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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