Chapter 10 imperfect comp

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Eastern Illinois University
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Monopolistic Competition
and Oligopoly
1

• Monopolistic competition
–Many producers
–Low barriers to entry
–Slightly different products
• A firm that raises prices: lose some
customers to rivals
–Some control over price „Price makers‟
• Downward sloping demand curve
–Act independently or interdependently
2

• Product differentiation
–Physical differences
• Appearance; quality
–Location
• Spatial differentiation
–Services
–Product image
• Promotion; advertising
3

Short-Run Profit or Loss
• Curves
–Demand curve, D
• Slopes downward
–Marginal revenue, MR
• Below the demand curve
• Slopes downward
–Average total cost, ATC
–Average variable cost, AVC
–Marginal cost, MC
4

Short-Run Profit or Loss
• Maximize profit: MR=MC
–Price: on D curve
• If p>ATC
–Economic profit
• If ATC>p>AVC
–Economic loss; Produce in short run
• If p<AVC: AVC curve above D curve
–Economic loss; Shut down in short run
5

Exhibit 1
6
Monopolistic Competitor in the Short Run
p
c
Dollarsperunit
Quantity per periodq0
MC
D
MR
ATC
e
Profit
(a) Maximizing short-run profit
The monopolistically competitive firm produces the level of output at which marginal revenue
equals marginal cost (point e) and charges the price indicated by point b on the downward-sloping
demand curve. In panel (a), the firm produces q units, sells them at price p, and earns a short-run
economic profit equal to (p-c) multiplied by q, shown by the blue rectangle. In panel (b), the
average total cost exceeds the price at the output where marginal revenue equals marginal cost.
Thus, the firm suffers a short-run loss equal to (c p) multiplied by q, shown by the pink rectangle.
p
c
Dollarsperunit Quantity per periodq0
MC
D
MR
AVC
e
Loss
(b) Minimizing short-run loss
ATC
b
c
b
c

Profit in the Long-Run
• Short run economic profit
–New firms enter the market
–Draw customers away from other firms
–Reduce demand facing other firms
–Profit disappears in long run
• Zero economic profit
7

Profit in the Long-Run
• Short run economic loss
–Some firms exit the market
–Their customers switch to other firms
–Increase demand facing the remaining
firms
–Loss is erased in the long run
• Zero economic profit
8

Exhibit 2
9
Long-Run Equilibrium in Monopolistic Competition
0 q Quantity per period
p
Dollars
perunit
D
MR
MC
a
ATC
b
If existing firms earn economic
profit in the short run, new firms
will enter the industry in the long
run. This entry reduces the
demand facing each firm. In the
long run, each firm‟s demand
curve shifts leftward until marginal
revenue equals marginal cost
(point a) and the demand curve is
tangent to the average total cost
curve (point b). Economic profit is
zero at output q. With zero
economic profit, no more firms will
enter, so the industry is in long-
run equilibrium. The same long-
run outcome occurs if firms suffer
a short-run loss. Firms leave until
remaining firms earn just a normal
profit.

Fast forward to creative destruction
• 1970s, videocassette recorders
–Expensive
–Increased demand for videotaped movies
–Video rental stores
• Security deposits
• Membership fees ($100)
• Little competition
• Short run economic profit
10

• Supply of rental stores increased
–Faster than demand
–Rental rates: $0.99;
–No fees or deposits
• Latest substitutes
–On-demand movies (broadband cable)
–Downloads from the Internet
–Grab-and-go rental kiosks
–Online rental services that mail DVDs
11

• Creative destruction
–„Out with the old, in with the new‟
–Technological change
–Some producers lose
–Consumers benefit
• Wider choice
• More competitive prices
12

Comparison
• Monopolistic competition and perfect
competition
–Zero economic profit in long run
–MR=MC for quantity
• Where demand curve is tangent to average
total cost curve
13

Comparison
• Perfect competition
–Firm‟s demand: horizontal line
–Produces at minimum average cost
–Productive and allocative efficiency
14

Comparison
• Monopolistic competition
–Downward sloping demand curve
–Not producing at minimum average cost
• Excess capacity
–Produces less, charges more
• Than perfect competitor
• In the long run
–Spend more to differentiate their
products
15

Comparison
• Excess capacity
–Difference between a firm‟s profit-
maximizing quantity
–And the quantity that minimizes average
cost
• Firms with excess capacity
–Could reduce average cost
–By increasing quantity
16

Exhibit 3
17
Perfect Competition Versus Monopolistic Competition in
Long-Run Equilibrium
p
Dollarsperunit
Quantity per periodq0
d=MR=AR
(a) Perfect competition
Cost curves are assumed to be the same in each panel. The perfectly competitive firm of panel (a) faces
a demand curve that is horizontal at market price p. Long-run equilibrium occurs at output q, where the
demand curve is tangent to the average total cost curve at its lowest point. The monopolistically
competitive firm of panel (b) is in long-run equilibrium at output q‟, where demand is tangent to the
average total cost curve. Because the demand curve slopes downward in panel (b), the tangency does
not occur at the minimum point of average total cost. Thus, the monopolistically competitive firm
produces less output and charges a higher price than does a perfectly competitive firm with the same
cost curves. Neither firm earns economic profit in the long run. The firm in monopolistic competition has
excess capacity, meaning that it could reduce average cost by increasing its rate of output.
(b) Monopolistic competition
p‟
Dollarsperunit
Quantity per periodq‟0
MC
D
MR
ATCATC
MC

Introduction to Oligopoly
• Oligopoly
–Few firms
–Each behaves interdependently
• The more similar the products
–The greater interdependence
• Undifferentiated oligopoly
–Oligopoly that sells a commodity
18

• Differentiated oligopoly
–Oligopoly that sells products that differ
across suppliers
• Product differentiation
• Physical qualities
• Sales location
• Services
• Product image
19

• Barriers to entry
–Economies of scale
–Legal restrictions
–Brand names
–Control over an essential resource
–High cost of entry
• Start-up costs; advertising
–Crowding out the competition
20

Exhibit 4
21
Economies of Scale as a Barrier to Entry
ca
Dollarsperunit
cb
Autos per yearS0 M
Long-run average cost
At point b, an existing firm can produce M or more automobiles at an average cost of
cb. A new entrant able to sell only S automobiles would incur a much higher average
cost of ca at point a. If automobile prices are below ca, a new entrant would suffer a
loss. In this case, economies of scale serve as a barrier to entry, insulating firms that
have achieved minimum efficient scale from new competitors.
a
b

Models of Oligopoly
• Interdependence
–Cooperation or
–Fierce competition
• Collusion
• Price leadership
• Game theory
22

Collusion and Cartels
• Collusion
–Agreement among firms to
• Increase economic profit by
– Dividing the market
– Fixing the price
• Cartel
–Group of firms that agree to coordinate
their production and pricing decisions
• To reap monopoly profit
–Illegal in U.S.
23

Exhibit 5
24
Cartel as a Monopolist
Quantity per periodQ0
MC
D
MR
p
Dollarsperunit
c
A cartel acts like a monopolist.
Here, D is the market demand
curve, MR the associated
marginal revenue curve, and
MC the horizontal sum of the
marginal cost curves of cartel
members (assuming all firms in
the market join the cartel).
Cartel profits are maximized
when the industry produces
quantity Q and charges price p.

Collusion and Cartels
• Maximize profit
–Allocate output among cartel members
–Same MC of the final unit produced
• Difficulties to maintain a cartel:
–Differentiated product
–Differences in average cost
–Many firms in the cartel
–Low barriers to entry
–Cheating
25

Price Leadership
• Price leadership
–Informal, tacit collusion
• Price leader
–Sets the price for the industry
–Initiate price changes
–Followed by the other firms
26

Price Leadership
• Obstacles
–U.S. antitrust laws
–Product differentiation
–No guarantee others will follow
–Barriers to entry
–Cheating
27

Game Theory
• Game theory
–Approach that analyzes oligopolistic
behavior
–Series of strategic moves and
countermoves by rival firms
• General approach
–Focus: each player‟s incentives to
cooperate or compete
28

Game Theory
• Prisoner‟s dilemma
–Game that shows why players have
difficulty cooperating
–Even though they would benefit from
cooperation
• Strategy
–Operational plan pursued by a player
29

Game Theory
• Payoff matrix
–Table listing the payoffs
• That each player can expect from each
move
• Based on the actions of the other player
• Dominant-strategy equilibrium
–Outcome achieved when each player‟s
choice does not depend on what the
other player does
30

Exhibit 6
31
The Prisoner‟s Dilemma Payoff Matrix (years in jail)
Jerry
Confess Clam up
Ben
Confess
Clam up
10
0
0
10
1
1
5
5
This matrix shows the years each prisoner can expect to spend in jail based on his
actions and the actions of the other prisoner. Ben‟s payoff is in red and Jerry‟s in blue.

Game Theory
• Duopoly
–Market with only two producers
• Nash equilibrium
–A player chooses the best strategy given
the strategies chosen by others
–No participant can improve his or her
outcome by changing strategies
• Even after learning of the strategies selected
by other participants
32

Exhibit 7
33
Price-Setting Payoff Matrix (profit per day)
Exxon
Low price High price
Texaco
Low
price
High
price
$200
$1,000
$1,000
$200
$700
$700
$500
$500
This matrix shows the daily profit each gas station can expect to earn based on the
price each charges. Texaco‟s price is in red and Exxon‟s is in blue.

Exhibit 8
34
Cola War Payoff Matrix (annual profit in billions)
Coke
Big
budget
Moderate
budget
Pepsi
Big
budget
Moderate
budget
$1
$4
$4
$1
$3
$3
$2
$2
This matrix shows annual profit each soft-drink company can expect to earn based on
the promotional budget each adopts. Pepsi‟s profit is in red and Coke‟s is in blue.

Game Theory
• One-shot versus repeated games
–One-shot game
• Game is played just once
–Repeated games
• Establish reputation for cooperation
• Tit-for-tat strategy
– Highest payoff
35

Game Theory
• Tit-for-tat
–Strategy in repeated games
–A player in one round of the game
mimics the other player‟s behavior in the
previous round
–Optimal strategy for getting the other
player to cooperate
36

Game Theory
• Coordination game
–Game in which a Nash equilibrium
occurs when each player chooses the
same strategy
–Neither player can do better than
matching the other player‟s strategy
37

Comparison
• Oligopoly
–If firms collude or operate with excess
capacity
• Higher price
• Lower output
–If price wars
• Lower price
–Higher profits in the long run
38

Timely fashions boost profit for Zara
• Zara
–Largest fashion retailer in Europe
• “Possibly the most innovative and
devastating retailer in the world”
–Owns workshops and factories
• Designing, fabric dyeing, tailoring, ironing
–Real-time sales data
–Direct shipments from factory to shops
–Two weeks to develop and deliver a new
item
39

• Zara
–10,000 new designs a year
–Distributes new fashion twice a week
–Little advertising
• Prime store location
• Word of mouth
40

• Zara
–Makes most of its own apparel and
selectively outsources the rest
• Reduces delays
• Exploits customer feedback
• Maintains flexibility
• Ensures quality
41

Exhibit 9
42
Comparison of Market Structures

Chapter 10 imperfect comp

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