Monopolistic Competition

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1 Monopolistic Competition and Product ifferentiation Outline for Lectures 19 and 20. Read Chapter 12 and the assigned class reading. Announcements What is Monopolistic Competition? Why oligopolists and monopolistically competitive firms differentiate their products. Prices and profits under monopolistic competition in the short- and long-run. Why monopolistic competition poses a tradeoff between lower prices and greater product diversity. Advertising and brand names. What is an oligopoly and why it occurs. Collusion. Game theory and the prisoners dilemma Tacit collusion Antitrust policy. 2 Monopolistic Competition Monopolistic competition is a market structure where: There are many competing producers in an industry, Each producer sells a differentiated product, and There is free entry into and exit from the industry in the long run. Examples of monopolistically competitive industries might include fast food, gas stations, coffee shops. 3 Product ifferentiation 4 Monopolistically Competitive Firm in the Short Run There are several ways in which companies differentiate their product: ifferentiation by style of type: Clothing stores; different types of cars; books; etc. As long as people p differ in their tastes, producers will find it profitable to produce a range of varieties. ifferentiation by location: ry cleaners, gas stations ifferentiation by quality: Ordinary and gourmet chocolate; fancy and other types of restaurants. Sellers of differentiated products have some market power. P Example #1 Example #2 Loss MC Profit P ATC Q Q MC ATC 1

2 5 Entry and Exit in Monopolistic Competition (remaining firms) 6 The Long-Run Zero-Profit Equilibrium Entry, if profits exist P, P, Exit, if losses exist Q 7 Monopolistic Competition versus Perfect Competition Price exceeds marginal cost. So selling more at the going price appeals to the producer, so they might, for example, advertise. P>MC is inefficient from the vantage point of society. There are people who are willing to pay more than the cost of producing a product, but the transaction does not occur. Like perfect competition, in the long-run equilibrium of a monopolistically competitive industry, there are many firms, all earning zero profit. But the perfectly competitive and monopolistically competitive firms produce at different points on the long-run average total cost curve. The monopolistically competitive firm does not produce at the minimum of the LRAC curve. 8 Comparing Long-Run Equilibrium in Perfect Competition and Monopolistic Competition 2

3 Advertising and Brand Names Oligopoly 9 10 Price exceeds MC, so advertising might increase profit. o ads change behavior (manipulate the weak-minded)? Some ads provide information. Why would a celebrity spokesperson influence buying decisions. A signal of the product quality? Brand names Convey information about product quality? Create market power (aspirin is an identical product, so branding creates market power for no good reason). An oligopoly is an industry with only a small number of producers. It is a common market structure. Cigarettes, batteries, breweries, breakfast cereals, autos, and airlines, among others. It arises from the same forces that lead to monopoly, but in weaker form. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition, Understanding Oligopoly Cartels 11 Formal models of oligopoly are difficult. Strategic interactions include a vast range of different possibilities, so there isn t a single workhorse model of oligopoly. The possibilities include: Cartels: act collectively like monopolists and split the economic profits. Non-cooperative behavior. Compete on prices (end up looking similar to a competitive industry). Compete on quantities. Interact strategically in the market, seeking the greatest advantage. 12 Seldom do members of the same trade meet together but the conversation turns to conspiring to raise prices (Adam Smith). Any time 30 of the wealthiest and most influential individuals get together behind closed doors and agree to reduce output, that cannot be a good thing for anyone but the monopolists (Rep. John Conyers,, MI). Three problems facing cartels. Illegal in the U.S. It is hard to restrict entry. It is hard to enforce output restrictions. 3

4 13 P M P C The Incentive to Cheat for a Member of a Cartel Market equilibrium S P M P C Firm incentives MC ATC 14 If Oligopolistic Firms Compete on Price (the Bertrand Model) The outcomes in oligopolistic markets will equal those in perfectly competitive markets. Firms will be willing to cut prices (to acquire market share) up to the point where price equals marginal costs. But this is the perfectly competitive outcome. Needless to say, firms with market power will generally try to avoid this outcome. The fact that firm s decisions are likely to be interrelated opens up the opportunity for a wide range of possible interactions. We will study some simple models of interactions using elementary ideas from game theory. Q M Q C Q firm 1 Q firm 1 cheat The Prisoners ilemma Clearly better efinitions Best response: highest payoff given other player s strategies ominant strategy: always the best response Nash equilibrium Nash equilibrium: all players play their best responses, given other player s actions. 4

5 Strategic interactions of uopolists: the market for Lysine 18 A Couple Further Words on Prisoners ilemma Games Not all games have dominant strategies it depends on the structure of the game. The two previous games were one-shot games. Most oligopolists will interact repeatedly in the market. A tit for tat strategy involves playing cooperatively at first, and then doing whatever the other player did in the previous period. Firms can make greater short-term profits by cheating, but long-term profits will be higher if they cooperate implicitly. This is referred to as tacit collusion. Nash outcome How Repeated Interaction Can Support Collusion The Kinked emand Curve Raise prices, others won t, so you lose lots of sales (elastic demand). Lower prices, others retaliate, so demand is very steep to the right of Q*. Changes in MC may have little effect on output! 5

6 21 Oligopoly in Practice Antitrust laws. Sherman Act of 1890 (forbids conspiring to restrict trade and forbids attempts at monopolization). Clayton Act (1914) allows private suits, restricts mergers. Abundant case law (complex area). Life can be hard for would-be colluders Hard with many firms. Hard with complex products and pricing schemes. ifferences in seniority or costs. Bargaining power of buyers (like Walmart ) 22 So What Should You Make of Oligopoly? In economics we typically ask how self-interested individuals would behave and analyze their interactions. Limited in the case of oligopoly, because we do not know the extent (and nature) of noncooperative interactions or whether they will collude. The perfectly competitive model and the logic of supply and demand can be very useful in analyzing oligopolistic markets. In cases where this isn t enough, economists write down models of the strategic interactions of firms, recognizing complications the arise from price wars, anti-trust policy and other issues. These models can be complicated! 6

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