Download Chapter 12 Monopolistic Competition and Oligopoly

Chapter 12
Monopolistic
Competition and
Oligopoly
Topics to be Discussed

Monopolistic Competition

Oligopoly

Price Competition

Competition Versus Collusion: The
Prisoners’ Dilemma
Chapter 12
Slide 2
Topics to be Discussed

Implications of the Prisoners’ Dilemma
for Oligopolistic Pricing

Cartels
Chapter 12
Slide 3
Monopolistic Competition

Characteristics
1) Many firms
2) Free entry and exit
3) Differentiated product
Chapter 12
Slide 4
Monopolistic Competition

The amount of monopoly power
depends on the degree of
differentiation.

Examples of this very common market
structure include:

Toothpaste

Soap

Cold remedies
Chapter 12
Slide 5
Monopolistic Competition

Toothpaste

Chapter 12
Crest and monopoly power

Procter & Gamble is the sole producer of
Crest

Consumers can have a preference for
Crest---taste, reputation, decay preventing
efficacy

The greater the preference
(differentiation) the higher the price.
Slide 6
Monopolistic Competition

Question

Chapter 12
Does Procter & Gamble have much monopoly
power in the market for Crest?
Slide 7
Monopolistic Competition

The Makings of Monopolistic Competition
 Two
Chapter 12
important characteristics

Differentiated but highly substitutable
products

Free entry and exit
Slide 8
A Monopolistically Competitive
Firm in the Short and Long Run
$/Q
Short Run
$/Q
MC
Long Run
MC
AC
AC
PSR
PLR
DSR
DLR
MRSR
QSR
Quantity
MRLR
QLR
Quantity
A Monopolistically Competitive
Firm in the Short and Long Run

Observations (short-run)

Downward sloping demand--differentiated
product

Demand is relatively elastic--good
substitutes

MR < P

Profits are maximized when MR = MC

This firm is making economic profits
Chapter 12
Slide 10
A Monopolistically Competitive
Firm in the Short and Long Run

Observations (long-run)

Profits will attract new firms to the industry
(no barriers to entry)

The old firm’s demand will decrease to DLR

Firm’s output and price will fall

Industry output will rise

No economic profit (P = AC)

P > MC -- some monopoly power
Chapter 12
Slide 11
Comparison of Monopolistically Competitive
Equilibrium and Perfectly Competitive Equilibrium
Monopolistic Competition
Perfect Competition
$/Q
$/Q
MC
Deadweight
loss
AC
MC
AC
P
PC
D = MR
DLR
MRLR
QC
Quantity
QMC
Quantity
Monopolistic Competition

Monopolistic Competition and Economic
Efficiency
 The
monopoly power (differentiation) yields
a higher price than perfect competition. If
price was lowered to the point where
MC = D, consumer surplus would increase
by the yellow triangle.
Chapter 12
Slide 13
Monopolistic Competition

Monopolistic Competition and Economic
Efficiency
 With
no economic profits in the long run,
the firm is still not producing at minimum
AC and excess capacity exists.
Chapter 12
Slide 14
Monopolistic Competition

Questions
1) If the market became competitive,
what would happen to output
and price?
2) Should monopolistic competition be
regulated?
Chapter 12
Slide 15
Monopolistic Competition

Questions
3) What is the degree of monopoly
power?
4) What is the benefit of product
diversity?
Chapter 12
Slide 16
Monopolistic Competition
in the Market for Colas and Coffee

The markets for soft drinks and coffee
illustrate the characteristics of
monopolistic competition.
Chapter 12
Slide 17
Elasticities of Demand for
Brands of Colas and Coffee
Brand
Colas:
Ground Coffee:
Chapter 12
Elasticity of Demand
Royal Crown
Coke
Hills Brothers
Maxwell House
Chase and Sanborn
-2.4
-5.2 to -5.7
-7.1
-8.9
-5.6
Slide 18
Elasticities of Demand for
Brands of Colas and Coffee

Questions
1) Why is the demand for Royal Crown
more price inelastic than for Coke?
2) Is there much monopoly power in
these two markets?
3) Define the relationship between
elasticity and monopoly power.
Chapter 12
Slide 19
Oligopoly

Characteristics

Small number of firms

Product differentiation may or may not exist

Barriers to entry
Chapter 12
Slide 20
Oligopoly

Examples

Automobiles

Steel

Aluminum

Petrochemicals

Electrical equipment

Computers
Chapter 12
Slide 21
Oligopoly

The barriers to entry are:

Chapter 12
Natural

Scale economies

Patents

Technology

Name recognition
Slide 22
Oligopoly

The barriers to entry are:

Chapter 12
Strategic action

Flooding the market

Controlling an essential input
Slide 23
Oligopoly


Management Challenges

Strategic actions

Rival behavior
Question

Chapter 12
What are the possible rival responses to a
10% price cut by Ford?
Slide 24
Oligopoly

Equilibrium in an Oligopolistic Market

In perfect competition, monopoly, and
monopolistic competition the producers did
not have to consider a rival’s response
when choosing output and price.

In oligopoly the producers must consider
the response of competitors when
choosing output and price.
Chapter 12
Slide 25
Oligopoly

Equilibrium in an Oligopolistic Market

Chapter 12
Defining Equilibrium

Firms doing the best they can and have
no incentive to change their output or
price

All firms assume competitors are taking
rival decisions into account.
Slide 26
Oligopoly

Nash Equilibrium

Chapter 12
Each firm is doing the best it can given
what its competitors are doing.
Slide 27
Oligopoly

The Cournot Model

Chapter 12
Duopoly

Two firms competing with each other

Homogenous good

The output of the other firm is assumed
to be fixed
Slide 28
Firm 1’s Output Decision
If Firm 1 thinks Firm 2 will
produce nothing, its demand
curve, D1(0), is the market
demand curve.
P1
D1(0)
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(0)
D1(75)
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MR1(75)
MC1
MR1(50)
12.5 25
Chapter 12
D1(50)
50
What is the output of Firm 1
if Firm 2 produces 100 units?
Q1
Slide 29
Oligopoly

The Reaction Curve

Chapter 12
A firm’s profit-maximizing output is a
decreasing schedule of the expected
output of Firm 2.
Slide 30
Reaction Curves
and Cournot Equilibrium
Q1
100
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model.
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce.
75
Firm 2’s Reaction
Curve Q*2(Q2)
50 x
25
Cournot
Equilibrium
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
Chapter 12
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximize its own profits.
50
x
75
x
100
Q2
Slide 31
Oligopoly

Questions
1) If the firms are not producing at the
Cournot equilibrium, will they adjust
until the Cournot equilibrium is
reached?
2) When is it rational to assume that its
competitor’s output is fixed?
Chapter 12
Slide 32
Oligopoly
The Linear Demand Curve

An Example of the Cournot Equilibrium

Chapter 12
Duopoly

Market demand is P = 30 - Q where Q =
Q1 + Q2

MC1 = MC2 = 0
Slide 33
Oligopoly
The Linear Demand Curve

An Example of the Cournot Equilibrium

Firm 1’s Reaction Curve
Total Revenue, R1  PQ1  (30  Q )Q1
 30Q1  (Q1  Q2 )Q1
 30Q1  Q12  Q2Q1
Chapter 12
Slide 34
Oligopoly
The Linear Demand Curve

An Example of the Cournot Equilibrium
MR1  R1 Q1  30  2Q1  Q2
MR1  0  MC1
Firm 1' s Reaction Curve
Q1  15  1 2 Q2
Firm 2' s Reaction Curve
Q2  15  1 2 Q1
Chapter 12
Slide 35
Oligopoly
The Linear Demand Curve

An Example of the Cournot Equilibrium
Cournot Equilibrium : Q1  Q2
15  1 2(15  1 2Q1 )  10
Q  Q1  Q2  20
P  30  Q  10
Chapter 12
Slide 36
Duopoly Example
Q1
The demand curve is P = 30 - Q and
both firms have 0 marginal cost.
30
Firm 2’s
Reaction Curve
Cournot Equilibrium
15
10
Firm 1’s
Reaction Curve
10
Chapter 12
15
30
Q2
Slide 37
Oligopoly
Profit Maximization with Collusion
R  PQ  (30  Q)Q  30Q  Q
MR  R Q  30  2Q
MR  0 when Q  15 and MR  MC
2
Chapter 12
Slide 38
Oligopoly
Profit Maximization with Collusion

Contract Curve

Q1 + Q2 = 15


Q1 = Q2 = 7.5

Chapter 12
Shows all pairs of output Q1 and Q2 that
maximizes total profits
Less output and higher profits than the
Cournot equilibrium
Slide 39
Duopoly Example
Q1
30
Firm 2’s
Reaction Curve
For the firm, collusion is the best
outcome followed by the Cournot
Equilibrium and then the
competitive equilibrium
Competitive Equilibrium (P = MC; Profit = 0)
15
Cournot Equilibrium
Collusive Equilibrium
10
7.5
Firm 1’s
Reaction Curve
Collusion
Curve
7.5 10
Chapter 12
15
30
Q2
Slide 40
First Mover Advantage-The Stackelberg Model

Assumptions

One firm can set output first

MC = 0

Market demand is P = 30 - Q where Q =
total output

Firm 1 sets output first and Firm 2 then
makes an output decision
Chapter 12
Slide 41
First Mover Advantage-The Stackelberg Model

Firm 1


Must consider the reaction of Firm 2
Firm 2

Chapter 12
Takes Firm 1’s output as fixed and
therefore determines output with the
Cournot reaction curve: Q2 = 15 - 1/2Q1
Slide 42
First Mover Advantage-The Stackelberg Model

Firm 1
 Choose
Q1 so that:
MR  MC, MC  0 therefore MR  0
R1  PQ1  30Q1 - Q12 - Q2Q1
Chapter 12
Slide 43
First Mover Advantage-The Stackelberg Model

Substituting Firm 2’s Reaction Curve
for Q2:
R1  30Q1  Q12  Q1 (15  1 2Q1 )
 15Q1  1 2 Q
2
1
MR1  R1 Q1  15  Q1
MR  0 : Q1  15 and Q2  7.5
Chapter 12
Slide 44
First Mover Advantage-The Stackelberg Model


Conclusion

Firm 1’s output is twice as large as firm 2’s

Firm 1’s profit is twice as large as firm 2’s
Questions

Why is it more profitable to be the first
mover?

Which model (Cournot or Shackelberg) is
more appropriate?
Chapter 12
Slide 45
Price Competition

Competition in an oligopolistic industry
may occur with price instead of output.

The Bertrand Model is used to illustrate
price competition in an oligopolistic
industry with homogenous goods.
Chapter 12
Slide 46
Price Competition
Bertrand Model

Assumptions

Homogenous good

Market demand is P = 30 - Q where
Q = Q1 + Q2

MC = $3 for both firms and MC1 = MC2 =
$3
Chapter 12
Slide 47
Price Competition
Bertrand Model

Assumptions

The Cournot equilibrium:


Chapter 12
P  $12
 for both firms  $81
Assume the firms compete with price, not
quantity.
Slide 48
Price Competition
Bertrand Model

How will consumers respond to a
price differential? (Hint: Consider
homogeneity)
 The
Nash equilibrium:
 P = MC; P1 = P2 = $3
 Q = 27; Q1 & Q2 = 13.5

Chapter 12
 0
Slide 49
Price Competition
Bertrand Model

Why not charge a higher price to raise
profits?

How does the Bertrand outcome compare to
the Cournot outcome?

The Bertrand model demonstrates the
importance of the strategic variable (price
versus output).
Chapter 12
Slide 50
Price Competition
Bertrand Model

Criticisms

When firms produce a homogenous good,
it is more natural to compete by setting
quantities rather than prices.

Even if the firms do set prices and choose
the same price, what share of total sales
will go to each one?

Chapter 12
It may not be equally divided.
Slide 51
Price Competition

Price Competition with Differentiated
Products

Chapter 12
Market shares are now determined not just
by prices, but by differences in the design,
performance, and durability of each firm’s
product.
Slide 52
Price Competition
Differentiated Products

Assumptions

Duopoly

FC = $20

VC = 0
Chapter 12
Slide 53
Price Competition
Differentiated Products

Assumptions

Firm 1’s demand is Q1 = 12 - 2P1 + P2

Firm 2’s demand is Q2 = 12 - 2P1 + P1
Chapter 12

P1 and P2 are prices firms 1 and 2
charge respectively

Q1 and Q2 are the resulting quantities
they sell
Slide 54
Price Competition
Differentiated Products

Determining Prices and Output

Set prices at the same time
Firm 1 :  1  P1Q1  $20
 P1 (12  2 P1  P2 )  20
 12 P1 - 2 P  P1 P2  20
2
1
Chapter 12
Slide 55
Price Competition
Differentiated Products

Determining Prices and Output

Firm 1: If P2 is fixed:
Firm 1' s profit maximizing price 
 1 P1  12  4 P1  P2  0
Firm 1' s reaction curve 
P1  3  1 4 P2
Firm 2' s reaction curve 
P2  3  1 4 P1
Chapter 12
Slide 56
Nash Equilibrium in Prices
P1
Firm 2’s Reaction Curve
Collusive Equilibrium
$6
$4
Firm 1’s Reaction Curve
Nash Equilibrium
$4
Chapter 12
$6
P2
Slide 57
Nash Equilibrium in Prices

Does the Stackelberg model prediction
for first mover hold when price is the
variable instead of quantity?
 Hint:
Chapter 12
Would you want to set price first?
Slide 58
A Pricing Problem
for Procter & Gamble
Differentiated Products

Scenario
1) Procter & Gamble, Kao Soap, Ltd.,
and Unilever, Ltd were entering the
market for Gypsy Moth Tape.
2) All three would be choosing their
prices at the same time.
Chapter 12
Slide 59
A Pricing Problem
for Procter & Gamble
Differentiated Products

Scenario
3) Procter & Gamble had to
consider competitors prices
when setting their price.
4) FC = $480,000/month and
VC = $1/unit for all firms
Chapter 12
Slide 60
A Pricing Problem
for Procter & Gamble
Differentiated Products

Scenario
5) P&G’s demand curve was:
Q = 3,375P-3.5(PU).25(PK).25

Chapter 12
Where P, PU , PK are P&G’s, Unilever’s,
and Kao’s prices respectively
Slide 61
A Pricing Problem
for Procter & Gamble
Differentiated Products

Problem

Chapter 12
What price should P&G choose and what is
the expected profit?
Slide 62
P&G’s Profit (in thousands of $ per month)
Competitor’s (Equal) Prices ($)
P&G’s
Price ($) 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80
1.10
-226
-215
-204
-194
-183
-174
-165
-155
1.20
-106
-89
-73
-58
-43
-28
-15
-2
1.30
-56
-37
-19
2
15
31
47
62
1.40
-44
-25
-6
12
29
46
62
78
1.50
-52
-32
-15
3
20
36
52
68
1.60
-70
-51
-34
-18
-1
14
30
44
1.70
-93
-76
-59
-44
-28
-13
1
15
1.80
-118
-102
-87
-72
-57
-44
-30
-17
A Pricing Problem
for Procter & Gamble

What Do You Think?
1) Why would each firm choose a
price of $1.40? Hint: Think Nash
Equilibrium
2) What is the profit maximizing price
with collusion?
Chapter 12
Slide 64
Competition Versus Collusion:
The Prisoners’ Dilemma

Why wouldn’t each firm set the
collusion price independently and
earn the higher profits that occur
with explicit collusion?
Chapter 12
Slide 65
Competition Versus Collusion:
The Prisoners’ Dilemma

Assume:
FC  $20 and VC  $0
Firm 1' s demand : Q  12  2 P1  P2
Firm 2' s demand : Q  12  2 P2  P1
Nash Equilibriu m : P  $4
Collusion :
P  $6
Chapter 12
  $12
  $16
Slide 66
Competition Versus Collusion:
The Prisoners’ Dilemma

Possible Pricing Outcomes:
Firm 1 : P  $6
Firm 2 : P  $6
P  $6
P  $4
 2  P2Q2  20
  $16
 (4)12  (2)(4)  6  20  $20
 1  P1Q1  20
 (6)12  (2)(6)  4  20  $4
Chapter 12
Slide 67
Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $4
Charge $6
$12, $12
$20, $4
$4, $20
$16, $16
Firm 1
Charge $6
Chapter 12
Slide 68
Competition Versus Collusion:
The Prisoners’ Dilemma

These two firms are playing a
noncooperative game.


Each firm independently does the best it
can taking its competitor into account.
Question

Chapter 12
Why will both firms both choose $4 when
$6 will yield higher profits?
Slide 69
Competition Versus Collusion:
The Prisoners’ Dilemma

An example in game theory, called the
Prisoners’ Dilemma, illustrates the
problem oligopolistic firms face.
Chapter 12
Slide 70
Competition Versus Collusion:
The Prisoners’ Dilemma

Scenario

Two prisoners have been accused of
collaborating in a crime.

They are in separate jail cells and cannot
communicate.

Each has been asked to confess to the
crime.
Chapter 12
Slide 71
Payoff Matrix for Prisoners’ Dilemma
Prisoner B
Confess
Confess
Prisoner A
Don’t
confess
Chapter 12
-5, -5
Don’t confess
-1, -10
Would you choose to confess?
-10, -1
-2, -2
Slide 72
Payoff Matrix for
the P & G Prisoners’ Dilemma

Conclusions: Oligipolistic Markets
1) Collusion will lead to greater profits
2) Explicit and implicit collusion is
possible
3) Once collusion exists, the profit
motive to break and lower price is
significant
Chapter 12
Slide 73
Payoff Matrix for the P&G Pricing
Problem
Unilever and Kao
Charge $1.40
Charge
$1.40
P&G
$12, $12
Charge $1.50
$29, $11
What price should P & G choose?
Charge
$1.50
Chapter 12
$3, $21
$20, $20
Slide 74
Implications of the Prisoners’
Dilemma for Oligipolistic Pricing

Observations of Oligopoly Behavior
1) In some oligopoly markets, pricing
behavior in time can create a
predictable pricing environment and
implied collusion may occur.
Chapter 12
Slide 75
Implications of the Prisoners’
Dilemma for Oligipolistic Pricing

Observations of Oligopoly Behavior
2) In other oligopoly markets, the firms
are very aggressive and collusion is
not possible.
Chapter 12

Firms are reluctant to change price
because of the likely response of their
competitors.

In this case prices tend to be relatively
rigid.
Slide 76
The Kinked Demand Curve
$/Q
If the producer raises price the
competitors will not and the
demand will be elastic.
If the producer lowers price the
competitors will follow and the
demand will be inelastic.
D
Quantity
Chapter 12
MR
Slide 77
The Kinked Demand Curve
$/Q
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.
MC’
P*
MC
D
Quantity
Q*
Chapter 12
MR
Slide 78
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership

Price Signaling
 Implicit
collusion in which a firm announces
a price increase in the hope that other
firms will follow suit
Chapter 12
Slide 79
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership

Price Leadership
 Pattern
of pricing in which one firm
regularly announces price changes that
other firms then match
Chapter 12
Slide 80
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing

The Dominant Firm Model

In some oligopolistic markets, one large
firm has a major share of total sales, and a
group of smaller firms supplies the
remainder of the market.

The large firm might then act as the
dominant firm, setting a price that
maximized its own profits.
Chapter 12
Slide 81
Price Setting by a Dominant Firm
Price
SF
D
The dominant firm’s demand
curve is the difference between
market demand (D) and the supply
of the fringe firms (SF).
P1
MCD
P*
DD
P2
QF QD
Chapter 12
QT
MRD
At this price, fringe firms
sell QF, so that total
sales are QT.
Quantity
Slide 82
Cartels

Characteristics
1) Explicit agreements to set output and
price
2) May not include all firms
Chapter 12
Slide 83
Cartels

Characteristics
3) Most often international

Chapter 12
Examples of
successful cartels
 OPEC
 International
Bauxite
Association
 Mercurio Europeo

Examples of
unsuccessful cartels
 Copper
 Tin
 Coffee
 Tea
 Cocoa
Slide 84
Cartels

Characteristics
4) Conditions for success
Chapter 12

Competitive alternative sufficiently
deters cheating

Potential of monopoly power--inelastic
demand
Slide 85
Cartels

Comparing OPEC to CIPEC

Chapter 12
Most cartels involve a portion of the market
which then behaves as the dominant firm
Slide 86
The OPEC Oil Cartel
Price
TD
SC
TD is the total world demand
curve for oil, and SC is the
competitive supply. OPEC’s
demand is the difference
between the two.
OPEC’s profits maximizing
quantity is found at the
intersection of its MR and
MC curves. At this quantity
OPEC charges price P*.
P*
DOPEC
MCOPEC
MROPEC
QOPEC
Chapter 12
Quantity
Slide 87
Cartels

About OPEC

Very low MC

TD is inelastic

Non-OPEC supply is inelastic

DOPEC is relatively inelastic
Chapter 12
Slide 88
The OPEC Oil Cartel
TD
Price
SC
The price without the cartel:
•Competitive price (PC) where
DOPEC = MCOPEC
P*
DOPEC
MCOPEC
Pc
MROPEC
QC
Chapter 12
QOPEC
QT
Quantity
Slide 89
The CIPEC Copper Cartel
Price
•TD and SC are relatively elastic
•DCIPEC is elastic
•CIPEC has little monopoly power
•P* is closer to PC
TD
SC
MCCIPEC
DCIPEC
P*
PC
MRCIPEC
QCIPEC
Chapter 12
QC
QT
Quantity
Slide 90
Cartels

Observations

Chapter 12
To be successful:

Total demand must not be very price
elastic

Either the cartel must control nearly all
of the world’s supply or the supply of
noncartel producers must not be price
elastic
Slide 91
The Cartelization
of Intercollegiate Athletics

Observations
1) Large number of firms (colleges)
2) Large number of consumers (fans)
3) Very high profits
Chapter 12
Slide 92
The Cartelization
of Intercollegiate Athletics

Question

Chapter 12
How can we explain high profits in a
competitive market? (Hint: Think cartel and
the NCAA)
Slide 93
The Milk Cartel

1990s with less government support,
the price of milk fluctuated more widely

In response, the government permitted
six New England states to form a milk
cartel (Northeast Interstate Dairy
Compact -- NIDC)
Chapter 12
Slide 94
The Milk Cartel

1999 legislation allowed dairy farmers in
Northeastern states surrounding NIDC
to join NIDC, 7 in 16 Southern states to
form a new regional cartel.

Soy milk may become more popular.
Chapter 12
Slide 95
Summary

In a monopolistically competitive
market, firms compete by selling
differentiated products, which are highly
substitutable.

In an oligopolistic market, only a few
firms account for most or all of
production.
Chapter 12
Slide 96
Summary

In the Cournot model of oligopoly, firms
make their output decisions at the same
time, each taking the other’s output as
fixed.

In the Stackelberg model, one firm sets
its output first.
Chapter 12
Slide 97
Summary

The Nash equilibrium concept can also
be applied to markets in which firms
produce substitute goods and compete
by setting price.

Firms would earn higher profits by
collusively agreeing to raise prices, but
the antitrust laws usually prohibit this.
Chapter 12
Slide 98
Summary

The Prisoners’ Dilemma creates price
rigidity in oligopolistic markets.

Price leadership is a form of implicit
collusion that sometimes gets around
the Prisoners Dilemma.

In a cartel, producers explicitly collude
in setting prices and output levels.
Chapter 12
Slide 99
End of Chapter 12
Monopolistic
Competition and
Oligopoly