Understanding Monopolistic Competition and Oligopoly

1. Chapter 12 Monopolistic Competition and Oligopoly

2. Topics to be Discussed • Monopolistic Competition • Oligopoly • Price Competition • Competition Versus Collusion: The Prisoners’ Dilemma • Implications of the Prisoners’ Dilemma for Oligopolistic Pricing • Cartels Chapter 12

3. Monopolistic Competition • Characteristics 1) Many firms 2) Free entry and exit 3) Differentiated product • The amount of monopoly power depends on the degree of differentiation. • Examples of this very common market structure include: • Toothpaste • Soap • The Makings of Monopolistic Competition • Two important characteristics • Differentiated but highly substitutable products • Free entry and exit Chapter 12

4. MC MC AC AC PSR PLR DSR DLR MRSR MRLR QSR QLR A Monopolistically CompetitiveFirm in the Short and Long Run $/Q $/Q Short Run Long Run Quantity Quantity

5. A Monopolistically CompetitiveFirm in the Short and Long Run • Observations (short-run) • Downward sloping demand--differentiated product • Demand is relatively elastic--good substitutes • MR < P • Profits are maximized when MR = MC • This firm is making economic profits Chapter 12

6. A Monopolistically CompetitiveFirm in the Short and Long Run • Observations (long-run) • Profits will attract new firms to the industry (no barriers to entry) • The old firm’s demand will decrease to DLR • Firm’s output and price will fall • Industry output will rise • No economic profit (P = AC) • P > MC -- some monopoly power Chapter 12

7. Deadweight loss MC AC MC AC P PC D = MR DLR MRLR QC QMC Comparison of Monopolistically CompetitiveEquilibrium and Perfectly Competitive Equilibrium Monopolistic Competition Perfect Competition $/Q $/Q Quantity Quantity

8. Monopolistic Competition • Monopolistic Competition and Economic Efficiency • The monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle. • With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12

9. Oligopoly • Characteristics • Small number of firms • Product differentiation may or may not exist • Barriers to entry • Examples • Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers Chapter 12

10. Oligopoly • The barriers to entry are: • Natural • Scale economies • Patents • Technology • Name recognition • Strategic action • Flooding the market • Controlling an essential input Chapter 12

11. Price Competition • Price Competition with Differentiated Products • Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product. Chapter 12

12. Oligopolistic Pricing • The Dominant Firm Model • In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. • The large firm might then act as the dominant firm, setting a price that maximized its own profits. Chapter 12

13. Cartels • Characteristics 1) Explicit agreements to set output and price 2) May not include all firms 3) Most often international • Examples of successful cartels : OPEC • Examples of unsuccessful cartels : Copper,Tin,Tea 4) Conditions for success • Competitive alternative sufficiently deters cheating • Potential of monopoly power--inelastic demand Chapter 12

14. Cartels • Observations • To be successful: • Total demand must not be very price elastic • Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic Chapter 12

15. The Cartelizationof Intercollegiate Athletics • Observations 1) Large number of firms (colleges) 2) Large number of consumers (fans) 3) Very high profits Chapter 12

16. Summary • In a monopolistically competitive market, firms compete by selling differentiated products, which are highly substitutable. • In an oligopolistic market, only a few firms account for most or all of production. • Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this. • In a cartel, producers explicitly collude in setting prices and output levels. Chapter 12