Download Characteristics Characteristics of Monopolistic Competition of

Characteristics of Monopolistic Competition
• large number of firms
• differentiated products (ie. substitutes)
• freedom of entry and exit
Examples
• Upholstered furniture: 122 firms; HHI* = 395
• Jewelry and Silverware: 302 firms; HHI = 321
• Metal Doors and Windows: 287 firms; HHI = 224
• Women's Clothing: 410 firms; HHI = 109
* HerfindahlHerfindahl-Hirschman Index
Herfindahl-Hirschman Index (HHI)
Maximizing Profits Within a
Monopolistically Competitive Firm
Since 1982, the U.S. Department of Justice, the Federal Trade
Commission, and state attorneys general have used the
Herfindahl-Hirschman Index (HHI) to measure market
concentration for purposes of antitrust enforcement.
For example, an industry consisting of only two firms with market
shares of 70% and 30% has an HHI of 70²+30², or 5800.
General frame of reference:
• < 100 is considered perfectly competitive
• < 1000 is considered unconcentrated
• 1000 - 1800 is considered moderately concentrated
• 1800 - 2499 is considered highly concentrated
• 2500 - 9999 is considered an oligopoly
• 10000 is considered a monopoly
MC
10
ATC
Cost / Revenue (Dollars)
The HHI of a market is calculated by summing the squares of
the market share percentages held by the top 50 firms.
8
PROFIT
6
D
2
0
0
1
When other firms see
these potential profits
they will enter the
industry, causing a
downward shift in the
demand for a given
firm’s product.
MC
10
Cost / Revenue (Dollars)
ATC
8
PROFIT
6
4
D
2
0
2
3
4
5
6
7
8
9
Profit Max:
Max: You guessed it!
Profits are still maximized
where marginal revenue is
equal to marginal cost!
MR
Output (Units Produced)
What if other firms see these profits?
Monopolistic Competition Output Levels
When other firms see
these potential profits
they will enter the
industry, causing a
downward shift in the
demand for a given
firm’s product.
12
MC
10
ATC
Cost / Revenue (Dollars)
Monopolistic Competition Output Levels
Why? Well, if you raise
your price then SOME of
your customers will switch
to your competition - but
not all. Some will stay for
your differential advantage.
4
What if other firms see these profits?
12
The demand curve is
downward sloping because
changes in price WILL
effect the quantity
demanded.
Monopolistic Competition Output Levels
12
8
PROFIT
6
4
D
2
0
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
8
9
MR
MR
Output (Units Produced)
7
Output (Units Produced)
1
What if other firms see these profits?
When other firms see
these potential profits
they will enter the
industry, causing a
downward shift in the
demand for a given
firm’s product.
12
MC
10
8
PROFIT
6
4
D
2
MC
10
ATC
0
8
6
4
D
2
0
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
When other firms see
these potential profits
they will enter the
industry, causing a
downward shift in the
demand for a given
firm’s product.
MC
10
ATC
8
LOSS
4
D
0
0
1
2
3
4
5
6
9
Remember, monomono-comp’s produce SUBSTITUES
SUBSTITUES!!
7
8
9
Loss: Eventually
Loss:
demand falls so low
that the price ends up
being lower than the
average total cost!
cost!
Therefore, if the demand
for your competitor’s
product increases…
Monopolistic Competition Output Levels
12
MC
10
ATC
Cost / Revenue (Dollars)
Monopolistic Competition Output Levels
12
2
8
Output (Units Produced)
What if other firms see these profits?
6
7
MR
MR
Output (Units Produced)
Cost / Revenue (Dollars)
When other firms see
these potential profits
they will enter the
industry, causing a
downward shift in the
demand for a given
firm’s product.
8
Competitor
6
1
2
MC
1
0
4
ATC
8
D
2
Cost / Revenue (Dollars)
Cost / Revenue (Dollars)
ATC
Monopolistic Competition Output Levels
12
Cost / Revenue (Dollars)
Monopolistic Competition Output Levels
What if other firms see these profits?
0
0
1
2
3
4
5
6
7
8
9
6
4
D
2
D2
0
0
MR
1
2
3
4
5
6
7
8
9
MR
MR
Output (Units Produced)
Output (Units Produced)
Therefore, if the demand
for your competitor’s
product increases…
then demand for your
product will decrease!
Monopolistic Competition Output Levels
12
MC
10
8
Competitor
6
1
2
Oh no!
MC
1
0
4
ATC
8
D
2
Cost / Revenue (Dollars)
Cost / Revenue (Dollars)
ATC
0
0
1
2
3
4
5
6
7
8
9
6
4
D
2
D2
Monopolistic Competition LongLong-Run Equilibrium
In the longlong-run, firms
will leave if they are
incurring losses.
Monopolistic Competition Output Levels
12
MC
10
ATC
Cost / Revenue (Dollars)
Remember, monomono-comp’s produce SUBSTITUES!
Output (Units Produced)
Thus, equilibrium is
achieved when profit
is maximized at the
break--even point
break
(price = ATC).
8
6
4
D
2
0
0
1
2
3
4
5
6
7
8
9
0
0
1
2
3
4
5
6
7
8
9
MR
MR
MR
Output (Units Produced)
Output (Units Produced)
Output (Units Produced)
2
Oh my gosh… Excess Capacity!!!
MC
10
Cost / Revenue (Dollars)
ATC
8
6
4
This is referred to as
“excess capacity.”
D
2
MC
10
ATC
0
8
6
4
D
2
D2
0
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
MR
Models used to explain the phenomenon
observed in oligopolies fall under two general
categories:
• recognized interdependence
• barriers to entry
a) traditional models
b) game theory models
• identical OR differentiated products
• typically have high costs which tends to
naturally limit the number of firms that can
compete in the market
gas companies
car manufacturers
pharmaceuticals
airlines
Traditional Models:
Maximizing Profits Within an Oligopoly
MC
10
ATC
8
If an oligopoly raises its
price then SOME of its
customers will switch to
the competition; but some
may stay for a differential
advantage.
PROFIT
4
D
0
1
2
3
4
5
6
7
8
MR
Output (Units Produced)
The Oligopolist’s Sticky Prices
9
Profit Max:
Max: Yup, profits are
still maximized where
marginal revenue is equal
to marginal cost, but …
barriers to entry allow
these profits to stay!!!
Prices within an
oligopolistic market tend to
be rather stable – in other
words, they are “sticky.”
Oligopoly Kinked Demand Model
12
10
Cost / Revenue (Dollars)
12
2
Kinked Demand Model
The demand curve is
downward sloping because
changes in price WILL
certainly effect the quantity
demanded.
Oligopoly Output Levels
0
9
Oligopoly Models
• few firms (typically 2 to 15) HHI > 2500
6
8
Output (Units Produced)
Characteristics of an Oligopoly
• examples:
7
MR
Output (Units Produced)
Cost / Revenue (Dollars)
Also note that, the more
inelastic the demand,
the greater the excess
capacity!
Monopolistic Competition Output Levels
12
Cost / Revenue (Dollars)
Note that, in the longlongrun, a monomono-comp
produces an output
where ATC is NOT at its
lowest point (as
(as one
would find in pure
competition.)
competition
.)
Monopolistic Competition Output Levels
12
Oh my gosh… Excess Capacity!!!
For this reason, many
economists believe that an
oligopoly faces a “kinked”
demand curve.
MC1
8
6
4
This is based on two
assumptions:
2
D
0
0
1
2
3
4
5
6
MR
Output (Units Produced)
7
8
9
a)
b)
price increases will NOT
be matched by
competitors;
price decreases WILL be
matched by competitors.
3
Kinked Demand Model
Kinked Demand Model
The Oligopolist’s Sticky Prices
MC2
8
MC1
6
4
2
D
0
0
1
2
3
4
5
6
7
8
9
Indeed, an oligopolist’s
marginal costs could shift
anywhere within the vertical
area of the marginal revenue
curve, and they still would
not increase their prices.
12
MC2
10
MC1
8
Other theories used to
explain sticky prices:
6
• long
long--term contracts
• menu costs
4
2
D
0
0
1
2
3
MR
Dominant Firm Model
Dominant Oligopoly Firm
1
2
1
0
Note:
Supply is
just for
nondominant
firms.
8
Cost / Revenue (Dollars)
Cost / Revenue (Dollars)
S
1
0
8
MC
2
D
0
6
Total
Market
Demand
at $6.00
Excess
demand
is
satisfied
by nondominant
firms
4
2
Note:
D
0
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
Demand is
for entire
market of
consumers.
MR
Output (Units Produced)
6
7
8
9
Game Theory Models
Oligopoly Market
1
2
Dominant
Oligopoly’s
demand at
$6.00
5
Output (Units Produced)
In the “dominant-firm” model, we see:
• One dominant firm that sets the price for the market (similar to a monopoly).
• At that price the market demands more than the dominant firm supplies.
• Remaining (non-dominant) firms sell an extra quantity of units that satisfies
the unmet demand at the market price.
• Thus, the non-dominant firms accept the price determined by the dominant
firm, and behave somewhat like firms within a purely competitive market.
6
4
MR
Output (Units Produced)
4
In fact, an oligopolist would
have to incur a MAJOR
increase in costs before it
would increase prices.
Oligopoly Kinked Demand Model
Cost / Revenue (Dollars)
Cost / Revenue (Dollars)
12
10
The Oligopolist’s Sticky Prices
Therefore, if an oligopolist
were to incur an increase in
costs within a certain range,
then it may NOT increase its
prices, as it would risk losing
too many sales to its
competitors.
Oligopoly Kinked Demand Model
Output (Units Produced)
Game theory is a technique for analysing how people, firms and
governments should behave in strategic situations (in which they must
interact with each other). In deciding what to do, each party must take into
account what the other party(s) are likely to do and how others might
respond to what they do.
In game theory, a dominant strategy is one that will deliver the best results
for the player, regardless of what anybody else does. One finding of game
theory is that there may be a large “first-move advantage” for companies that
beat their rivals into a new market or come up with an innovation.
One special case identified by the theory is the zero-sum game, where
players see that the total winnings are fixed. In other words, for some to do
well, others must lose.
Far better is the positive-sum game, in which competitive interaction has
the potential to make all the players richer.
Another problem analysed by game theorists is the prisoner’s dilemma.
John F. Nash Jr.
The Nash Equilibrium
Named after John Nash, a mathematician
and Nobel prize-winning economist, this is
an important concept in game theory.
John F. Nash, 1928 -
Russell Crow portrays John Nash in A Beautiful Mind
John F. Nash, 1928 -
A “Nash Equilibrium” occurs when each
player is pursuing their best possible
strategy in the full knowledge of the other
players’ strategies.
A Nash equilibrium is reached when
neither player has any incentive to change
his strategy, because each player feels he
has obtained the best possible outcome
regardless of which strategy his opponent
employs.
4
Prisoner’s Dilemma
An illustration of Nash Equilibrium
1 yr.
10 yrs.
1 yr.
2 yrs.
2 yrs.
Consider Bob’s options…
1. If Art denies and Bob denies, then Bob
will get two years. Bob is better off
confessing and getting one year.
The trick is to
compare across
the firm’s
strategies!
Belco’s
Strategies
2. If Art confesses and Bob denies, then
Bob will get ten years, so Bob is much
better to confess and take three years.
Thus, both parties will rationally choose to confess, and take three years – even though they
could have been better off denying. Each party does this because, considering the possible
options of the other party, they always found the better option was to confess. When neither
party has an incentive to change their strategy, they are in “Nash Equilibrium.”
Airtouch has no dominant
strategy because it’s
better off with a morning
departure if Windward
chooses a morning
departure, but it’s better
off with an evening
departure if Windward
chooses an evening
departure. No particular
strategy proves to be
consistently superior.
1. If Belco complies and Acme complies, then
Acme will earn 2 million. Acme is better off
cheating and earning 4.5 million.
Confess
Cheat Comply
$0
2. If Belco cheats and Acme complies, then
Acme will lose 1 million, so Acme is again better
off to cheat and earn zero profit.
-1.0m
$0
4.5m
4.5m
Consider Belco’s options…
1. If Acme complies and Belco complies, then
Belco will earn 2 million. Belco is better off
cheating and earning 4.5 million.
2.0m
-1.0m
2. If Acme cheats and Belco complies, then
Belco will lose 1 million. Belco is again better off
to cheat and earn zero profit.
2.0m
Thus, both parties will rationally choose to cheat, and earn zero profits – even though they could have been
better off by complying with a collusive deal to restrict output. They will compete as fiercely as pure competitors continually lowering their prices and increasing production until they reach a point where they are breaking even.
This is where they will find themselves in Nash Equilibrium. They will have no motivation to move from this point.
Windward DOES have a
dominant strategy
because it’s better off with
a morning departure
regardless of whether
Airtouch chooses a
morning or an evening
departure. This one
particular strategy proves
to be consistently
superior.
Again, we compare
across the firm’s
strategies!
Game Theory Model
If both firms know all of the
information in the payoff matrix,
then they will logically choose to
leave in the morning. This is
because Windward will leave in
the morning no matter what
(that’s their dominant strategy).
Knowing this, Airtouch will
choose to leave in the morning
in this case because that is the
option that gives them the most
profit in that scenario. Airtouch
will earn $1,000.00, and
Windward will earn $700.00.
Although each oligopolist would be better off cooperating with each other, they decide not to
cooperate in an act of self-preservation.
• Thus, each firm will end up competing as fervently as if they were operating within a purely
competitive market.
• Thus, each firm will end up producing at the output associated with the lowest point on their ATC
curve. (The break-even point!)
• This determines the price for the market, while market demand at that price determines the
quantity demanded.
• Quantity demanded at the market price sets the number of firms that can be supported.
Oligopoly Firm
Oligopoly Market
1
2
Output is
for one
firm.
1
2
MC
1
0
Quantity for
entire
market.
Thus, more
than one
firm can be
supported!
1
0
ATC
8
8
Cost / Revenue (Dollars)
3 yrs.
10 yrs.
Acme’s Strategies
2. If Bob confesses and Art denies, then
Art will get ten years, so Art is much better
off confessing and taking three years.
Cheat
Confess
Deny
Bob’s
Strategies
3 yrs.
Deny
Comply
Art’s Strategies
Confess
Consider Art’s options…
1. If Bob denies and Art denies, then Art
will get two years. Art is better off
confessing and getting one year.
Cost / Revenue (Dollars)
Art and Bob are both suspects in a crime, and they
are both offered the following deal if they
confess…
The Implications: The Duopolist’s Dilemma
Acme and Belco are the only firms operating within a given market. Thus, they are operating in
a duopoly. Both firms could increase their profits if they were to collude with each other in an
effort to restrict output. However, each firm could make even more money if they agreed to
collude, but then cheated and secretly increased their output. Thus, each firm is faced with the
following payoff matrix…
Consider Acme’s options…
6
4
2
0
6
4
Note:
2
D
0
0
1
2
3
4
5
6
Output (Units Produced)
7
8
9
0
1
2
3
4
5
6
7
8
9
Demand is
for entire
market of
consumers.
Output (Units Produced)
5