Download VIII. Monopolistic Competition and Oligopoly.

Monopolistic Competition
and Oligopoly
Monopolistic Competition
What are the characteristics of monopolistic
competition?
1. large number of independent sellers
2. no or low barriers to entry
3. differentiated product
Recall: differentiated products are
products that are distinguished from similar
products by such characteristics as quality,
design, and location.
examples: service stations, aspirin, tissues,
retail stores
Demand Curve for the Monopolistic
Competitor’s Product
Since the product is differentiated, there is some
brand loyalty and the firm has some control over
price.
So the demand curve for the monopolistically
competitive firm’s product is NOT horizontal.
Since good substitutes are available, however,
the demand curve is fairly elastic, that is, fairly
flat.
The demand curve for the monopolistic
competitor’s product is flatter than the demand
curve for the monopolist’s product, but not
horizontal like the demand curve for the perfect
competitor’s product.
p.c.
m.c.
P
monopoly
P
P
D
D
Q
D
Q
Q
The firm’s profits are maximized where
MR = MC.
$
MC
P*
ATC

ATC*
MR
Q*
D
Q
In the short run
the firm may have
positive, negative,
or zero profits.
In the long run, however, since barriers to entry
are small, positive profits will attract new firms.
$
MC
P*
ATC
ATC*=P*
MR
Q*
D
Q
That will expand
industry output,
which will lower
prices and reduce
profits to zero.
Advertising
Perfectly competitive firms don’t advertise
because everyone knows the products are
all the same.
Monopolistic competitors advertise to
convince consumers that their product is
better than others.
Whether advertising is socially beneficial or
detrimental depends on the type of advertising.
When it is informative to consumers, it is
beneficial.
When it is misleading, however, it is
detrimental.
How does advertising affect price and profits?
Advertising can create brand loyalty and decrease
the price elasticity of demand.
Advertising can also provide information about
where products can be found, thereby increasing
competition.
As a consequence, advertising can result in either
an increase or a decrease in the price of the
product compared to what it would be if there
were no advertising in the industry.
Advertising increases costs.
However, advertising can also increase revenues.
So advertising may cause profits to either increase
or decrease relative to what they would be if
there were no advertising in the industry.
Oligopoly
What are the characteristics of oligopoly?
1. few firms
2. either homogeneous or differentiated products
3. interdependence of firms - policies of one firm
affect the other firms
4. substantial barriers to entry
examples: auto industry and cigarette industry
Profits in Oligopolistic Markets
The fact that there are substantial barriers to
entry implies that it is possible in oligopoly to
earn positive long run profits.
However, if oligopolists compete in a cutthroat
manner, undercutting each other’s prices, they
may drive prices down to where profits are
zero.
Short & Long Run Profit Possibilities by Market Structure
No or Low Barriers to Entry
High Barriers to Entry
Perfect
Competition
Monopolistic
Competition
Monopoly
Oligopoly
Short Run Profit
Possibilities
positive,
negative,
zero
positive,
negative,
zero
positive,
negative,
zero
positive,
negative,
zero
Long Run Profit
Possibilities
zero
zero
positive,
zero
positive,
zero
Notes:
(1) Anything (positive profits, losses, or breaking even) is possible in the short run
in any of the four market structures.
(2) When barriers to entry are low or non-existent, breaking even is the only long
run profit possibility.
(3) When barriers to entry are high, long run profits may be positive or zero.
(4) Losses (negative profits) are only possible in the short run.
Sweezy’s kinked demand curve
model of oligopoly
Assumptions:
1. If a firm raises prices, other firms won’t follow
and the firm loses a lot of business.
So demand is very responsive or elastic to
price increases.
2. If a firm lowers prices, other firms follow and
the firm doesn’t gain much business.
So demand is fairly unresponsive or inelastic to
price decreases.
The Kinked Demand Curve
$
P*
D
Q*
quantity
MR Curve
for the top part of the Demand Curve
$
D
P*
MR
Q*
quantity
Drawing MR Curve
for the bottom part of the Demand Curve
$
P*
MR
D
Q*
quantity
MR Curve
for the bottom part of the Demand Curve
$
P*
MR
D
Q*
quantity
The Kinked Demand Curve
and the MR Curve
$
P*
MR
D
Q*
quantity
The MC curve intersects the MR curve
in the vertical segment.
$
MC
P*
MR
D
Q*
quantity
The ATC curve can be added to the graph. To
show positive profits, part of ATC curve must lie
under part of the demand curve.
$
MC
ATC
P*
D
Q* MR
quantity
The ATC* value can be found on the ATC curve
above Q*.
$
MC
ATC
P*
ATC*
D
Q* MR
quantity
TC = ATC . Q
$
MC
ATC
P*
ATC*
D
Q* MR
quantity
TR = P . Q
$
MC
ATC
P*
ATC*
D
Q* MR
quantity
Profit = TR - TC
$
MC
P*
ATC*
ATC
profit
D
Q* MR
quantity
Price Rigidity
in Oligopoly Markets
$
MC
P*
MR
Suppose costs change slightly. So
the MC curve moves up or down a
little, but still intersects the MR
curve in the vertical segment.
Then the profit-maximizing levels of
output and price remain the same.
Thus, based on the kinked demand
curve model of oligopoly, price
rigidity would be expected.
This expectation is consistent with
price rigidity that is often observed
in oligopoly markets.
D
Q*
quantity
Price Leadership Models
A. Dominant firm price leadership
B. Barometric price leadership
Dominant firm price leadership
To maintain its dominance, the dominant
firm may
1. Keep industry prices low enough to deter
entry or expansion by other firms,
2. Use non-price competition (for example,
quality differences), or
3. Act defensively, using confrontation,
disciplinary action, & persecution of
troublesome firms.
Dominant firm price leadership
Strategies for the smaller firms include
• product differentiation,
• cost-cutting, and
• instituting new ways of distributing the
product and serving the customer.
Barometric price leadership
There may be several principal firms, with or
without a competitive fringe of small firms.
One firm is not powerful enough to impose
its will on the others.
The firm just appraises industry conditions &
acts first to announce new prices
consistent with these conditions.
Oligopoly is sometimes studied using
game theory.
In game theory, we have information on the
players, the possible strategies, and the
payoffs associated with those strategies.
Example 1
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$90
$100
$90
(25, 50) (45, 10)
$100
(10, 75) (70, 20)
If A chooses a price of
$90, B will be better off
choosing $90 as well.
B’s payoff would be $50
million instead of $10
million.
If A chooses $100, B will
still be better off with a
price of $90. B’s payoff
would be $75 million
instead of $20 million.
So B will choose a price
of $90, regardless of
what A does.
Dominant Strategy
a strategy that a player is better off adopting
regardless of the strategy adopted by the
other player.
In example 1, we found that firm B would
choose a price of $90 regardless of what A
chose. Thus, for B, a price of $90 is a
dominant strategy.
Example 1
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$90
$100
$90
$100
(25, 50) (45, 10)
(10, 75) (70, 20)
Notice that if B
chooses a price of
$90, A will be better off
choosing $90 as well.
A’s payoff would be
$25 million instead of
$10 million.
If B chooses $100, A
will be better off with a
price of $100. A’s
payoff would be $70
million instead of $45
million.
So A does NOT have a
dominant strategy.
Example 1
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$90
$100
$90
(25, 50) (45, 10)
$100
(10, 75) (70, 20)
We found that B will
choose a price of $90,
no matter what A does.
Then since B chooses
$90, A will choose $90
also. A’s payoff will be
$25 million instead of
$10 million.
Example 2
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$10
$15
$10
(10, 8)
(18, 3)
$15
(5, 17)
(15, 12)
If B chooses a price of
$10, A will be better off
choosing $10 as well.
A’s payoff would be
$10 million instead of
$5 million.
If B chooses $15, A
will still be better off
with a price of $10. A’s
payoff would be $18
million instead of $15
million.
So A will choose a
price of $10,
regardless of what B
does.
So A has a dominant
strategy.
Example 2
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$10
$15
$10
(10, 8)
(18, 3)
$15
(5, 17)
(15, 12)
If A chooses a price of
$10, B will be better off
choosing $10 as well.
B’s payoff would be $8
million instead of $3
million.
If A chooses $15, B
will still be better off
with a price of $10.
B’s payoff would be
$17 million instead of
$12 million.
So B will choose a
price of $10,
regardless of what A
does.
So B has a dominant
strategy.
Example 2
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$10
$15
$10
(10, 8)
(18, 3)
$15
(5, 17)
(15, 12)
When both players have
a dominant strategy, the
result is called a
dominant strategy
equilibrium.
Some games have a
dominant strategy
equilibrium, but some do
not.
In this example, the
dominant strategy
equilibrium is the
situation is which both A
and B charge $10.
Here, both players had
the same dominant
strategy; that does NOT
have to be the case in a
dominant strategy
equilibrium.
Example 2
Payoffs in millions of dollars
(Firm A’s payoff, Firm B’s payoff)
Firm B’s
price strategy
Firm A‘s
price strategy
$10
$15
$10
(10, 8)
(18, 3)
$15
(5, 17)
(15, 12)
Suppose that they had
both chosen $15 instead
of both choosing $10.
A would have had $15
million instead of $10
million & B would have
had $12 million instead
of $8 million.
So both A & B would
have been better off.
In this type of situation,
communication would
enable them to agree on
the more profitable
solution.
Example 3
Payoffs (A, B)
We can see in this
example that no matter
what B chooses, A will
be better off with a
strategy other than Z.
B’s strategy
A‘s strategy
X
Y
Z
If B chose strategy X, A
would be better off with
strategy X.
X
(6,4) (4, 3) (4,2)
If B chose strategy Y, A
would be better off with
strategy Y.
Y
(2, 1) (5, 5) (2, 2)
If B chose strategy Z, A
would be better off with
strategy X.
Z
(1, 1) (1, 3) (3, 6)
So A will not choose
strategy Z.
Example 3
Payoffs (A, B)
Look at the remaining 2
rows.
B’s strategy
A‘s strategy
X
X
Y
Z
(6,4) (4, 3) (4,2)
Y
(2, 1) (5, 5) (2, 2)
Z
(1, 1) (1, 3) (3, 6)
If A chooses X, then B is
better off with strategy X
than with strategy Z.
If A chooses Y, B is
better off with strategy Y
than with strategy Z.
So B would not choose
strategy Z either.
Beyond that, if A & B act
simultaneously &
independently, we can’t
say what will happen.
Example 3
Payoffs (A, B)
Suppose, however, that
A acts first.
B’s strategy
A‘s strategy
X
Y
Z
A knows that if he/she
chooses X, B would
choose X too.
If A chooses Y, B would
choose Y too.
X
(6,4) (4, 3) (4,2)
Of those two outcomes,
A would be better off at
(X, X) than at (Y, Y).
Y
(2, 1) (5, 5) (2, 2)
So A would choose X &
so would B.
Z
(1, 1) (1, 3) (3, 6)
Example 3
Payoffs (A, B)
Suppose B acts first.
B’s strategy
A‘s strategy
X
X
Y
B knows that if he/she
chooses X, A would
choose X too.
Z
(6,4) (4, 3) (4,2)
Y
(2, 1) (5, 5) (2, 2)
Z
(1, 1) (1, 3) (3, 6)
If B chooses Y, A would
choose Y too.
Of those two outcomes,
B would be better off at
(Y, Y) than at (X, X).
So B would choose Y &
so would A.
Sometimes a set of strategies is
a “Nash equilibrium.”
A Nash equilibrium is a set of strategies for the
players, such that no player can improve his or
her payoff unilaterally, that is, acting individually
without consulting the other player(s).
So, if player A can NOT improve its situation by
switching to another strategy, and player B can
NOT improve its situation by switching to
another strategy, then you have a Nash
equilibrium.
A game may have more than one Nash equilbrium.
Example 3
Each of these two points
is a Nash equilibrium.
Payoffs (A, B)
Look first at point (X,X)
with payoffs (6,4).
B’s strategy
A‘s strategy
X
Y
Z
X
(6,4) (4, 3) (4,2)
Y
(2, 1) (5, 5) (2, 2)
Z
(1, 1) (1, 3) (3, 6)
If A switches to a
different strategy (that is,
a different row), A’s
payoff will be less than 6.
If B switches to a
different strategy (that is,
a different column), B’s
payoff will be less than 4.
So neither player can
unilaterally improve
his/her situation and
(X,X) is a Nash
equilibrium.
Example 3
Look now at point (Y,Y)
with payoffs (5,5).
Payoffs (A, B)
If A switches to a
different strategy (that is,
a different row), A’s
payoff will be less than 5.
B’s strategy
A‘s strategy
X
Y
Z
X
(6,4) (4, 3) (4,2)
Y
(2, 1) (5, 5) (2, 2)
Z
(1, 1) (1, 3) (3, 6)
If B switches to a
different strategy (that is,
a different column), B’s
payoff will be less than 5.
So neither player can
unilaterally improve
his/her situation and
(Y,Y) is a Nash
equilibrium.
The Prisoners’ Dilemma Problem
Two individuals have committed a burglary. The police
know it, but don’t have the evidence to prove it.
Lacking a confession by either one, the police would have
to let them both go free.
The police separate the partners & say to each individually:
“We are willing to make a deal with you. Confess to the
crime, implicating your partner and we will let you go free
and you get the loot for yourself and your partner will be
locked up for a long time. If you both confess, you both
go to jail but for a shorter time. If you do not confess, but
your partner does, he/she goes free to enjoy the loot and
you get locked up for a long time.” The criminals also
know that if they both remain silent they both go free and
split the loot.
So the payoff table might look like this:
Prisoner B
Prisoner
A
remain
silent
confess
remain
silent
(4, 4)
(-10, 8)
confess
(8,-10)
(-5, -5)
Both remaining silent is not a Nash equilibrium:
If A remained silent, B could improve his/her situation by
confessing, & vice versa.
Whether A
confesses or not,
B is better off
confessing.
Whether B
confesses or not,
A is better off
confessing.
Both criminals’
confessing is a
Nash equilibrium:
If A is going to
confess, B will
make things
worse for
him/herself by
remaining silent,
& vice versa.