powerpoint to accompany chapter 9 monopolistic competition and oligopoly

PowerPoint

to accompany

Chapter 9

Monopolistic competition

and oligopoly

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

1. Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves.

2. Explain how a monopolistically competitive firm decides the quantity to produce and the price to charge.

3. Analyse the situation of a monopolistically competitive firm in the long run.

Learning Objectives


4. Compare the efficiency of monopolistic competition and perfect competition.

5. Show how barriers to entry explain the existence of oligopolies.

6. Use game theory to analyse the actions of oligopolistic firms.

Learning Objectives


Starbucks has been competing in a highly contested market for over three decades, but was able to maintain profits and expand its operation across the globe thanks to successful differentiation strategy. It is only recently that Starbucks ran into trouble, with its strategy no longer successful in all markets.

Starbucks: growth through product differentiation – decline through competition



Monopolistic competition: A market structure in which barriers to entry are low, and many firms compete by selling similar, but not identical, products.

Oligopoly: A market structure in which a small number of interdependent firms compete.


Price (dollars per

cup)

Quantity (per week)

Demand

0

$3.25

3.00

3000

The downward-sloping demand curve for a monopolistically competitive firm: Figure 9.1

2400

Marginal revenue for a monopolistically competitive firm: Table 9.1



Price (dollars per

cup)

Quantity (per week)

Demand

0

$3.50

3.00

6

How a price cut affects a firm’s revenue: Figure 9.2

5

Loss of revenue from price cut = $0.50 x 5 = $2.50

Gain in revenue from price cut = $3.00 x 1 = $3.00


Demand and marginal revenue for a firm in a monopolistically competitive market

LEARNING OBJECTIVE 1

Marginal revenue for a firm with a downward-sloping demand curve

Every firm that has the ability to affect the price of the good or service it sells will have a marginal revenue curve that is below its demand curve.

The demand and marginal revenue curves for a monopolistically competitive firm: Figure 9.3


Price

Quantity

Demand

MR

0


Another way to calculate profit is using the following formula:

Profit = (P-ATC) x Q

where, P is price, ATC is average total cost and Q is quantity traded.

Note: P- ATC provides ‘profit per unit’.

Remember: Profit is maximised/loss is minimised when MR=MC.


How a monopolistically competitive firm maximises profits in the short run

Profit-maximising quantity and price for a monopolistic competitor: Figure 9.4a


Price (dollars per cup)

Quantity (cups per week)

Demand

MR

0

MC$6.00

3.50

5

1.50

Profit-maximising quantity

Profit-maximising

priceB

A

Short-run profits for a monopolistic competitor: Figure 9.4b


Demand

MR

0

MC$6.00

3.50

5

2.50

B

A

ATCProfit




Wrong approach to profit maximisation


Anton is a restaurant owner primarily specialising in light evening meals. Business generates revenues of $8 000 per week. Total cost of rent, labour, overheads and ingredients of cooking 400 meals (per week) is $6 000 per week.

He would like to expand his business by offering good quality but inexpensive take-away lunches for students of a nearby college. Anton expects to sell 100 take-away lunches per week for $8 each. The cost of each lunch is expected to be $6.



Anton believes that price of each sold meal should be compared with ATC.

Price of each of these extra 100 meals is $8. Anton calculates ATC of all meals = [(6 000 +

(6x100)]/(400+100) = $13.20 As revenue from each extra meal to be sold is

smaller than ATC, he decides against the expansion of the business.

Do you think Anton is right? If not, why?





STEP 1:: Review the chapter material. The problem is about how monopolistically competitive firms maximise profits, so you may want to review the section ‘How a monopolistically competitive firm maximises profit in the short run’.

STEP 2: Analyse the costs described in the problem.

To maximise profits, Anton should base the decision on expansion on the interaction of marginal revenue and marginal cost. Rent, labour and other overheads related to preparation of evening meals have nothing to do with lunch meals and should be treated as fixed costs in this decision. Therefore, it is wrong to include those costs in the decision making process (ATC).




STEP 3: Explain whether Anton should expand his business. Anton should compare the MR from producing each of these 100 meals with MC of producing these extra meals.

Marginal revenue is 8x100 = $800

Marginal cost is 6x100 = $600.

It is evident that expansion of the business is profitable, since it will add $200 ($800-$600) to the total weekly profits.


What happens to profits in the long run?

Is zero economic profit inevitable in the long run?

Relatively easy entry into the market causes the disappearance of economic profits in the long run.

Exception: If a firm finds new ways of differentiating its product/service or finds new ways of lowering the cost of producing its product/service, it can maintain economic profits, even in the long run.


Short-run profits for a monopolistic competitor: Figure 9.5a


Demand(short run)MR(short run)

0

MC

P(short run)

Q (short run)

A

ATC

Short-run profit



Short-run profits for a monopolistic competitor: Figure 9.5b


Demand(short run)

MR(short run)0

MC

P(short run)

Q(short run)

A

ATC



Demand(long run)MR(long run)

Q(long run)

BP(long run)

The short and long run for a monopolistically competitive firm: Table 9.2



The changing fortunes of Apple’s Macintosh computer

Macintosh lost its differentiation in the 1990s, but still retained a loyal – if small – following that is steadily on the increase today.

MAKING THE CONNECTION9.1


Comparing perfect competition and monopolistic competition


There are two important differences between long-run equilibrium in the two markets.

1. Monopolistically competitive firms charge a price greater than marginal cost.

2. Monopolistically competitive firms do not produce at minimum average total cost.

0

(a) Perfect competition

Quantity

MC

D=MRP = MC

Comparing long-run equilibrium under perfect competition and monopolistic competition: Figure 9.6

Qc

Price and cost


ATC

(b) Monopolistic competition

0

(a) Perfect competition

Quantity

MC

D=MRP = MC

D

Comparing long-run equilibrium under perfect competition and monopolistic competition: Figure 9.6

Qc

Price and cost

Quantity0 Qpc

MC


Price and cost

P

Qmc

MC

MR

ATC

ATC

Excess capacity


Comparing Perfect Competition and Monopolistic Competition


Excess capacity under monopolistic competition

The profit-maximising level of output for a monopolistically competitive firm is at a level of output where MR=MC. Thus, price is greater than marginal cost and the firm is not at the minimum point of its average total cost curve.


Comparing perfect competition and monopolistic competition


Is monopolistic competition inefficient? Monopolistic competition is inefficient in

terms of allocative and productive efficiency. However, it is more efficient in terms of

dynamic efficiency.How consumers benefit from monopolistic

competition. From being able to purchase a product that

is differentiated and more closely suited to their tastes.


Oligopoly

Oligopoly: A market structure in which a small number of interdependent firms compete.

Game theory is the approach used to analyse competition among oligopolists.



Many of the largest corporations in Australia, such as Dick Smith, Qantas, Wesfarmers, Myer, etc., started as small businesses. Today, these firms compete in oligopoly markets, where their profits depend crucially on their interactions with other firms.

Competing in the retail market



Oligopoly and barriers to entry

Barrier to entry: Anything that keeps new firms from entering an industry in which existing firms are earning economic profits.

Examples are economies of scale, ownership of a key input and government-imposed barriers.

Economies of scale: Economies of scale exist when a firm’s long-run average costs fall as it increases output.



Game theory: The study of how people make decisions in situations where attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms.

Using game theory to analyse oligopoly



Key characteristics of all games:

Rules that determine what actions are allowable.

Strategies that players employ to attain their objectives in the game.

Payoffs that are the results of the interaction among the players’ strategies.

Business strategy: Actions taken by a firm to achieve a goal, such as maximising profits.




A Duopoly Game: Price competition between two firms.

Payoff matrix: A table that shows the payoffs that each firm earns from every combination of strategies adopted by the firms.




A Duopoly Game: Figure 9.7


Collusion: An agreement among firms to charge the same price, or to otherwise not compete.

Dominant Strategy: A strategy that is the best for a firm, no matter what strategies other firms use.

Nash equilibrium: A situation where each firm chooses the best strategy, given the strategies chosen by other firms.




Firm behaviour and the prisoners’ dilemma dominant strategy

Cooperative equilibrium: An equilibrium in a game in which players cooperate to increase their mutual payoff.

Non-cooperative equilibrium: An equilibrium in a game in which players do not cooperate but pursue their own self-interest.




Firm behaviour and the prisoners’ dilemma dominant strategy.

Prisoners’ dilemma: A game where pursuing dominant strategies results in non-cooperation that leaves everyone worse off.




Can firm’s escape the prisoner’s dilemma?

The prisoner’s dilemma is not always applicable as it assumes the game will only be played once.

Most of the time, managers are playing a repeated game.




Can firm’s escape the prisoner’s dilemma?

Losses for not cooperating are greater in a repeated game.

Retaliation strategies can be used against those who don’t cooperate

Are more likely to see cooperative behaviour in repeated games.



Changing the payoff matrix in a repeated game: Figure 9.8



Is Virgin Blue’s business strategy more important than the structure of the airline industry?

Virgin Blue’s business strategy allowed it to remain profitable when other airlines faced heavy losses.



Westpac's prisoners’ dilemma

In just three months in 2008, the Reserve Bank of Australia, reduced its cash rate (interest rate) by a combined value of 2%.

Assume that Westpac is deciding whether to introduce the reduction in its lending rates. The impact on profitability for Westpac depends upon the actions of its competitors (other three big banks of ‘Big 4 group’ – CBA, ANZ and NAB).

Construct the payoff matrix using the following hypothetical information:





If neither Westpac nor the other ‘Big 4’ banks reduce their lending rates: All banks earn $500 million per year.

If all banks reduce: All banks earn $400 million per year.

If Westpac reduces but other ‘Big 4’ banks do not: Westpac (due to large increase in the number of customers) earns 600 million and other Big 4 banks earn $350 million per year in profits.

If Westpac does not reduce but the other ‘Big 4’ banks do: Westpac earns 200 million and other Big 4 banks earn $550 million per year in profits.




If Westpac wants to maximise profit, will it reduce its lending rates? Briefly explain.

If other banks want to maximise profits will they reduce their lending rates? Briefly explain.

Is there a Nash equilibrium to this rate reduction exercise? If so, what is it?




STEP 1:: Review the chapter material. The problem uses payoff matrices to analyse the business situation, so you may want to review the section ‘A duopoly game: price competition between two firms’.

STEP 2: Construct payoff matrix.


Westpac's prisoners’ dilemma Other ‘Big 4’ banks

Westpac

Reduce Do not reduce

Reduce

Do not reduce

Westpac earns $400

million profit

Other banks earn

$400 million profit

Westpac earns $600

million profit

Other banks earn

$350 million profit

Westpac earns $200

million profit

Other banks earn

$550 million profit

Westpac earns $500

million profit

Other banks earn

$500 million profit



Is There a Dominant Strategy for Bidding on eBay?

On eBay, bidding the maximum value you place on an item is a dominant strategy.



An Inside LookMaccas coffee bars to take on Starbucks


An Inside LookFigure 1: The effect of entry on price, quantity and profits at Starbucks

Insert Figure 1 from page 281, as large as possible

while retaining clarity


Key Terms Barrier to entry

Business strategy

Collusion

Cooperative equilibrium

Dominant strategy

Economies of scale

Game theory


Nash equilibrium

Non-cooperative equilibrium

Oligopoly

Payoff matrix

Prisoners’ dilemma


Get Thinking!Good examples of monopolistic competition can be found in the hospitality business.

Think about a street in your suburb with large number of restaurants.

Use some Internet search engines to assist you

http://www.restaurant.org.au

http://www.restaurantsofaustralia.com.au

Answer the following questions:

a. How many restaurants are there?

b. What prices do these restaurants charge? If higher, why do you think they are able to do that and do not lose customers?

c. If restaurants were a perfectly competitive market, what benefits and disadvantages would it bring to you, as a consumer?


Get Thinking!In May 2008, the 3rd largest Australian bank - Westpac made a merger offer to the 5th largest bank – St. George. This merger was approved by the Federal Court of Australia in November 2008.

1. What do you think this merger means for the Australian banking sector in terms of competition?

2. What do you think customers of both banks gain and/or lose from this merger?

3. How do you think this merger will affect the new entity’s competitive position on the international market?


Check Your Knowledge

Q1. When a monopolistically competitive firm cuts price, good and bad things happen. Which of the following is considered a good thing?

a. The price effect.

b. The output effect.

c. The revenue effect.

d. All of the above are good things.



Q2. If marginal revenue slopes downward, which of the following is true?

a. The firm must cut the price to sell a larger quantity.

b. The firm must increase the price to sell a larger quantity.

c. The firm must cut its price if it wants to keep on selling the same quantity day after day.

d. The firm is unable to adjust price in order to adjust quantity sold.


Check Your KnowledgeQ3. Refer to the figure below. In

order to maximise profit, what price should the firm charge?

a. $18

b. $15

c. $8

d. $4


Check Your KnowledgeQ4. Which of the following types of firms use

the marginal revenue equals marginal cost approach to maximise profits?

a. Perfectly competitive firms.

b. Monopolistically competitive firms.

c. Both perfectly competitive and monopolistically competitive firms.

d. Neither perfectly competitive nor monopolistically competitive firms



Q5. Economies of scale exist when a firm’s ___________ average costs fall as it __________ output.

a. short-run; increases

b. short-run; decreases

c. long-run; increases

d. long-run; decreases



Q6. Match the following definition with one of the terms below: ‘A situation

where each firm chooses the best strategy, given the strategies chosen by other firms.’

a. Payoff matrix.

b. Collusion.

c. Dominant strategy.

d. Nash equilibrium.



Q6. Match the following definition with one of the terms below: ‘A situation where

each firm chooses the best strategy, given the strategies chosen by other firms.’

a. Payoff matrix.

b. Collusion.

c. Dominant strategy.

d. Nash equilibrium.



Q7. A game where pursuing dominant strategies results in non-cooperation that leaves everyone worse off is called:

a. A cooperative equilibrium.

b. A non-cooperative equilibrium.

c. The Prisoners’ dilemma.

d. A dominant strategy.

powerpoint to accompany chapter 9 monopolistic competition and oligopoly

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