Monopolistic Competition and Oligopoly
14
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Monopolistic Competition
• Relatively large number of sellers
• Differentiated products
• Easy entry and exit
• Advertising
LO1
Monopolistically Competitive
• Industry concentration
• Measured by:
• Four-firm concentration ratios
•Percentage of 4 largest firms
• Herfindahl index
• Sum of squared market shares
LO1
4-Firm CR = Output of four largest firmsTotal output in the industry
HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2
Low Concentration Industries(1)
Industry(2)
4-Firm Concentration
Ratio
(3)Herfindahl
Index
(1)Industry
(2)4-Firm
Concentration Ratio
(3)Herfindahl
Index
Adhesives 23 235Wood containers and pallets 11 51
Ready-mix concrete 23 313Textile bags and canvas 10 68
Asphalt paving 22 188Metal working machinery 9 33
Bolts, nuts, and rivets 21 162 Apparel 8 44
Plastic pipe 21 187Plastics and rubber products 8 31
Sawmills 15 98 Sheet metal work 7 30
Wood trusses 14 102 Signs 7 28
Metal stamping 14 88 Stone products 7 23
Curtains and draperies 14 85 Quick printing 4 8
Metal windows and doors 13 109 Retail bakeries 4 7
LO1
Price and Output in Monopolistic Comp
• Demand is highly elastic
• Short run profit or loss
• Produce where MR=MC
• Long run normal profit
• Entry and exit
• Inefficient
• Product variety
LO2
The Short Run: Profit or Loss
LO2
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D1
ATC
EconomicProfit
Q1
A1
P1
0
The Short Run: Profit or Loss
LO2
Quantity
Pri
ce
an
d C
os
ts
MC
MR
D2
ATC
Loss
Q2
A2
P2
0
MR = MC
The Long Run: Only a Normal Profit
LO2
Quantity
Pri
ce
an
d C
os
ts
MC
MR
D3
ATC
Q3
P3= A3
0
MR = MC
Monopolistic Competition: Efficiency
• Inefficient
• Productive inefficiency
•P > ATC
• Allocative inefficiency
•P > MC
LO2
Monopolistic Competition: Efficiency
LO2
P=MC=Min ATC for pure competition (recall)
P4
Q4
Price is Lower
Excess Capacity atMinimum ATC
Monopolistic competition is not efficient
Product Variety
• The firm constantly manages price, product, and advertising.
• Better product differentiation
• Better advertising
• The consumer benefits by greater array of choices and better products.
• Types and styles
• Brands and quality
LO2
Oligopoly
• A few large producers
• Homogeneous or differentiated products
• Limited control over price
• Mutual interdependence
• Strategic behavior
• Entry barriers
• Mergers
LO3
Oligopolistic Industries
• Four-firm concentration ratio
• 40% or more to be oligopoly
• Shortcomings
• Localized markets
• Inter-industry competition
• World price
• Dominant firms
LO3
High Concentration Industries(1)
Industry(2)
4-Firm Concentration
Ratio
(3)Herfindahl
Index
(1)Industry
(2)4-Firm
Concentration Ratio
(3)Herfindahl
Index
Primary copper 99 ND Phosphate fertilizers 83 ND
Household laundry equipment 98 ND Aircraft 81 ND
Cigarettes 98 ND Breakfast cereals 80 2426
Cane sugar refining 95 ND Petrochemicals 80 2535
Household refrigerators/freezers 92 ND
Small-arms ammunition 79 2447
Beer 90 ND Primary aluminum 77 2250
Glass containers 87 2507 Metal cans 77 1786
Electronic computers 87 ND Burial caskets 74 1979
Women’s handbags and purses 86 ND Tires 73 1540
Light trucks and utility vehicles 84 2680
Household vacuum cleaners 71 1519
LO1
Game Theory Overview
• Oligopolies display strategic pricing behavior
• Mutual interdependence
• Collusion
• Incentive to cheat
• Prisoner’s dilemma
LO4
Game Theory Overview
LO4
RareAir’s Price Strategy
Up
tow
n’s
Pri
ce
Str
ate
gy A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low•2 competitors•2 price strategies
•Each strategy has a payoff matrix
•Greatest combinedprofit
• Independent actionsstimulate a response
Game Theory Overview
LO4
RareAir’s Price Strategy
Up
tow
n’s
Pri
ce
Str
ate
gy A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low• Independently lowered prices in expectation of greater profit leads to worst combined outcome
•Eventually low outcomes make firms return to higher prices.
3 Oligopoly Models
• Kinked Demand Curve
• Collusive Pricing
• Price Leadership
• Reasons for 3 models
• Diversity of oligopolies
• Complications of interdependence
LO5
Kinked-Demand Theory
• Noncollusive oligopoly
• Uncertainty about rivals reactions
• Rivals match any price change
• Rivals ignore any price change
• Assume combined strategy
• Match price reductions
• Ignore price increases
LO5
Kinked Demand Curve
LO5
P0
MR2
D2
D1
MR1
e
f
g
Rivals IgnorePrice Increase
Rivals MatchPrice Decrease
Q0
MR2
D2
D1
MR1Q0
MC1
MC2
P0
e
f
g
Kinked Demand Curve
• Criticisms
• Explains inflexibility, not price
• Prices are not that rigid
• Price wars
LO6
Cartels and Other Collusion
LO6
D
MR=MC
ATC
MC
MR
P0
A0
Q0
EconomicProfit
Global Perspective
LO6
Overt Collusion
• Cartels - a group of firms or nations that collude
• Formally agreeing to the price
• Sets output levels for members
• Collusion is illegal in the United States
• OPEC
LO6
Obstacles to Collusion
• Demand and cost differences
• Number of firms
• Cheating
• Recession
• New entrants
• Legal obstacles
LO6
Price Leadership Model
• Price Leadership
• Dominant firm initiates price changes
• Other firms follow the leader
• Use limit pricing to block entry of new firms
• Possible price war
LO6
Oligopoly and Advertising
• Prevalent to compete with product development and advertising
• Less easily duplicated than a price change
• Financially able to advertise
LO7
Positive Effects of Advertising
• Low-cost way of providing information to consumers
• Enhances competition
• Speeds up technological progress
• Can help firms obtain economies of scale
LO7
Oligopoly and Advertising
LO7
The Largest U.S. Advertisers, 2010
CompanyAdvertising Spending Millions of $
Procter & Gamble $3124
General Motors $2131
AT&T $2093
Verizon $1823
News Corp $1368
Pfizer $1229
Time Warner $1194
Johnson & Johnson $1140
Ford Motor $1132
L’Oreal $1112
Source: Kantar Media, www.kantarmedia.com
Negative Effects of Advertising
• Can be manipulative
• Contains misleading claims that confuse consumers
• Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product.
LO7
Global Perspective
LO7
Oligopoly and Efficiency
• Oligopolies are inefficient
• Productively inefficient P > min ATC
• Allocatively inefficient P > MC
• Qualifications
• Increased foreign competition
• Limit pricing
• Technological advance
LO7
Oligopoly in the U.S. Beer Industry
• The U.S. beer industry is now an oligopoly
• Changes in demand• Change in tastes• Consumed at home and mass
produced• Changes in supply
• Technological advance• Economies of scale