9 Monopolistic Competitionand Oligopoly

ECONOMICS5e
MichaelParkin
CHAPTER
14
Monopolistic
Competitionand
Oligopoly
LearningObjectives
Explain how price and output are
determined
in
a
competitiveindustry
monopolistically
Explainwhyadvertisingcostsarehighina
monopolisticallycompetitiveindustry
Explainwhythepricemightbestickyinan
oligopolyindustry
Copyright 1998 Addison Wesley Longman, Inc.
TM 14-2
LearningObjectives(cont.)
Explain how price and output are
determined when an industry has one
dominantfirmandseveralsmallfirms
Usegametheorytomakepredictionsabout
price wars and competition among a small

numberoffirms
TM 14-3
LearningObjectives
Explainhowpriceandoutputaredetermined
inamonopolisticallycompetitiveindustry
Explain why advertising costs are high in a

oligopolyindustry
TM 14-4
MonopolisticCompetition
Monopolisticcompetition
Alargenumberoffirmscompete.
Smallmarketshare
Ignoreotherfirms
CollusionImpossible
Eachfirmproducesadifferentiatedproduct.
Aproductslightlydifferentfromtheproductsof
competingfirms.
TM 14-5
Monopolisticcompetition(cont.)
Firmscompeteonproductquality,price,and
marketing.
Qualitydesign,reliability,service,easeof
accesstotheproduct.
Pricedownwardslopingdemandcurve.
Atradeoffbetweenpriceandquality.
Marketingadvertisingandpackaging.
Firmsarefreetoenterandexit.
TM 14-6
Monopolisticcompetition(cont.)
Consequently,afirminmonopolisticcompetition
cannotmakeaneconomicprofitinthelongrun.
TM 14-7
ExamplesofMonopolistic
Competition
TM 14-8
Asaresultofthecharacteristicsof
monopolisticcompetition:
Noonefirmcaneffectivelyinfluencewhat
otherfirmsdo.
Thefirmfacesadownwardslopingdemand
curve.
Firmscannotearnlongruneconomicprofit.
TM 14-9
OutputandPricein
ShortRun:EconomicProfit
Thefirminmonopolisticcompetitionlooksjust
likeasinglepricemonopoly.
The key difference between monopoly and

monopolisticcompetitionliesinthelongrun.
TM 14-10
Shortrun
Price(dollarsper
jacket)
220
MC
ATC
190
160
Economic
profit
140
120
MR
0
50
100
150
200
250
300
Quantity(jacketsperday)
TM 14-11
OutputandPricein
LongRun:ZeroEconomicProfit
Economicprofitattractsnewentrants.
Asnewfirmsentertheindustry,thefirms
demandcurveandmarginalrevenuestartto
shiftleftward.
Theprofitmaximizingquantityandpricefall.
TM 14-12
Price(dollarsperjacket)
Longrun
220
MC
180
Zero
economic
profit
160
ATC
145
120
MR
0
50
100
D
150
200 250 300

TM 14-13
andEfficiency
Marginalbenefitexceedsmarginalcostand
productionislessthanitsefficientlevel.
Therefore,themarketstructureis
inefficient.
TM 14-14
andEfficiency
The monopolistically competitive industry
produces an output at which price equals
average total cost but exceeds marginal
cost.
This outcome means that firms in
monopolistic competition always have
excesscapacityinlongrunequilibrium.
TM 14-15
ExcessCapacity
Afirmscapacityoutputistheoutputat
whichaveragetotalcostisaminimumthe
outputatthebottomoftheUshapedATC
curve.
Thefirmproducesasmalleroutputthan
thatwhichminimizesaveragetotalcost.
TM 14-16
ExcessCapacity
180
MC
ATC
160
145
Excess
capacity
Profit
120
maximizing
output
0
Capacity
output
MR
D
50
100
150
TM 14-17
LearningObjectives
Explainwhyadvertisingcostsarehighina
oligopolyindustry
TM 14-18
ProductDevelopmentand
Marketing
InnovationandProductDevelopment
Tomaintainitseconomicprofit,afirmmust
seek out new products that will provide it
with a competitive edge, even if
temporarily.
TM 14-19
Marketing
EfficiencyandProductInnovation
Twoviews
Improvedproductsthatbringgreatbenefitsto
theconsumer.
Butmanysocalledimprovementsamountto
littlemorethanchangingtheappearanceofa
product.
TM 14-20
Marketing
Marketing
Advertising and packaging are the principle
means used by firms to attempt to create a
consumer perception of product differentiation
evenwhenactualdifferencesaresmall.
TM 14-21
Marketing
MarketingExpenditures
Advertisingexpendituresaffecttheprofits
intwoways:
Increasecosts
Changedemand
TM 14-22
Marketing
SellingCostsandTotalCosts
Advertisingexpendituresincreasethecosts
ofamonopolisticallycompetitivefirm
abovethoseofacompetitivefirmor
monopoly.
Sellingcostsarefixedcosts.
TM 14-23
AdvertisingExpenditures
TM 14-24
Marketing
SellingCostsandDemand
Advertisingincreasescompetition.
To the extent that advertising increases
competition, it decreases the demand faced by
anyonefirm.
TM 14-25
SellingCostandTotalCosts
Advertising
cost
200
Averagetotalcost
withadvertising
180
170
160
Byincreasingthe
140
quantitybought,
advertisingcan
120
decreaseATC
0
25
Averagetotalcost
withnoadvertising
MR
130
200
300
TM 14-26
Efficiency:TheBottomLine
The bottom line on the question of

efficiency of monopolistic competition is
ambiguous.
TM 14-27
LearningObjectives
Definemonopolisticcompetitionand
oligopoly
oligopolyindustry
TM 14-28
Oligopoly
Priceandquantityofaproducerdependsupon
thatoftheotherproducers.
Modelsdevelopedtoexplainthepricesand
quantitiesinoligopolymarkets:
Traditional
KinkedDemandCurveModel
DominantFirmModel
GameTheory
TM 14-29
TheKinkedDemand
CurveModel
Assumption
Ifafirmraisesitsprice,otherswillnotfollow.
moreelasticresponse
Ifafirmcutsitsprice,sowilltheotherfirms.
lesselasticresponse
Thisassumptionresultsinthekinked
demandcurve.
TM 14-30
Priceandcost(dollars)
TheKinkedDemand
CurveModel
MC1
MC0
P
a
b
0
D
MR
Quantity
TM 14-31
TheKinkedDemand
CurveModel
Problems
Beliefsaboutthedemandcurvearenotalways
correct.
Otherfirmsmay,infact,followapriceincrease.
Thismayresultinthefirmincurringan
economicloss.
TM 14-32
Explainhowpriceandoutputare
determinedwhenanindustryhasone
pricewarsandcompetitionamongasmall
numberoffirms
TM 14-33
DominantFirmOligopoly
Adominantfirmoligopolymayexistifone
firm:
Hasabigcostadvantageovertheotherfirms.
Sellsalargepartoftheindustryoutput.
Setsthemarketprice.
Otherfirmsarepricetakers.
TM 14-34
LetsuseBigGasanexample.
BigGisthedominantgasstationina
city.
TM 14-35
Tensmallfirmsandmarketdemand
BigGspriceandoutput
decision
Price(dollarspergallon)
S10
1.50
1.00
MC
1.50
1.00
D
0.50
0.50
XD
MR
10
20
Quantity(thous.ofgal./week)
10
20
Quantity(thous.ofgal./week)
TM 14-36
Explainhowpriceandoutputare
determinedwhenanindustryhasone
pricewarsandcompetitionamongasmall
numberoffirms
TM 14-37
GameTheory
InventedbyJohnvonNeumannin1937.
Wewilluseittohelpunderstandoligopoly.
TM 14-38
GameTheory
Whatisagame?
Gameshave3features:
Rules
Strategies
Payoffs
ThePrisonersDilemmaisagamethatis
usedtogeneratepredictions.
TM 14-39
ThePrisonersDilemma
Art&Bobarecaughtstealingacar.
TheD.A.feelstheyareresponsiblefora
robberymonthsearlier.
TheD.A.decidestomakethemplaya
game.
TM 14-40
ThePrisonersDilemma
Rulesofthegame
Prisonersareputinseparateroomsandcannot
communicatewiththeother.
Theyaretoldthattheyareasuspectintheearlier
crime.
Ifbothconfess,theywillget3years.
Ifoneconfessesandtheotherdoesnot,theconfessor
willget1yearwhiletheothergets10.
TM 14-41
ThePrisonersDilemma
Strategies(possibleactions)
Theycaneach:
Confesstotherobbery
Denyhavingcommittedtherobbery
TM 14-42
ThePrisonersDilemma
Payoffs
Fouroutcomesarepossible:
Bothconfess.
Bothdeny.
ArtconfessesandtheBobdenies.
BobconfessesandArtdenies.
TM 14-43
PrisonersDilemmaPayoffMatrix
Artsstrategies
Confess
Deny
3years
10years
Confess
Bobs
strategies
3years
1year
1year
2years
Deny
10years
2years
TM 14-44
ThePrisonersDilemma
Adominantstrategyemerges.
ArtandBobshouldbothdenybecause:
Iftheybothdeny,theywillonlyget2yearsbut
theydontknowiftheotherwilldeny.
IfArtdenies,butBobdoesnot,Artwillonlyget1
year.
IfArtdenies,butBobconfesses,Artwillget10
years.
Theybotheventuallydecideitisbesttoconfess
Nashequilibrium.
TM 14-45
AnOligopolyPriceFixingGame
Duopoly
Amarketstructurewithtwofirms.
WewilluseTrickandGearasourtwofirms.
Theyagreewitheachothertorestrictoutputin
ordertoraisepricesandprofitsacollusive
agreement.
TM 14-46
Acartelisagroupoffirmsthatenterintoa
collusiveagreement.
Thefirmsinthecartelcan:
Comply
Cheat
TM 14-47
Fouroutcomesarepossible
Bothfirmscomply
Bothfirmscheat
TrickcompliesandGearcheats
GearcompliesandTrickcheats.
TM 14-48
CostsandDemandConditions
Theconditionsare:
TrickandGearfaceidenticalcosts.
Theswitchgearstheyproduceareidentical.
Theyareanaturalduopoly.
TM 14-49
IndividualFirm
MC
10
ATC
Priceandcost(thous.of$/unit)
CostsandDemand
Industry
10
Minimum
ATC
Quantity(thous.of
switchgears/week)
Quantity(thous.of
switchgears/week)
TM 14-50
ColludingtoMaximizeProfits
Thesefirmsmaybenefitfromcolluding.
Theyattempttobehavelikeamonopoly.
Theyagreetorestrictoutputtoalevelthat
makesmarginalrevenueandmarginalcost
equal.
TM 14-51
IndividualFirm
MC ATC
10
9
8
6
Economic
Profit
ColludingtoMakeMonopolyProfits
Industry
10
9
MC1
Collusionachieves
monopolyoutcome
MR
0
Quantity(thous.of
switchgears/week)
Quantity(thous.of
switchgears/week)
TM 14-52
OneFirmCheatsona
CollusiveAgreement
Previousexample
Eachfirmproduced2,000unitsandearned$2millionin
economicprofit.
Now,TrickconvincesGearthatitcannotsell2,000
unitsaweekandmustcutitspricetobeabletodoso.
Gearcutsitsprice,butitdoesnotchangeoutput.
Trickliesandcheatsontheiragreementitincreasesoutput.
TM 14-53
OneFirmCheats
Complier
Cheater
ATC
8.0
7.5
Economic
loss
ATC
10.0
10.0
Price&cost
Price&cost
Price&cost
10.0
7.5
6.0
Quantity(thousands
ofswitchgears/week)
8.0
7.5
Compliers
output
Economic
profit
3
Industry
Quantity(thousands
ofswitchgears/week)
Cheats
output
0 1 2 3 4 5 6 7
Quantity(thousands
ofswitchgears/week)
TM 14-54
BothFirmsCheat
Bothfirmswillcheataslongasprice
exceedsmarginalcost.
Whenpriceequalsmarginalcosttheywill
nolongerhaveanincentivetocheat.
TM 14-55
IndividualFirm
MC ATC
10
BothFirmsCheat
Quantity(thous.of
switchgears/week)
Industry
10
MC1
6
Bothcheatingachieves
competitiveoutcome
Quantity(thous.of
switchgears/week)
TM 14-56
ThePayoffMatrix
Now,letsillustratethesepossibilities
usingaduopolypayoffmatrix.
TM 14-57
DuopolyPayoffMatrix
Gearsstrategies
Cheat
Comply
$0
Cheat
Tricks
strategies
$0
$1.0m
+$4.5m
+$4.5m
+$2m
Comply
$1.0m
+$2m
TM 14-58
Equilibriumofthe
DuopolistsDilemma
Atequilibrium,itpaysbothfirmstocheat.
Whatifthisgameisrepeatedoverandover
again?Willtheoutcomediffer?
TM 14-59
RepeatedGames
Ifthisisrepeated,onefirmhastheopportunity
topenalizetheother.
Acooperativeequilibriummayoccur.
Thisoccurswhenthefirmsmakeandsharethe
monopolyprofit.
Mustbepenalizedforcheating.
titfortatstrategy
triggerstrategy
TM 14-60
GamesandPriceWars
Somepricewarsresemblethetitfortat
strategy.
Pricewarssometimesresultfromnewfirms
enteringamonopolyindustry.
TM 14-61
OtherOligopolyGames
AnR&DGame
FirmsspendlargesumsofmoneyinR&Dinthe
attemptto:
developthemosthighlyvaluedproduct
developtheleastcosttechnology
gainacompetitiveedgetoincreasemarketshareand
profit
ShouldafirmspendmoneyinR&D?
TM 14-62
PampersVersusHuggies:AnR&DGame
Procter&Gamblesstrategies
R&D
NoR&D
+$45m
R&D
+$5m
$10m
+$85m
Kimberly
Clarks
strategies
+$85m
+$70m
NoR&D
$10m
+$30m
TM 14-63
ContestableMarkets
Amarketinwhichonefirm(orasmall
numberoffirms)operates,butinwhich
bothentryandexitarefree,sothefirm(s)in
themarketfacescompetitionfrompotential
entrantsisacontestablemarket.
TM 14-64
EntryDeterrenceGame
Letsseewhathappenswhena
firmattemptstoenteramarket
dominatedbyasinglefirm.
TM 14-65
DuopolyPayoffMatrix
Agilesstrategies
Enterandset
pricebelow
Agilesprice
Wannabes
strategies
Monopolyprice
Competitiveprice
Economic
loss
Economic
loss
Economic
profit
Monopoly
profit
Notenter
Normal
profit
Economic
loss
Normal
profit
Normal
profit
TM 14-66
EntryDeterrenceGame
Thepracticeofchargingapricebelowthe
monopoly profitmaximizing price and
producing a quantity greater than that at
which marginal revenue equals marginal
cost in order to deter entry is limit
pricing.
TM 14-67

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ECONOMICS5e

Copyright 1998 Addison Wesley Longman, Inc.

price wars and competition among a small

Copyright 1998 Addison Wesley Longman, Inc.

Explain why advertising costs are high in a

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

The key difference between monopoly and

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

200 250 300

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

The bottom line on the question of

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

Copyright 1998 Addison Wesley Longman, Inc.

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