Download Monopolistic Competition

MONOPOLISTIC COMPETITION
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Principles of
Microeconomic Theory,
ECO 284
John Eastwood
CBA 213
523-7353
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e-mail address:
[email protected]

http://jan.ucc.nau.edu/~jde
1
Basic Assumptions
(Characteristics):
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Many Sellers and
Buyers
Product
Differentiation
Low Barriers to Entry
2
Behavior of Firms in Monopolistic
Competition:
They are Price Searchers (Makers)
 But Lack Market Power
 P > MR

3
Monopolistic Comp. and
Resource Allocation
All firms maximize profits by producing the
quantity of output where . . .
 MR = MC. Given that P > MR, it follows
that the m.c. firm will produce a quantity of
output where P > MC.
 Thus the allocation of resources under
monopolistic comp. is inefficient.

4
From Short-Run Profits to Long
Run Equilibrium
TR > TC -- positive economic profits will
attract new firms (in the long run).
 The demand curve faced by each of the
incumbent firms, Df, shifts left.
 As the industry grows, resource prices may
rise. If so, the cost curves shift up.
 Entry will continue until economic profits
fall to zero.

5
From Short-Run Losses to Long
Run Equilibrium
TR < TC -- Negative economic profits will
cause firms to exit (in the long run).
 As some firms leave, the demand curve
faced by each of the remaining firms will
increase -- Df shifts right
 Resource prices may be affected.
 Exit will continue until economic losses fall
to zero.
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6
The Excess Capacity Theorem
In equilibrium, a m.c. firm will produce an
output smaller than the one that would
minimize ATC.
 The difference between the output that
minimizes ATC and the actual output of the
firm is excess capacity.
 While excess capacity is economically
inefficient, it is the price of variety.

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Advertising
Shifts the cost curves upward.
 Seeks to differentiate the firm’s product
from that of its competitors.
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Successful Advertising
If it is successful, it shifts the demand for
the firm’s product to the right as the firm
gains a larger share of the market.
 It may also make demand less elastic.
Consumers will perceive competing
products as poor substitutes.

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Competitors’ Advertising

When a firm’s competitors respond with
their own advertising the above effects will
be reversed to some extent.
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Advertising may be informative
or persuasive.

Most economists agree that advertisements
that are merely persuasive waste society’s
scarce resources.
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How much is spent on
advertising?
Expenditures in the USA total roughly two
percent of GDP.
 In 1995, GDP was $7,245.8 billion.
 Two percent equals $144.9 billion.
 But its importance may be even greater than
this figure would suggest.

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Galbraith’s view of advertising
It wastes resources by promoting contrived
obsolescence
 It distorts resource allocation in favor of
private goods and away from public goods.
 It reverses the notion of consumer
sovereignty.

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The Revised Sequence
Galbraith argues that businesses create
wants through advertising.
 As a large corporation develops a new
product it plans and executes an advertising
campaign to create a demand for that
product.
 Demand then depends on output (the
dependency effect).

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Implications of the Revised
Sequence

Galbraith then concludes that much of our
production is wasteful.
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Critique

Other economists have criticized
Galbraith’s theories. For example, Frederic
Hayek argued that the dependency effect is
a non-sequitur (a Latin phrase which
translates as “does not follow”).
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OLIGOPOLY
Few Sellers
 No single model
 Nevertheless, there are three basic
assumptions common to the different
models of oligopoly we will review.
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Basic Assumptions:
Few Sellers and Many Buyers
 Price Searchers (Makers)
 Significant Barriers to Entry
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Barriers to Entry

The oligopolist is protected by barriers to
entry (BTE). Examples:
–
–
–
–
–
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Economies of scale & capital requirements
Control of input supplies
Cost differences
Government regulation of entry
Product complexity & Product proliferation
Product recognition
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Lerner Index of Monopoly Power
LMP = (P - MC)/ P
 Measures “monopoly power” as the
difference between price and marginal cost,
expressed as a percentage of price.
 Real-world monopolies may have other
control over markets, such as the ability to
withhold technology.

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Classification of Real-World
Market Structures
Concentration ratios measure the percentage
of sales, assets, output, or employment that
is controlled by the largest X firms in the
industry.
 For example, a four-firm sales concentration
ratio expresses the sales of the four largest
firms as a percentage of industry sales.

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Four-Firm Sales Concentration
Ratio, CR4
For many years, it was the “measuring
stick” by which the competitiveness of an
industry was measured.
 When the ratio exceeds, say, 50 percent, the
industry is said to be “concentrated.”
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Limitations of CR4
• Concentration ratios often ignore two key
considerations:
• (1) the presence of foreign competition;
• (2) the degree to which market power is
dispersed beyond the four biggest firms
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The Herfindahl-Hirschman Index
(HHI)

HHI equals the sum of the squared market
shares of each firm in the industry – that is:
HHI = (S1)2 + (S2)2 +(S3)2 + ... + (Sn)2,
where S1 through Sn are the market shares
of firms 1 through n. (n  50 largest firms)
 For monopoly, the HHI is 1002, or 10,000.
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Interpreting HHI

The Justice Department considers
–
–
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HHI < 1,000 competitive (10 firms @ 10%)
HHI > 1,800 concentrated
A merger in a previously unconcentrated
industry that raises the HHI value by less
than 100 (under Clinton) or 200 (under
Reagan & Bush) points is allowable.
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Market Share Predicts
Profitability

The market share of an individual firm is a
better predictor of its profitability than the
overall concentration ratio for its industry.
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Example: Market Shares (Sales)
Industry #1 has 4 firms @20% each & 20
firms @1% each.
 Industry #2 has 1 firm @77% & 23 firms
@1% each
 Calculate CR4 and HHI for each industry.
 Which is a better measure of concentration?

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Calculation Detail (industry #1)
Share
Share2
1
20
400
2
20
400
3
20
400
4
20
400
1
20
CR4 = 80
1
20
HHI = 1620
Firm #
5 - 24 each
subtotal
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OLIGOPOLY
When firms are interdependent, we must
ask how one firm reacts to the actions of
another.
 Strategic behavior becomes important.
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The Kinked Demand Curve
Theory

Assume that the oligopolist believes that its
rivals will match any price cut it initiates,
but ignore any price increase it initiates.
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The Kinked Demand Curve
The above assumption on how rival firms
react implies that Dfirm has a “kink” at the
presently prevailing price.
 There is a corresponding discontinuity (gap)
in the MR curve.
 This gap implies that MC can shift
somewhat without causing the firm to
change its price or output
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Predictions of the Model:
Price Rigidity -- Price changes will not
necessarily follow from changes in MC.
 Non-Price Competition -- Firms will
compete through advertising and/or product
differentiation. Firms will avoid competing
by reducing price.
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Criticisms of the Kinked Demand
Curve Theory:
How did the industry arrive at the prevailing
price?
 Empirical evidence points out a number of
oligopolies whose behavior can not be
explained by the kinked demand curve.
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A Formal Price Leadership
Model
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This model is one example of a group of
models that fall into the category called
“Price Leadership Theory.” Such models
provide one explanation of the level of the
prevailing price in the Kinked Demand
Curve Model. This next model provides an
independent theory of oligopolistic behavior
that applies to certain markets
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The Key Assumptions

The industry is dominated by a single firm,
the dominant firm (a.k.a. the price leader),
which sets price to maximize its own
profits. There are a large number of small
firms, known as fringe firms, that act as
price takers. They set their prices to equal
those of the price leader.
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Equilibrium Price and Quantity:

First, draw the market D and S curves in the
absence of the price leader. Next to this
graph, draw the demand curve of the price
leader as the difference between Demand
and Supply, (Qd - Qs at each price). Add the
MR and MC curves. The presence of the
price leader leads to a lower market price.
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Policy Implications:
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Observe how the nature of this market
causes the small firms to follow any price
change imposed by the dominant firm -without any explicit agreement. In this
particular model, the oligopolist’s presence
contributes to economic efficiency, and
benefits consumers, but other models imply
results that are less benign.
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Examples

At one time or another, the following firms
have been price leaders in their industries:
R.J. Reynolds in cigarettes; General Motors
in autos; Kellogg in breakfast cereals;
Goodyear in tires.
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Cartel Theory
In a cartel, several firms collude in an
attempt to monopolize the market.
 The Incentive to Collude -- Price
competition may result in lower profits for
all firms. If firms cooperate, they may earn
higher profits.
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Optimal Cartel Behavior
The Cartel behaves just as a monopolist
would, restricting output and raising price.
 Cartels often fail
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Problems Cartels Face
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Tough to form
Members must agree on the cartel’s policies
High profits may attract new entrants
New entrants will increase the industry’s supply
The cartel will be forced to cut production or
accept a lower price.
Each member has an incentive to cheat.
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Limit Pricing
If an existing firm has a lower ATC than
potential new entrants, it may be able to
prevent entry through limit pricing:
 Limit Price: The lowest price at which a
new firm can enter an industry and just
cover average total cost.
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Lower ATC may result from
IRS
 more efficient production (including
patented production methods)
 lower input prices.

–
–
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size (market power as a buyer);
“track record”
political influence (Galbraith)
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The Theory of Contestable
Markets
Recent developments in industrial
organization have focused on the issue of
entry and exit from the industry.
 William Baumol and others developed the
theory of contestable markets, offering the
first alternative to the SCP paradigm.
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What is a Contestable Market?
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Potential entrants must be able to serve the same
market as existing firms.
New firms may use the same production
techniques and produce at the same per unit cost
as existing firms
Potential entrants incur zero sunk costs.
Potential entrants estimate profits based on
existing industry prices (i.e., their entry will not
depress prices and profits).
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Airline industry as an example
A route served by only two carriers could
result in anti-competitive behavior.
 Could those carriers earn positive LR
economic profits?
 If other BTE are absent, this route may be a
contestable market, another carrier could
transfer planes to this route. If profits fell, it
could transfer its planes to some other route.
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Sustainable industrial
configuration
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A configuration is sustainable when no firm
is making economic profits and thus there is
no incentive for entry. If the above four
conditions hold, then either the incumbents
will hold prices and profits down to deter
entry, or new firms will enter, ultimately
driving down prices.
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Conclusions of Contestable
Market Theory
Concentration does not always lead to anticompetitive behavior. Potential entrants
keep existing firms from restricting output
and raising price.
 Concentration does not necessarily imply
positive economic profits. If entry is easy,
positive economic profits will attract new
entrants.
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More Conclusions
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Contestablility threatens inefficient firms.
– If existing firms do not produce at minimum
ATC, new firms may enter. Price will decline,
and existing firms will be forced to become
efficient or exit.
If potential entrants cause existing firms to
produce at the min. ATC, and to charge a price
equal to ATC, then P=MC=ATC
– allocative & technical efficiency.
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Criticisms of Contestable Market
Theory
Given substantial BTE, the theory does not
apply.
 Example:

–
an incumbent builds a large factory filled with
specialized capital goods (machines), and
enjoys substantial economies of scale. These
machines cannot be used to produce any other
good, hence their cost is sunk. Such sunk costs
may serve as a strategic BTE.
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Example continued &
A further implication
–
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If a potential entrant could match the
incumbent’s costs only by building a similar
factory, and incurring substantial sunk costs,
then it might not enter.
Yet, if economic strategy may create BTE,
then structure depends on conduct, and the
SCP paradigm must be rejected.
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