MONOPOLISTIC COMPETITION

1. MONOPOLISTIC COMPETITION • Principles of Microeconomic Theory, ECO 284 • John Eastwood • CBA 213 • 523-7353 • e-mail address: John.Eastwood@nau.edu • http://jan.ucc.nau.edu/~jde

2. Basic Assumptions (Characteristics): • Many Sellers and Buyers • Product Differentiation • Low Barriers to Entry

3. Behavior of Firms in Monopolistic Competition: • They are Price Searchers (Makers) • But Lack Market Power • P > MR

4. Monopolistic Comp. and Resource Allocation • All firms maximize profits by producing the quantity of output where . . . • MR = MC. Given that P > MR, it follows that the m.c. firm will produce a quantity of output where P > MC. • Thus the allocation of resources under monopolistic comp. is inefficient.

5. From Short-Run Profits to Long Run Equilibrium • TR > TC -- positive economic profits will attract new firms (in the long run). • The demand curve faced by each of the incumbent firms, Df, shifts left. • As the industry grows, resource prices may rise. If so, the cost curves shift up. • Entry will continue until economic profits fall to zero.

6. From Short-Run Losses to Long Run Equilibrium • TR < TC -- Negative economic profits will cause firms to exit (in the long run). • As some firms leave, the demand curve faced by each of the remaining firms will increase -- Df shifts right • Resource prices may be affected. • Exit will continue until economic losses fall to zero.

7. The Excess Capacity Theorem • In equilibrium, a m.c. firm will produce an output smaller than the one that would minimize ATC. • The difference between the output that minimizes ATC and the actual output of the firm is excess capacity. • While excess capacity is economically inefficient, it is the price of variety.

8. Advertising • Shifts the cost curves upward. • Seeks to differentiate the firm’s product from that of its competitors.

9. Successful Advertising • If it is successful, it shifts the demand for the firm’s product to the right as the firm gains a larger share of the market. • It may also make demand less elastic. Consumers will perceive competing products as poor substitutes.

10. Competitors’ Advertising • When a firm’s competitors respond with their own advertising the above effects will be reversed to some extent.

11. Advertising may be informative or persuasive. • Most economists agree that advertisements that are merely persuasive waste society’s scarce resources.

12. How much is spent on advertising? • Expenditures in the USA total roughly two percent of GDP. • In 1995, GDP was $7,245.8 billion. • Two percent equals $144.9 billion. • But its importance may be even greater than this figure would suggest.

13. Galbraith’s view of advertising • It wastes resources by promoting contrived obsolescence • It distorts resource allocation in favor of private goods and away from public goods. • It reverses the notion of consumer sovereignty.

14. The Revised Sequence • Galbraith argues that businesses create wants through advertising. • As a large corporation develops a new product it plans and executes an advertising campaign to create a demand for that product. • Demand then depends on output (the dependency effect).

15. Implications of the Revised Sequence • Galbraith then concludes that much of our production is wasteful.

16. Critique • Other economists have criticized Galbraith’s theories. For example, Frederic Hayek argued that the dependency effect is a non-sequitur (a Latin phrase which translates as “does not follow”).

17. OLIGOPOLY • Few Sellers • No single model • Nevertheless, there are three basic assumptions common to the different models of oligopoly we will review.

18. Basic Assumptions: • Few Sellers and Many Buyers • Price Searchers (Makers) • Significant Barriers to Entry

19. Barriers to Entry • The oligopolist is protected by barriers to entry (BTE). Examples: • Economies of scale & capital requirements • Control of input supplies • Cost differences • Government regulation of entry • Product complexity & Product proliferation • Product recognition

20. Lerner Index of Monopoly Power • LMP = (P - MC)/ P • Measures “monopoly power” as the difference between price and marginal cost, expressed as a percentage of price. • Real-world monopolies may have other control over markets, such as the ability to withhold technology.

21. Classification of Real-World Market Structures • Concentration ratios measure the percentage of sales, assets, output, or employment that is controlled by the largest X firms in the industry. • For example, a four-firm sales concentration ratio expresses the sales of the four largest firms as a percentage of industry sales.

22. Four-Firm Sales Concentration Ratio, CR4 • For many years, it was the “measuring stick” by which the competitiveness of an industry was measured. • When the ratio exceeds, say, 50 percent, the industry is said to be “concentrated.”

23. Limitations of CR4 • Concentration ratios often ignore two key considerations: • (1) the presence of foreign competition; • (2) the degree to which market power is dispersed beyond the four biggest firms

24. The Herfindahl-Hirschman Index (HHI) • HHI equals the sum of the squared market shares of each firm in the industry – that is: HHI = (S1)2 + (S2)2 +(S3)2 + ... + (Sn)2,where S1 through Sn are the market shares of firms 1 through n. (n £ 50 largest firms) • For monopoly, the HHI is 1002, or 10,000.

25. Interpreting HHI • The Justice Department considers • HHI < 1,000 competitive (10 firms @ 10%) • HHI > 1,800 concentrated • A merger in a previously unconcentrated industry that raises the HHI value by less than 100 (under Clinton) or 200 (under Reagan & Bush) points is allowable.

26. Market Share Predicts Profitability • The market share of an individual firm is a better predictor of its profitability than the overall concentration ratio for its industry.

27. Example: Market Shares (Sales) • Industry #1 has 4 firms @20% each & 20 firms @1% each. • Industry #2 has 1 firm @77% & 23 firms @1% each • Calculate CR4 and HHI for each industry. • Which is a better measure of concentration?

28. Calculation Detail (industry #1)

29. OLIGOPOLY • When firms are interdependent, we must ask how one firm reacts to the actions of another. • Strategic behavior becomes important.

30. The Kinked Demand Curve Theory • Assume that the oligopolist believes that its rivals will match any price cut it initiates, but ignore any price increase it initiates.

31. The Kinked Demand Curve • The above assumption on how rival firms react implies that Dfirm has a “kink” at the presently prevailing price. • There is a corresponding discontinuity (gap) in the MR curve. • This gap implies that MC can shift somewhat without causing the firm to change its price or output

32. Predictions of the Model: • Price Rigidity -- Price changes will not necessarily follow from changes in MC. • Non-Price Competition -- Firms will compete through advertising and/or product differentiation. Firms will avoid competing by reducing price.

33. Criticisms of the Kinked Demand Curve Theory: • How did the industry arrive at the prevailing price? • Empirical evidence points out a number of oligopolies whose behavior can not be explained by the kinked demand curve.

34. A Formal Price Leadership Model • This model is one example of a group of models that fall into the category called “Price Leadership Theory.” Such models provide one explanation of the level of the prevailing price in the Kinked Demand Curve Model. This next model provides an independent theory of oligopolistic behavior that applies to certain markets

35. The Key Assumptions • The industry is dominated by a single firm, the dominant firm (a.k.a. the price leader), which sets price to maximize its own profits. There are a large number of small firms, known as fringe firms, that act as price takers. They set their prices to equal those of the price leader.

36. Equilibrium Price and Quantity: • First, draw the market D and S curves in the absence of the price leader. Next to this graph, draw the demand curve of the price leader as the difference between Demand and Supply, (Qd - Qs at each price). Add the MR and MC curves. The presence of the price leader leads to a lower market price.

37. Policy Implications: • Observe how the nature of this market causes the small firms to follow any price change imposed by the dominant firm -- without any explicit agreement. In this particular model, the oligopolist’s presence contributes to economic efficiency, and benefits consumers, but other models imply results that are less benign.

38. Examples • At one time or another, the following firms have been price leaders in their industries: R.J. Reynolds in cigarettes; General Motors in autos; Kellogg in breakfast cereals; Goodyear in tires.

39. Cartel Theory • In a cartel, several firms collude in an attempt to monopolize the market. • The Incentive to Collude -- Price competition may result in lower profits for all firms. If firms cooperate, they may earn higher profits.

40. Optimal Cartel Behavior • The Cartel behaves just as a monopolist would, restricting output and raising price. • Cartels often fail

41. Problems Cartels Face • Tough to form • Members must agree on the cartel’s policies • High profits may attract new entrants • New entrants will increase the industry’s supply • The cartel will be forced to cut production or accept a lower price. • Each member has an incentive to cheat.

42. Limit Pricing • If an existing firm has a lower ATC than potential new entrants, it may be able to prevent entry through limit pricing: • Limit Price: The lowest price at which a new firm can enter an industry and just cover average total cost.

43. Lower ATC may result from • IRS • more efficient production (including patented production methods) • lower input prices. • size (market power as a buyer); • “track record” • political influence (Galbraith)

44. The Theory of Contestable Markets • Recent developments in industrial organization have focused on the issue of entry and exit from the industry. • William Baumol and others developed the theory of contestable markets, offering the first alternative to the SCP paradigm.

45. What is a Contestable Market? • Potential entrants must be able to serve the same market as existing firms. • New firms may use the same production techniques and produce at the same per unit cost as existing firms • Potential entrants incur zero sunk costs. • Potential entrants estimate profits based on existing industry prices (i.e., their entry will not depress prices and profits).

46. Airline industry as an example • A route served by only two carriers could result in anti-competitive behavior. • Could those carriers earn positive LR economic profits? • If other BTE are absent, this route may be a contestable market, another carrier could transfer planes to this route. If profits fell, it could transfer its planes to some other route.

47. Sustainable industrial configuration • A configuration is sustainable when no firm is making economic profits and thus there is no incentive for entry. If the above four conditions hold, then either the incumbents will hold prices and profits down to deter entry, or new firms will enter, ultimately driving down prices.

48. Conclusions of Contestable Market Theory • Concentration does not always lead to anti-competitive behavior. Potential entrants keep existing firms from restricting output and raising price. • Concentration does not necessarily imply positive economic profits. If entry is easy, positive economic profits will attract new entrants.

49. More Conclusions • Contestablility threatens inefficient firms. • If existing firms do not produce at minimum ATC, new firms may enter. Price will decline, and existing firms will be forced to become efficient or exit. • If potential entrants cause existing firms to produce at the min. ATC, and to charge a price equal to ATC, then P=MC=ATC • allocative & technical efficiency.

50. Criticisms of Contestable Market Theory • Given substantial BTE, the theory does not apply. • Example: • an incumbent builds a large factory filled with specialized capital goods (machines), and enjoys substantial economies of scale. These machines cannot be used to produce any other good, hence their cost is sunk. Such sunk costs may serve as a strategic BTE.