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MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
13
CHAPTER
Objectives
After studying this chapter, you will able to
 Define and identify monopolistic competition
 Explain how output and price are determined in a
monopolistically competitive industry
 Explain why advertising costs are high in a
monopolistically competitive industry
Objectives
After studying this chapter, you will able to
 Explain why the price might be sticky in oligopoly
 Explain how price and output are determined when there
is one dominant firm and several smaller firms in a
market
 Use game theory to make predictions about price wars
and competition among a small number of firms
PC War Games
Each PC maker tells us that they have the best product at
the best price.
Just two big chip makers produce almost all the processor
and memory chips in our PCs.
Firms in these markets are neither price takers like those
in perfect competition, nor are they protected from
competition by barriers to entry like a monopoly.
How do such firms choose the quantity to produce and
price?
Monopolistic Competition
Monopolistic competition is a market with the following
characteristics:
 A large number of firms.
 Each firm produces a differentiated product.
 Firms compete on product quality, price, and marketing.
 Firms are free to enter and exit the industry.
Monopolistic Competition
Large Number of Firms
The presence of a large number of firms in the market
implies:
 Each firm has only a small market share and therefore
has limited market power to influence the price of its
product.
 Each firm is sensitive to the average market price, but no
firm pays attention to the actions of the other, and no one
firm’s actions directly affect the actions of other firms.
 Collusion, or conspiring to fix prices, is impossible.
Monopolistic Competition
Product Differentiation
Firms in monopolistic competition practice product
differentiation, which means that each firm makes a
product that is slightly different from the products of
competing firms.
Monopolistic Competition
Competing on Quality, Price, and Marketing
Product differentiation enables firms to compete in three
areas: quality, price, and marketing.
Quality includes design, reliability, and service.
Because firms produce differentiated products, each firm
has a downward-sloping demand curve for its own
product.
But there is a tradeoff between price and quality.
Differentiated products must be marketed using
advertising and packaging.
Monopolistic Competition
Entry and Exit
There are no barriers to entry in monopolistic competition,
so firms cannot earn an economic profit in the long run.
Examples of Monopolistic Competition
Figure 13.1 on the next slide shows market share of the
largest four firms and the HHI for each of ten industries
that operate in monopolistic competition.
Monopolistic Competition
The red bars
refer to the 4
largest firms.
Green is the
next 4.
Blue is the
next 12.
The numbers
are the HHI.
Output and Price in Monopolistic
Competition
Short-Run Economic Profit
A firm that has decided the quality of its product and its
marketing program produces the profit maximizing
quantity at which its marginal revenue equals its marginal
cost (MR = MC).
Price is determined from the demand curve for the firm’s
product and is the highest price the firm can charge for the
profit-maximizing quantity.
Output and Price in Monopolistic
Competition
Figure 13.2(a) shows a
short-run equilibrium for a
firm in monopolistic
competition.
It operates much like a
single-price monopolist.
Output and Price in Monopolistic
Competition
The firm produces the
quantity at which price
equals marginal cost and
sells that quantity for the
highest possible price.
It earns an economic
profit (as in this example)
when P > ATC.
Output and Price in Monopolistic
Competition
Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn
an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition
maximizes its profit by producing the quantity at which its
marginal revenue equals its marginal cost, MR = MC.
Output and Price in Monopolistic
Competition
As firms enter the industry, each existing firm loses some
of its market share. The demand for its product decreases
and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which
MR = MC and lowers the maximum price that the firm can
charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and
firms earn zero economic profit.
Output and Price in Monopolistic
Competition
This figure shows a firm in
monopolistic competition
moving from short-run
equilibrium to long-run
equilibrium.
If firms incur an economic
loss, firms exit to restore
the long-run equilibrium
just described.
Output and Price in Monopolistic
Competition
Monopolistic Competition and Efficiency
Firms in monopolistic competition are inefficient and
operate with excess capacity.
Figure 13.3 on the next slide illustrates these propositions.
Output and Price in Monopolistic
Competition
Because they productdifferentiate and face a
downward-sloping
demand curve for their
products, firms in
monopolistic competition
receive a marginal
revenue that is less than
price for all levels of
output.
Output and Price in Monopolistic
Competition
Firms maximize profit by
setting marginal revenue
equal to marginal cost, so
with marginal revenue
less than price, marginal
cost is also less than
price.
Output and Price in Monopolistic
Competition
Because price equals the
marginal benefit, marginal
cost is less than marginal
benefit.
Underproduction in
monopolistic competition
creates deadweight loss.
Output and Price in Monopolistic
Competition
A firm’s capacity output is
the output at which average
total cost is at its minimum.
At the long-run profit
maximizing output, price
equals average total cost.
But recall that MR < P,
which means that MC <
ATC.
Output and Price in Monopolistic
Competition
If MC < ATC, then the
ATC curve is falling.
With output in the range of
falling ATC, output is less
than capacity output.
Goods are not produced
at the minimum unit cost
of production in the long
run.
Product Development and Marketing
Innovation and Product Development
We’ve looked at a firm’s profit-maximizing output decision
in the short run and the long run of a given product and
with given marketing effort.
To keep earning an economic profit, a firm in monopolistic
competition must be in a state of continuous product
development.
New product development allows a firm to gain a
competitive edge, if only temporarily, before competitors
imitate the innovation.
Product Development and Marketing
Innovation is costly, but it increases total revenue.
Firms pursue product development until the marginal
revenue from innovation equals the marginal cost of
innovation.
Production development may benefit the consumer by
providing an improved product, or it may only create the
appearance of a change in product quality.
Regardless of whether a product improvement is real or
imagined, its value to the consumer is its marginal benefit,
which is the amount the consumer is willing to pay for it.
Product Development and Marketing
Marketing
A firm’s marketing program uses advertising and
packaging as the two principal methods to market its
differentiated products to consumers.
Firms in monopolistic competition incur heavy marketing
and advertising expenditures to enhance the perception of
quality differences between their product and rival
products. These costs make up a large portion of the price
for the product.
Product Development and Marketing
Figure 13.4 shows
estimates of the
percentage of sale price
for different monopolistic
competition markets.
Cleaning supplies and toys
top the list at almost 15
percent.
Product Development and Marketing
Selling Costs and Total Costs
Selling costs, like advertising expenditures, fancy retail
buildings, etc. are fixed costs.
Average fixed costs decrease as production increases, so
selling costs increase average total costs at any given
level of output but do not affect the marginal cost of
production.
Selling efforts such as advertising are successful if they
increase the demand for the firm’s product.
Product Development and Marketing
Advertising costs might
lower the average total
cost by increasing
equilibrium output and
spreading their fixed costs
over the larger quantity
produced.
Here, with no advertising,
the firm produces 25 units
of output at an average
total cost of $170.
Product Development and Marketing
With advertising, the firm
produces 130 units of
output at an average total
cost of $160.
The advertising
expenditure shifts the
average total cost curve
upward, but the firm
operates at a higher output
and lower ATC than it
would without advertising.
Product Development and Marketing
But advertising can increase a firm’s demand and profits in
the short run only.
Economic profit leads to entry, which decreases the
demand for each firm’s product in the long run.
To the extent that advertising and selling costs provide
consumers with information and services that they value
more highly than their cost, these activities are efficient.
Oligopoly
Oligopoly is a market in which a small number of firms
compete.
In oligopoly, the quantity sold by one firm depends on the
firm’s own price and the prices and quantities sold by the
other firms.
The response of other firms to a firm’s price and output
influence the firm’s profit-maximizing decision.
Oligopoly
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm
believes that if it raises its price, its competitors will not
follow, but if it lowers its price all of its competitors will
follow.
Oligopoly
Figure 13.6 shows the
kinked demand curve
model.
The demand curve that a
firm believes it faces has a
kink at the current price
and quantity.
Oligopoly
Above the kink, demand is
relatively elastic because
all other firm’s prices
remain unchanged.
Below the kink, demand is
relatively inelastic because
all other firm’s prices
change in line with the
price of the firm shown in
the figure.
Oligopoly
The kink in the demand
curve means that the MR
curve is discontinuous at
the current quantity—shown
by the gap AB in the figure.
Oligopoly
Fluctuations in MC that
remain within the
discontinuous portion of the
MR curve leave the profitmaximizing quantity and
price unchanged.
For example, if costs
increased so that the MC
curve shifted upward from
MC0 to MC1, the profitmaximizing price and
quantity would not change.
Oligopoly
The beliefs that generate
the kinked demand curve
are not always correct and
firms can figure out this
fact
If MC increases enough,
all firms raise their prices
and the kink vanishes.
A firm that bases its
actions on wrong beliefs
doesn’t maximize profit.
Oligopoly
Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that
has a significant cost advantage over many other, smaller
competing firms.
The large firm operates as a monopoly, setting its price
and output to maximize its profit.
The small firms act as perfect competitors, taking as given
the market price set by the dominant firm.
Oligopoly
Figure 13.7 shows a dominant firm industry. On the left are
10 small firms and on the right is one large firm.
S10
Oligopoly
The demand curve, D, is the market demand curve and the
supply curve S10 is the supply curve of the 10 small firms.
S10
Oligopoly
At a price of $1.50, the 10 small firms produce the quantity
demanded. At this price, the large firm would sell nothing.
S10
Oligopoly
But if the price was $1.00, the 10 small firms would supply
only half the market, leaving the rest to the large firm.
Oligopoly
The demand curve for the large firm’s output is the curve
XD on the right.
Oligopoly
The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.
Oligopoly
The large firm maximizes profit by setting MR = MC. Let’s
suppose that the marginal cost curve is MC in the figure.
Oligopoly
The profit-maximizing quantity for the large firm is 10 units.
The price charged is $1.00.
Oligopoly
The small firms take this price and supply the rest of the
quantity demanded.
Oligopoly
A dominant firm oligopoly can arise only if one firm has
lower costs than the others.
Oligopoly
In the long run, such an industry might become a monopoly
as the large firm buys up the small firms and cuts costs.
Oligopoly Games
Game theory is a tool for studying strategic behavior,
which is behavior that takes into account the expected
behavior of others and the mutual recognition of
interdependence.
What Is a Game?
All games share four features:
 Rules
 Strategies
 Payoffs
 Outcome
Oligopoly Games
The Prisoners’ Dilemma
The prisoners’ dilemma game illustrates the four features
of a game.
The rules describe the setting of the game, the actions the
players may take, and the consequences of those actions.
In the prisoners’ dilemma game, two prisoners (Art and
Bob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicate
with the other.
Oligopoly Games
Each is told that both are suspected of committing a more
serious crime.
If one of them confesses, he will get a 1-year sentence for
cooperating while his accomplice get a 10-year sentence for
both crimes.
If both confess to the more serious crime, each receives 3
years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the
minor crime only.
Oligopoly Games
In game theory, strategies are all the possible actions of
each player.
Art and Bob each have two possible actions:
 Confess to the larger crime
 Deny having committed the larger crime
Because there are two players and two actions for each
player, there are four possible outcomes:
 Both confess
 Both deny
 Art confesses and Bob denies
 Bob confesses and Art denies
Oligopoly Games
Each prisoner can work out what happens to him—can work
out his payoff—in each of the four possible outcomes.
We can tabulate these outcomes in a payoff matrix.
A payoff matrix is a table that shows the payoffs for every
possible action by each player for every possible action by
the other player.
The next slide shows the payoff matrix for this prisoners’
dilemma game.
Payoff
Matrix
Oligopoly Games
Oligopoly Games
If a player makes a rational choice in pursuit of his own
best interest, he chooses the action that is best for him,
given any action taken by the other player.
If both players are rational and choose their actions in this
way, the outcome is an equilibrium called Nash
equilibrium—first proposed by John Nash.
The following slides show how to find the Nash
equilibrium.
Bob’s
view
of the
world
Bob’s
view
of the
world
Art’s
view
of the
world
Art’s
view
of the
world
Equilibrium
Oligopoly Games
An Oligopoly Price-Fixing Game
A game like the prisoners’ dilemma is played in duopoly.
A duopoly is a market in which there are only two
producers that compete.
Duopoly captures the essence of oligopoly.
Figure 13.8 on the next slide describes the demand and
cost situation in a natural duopoly.
Oligopoly Games
Part (a) shows each firm’s cost curves.
Part (b) shows the market demand curve.
Oligopoly Games
This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.
Oligopoly Games
How does this market work?
What is the price and quantity produced in equilibrium?
Oligopoly Games
Suppose that the two firms enter into a collusive
agreement.
A collusive agreement is an agreement between two (or
more) firms to restrict output, raise price, and increase
profits.
Such agreements are illegal in the United States and are
undertaken in secret.
Firms in a collusive agreement operate a cartel.
Oligopoly Games
The possible strategies are:
 Comply
 Cheat
Because each firm has two strategies, there are four
possible outcomes:
 Both comply
 Both cheat
 Trick complies and Gear cheats
 Gear complies and Trick cheats
Oligopoly Games
The first possible outcome—both comply—earns the
maximum economic profit, which is the same as a monopoly
would earn.
Oligopoly Games
To find that profit, we set marginal cost for the cartel equal to
marginal revenue for the cartel. Figure 13.9 shows this
outcome.
Oligopoly Games
The cartel’s marginal cost curve is the horizontal sum of the
MC curves of the two firms and the marginal revenue curve
is like that of a monopoly.
Oligopoly Games
The firms maximize economic profit by producing the
quantity at which MCI = MR.
Oligopoly Games
Each firm agrees to produce 2,000 units and each firm
shares the maximum economic profit.
Oligopoly Games
When each firm produces 2,000 units, the price is greater
than the firm’s marginal cost, so if one firm increased
output, its profit would increase.
Oligopoly Games
Figure 13.10 shows what happens when one firm cheats
and increases its output to 3,000 units. Industry output
rises to 5,000 and the price falls.
Oligopoly Games
For the complier, ATC now exceeds price.
For the cheat, price exceeds ATC.
Oligopoly Games
The complier incurs an economic loss.
The cheat earns an increased economic profit.
Oligopoly Games
Either firm could cheat, so this figure shows two of the
possible outcomes.
Next, let’s see the effects of both firms cheating.
Oligopoly Games
Figure 13.11 shows the outcome if both firms cheat and
increase their output to 3,000 units.
Oligopoly Games
Industry output is 6,000 units, the price falls, and both
firms earn zero economic profit—the same as in perfect
competition.
Oligopoly Games
You’ve now seen the four possible outcomes:
 If both comply, they make $2 million a week each.
 If both cheat, they earn zero economic profit.
 If Trick complies and Gear cheats, Trick incurs an
economic loss of $1 million and Gear makes an economic
profit of $4.5 million.
 If Gear complies and Trick cheats, Gear incurs an
economic loss of $1 million and Trick makes an economic
profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly
game.
Payoff
Matrix
Trick’s
view
of the
world
Trick’s
view
of the
world
Gear’s
view
of the
world
Gear’s
view
of the
world
Equilibrium
Oligopoly Games
The Nash equilibrium is where both firms cheat.
The quantity and price are those of a competitive market,
and the firms earn normal profit.
Other Oligopoly Games
Advertising and R & D games are also prisoners’
dilemmas.
An R & D Game
Procter & Gamble and Kimberley Clark play an R & D
game in the market for disposable diapers.
Repeated Games and Sequential Games
A Repeated Duopoly Game
If a game is played repeatedly, it is possible for duopolists
to successfully collude and earn a monopoly profit.
If the players take turns and move sequentially (rather
than simultaneously as in the prisoner’s dilemma), many
outcomes are possible.
In a repeated prisoners’ dilemma duopoly game, additional
punishment strategies enable the firms to comply and
achieve a cooperative equilibrium, in which the firms
make and share the monopoly profit.
Repeated Games and Sequential Games
One possible punishment strategy is a tit-for-tat strategy,
in which one player cooperates this period if the other
player cooperated in the previous period but cheats in the
current period if the other player cheated in the previous
period.
A more severe punishment strategy is a trigger strategy in
which a player cooperates if the other player cooperates
but plays the Nash equilibrium strategy forever thereafter if
the other player cheats.
Repeated Games and Sequential Games
Table 13.4 (page 297) shows that a tit-for-tat strategy is
sufficient to produce a cooperative equilibrium in a
repeated duopoly game.
Price wars might result from a tit-for-tat strategy where
there is an additional complication—uncertainty about
changes in demand.
A fall in demand might lower the price and bring forth a
round of tit-for-tat punishment.
Repeated Games and Sequential Games
A Sequential Entry Game in a Contestable Market
In a contestable market—a market in which firms can
enter and leave so easily that firms in the market face
competition from potential entrants—firms play a
sequential entry game.
Repeated Games and Sequential Games
Figure 13.12 shows the game tree for a sequential entry
game in a contestable market.
Repeated Games and Sequential Games
In the first stage, Agile decides whether to set the
monopoly price or the competitive price.
Repeated Games and Sequential Games
In the second stage, Wanabe decides whether to enter or
stay out.
Repeated Games and Sequential Games
In the equilibrium of this entry game, Agile sets a
competitive price and earns a normal profit to keep
Wanabe out.
A less costly strategy is limit pricing, which sets the price
at the highest level that is consistent with keeping the
potential entrant out.
MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
THE END
13
CHAPTER