Chapter 15 - Monopolistic competition and oligopoly. In this chapter you will learn: What the features of oligopoly and monopolistic competition are? How to calculate the short‐run and long‐run profit‐maximizing price and quantity for a monopolistically competitive firm? What the welfare costs of monopolistic competition are?...
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Chapter 15
Monopolistic Competition
and Oligopoly
What will you learn in this chapter?
• What the features of oligopoly and monopolistic competition
are
• How to calculate the short‐run and long‐run profit‐maximizing
price and quantity for a monopolistically competitive firm
• What the welfare costs of monopolistic competition are
• How product differentiation motivates advertising and branding
• What the strategic production decision of firms in an oligopoly is
• Why firms in an oligopoly have an incentive to collude, and why
they might fail to do so
society as a whole in an oligopoly to monopoly and perfect
competition
What sort of market?
What sort of market is the music industry?
Universal
31.61%
EMI 10.21%
Other firms
12.61%
Warner
Sony
27.44%
• Dominated by four labels.
– None big enough to dominate the industry.
– Not a monopoly market.
• Products are not standard.
– Not a perfectly competitive market.
• Two markets lie between the extreme models of monopoly and perfect competition.
– Oligopoly.
– Monopolistic competition.
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Oligopoly and monopolistic competition
selling a similar good or service.
–Strategic interactions between a firm and its rivals
have a major impact on its success
•An individual firm’s price and quantity affect others’
profitability
•No interaction in perfectly competitive or monopoly
markets
–Existence of some barrier to entry
•These barriers to entry may be overcome, but it may be
costly
Oligopoly and monopolistic competition
many firms that sell similar, but differentiated,
goods and services
–Able to earn a positiveprofit in the short run by selling
a differentiated product
–Offer goods that are similar to competitors’ products
but more attractive in some ways
that their products are unique, a practice known
–This is the role of advertising and branding.
Monopolistic competition in the short run
monopolist in the short run
Price ($)
Elvis records (thousands)
MC
MR
ATC
D
3
Consumer surplus
Profit/producer surplus
Producer surplus Deadweight loss
4.70
• Produce where MR = MC.
• Charge corresponding price on demand curve.
• Firm earns profits by extracting consumer surplus.
• Create deadweight loss.
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Active Learning: Monopolistic competition
in the short run
In the short‐run, what price and quantity should
General Mills set for its ice cream, Häagen‐Dazs?
Price ($)
Häagen-Dazs (thousands)
MC
MR
ATC
D
P1
P4
P2
Q2
Monopolistic competition in the long run
0
Price ($)
Elvis records (thousands)
Deadweight loss Producer surplus
Consumer surplus
MC
MR
ATC
D
firms are similar in the short run
monopolistically competitive market
Positive economic profits:
• Firm entry causes range of substitutes.
• Existing firms’ demand curves shift left.
• Entry continues until there are zero economic profits.
Negative economic profits:
• Firm exit causes fewer substitutes.
• Existing firms’ demand curves shift right.
• Exit continues until there are zero economic profits.
Because profits are zero, this is the same quantity as where ATC is tangent to demand.
0
loss
Producer surplus
Elvis records (thousands)
Price ($)
MC
MR
ATC
D
Consumer surplus
0
Perfect competition Price ($)
MC
ATC P=MR (Demand)
Elvis records (thousands)
In perfect competition, firms produce where ATC is lowest This is the efficient choice.
In monopolistic competition,
firms produce when ATC is
still decreasing.
Monopolistic competition in the long run
• Similar to monopolists, monopolistically competitive firms
operate at smaller‐than‐efficient scale
– This would decrease profits.
• Sets price at P = min(ATC) = MC.
• Efficient scale.
• Sets price at P = ATC > MC.
• Produce at smaller‐than efficient scale.
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Monopolistic competition in the long run
same situation as perfectly competitive firms
possible for a monopolistically competitive
to innovate , because there is no danger of
customers switching to a firm with newer and
better products.
The welfare costs of monopolistic
competition
–Firms maximize profits at a P > MC
–Quantity is reduced
–Deadweight loss occurs and the market does not
maximize total surplus
–Regulating a lower price would mean that those firms
that could not produce at a lower cost would be forced
to leave the market
–Consumers would get a greater quantity of similar
products at a lower price, but they would loseproduct
variety
Product differentiation, advertising, and
branding
economic profits in the short run
their products cannot easily be substituted
though it generally appeals to image over reality
reputation; though it may perpetuate false perceptions
of product differences that represent barriers to enter
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Music label:
Should we promote a
new album?
Fans: Do we like
this album?
$10 million
-$5 million
Fans: Do we like
this album?
$2 million
-$50,000
Yes
Yes
No
No Yes Album Profits
No
Advertising as a signal
product from an ad, as firms know more about
the true quality of their products than consumers
is costly to advertise
• For example, music companies typically only promote ‘good’ albums.
profitable to advertise albums fans are going to enjoy.
unprofitable to advertise albums fans are not going to enjoy.
• Consumers can use promotion efforts as a signal of album quality.
Oligopoly
a few identifiable rivals with market power.
price and quantity that take into account the
expected choices of their competitors.
Oligopolies in competition
Warner and Universal, selling a standardized
good—an album
–Each firm has fixed costs of $100 million
–Each firm has marginal costs of $0
maximized
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Oligopolies in competition
• Below is the market demand for albums and each firm’s
demand curve
Demand curve
0
Price ($)
Millions of albums
140
Demand and revenue schedule
Albums
(millions)
Price
($)
40
60
70
90
100
120
50
20
16
14
10
8
4
2
130
800
960 980
900 800
480 260 0
Revenue
(millions of $)
Monopoly
14
70
Monopoly equilibrium
Perfect
competition
Perfect competition equilibrium
•Acting as monopolists, each sets price to maximize total profit; each produces 35M albums at $ 14.
•Acting as perfectly competitive firms, each sets price equal to zero; each produces 70M albums at $ 0.
Oligopolies in competition
• Acting as joint monopolists, per firm profits are (35M x $14)
‐ $100M = $390M
without letting Universal know
is lowered to $12, and per firm profits are:
Oligopolies in competition
• Each firm has an incentive to gain higher profits by
increasing quantity, but this comes at a cost of a lower
market price
–Quantity effect:An additional unit of output sold increases
a firm’s profit if price > marginal cost
–Price effect:An additional unit of output lowers market
price, and firm earns lower profit per unit sold
• If the quantity effect is greater than the price effect,
firms increase their quantity sold
–They will continue to increase output until the quantity
effect equals the price effect
• The price effect is smaller when there are more firms
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Compete or collude?
about price and quantity is collusion
–Compete: $350M each in profits
–Collude: $390M each in profits
collude?
Compete or collude?
• The previous example of why firms don’t collude to make
higher profits can be understood using the prisoner’s dilemma
• Firms earn highest profits by
colluding.
• Firms earn lowest profits by
competing.
• Each firm has an incentive to
renege on a collusion deal and compete regardless of what the other firm does.
• Reneging on collusion leads to competitive equilibrium.
Q = 80m
P = $12
Universal Music Group
Collude
Produce 35M CDs
Compete
Produce 45M CDs
Profit: $390m
Profit: $390m
Q = 90m Profit: $320m
P = $10
Q = 70m
P = $14
Q = 80m
P = $12
Profit: $440m
Profit: $320m
Profit: $440m
Profit: $350m
Profit: $350m
Compete or collude?
• In oligopoly markets, competing is a dominant strategy
for both firms
–A dominant strategy is one in whichit is best for a firm to
follow no matter what strategy other firms choose
• Since all firms in this game have a dominant strategy,
the result is a Nash equilibrium, an equilibrium in which
each party chooses an action that is optimal given the
choices of rivals
–If the output decision is made repeatedly, both firms may
take an initial chance that the other will hold up its end of
an initial agreement to collude
• This strategy often holds firms together in a cartel
–A cartel is a group of firms who collude to make collective
production decisions
–Cartels are mostly illegal
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Oligopoly and public policy
anti‐competitive (colluding) behavior.
bids it had received to supply heavy machinery.
–Government agencies discovered that 47
manufacturers had submitted identical bids for the
previous three years
–The estimated cost of this cartel to U.S. taxpayers
was $175 million per year
Perfect competition
S
D
10
90
Price ($)
Competitive oligopoly
S
D
12
80
Price ($)
Consumer Surplus Producer Surplus Deadweight loss
Collusion
S
D
14
70
Price ($)
S
D
14
70
Monopoly Price ($)
Albums (millions) Albums (millions)
Deadweight loss under varying amounts of
competition The deadweight losses incurred can be compared
under varying amounts of competition
• Perfectly competitive firms have zero DWL
• Competitive oligopolies
have some DWL, but less than colluding oligopolies
• Colluding oligopolies and monopolies have identical DWL
–The DWL is the largest
Summary
–Monopolistic competition
–Oligopoly
many firms that sell goods and services that are
similar, but slightly different
that sell a similar good or service
–Firms tend to know their competition
–Each firm has some price‐setting power
–No one firm has total market control
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Summary
• In monopolistically competitive markets, firms can earn
short‐run profits
• The less substitutable a good seems, the less likely
consumers are to switch to other products if the price
increases
• This provides incentives to producers to differentiate
their products by:
–Making them truly different
–Convincing consumers that they are different through
advertising and branding
• Advertising and branding either explicitly gives the
desired information to the consumer or signals the
quality of their products
Summary
and quantity decisions
producing the equivalent monopoly quantity and
splitting revenues
–Profits increase when a colluding firm deviates by
increasing quantity, which is the quantity effect
–Profits decrease when a colluding firm deviates by
increasing quantity, which is the price effect
effect is equal to the price effect when MC = 0