ubea 1013: economics 1 chapter 7: market structure: monopolistic competition & oligopoly 7.1...

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UBEA 1013: ECONOMICS

CHAPTER 7: CHAPTER 7: MARKET STRUCTURE: MONOPOLISTIC MARKET STRUCTURE: MONOPOLISTIC

COMPETITION & OLIGOPOLYCOMPETITION & OLIGOPOLY

7.1 Characteristic

7.2 Short-run Decision: Profit Maximization

7.3 Short-run Decision: Minimizing Loss

7.4 Long-run Equilibrium

7.5 Oligopoly Model

7.6 Games Theory

7.7 Efficiency

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Monopoly:• Single firm (firm = market).• Single unique product (no

close substitute).• Restriction to entry.• Market power: the highest but

still constraint by market demand.

Monopoly

Perfect competition:• Many firms.• Homogenous product.• Free entry & exit.• Market power: the lowest (firm

as price taker).

Perfect Competition

Market structure compared:

More competing firms

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Oligopoly:• Few big firms.• Can be homogenous or

differentiated.• Few restriction to entry.• Market power: Yes but may face

fierce competition among few big firms (except collusion happen).

• Strategic behavior.

Monopoly

Monopolistic competition:• Many firms.• Differentiated product.• Free entry & exit.• Market power: Yes but limited.• Price & quality competition.

Perfect Competitio

n

Market structure compared:

More competing firms

OligopolyOligopoly MonopolistMonopolistic ic

CompetitioCompetitionn

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Monopolistic competition is a market structure in which:• (1A) A large number of independent firms compete.• (2A) Each firm produces a differentiated product.• (3A) Firms compete on product quality, price, and

marketing.• (4A) Firms are free to enter and exit.

7.1 Characteristic7.1 Characteristic

Oligopoly is a market type in which:

• (1B) A small number of firms compete.

• (2B) Product can be homogenous or differentiated.

• (3B) Strategic behavior explained firms’ decisions. (Game Theory)

• (4B) Natural or legal barriers prevent the new entry.

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• (1A) The market that has a large number of firms (like in perfect competition) has three implications:

• (i) small market share for each firm, therefore each firm has only a small market share and therefore has limited market power to influence the price of its product

• (ii) Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firm’s actions directly affect the actions of other firms.

• (iii) Collusion, or conspiring to fix prices, is impossible.

Monopolistic competition

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• (2A) Product differentiation is a strategy that firms use to achieve market power. Accomplished by producing products that have distinct positive identities in consumers’ minds (mean seen as slightly different). This differentiation is often accomplished through advertising.

• (2A & 3A) Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the marketplace.

• (4A) Free entry & exit: There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.


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• (3A) Competing on Quality, Price, and Marketing

Product differentiation enables firms to compete in three areas: quality, price, and marketing.

Quality includes design, reliability, and service.

Because firms produce differentiated products, each firm has a downward-sloping demand curve for its own product. Thus, there are different prices for each differentiated products (but usually, the different in price is not too huge.

Differentiated products must be marketed using advertising and packaging. Branding will further differentiate the product and usually will enhance the perceived quality of the particular firm’s product.

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(3A) Selling efforts such as advertising are successful if they increase the demand for the firm’s product. Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced.

Figure 7.1: With no advertising, the firm produces 25 units of output at an average total cost of $60.

With advertising, the firm produces 100 units of output at an average total cost of $40.

The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.

Figure 7.1: Advertising Effect

Monopolistic CompetitionMonopolistic Competition

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• Identifying Monopolistic Competition

Two indexes:

• The four-firm concentration ratio

• The Herfindahl-Hirschman Index

The four-firm concentration ratio– The percentage of the value of sales accounted for by the four

largest firms in the industry.– The range of concentration ratio is from almost zero for perfect

competition to 100 percent for monopoly.• A ratio that exceeds 40 percent: indication of oligopoly.• A ratio of less than 40 percent: indication of monopolistic

competition.


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Herfindahl-Hirschman Index (HHI)– HHI is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.

– Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent.– HHI = 502 + 252 + 152 + 102 = 3,450

– A market with an HHI less than 1,000 is regarded as competitive.

– An HHI between 1,000 and 1,800 is moderately competitive.


ANTITRUST DIVISION ACTION

UnconcentratedNo challenge

Moderate Concentration

Challenge if Index is raised by more than 100 points by

the merger

HHI

1,800

1,000

0

ConcentratedChallenge if Index is raised by more than 50 points by

the merger

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Monopolistic competition is a market structure in which:• (1A) A large number of independent firms compete.• (2A) Each firm produces a differentiated product.• (3A) Firms compete on product quality, price, and

marketing.• (4A) Firms are free to enter and exit.

7.1 Characteristic7.1 Characteristic

Oligopoly is a market type in which:

• (1B) A small number of firms compete.

• (2B) Product can be homogenous or differentiated.

• (3B) Strategic behavior explained firms’ decisions. (Game Theory)

• (4B) Natural or legal barriers prevent the new entry.

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• (2B) In contrast to monopolistic competition and perfect competition, an oligopoly consists of a small number of firms:

• Each firm has a large market share.

• The firms are interdependent. Thus, the behavior of oligopoly firms depend on the behavior of other (oligopoly) firms in the industry. Before making a decision, each firm must consider how the other firms will react to its decision and influence its profit. (3B)

• The firm have incentive to collude. [Collusion Model]. Collusion occurs when price- and quantity-fixing agreements are explicit. E.g is cartel (a group of firms that gets together and makes price and output decisions to

maximize joint profits). Tacit collusion occurs when firms end up fixing price without a specific agreement, or when such agreements are implicit.

Oligopoly Characteristic

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Oligopoly

• (4B) Barriers to Entry

– Either natural or legal barriers to entry can create an oligopoly.

– Natural barriers arise from the combination of the demand for a product and economies of scale in producing it.

– If the demand for a product limits to a small number the firms that can earn an economic profit, there is a natural oligopoly.

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Figure 7.2(a): Natural duopoly

Figure 7.2(a) show a natural duopoly situation.

Here, where price equals minimum ATC, the lowest possible price, two firms can produce the quantity demanded in the market.

Figure 7.2(b) show a natural oligopoly with three firms.

Here, where price equals minimum ATC, the lowest possible price, three firms can produce the quantity demanded in the market.

Figure 7.2(b): Natural oligopoly with three firms

OligopolyOligopoly

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(4B) Contestable Market

• A market is perfectly contestable if entry to it and exit from it are costless.

• In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.

• Oligopolies are concentrated industries. At one extreme is the cartel, in essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolies firms.

OligopolyOligopoly

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• The demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, but more elastic than the demand curve faced by a monopoly.

Another Characteristic: Demand Curve & Equilibrium Outcome

Figure 7.3: Monopolistic Competition Demand Curve


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Competitive Outcome: Price equals marginal cost.

Monopoly Outcome: The firm would be a single-price monopoly.

Possible Oligopoly Outcomes: The extremes of perfect competition and monopoly provide the maximum range within which the oligopoly outcome might lie.

OligopolyOligopoly

Figure 7.4:Possible Oligopoly Outcome

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7.2 Short-run Decision: Profit Maximization

The firm in monopolistic competition makes its output and price decision just like a monopoly firm does, that is

MR = MC.MR = MC.

• In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC.

• This firm is earning positive profits in the short-run.

Figure 7.2: Profit Maximization


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The firm in monopolistic competition might incurred loses in the short-run. Profit are not guarantee. But, loss minimized

when MR = MC.MR = MC.

• Loss is minimized at MC = MR at 40 thousand of output.

• The price = $40 per month which is less than ATC ($50). Therefore, the firm incurs losses.

Figure 7.3: Loss Minimization

7.3 Short-run Decision: Minimizing Loss


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7.4 Long-run Decision: Monopolistic Competition

• Long Run: Zero Economic Profit

Economic profit induces entry and economic loss induces exit, as in perfect competition.

Entry decreases the demand for the product of each firm. Exit increases the demand for the product of each firm.

In the long run, economic profit is competed away and firms earn normal profit.

Figure 7.4 illustrates long-run equilibrium where the firm’s demand curve is just tangent to its average cost curve.

Figure 7.4: Long-Run Equilibrium

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7.5 Oligopoly Model

Possible Behavior / StrategyPossible Behavior / Strategy

Compete Not to compete

i. Quantity leadership (Stackelberg Model)ii. Price Leadership Modeliii. Simultaneous Quantity Setting (Cournot Model)iv. Simultaneous Price Setting (Bertrand Model)

Collusion Model

Plus one general model: Kinked Demand Curve Model

<< Assumption for oligopoly model analysis: Identical product >>

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• The Kinked Demand Curve Model– In the kinked demand curve model of oligopoly, each firm

believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow (the general assumption).

OligopolyOligopoly

• Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firm’s quantity demanded (demand is elastic).

• Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).

Figure 7.5: Kinked Demand Curve

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UBEA 1013: ECONOMICS OligopolyOligopoly

i. Quantity leadership (Stackelberg Model)– The dominant firm (leader) choose an output level

that can maximize its profit– Then, the smaller firms (followers) response and

choose their respective output level given the choice of their leader.

– The leader is aware that its actions influence the output choices of its follower. Thus, its decision need to consider the expected reaction of its follower.

– The equilibrium(s) for Stackelberg model reflects in the Nash equilibrium of games theory in which each player takes the best possible action given the action of the other player .

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ii. Price leadership– The dominant firm (leader) set a price level – Then, the smaller firms (followers) follow its pricing

policy due to assumption that products are identical. So, if firms charge different price, the customers would prefer the producer with the lowest price.

– Thus, it is like a perfectly competitive market. Each follower firm takes the price as being outside of its control because it is only a small part of the market.

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• The price-leadership model outcome:

– The quantity demanded in the industry is split between the dominant firm and the group of smaller firms.

– This division of output is determined by the amount of market power of the dominant firm.

– The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

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• Large, powerful firm (the leader) can drive smaller firms out of the market by temporarily selling at an artificially low price. This practice is called predatory pricing.

• Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.

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iii. Simultaneous Quantity Setting (Cournot Model) – The oligopoly firms simultaneously trying to decide

what quantity to produce.– Each firm has to forecast what the other firm’s output

will be in order to make a sensible decision itself.– A series of output adjustment lead to a final decision of

output where every firm’s expectation about the other firms’ output choices is satisfied (called Cournot equilibrium).

– In Cournot equilibrium, neither firms will find it profitable to change its output once it discovers the choice actually made by other firms (satisfied with this discovery).

– Cournot equilibrium can be generalized in the Nash equilibrium (one of the Game Theory strategy).

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UBEA 1013: ECONOMICS OligopolyOligopolyiv. Simultaneous Price Setting (Bertrand Model)

– The oligopoly firms simultaneously trying to decide what price to produce.

– Interestingly, the Bertrand equilibrium is the same as perfect competition equilibrium. The logic?

– No firm will be setting its price below its MC as they will suffer losses. (assuming same cost structure and product identical).

– If Firm A is believed to set price above MC, Firm B (or other firms) can under-cut to set a slightly lower than Firm A price to gain customers.

– However, this knowledge is also known by Firm A and other firms (not only Firm B). So, what is the price that give no chance for other to under-cut?

– It is when price equal MC!!! (the perfect competitive profit maximization condition).

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7.6 Game Theory7.6 Game Theory

Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence.

What Is a Game?

All games share four features: – Rules – Strategies – Payoffs– Outcome.

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• Game theory analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms.

• In game theory, firms are assumed to anticipate rival reactions.

Game TheoryGame Theory

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UBEA 1013: ECONOMICS Game TheoryGame Theory

• The strategy that firm A will actually choose depends on the information available about B’s likely strategy.

Payoff Matrix for Advertising Game

• Regardless of what B does, it pays for A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.

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• The Prisoners’ Dilemma is a game in which:

• The players are prevented from cooperating with each other;

• Each player in isolation has a dominant strategy;

• The dominant strategy makes each player worse off than in the case in which they could cooperate.

Game TheoryGame Theory

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• Ginger and Rocky have dominant strategies to confess even though they would be better off if they both kept their mouths shut.

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• In game theory, when all players are playing their best strategy given what their competitors are doing, the result is called Nash equilibrium.

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• When uncertainty and risk are introduced, the game changes. A maximin strategy is a strategy chosen to maximize the minimum gain that can be earned.

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• While explicit collusion violates the antitrust statutes, strategic reaction does not.

• Strategic reaction in a repeated game may still have the same effect as tacit collusion.

• Repeated Games

– Most real-world games get played repeatedly.

– Repeated games have a larger number of strategies because a player can be punished for not cooperating.

– This suggests that real-world duopolists might find a way of learning to cooperate so they can enjoy monopoly profit.

– The larger the number of players, the harder it is to maintain the monopoly outcome.

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• The strategy to respond in a way that lets your competitors know you will follow their lead is called tit-for-tat strategy. If one leads and the competitor follows, both will be better off.

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7.7 Efficiency of Monopolistic Competition

• In the long-run, positive economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:

– Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product.

– Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity. (A firm has excess capacity if it produces less than the quantity at which ATC is a minimum).

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7.7 Efficiency of Oligopoly

• Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons:

– Profit-maximizing oligopolists are likely (but not always) to price above marginal cost. So, the quantity produced is less than the efficient quantity (like in perfect competition market).

– Strategic behavior can force firms into deadlocks that waste resources.

– Product differentiation and advertising may pose a real danger of waste and inefficiency.

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Further Example of Game Theory

Table 8.2: Dominant Equilibrium

Table 8.3: Nash Equilibrium & Cournot ModelTable 8.4: Nash Equilibrium & Stackelberg Model

Table 8.5: No Nash Equilibrium

Table 8.7: Prisoner’s Dilemma: Price War Decision

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ubea 1013: economics 1 chapter 7: market structure: monopolistic competition & oligopoly 7.1...

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