Chapter 10. Monopolistic Competition and Oligopoly: N N N N N N N N

Chapter 10.
Monopolistic Competition and Oligopoly
Topics to be Discussed
n Monopolistic Competition
n Oligopoly
n First Mover Advantage---The Stackelberg Model
n Price Competition
n Competition Versus Collusion
n Implications of Oligopolistic Pricing
n Cartels
Monopolistic Competition
n Characteristics
1) Many firms
2) Free entry and exit
3) Differentiated product
n The amount of monopoly power depends on the degree of differentiation.
n Examples of this very common market structure include:
• Toothpaste
• Crest and monopoly power
– Procter & Gamble is the sole producer of Crest
– Consumers can have a preference for Crest---taste, reputation, decay preventing efficacy
– The greater the preference (differentiation) the higher the price.
n Question: Does Procter & Gamble have much monopoly power in the market for Crest?
n The Makings of Monopolistic Competition
• Two important characteristics
– Differentiated but highly substitutable products
– free entry and exit
1
n Observations (short-run)
• Downward sloping demand--differentiated product
• Demand is relatively elastic--good substitutes
• MR < P
• Profits are maximized when MR = MC
• This firm is making economic profits
n Observations (long-run)
• Profits will attract new firms to the industry (no barriers to entry)
• The old firm’s demand will decrease to DLR
• Firm’s output and price will fall
• Industry output will rise
• No economic profit (P = AC)
• P > MC -- some monopoly power
2
n Monopolistic Competition and Economic Efficiency
• The monopoly power (differentiation) yield a higher price than perfect competition. If
price was lowered to the point where MC = D, consumer surplus would increase by the yellow
triangle.
n Monopolistic Competition and Economic Efficiency
• With no economic profits in the long run, the firm is still not producing at minimum AC
and excess capacity exists.
n Questions
1) If the market became competitive, what would happen to output and price?
2) Should monopolistic competition be regulated?
3) What is the degree of monopoly power?
4) What is the benefit of product diversity?
3
Oligopoly
n Characteristics
• Small number of firms
• Product differentiation may or may not exist
• Barriers to entry
n Oligopoly markets commonly exist

n Examples
• Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers
n The barriers to entry are:
• Natural
– Scale economies, Patents, Technology, Name recognition
n Question
• What are the possible rival responses to a 10% price cut by Ford?
n Equilibrium in an Oligopolistic Market

• In perfect competition, monopoly, and monopolistic competition the producers did not
have to consider a rival’s response when choosing output and price.
• In oligopoly the producers must consider the response of competitors when choosing
output and price.
n Equilibrium in an Oligopolistic Market

• Defining Equilibrium
– Firms doing the best they can and have no incentive to change their output or price
– All firms assume competitors are taking rival decisions into account.
n Nash Equilibrium
• Each firm is doing the best it can given what its competitors are doing.
n The Cournot Model

• Duopoly
– Two firms competing with each other
– Homogenous good
– The output of the other firm is fixed
n An Example of the Cournot Equilibrium

• Duopoly
– Market demand is P =950 - Q where Q = Q1 + Q2
– MC1 = MC2 = AC=50
Firm 1’s Output Decision

n The Reaction Curve
• F1’s profit-maximizing output is a decreasing schedule of the expected output of F2.
1. Reaction Curves
2.Competitive Equilibrium and Cournot Equilibrium
3.Collusive Equilibrium and Contract Curve.
n Questions
4
1) If the firms are not producing at the Cournot equilibrium, will they adjust
until the Cournot equilibrium is reached?
2) When is it rational to assume that its competitor’s output is fixed?
First Mover Advantage--The Stackelberg Model

n Assumptions
• One firm can set output first
• MC = 50
• Market demand is P = 950 - Q where Q = total output
• Firm 1 sets output first and firm 2 then makes an output decision
n Firm 1
• Must consider the reaction of Firm 2
n Firm 2
• Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction
curve--Q2 = 450 - 1/2Q1
n Questions
• Why is it more profitable to be the first mover?
Implications of the Oligipolistic Pricing

n Observations of Oligopoly Behavior
1) In some oligopoly markets, pricing behavior in time can create a predictable pricing
environment and implied collusion may occur.
2) In other oligopoly markets, the firms are very aggressive and collusion is not
possible.
– Firms are reluctant to change price because of the likely response of their competitors.
– In this case prices tend to be relatively rigid.
The Kinked Demand Curve
1. If the producer raises price the competitors will not and the demand will be elastic.
2. If the producer lowers price the competitors will follow and the demand will be inelastic.
3. With two demand functions there are two marginal revenue functions.
5
4. So long as marginal cost is in the vertical region of the marginal revenue curve,
price and output will remain constant.
6
n The Dominant Firm Model
• In some oligopolistic markets, one large firm has a major share of total sales, and a group
of smaller firms supplies the remainder of the market.
• The large firm might then act as the dominant firm, setting a price that maximized its own
profits.
Cartels
n Characteristics
1) Explicit agreements to set output and price
2) May not include all firms
3) Most often international
– Examples of successful cartels
• OPEC
• International Bauxite Association
– Examples of unsuccessful cartels
• Copper, Tin, Coffee, Tea, Cocoa
4) Conditions for success
– Competitive alternative sufficiently deters cheating
– Potential of monopoly power--inelastic demand
Summary
n In a monopolistically competitive market, firms compete by selling differentiated
products, which are highly substitutable.
n In an oligopolistic market, only a few firms account for most or all of production.
n In the Cournot model of oligopoly, firms make their output decisions at the same time,
each taking the other’s output as fixed.
n In the Stackelberg model, one firm sets its output first.
n Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust
laws usually prohibit this.
n In a cartel, producers explicitly collude in setting prices and output levels.
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Chapter 10. Monopolistic Competition and Oligopoly: N N N N N N N N

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Chapter 10.

Monopolistic Competition and Oligopoly

n Oligopoly markets commonly exist

n Equilibrium in an Oligopolistic Market

n Equilibrium in an Oligopolistic Market

n The Cournot Model

n An Example of the Cournot Equilibrium

Firm 1’s Output Decision

First Mover Advantage--The Stackelberg Model

Implications of the Oligipolistic Pricing

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