Chapter 11: Monopolistic Competition and Oligopoly

Contrast Between Monopolistic Competition and Oligopoly Monopolistic Competition in Detail Oligopoly in Detail Game Theory Market Structure Measurement

More Market Structures Needed

Few firms have perfect monopoly or are in a perfectly competitive industry Need something closer to observed business reality What can explain this?

Monopolistic Competition

Market structure characterized by a large number of sellers of differentiated products Lack of perfect substitutes Tide, Dockers, Campbells Soup? May be perceived differences? Not price takers some discretion in setting price Competition from imitators Profits still driven to normal risk-adjusted rate of return in the long run

Oligopoly

Market Structure characterized by few sellers and interdependent price/output decisions Significant barriers to entry Product could be homogenous (similar) or differentiated Potential for economic profits in the long run Incentive for illegal price setting Competition can be vigorous among the few firms

The Changing Nature of Markets

1980s auto industry considered oligopoly GM, Ford, Chrysler Today monopolistically competitive? Adding Toyota, Honda, Nissan

Review: Monopolistic Competition

Large number of buyers and sellers: each firm produces a small portion of the industry output, each customer buys only a small part of the total Product Differentiation: The output of each firm is (or is perceived to be) different from, although comparable with, the output of other firms in the industry Free entry and exit: Firms are not restricted from entering or leaving the industry

Close to Reality?

Not as restrictive as perfect competition Fairly common in actual markets Discount and fashion retail, electronics, food manufacturing? Firms have some control over pricing policy Limited by competitors offering similar products Americas Choice or Roundys Vs Del Monte?

Monopolistic Competition Continued

A price change does not cause competitors to change price (oligopoly) Unique products Quality, packaging, advertising, branding Downward sloping demand curve price flexibility Degree of price flexibility depends on differentiation

Product Differentiation and Elasticity of Demand

Figure 11.1
Price per unit ($)

DA DB

Quantity per time period

Copyright 2000 by Harcourt, Inc.

Consumers view product A as only slightly differentiated Close to being a price taker (near horizontal) Product B is highly differentiated Consumers less willing to accept substitutes for B (change in price little change in demand, demand elasticity) Change price of A, large change in demand

Price and Output in Monopolistic Competition

Elements of both perfect competition and monopoly Monopoly in the short-run New product introduction, creative marketing, branding, etc. Over time monopoly profits attract competitors In long run competitors emerge to offer similar but imperfect substitutes and profits erode Seems close to reality kids toys for example?

On the Graph
Demand and MR fall in LR D1 to D2 and MR1 to MR2 with new competitors Price falls from P1 to P2 in the long run At P2=ATC=D2 so economic profits driven to zero

Monopolistic Competition
$ per unit of output

Close to PC

Like Monopoly

P1 P 2= ATC2 ATC 1 P3

L M

MC

ATC

D3

D1

MR1
MR2 0
1

D2

Q2 Q1 Q3 Quantity per time period

Even in Long Run not same as PC

If new entrants offered perfect substitutes as opposed to similar products, LR demand curve would be nearly horizontal like PC See: D3, P3 and Q3 on previous graph (Q1,P1) is monopoly (Q3,P3) is perfect competition (Q2,P2) is monopolistic competition

Is Monopolistic Competition Realistic?

The case of Xerox Introduced Xerox 914 Copier in 1960 Improvement over coated paper copiers Monopoly in 1970 1970 to 1980, domestic and foreign competition IBM, Kodak, 3M 1970 to 1978 Xerox market share fell from 98% to 56% Stockholder return fell from 23.6% to 18.2% Now a competitive industry

Oligopoly
Monopolistic Competition assumed that price decisions did not consider competitor actions Appropriate for some industries but not others When firm actions cause competitors to react, we have oligopoly

Oligopoly: A Review
Few Sellers a handful of firms dominate the industry output Homogenous or unique product can be either Blocked entry and exit firms restricted from entering or leaving industry Imperfect information often cost, price, quality information is not known by buyers

In the real world?

Aluminum Cigarettes Electrical Equipment Filmed Entertainment Ready to eat cereal Airlines Small number of firms dominate each

Ready to eat cereal in detail

Kellogg, General Mills, General Foods, RJR Nabisko, Quaker Oats make all of US production Customer loyalty allows large profit margins Corn Flakes, Frosted Flakes, Cheerios, Raisin Bran, Wheaties dominate industry New firms have trouble entering market Imperfect information in that people dont seem to realize that generic brands are almost identical

Airlines
Relatively small number Huge capital costs cause entry and exit barriers Rate wars firms clearly react to competitors

Price and Output in Oligopoly

In oligopoly, if one firm in an industry changes its price the other firms react This means a shift in the demand curve (not a change in output or own price)

Oligopoly

Figure 11.3
Price per unit ($)

P1

P2 D1 D2 Q1 Q 3 Q2 Quantity per time period (a) Demand curves that do not explicitly recognize reactions 2000 by Harcourt, Inc. Copyright

Initially, Firm 1 produces Q1 at a price P1 (D1 demand curve) Firm 1 cuts price to P2 and this increases demand for product to Q2 Other firms respond with price shift so demand curve for Firm 1 shifts in (less demand) and they end up at P2 and Q3

Oligopoly
Figure 11.3b
Price per unit ($)

P1

P2 D1 D3 D2 Q1 Q3 Q2 Quantity per time period (b) Demand curve that recognizes reactions

If firms actually knew how their competitors would react we could draw demand curve D3 Firms would know that by cutting price to P2 they would end up at Q3 real demand curve for the firm is D3

Copyright 2000 by Harcourt, Inc.

Cartel

Cartel: Firms operating with a formal agreement to fix prices and output Would benefit all firms They are said to be in collusion if a covert, informal agreement among firms in an industry is made to fix prices and output Both illegal in the United States Some multinational firms do operate like this in foreign markets OPEC in the oil market

Cartel
Figure 11.4
Firm A Price and cost ($) MC A Firm B Price and cost ($) Price and cost ($) SMC ATC A MC B ATC B P* D MR 0 XA Output 0 XB Output 0 X Output
Copyright 2000 by Harcourt, Inc.

Industry

If a cartel has absolute control over all firms in an industry they can operate as a monopoly Summing each firms MC curve gives the industry MC Combining this with the industry MR shows the profit maximizing output and price Like a monopoly Profits divided among firms by production, market share, etc.

Cartels are hard to keep together

Long-run problems New firms entering market Disagreements among members One firm often tries to subvert the cartel, which is extremely profitable

Game Theory
First applied during WWII to deal with hard to predict moves of the enemy General framework to help decision making when firm payoffs depend on actions taken by other firms Used extensively in economic research

Game Theory Basics

Because competitive firm decisions are important in oligopoly markets, game theory has many applications Simultaneous move game choices are made without specific knowledge of competitor counter moves 2 firms set prices without knowledge of each others decision Sequential move game choices are made after observing competitor moves One firm sets a price after observing their rival

The Prisoners Dilemma

Classic conflict of interest situation Use to understand game theory before applying to firms and economics

The Prisoners Dilemma

Bonnie and Clyde are jointly accused of committing a bank robbery Conviction of either cannot be secured without a confession by the one or both suspects Held in isolation The choices for Bonnie and Clyde

Prisoners Dilemma Payoff Matrix

Suspect #2: Clyde (bottom) Not Confess Not Confess Suspect #1: Bonnie (Top) Confess 2 YEARS LIFE 5 YEARS 5 YEARS FREEDOM FREEDOM Confess

LIFE 2 YEARS

The Scenarios

Each suspect can control the range of sentencing outcomes, but not the ultimate outcome (no dominant strategy) Dominant Strategy: Decision that gives the best result for either party regardless of the action taken by the other Both would be better off if they knew the other wouldnt confess Failing to confess makes them open to the harsh sentence To confess or not to confess? Secure Strategy: Decision that guarantees the best possible outcome given the worst possible scenario Secure strategy is to confess avoid Life avoids worse possible scenario which is that the other confesses and you dont

A more practical game: Coke Vs Pepsi

Coke and Pepsi face scenarios like this every day Should Coke or Pepsi offer a special discount to a large grocery retailer?

Hypothetical Prisoners Dilemma faced by Coke and Pepsi

Pepsi (right) Discount Price Discount Price Coke (left) Regular Price $1,500, $6,500 $12,500, $9,000 $4,000, $2,000 Regular Price $10,000, $1,000

Weekly Profits from Grocery Store

The Choices

If neither offers discount, $12,500 for Coke and $9,000 for Pepsi best scenario Only Coke offers discount - $10,000 for Coke and $1,000 for Pepsi Only Pepsi offers discount -- $6,500 Pepsi and $1,500 for Coke Only way Coke can avoid the $1,500 is to grant the discount Only way Pepsi can avoid the $1,000 is to grant the discount Only secure strategy is for both to offer the discount and getting $4,000 and $2,000

Nash Equilibrium

The previous example where both firms offer the discount regardless of the other firms actions is called Nash Equilibrium Secure strategy is chosen Nash Equilibrium: Set of decision strategies in which no player can improve through a unilateral change in strategy Given that Coke (Pepsi) offers discount, other firms best option is secure strategy (discount) Colluding is the best option if legal

Market Structure Measurement

Economic Census: Comprehensive statistical profile of the economy, from the national, to the state, to the local level Every 5 years 2002 last Primary source of detailed facts about the nations economy Market Share, Market Size, Plans for expansion, etc.

How the census data are collected and published

For the 1997 census forms were mailed to over 5 million companies Compliance is required by law Data is classified by NAICS North American Industry Classification System: Method for categorizing establishments by the principal economic activity in which they are engaged

NAICS

Replacement for Standard Industrial Classification (SIC) 6 digits of detail Example: Broad to narrow definition
NAICS Code 51 513 5133 51332 513321 Description Information Broadcast and Telecom Telecom Wireless telecom no satellite Paging

NAICS Level Sector Subsector Industry Group Industry US Industry

Problem Set #6 (due next Monday)

P 11.5, P 11.6

Group Assignment (due next Monday)

Research and Answer the following questions for your industry (internet searches will provide info you need). Be prepared to discuss in class next week. Explain the structure of the industry. What part of the industry was deregulated (or is being considered for deregulation)? What is/was the motivation to deregulate? Current status of deregulation? Impact on the industry? Successful?

John Deere Electric Utilities GE Service Telecommunications AMX1 (Jennifer, Jeremy, etc.) Railroads AMX2 Airlines Harley Trucking Levitra - Banking