Download Chapter Fourteen

Monopolistic Competition and
Oligopoly
Chapter 14
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Monopolistic Competition
Monopolistic competition is a common form of
industry structure in Canada, characterized by:
a large number of firms, none of which can influence
market price by virtue of size alone
some degree of market power achieved through the
production of differentiated products
no barriers to entry or exit
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Concentration Ratios in Selected
Industries, 1988 (Table 14.1)
CR4 and CR8 refer to the percentage of revenue
controlled by the largest 4 and the largest 8 enterprises.
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Product Differentiation
Product differentiation refers to a strategy that
firms use to achieve market power.
 Achieved by producing products that have
distinct positive identities in the minds of
consumers
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The Case for Product Differentiation
& Advertising
Provides consumers with variety in markets
Ensures that the quality of products remains
high
Satisfies a wide range of consumer tastes
Provides for product innovation
Encourages competition among firms, providing
for efficiency
Advertising provides information for consumers
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The Case Against Product
Differentiation & Advertising
Society’s scarce resources are wasted as firms
attempt to make small changes in products
Information content of advertising is minimal
and often misleading
High advertising costs may serve as a barrier to
entry in some industries
Advertising imposes costs on society because it
is bothersome
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Product Differentiation Reduces the
Elasticity of Demand Facing a Firm
(Figure 14.1)
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Price / Output Determination in the
Short Run
To maximize profit, the monopolistically
competitive firm will increase production until
the marginal revenue from increasing output
and selling it, no longer exceeds the marginal
cost of producing it. This occurs at the point
where MC = MR.
It is therefore possible for the monopolistically
competitive firm to earn short-run profits or
suffer short-run losses.
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A Monopolistically Competitive Firm
Earning Short-Run Profits (Figure 14.2a)
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A Monopolistically Competitive Firm
Suffering Short-Run Losses (Figure 14.2b)
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Monopolistically Competitive Firm at
Long-Run Equilibrium (Figure 14.3)
 As new firms enter the
monopolistically
competitive industry the
demand curves of
profit-making firms
begin to shift left.
 The process continues
until profits are
eliminated and the
demand curve is just
tangent to the average
total cost curve.
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Economic Efficiency and Resource
Allocation for Monopolistic Competition
Price is greater than marginal cost, greater than
the perfectly competitive solution.
The long-run equilibrium quantity of output is to
the left of the minimum of ATC.
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Oligopoly
Oligopoly is a form of industry structure
characterized by:
a few firms, each large enough to influence market
price
differentiated or homogeneous products
firms behaving in a way that depends to a great
extent on the behaviour of other firms
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Concentration Ratios in Selected
Industries, 1988 (Table 14.5)
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Oligopoly Models
The Collusion Model
The Cournot Model
The Kinked Demand Model
The Price Leadership Model
Game Theoretic Models
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Collusion Model
Cartel refers to a group of firms that gets
together and makes joint price and output
decisions in order to maximize joint profits.
A modern example is OPEC.
Collusion occurs when price and quantity fixing
agreements among producers are explicit.
Tacit collusion occurs when such agreements
are implicit.
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Assumptions of the Cournot Model
There are two firms in the industry - a duopoly.
Each firm takes the output of the other firm as
given.
Both firms maximize profits.
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Cournot Model
The Cournot Model is model of a two-firm
industry (duopoly) in which a series of output
adjustment decisions leads to a final level of
output that is between that which would prevail
if the market were organized competitively and
that which would be set by a monopoly.
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The Kinked Demand Curve Model
The kinked demand curve model is a model of
oligopoly in which the demand curve facing
each individual firm has a kink in it.
The kink follows from the assumption that
competitive firms will follow suit if a single firm
cuts price, but will not follow suit it a single firm
raises price.
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The Kinked Demand Curve Oligopoly
Model (Figure 14.4)
 If the firm increases its
price the demand will
fall off quite quickly.
 If the firm drops its
price the other firms
follow and quantity
demanded does not
change as much.
 Demand is elastic
above P* and inelastic
below P*.
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The Price Leadership Model
The price leadership model is a form of
oligopoly in which one dominant firm sets prices
and all the smaller firms in the industry follow
its pricing policy.
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The Price Leadership Model
(Figure 14.5)
The leading firm maximizes profits by assuming that the demand it
will face is the total market demand minus the amount supplied by
the firms that are expected to follow its leadership.
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Results of the Price Leadership Model
The quantity demanded in the industry is split
between the dominant firm and the group of
smaller firms.
This division of output is determined by the
amount of market power that the dominant firm
has.
The dominant firm has an incentive to push
smaller firms out of the industry in order to
establish a monopoly.
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Game Theory
Game theory analyzes oligopolistic behaviour as
a complex series of strategic moves and reactive
countermoves among rival firms.
In game theory, firms are assumed to anticipate
rival reactions.
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Dominant Strategy and Nash
Equilibrium
A dominant strategy in game theory is a
strategy that is best no matter what the
opposition does.
Nash equilibrium is the result in game theory,
when all players play their best strategy given
what their competitors are doing.
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Payoff Matrix for an Advertising
Game (Figure 14.6)
The dominant strategy for A and B is to advertise.
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The Prisoner’s Dilemma
(Figure 14.7)
The dominant strategy is for both Rocky and
Ginger to confess.
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Payoff Matrixes for Left / Right Top / Bottom Strategies (Figure 14.8a)
 In this game C does not
have a dominant
strategy but D does,
right.
 Since D’s behaviour is
predictable C will play
accordingly, in this case
bottom.
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Payoff Matrixes for Left / Right Top / Bottom Strategies (Figure 14.8b)
 In this game C does not
have a dominant strategy
but D does, right.
 Since C stands to lose
such a large amount,
uncertainty and risk will
probably cause C to
choose top rather than
risk bottom, despite
knowledge of D’s
dominant strategy.
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Maximin Strategy
A maximin strategy in game theory is a strategy
chosen to maximize the minimum gain that can
be earned.
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Contestable Markets
A market in which entry and exit are costless.
Because entry is cheap, firms are continually
faced with competition or the threat of
competition.
In contestable markets, firms behave like
perfectly competitive firms.
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Oligopoly and Economic Performance
Market concentration leads to pricing above
marginal cost and output below the efficient
level.
Entry barriers prevent the efficient flow of
resources between firms and industries.
Product differentiation may lead to efficiency
losses.
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Review Terms & Concepts
 cartel
 cournot model
 dominant strategy
 game theory
 kinked demand curve
model
 maximin strategy
 monopolistic competition
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 Nash equilibrium
 oligopoly
 perfectly contestable
market
 price leadership
 product differentiation
 tacit collusion
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