Pricing and Output Decisions: Monopolistic Competition and Oligopoly

2. Pricing and Output Decisions:Monopolistic Competition and Oligopoly Introduction Monopolistic Competition Oligopoly Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence Competing in Imperfectly Competitive Markets Strategy: The Fundamental Challenge for Firms in Imperfect Competition

3. Learning Objectives Cite the main differences between monopolistic competition and oligopoly Describe the role that mutual interdependence plays in setting prices in oligopolistic markets Illustrate price rigidity in oligopoly markets using the “kinked demand curve” Elaborate on how non-price factors help firms in monopolistic competition and oligopoly to differentiate their products and services Cite and briefly describe the five forces in Porter’s model of competition

4. Introduction Imperfect Competition Some market power but not absolute market power Have the ability to set prices within the limits of certain constraints Mutual Interdependence: interaction among competitors when making decisions

5. Introduction Perfect Monopolistic Competition Monopoly Competition Oligopoly Market Power? No Yes, subject to Yes Yes government regulation Mutual interdependence No No No Yesamong competing firms? Non-price competition? No Optional Yes Yes  Easy market entry or exit ? Yes No Yes, No, relatively relatively easy difficult

6. Monopolistic Competition Characteristics Many firms Relatively easy entry Product differentiation Can set price at a level higher than the price established by perfect competition Use MR = MC rule to maximize profit If earning above-normal profits, newcomers will enter the market Market supply curve shifts out and to the right Firm’s demand curve shifts down and to the left Ultimately, in the long run, firms earn only normal profit

7. Oligopoly Oligopoly is a market dominated by a relatively small number of large firms Products are either standardized or differentiated Measures of Market Concentration Herfindahl-Hirschman index (HH): measure of market concentration (max HH = 10,000) n: number of firms in the industry Si: firm’s market share Unconcentrated markets have HH < 1,000

8. Pricing in an Oligopolistic Market:Rivalry and Mutual Interdependence Mutual Interdependence: relatively few sellers create a situation where each is carefully watching the others as it sets its price. Kinked Demand Curve Model Basic Assumption: competitor will follow a price decrease but will not make a change in reaction to a price increase.

9. Pricing in an Oligopolistic Market:Rivalry and Mutual Interdependence If reduce price and competitors match the price cut then move along more inelastic demand segment Di. If increase price and competitors do not follow then move along the more elastic segment Df. Marginal Revenue curve will be discontinuous where the kink occurs (at point A).

10. Pricing in an Oligopolistic Market:Rivalry and Mutual Interdependence Price Leader: one firm in the industry takes the lead in changing prices. The price leader assumes that firms will follow a price increase. It assumes that firms may follow a reduction in price, but will not go even lower in order not to trigger a price war. Non-Price Leader: firm that leads the differentiation of products on other, non-price attributes.

11. Competing in ImperfectlyCompetitive Markets Non-Price Competition: any effort made by firms other than a change in the price of the product in question in order to change the demand for their product. Efforts intended to influence the non-price determinants of demand Tastes and preferences Income Prices of substitutes and complements Number of buyers Future expectations of buyers about the product price

12. Competing in ImperfectlyCompetitive Markets Non-price variables: any factor that managers can control, influence, or explicitly consider in making decisions affecting the demand for their goods and services. Advertising Promotion Location and distribution channels Market segmentation Loyalty programs Product extensions and new product development Special customer services Product “lock-in” or “tie-in” Pre-emptive new product announcements

13. Competing in ImperfectlyCompetitive Markets Equalizing at the margin: general economic concept which managers can use to help make an optimal decision. Can be used to decide the optimal expenditure level of a non-price factor that influences a firm’s demand. MR = MC is an example of equalizing at the margin. Revenue and costs may be realized over a long period of time. Firm must adjust MR, MC for the time value of money.

14. Strategy: The Fundamental Challenge for Firms in Imperfect Competition Strategy is important when firms are price makers and are faced with price and non-price competition as well as threats from new entrants into the market. More important for firms in imperfectly competitive markets than those in perfectly competitive markets or monopoly markets.

15. Strategy: The Fundamental Challenge for Firms in Imperfect Competition Economics and strategy can be said to be linked almost by definition Managerial Economics: the use of economic analysis to make business decisions involving the best use of an organization’s scarce resources. Strategy: the means by which an organization uses its scarce resources to relate to the competitive environment in a manner that is expected to achieve superior business performance over the long run.

16. Strategy: The Fundamental Challenge for Firms in Imperfect Competition Industrial Organization: studies the way that firms and markets are organized and how this organization affects the economy from the viewpoint of social welfare. How does industry concentration affect the behavior of firms competing in the industry?

17. Strategy: The Fundamental Challenge for Firms in Imperfect Competition Structure-Conduct-Performance (S-C-P) Paradigm Structure affects conduct which affects performance Structure: number of firms in industry, conditions of entry, product differentiation Conduct: pricing strategies and other activities such as advertising, product development, legal tactics, choice of product, and potential for collusion Performance: maximization of society’s welfare

18. Strategy: The Fundamental Challenge for Firms in Imperfect Competition The “New” Theory of Industrial Organization There is no necessary connection between industry structure and performance that uniquely leads to maximum social welfare. Weak evidence of relationship between concentration and profit levels. Theory of Contestable Markets Performance by firms is ultimately influenced, not by the presence of competition, but by the threat of potential competition.

19. Strategy: The Fundamental Challenge for Firms in Imperfect Competition Porter’s Five Forces Model: illustrates the various factors that affect the ability of any firm in the industry to earn a profit.

20. Strategy: The Fundamental Challenge for Firms in Imperfect Competition Porter’s generic strategies for earning above-average return on investment Differentiation approach: related to the case of a monopoly or monopolistically competitive market Following MR = MC rule, firm sets a price on the demand line that is above AC Cost Leadership approach: based on perfect competition Maintain cost structure low enough so when P = MC, there is a positive difference between P and AC