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C h a p t e r 13 MONOPOLISTIC COMPETITION AND OLIGOPOLY O u t l i n e PC War Games A. Each PC maker tells us that they have the best product at the best price. B. Just two big chip makers produce almost all the processor and memory chips in our PCs. C. 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? I. Monopolistic Competition A. Monopolistic competition is a market with the following characteristics: 1.There are a large number of firms, with each firm producing a differentiated product. 2.Firms compete on product quality, price, and marketing. 3.Firms are free to enter and exit the industry. B. Monopolistic Competition The presence of a large number of firms in the market implies: 197 198 CHAPTER 13 1. Each firm has only a small market share and therefore has limited market power to influence the price of its product. 2. 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. 3. Collusion, or conspiring to fix prices, is impossible. C. 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. D. Competing on Quality, Price, and Marketing Product differentiation enables firms to compete in three areas: quality, price, and marketing. 1. Quality includes design, reliability, and service. 2. 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. 3. Differentiated products must be marketed using advertising and packaging. E. Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. F. Entry and Exit Figure 13.1 (page 281) shows market share of the largest four firms and the HHI for each of ten industries that operate in monopolistic competition. II. Output and Price in Monopolistic Competition A. Short-Run Economic Profit 198 1. 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). a) 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. b) A firm in monopolistic competition can earn an economic profit in the short run if: P > ATC. It operates much like a single-price monopolist. 2. Figure 13.2a (page 282) shows a short-run equilibrium output and price for a firm in monopolistic competition. B. Long Run: Zero Economic Profit 1. 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). a) 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. b) 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. c) 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 6 199 200 CHAPTER 13 quantity fall with firm entry until P = ATC and firms earn zero economic profit. 2. Figure 13.2b (page 282) shows a long-run equilibrium output and price for a firm in monopolistic competition. 3. If firms incur an economic loss, firms exit to restore the long-run equilibrium just described. C. Monopolistic Competition and Efficiency 1. Firms in monopolistic are inefficient and operate with excess capacity. 2. Figure 13.3 (page 283) illustrates these propositions. a) Because they product differentiate and face a downward-sloping demand curve for their products, firms in monopolistic competition receive a marginal revenue that is less than price, MR < P, for all levels of output. b) Firms maximize profit by setting marginal revenue equal to marginal cost, MR = MC, so with marginal revenue less than price, MR < P, marginal cost is less than price, MC < P. Because price equals the marginal benefit, P = MB, marginal cost is less than marginal benefit, MC < MB. Underproduction in monopolistic competition creates deadweight loss. 3. A firm’s capacity output is the output at which average total cost is at its minimum. At the long-run profit maximizing output MR = MC and P = ATC. But recall that MR < P, which means that MC < ATC. Also recall (from Chapter 10) that if MC < ATC, then ATC falls as output increase. If output is in the range of falling ATC, 200 output must be less than capacity output. Goods are not produced at the minimum unit cost of production in the long run. III. Product Development and Marketing A. Innovation and Product Development 1. 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. 2. New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation. 3. Innovation is costly, but it also increases total revenue. a) Firms pursue product development until the marginal revenue from innovation equals the marginal development cost. 4. Production development may benefit the consumer by providing improvements in product quality, or it may mislead the consumer by giving only the appearance of 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 the improvement. B. Marketing 1. A firm’s marketing program uses advertising and packaging as the two principal methods to market its differentiated products to consumers. 2. 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. Figure 13.4 (page 285) shows estimates of the percentage of sale price for different monopolistic competition markets. 6 201 202 CHAPTER 13 3. Selling Costs and Total Costs a) 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. b) Selling efforts such as advertising are successful if they increase demand for the firm’s product. But a firm’s demand and profits can only increase in the short run. Economic profits lead to the entry of more firms, which decrease the demand for each firm’s product in the long run. 4. 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. IV. Oligopoly A. Oligopoly is a market in which a small number of firms compete. 1. 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. 2. The response of other firms to a firm’s price and output influence the firm’s profit maximizing decision. B. The Kinked Demand Curve Model 1. In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its 202 competitors will not follow, but if it lowers its price all of its competitors will follow. 2. Figure 13.6 (page 287) shows the kinked demand curve model. a) The demand curve that a firm believes it faces has a kink at the current price and quantity. Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged; and 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. b) The kink in the demand curve means that the MR curve is discontinuous at the current quantity. Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged. 3. 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. C. Dominant Firm Oligopoly 1. In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. a) The large firm operates as a monopoly, setting its price and output to maximize its profit. b) The small firms act as perfect competitors, taking as given the market price set by the dominant firm. 6 203 204 CHAPTER 13 2 Figure 13.7 (page 288) shows a dominant firm industry. V. Oligopoly Games A. 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. B. What Is a Game? 1. All games share four features: a) rules, b) strategies, c) payoffs, and d) an outcome. C. The Prisoners’ Dilemma 1. The prisoners’ dilemma game illustrates the four features of a game. a) The rules describe the setting of the game, the actions the players may take, and the consequences of those actions. i) In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. ii) Each is held in a separate cell and cannot communicate with each other. 204 iii) 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. b) The strategies for both prisoners are to either to confess or deny committing the serious crime. c) The game’s payoff matrix is a table, like the one in Table 13.1 (page 290), that shows the payoffs for every possible action by each player for every possible action by the other player. i) Art’s payoff from each combination of actions is shown in the top of each payoff box, and Bob’s is shown as the bottom of each payoff box. ii) There are four possible outcomes: Bob and Art both confess (top left box), both Bob and Art deny (bottom right box), Bob confesses but Art does not (top right box), and Art confesses but Bob does not (bottom left box). d) 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. 2. In the prisoners’ dilemma game, the best strategy is for each prisoner to confess. Regardless of Bob’s 6 205 206 CHAPTER 13 decision, Art’s best outcome occurs by confessing. Regardless of Art’s decision, Bob’s best outcome occurs by confessing. So both prisoners confess and each gets 3 years in jail for committing both crimes. 3. This outcome is not the best for either player. Both players would be better off if each had denied. But because they can’t communicate about their decisions, there is no way to strike a deal that enables them to cooperate and get the best joint outcome. D. An Oligopoly Price-Fixing Game 1. 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. 2. Figure 13.8 (page 291) describes the demand and cost conditions in a natural duopoly. Given the market demand, two firms can produce the good at a lower average total cost than either one firm or three firms. 3. The firms in a duopoly can enter into a collusive agreement in which two (or more) competitors agree to restrict output, raise the price, and increase profits. Firms that have entered into a collusive agreement have formed a cartel. (Cartels are illegal in the United States.) 206 4. In a cartel, each firm has two strategies: comply with the agreement or cheat. a) If both firms comply, they maximize industry profit by producing the same output as a monopoly would, charging the monopoly price, and sharing the resulting economic profit. Figure 13.9 (page 292) shows this outcome. b) If one firm cheats and the other complies, the firm that complies incurs an economic loss, and the firm that cheats makes an economic profit that is larger than its share of the maximum industry profit if it complies. Figure 13.10 (page 293) shows this outcome: part (a) shows the complier’s loss and part (b) shows the cheat’s economic profit. 6 207 208 CHAPTER 13 c) If both firms cheat, they each earn normal profit (zero economic profit). Figure 13.11 (page 294) shows this outcome. 5. Table 13.2 (page 295) shows the payoff matrix for this game. The Nash equilibrium is where both firms cheat, the quantity and price are those of a competitive market, and the firms earn normal profit. 208 6. If both firms cheat, they each earn normal profit (zero economic profit). Figure 13.11 (page 294) shows this outcome. 7. A similar prisoner’s dilemma research and development game describes the outcome in the market for disposable diapers. Table 13.3 (page 296) describes the payoff matrix for this game. 6 209 210 CHAPTER 13 VI. Repeated Games and Sequential Games A. A Repeated Duopoly Game 1. 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. 2. 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. a) 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. b) 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. 3. Table 13.4 (page 297) shows that a tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game. 210 4. 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. B. A Sequential Entry Game in a Contestable Market 1. 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. 2. Figure 13.12 (page 299) shows the game tree for a sequential entry game in a contestable market. a) In this entry game, the firm in the market sets a competitive price and earns a normal profit to keep the potential entrant out. b) A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out. 6 211