Chap7

CHAPTER 7: MARKET STRUCTURE: MONOPOLISTIC COMPETITION & OLIGOPOLY

7.1 Characteristic of Monopolistic Competition 7.2 Short-run Decision: Profit Maximization 7.3 Short-run Decision: Minimizing Loss 7.4 Long-run Equilibrium 7.5 E conomic E fficiency and R esource A llocation Chapter Outline

7. 6 Characteristic of Oligopoly 7.7 Oligopoly Model 7.8 Games Theory Chapter Outline

Definition: A common form of industry (market) structure characterized by a large number of small firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease. For example: an individual restaurant MONOPILSTIC COMPETITION

Large number of sellers A large number of firms but it is less than perfect competition. The size of each firm is small and therefore, no individual firm can influence the market price. Product differentiation The firms produce goods which are differentiated, that is, they are not identical. Each seller will use various methods to differentiate their products from other sellers. Differentiation of the product may be through the packaging, design, labeling, advertising and brand names.

characteristic.. Free entry & exit There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run. Advertising Each firm tries to promote its product by using different types of advertisements include banners, media advertisements, pamphlets etc. provides consumers with the valuable information on product availability, quality, and price.

characteristic.. Non-price competition Monopolistic do not compete base on price as they are price takers. They create a sense of brand consciousness among customers. Types of non-price competition are advertisements, promotions, discounts, free gifts and so on.

When MR = MC; The profit-maximizing quantity occurs while the price is found up on the demand curve at that quantity . The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.

There is not guaranteed an economic profit in the market. When ATC > demand curve, no quantity allows the firm to escape a loss. Firm must decide whether to produce at a loss or choose to shut down. Keep production: As long as price exceeds AVC. Shut down: If the price cannot cover the AVC. 7.3 SHORT-RUN DECISION: MINIMIZING LOSS

Firm will continue to produce in the short run if the price exceeds AVC. SHORT-RUN DECISION: MINIMIZING LOSS

Free entry : If the firms are making supernormal profit in the short-run, they will attract more firms to enter the market. Decrease the demand for existing firms , so the demand curve will shift leftward. The process will continue until all profits are eliminated and (P = ATC). In the long-run, a monopolistic firm will earn normal profit . 7.4 LONG-RUN EQUILIBRIUM

Free entry : LONG-RUN EQUILIBRIUM Quantity Price MC ATC DD 0 DD 1 MR P 0 P 1 = ATC Q

Free exit : If the firms are making subnormal profit in the short-run, the existing firms will exit from the market. Increase the demand for existing firms , so the demand curve will shift rightward. The process will continue until all losses are eliminated and (P = ATC). In the long-run, a monopolistic firm will earn normal profit . LONG-RUN EQUILIBRIUM

LONG-RUN EQUILIBRIUM Free exit ?

There are two noteworthy differences between monopolistic and perfect competition excess capacity and markup over MC . Excess Capacity Free entry results in competitive firms producing at the point where ATC is minimized, which is the efficient scale of the firm. In monopolistic competition, the firm has excess capacity if its output is less than the efficient scale of perfect competition. 7.5 ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION

Mark up over marginal cost F or a competitive firm , price equal marginal cost. For a monopolistically competitive firm, price exceeds marginal cost because the firm has some market power. Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically firm.

Monopolistic versus perfect competition D Quantity Price MC ATC MR P Q MC Price Quantity MC ATC P=MR P=MC Q PC (efficient scale) a) Monopolistic b) Perfect Competition MC

OLIGOPOLY Definition: A form of industry (market) structure characterized by a few dominant firms . Products may be homogenous or differentiated . The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others (interdependent) . For example: automobile industry/ petroleum

Few in number but large in size The market share of each firm is large enough to dominate the market and its controlled by a few firms. Interdependent The behavior of oligopoly firms depend on the behavior of other firms in the industry before making the decision. Homogeneous or differentiated product The products sold may be homogeneous or differentiated. Example: Petroleum (homogenous) and automobiles (differentiated).

characteristic Barriers to entry Advertising a new product enough to compete with established brands. Incentive to collude Colluding firms usually reduce output, increase price, and block the entry of new firms to achieve the monopoly power.

Price Rigidity and Kinked Demand Curve Price rigidity explain the behavior of an oligopoly firm which has no incentive to either increase or decrease the price of its products. The theory of a kinked demand curve is based on two assumptions : If an oligopoly reduces the price of his product, his rivals will follow and reduces their price too, so as to avoid losing customers. If an oligopolist increase the price of his products, his rival will not increase their price but instead maintain the same prices, thereby gaining customers from which firms which increase their price.

Price Rigidity and Kinked Demand Curve (continue..) Based on this two assumptions, oligopoly will face a kinked demand curve. It assumes that rivals will match a price cut but ignore a price increase. The kinked demand curve creates a gap in the MR curve, illustrates the price rigidity of a firm in an oligopoly. Equilibrium price and quantity occur at P* and Q*, when MR = MC. As long as MR intersect with MC curve in the gap, price and output will remain constant.

Demand is elastic above the kink, where an increase in price to more than P* will lead to a large drop in quantity as more customers switch to the rival’s lower priced product. Demand is inelastic below the kink where decreasing the price will only reflect a small increase in quantity since all the other firms have reduced their price to below P*. Kinked Demand Curve elastic inelastic

Definition : 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. Types : Dominant strategies Nash equilibrium Prisoners’ dilemma

“ If I believe that my competitors are rational and act to maximize their own profits, how should I take their behavior into account when making my own profit-maximizing decisions?”

Definition : Dominant Strategy is one that is optimal no matter what an opposition does. Example: A & B sell competing products They are deciding whether to undertake advertising campaigns. Their decision is interdependence on other firm decision.

Payoff Matrix for Advertising Game: (A,B) Firm A Advertise Not Advertise Advertise Not Advertise Firm B Dominant Strategies A A B A A A What strategy should each firm choose? Game Theory A B A B A B 10 , 5 15 , 0 10 , 2 6 , 8

Firm A: If firm B does advertise, Firm A will earn a profit of 10 if it also advertise and 6 if it doesn’t. Thus, firm A should advertise if firm B advertise. If firm B doesn’t advertise, firm A would earn profit of 15 if it advertise and 10 if it doesn’t. Thus, firm A should advertise whether firm B advertise or not. Firm A has dominant strategy!

Firm B: If firm A does advertise, Firm B will earn a profit of 5 if it also advertise and 0 if it doesn’t. Thus, firm B should advertise if firm A advertise. If firm A doesn’t advertise, firm B would earn profit of 8 if it advertise and 2 if it doesn’t. Thus, firm B should advertise whether firm A advertise or not Firm B has dominant strategy!

Observations Dominant strategy for A & B is to advertise Do not worry about the other player Equilibrium in dominant strategy Both firms with advertise. Firm A Advertise Not Advertise Advertise Not Advertise Firm B 10, 5 15, 0 10, 2 6, 8

Equilibrium in dominant strategies Outcome of a game in which each firm is doing the best it can regardless of what its competitors are doing. Optimal strategy is determined without worrying about actions of other players. However, not every game has a dominant strategy for each player

Definition: When all players are playing their best strategy given what their competitors are doing. Game Without Dominant Strategy The optimal decision of a player without a dominant strategy will depend on what the other player does. Revising the payoff matrix we can see a situation where no dominant strategy exists.

Firm A Advertise Not Advertise Advertise Not Advertise Firm B Nash Equilibrium A A A A B B B B What strategy should each firm choose? 10 , 5 15 , 0 20 , 2 6 , 8

Observations A: No dominant strategy; depends on B’s actions B: Dominant strategy is to Advertise Firm A determines B’s dominant strategy and makes its decision accordingly 10 , 5 15 , 0 20 , 2 6 , 8 Firm A Advertise Don’t Advertise Advertise Don’t Advertise Firm B

In order for firm A to determine whether to advertise, firm A must first try to determine what firm B will do. If firm B advertises, firm A earns a profit of 10 if it advertises and 6 if it does not. If firm B does not advertise, firm A earns a profit of 15 if it advertises and 20 if it does not. Thus, firm A should advertise if firm B advertise , and it should not advertise if firm B doesn’t . 10, 5 15, 0 20, 2 6, 8 Firm A Advertise Not Advertise Advertise Not Advertise Firm B

Firm A has to determines B’s dominant strategy and makes its decision accordingly. Firm B’s dominant strategy is to advertise , therefore, the optimal strategy for firm A is also to advertise. This is Nash equilibrium. Only when each player has chose its optimal strategy given the strategy of the other player do we have Nash equilibrium . 10, 5 15, 0 20, 2 6, 8 Firm A Advertise Not Advertise Advertise Not Advertise Firm B

Definition: 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.

Prisoners’ Dilemma Firm A Low Price High Price Low Price High Price Firm B What strategy should each firm choose? 2 , 2 5 , 1 3 , 3 1 , 5

Firm A: If firm B charged a low price, firm A would earn a profit of 2 if it also charged the low price and 1 if it charge a high price. If firm B charged the high price ,firm A would earn a profit of 5 if it charged the low price and 3 if it charged the high price. Thus, firm A should adopt its dominant strategy of charging the low price .

Firm B: If firm A charged a low price, firm B would earn a profit of 2 if it also charged the low price and 1 if it charge a high price. If firm A charged the high price, firm B would earn a profit of 5 if it charged the low price and 3 if it charged the high price. Thus, firm B should adopt its dominant strategy of charging the low price.

However, both firms could do better (i.e., earn higher profit of 3) if they cooperated and both charged the higher price (the bottom right cell). Thus, both firms are in a prisoners’ dilemma: Each firm will charge the lower price and earn a smaller profit because if it charges the high price, it cannot trust its rival to also charge the high price.

Suppose that firm A charged the high price with the expectation that firm B would also charge the high piece (so that each firm would earn a profit of 3). Given that firm A has charged the higher, however, firm B now has an incentive to charge the low price, because by doing so it can increase its profits to 5.

Suppose that firm B charged the high price with the expectation that firm A would also charge the high piece (so that each firm would earn a profit of 3). Given that firm B has charged the higher, however, firm A now has an incentive to charge the low price, because by doing so it can increase its profits to 5.

The net result is that each firm charges the low price and earns a profit of only 2. Only if the two firms cooperate and both charge the high price will they earn the highest profit of 3 (and overcome their dilemma)

Conclusion: The concept of the prisoner’s dilemma can be used to analyze price and non-price competition in oligopolistic markets, as well as the incentive to cheat in a cartel (i.e., the tendency to secretly cut prices or to sell more than the allocated quota.

Game Theory Ginger and Rocky have dominant strategies to confess even though they would be better off if they both kept their mouths shut.

Comparison for Market Structure Characteristics of Different Market Organizations

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