Download Chapter 13 monopolistic competition and oligopoly Outline I. What is

Chapter 13 monopolistic competition and oligopoly
Outline
I.
What is Monopolistic Competition?
A. Monopolistic competition is a market with the following characteristics:
1.
A large number of firms compete.
2.
Each firm produces a differentiated product.
3. Firms compete on product quality, price, and marketing.
4. Firms are free to enter and exit.
B. The presence of a large number of firms in the market implies:
1.
Each firm supplies only a small part of the total industry output and so has only limited
power to influence the price of its product.
2.
Each firm is sensitive to the average market price but pays no attention to any one
individual competitor.
3.
No one firm can dictate market conditions and no one firm’s actions directly affect the
actions of another.
4. Collusion, or conspiring to fix prices, is impossible.
C. 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. Product differentiation enables firms to compete in three areas: quality, price, and marketing.
1.
The quality of a product is the physical attributes that make it different from the products
of other firms. Examples include product design, reliability, and service.
2.
Each firm faces a downward-sloping demand curve for its own product because each
firm produces a differentiated product. This allows each firm to set its own price. The
price is related to quality: A higher quality product allows the firm to set a higher price.
3.
A firm in monopolistic competition must market its product because all other firms offer
differentiated products. This fact means the product must be marketed using advertising
and packaging.
E. There are no barriers to entry or exit in monopolistic competition, so firms cannot earn an
economic profit in the long run.
1.
Examples of a monopolistically competitive industry include audio and video equipment,
computers, frozen foods, men’s clothing, and sporting goods.
2.
Figure 13.1 shows market share of the largest four firms for each of ten industries that
operate in monopolistic competition.
II. Price and Output in Monopolistic Competition
A. Similar to a monopoly, the MR curve for a firm in monopolistic competition is downward
sloping and lies under its demand curve. In the short run, a firm in monopolistic competition
makes its output and price decision just like monopoly firm does.
1.
A firm that has decided the quality of its product and its marketing program produces the
profit maximizing quantity at which MR = MC.
2.
A firm in monopolistic competition can
earn an economic profit in the short run
only if P > ATC.
3.
Figure 13.2 shows a short-run
equilibrium output and price decision for
a firm in monopolistic competition
making a positive economic profit.
B. In the long run, firms in monopolistic
competition will be unable to earn economic
profit.
1.
When firms are earning economic profit
(that is, when P > ATC), the existence of
the economic profit induces entry by
new firms, which continues as long as
firms in the industry earn an economic
profit.
a)
As firms enter the industry, each
existing firm loses some of its market share. The demand for its product decreases
and the demand curve shifts leftward.
b) 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.
c)
The price the firm charges and the quantity it sells falls as firms enter. Eventually
entry results in P = ATC and the firms earn zero economic profit (normal profit).
2.
When firms are incurring an economic
loss (that is, when P < ATC), the
economic loss will induce firms to leave
the market, which continues as long as
firms in the industry bear an economic
loss. Figure 13.3 illustrates a firm in
monopolistic competition making an
economic loss.
a)
As firms exit the industry, each
remaining firm gains some of its
market share. The demand for its
product increases and the demand
curve shifts rightward.
b) The increase in demand increases
the quantity at which MR = MC and
raises the maximum price that the
firm can charge to sell this quantity.
c)
The price that each remaining firm
charges and the quantity it sells rise
as firms exit. Eventually exist
results in P = ATC and firms again
earn zero economic profit (normal
profit).
d) Figure 13.4 shows the long run
output and price decision for a firm
in monopolistic competition.
C. Comparing Monopolistic Competition with
Perfect Competition
1.
Firms in monopolistic are inefficient
and operate with excess capacity, which
means the firm produces a quantity less
than the minimum efficient scale.
a)
2.
Figure 13.5 illustrates this
proposition.
Firms maximize profit by choosing to produce output where MR = MC.
a)
The firm in monopolistic competition retains some market power, which means
MR < P for all quantities.
b) The fact that the firm has some market power means that at the profit maximizing
level of output chosen by the firm P > MC.
c)
3.
A firm’s markup is the amount by which price exceeds marginal cost.
Because a firm in monopolistic competition has P > MC, the firm produces where
MC < MB since price equals the marginal benefit to society.
a)
The under-production in monopolistic competition creates a deadweight loss.
b) Monopolistically competitive firms produce at inefficient levels of output relative to
perfect competition.
c)
But firms in monopolistic competition produce a variety of different goods whereas
firms in perfect competition produce identical goods. People value variety, so
monopolistic competition is not necessarily inferior to perfect competition.
III. Product Development and Marketing
A. A firm in monopolistic competition must be in a state of continuous product development to
keep earning an economic profit.
1.
New product development allows a firm to gain a competitive edge, if only temporarily,
before competitors imitate the innovation.
2.
Firms pursue product development until the marginal revenue from innovation equals the
marginal development cost.
3.
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).
4.
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. Firms use advertising and packaging as
the two principal methods to
differentiate its products from
competitors by actively marketing their
products to consumers.
1.
Firms in monopolistic competition
incur heavy advertising
expenditures which make up a
large portion of the price it charges
for the product.
2.
Figure 13.6 shows estimates of this
percentage of sale price for
different monopolistic competition
markets.
3.
These selling costs (like advertising
expenditures, fancy retail buildings,
etc.) are fixed costs.
a)
This fact means selling costs
increase average total costs at
any given level of output but do
not affect the variable costs
(including the marginal cost) of
production.
b) Figure 13.7 shows how an
advertising expenditures shift
the ATC curve upward.
C. Selling efforts such as advertising are
successful only if they increase demand
for the firm’s product.
1.
When each firm advertises its
product, the advertising increases the price the firm can charge but it also makes the
demand more elastic.
2.
A firm’s increased demand and profits can only be experienced by firms in the short run.
3.
Profits lead to the entry of more firms into the market, which decreases the demand for
each firm’s product in the long run and lowers the price each firm can charge.
D. 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 an efficient allocation
of resources.
1.
Similarly, developing and marketing a brand name provides information about the
quality of a product to consumers and an incentive to the producer to achieve a high and
consistent quality standard.
2.
Heavy marketing and advertising expenditures by a firm are a signal to consumers that
their product is of high quality. A signal is an action taken by an informed person (or
firm) to send a message to uninformed people.
IV. Oligopoly
A. The distinguishing features of an oligopoly are that:
1.
Natural or legal barriers prevent the entry of new firms.
2.
A small number of firms compete.
B. Oligopoly markets share some characteristics of other market structures:
1.
Oligopoly is similar to a monopoly in that each firm has market power to determine its
own price.
2.
Oligopoly might be similar to monopolistic competition in that each firm makes a
differentiated product, but this is not a necessary condition for oligopoly.
C. The number of firms in a natural oligopoly can be determined by the minimum efficient scale
of the firms and the total size of the market.
1.
The minimum efficient scale, combined with the size of the total market demand for the
product, will determine how many firms survive in the market.
2.
If only two firms operate in an oligopoly market, it is called a duopoly.
D. The quantity sold by one firm in an oligopoly depends on each firm’s own price and the
prices and quantities sold by all the other firms.
1.
This interdependence between firms motivates each firm to behave cooperatively instead
of competitively toward each other in an attempt to maximize profits for all firms.
2.
A cartel is a group of firms acting together—colluding—to limit output, raise price, and
increase economic profit.
E. There are two traditional oligopoly models
1.
The kinked demand curve model of oligopoly is based on the assumption that each firm
believes that if it raises its price, others will not follow but that if it cuts its own price, so
will the other firms.
a)
Figure 13.11 shows the kinked
demand curve model. The demand
curve that an oligopoly firm
believes it faces has a kink at the
current price and quantity.
b) 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.
c)
The kink in the demand curve
means that the MR curve is
discontinuous at the current
quantity.
d) Fluctuations in MC that remain within the discontinuous portion of the MR curve
leave the profit-maximizing quantity and price unchanged.
e)
The beliefs that generate the kinked demand curve are not always correct. In
particular, if MC increases enough, all firms raise their prices and the kink vanishes.
2.
In the dominant firm oligopoly model, there is one large firm that has a significant cost
advantage over the other, smaller competing firms and it produces a large part of the
industry output.
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 and producing output to satisfy the remaining demand in the
market.
c)
Figure 13.12 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 recognition of mutual interdependence.
B. All games share four important features:
1.
The rules of a game describe the setting of the game, the actions the players may take,
and the consequences of those actions.
2.
The strategies are all the possible actions of each player in the game.
3.
The payoffs are described in a payoff matrix, which is a table that shows the payoffs
for every possible action by each player for every possible action by each other player.
4.
The outcomes of a game are the results produced by the interaction of all the choices
made by each of the players’ decisions. In a Nash equilibrium, player A takes the best
possible action given the action of player B and player B takes the best possible action
given the action of player A.
C. The prisoners’ dilemma is a good game for illustrating these four features. The following is
an example.
1.
Art and Bob have been caught stealing cars. The rules of their prisoner’s dilemma game
are as follows:
a)
Both have been convicted of committing this crime and will be sentenced to two
years in jail.
b) Both prisoners are also strongly suspected of committing a more serious crime for
which there exists insufficient evidence for a conviction.
c)
During interrogation for the more serious crime, Art and Bob are held in a separate
cell and they cannot communicate with each other.
d). Each is told that they are both suspected of committing the more serious crime and
that the other is being asked to confess in return for a lighter prison sentence for the
more serious crime.
2.
e)
Each prisoner is given a deal to consider: Each prisoner is told that he will receive
only a 1-year jail sentence for the serious crime and no time for the less serious
crime (for a total of 1 year jail time for both crimes) if he cooperates by giving up a
confession that implicates them both and the other prisoner denies the crime.
However, if he refuses to confess and his partner does confess, then he will get the
full 8 years jail term for the serious crime a total of a 10-year sentence to be served
for committing both crimes.
f)
Each prisoner knows that if they both confess to the more serious crime, each will
receive a total of 3 years in jail for committing both crimes. Otherwise, if neither
confesses, each prisoner will serve only a 2-year sentence for the minor crime.
The strategies for both prisoners are the same:
a)
Each can confess to committing the serious crime.
b) Each can deny committing the serious crime.
3.
The game’s payoff matrix is a
table, like the one in Table 13.1,
that shows the payoffs for every
possible action by each player for
every possible action by the other
player.
a)
In Table 13.1, Art’s payoff
from each combination of
actions is shown in the top of
each payoff box, and Bob’s
payoff is shown in the bottom
of each payoff box.
b) There are four possible
outcomes: Bob and Art both
confess (top left payoff box),
Bob and Art both deny
(bottom right payoff box), Bob confesses but Art does not (top right payoff box),
and Art confesses but Bob does not (bottom left payoff box).
c)
4.
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 possible action to be taken by the other player.
If both players are rational and choose their actions in this way, the outcome is
called a Nash equilibrium—first proposed by John Nash.
The dilemma of the prisoners’ dilemma game is that the best strategy is for each prisoner
to confess, which does not create the best outcome for either prisoner.
a)
Regardless of Bob’s decision, Art’s best payoff occurs by confessing.
b) Regardless of Art’s decision, Bob’s best payoff occurs by confessing.
c)
So both prisoners confess and the Nash Equilibrium outcome that results is that each
prisoner gets 3 years in jail for committing both crimes.
d) Both players would be better off if each had denied the crime, 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 application of the prisoners’ dilemma can help us understand the behavior of firms in a
natural duopoly, which captures the essence of an oligopoly market.
1.
Figure 13.13 shows a natural duopoly:
a)
Demand and cost conditions are such that two firms can produce the good to satisfy
demand at a lower ATC than only one firm or three firms.
b) The firms in a duopoly can enter into a collusive agreement, which is an
agreement in which two (or more) competitors agree to restrict output, raise the
price, and increase profits.
c)
2.
Firms that have entered into a collusive agreement have formed a cartel (which is
illegal in the United States.)
In a cartel, each firm has two strategies:
a)
Comply with the agreement
b) Cheat on the agreement
3.
There are four possible payoffs depending upon the strategy followed by each player:
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 13.14 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 13.15 shows this outcome.
c)
If both firms cheat, they each earn a normal profit (zero economic profit). Figure
13.16 shows this outcome.
4.
Table 13.2 shows the payoff matrix
for this game.
a)
The Nash equilibrium is where
both firms cheat.
b) The quantity and price are
those of a competitive market,
and the firms earn normal
profit.
E. Another application of the prisoners’
dilemma can also help us understand
the behavior of two firms operating in a
market of monopolistic competition that
are engaged in developing and
marketing rival products. Consider the
situation facing both Procter & Gamble and Kimberly-Clark as they compete in the
disposable diaper market:
1.
The key to success for each firm is to develop a product that is more highly valued by
consumers and less costly to produce than the rival firm.
a)
Higher valued products increase market share and increase the price and total
revenues for the firm.
b) Lower costs and higher prices combine to increase profits.
c)
2.
However, research and development (R&D) costs are high and must be subtracted
from these higher profits.
There are two different strategies that each firm can pursue:
a)
Spend money on R&D.
b) Do not spend money on R&D.
3.
The payoff matrix in Table 13.3
illustrates the four different payoffs
that can arise in this game. The
payoff for Procter and Gamble
appear in the top of each box and
the payoff for Kimberly-Clark
appears in the bottom of each box.
The payoff matrix has four boxes,
representing the four possible
outcomes:
a)
Both firms spend money on
R&D.
b.
Neither firm spends money on
R&D.
c)
Procter & Gamble spends on
R&D and Kimberly-Clark will
not.
d) Kimberly-Clark spends on R&D and Procter & Gamble will not.
4.
The Nash equilibrium outcome is that both firms spend money on R&D.
a)
Regardless of what Kimberly-Clark decides to do, the best strategy for Procter &
Gamble is to spend money on R&D.
b) Regardless of what Procter & Gamble decides to do, the best strategy for KimberlyClark is to spend money on R&D.
c)
Both firms create innovative products that are cheaper to produce, which benefits
the consumer but fails to maximize joint profits.
d) A dominant strategy equilibrium is a Nash Equilibrium outcome where the best
strategy for any player in the game is to cheat on the agreement (act noncooperatively) regardless of the strategy of the other player.
F.
A Game of Chicken
A game of “chicken” is exemplified by two cars racing toward each other.
1.
The first driver to swerve and avoid crashing is “chicken.”
2.
The payoffs are a big loss for both players if no one chickens, zero for both if both
chicken, and if one chickens, a loss for the chicken and a gain for the other player.
3.
R&D that creates a new technology that any firm can use is an economic example of the
game of chicken.
4.
There are two equilibrium outcomes, one in which each player chickens (that is, each
player undertakes the research) and the other player does not. This equilibrium is not a
Nash equilibrium.
VI. Repeated Games and Sequential Games
A. If a game is played repeatedly, it is possible for players of the game (like in the two firms in
the duopolies game) to act cooperatively and successfully collude (to earn a monopoly
profit).
1.
Knowing that multiple chances to play the same game will occur changes the dominant
strategy for players in this type of sequential game.
2.
Many different outcomes are possible because information about players’ behavior in
prior games can be incorporated into current games.
B. For example, additional punishment strategies in a repeated prisoners’ dilemma duopoly
game enable the firms to comply and achieve a cooperative equilibrium, in which the
firms make and share the monopoly profit.
1.
One possible punishment strategy is a tit-for-tat strategy, in which one player cooperates
in the current 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.
2.
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.
C. A tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly
game, allowing all firms to enjoy economic profit.
1.
If each firm cooperates in the first period, then this cooperation might provide evidence
of trustworthiness that the other firms can rely upon in choosing their second period
strategy.
2.
However, a price war might result from relying on a tit-for-tat strategy, especially when
there is the additional complication of uncertainty about unforeseen changes in consumer
demand.
a)
A random decrease in demand might convince some firms to lower their price
b) It is difficult for the firms to determine if the low price is the result of weaker
demand or of non-cooperative behavior on the part of those firms lowering their
price.
c)
This fall in price might result in a round of tit-for-tat punishment by all firms.
D. However, non-cooperative outcomes are also possible if the firms operate in a contestable
market.
1.
A contestable market is a market in which firms can enter and leave so easily that
those firms in the market face competition from potential entrants. These firms play a
sequential entry game.
2.
Figure 13.17 shows the game tree for a sequential entry game in a contestable market.
a.
In this entry game, the firms in the market set a competitive price and earn only a
normal profit to keep the potential entrant out.
b.
However, a less costly strategy is limit pricing, which sets the price at the highest
level that inflicts a loss on the entrant. This strategy will keep the potential entrant
out while allowing the existing firms to earn economic profit.