Download Chapter 6

Chapter 6
Monopolistic
competition and
oligopoly
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-1
Learning Objectives
• Discuss the nature and prevalence of monopolistic
competition.
• Analyse and evaluate the price–output behaviour of
monopolistically competitive firms.
• Discuss the implications of monopolistic competition
for economic efficiency.
• Explain and assess the role of non-price competition
—that is, competition based on product quality and
advertising—in monopolistically competitive
industries.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-2
Learning Objectives (cont.)
• Define oligopoly, assess its occurrence, and note the
reasons for its existence.
• Examine the behaviour of oligopoly in terms of a
simple game theory framework.
• Survey four models of the possible courses of price–
output behaviour that oligopolistic industries might
follow.
• Discuss the role of non-price competition, that is,
competition on the basis of product development and
advertising in oligopolistic industries.
• Provide some comments on the economic efficiency
and social desirability of oligopoly.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-3
Monopolistic Competition
Described
• Relatively large numbers of firms
– small market share
– no collusion
– independent actions
• Product differentiation
– competition based not just on price:
 quality, brands, services, location, promotion and
packaging
• Ease of entry
– low economies of scale
– low set-up costs.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-4
Price and Output Determination
The Firm’s Demand Curve
• Highly elastic, Why?
– More close substitutes than a pure monopolist.
– Not perfect substitutes (as is the case with perfect
competition).
– Elasticity depends on:
 number of rivals
 degree of product differentiation.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-5
Short-Run Price and Output
Determination
• How much to produce?
– MR = MC
• Profits or losses in the short run
– Profits:
When AC > AR (D)—entry of new firms
– Losses:
When AC < AR (D)—exit of existing firms.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-6
Short-Run Price and Output
Determination: Short-Run Profits
Price and Costs
P
MC
Economic
Profits
AC
D
MR
Q
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-7
Short-Run Price and Output
Determination: Short-Run Losses
MC
Price and Costs
P
AC
Losses
D
MR
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
Q
6-8
Long Run
• How much to produce?
– MR = MC
• Firms tend to break even, i.e. normal profit
– Tangency solution: profit-maximising firm will produce an
output when its demand curve is at a tangent to its AC curve
– When AC = AR (D).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-9
Long-Run Equilibrium
• Why do monopolistically competitive firms tend to
break even in the long run?
– Profits attract new entrants
– Losses encourage exits
• Complications
– some product differentiation
– some entry is partially restricted
– some economic losses may be tolerated by firms in the long
run.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-10
Long-Run Equilibrium (cont.)
MC
Price and Costs
P
AC
D
MR
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
Q
6-11
Monopolistic Competition and
Economic Efficiency
• Productive inefficiency: Minimum ATC is not
necessarily chosen
– excess capacity
• Allocative inefficiency:
– price does not necessarily equal MC
• Redeeming features
– product variety.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-12
Non-Price Competition
• Assists firms to improve their long-run equilibrium
position.
• Product differentiation and product development
– at a point in time
– over time.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-13
The Economics of Advertising
• The case for advertising
– information and efficiency
– competition
– communication support
• The case against advertising
– persuasion and wastage
– concentration
– media bias.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-14
Characteristics of Oligopoly
• ‘Fewness’: few firms dominate the market
– Firms are mutually interdependent and must consider the
possible reactions of rivals to their price and product
development decisions.
– Firms may collude or act independently.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-15
Characteristics of Oligopoly
(cont.)
• Product differentiation?
– Homogeneous or differentiated product
– Examples:
 petroleum products
 aluminium
 insurance
 motor vehicles
• Concentration ratios: the percentage of total industry
sales accounted for by a given number of the largest
firms in each industry.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-16
Characteristics of Oligopoly
(cont.)
High Barriers to Entry
• Causes
– economies of scale
– mergers
 give firms more market power, influence, etc.
– ownership of patents, copyrights
– control of strategic raw materials
– technological progress.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-17
Oligopoly Behaviour: A Game
Theory Overview
• Compare the behaviour of oligopolists to a simple
duopoly game of strategy, actions and pay-offs as
shown in the profit pay-off matrix.
• mutual interdependence
– the fate of one firm lies partially or wholly with the
performance or decisions of other firms in that same industry
• incentives to collude
• incentives to cheat.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-18
Profit Pay-offs for a Duopoly
Giant’s pricing strategy
High
Low
B
$15m
High
$12m
$12m
$6m
C
D
$6m
Low
Big’s pricing strategy
A
$15m
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
$8m
$8m
6-19
Maximin Strategies and Optimal
Pricing Strategy
Maximin strategies
• Strategies chosen by players in a game to maximise
their minimum expected pay-off from the game.
• The equilibrium pair of strategies under this rule will
result in a Nash equilibrium which is for each firm to
charge a low price, regardless of the choice the other
firm makes.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-20
Price–Output Behaviour in Four
Models
• Four Models of Oligopoly
–
–
–
–
the kinked demand curve
collusive pricing
price leadership models
cost-plus pricing
• No standard model of oligopoly due to:
– diversity
– Interdependence.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-21
Kinked Demand: Non-Collusive
Oligopoly Model
• Output occurs where MR = MC.
• Price remains stable over a variety of cost scenarios
– Avoiding price wars.
– Firms ignore price increases.
– Firms match price decreases.
• Criticisms
– How is the current price set?
– Prices may not be as inflexible as model suggests.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-22
The Kinked Demand Curve
P
The firm’s demand
and marginal
revenue curves
MR1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
D1
Q
6-23
The Kinked Demand Curve (cont.)
P
The rival’s demand
and marginal
revenue curves
D2
MR1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
D1
Q
MR2
6-24
The Kinked Demand Curve (cont.)
P
Rivals tend to
follow a price cut
D2
MR1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
D1
Q
MR2
6-25
The Kinked Demand Curve (cont.)
P
Rivals tend to
follow a price cut
or ignore a
price increase
D2
MR1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
D1
Q
MR2
6-26
The Kinked Demand Curve (cont.)
P
Effectively creating …
D2
MR1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
D1
Q
MR2
6-27
The Kinked Demand Curve (cont.)
Effectively creating
a kinked demand curve
P
D2
MC1
P
MR2
X
Q
MR1
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
MC2
D1
Q
6-28
Collusion and Cartels
• Overt or covert agreements to fix prices, divide up or
share the market or limit competition between firms.
• Output and price: same as a monopolist
• Forms:
– Cartels
 groups of firms that agree either formally or informally to
set prices and output levels of a product among
members
– ‘Gentlemen’s agreements’
 groups of firms agree verbally to set prices and output
levels, usually in an informal setting, such as a golf
course.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-29
Price
Collusion and Profit Maximisation
MC
P
ATC
D
MR = MC
Profit
MR
Q
Q
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-30
Obstacles to Collusion
•
•
•
•
•
demand and cost differences between firms
numbers of firms
cheating
recession
legislative obstacles: Trade Practices Law.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-31
Price Leadership: Tacit Collusion
Model
Price leadership
• A type of gentlemen’s agreement in which oligopolists
automatically follow the price initiatives of the
dominant firm in an industry.
• Infrequent price changes by price leader.
• Price announcements often made through indirect
channels such as trade publications.
• Price leader may choose strategies to block potential
entrants: limit-pricing or price blocking.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-32
Cost-Plus Pricing Model
• An oligopolist uses a standard formula to estimate
cost per unit of output and adds a mark-up to
determine price.
• Advantages for multi-product firms.
• Consistent with outright collusion.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-33
Non-Price Competition
• Oligopolists dislike competing on price.
• Oligopolists must rely on non-price competition
– advertising
– product development
• Oligopolists typically have substantial resources to
support non-price competition.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-34
Oligopoly and Economic
Efficiency
• Productive inefficiency
– Minimum ATC is not necessarily chosen
 under-allocation of resources
• Allocative inefficiency:
– Price does not necessary equal MC
 output is restricted
• Dynamic efficiency.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-35
Oligopoly and Economic
Efficiency (cont.)
• Long-term improvements in product quality and
production methods may occur
– competitive view
– Schumpeter–Galbraith view
 Oligopolists have both the incentive and financial and
technical resources to be more technologically
progressive than competitive firms
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-36
Oligopoly and Economic Efficiency
(cont.)
• Technical Advance: what is the evidence?
– Giant corporate oligopolies are probably not the leaders in
technological advance.
– In Australia in the 1980s and 1990s more than half of the
research and development efforts were supported by
government rather than business.
– The private sector has imported much of the technology
through parent overseas companies.
– Technological advances in Australian industry is
science- based and research-orientated rather than
market driven.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-37
Next Chapter:
Market failure and
resource allocation
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
6-38