurveThe Kinked Demand Curve
$/Q
D
P*
Q*
MC
MC’
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.
MR
Quantity

16. RecapRecap
 Monopolistic CompetitionMonopolistic Competition
– CharacteristicsCharacteristics
– Short run and long runShort run and long run
 OligopolyOligopoly
– CharacteristicsCharacteristics
– Price rigidity-market equlibriumPrice rigidity-market equlibrium