Monopolistic Competition and Oligopoly

1. Monopolistic Competition and Oligopoly Chapter 17 and THEN Chapter 16

2. Think about it… • Think about the market for books…what characteristics does this market have that fit with perfect competition? What about monopoly? • Come up with one example of how this market could be a perfectly competitive one and one example of how it could be like a monopoly.

3. Monopolistic Competition Characteristics

4. 1. Relatively Large Number of Sellers • Each firm has a small market share • No collusion • Independent action by each firm: • each firm can set its own price without considering the impact or reaction by other firms

5. 2. Differentiated Products • Product Attributes are not homogenous: • design, workmanship, style, quality • Service can be at different levels: • Friendliness, helpfulness, • Location can create advantage: • accessibility to customers

6. 2. Differentiated Products • Brand Names can create advantage: • Anyone have a brand that they exclusively buy? • Some people only buy apple products, some only wear Nike apparel or drive domestic cars, etc.

7. 2. Differentiated Products • Brand Names can create advantage: • Trademarks/logos can also add to customer base • Let’s see how well you guys do with this!

8. 2. Differentiated Products • Brand Names can create advantage: • celebrity endorsements • Think of three celebrities that endorse products you buy.

9. 2. Differentiated Products • Some control over price

10. 2. Differentiated Products • Product Development: • Always possibility of improving product or coming up with new uses for product • Think about the evolution of the smart phone

11. 3. Free Entry • Firms can enter/exit market without restriction • Causes the market to adjust to economic profits = zero • What type of profits are we making at that point?

12. 3. Easy Entry and Exit • Industry usually has small firms • More difficult to enter than in perfect competition due to brand name loyalty, patents, trademarks etc…. • Easy to exit

13. Nonprice Competition • Advertising • What makes an ad good? What makes an ad bad? • What is the goal of advertising?

14. Worksheet Review

15. Worksheet Review

16. Firm’s Demand Curve • Downward Sloping • Highly, but not perfectly, elastic because: • Fewer rivals • Not perfect substitutes

17. Profit Maximization • MR = MC • Go down to x-axis for quantity • Go up to demand curve for price

18. Short Run • Excess Profit: P > ATC • Normal Profit: P = ATC • Loss: P < ATC

19. Long Run • Normal Profit (Break Even) Only • If excess profits in short run: • More firms enter • Demand curve for each firm will decrease • If losses in short run: • More firms leave • Demand curve for each firm will increase

20. Excess Capacity • Entry/Exit drive firm to a point of tangency between demand and ATC curves • Quantity produced is smaller than the quantity at minimum ATC • Bottom of the curve • Quantity that minimizes ATC = efficient scale • Firms have excess capacity in Monopolistic Competition • Firm could increase quantity and lower ATC

21. Excess Capacity • Reasons: • Plant and equipment are underused • Too many firms in industry • Fewer firms could produce same total output at lower prices and lower minimum costs

22. MC Difference • In Perfect Competition – P = MC in long run equilibrium • In Monopolistic Competition – P > MC in long run equilibrium • What does that mean for profit when selling one unit more?

23. Welfare of Society • Deadweight Loss created • Some consumers value the good more than MC but less than P • Hard to regulate these types of firms • Number of firms in the market is not “ideal” • Might not be enough exit and entry

24. Welfare of Society • Externalities with exit/entry • New firm enters = consumer surplus from introduction of new product • Product-variety externality = positive • New firm enters = other firms lose customers and profits • Business-stealing externality = negative

25. Oligopoly – Chapter 16 • Industry dominated by a few, interdependent, large producers of a homogenous or differentiated product • Measure using a “concentration ratio” • Percent of total output supplied by the four largest firms • Normally ratio = under 50% • When higher = oligopoly

26. Oligopoly Industries • Breakfast cereal • Aircraft manufacturers • Cigarettes • Household laundry equipment

27. Oligopoly Characteristics

28. 1. Few Large Producers • Top revenue producing firms control most of the industry’s market • “Big Three” “Big Six” “Big Four”

29. 2. Product = Homogenous or Differentiated

30. 2a. Homogenous Product • Pure oligopoly • Steel, copper, zinc, aluminum, lead, cement, industrial alcohol

31. 2b. Differentiated Product • Differentiated oligopolies • Real or perceived differences • Automobiles, tires, household appliances, electronics equipment, breakfast cereals, cigarettes, sporting goods, soda • Reliance on advertising, product placement, celebrity endorsements, etc….

32. 2b. Differentiated Product • Positive effects of advertising: • Provides information about product • Lowers customers’ search cost • Makes customers more quickly aware of new products and encourages new products to be made • Negative effects of advertising: • Brand name loyalty for inferior products • Higher costs and higher prices • Ads cancel each other out and firms do not get more business

33. 3. Interdependence • Each firm can set its own price, but it considers the prices and reactions of other firms in the industry • Can collude • Collusion = an agreement among firms in a market about quantities to produce or prices to charge • Cartel = group of firms acting in unison

34. 4. Entry Barriers • Economies of scale will benefit the large, existing firms • Smaller firms entering will have small market shares and will not be able to realize economies of scale and will have to charge higher prices • High capital requirements • Brand name identification • Limit Pricing

35. 5. Mergers • Combining of two or more firms • Horizontal: Firms producing same/similar product • Vertical: Firms in different stages of production of same product • Conglomerate: Firms in unrelated industries

36. 6. Prices • Inflexible, “sticky,” or rigid • Takes them awhile to adjust • All firms tend to change prices together either collusively or in reaction to each other

37. Kinked Demand Curve • Demand is highly elastic above the going price because other firms will not react to price increase by one firm and they will benefit from getting that firm’s customers • Demand is less elastic below the going price because the other firms will lower their price to maintain their customers; therefore the quantity demanded will not change very much for each firm

38. D1-Other Firms Match Price Changes MR1 P1 D2-Others Ignore Price Changes MR2 Dkinked MRkinked Q1 Graph of a Kinked Demand Curve P Q

39. Obstacles to Colluding • Demand and cost differences for each firm will make it difficult to agree on a price • Number of firms increasesmore difficult to collude • Antitrust laws • New suppliers: New oil reserves found in Great Britain, Norway, and Russia • Declining quantity demanded decreases ability to control market • Recessions will encourage firms to lower prices

40. Obstacles to Colluding 7. Greater profits might encourage more firms to enter 8. Cheating is profitable for each individual firm (i.e., prisoner’s dilemma)

41. Price Leadership Model • Dominant firm initiates price changes and other firms follow • Sometimes leads to price wars—each firm lowers its prices

42. Benefits of Oligopolies • Limit Pricing: firms may imitate perfect competition by charging lower prices to keep out competitors • Higher profits can be used for more research and development and better products in the long run

43. (Four-Firm) Concentration Ratio • Percentage of industry sales made by four largest firms • Tight Oligopoly: 2-3 dominate • Loose Oligopoly: 6-7 have 70%-80%

44. Herfindahl Index • Sum of squared percentage market shares of all firms in the industry • Use to tell industry type