Download Lecture 7 - Har Wai Mun

UBEA 1013: ECONOMICS
CHAPTER 7:
MARKET STRUCTURE: MONOPOLISTIC
COMPETITION & OLIGOPOLY
7.1 Characteristic
7.2 Short-run Decision: Profit Maximization
7.3 Short-run Decision: Minimizing Loss
7.4 Long-run Equilibrium
7.5 Oligopoly Model
7.6 Games Theory
7.7 Efficiency
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UBEA 1013: ECONOMICS
Market structure compared:
More competing firms
Monopoly
Monopoly:
• Single firm (firm = market).
• Single unique product (no
close substitute).
• Restriction to entry.
• Market power: the highest but
still constraint by market
demand.
Perfect Competition
Perfect competition:
• Many firms.
• Homogenous product.
• Free entry & exit.
• Market power: the lowest (firm
as price taker).
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UBEA 1013: ECONOMICS
Market structure compared:
More competing firms
Monopoly
Oligopoly
Oligopoly:
• Few big firms.
• Can be homogenous or
differentiated.
• Few restriction to entry.
• Market power: Yes but may face
fierce competition among few big
firms (except collusion happen).
• Strategic behavior.
Monopolistic
Competition
Perfect
Competition
Monopolistic competition:
• Many firms.
• Differentiated product.
• Free entry & exit.
• Market power: Yes but limited.
• Price & quality competition.
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UBEA 1013: ECONOMICS
7.1 Characteristic
Monopolistic competition is a market structure in which:
• (1A) A large number of independent firms compete.
• (2A) Each firm produces a differentiated product.
• (3A) Firms compete on product quality, price, and
marketing.
• (4A) Firms are free to enter and exit.
Oligopoly is a market type in which:
• (1B) A small number of firms compete.
• (2B) Product can be homogenous or differentiated.
• (3B) Strategic behavior explained firms’ decisions.
(Game Theory)
• (4B) Natural or legal barriers prevent the new entry. 4
UBEA 1013: ECONOMICS
Monopolistic competition
• (1A) The market that has a large number of firms (like in
perfect competition) has three implications:
• (i) small market share for each firm, therefore each firm
has only a small market share and therefore has limited
market power to influence the price of its product
• (ii) 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.
• (iii) Collusion, or conspiring to fix prices, is impossible.
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UBEA 1013: ECONOMICS
Monopolistic competition
• (2A) Product differentiation is a strategy that firms use to
achieve market power. Accomplished by producing products
that have distinct positive identities in consumers’ minds
(mean seen as slightly different). This differentiation is often
accomplished through advertising.
• (2A & 3A) Advertising provides consumers with the valuable
information on product availability, quality, and price that they
need to make efficient choices in the marketplace.
• (4A) Free entry & exit: There are no barriers to entry in
monopolistic competition, so firms cannot earn an economic
profit in the long run.
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UBEA 1013: ECONOMICS
Monopolistic competition
• (3A) 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. Thus,
there are different prices for each differentiated products (but
usually, the different in price is not too huge.
Differentiated products must be marketed using advertising and
packaging. Branding will further differentiate the product and
usually will enhance the perceived quality of the particular firm’s
product.
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UBEA 1013: ECONOMICS
Monopolistic Competition
(3A) Selling efforts such as advertising are successful if they increase
the demand for the firm’s product. Advertising costs might lower the
average total cost by increasing equilibrium output and spreading their
fixed costs over the larger quantity produced.
Figure 7.1: With no advertising,
the firm produces 25 units of
output at an average total cost of
$60.
Figure 7.1: Advertising Effect
With advertising, the firm
produces 100 units of output at
an average total cost of $40.
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.
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UBEA 1013: ECONOMICS
•
Monopolistic Competition
Identifying Monopolistic Competition
Two indexes:
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index
The four-firm concentration ratio
– The percentage of the value of sales accounted for by the four
largest firms in the industry.
– The range of concentration ratio is from almost zero for perfect
competition to 100 percent for monopoly.
• A ratio that exceeds 40 percent: indication of oligopoly.
• A ratio of less than 40 percent: indication of monopolistic
competition.
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UBEA 1013: ECONOMICS
Herfindahl-Hirschman Index (HHI)
– HHI is a mathematical calculation
that uses market share figures to
determine whether or not a
proposed merger will be challenged
by the government.
– Example, four firms with market
shares as 50 percent, 25 percent,
15 percent, and 10 percent.
– HHI = 502 + 252 + 152 + 102 =
3,450
– A market with an HHI less than
1,000 is regarded as competitive.
– An HHI between 1,000 and 1,800
is moderately competitive.
Monopolistic Competition
ANTITRUST DIVISION
ACTION
Concentrated
HHI
1,800
1,000
0
Challenge if Index
is raised by more
than 50 points by
the merger
Moderate
Concentration
Challenge if Index
is raised by more
than 100 points by
the merger
Unconcentrated
No challenge
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UBEA 1013: ECONOMICS
7.1 Characteristic
Monopolistic competition is a market structure in which:
• (1A) A large number of independent firms compete.
• (2A) Each firm produces a differentiated product.
• (3A) Firms compete on product quality, price, and
marketing.
• (4A) Firms are free to enter and exit.
Oligopoly is a market type in which:
• (1B) A small number of firms compete.
• (2B) Product can be homogenous or differentiated.
• (3B) Strategic behavior explained firms’ decisions.
(Game Theory)
• (4B) Natural or legal barriers prevent the new entry.11
UBEA 1013: ECONOMICS
Oligopoly Characteristic
• (2B) In contrast to monopolistic competition and perfect
competition, an oligopoly consists of a small number of firms:
• Each firm has a large market share.
• The firms are interdependent. Thus, the behavior of
oligopoly firms depend on the behavior of other (oligopoly)
firms in the industry. Before making a decision, each firm
must consider how the other firms will react to its decision
and influence its profit. (3B)
• The firm have incentive to collude. [Collusion Model].
Collusion occurs when price- and quantity-fixing
agreements are explicit. E.g is cartel (a group of firms that
gets together and makes price and output decisions to
maximize joint profits). Tacit collusion occurs when firms
end up fixing price without a specific agreement, or when
such agreements are implicit.
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UBEA 1013: ECONOMICS
Oligopoly
• (4B) Barriers to Entry
– Either natural or legal barriers to entry can create an oligopoly.
– Natural barriers arise from the combination of the demand for
a product and economies of scale in producing it.
– If the demand for a product limits to a small number the firms
that can earn an economic profit, there is a natural oligopoly.
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Oligopoly
Figure 7.2(a) show a natural duopoly
situation.
Figure 7.2(b) show a natural oligopoly
with three firms.
Here, where price equals minimum
Here, where price equals minimum
ATC, the lowest possible price,
two firms can produce the quantity
demanded in the market.
ATC, the lowest possible price,
three firms can produce the
quantity demanded in the market.
Figure 7.2(a): Natural duopoly
Figure 7.2(b): Natural oligopoly
with three firms
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UBEA 1013: ECONOMICS
Oligopoly
(4B) Contestable Market
• A market is perfectly contestable if entry to it and exit from it are
costless.
• In contestable markets, even large oligopolistic firms end up
behaving like perfectly competitive firms. Prices are pushed to
long-run average cost by competition, and positive profits do not
persist.
• Oligopolies are concentrated industries. At one extreme is the
cartel, in essence, acting as a monopolist. At the other extreme,
firms compete for small contestable markets in response to
observed profits. In between are a number of alternative models,
all of which stress the interdependence of oligopolies firms.
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UBEA 1013: ECONOMICS
Monopolistic Competition
Another Characteristic: Demand Curve & Equilibrium Outcome
Figure 7.3: Monopolistic Competition
Demand Curve
• The demand curve
faced by a
monopolistic
competitor is likely to
be less elastic than
the demand curve
faced by a perfectly
competitive firm, but
more elastic than the
demand curve faced
by a monopoly.
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UBEA 1013: ECONOMICS
Competitive Outcome:
Price equals marginal
cost.
Oligopoly
Figure 7.4:Possible Oligopoly Outcome
Monopoly Outcome:
The firm would be a
single-price monopoly.
Possible Oligopoly
Outcomes: The
extremes of perfect
competition and
monopoly provide the
maximum range within
which the oligopoly
outcome might lie.
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UBEA 1013: ECONOMICS
Monopolistic Competition
7.2 Short-run Decision: Profit Maximization
The firm in monopolistic competition makes its output and
price decision just like a monopoly firm does, that is
MR = MC.
Figure 7.2: Profit Maximization
• In the short-run, a
monopolistically
competitive firm will
produce up to the
point where MR = MC.
• This firm is earning
positive profits in the
short-run.
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UBEA 1013: ECONOMICS
Monopolistic Competition
7.3 Short-run Decision: Minimizing Loss
The firm in monopolistic competition might incurred loses in
the short-run. Profit are not guarantee. But, loss minimized
when MR = MC.
Figure 7.3: Loss Minimization
• Loss is minimized at
MC = MR at 40
thousand of output.
• The price = $40 per
month which is less
than ATC ($50).
Therefore, the firm
incurs losses.
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UBEA 1013: ECONOMICS
7.4 Long-run Decision: Monopolistic Competition
• Long Run: Zero Economic
Profit
Figure 7.4: Long-Run Equilibrium
Economic profit induces entry
and economic loss induces
exit, as in perfect competition.
Entry decreases the demand for
the product of each firm. Exit
increases the demand for the
product of each firm.
In the long run, economic profit
is competed away and firms
earn normal profit.
Figure 7.4 illustrates long-run
equilibrium where the firm’s
demand curve is just tangent to
its average cost curve.
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UBEA 1013: ECONOMICS
7.5 Oligopoly Model
Possible Behavior / Strategy
Compete
Not to compete
Collusion Model
i.
ii.
iii.
iv.
Quantity leadership (Stackelberg Model)
Price Leadership Model
Simultaneous Quantity Setting (Cournot Model)
Simultaneous Price Setting (Bertrand Model)
Plus one general model: Kinked Demand Curve Model
<< Assumption for oligopoly model analysis: Identical product >>
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UBEA 1013: ECONOMICS
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 (the
general assumption).
Figure 7.5: Kinked Demand Curve
• Above P*, an increase in
price, which is not followed by
competitors, results in a large
decrease in the firm’s quantity
demanded (demand is
elastic).
• Below P*, price decreases are
followed by competitors so the
firm does not gain as much
quantity demanded (demand
is inelastic).
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UBEA 1013: ECONOMICS
Oligopoly
i. Quantity leadership (Stackelberg Model)
– The dominant firm (leader) choose an output level
that can maximize its profit
– Then, the smaller firms (followers) response and
choose their respective output level given the choice
of their leader.
– The leader is aware that its actions influence the
output choices of its follower. Thus, its decision need
to consider the expected reaction of its follower.
– The equilibrium(s) for Stackelberg model reflects in
the Nash equilibrium of games theory in which each
player takes the best possible action given the action
of the other player .
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UBEA 1013: ECONOMICS
Oligopoly
ii. Price leadership
– The dominant firm (leader) set a price level
– Then, the smaller firms (followers) follow its pricing
policy due to assumption that products are identical.
So, if firms charge different price, the customers
would prefer the producer with the lowest price.
– Thus, it is like a perfectly competitive market. Each
follower firm takes the price as being outside of its
control because it is only a small part of the market.
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UBEA 1013: ECONOMICS
•
Oligopoly
The price-leadership model outcome:
– 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 of the dominant firm.
– The dominant firm has an incentive to push smaller
firms out of the industry in order to establish a
monopoly.
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UBEA 1013: ECONOMICS
Oligopoly
• Large, powerful firm (the leader) can drive smaller
firms out of the market by temporarily selling at an
artificially low price. This practice is called predatory
pricing.
• Such behavior became illegal in the United States
with the passage of antimonopoly legislation around
the turn of the century.
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Oligopoly
iii. Simultaneous Quantity Setting (Cournot Model)
– The oligopoly firms simultaneously trying to decide
what quantity to produce.
– Each firm has to forecast what the other firm’s output
will be in order to make a sensible decision itself.
– A series of output adjustment lead to a final decision of
output where every firm’s expectation about the other
firms’ output choices is satisfied (called Cournot
equilibrium).
– In Cournot equilibrium, neither firms will find it profitable
to change its output once it discovers the choice
actually made by other firms (satisfied with this
discovery).
– Cournot equilibrium can be generalized in the Nash
equilibrium (one of the Game Theory strategy).
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UBEA 1013: ECONOMICS
Oligopoly
iv. Simultaneous Price Setting (Bertrand Model)
– The oligopoly firms simultaneously trying to decide
what price to produce.
– Interestingly, the Bertrand equilibrium is the same as
perfect competition equilibrium. The logic?
– No firm will be setting its price below its MC as they will
suffer losses. (assuming same cost structure and
product identical).
– If Firm A is believed to set price above MC, Firm B (or
other firms) can under-cut to set a slightly lower than
Firm A price to gain customers.
– However, this knowledge is also known by Firm A and
other firms (not only Firm B). So, what is the price that
give no chance for other to under-cut?
– It is when price equal MC!!! (the perfect competitive
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profit maximization condition).
UBEA 1013: ECONOMICS
7.6 Game Theory
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.
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Game Theory
• Game theory analyzes
oligopolistic behavior 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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UBEA 1013: ECONOMICS
Game Theory
Payoff Matrix for Advertising Game
• The strategy that firm A will actually choose depends
on the information available about B’s likely strategy.
• Regardless of what B does, it pays for A to advertise.
This is the dominant strategy, or the strategy that is
best no matter what the opposition does.
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UBEA 1013: ECONOMICS
Game Theory
• The Prisoners’ Dilemma is a game
in which:
• The players are prevented from
cooperating with each other;
• Each player in isolation has a dominant
strategy;
• The dominant strategy makes each
player worse off than in the case in
which they could cooperate.
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Game Theory
• Ginger and Rocky have dominant strategies
to confess even though they would be better
off if they both kept their mouths shut.
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UBEA 1013: ECONOMICS
Game Theory
• In game theory, when
all players are playing
their best strategy
given what their
competitors are doing,
the result is called
Nash equilibrium.
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UBEA 1013: ECONOMICS
Game Theory
• When uncertainty and
risk are introduced, the
game changes. A
maximin strategy is a
strategy chosen to
maximize the
minimum gain that can
be earned.
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UBEA 1013: ECONOMICS
Game Theory
• While explicit collusion violates the antitrust statutes,
strategic reaction does not.
• Strategic reaction in a repeated game may still have the
same effect as tacit collusion.
• Repeated Games
– Most real-world games get played repeatedly.
– Repeated games have a larger number of strategies
because a player can be punished for not
cooperating.
– This suggests that real-world duopolists might find a
way of learning to cooperate so they can enjoy
monopoly profit.
– The larger the number of players, the harder it is to
maintain the monopoly outcome.
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Game Theory
• The strategy to respond
in a way that lets your
competitors know you
will follow their lead is
called tit-for-tat
strategy. If one leads
and the competitor
follows, both will be
better off.
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UBEA 1013: ECONOMICS
7.7 Efficiency of Monopolistic Competition
• In the long-run, positive economic profits are
eliminated; thus, we might conclude that
monopolistic competition is efficient, however:
– Price is above marginal cost. More output
could be produced at a resource cost below the
value that consumers place on the product.
– Average total cost is not minimized. The
typical firm will not realize all the economies of
scale available. Smaller and smaller market
share results in excess capacity. (A firm has
excess capacity if it produces less than the
quantity at which ATC is a minimum).
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UBEA 1013: ECONOMICS
7.7 Efficiency of Oligopoly
• Oligopolies, or concentrated industries, are likely to be
inefficient for the following reasons:
– Profit-maximizing oligopolists are likely (but not always)
to price above marginal cost. So, the quantity produced
is less than the efficient quantity (like in perfect
competition market).
– Strategic behavior can force firms into deadlocks that
waste resources.
– Product differentiation and advertising may pose a real
danger of waste and inefficiency.
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UBEA 1013: ECONOMICS
Further Example of Game Theory
Table 8.2: Dominant Equilibrium
Table 8.3: Nash Equilibrium & Cournot Model
Table 8.4: Nash Equilibrium & Stackelberg Model
Table 8.5: No Nash Equilibrium
Table 8.7: Prisoner’s Dilemma: Price War Decision
End
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