Ecn Unit 10 Monopolistic Competition & Oligopoly

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1 Ecn Unit 10 Monopolistic Competition & Oligopoly An industry characterized by monopolistic competition is similar to the case of perfect competition in that there are many firms, and entry into the industry is not restricted by any barriers. However, it differs from perfect competition because the products sold by different firms are differentiated from one another.* For example, there may be differences in product quality, appearance, or reputation. Essentially what we re dealing with here are industries that have a lot of different brands to choose from. Examples are clothes, toothpaste, cereal, soft drinks, etc.. Each firm is the sole supplier of its own brand, but other brands of the same type of product exist and are close, although not perfect, substitutes. The following conditions prevail in a monopolistically competitive market: 1. Many firms each with a small market share (larger market share than was the case with PC firms). 2. Each firm s product is a close, though not perfect, substitute for the product of other firms. 3. The actions of any single firm will affect its own profitability, but will not have a significant impact on the profitability of other firms in the industry (we need this assumption to separate monopolistic competition from oligopoly, where each firm s market strategy is strongly influenced by the actions of other firms). 4. Entry into and exit from the industry are relatively easy. 5. There is no incentive to cooperate with other firms (again, this assumption is a critical difference between monopolistic competition and oligopoly). What does the demand curve for a monopolistically competitive firm s product look like? Are monopolistically competitive firms price makers or price takers? price and quantity decided upon by the monopolistically competitive firm? How are the profit maximizing If economic profits > 0 exist for monopolistically competitive firms in the short-run, what will happen in the long-run? How long will this action persist? Explain the effects that the above answer will have on the demand for any firm s product. In the space below, show that the monopolistically competitive firm is earning positive economic profits. Next, change your graph to show the effects of the entry of new firms into the market.

2 P MC ATC D MR Q What can we say about the long-run price of a product produced by a firm in a monopolistically competitive industry? Is monopolistic competition inefficient? Given your above answer, can you conclude that monopolistic competition is socially undesirable? Oligopoly exists when a few large firms dominate a market. We encounter monopolistic markets for both homogenous and heterogeneous goods. By a few firms, we typically mean between 3 and 10. Note: when a market is controlled by 2 firms, we have a duopoly. A good rule of thumb is that if the largest 4 firms control 40% or more of the total market supply, then the industry can be considered an oligopoly. Using this measure, approximately half of all US manufacturing industries are oligopolies.

3 The largest firms in oligopolistic markets have large enough market shares so that they can influence market price. Further, because market shares are so big, the actions of other firms are important to the price and output decisions of each firm. That is, contrary to the assumptions of perfect competition and monopolistic competition, individual firms in oligopolies can threaten the profitability of other firms. So oligopolistic firms are always watching each other, and basing their own decisions, in large part, on what other firms are doing. In short, we can say that the characteristic that separates oligopoly from other market structures is the mutual interdependence of competing firms. Give examples of Oligopolies in markets for heterogeneous goods Why do these firms typically spend huge amounts on advertising? Give examples of Oligopolies in markets for homogeneous goods How can a few firms control an entire market? What must exist for oligopolies to remain oligopolies? Because the interdependence among firms in an oligopoly situation can take many different forms (they can cooperate, or compete in varying degrees), and because there are many different types of oligopolies (some are closer to monopolistic competition, some closer to monopoly) it is not possible to study oligopoly with a single behavioral model as we did with other market structures. Instead, we will develop multiple models for different types of firm interaction. 1. The Kinked Demand Curve Model (Noncollusive Oligopoly) This model applies to a mature heterogeneous product oligopoly market where price has already been determined. The kinked demand curve model was developed to try and explain why prices in some oligopolistic industries tend to remain rigid despite changes in cost and demand conditions. Examples where this model is applicable are the markets for TV sets, kitchen appliances, and automobiles. Prices of these items change very slowly over time. The basic reason why is that individual oligopolists are afraid to change price because they do not know how their competitors will react. Consider an oligopoly consisting of three firms, A, B, and C, each having one-third of the total market for a differentiated product. Assume the current price of firm A s product is $ and quantity demanded is 100,000 units. The shape of the demand for A s product depends on the price elasticity of demand how quantity demanded for A s product will change with a change in price. The price elasticity of demand for A s product is therefore dependent upon the pricing behavior of firms B and C. If firm A lowers price to $400.00, what options do firms B and C have?

4 If firm A raises price to $600.00, what options do firms B and C have? If B and C ignore the price change by firm A, that is, they do not react to it, what does this imply about the elasticity of demand for A s product? Draw this demand curve (passing through the point p = 500, Q = 100,000), and the corresponding MR curve, in the space below and label it D w/ no reaction by other firms. If B and C match the price change by firm A, what does this imply about the elasticity of demand for A s product? Draw this demand curve (also passing through the point p = 500, Q = 100,000), and the corresponding MR curve, in the space below and label it D w/ reaction by other firms. P ,000 Q Which demand curve more likely represents the changes that will result if A increases price? Which demand curve more likely represents the changes that will result if A decreases price? Given the above conclusions, why is firm A unlikely to change price even if there is a change in MC? Explain intuitively and using your graph. 2. Cartels (Collusive Behavior Among Firms) -- Oligopoly often leads to collusion when a formal or informal arrangement is made between firms to restrict output and/or fix prices. A cartel is a group of sellers of a product who have joined together in such an agreement hoping to gain the advantages of a monopoly. Why would firms in an oligopoly want to collude?

5 Again consider an oligopoly consisting of three firms, A, B, and C, each having one-third of the total market, this time for a homogenous product. Assume the firms all have the same cost structures, and that since the product is homogenous, the individual demand curves are identical. If we again assume that each firm is uncertain about the way other firms will behave, the shape of individual demand curves is unknown. However, if each firm knows that the other firms will always match price changes, the uncertainty is removed, and each firm can act in a profit maximizing fashion. Assume that the 3 firms agree to behave in such a way as to maximize industry profits. They agree to divide the optimal market quantity equally among the 3 firms, and each firm will produce no more than this amount. Given the left graph below represents the sum of costs and demand for all 3 firms (i.e.: this is a market representation) how should the firms agree to set price and quantity? P MC MKT MC A ATC A D MK T MR MKT Q MKT Q A Given the right graph above represents the marginal and average total costs for firm A, show that when the firms form a collusive agreement to produce the quantity to maximize industry profits and divide output equally, firm A will earn economic profit > 0. What will happen if one firm cheats on the cartel agreement and produces more than 1/3 the optimal amount? The Theory of Games Game theory is a mathematical technique for analyzing the decisions of interdependent oligopolistic firms in uncertain situations. A game here is simply a competitive situation where two or more firms or individuals pursue their interests and no person can dictate the final outcome or payoff. The fundamental tool of game theory is the payoff matrix. This is simply a way of organizing the potential outcomes of a given game when they are contingent upon the game player s actions. To illustrate the payoff matrix

6 and the general idea of game theory we will go through an example that really has nothing to do with economics The Prisoners Dilemma. The setup: You and your friend Bugsy are the prime suspects for knocking over a liquor store. The cops pick you up, and immediately after your arrest you and Bugsy are separated and questioned individually by the district attorney. Without a confession, the DA has insufficient evidence for a conviction. During your interrogation, you are told the following: a. The police do have sufficient evidence to convict you and Bugsy of a lesser crime. b. If you and Bugsy both confess to the liquor store heist, you will each get a 5 year sentence. c. If neither of you confesses, you will each be charged with the lesser crime, and sent up the river for 2 years. d. If Bugsy confesses (turns state s evidence) and you do not, Bugsy will get a reduced sentence of only 1 year while you will be convicted of the liquor store robbery and get sent to the big house for 10 years. Bugsy is told the exact same information. What will you do? Use the following table to show the outcomes of the dilemma. Confess You Do not Confess Confesses Bugsy Does not Confess

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