Chapter 16 Monopolistic Competition and Oligopoly

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1 Chapter 16 Monopolistic Competition and Oligopoly Market Structure Market structure refers to the physical characteristics of the market within which firms interact It is determined by the number of firms in the market and the barriers to entry A monopolistically competitive market is a market in which there are many firms selling differentiated products and few barriers to entry An oligopolistic market is a market in which there are only a few firms and firms explicitly take other firms likely response into account Characteristics of Monopolistic Competition Four distinguishing characteristics: 1. Many sellers that do not take into account rivals reactions 2. Product differentiation where the goods that are sold aren t homogenous 3. Multiple dimensions of competition make it harder to analyze a specific industry, but these methods of competition follow the same two decision rules as price competition, marginal costs and marginal benefits. 4. Ease of entry of new firms in the long run because there are no significant barriers to entry 16-3

2 Output, Price, and Profit of a Monopolistic Competitor Like a monopoly, The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve Marginal revenue is below price (MR < P) At profit maximizing output, marginal cost will be less than price (MC< P) Like a perfect competitor, zero economic profits exist in the long run Determining Profits Graphically: Monopolistic Competition Profits Losses Break even A monopolistic firm can earn profits, losses, or break even in the short run 16-5

3 Monopolistic Competition Compared with Perfect Competition Graph In monopolistic competition in the long run, P > min ATC, In perfect competition in the long run, P = min ATC Outcome: Monopolistic competition output is lower and price is higher than perfect competition 16-7

4 Comparing Monopolistic Competition with Monopoly It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry For a monopolistic competitor in long-run equilibrium, At the long-run equilibrium, ATC is not at its minimum. Advertising and Monopolistic Competition (P = ATC) > (MC = MR) Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do The goals of advertising are to increase demand and make demand more inelastic Advertising increases ATC The increase in cost of a monopolistically competitive, comparing to perfect competition, is the cost of differentness Consumers may be better off with differentiated products. Characteristics of Oligopoly - Oligopolies are made up of a small number of firms in an industry - In any decision a firm makes, it must take into account the expected reaction of other firms - Oligopolistic firms are mutually interdependent - Oligopolies can be collusive or noncollusive - Firms may engage in strategic decision making where each firm takes explicit account of a rival s expected response to a decision it is making 16-8

5 Models of Oligopoly Behavior There is no single model of oligopoly behavior An oligopoly model can take two extremes: The cartel model is when a combination of firms acts as if it were a single firm and a monopoly price is set The contestable market model is a model of oligopolies where barriers to entry and exit, not market structure, determine price and output decisions and a competitive price is set Other models of oligopolies give price results between the two extremes The Cartel Model - A cartel model of oligopoly is a model that assumes that oligopolies act as if they were a monopoly and set a price to maximize profit - Output quotas are assigned to individual member firms so that total output is consistent with joint profit maximization - If oligopolies can limit the entry of other firms, they can increase profits Implicit Price Collusion - Explicit (formal) collusion is illegal in the U.S. while implicit (informal) collusion is permitted - Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another - Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow - Note that, technological change can eliminate demand for its monopolized product

6 Why Are Prices Sticky? - One characteristic of informal collusive behavior is that prices tend to be sticky they don t change frequently - Informal collusion is an important reason why prices are sticky - Another is the kinked demand curve - If a firm increases price, others won t go along, so demand is very elastic for price increases - If a firm lowers price, other firms match the decrease, so demand is inelastic for price decreases Why Are Prices Sticky? - One characteristic of informal collusive behavior is that prices tend to be sticky they don t change frequently - Informal collusion is an important reason why prices are sticky - Another is the kinked demand curve - If a firm increases price, others won t go along, so demand is very elastic for price increases - If a firm lowers price, other firms match the decrease, so demand is inelastic for price decreases 16-14

7 The Kinked Demand Curve Graph P If P increases, others won t go along, so D is elastic A gap in the MR curve exists A large shift in marginal cost is required before firms will change their price P MC 1 Gap MC 2 If P decreases, other firms match the decrease, so D is inelastic Q MR D Q 16-15

8 The Contestable Market Model The contestable market model is a model of oligopolies where barriers to entry and exit, not market structure, determine price and output decisions and a competitive price is set Even if the industry contains only one firm, it will set a competitive price if there are no barriers to entry Much of what happens in oligopoly pricing is dependent on the specific legal structure within which firms interact Comparing Contestable Market and Cartel Models The cartel model is appropriate for oligopolists that collude, set a monopoly price, and prevent market entry The contestable market model describes oligopolies that set a competitive price and have no barriers to entry Oligopoly markets lie between these two extremes, cartel model and contestable market Both models use strategic pricing decisions where firms set their price based on the expected reactions of other firms New Entry as a Limit on the Cartelization Strategy and Price Wars The threat of outside competition limits oligopolies from acting as a cartel e.g. big bank enters to small town The threat will be more effective if the outside competitor is much larger than the firms in the oligopoly e.g. the enter of multinational companies Price wars are the result of strategic pricing decisions gone wild to drive a disliked competitor out of business A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business 16-16

9 Comparison of Market Structures Monopoly Oligopoly Monopolisti c Competitio n Perfect Competition No. of firms One Few Many Almost infinite Barriers to entry Significant Significant Few None Pricing decisions MC = MR Strategic pricing MC = MR MC = MR = P Output decisions Most output restriction Output restricted Output restricted, product differentiatio n No output restriction Interdependen ce No competitor s Interdepend ent decisions Each firm independent Each firm independent LR profit Possible Possible None None P and MC P > MC P > MC P > MC P = MC 16-19

10 Classifying Industries and Markets in Practice An industry seldom fits neatly into one category or another One way to classify markets in practice is by its cross price elasticity Cross-price elasticity measures the responsiveness of the change in demand for a good to a change in the price of a related good Goods with a cross-price elasticity of 3 or more are in the same industry The North American Industry Classification System North American Industry Classification System (NAICS) is an industry classification system that categorizes industries by the type of economic activity and groups firms with like production processes Two Digit Sectors Three to Six Digit Sectors 23 Construction 42 Wholesale Trade 51 Information 517 Telecommunications 5172 Wireless telecommunications carriers Paging 61 Education Services 16-20

11 Empirical Measures of Industry Structure The concentration ratio is the value of sales by the top firms of an industry stated as a percentage of total industry sales The Herfindahl index is the sum of the squared value of the individual market shares of all firms in the industry Because it squares market shares, the Herfindahl index gives more weight to firms with large market shares than does the concentration ratio measure Concentration Ratios and the Herfindahl Index Industry Four Firm Concentration Ratio Herfindahl Index Poultry Soft drinks Breakfast cereal 78 2,999 Soap and detergent Men s footwear Women s footwear 64 1,556 Pharmaceuticals Computer equipment 49 1,183 Burial caskets 73 2,

12 Conglomerate Firms and Bigness Neither the four-firm concentration ratio nor the Herfindahl index gives a complete picture of corporations bigness because many firms are conglomerates Conglomerates are huge corporations whose activities span various unrelated industries Oligopoly Models and Empirical Estimates of Market Structure The cartel model fits best with empirical measurements because it assumes that the structure of the market is directly related to the price a firm charges It predicts that oligopolies charge higher prices than monopolistic or perfect competitors The contestable market model gives less weight to the empirical estimates of market structure Markets that look oligopolistic could be highly competitive 16-24

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