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Title: PC. Comparing Monopolistic Competition with Monopoly ..


1
Monopolistic Competition, Oligopoly, and
Strategic Pricing
  • Chapter 13

2
Introduction
  • In discussing real-world competition, the focus
    quickly becomes market structure.
  • Market structure is the physical characteristics
    of the market within which firms interact.

3
Introduction
  • Market structure involves the number of firms in
    the market and the barriers to entry.
  • Perfect competition, with an infinite number of
    firms, and monopoly, with a single firm, are
    polar opposites.

4
Introduction
  • Monopolistic competition and oligopoly lie
    between these two extremes.
  • Monopolistic competition is a market structure in
    which there are many firms selling differentiated
    products.
  • Oligopoly is a market structure in which there
    are a few interdependent firms.

5
Introduction
  • Most U.S. industry structures fall almost
    entirely between monopolistic competition and
    oligopoly.
  • Perfectly competitive and monopolistic industries
    are nearly nonexistent.

6
Problems Determining Market Structure
  • Defining a market has problems
  • What is an industry and what is its geographic
    market -- local, national, or international?
  • What products are to be included in the
    definition of an industry?

7
Classifying Industries
  • One of the ways in which economists classify
    markets is by cross-price elasticities.
  • Cross-price elasticity measures the
    responsiveness of the change in demand for a good
    to change in the price of a related good.

8
Classifying Industries
  • Industries are classified by government using the
    North American Industry Classification System
    (NAICS).
  • The North American Industry Classification System
    (NAICS) is a classification system of industries
    adopted by Canada, Mexico, and the U.S. in 1997.

9
Classifying Industries
  • When economists talk about industry structure the
    general practice is to refer to three-digit
    industries.
  • Under the NAICS, a two-digit industry is a
    broadly based industry.
  • A three-digit industry is a specific type of
    industry within a broadly defined two-digit
    industry.

10
Two- and Four- Digit Industry Groups
11
Determining Industry Structure
  • Economists use one of two methods to measure
    industry structure
  • The Concentration Ratio
  • The Herfindahl Index

12
Concentration Ratio
  • The concentration ratio is the percentage of
    industry output that a specific number of the
    largest firms have.

13
Concentration Ratio
  • The most commonly used concentration ratio is the
    four-firm concentration ratio.
  • The higher the ratio, the closer to an
    oligopolistic or monopolistic type of market
    structure.

14
The Herfindahl Index
  • The Herfindahl index is an alternative method
    used by economists to classify the
    competitiveness of an industry.
  • It is calculated by adding the squared value of
    the market shares of all firms in the industry.

15
The Herfindahl Index
  • Two advantages of the Herfindahl index is that it
    takes into account all firms in an industry as
    well as giving extra weight to a single firm that
    has an especially large market share.

16
The Herfindahl Index
  • The Herfindahl Index is important because it is
    used as a marker by the Justice Department for
    allowing or disallowing mergers to take place.
  • If the index is less than 1,000, the industry is
    considered competitive thus allowing the merger
    to take place.

17
Concentration Ratios and the Herfindahl Index
18
Conglomerate Firms and Bigness
  • Neither the four-firm concentration ratio or the
    Herfindahl index gives a complete picture of
    corporations size.

19
Conglomerate Firms and Bigness
  • This is because many firms are conglomerateshuge
    corporations whose activities span various
    unrelated industries.

20
The Importance of Classifying Industry Structure
  • Classifying industry structure is important
    because structure affects firm behavior.
  • The greater the number of sellers, the more the
    likelihood the industry is competitive.

21
The Importance of Classifying Industry Structure
  • The number of firms in an industry plays a role
    in determining whether firms explicitly take
    other firms actions into account.
  • Oligopolies take into account the reactions of
    other firms monopolistic competitors do not.

22
The Importance of Classifying Industry Structure
  • In monopolistic competition, the large number of
    firms makes it unlikely that an individual firm
    will explicitly take into account rival firms
    responses to their decisions.

23
The Importance of Classifying Industry Structure
  • In oligopoly, with fewer firms, each firm
    explicitly engages in strategic decision making.
  • Strategic decision making taking explicit
    account of a rivals expected response to a
    decision you are making.

24
Monopolistic Competition
  • The four distinguishing characteristics of
    monopolistic competition are
  • Many sellers.
  • Differentiated products.
  • Multiple dimensions of competition.
  • Easy entry of new firms in the long run.

25
Many Sellers
  • When there are many sellers as in monopolistic
    competition, they do not take into account
    rivals reactions.
  • The existence of many sellers also makes
    collusion difficult.
  • Monopolistically competitive firms act
    independently.

26
Differentiated Products
  • The many sellers characteristic gives
    monopolistic competition its competitive aspect.
  • Product differentiation gives monopolistic
    competition its monopolistic aspect.

27
Differentiated Products
  • Differentiation exists so long as advertising
    convinces buyers that it exists.
  • Firms will continue to advertise as long as the
    marginal benefits of advertising exceed its
    marginal costs.

28
Multiple Dimensions of Competition
  • One dimension of competition is product
    differentiation.
  • Another is competing on perceived quality.
  • Competitive advertising is another.
  • Others include service and distribution outlets.

29
Easy Entry of New Firms in the Long Run
  • There are no significant barriers to entry.
  • Barriers to entry prevent competitive pressures.
  • Ease of entry limits long-run profit.

30
Output, Price, and Profit of a Monopolistic
Competitor
  • A monopolistically competitive firm prices in the
    same manner as a monopolistwhere MC MR.
  • But the monopolistic competitor is not only a
    monopolist but a competitor as well.

31
Output, Price, and Profit of a Monopolistic
Competitor
  • At equilibrium, ATC equals price and economic
    profits are zero.
  • This occurs at the point of tangency of the ATC
    and demand curve at the output chosen by the firm.

32
Monopolistic Competition
33
Comparing Monopolistic Competition with Perfect
Competition
  • Both the monopolistic competitor and the perfect
    competitor make zero economic profit in the long
    run.

34
Comparing Monopolistic Competition with Perfect
Competition
  • The perfect competitors demand curve is perfectly
    elastic.
  • Easy entry, zero economic profits, and a uniform
    product means that the perfect competitor
    produces at the minimum of the ATC curve.

35
Comparing Monopolistic Competition with Perfect
Competition
  • A monopolistic competitor faces a downward
    sloping demand curve, and produces where MC MR.
  • The ATC curve is tangent to the demand curve at
    that level, which is not at the minimum point of
    the ATC curve.

36
Comparing Monopolistic Competition with Perfect
Competition
  • Increasing market share is a relevant concern for
    a monopolistic competitor but not for a perfect
    competitor.

37
Comparing Monopolistic Competition with Perfect
Competition
  • In the real world of monopolistic competition,
    increasing output and market share lowers average
    total cost.

38
Comparing Perfect and Monopolistic Competition
Perfect competition
Monopolistic competition
39
Comparing Monopolistic Competition with Monopoly
  • The difference between a monopolist and a
    monopolistic competitor is in the position of the
    average total cost curve in long-run equilibrium.

40
Comparing Monopolistic Competition with Monopoly
  • For a monopolist, the average total cost curve
    can be, but need not be, at a position below
    price so that the monopolist makes a long-run
    economic profit.

41
Comparing Monopolistic Competition with Monopoly
  • For a monopolistic competitor, the average total
    cost curve is tangent to the demand curve at the
    price and output chose by the monopolistic
    competitor so that there are zero economic
    profits in the long run.

42
Advertising and Monopolistic Competition
  • Firms in a perfectly competitive market have no
    incentive to advertise they can sell all they
    produce at the market price.
  • Monopolistic competitors have a strong incentive
    to do so.

43
Advertising and Monopolistic Competition
  • The primary goals of the advertiser is to
  • move the demand curve to the right and
  • make it more inelastic.

44
Advertising and Monopolistic Competition
  • Advertising shifts the demand curve shifts out
    and shifts the ATC curve up.
  • That way the firm can sell more, charge more, or
    both.

45
Advertising the Creation of Name Brands
  • There is a sense of trust in buying brands we
    know.
  • Advertising creates Name Brand Recognition.
  • Consumers are sometimes willing to pay more to
    reduce their uncertainty about the quality of the
    product.
  • Companies that develop name brands can often
    charge more than for no name homogeneous
    products.

46
Oligopoly
  • Oligopoly is a market structure where there are a
    small number of mutually interdependent firms.
  • Each firm must take into account the expected
    reaction of other firms to its profit maximizing
    output decision.

47
Models of Oligopoly Behavior
  • No single general model of oligopoly behavior
    exists.
  • Two models of oligopoly behavior are the cartel
    model and the contestable market model.

48
Models of Oligopoly Behavior
  • In the cartel model, the firms in the industry
    (oligopolies) collude to set a monopoly price.
  • In the contestable market model, an oligopolistic
    firm with no barriers to entry sets a competitive
    price.

49
The Cartel Model
  • A cartel (sometimes called a trust) is a
    combination of firms that acts as it were a
    single firm.
  • A cartel is a shared monopoly.

50
The Cartel Model
  • If oligopolies can limit the entry of other firms
    and form a cartel, they can increase the profits
    going to the combination of firms in the cartel.

51
The Cartel Model
  • The model assumes that oligopolies act as if they
    were monopolists that have assigned output quotas
    to individual member firms so that total output
    is consistent with joint profit maximization.

52
Implicit Price Collusion
  • Formal collusion is illegal in the U.S. while
    informal collusion is permitted.
  • Implicit price collusion exists when multiple
    firms make the same pricing decisions even though
    they have not consulted with one another.

53
Implicit Price Collusion
  • Sometimes the largest or most dominant firm takes
    the lead in setting prices and the others follow.

54
Cartels and Technological Change
  • Cartels can be destroyed by an outsider with
    technological superiority.
  • Thus, cartels with high profits will provide
    incentives for significant technological change.

55
Why Are Prices Sticky?
  • Informal collusion is an important reason why
    prices are sticky.
  • Another is the kinked demand curve.

56
Why Are Prices Sticky?
  • When there is a kink in the demand curve, there
    has to be a gap in the marginal revenue curve.
  • The kinked demand curve is not a theory of
    oligopoly but a theory of sticky prices.

57
The Kinked Demand Curve
MC1
58
The Contestable Market Model
  • According to the contestable market model,
    barriers to entry and barriers to exit determine
    a firms price and output decisions.
  • Even if the industry contains only one firm, it
    could still be a competitive market if entry is
    open.

59
The Contestable Market Model
  • The stronger the ability of the oligopolists to
    collude and prevent market entry, the closer it
    is to a monopolistic situation.
  • The weaker the ability to collude is, the more
    competitive it is.

60
Strategic Pricing and Oligopoly
  • Both the cartel and contestable market models use
    strategic pricing decisionsthey set their prices
    based on the expected reactions of other firms.

61
Strategic Pricing and Oligopoly
  • Cartelization strategy is limited by entry of new
    firms because the newcomer may not want to
    cooperate with the other firms.

62
Price Wars
  • Price wars are the result of strategic pricing
    decisions gone wild.
  • Sometimes a firm engages in this activity because
    it hates its competitor.

63
Price Wars
  • A firm may develop a predatory pricing strategy
    as a matter of policy
  • A predatory pricing strategy involves temporarily
    pushing the price down in order to drive a
    competitor out of business.

64
Game Theory and Strategic Decision Making
  • Most oligopolistic strategic decision making is
    carried out with explicit or implicit use of game
    theory.
  • Game theory is the application of economic
    principles to interdependent situations.

65
The Prisoners Dilemma and a Duopoly Example
  • The prisoner's dilemma can be used to illustrate
    the behavior of a duopoly.
  • The prisoners dilemma is one well-known game
    that demonstrates the difficulty of cooperative
    behavior in certain circumstances.

66
The Prisoners Dilemma and a Duopoly Example
  • The prisoners dilemma has its simplest
    application when the oligopoly consists of only
    two firmsa duopoly.

67
The Prisoners Dilemma and a Duopoly Example
  • By analyzing the strategies of both firms under
    all situations, all possibilities are placed in a
    payoff matrix.
  • A payoff matrix is a box that contains the
    outcomes of a strategic game under various
    circumstances.

68
Firm and Industry Duopoly Cooperative Equilibrium
69
Firm and Industry Duopoly Equilibrium When One
Firm Cheats
70
Duopoly and a Payoff Matrix
  • The duopoly is a variation of the prisoner's
    dilemma game.
  • The results can be presented in a payoff matrix
    that captures the essence of the prisoner's
    dilemma.

71
The Payoff Matrix of Strategic Pricing Duopoly
A Does not cheat
A Cheats
A 200,000
B Does not cheat
B 75,000
B 75,000
A 0
B Cheats
B 200,000
B 0
72
Oligopoly Models, Structure, and Performance
  • Oligopoly models are based either on structure or
    performance.
  • The four-fold division of markets considered so
    far are based on market structure.
  • Structure means the number, size, and
    interrelationship of firms in the industry.

73
Oligopoly Models, Structure, and Performance
  • A monopoly is the least competitive, perfectly
    competitive industries are the most competitive.

74
Oligopoly Models, Structure, and Performance
  • The contestable market model gives less weight to
    market structure.
  • Markets in this model are judged by performance,
    not structure.
  • Close relatives of it have previously been called
    the barriers-to-entry model, the stay-out pricing
    model, and the limited-pricing model.

75
Oligopoly Models, Structure, and Performance
  • There is a similarity in the two approaches.
  • Often barriers to entry are the reason there are
    only a few firms in an industry.
  • When there are many firms, that suggests that
    there are few barriers to entry.
  • In such situations, which make up the majority of
    cases, the two approaches come to the same
    conclusion.

76
Monopolistic Competition, Oligopoly, and
Strategic Pricing
  • End of Chapter 13
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