Monopolistic Competition and Oligopolies
Monopolistic Competitive Markets
|Social welfare is lowest
||Social welfare is highest|
(1 - firm)
- Monopolistic Competitive Market - similar to a purely competitive market, but firms have a touch of
- Called a price searcher
- Many firms in market, but not as many as pure competition
- Producers are independent
- Collusion is not possible
- Low entry barriers
- If one firm earns economic profit, then new firms enter the market
- Produce differentiated products
- Give s little monopoly power
- Face a downward sloping demand curve
- Different from competitors' products
- Nonprice competition - compete in other areas other than price
- Product quality - physical or qualitative differences
- Services - condition surrounding the sale of a product
- Location and accessibility
- Gas station versus store, when buying Pepsi.
- Promotion, packaging, and brand names - imaginary or real differences in quality
- Use advertising to create differentiated product
- Advertising -
- Provides information; informs consumers about new products
- Provides revenue to TV, radio stations & internet
- Is successful when based on a product's uniqueness
- Allows firms to expand output and realize greater economies of scale. Consumers buy more
- Promotes competition.
- Advertising -
- Persuades and not informs
- Promotes artificial distinctions
- Higher costs to consumers
- Contributes little to human well-being
- Has large social cost, if people are enticed to smoke cigarettes or drink alcohol
- Tends to be self-canceling
- If Pepsi spends $1 million on advertising, then Coca-Cola will match or exceed that.
- May promote growth for monopolies
- High advertising costs create a barrier
- $1 million in advertising to enter into new market
Price and Output for Monopolistic Competition
|Price searchers face a downward-sloping highly-elastic demand curve
- Monopolistic competitive firm faces a downward sloping demand function
- Created from product differentiation
- Not as steep as a monopoly
- Demand function is more elastic
- If firm raises price to much, then consumers can switch to competitor
- Monopolistic competitive firms do not have an incentive to increase market price
- Shown below in graph
- Demand function is elastic
- Original price and quantity is (P1, and q1)
- q is production for a firm
- Lower price to P2 and increasing production to q2 causes revenue to change
- Red area is revenue loss and green area is revenue gained
- The price decrease lowers total revenue for the firm
- These firms maximize profuts when MR = MC
- A price searcher expands output when MR > MC
- A price searcher contracts output when MC > MR
- However, P > MC, because demand function is downward sloping
- Note allocative efficient
|Monopolistic Competitive Firm|
||Price, Per-Unit Costs|
- If firms are making economic profits, then rival firms will enter
- SR supply increases.
- Market price decreases
- Each firm's demand and MR curves will shift inward until economic profits are eliminated.
- Example: 10 shoe companies
- 10 more companies enter the shoe market
- Customers have more choices and spread out their consumption over 20 firm's products
- Each firm experiences a decrease in demand for their product
- Economic losses cause price searchers to exit from the market.
- SR supply decreases
- Market price increases
- Each firm's demand and MR curve will shift outward until economic losses are eliminated
- Example: 20 computer companies
- 10 companies leave the market, because of losses
- Customers have less choices and focus their consumption on the 10 remaining firm's products.
- Each firm experiences an increase in demand for their
||Profits and losses determine the size of the industry|
Comparing Price Takers to Price Searchers
- Incentives to innovative and adopt technology that reduces costs
- Earn zero economic profit in the long run
- Economic profits attract new firms to the market
- Supply increases and curve shifts right
- Price decreases until firms earn zero economic profit
- Economic losses cause some firms to leave the market
- Supply decreases and curve shifts left
- Price increases until firms earn zero economic profit
- Allocative efficiency - goods desired by consumers are produced at the lowest cost P = MC
- Pure competitive market is allocative efficient
- Monopolistic competitive market is not allocative efficient
- Productive efficiency - goods are produced at minimum long-run costs
- Price taker is productive efficient
- Price searcher is not productive efficient
- Producing less output at a higher price
- Too much duplication
- Many restaurants, gas stations, & stores
- Consolidate them so they produce larger output
||Price Searcher with low entry barriers|
||Historically, economist criticized monopolistic competitive markets. Recently economists are more positive about them, because
consumers have a variety of quality and styles to choose from.|
Characteristics of Oligopoly
Oligopoly - small number of rival firms in the market
- Mutual interdependence - a firm has to consider the
competitors, when deciding prices, production level, or product quality
- The rival firms react to the firm's decision
- Mergers - a firm can buy other firms and combine them into one company.
- Firm controls a larger market share and could gain more monopoly power
- Oligpopolies have entry barriers
- Example: Automobile industry - economies of scale.
- To achieve low-per unit costs, a car manufacturer has to produce over a million cars.
- If demand is only 6 million cars, then the market cannot support more than 6 firms.
- Products may be identical (homogeneous) or differentiated
- Identical products - milk, cement, gasoline, etc.
- Differentiated products - sodas, shoes, computers, etc.
- Use product style, quality, and advertising
- Example - Beer industry
- In 1947, beer industry had over 400 independent breweries
- In 1967, there were 124 suppliers
- In 1980, there were 33
- Currently, four brewing companies dominate the U.S. market
- Anheuser-Busch - 49% of market
- SABMiller - 20% of market
Economists use two methods to determine how concentrated a market is
- Concentration Ratio - calculate
the percentage concentration of the four largest firms in the market
- If concentration ratio is 0%, no firm has a market share; purely competitive
- If concentration ratio is 100%, the four largest firms completely dominated the market
- Herfindahl index - for each firm, take the percent market share and square, add all firms together
- Benefit - includes all firms in the market and can tell if market had a monopoly
- Monopoly - market share is 100%
- Herfindahl index = 1002 = 10,0000
- Pure competitive market - market share is 0%
- Herfindahl index = 02 = 0
Source: McDonnell and Brue (2008), p.452
- Localized markets - a market is for a small area and isolated from other markets
- The concentration ratio or Herfindahl index is calculated for whole market
- A firm can dominate a local market
- Example - cement production seems to be in a competitive market
- Cement is bulky and has high transportation costs, thus, these firms may be monopolies at the local level
- Interindustry Competition - a product in the market may compete with products from other
- Example: Breakfast cereals seems to be a concentrated industry
- If these companies raise the price too much, consumers may switch to other breakfast foods
- International Competition - a concentrated industry may be competing with other large
companies from other countries
- Example: Motor vehicles is a concentrated industry; they compete with car manufacturers from Japan, South Korea, and
Price and Output under Oligopoly
- Several theories explain price and output.
- Strategic behavior (i.e. game theory) - when one firm makes
a decision, it has to consider how its rival will respond
- Many possible scenarios
- Two extreme scenarios:
- Price war - a firm lowers its price to gain a larger market. The other firms will also lower their
prices, until economic profit = 0. The firms are independent and no collusion.
- Outcome is similar to a competitive market.
- P = long run ATC
- P = MC
- sellers cooperate together
- Different levels
- If firms collude, they lower production levels, causing the market price to increase
- Opposite of competition.
- Similar to a monopoly - productive and allocative inefficient
- Could earn economic profits
- The outcome may lie between these two extreme outcomes.
- Note - book explains "kinked" demand.
- Demand has two demand functions
- Elastic demand - if competitors do not change their prices, when a firm changes its price
- A firm can capture more consumers
- Inelastic demand - if competitors change their price to match a change in a firm's price
- A firm cannot capture more consumers because other firms lower their price
- Put the two demand functions together and we have a "kinked" demand function
- A firm lowers its price to capture more consumers until it hits the point where the kink is.
- That point is where competitors will also lower their price
||The microprocessor market is dominated by Intel and AMD. These
two companies are fierce competitors.|
- Cartel - sellers organize together and make joint decisions
- Highest form of collusion
- Example: Organization of Petroleum Exporting Countries (OPEC).
- 11 Oil producing countries.
- Saudi Arabia
- United Arab Emirates
- Successful in increasing oil prices in 1973, early 1980s, and 2000.
- U.S. entered into a recession a year later.
- Obstacles which prevent collusion.
- As the number of firms increases, collusion becomes less effective.
- More difficult to communicate, negotiate, and reach agreements.
- Many time OPEC could not agree on production quotas.
- Firms have different market shares, different costs, etc
- Firms may have trouble agreeing
- Strong incentive to cheat and secretly sell its product
- Big problem with OPEC
- Nonprice competition (get around a fixed price)
- Better quality & service.
- Larger containers (more for each $)
- Low entry barriers.
- New rivals enter the market because of economic profits.
- Economic profits decrease.
- When oil prices are high, new oil wells are opened in Alaska, Oklahoma, Texas, etc.
- Unstable demand conditions.
- Oligopolists are uncertain how consumers will react.
- In long run, consumer reduced demand for gas.
- Bought fuel efficient cars.
- Traveled less.
- Moved closer to work, etc.
- Economy enters recession
- Consumers lower their spending, the cartel could breakup if they cannot sell their quotas
- Antitrust laws
- It is illegal to collude in the U.S.
- As the threat of getting caught increases, firms are less likely
- Tacit understandings (i.e.
Gentlemen's agreements) - competitors verbally agree and commit to the agreement by shaking hands
- CEOs of rival companies playing golf together and talk about business
- Price Leadership - one firm in the industry is the price leader and the others are followers
- No collusion!
- Examples of price leaders
- General Motors - automobile market
- Kellogg - breakfast cereal market
- American Airlines - air travel market
- Price changes are infrequently
- For car industry, new prices are announced in the fall
- A firm publicly announces a price change
- A leader may not want to choose a price that maximizes profits
- May choose a lower price to discourage new rivals into market
Contestable Market and Potential Competition
Contestable market- a highly competitive market because of potential competition
- Few sellers
- Low entry and exit costs
- Example: Airline industry
- Airline route between Salt Lake City and Albuquerque are served by two airlines.
- A high barriers industry because airplanes cost millions of dollars plus facilities for tickets, baggage, etc.
- The two airlines could collude and drive up the price
- If two airlines are making a economic profit, other airlines can switch routes with very little cost, driving profits to zero.
- Firms earn zero economic profit in long run.
||Government can make market more competitive by reducing entry barriers and encouraging potential
The Prisoner's Dilemma & Game Theory
|A simple game theory example. Two firms have an advertising war.
- Two firms: Coca-Cola & Pepsi
- No collusion
- If both firms have the same advertising budget, then each firm has 1/2 the market
- Both firms earn the same profit.
- If one firm has a larger advertising budget
- Has more than 1/2 the market.
- Earns more profit.
Starting in cell A.
- Starting in Cell A, firms have the same advertising budget and a profit of $1,000 each.
- Pepsi decides to advertise more and we move to cell C.
- Pepsi has more of the market, a profit of $1,200, while Coca-Cola's profit is $600.
- Coca-Cola increases its advertising budget and we move to cell D.
- Firms will be better off at cell A, but end up at cell D.
- Strong incentive to collude.
- Same thing happens if we start in Cell A and Coca-cola increases its advertising.
||Small Ad, Budget Large Ad. Budget|
||Small Ad. Budget
Large Ad. Budget
- monopolistic competitive market
- product differentiation
- nonprice competition
- homogeneous oligopoly
- differentiated oligopoly
- mutual interdependence
- concentration ratio
- localized markets
- interindustry competition
- international competition
- Herfindahl index
- strategic behavior
- game theory
- kinked-demand curve
- price war
- tacit understandings
- price leadership