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Monopolistic Competition and Oligopoly Chapter 11 Monopolistic Competition • Large number of sellers –Small market shares –No collusion –Independent action • Differentiated Products –Product attributes –Service –Location –Brand names and packaging –Some control over price 11-2 Monopolistic Competition • Easy entry and exit • Need for advertising –Nonprice Competition • Which industries? –Degree of concentration –Four-firm concentration ratio –Herfindahl index 11-3 Monopolistic Competition • Firm’s demand curve –Highly elastic, differentiating it from monopoly and pure competition • Short run profit or loss –Produce where MR=MC 11-4 Monopolistic Competition Short-Run Profits Price and Costs MC ATC P1 A1 Economic Profit D1 MR = MC MR 0 Q1 Quantity 11-5 Monopolistic Competition Short-Run Losses Price and Costs MC ATC A2 P2 Loss D2 MR = MC MR 0 Q2 Quantity 11-6 Monopolistic Competition • Long run normal profit –Entry and exit –As firms enter, the demand faced by individual firm falls until it is tangential to ATC 11-7 Monopolistic Competition Long-Run Equilibrium MC Price and Costs ATC P3= A3 D3 MR = MC MR 0 Q3 Quantity 11-8 Monopolistic Competition P=MC=Min ATC for pure competition (recall) Price and Costs MC ATC P3= A3 P4 Price is Lower D3 MR = MC Excess Capacity at Minimum ATC 0 MR Q3 Q4 Quantity Monopolistic competition is not efficient 11-9 Monopolistic Competition • Inefficient –Neither allocative nor productive efficiency achieved • Product variety –Can maintain profits by maintaining product differentiation 11-10 Oligopoly • A few large producers • Homogeneous or differentiated products • Control over price –Mutual interdependence –Strategic behavior • Entry barriers • Mergers 11-11 Oligopoly • Four-firm concentration ratio –Needs to be more than 40% Shortcomings: 1. Localized markets 2. Inter-industry competition –substitutes 11-12 Oligopoly 3. World trade –Import Competition 4. Dominant firms –A firm may have close to 100% share and operate as a monopoly while others operate as oligopoly • Solution: Herfindahl index 11-13 Game Theory RareAir’s Price Strategy High Uptown’s Price Strategy • 2 competitors • 2 price strategies • Each strategy has a payoff matrix • Greatest combined profit • Independent actions stimulate a response A $12 Low B $15 High $12 C $6 $6 D $8 Low $15 $8 11-14 Game Theory RareAir’s Price Strategy High Uptown’s Price Strategy • Independently lowered prices in expectation of greater profit leads to the worst combined outcome • Eventually low outcomes make firms return to higher prices A $12 Low B $15 High $12 C $6 $6 D $8 Low $15 $8 11-15 Game Theory • Mutual interdependence –Pricing policy • Collusion –Enhances profit by agreeing to a high price policy • Incentive to cheat • Prisoner’s dilemma –Fearful that other will cheat, both firms will probably cheat 11-16 Three Oligopoly Models 1. Kinked-demand curve 2. Collusive pricing 3. Price leadership • Why three models? –Diversity of oligopolies –Complications of interdependence 11-17 Kinked-Demand Curve • Noncollusive oligopoly • What does D look like? –Will depend on how rivals react to a price change 1.Match price changes –Steep D and MR because if P cut, sales will increase modestly as other firms also cut P 11-18 Kinked-Demand Curve 2. Ignore price changes –Flatter D and MR –P cut will ensure significant gain in sales –As P rises, all sales will not be lost due to product differentiation 11-19 Kinked-Demand Curve Price Competitor and rivals strategize versus each other D2 g MR2 D1 0 MR1 Quantity Combined strategy • Which assumption should the firm make about its rivals? –Depends on direction of price change • Match price decline below P0 • as they act to prevent price cutter from taking their customers • Ignore price increases above P0 Kinked-Demand Curve Competitor and rivals strategize versus each other Consumers effectively have 2 partial demand curves and each part has its own marginal revenue part e P0 f D2 Rivals Match g Price Decrease 0 Q0 MR1 Quantity MR2 Price and Costs Price Rivals Ignore Price Increase MC1 D2 P0 e MR2 f MC2 g D1 D1 0 Q0 MR1 Quantity Resulting in a kinked-demand curve to the consumer – price and output are optimized at the kink 11-22 Price inflexibility • On the D side, any change in P will be for the worse • If it raises P, many customers will desert it • If it lowers P, sales will only improve modestly as rivals also lower P • On the cost side, all positions of MC between MC1 and MC2 will result in same decision Kinked-Demand Curve • Criticisms of the model: 1. Explains inflexibility not how does price get to P0 2. Prices are not that rigid when macroeconomy is unstable resulting in price wars 11-24 Cartels and Other Collusion • Price and output –Joint profit maximization Price and Costs MC Effectively Sharing The Monopoly Profit P0 ATC A0 MR=MC Economic Profit D MR Q0 Quantity 11-25 Cartels and Other Collusion • Covert collusion –Tacit understandings • Obstacles to collusion –Demand and cost differences –Number of firms –Cheating –Recession –Potential entry –Legal obstacles: antitrust law 11-26 Price Leadership Model • One dominant firm sets price • Infrequent price changes –Risk that rivals might not follow • Communications • Limit pricing –May lower prices to discourage entry • Breakdowns in price leadership: –Price wars 11-27 Oligopoly and Efficiency • Not productively efficient • Not allocatively efficient • Tendency to share the monopoly profit • Qualifications –Increased foreign competition –Limit pricing –Technological advance 11-28