Download Chapter 13

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