Learning Objectives To define monopolistic competition and oligopoly and analyse the price-output behaviour of firms in these industries

To explain and assess the role of non-price competition To discuss the implications of monopolistic competition and oligopoly for economic efficiency To assess the social desirability of oligopoly

Introduction

Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly. Markets that have some features of competition and some features of monopoly. Types of Imperfectly Competitive Markets Monopolistic Competition
Many firms selling products that are similar but not

identical.

Oligopoly
Only a few sellers, each offering a similar or identical

product to the others.

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Attributes

Relatively large number of sellers. Product differentiation Free entry and exit

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Many Sellers There are many firms competing for the same group of customers. Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.

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Product Differentiation Each firm produces a product that is at least slightly different from those of other firms. Rather than being a price taker, each firm faces a downward-sloping demand curve. Some degree of market power is achieved by firms producing differentiated products. Product differentiation is a strategy that firms use to achieve market power. Accomplished by producing products that have distinct positive identities in consumers minds. This differentiation is often accomplished through advertising.

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Free Entry or Exit Firms can enter or exit the market without restriction. The number of firms in the market adjusts until economic profits are zero.

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 The demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, but more elastic than the demand curve faced by a monopoly.

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MC AC

Ps
Economic Profit

ACs

AR = D

MR

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Qs

Effect of Short Run Profits

Existence of above-normal profit will attract new firms into the industry As new firms enter the industry the number of products offered rises Which reduces demand for existing firms products Whose demand curves shift left And economic profits disappear

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Effect of Short Run Losses

If existing firms make losses (P<ATC) some firms will shut down As firms exit the industry the number of products offered declines Which increases demand for products of surviving firms Whose demand curves shift right And profits rise

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Long Run

Firms tend to break even - normal profit

P = ATC Tangency solution: firm will produce an output where its demand curve is at a tangent to its ATC curve Profits attract new entrants Losses encourage firms to leave industry Some product differentiation cannot be imitated Some entry is partially restricted Some economic losses may be tolerated by firms in the long-run.

Why?

Complications

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$
LRMC

LRAC

PL
ARL = DL

MRL

Q
O
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QL

In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC. This firm is earning positive profits in the shortrun.

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As new firms enter a monopolistically competitive industry, the demand curves of existing firms shift to the left, pushing MR with them. In the long run, profits are eliminated. This occurs for a firm when its demand curve is just tangent to its average cost curve
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Product differentiation is a strategy that firms use to achieve market power. Accomplished by producing products that have distinct positive identities in consumers minds. This differentiation is often accomplished through advertising.

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Advertising The case for advertising

Information and choice Efficiency and search costs Competition Support for the media and communications

The case against advertising

Unjustified persuasion Wastage Impedes competition Media bias

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Table 1: Advertisement Expenditure by Brand in Malaysia 2010

Rank 1
2 Top 10 Ads spend by Brand (Ranked by June'09) Jun'09 (RM'000) May'09 (RM'000) Apr'09 (RM'000) Jun'09 vs May'09 (%)

MAXIS
CELCOM

8,681
8,132

8,529
9,170

5,005
10,904

1.8
-11.3

3
4 5 6 7 8 9 10

DIGI
KEM.KESIHATAN TM KEM.PENERANGAN AIRASIA WALL'S GIANT MILO

7,620
6,943 6,824 6,366 5,410 4,722 4,580 4,464

7,525
3,452 6,987 5,602 3,948 2,340 5,312 1,759

8,139
1,859 8,889 359 2,885 934 3,464 685

1.3
101.1

-2.3
13.6 37 101.8 -13.8 153.7

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Share of Advertising Expenditure in Malaysia (June-09)

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The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. Product differentiation helps to ensure high quality and efficient production.

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Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the marketplace.

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Critics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.

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Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the marketplace.

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Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. People exist to satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.

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In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product. Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity. Non-price competition competition in terms of product promotion (advertising, packaging) or product development.
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Productive inefficiency

P min ATC Excess capacity Too many small firms each producing too little P > MC

Allocative inefficiency

Redeeming feature

product variety

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Non-Price Competition
Aims

to accentuate the differences in products

Shift

the products demand curve to the right Make demand less price elastic
Incentive

to advertise to attract buyers from rivals products and improve firms long run position

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Non-price competition
1.Promotion shifts DC to right, increasing sales to Q1 2.Can also make demand more inelastic so can raise price to P2

$ P2 P1

Revenue increase

D2 After promotion
D1 Before promotion

Q1

Q2 Q1

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Advertising

The case for advertising Information and choice Efficiency and search costs Competition Support for the media and communications The case against advertising Unjustified persuasion Wastage Impedes competition Media bias

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Monopoly vs. monopolistic competition vs. perfect competition

Monopoly:

Price > MC, how high depends on contestability of the market. Economic profits in long-run

Monopolistic Competition:

Price > MC, how high depends on product differentiation. Normal profits in the longrun
Price = MC and also minimum ATC in the longrun. Normal profits in the long-run

Perfect Competition:

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An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated.

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Attributes

Few sellers offering similar or identical products Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. Interdependent firms. Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost Barriers to entry.

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All kinds of oligopoly have one thing in common:

The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry.

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Sources
Economies of scale Large capital investment required Patented production processes Brand loyalty Control of a raw material or resource Government franchise

Concentration ratios Percentage of market turnover produced by a given number of the largest firms

Measured by

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Price-output behaviour

Mutual Interdependence results in: Each firm must consider the reactions of rivals when formulating strategies Firms operate in a climate of uncertainty Oligopoly strategy can be explained using Game Theory. There are a number of different models to explain price/output in oligopoly. Kinked demand curve Collusion and cartels Price leadership Cost-plus pricing

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A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. Price and Quantity Supplied The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 gallons The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 gallons

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Table 1: The Demand Schedule for Water

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Price and Quantity Supplied The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 gallons The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 gallons

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Price and Quantity Supplied

The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water. So what outcome then could be expected from duopolists?

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The duopolists may agree on a monopoly outcome.

Collusion An agreement among firms in a market about quantities to produce or prices to charge. Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when such agreements are implicit. Cartel A group of firms acting in unison. A group of firms that gets together and makes price and output decisions to maximize joint profits is called a cartel.

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Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

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Incentive to collude
Firms have an incentive to collude in order to raise profits and remove uncertainty.

Strategies of colluding firms.

Overt or Covert

Outcome and price are the same as for monopoly. Individual firms have an incentive to cheat and reap short-term profit. Oligopolistic collusion is often unstable.

Reduce output; set production quotas to share the market Raise prices; fix prices at a higher level Block entry of new firms

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A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen. When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

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Summary

Possible outcome if oligopoly firms pursue their own self-interests:

Joint output is greater than the monopoly quantity but

less than the competitive industry quantity. Market prices are lower than monopoly price but greater than competitive price. Total profits are less than the monopoly profit.

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How increasing the number of sellers affects the price and quantity:

The output effect: Because price is above marginal cost, selling more at the going price raises profits. The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.

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As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

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The Cournot model is a model of a two-firm industry (duopoly) in which a series of output-adjustment decisions leads to a final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly.

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The kinked demand curve model is a model of oligopoly in which the demand curve facing each individual firm has a kink in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price.

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Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firms quantity demanded (demand is elastic). Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).

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Price leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy. The price-leadership model outcome: The quantity demanded in the industry is split between the dominant firm and the group of smaller firms.

This division of output is determined by the amount of market power of the dominant firm. The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

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Game theory analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms. In game theory, firms are assumed to anticipate rival reactions.

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 The strategy that firm A will actually choose depends on the information available about Bs likely strategy.
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 Regardless of what B does, it pays for A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.

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 The Prisoners Dilemma is a game in which:

The players are prevented from cooperating with each other; Each player in isolation has a dominant strategy; The dominant strategy makes each player worse off than in the case in which they could cooperate.

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 Ginger and Rocky have dominant strategies to confess even though they would be better off if they both kept their mouths shut.
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 In game theory, when all players are playing their best strategy given what their competitors are doing, the result is called Nash equilibrium.

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 When uncertainty and risk are introduced, the game changes. A maximin strategy is a strategy chosen to maximize the minimum gain that can be earned.

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 While explicit collusion violates the antitrust statutes, strategic reaction does not. Strategic reaction in a repeated game may still have the same effect as tacit collusion.

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 The strategy to respond in a way that lets your competitors know you will follow their lead is called tit-for-tat strategy. If one leads and the competitor follows, both will be better off.

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 Game theory has been used to help understand many phenomena from the provision of local public goods and services to nuclear war.

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