Monopolistic Competition and Oligopoly

Study Session 5

Exam Focus

Make sure you know the characteristics of both of these types of markets. For monopolistic competition, know the importance of advertising, product differentiation, and product innovation and arguments about the economic efficiency of these activities. Be able to explain how-firms in monopolistic competition earn economic profits in the short run, and how output and price are determined in the long run. Understand the incentives of oligopolists to collude and how the Prisoners' Dilemma relates to oligopoly output decisions when two firms enter into a price-fixing agreement.

LOS 20.a: Describe the characteristics of monopolistic competition and an oligopoly.

Monopolistic competition has the following market characteristics:

• A large number of independent sellers: (1) Each firm has a relatively small market share, so no individual firm has any significant power over price. (2) Firms need onlv pay attention to average market price, not the price of individual competitors. (3) There are too many firms in the industry for collusion (price fixing) to be possible.

• Each seller produces a differentiated product, so every firm has a product that is slightly different from its competitors (at least in the minds of consumers). The competing products are close substitutes for one another.

• Firms compete on price, quality, and marketing as a result of product differentiation. Quality is a significant product differentiating characteristic. Price and output can be set by firms because they face downward sloping demand curves, but there is usually a strong correlation between quality and the price that firms can charge. Marketing s a must in order to inform the market about a product's (differentiating) characteristics.

• Low barriers to entry so that firms are free to enter and exit the market. If firms in the industry are earning economic profits, new firms can be expected to enter the industry.

Firms in monopolistic competition face downward-sloping demand curves (they are price searchers). Their demand curves are highly elastic because competing products are perceived by consumers as close substitutes. Think about the market for toothpaste. All toothpaste is quite similar, but differentiation occurs due to taste preferences, influential advertising, and the reputation of the seller. However, if the price of your favorite brand increased significantly, you would be more likely to try other brands, which you would likely not do if the prices of all brands were similar.

Oligopoly is a form of market competition characterized by:

• A small number of sellers.

• Interdependence among competitors (decisions made by one firm affect the demand, price, and profit of others in the industry).

• Significant barriers to entry which often include large economics of scale.

• Products may be similar or differentiated.

In contrast to a monopolist, oligopolists are highly dependent upon the actions of their rivals when making business decisions. Price determination in the auto industry is a good example. Automakers tend to play "follow the leader" and announce price increases or decreases in close synchronization. They are not working explicitly together, but the actions of one producer have a large impact on the others. In addition, the barriers to entry are high in oligopoly markets. The enormous capital investment necessary to start a new auto company or airplane manufacturing firm, because of the large economies of scale in those industries, poses a significant barrier to entry.

i.OS 20.b: Determine the profit-maximizing. (ioss-minirnr/ing) output under monopolistic competition and an oligopoly, explain why long-run economic profit under monopolistic competition is zero, and determine if monopolistic competition is efficient.

The price/output decision for monopolistic competition is illustrated in Figure 1. Panel (a) of Figure 1 illustrates the short-run price/output characteristics of monopolistic competition for a single firm. As indicated, firms in monopolistic competition maximize economic profits by producing where marginal revenue, MR, equals marginal cost, MC, and by charging the price for that quantity from the demand curve, D. Here the firm earns positive economic profits because price, P , exceeds average total cost (ATC ). Due to low barriers to entry, competitors will enter the market in pursuit of these economic profits.

Panel (b) of Figure 1 illustrates long-run equilibrium for a representative firm after new firms have entered the market. As indicated, the entry of new firms shifts the demand curve faced by each individual firm down to the point where price equals average total cost (P = A'FC ) such that economic profit is zero. At this point, there is no longer an incentive for new firms to enter the market, and long-run equilibrium is established. The firm in monopolistic competition continues to produce at the quantity where MR = MC but no longer earns positive economic profits.

Figure 1: Short-Run and Long-Run Output Under Monopolistic Competition

(a) Short-Run Output Decision for a Firm

(b) Long-Run Output Decision for a Firm

(a) Short-Run Output Decision for a Firm

(b) Long-Run Output Decision for a Firm

Figure 2 illustrates the differences between long-run equilibrium in markets with monopolistic competition and markets with perfect competition. Note that with monopolistic competition, price is greater than marginal cost (suggesting inefficient allocation of resources), average total cost is not at a minimum for the quantity produced (suggesting inefficient scale of production), and the price is slightly higher than under perfect competition. The point to consider here, however, is that perfect competition is characterized by no product differentiation. The question of the efficiency of monopolistic competition becomes: Is there an economically efficient amount of product differentiation?

Figure 2 illustrates the differences between long-run equilibrium in markets with monopolistic competition and markets with perfect competition. Note that with monopolistic competition, price is greater than marginal cost (suggesting inefficient allocation of resources), average total cost is not at a minimum for the quantity produced (suggesting inefficient scale of production), and the price is slightly higher than under perfect competition. The point to consider here, however, is that perfect competition is characterized by no product differentiation. The question of the efficiency of monopolistic competition becomes: Is there an economically efficient amount of product differentiation?

In a world with only one brand of toothpaste, clearly average production costs would be lower. That fact alone probably does not mean that a world with only one brand/type of toothpaste would be a better world. While product differentiation has costs, it also has benefits to consumers. As we will see in the next section, additional benefits in terms of greater product innovation and the information about quality that can be conveyed by brand names may also offset the apparent lack of efficiency in markets characterized by monopolistic competition.

Figure 2: Firm Output Under Monopolistic and Perfect Competition

(a) Monopolistic Competition

(b) Perfect Competition

Price

MC ATC

Quantity

(b) Perfect Competition

Quantity

Quantity

Efficiency of monopolistic competition is unclear. Consumers definitely benefit from brand name promotion and advertising because they receive information about the nature of a product. This often enables consumers to make better purchasing decisions. Convincing consumers that a particular brand of deodorant will actually increase their confidence in a business meeting or make them more attractive to the opposite sex is not easy or inexpensive. Whether the perception of increased confidence or attractiveness from using a particular product is worth the additional cost of advertising is a question probably better left to consumers of the products. Some would argue that the increased cost of advertising and sales is not justified by the benefits of these activities.

For an oligopoly, interdependence among firms is a factor in the price/output decision. Oligopoly pricing models are described later in this topic.

LOS 20.c: Explain the importance of innovation, product development, advertising, and branding under monopolistic competition.

Product innovation is a necessary activity as firms in monopolistic competition pursue economic profits. Firms that bring new and innovative products to the market are confronted with less-elastic demand curves, enabling them to increase price and earn economic profits. However, close substitutes and imitations will eventually erode the initial economic profit from an innovative product. Thus, firms in monopolistic competition must continually look for innovative product features that will make their products relatively more desirable to some consumers than those of the competition.

Innovation does not come without costs. The costs of product innovation must be weighed against the extra revenue that it produces. A firm is considered to be spending the optimal amount on innovation when the marginal cost of (additional) innovation just equals the marginal revenue (marginal benefit) of additional innovation.

Advertising expenses are high for firms in monopolistic competition. This is to inform consumers about the unique features of their products and to create or increase a perception of differences between products that are actually quite similar. We just note here that advertising costs for firms in monopolistic competition are greater than those for firms in perfect competition and those that are monopolies.

As you might expect, advertising costs increase the average total cost curve for a firm in monopolistic competition. The increase to average total cost attributable to advertising decreases as output increases because more fixed advertising dollars are being averaged over a larger quantity. In fact, if advertising leads to enough of an increase in output (sales), it can actually decrease a firm's average total cost.

Brand names provide information to consumers by providing them with signals about the quality of the branded product. Many firms spend a significant portion of their advertising budget on brand name promotion. Seeing the brand name Toyota on an automobile likely tells a consumer more about the quality of a newly introduced automobile than an inspection of the automobile itself would reveal. At the same time, the reputation Toyota has for high quality is so valuable that the firm has an added incentive not to damage it by producing cars and trucks of low quality.

LOS 20.d: Explain the kinked demand curve model and the dominant firm model, and describe oligopoly games including the Prisoners' Dilemma.

One traditional model of oligopoly, the kinked demand curve model, is based on the assumption that an increase in a firm's product price will not be followed by its competitors, but a decrease in price will. According to the kinked demand curve model, each firm believes that it faces a demand curve that is more elastic (flatter) above a given price (the kink in the demand curve) than it is below the given price. The kinked demand curve model is illustrated in Figure 3 where the "kink" price is at price PK where a firm produces Q^. A firm believes that if it raises its price above PK, its competitors will remain at PK, and it will lose market share because it has the highest price. Above PK the demand curve is considered to be relatively elastic, where a small price increase will result in a large decrease in demand. On the other hand, if a firm decreases its price below P^, other firms will match the price cut, and all firms will experience a relatively small increase in sales.

Figure 3: Kinked Demand Curve Model

Price

'More elastic

Less elastic

Price

'More elastic

Less elastic

Quantity

Another traditional oligopoly model, the dominant firm oligopoly model, is based on the assumptions that one of the firms in an oligopoly market has a significant cost advantage over its competitors and that this dominant firm produces a relatively large proportion of the industry's output. Under this model, the dominant firm sets the price in the oligopoly market, and the remaining firms are essentially price takers, with little power to set their own prices.

Oligopoly Games

Game theory is used to examine strategic behavior in an oligopoly. Prisoners' Dilemma is a simple game that may be used to describe the decisions faced by firms competing under oligopoly conditions. Prisoners' Dilemma may be described as follows:

'Iwo suspects, A and B, are believed to have committed a serious crime. However, the prosecutor does not feel that the police have sufficient evidence tor a conviction. The prisoners are separated and offered the following deal:

• If Prisoner A confesses and Prisoner B remains silent, Prisoner A goes free and Prisoner B receives a 10-year prison sentence.

• If Prisoner B confesses and Prisoner A remains silent, Prisoner B goes free and Prisoner A receives a 10-year prison sentence.

• If both prisoners remain silent, each will receive a 6-month sentence.

• If both prisoners confess, each will receive a 2-vear sentence.

Each prisoner must choose either to betrav the other bv confessing, or to remain silent. Neither prisoner, however, knows for sure what the other prisoner will choose to do. f he result for each of these four possible outcomes is presented in Figure 4.

Figure 4: Prisoners' Dilemma

Prisoner B is silent

Prisoner B confesses

Prisoner A is silent

A gets 6 months B gets 6 months

A gets 1 0 vears B goes free

Prisoner A confesses

A goes free B gets 10 years

A gets 2 years B gets 2 years

What should the prisoners do? Well, the solution to the Prisoners' Dilemma is to take the best course of action given the action taken by the other prisoner. This means that both prisoners will confess. Why?

Consider Prisoner B's choices. If Prisoner A remains silent, Prisoner B's best option is to confess and go free. If Prisoner A confesses, Prisoner B's best option is to confess and get two years instead of ten. So in either case Prisoner B's best option is to confess. A similar analysis reveals that confessing is Prisoner's A best option as well. The dilemma is that both prisoners know that if they both remain silent, thev will only receive a 6-month sentence, but neither has any way of knowing what the other will do.

Oligopoly firms are in a Prisoners' Dilemma type of situation because thev can each earn a greater profit if they agree to share a restricted output quantity, but only if neither cheats on the agreement. Oligopolists maximize their total profits by joining together (colluding) and operating as a single seller (monopolist).

Collusion is when firms make an agreement among themselves to avoid various competitive practices, particularly price competition, for example by forming a cartel in which the firms all act as a monopoly. Figure 5 illustrates a two-firm oligopoly with the potential for collusion.

Figure 5: Cost and Demand for 2-Firm Industry

Let's assume that Firm A and Firm B are only two firms in an oligopoly market and the: each produce half of the industry's output of an identical product. Figure 5(a) shows that each of these firms produces quantity Q/2 at price P where marginal cost, MC, equals the minimum average total cost, ATC. Figure 5(b) is the industry demand curve, D, where Q is the quantity demanded at price P.

Now, let's assume that Firm A and Firm B have entered into an agreement to reduce output and earn increased profits. As in the Prisoners' Dilemma, these firms have two possible strategies, to honor the agreement or to cheat, so there are four possible outcomes:

• Each firm honors the agreement.

• Firm A honors the agreement while Firm B cheats.

• Firm B honors the agreement while Firm A cheats.

Let's examine the economic implications of each of these outcomes. Figure 6 illustrates the profit maximizing price and quantity if Firm A and Firm B collude and act jointly as if they were a single monopoly firm.

Figure 6: Price Fixing to Earn Monopoly Profits

Price (Vice

Price (Vice

If both firms honor the contract, total economic profit will be maximized, and both firms will share it equally. Figure 6(a) shows the marginal cost, MC, and average total cost, ATC, for the each of the firms. Figure 6(b) shows the industry's demand curve, D, marginal cost curve, MC[ND, and marginal revenue curve, MR. Note that the industry marginal cost curve, MCIND, is the horizontal sum of the marginal cost curves, MC, for the two firms.

To earn the maximum monopoly profit, the combined output of the two firms must equal the quantity where the marginal revenue for the industry equals the industry's marginal cost. This is quantity Q^ in Figure 6(b). At QM, the market price will be PM. This is the fixed price that the firms will agree to, because at this price, industry demand will be restricted to the monopolistic profit-maximizing quantity Q^ Assuming that each firm agrees to produce half of the profit maximizing quantity, each firm will produce Q^/2 at price PM and earn the economic profit indicated in the shaded area in Figure 6(a).

If one firm cheats on the agreement bv increasing output above its agreed-upon share, the total economic profit to the industry will be less than that of a monopoly, but the economic profit to the cheating firm will be greater than it would have realized when both firms honored the agreement. On the other hand, the firm that honors the agreement will now be producing the agreed-upon quantity at the same average total cost, but selling at a lower price than expected. This firm may believe that demand has fallen and that the equilibrium price for the agreed-upon total output has fallen. So, the firm that honors the agreement will experience an economic loss. However, the firm that cheated on the agreement by increasing output will realize an increased economic profit by selling more at the lower price, but at a lower average total cost. Total economic profit to the industry will decline.

If both firms cheat by increasing quantity, each firm will increase output to the point where price equals marginal cost and average total cost. The resulting price and output will approach that of a perfectly competitive industry.

Figure 7 below presents the possible outcomes of the collusive agreement between Firm A and Firm B. As in the Prisoners' Dilemma, they will both cheat. Why? Consider the following argument for Firm A.

• Given that Firm B honors the agreement: Firm A will earn an economic profit if it honors the agreement, but an even greater economic profit if it cheats. Best Strategy: Firm A should cheat.

• Given that Firm B cheats: Firm A will experience an economic loss if it honors the agreement, and zero economic profit if it cheats. Best Strategy: Firm A should cheat.

Therefore, Firm A will cheat. Firm B will cheat as well, based on the same logic. (In game theory they are said to have arrived at "Nash equilibrium," meaning each firm makes its best choice given the action of the other firm.)

Figure 7: Prisoners' Dilemma for Two Firms

Firm B honors

Firm B cheats

Firm A honors

A earns economic profit

A has an economic loss

B earns economic profit

B earns increased economic profit

Firm A cheats

A earns increased economic profit

A earns zero economic profit

B has an economic loss

B earns zero economic profit

The probability of successful collusion is greater when cheating is easy to detect, when there are fewer oligopoly firms in a market, when the threat of new entrants to the market is less, and when enforcement of anti-collusion laws and penalties for colluding are weaker.

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