MONOPOLISTIC COMPETITION AND OLIGOPOLY

1. MONOPOLISTIC COMPETITION AND OLIGOPOLY Chapter 13

2. Today’s lecture will: • Discuss the four distinguishing characteristics of monopolistic competition. • Demonstrate graphically the equilibrium of a monopolistic competitor. • State the central element of oligopoly.

3. Today’s lecture will: • Explain why decisions in the cartel model depend on market share and decisions in the contestable market model depend on barriers to entry. • Explain two empirical methods of determining market structure.

4. Characteristics of Monopolistic Competition • Many sellers • Differentiated products • Multiple dimensions of competition • Easy entry of new firms in the long run

5. QM Equilibrium in Monopolistic Competition Profit maximizing output is where MR=MC. MC Price ATC PM At equilibrium P=ATC and economic profits are zero. MR D 0 Quantity

6. Price PM PC 0 QC Quantity QM QC Comparing Perfect and Monopolistic Competition Perfect competition Monopolistic competition Price MC MC ATC ATC PC D MR D 0 Quantity

7. Comparing Monopolistic Competition with Monopoly • It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry. • No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry.

8. Advertising and Monopolistic Competition • Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do. • The goals of advertising are to increase demand and make demand more inelastic. • Advertising increases ATC.

9. Characteristics of Oligopoly • Oligopolies are made up of a small number of mutually interdependent firms. • Each firm must take into account the expected reaction of other firms. • Oligopolies can be collusive or noncollusive.

10. Models of Oligopoly Behavior • There is no single model of oligopoly behavior. • Two models of oligopoly behavior are: • The cartel model – the combination of firms acts as if it were a monopoly. • The contestable market model – existence of barriers to entry, not market structure, determine price and output decisions.

11. The Cartel Model • Oligopolies act as if they were a monopoly and set a price to maximize profit. • Output quotas are assigned to individual member firms so that total output is consistent with joint profit maximization. • If oligopolies can limit the entry of other firms, they can increase profits.

12. Implicit Price Collusion • Formal collusion is illegal in the U.S. while informal collusion is permitted. • Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another. • Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.

13. Why Are Prices Sticky? • Informal collusion is an important reason why prices are sticky. • Another is the kinked demand curve. • If a firm increases price, others won’t go along, so demand is very elastic for price increases. • If a firm lowers price, other firms match the decrease, so demand is inelastic for price decreases.

14. Price 0 Quantity The Kinked Demand Curve a b MC0 P MR1 c MC1 D1 d D2 Q MR2

15. The Contestable Market Model • According to the contestable market model, barriers to entry and exit determine a firm’s price and output decisions. • Even if the industry contains only one firm, it will set a competitive price if there are no barriers to entry.

16. Comparing the Contestable Market and Cartel Models • The cartel model is appropriate for oligopolists that collude, set a monopoly price, and prevent market entry. • The contestable market model describes oligopolies that sets a competitive price and has no barriers to entry. • Oligopoly markets lie between these two extremes. • Both models use strategic pricing decisions – firms set their price based on the expected reactions of other firms.

17. New Entry and Price Wars • The threat of outside competition limits oligopolies from acting as a cartel. • Price wars are the result of strategic pricing decisions gone wild. • A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business.

18. Comparison of Market Structures Structure Characteristics

19. Classifying Industries • Cross-price elasticity measures the responsiveness of the change in demand for a good to a change in the price of a related good. • Goods with a cross-price elasticity of 3 or more are in the same industry. • North American Industry Classification System (NAICS) is an industry classification system adopted by Canada, Mexico, and the U.S. in 1997.

20. Industry Groupings in NAICS 44-45 Retail Trade 51 Information __ 517 Telecommunications 5172 Wireless telecommunications and carriers (except satellite) 517211 Paging • Finance and insurance • 53 Real estate and rental and leasing

21. Determining Industry Structure • The concentration ratio – the value of sales by the top firms of an industry as a percentage of total industry sales • The Herfindahl index – the sum of the squared value of the individual market shares of all firms in the industry

22. Four - firm Herfindahl Industry concentration index ratio Meat products 42 393 Breakfast cereal 78 2,445 Book printing 39 364 Stationary 28 1,128 Soap and detergent 61 1,619 Men’s footwear 42 857 Computer and peripherals 49 728 Burial caskets 73 2,965 Radio, TV, wireless 43 972 broadcasting Concentration Ratios and the Herfindahl Index

23. Conglomerate Firms and Bigness • Neither the four-firm concentration ratio nor the Herfindahl index gives a complete picture of corporations’ bigness because many firms are conglomerates. • Conglomerates – huge corporations whose activities span various unrelated industries.

24. Summary • Monopolistic competition is characterized by: • Many sellers • Differentiated products • Multiple dimensions of competition • Ease of entry of new firms • The central characteristic of oligopoly is that there are a small number of interdependent firms.

25. Summary • Monopolistic competitors differ from perfect competitors in that the former face a downward sloping demand curve. • Monopolistic competitors differ from monopolists in that monopolistic competitors make zero long-run profit. • In monopolistic competition firms act independently; in an oligopoly they take account of each other’s actions.

26. Summary • An oligopolist’s price will be somewhere between the competitive price and the monopolistic price. • A contestable market theory of oligopoly judges an industry’s competitiveness more by performance and barriers to entry than by structure. • Cartel models of oligopoly concentrate on market structure.

27. Summary • Industries are classified by economic activity in the North American Industry Classification System (NAICS). Industry structures are measured by concentration ratios and Herfindahl indexes. • A concentration ratio is the sum of market shares of the largest firms in an industry. • A Herfindahl index is the sum of the squares of the market shares of all firms in an industry.

28. Review Question 13-1 Explain the difference in short-run and long-run equilibrium for a monopolistic competitor. In the short-run, a monopolistic competitor produces where MR=MC. As long as P>ATC, the firm will make an economic profit. However, other firms enter the industry and decrease the market share of the original firms. The demand curve for all firms will shift to the left until P=ATC. There are no economic profits in long-run equilibrium. Review Question 13-2 Compare long-run equilibrium in oligopoly with perfect competition and monopoly with respect to price and output . Equilibrium output for an oligopolistic market is larger than output for a monopoly, but less than output for a perfectly competitive market. Prices in oligopoly are lower than those for monopoly, but higher than those in perfect competition.