Chapter 21 “Oligopoly and Monopolistic Competition”

1. ECONOMICS: EXPLORE & APPLYby Ayers and Collinge Chapter 21“Oligopoly and Monopolistic Competition”

2. Learning Objectives • Explain the meaning and significance of mutual interdependence. • Identify the models associated with oligopoly. • Describe the characteristics of monopolistic competition. • Define product differentiation and state its implications.

3. Learning Objectives • Relate how and why firms charge some consumers more than others for the same products. • Explain why oligopoly brings economic change.

4. 21.1OLIGOPLY • Oligopoly is characterized by multiple firms, one or more of which will produce a significant portion of industry output. • Oligopoly firms are mutually interdependent, with actions of one firm inducing other firms to take counteractions. • Oligopoly products may be differentiated or homogeneous.

5. Oligopoly Products May Be Differentiated or Homogeneous Differentiated Oligopolies: cigarettes and automobiles Homogeneous Oligopolies: steel, aluminum, and copper

6. Measuring Market Power • Market power is the ability of a firm to control the price it charges for its output. • Purely competitive firms have no market power, as they are price takers. • Monopoly firms have the most market power because they have no competition. • We must assess the market power of the firms that are neither purely competitive and monopolistic, and one method to measure market power is the four firm concentration ratio.

7. Measuring Market Power • To compute a four-firm concentration ratio: = Sales by four largest firms in an industry Sales by all firms in and industry • The larger the concentration ratio, the more market power the firms in the industry possess. • Concentration ratios do not take into account sales by foreign firms, nor do they account for differences in size among the four firms.

8. Measuring Market Power

9. Mergers and Spin-offs • A merger occurs when one firm combines with another firm to form a single firm. • Horizontal merger occurs when an firm merges another in the same line of business. • Vertical Integration occurs when a firm acquires another firm that supplies it with an input. • Conglomerate Merger occurs when firms in unrelated businesses merge.

10. 21.2OLIGOPOLY MODELS Oligopoly is the only market structure for which there are a variety of models. Contestable markets occur when new rivals can enter or exit the market cheaply. Price leadership model is based on observable oligopoly behavior. When one firm changes its selling price, the remaining firms in the industry.

11. Oligopoly Models A Cartel is a form of oligopoly in which firms in an industry collude. Collusion means that firms jointly plan price and output. Cartels are illegal in the United States. A dominant firm with a competitive fringe is an oligopoly model that combines the competitive and monopoly models

12. Reasons for Difficulty in Keeping Cartels Together Illegal in the U.S. Any member has the incentive to cheat Cartel members may drop out High cartel profits may induce competition Higher prices can lead to the development of substitute goods

13. The Nominal and Real Price of Oil Oil production (percentage of world market) Price ($ per barrel) 35 30 25 20 15 10 5 0 50 40 30 20 10 0 OPEC oil production Nominal price Real price ’70 ’75 ’80 ’85 ’90 ’95 ‘00

14. #3 The price from step #2 becomes the market price. Firms in the competitive fringe are price takers at that price. The total quantity of output equals the quantity supplied by the competitive fringe plus the quantity supplied by the dominant firm. Actual market equilibrium occurs at this point, as other firms take this price competitive equilibrium.  #1 The firm's computes its residual demand, the shortage that would occur in the competitive market at each price below the competitive equilibrium. #2 The dominant firm chooses its quantity by equating marginal revenue to marginal cost, which determines the price. Oligopoly Models Marginal cost Competitive supply The dominant firm with a competitive fringe chooses its output and price in three steps: • Price Dominant firm’s demand • Market quantity Dominant firm’s quantity Firm’s quantity Marginal revenue Total quantity Competitive fringe quantity Dominant firm’s quantity

15. Game Theory Game theoryemploys mathematics to analyze the behavior of parties whose interests conflict. This method may be employed to deepen the understanding of oligopoly behavior. The tool of analysis is the payoff matrix. An example of game theory is the prisoners dilemma.

16. confess confess Keep quiet confess Keep quiet Keep quiet Game Theory Outcome Prison sentence (years) Decision 1 Decision 2 √ Happy Al 5 5 √ Al: Confess or keep quiet? Happy Al 1 20 Happy: Confess or keep quiet? √ Happy Al 20 1 Al: Confess or keep quiet? Happy Al 3 3 Prisoner’s Dilemma: Happy is better off confessing no matter what Al does. The outcome of these decisions is a prison sentence of 5 years apiece, as shown in the yellow boxes. Note that Al and Happy's collective interest is better served by collusion, in which they both keep quiet and are sentenced to 3 years each.

17. High price High price Low price High price Low price Low price Game Theory Outcome Profit (loss) Decision 1 Decision 2 X–co Y–co $10 m $10 m X-co: High or low price? X–co Y–co $15 m ($5 m) Y-co: High or low price? √ X–co Y–co ($5 m) $15 m X-co: High or low price? X–co Y–co $1 m $1 m √ √ Prisoner’s Dilemma in a Two-Firm Oligopoly: These firms face the dilemma of whether to price high or low. Their collective interest calls for a high price. In the absence of collusion, however, their dominant strategies cause the price to be low.

18. The Model of Kinked Demand • Prices in oligopoly sometimes seems “sticky”,meaning resistant to change. • The kinked demand curve model offers an explanation. • In this model, any firm that raises its price, loses a significant fraction of its customers to other firms that are assumed to keep their prices constant. • However if a firm lowers its price, it does not gain customers from other firms, because the other firms in the industry would feel the competitive need to lower their prices too.

19. Marginal cost can shift, yet still intersect marginal revenue at the same quantity. Price As a consequence, marginal revenue is discontinuous (vertical) at the quantity associated with the kink. The Kinked Demand Curve Marginal Cost Dollars Kink The kinked demand curve model assumes that firms match price decreases by their competitors, but do not match price increases. • Firm’s Demand Quantity Profit maximizing quantity Marginal revenue

20. 21.3MONOPOLISTIC COMPETITION • Monopolistic competition is a market characterized by many firms, product differentiation, and relatively easy entry of new firms. • Monopolistically competitive firms face a downward sloping demand curve that is less elastic than that of a purely competitive firm, but more elastic than that of a monopolist. • Specifically, each firm faces a demand curve that is highly elastic, which gives it a relatively flat appearance.

21. Monopolistic Competition • The firm’ demand curve is influenced by its own actions , and the actions of its competitors. • Monopolistically competitive firm’s have the incentive to advertise and vary their products as a way of increasing their demand at the expense of their competitors. • In the short-run monopolistically competitive firms will continue to enter or exit a market until a long-run equilibrium is reached in which additional entrants would expect additional profits.

22. Price Marginal cost = marginal revenue Output and Price in Monopolistic Competition Marginal Cost Under monopolistic competition, demand is much more elastic. As a result, the profit-maximizing output occurs close to the efficient output, given by the intersection of marginal cost and the firm’s demand. Dollars • • Firm’s Demand Marginal revenue Profit-maximizing quantity Quantity

23. Price Profit, Loss, and Breakeven in Monopolistic Competition Marginal Cost Dollars Profitable firm • Profit Average cost • Firm’s Demand • Marginal revenue Profit-maximizing quantity Quantity

24. Profit, Loss, and Breakeven in Monopolistic Competition Marginal Cost Average cost Dollars • Firm with a loss Loss Price • • Firm’s Demand Marginal revenue Profit-maximizing quantity Quantity

25. Profit, Loss, and Breakeven in Monopolistic Competition Marginal Cost Average cost Dollars Firm that breaks even Price • • Firm’s Demand Marginal revenue Profit-maximizing quantity Quantity

26. The key to riches in monopolistic competition is successful product differentiation in such things as… Size Taste Shape Style Color Texture Quality Location Packaging Advertising Service 21.4 WAYS TO COMPLETE

27. Advertising and Product Differentiation • If the marginal revenue generated by advertising exceeds the marginal cost of advertising, advertising raises profits. • Otherwise it does not. • The profit-maximizing firm will adjust its hours of operation, selection of merchandise, and every other aspect of product differentiation with this same principle in mind.

28. Advertising aims to strengthen preferences for the firm’s products. Advertising to Shift Demand $ Firm’s demand Marginal Revenue Quantity

29. Price Discrimination Under Monopolistic Competition and Oligopoly • Price discrimination is selling a good or service at different prices when such differences are not cause by differences in production cost. • Price discrimination is feasible when different prices can be charged to different market segments. • A firm cannot practice price discrimination if buyers who buy at a low price, can resell those goods to other buyers at a higher price, which is a practice called arbitrage.

30. 21.5 EXPLORE & APPLYOligopoly –Changing Way of Life FOUR-FIRM CONCENTRATION RATIOS FOR RETAILING KIND OF BUSINESS CONCENTRATION COMMENT RATIO Discount department 87.9 Highly concentrated, storesindicating probable oligopoly Radio, television, and 62.3 Relatively high other electronics stores concentration ratio, indicating possible oligopoly Pharmacies and drug 46.6 Moderate concentration stores ratio Clothing stores 25.5 Fairly competitive Nursery and garden centers 12.4 Competitive All retail firms 7.9 Low concentration ratio indicates retailing is highly competitive

31. Oligopoly –Changing Way of Life TOP TEN U.S. RETAILERS FIRM SALES (IN BILLIONS OF DOLLARS) 1. Wal-Mart 219.8 2. Home Depot 53.55 3. Kroger 50.1 4. Sears, Roebuck, and Co. 41.1 5. Target Corp. 39.4 6. Albertson’s Inc. 37.9 7. K-Mart 37.0 8. Costco Wholesale Corp. 34.8 9. Safeway 34.3 10. J. C. Penney 32.0

32. oligopoly mutually interdependent differentiated product monopolistic competition four-firm concentration ratio merger horizontal merger vertical merger conglomerate merger contestable market price leadership cartel dominant firm with a contestable market game theory kinked demand curve monopolistic competition Terms along the Way

33. Test Yourself • Which is the best example of a vertical merger? • A computer manufacturer merges with a computer store. • Two book publishers merge. • A jewelry store merges with a furniture store. • A Cosmetics manufacturer merges with a pizza restaurant.

34. Test Yourself 2. Price leadership describes a model of • cartel • monopoly • oligopoly • monopolistic competition

35. Test Yourself 3. Cartels are difficult to maintain over time for each of the following reasons, EXEPT that • Individual members cheat by charging less than the cartel price. • consumers substitute other goods for the product of the cartel. • new competitors that are not cartel members may enter the market. • legal barriers prohibit any member of the cartel from dropping out.

36. Test Yourself 4. In the game theory model of oligopoly, prices • are are set with little concern for whether profits are maximized. • are set strategically, as though firms are all playing in the same game. • fall when cost rise, and when cost fall. • remain stable in response to moderate changes in cost.

37. Test Yourself 5. In which market structure do firms ALWAYS produce differentiated products? • Pure competition. • Monopoly. • Monopolistic competition. • Game theory.

38. Test Yourself 6. Fast food restaurants are examples of • pure competition • monopolistic competition • oligopoly • monopoly

39. Test Yourself 7. Monopolistically competitive firms • are mutually interdependent. • are also called price takers. • maximize profits by setting marginal revenue equal to marginal cost. • are few in number.

40. The End! Next Chapter 22 “Market for Labor and Other Inputs”