I.
Review market structure characteristics from beginning of
Chapter 7.
II.
Monopolistic Competition: Characteristics, Occurrence, Price
and Output Determination
A.
Monopolistic competition refers to a market situation in which a
relatively large number of sellers offer similar but not identical
products.
1.
Each firm has a small percentage of the total market.
2.
Collusion is nearly impossible with so many firms.
3.
Firms act independently; the actions of one firm are ignored
by the other firms in the industry.
B.
Product differentiation and other types of nonprice
competition give the individual firm some degree of monopoly power
that the purely competitive firm does not possess.
1.
Product differentiation may be physical (qualitative).
2.
Services and conditions accompanying the sale of the product
are important aspects of product differentiation.
3.
Location is another type of differentiation.
4.
Brand names and packaging lead to perceived differences.
5.
Product differentiation allows producers to have some control
over the prices of their products.
C.
Similar to pure competition, under monopolistic competition
firms can enter and exit these industries relatively easily.
D.
Examples of real‑world industries that fit this model include
grocery stores, restaurants, medical care, and real estate sales.
E.
Monopolistic Competition:
Price and Output Determination
1. The
firm’s demand curve is highly, but not perfectly, elastic.
It is more elastic than the
monopoly’s demand curve because the seller has many rivals
producing close substitutes.
It
is less elastic than in pure competition, because the seller’s
product is differentiated
from its rivals, so the firm has some control over price.
2. In the
short‑run situation, the firm will maximize profits or minimize
losses by producing
where marginal cost and marginal revenue are equal, as was
true in pure competition and
monopoly. The
profit‑maximizing situation is illustrated in Figure 9.1a, and the
loss‑minimizing
situation is illustrated in Figure 9.1b.
3. In the
long‑run situation, the firm will tend to earn a normal profit only,
that is, it will
break even (Figure 9.1c).
a. Firms
can enter the industry easily and will if the existing firms are
making an
economic profit. As
firms enter the industry, this decreases the demand curve facing
an individual firm as
buyers shift some demand to new firms; the demand curve will
shift until
the firm just breaks even.
If the demand shifts below the break‑even point
(including a normal profit), some firms will leave the industry in
the long run.
b. If firms
were making a loss in the short run, some firms will leave the
industry. This
will
raise the demand curve facing each remaining firm as there are fewer
substitutes for buyers.
As this happens, each firm will see its losses disappear
until it reaches
the break‑even (normal profit) level of output and price.
c.
Complicating factors are involved with this analysis.
i.
Some firms may achieve a measure of differentiation that is not
easily duplicated
by rivals (brand names, location, etc.) and can realize
economic profits even in
the long run.
ii. There
is some restriction to entry, such as financial barriers that exist
for new
small businesses, so economic profits may persist for
existing firms.
iii. Long‑run
below‑normal profits may persist, because producers like to maintain
their way of life as entrepreneurs despite the low economic
returns.
III.
Monopolistic Competition and Economic Efficiency
A.
Review the definitions of allocative and productive efficiency:
1.
Allocative efficiency occurs when price = marginal cost,
i.e., where the right amount of resources are allocated to the
product.
2.
Productive efficiency occurs when price = minimum average
total cost, i.e., where production occurs using the least-cost
combination of resources.
B.
Excess capacity will tend to be a feature of monopolistically
competitive firms (Figure 9.2).
1.
Price exceeds marginal cost in the long run, suggesting that
society values additional units that are not being produced.
2.
Firms do not produce the lowest average-total-cost level of
output (Figure 9.2).
3.
Average costs may also be higher than under pure competition,
due to advertising and other costs involved in differentiation.
C.
Monopolistic Competition:
Product Variety
1. A
monopolistically competitive producer may be able to postpone the
long-run outcome
of just normal profits through product development and
improvement and advertising.
2. Compared
with pure competition, this suggests possible advantages to the
consumer.
a.
Developing or improving a product can provide the consumer with a
diversity of
choices.
b. Product
differentiation is at the heart of the tradeoff between consumer
choice and
productive efficiency.
The greater number of choices the consumer has, the greater
the excess capacity problem.
IV.
Oligopoly:
Characteristics and Occurrence
A.
Oligopoly exists where a few large firms producing a homogeneous or
differentiated product dominate a market.
1.
“A few large producers” is intentionally vague.
If there are dominant firms that can be clearly identified,
and few enough that firms are mutually interdependent in their
pricing and output decisions, then you’ve got oligopoly.
2.
Some oligopolistic industries produce standardized products
(steel, zinc, copper, cement), whereas others produce differentiated
products (automobiles, detergents, greeting cards).
3.
Oligopolies exert some control over price, but mutual
interdependence requires strategic behavior – self-interested
behavior that accounts for the reactions of others.
4.
Illustrating the
Idea: Creative Strategic Behavior
Strategic behavior can come in the form of pricing decisions,
product differentiation, or through creative marketing (creating
perceived product differences).
It can apply to either competitive or collusive behavior
(including cheating on collusive agreements).
B.
Barriers to entry
1.
Economies of scale may exist due to technology and market
share.
2.
The capital investment requirement may be very large.
3.
Other barriers to entry may exist, such as patents, control
of raw materials, preemptive and retaliatory pricing, substantial
advertising budgets, and traditional brand loyalty.
C.
Although some firms have become dominant as a result of
internal growth, others have gained this dominance through mergers.
(Section 7 of the Clayton Act prohibits mergers that “substantially”
lessen competition.
V.
Oligopoly Behavior:
A Game Theory Overview
A.
Oligopoly behavior is similar to a game of strategy, such as poker,
chess, or bridge. Each
player’s action is interdependent with other players’ actions.
Game theory can be applied to analyze oligopoly behavior.
A two-firm model or duopoly will be used.
B.
Figure 9.3 illustrates the profit payoffs for firms in a
duopoly in an imaginary athletic-shoe industry.
Pricing strategies are classified as high-priced or
low-priced, and the profits in each case will depend on the rival’s
pricing strategy.
C.
Mutual interdependence is demonstrated by the following:
RareAir’s best strategy is to have a low-price strategy if
Uptown follows a high-price strategy.
However, Uptown will not remain there, because it is better
for Uptown to follow a low-price strategy when RareAir has a
low-price strategy.
Each possibility points to the interdependence of the two firms.
This is a major characteristic of oligopoly.
D.
Another conclusion is that oligopoly can lead to collusive behavior.
In the athletic-shoe example, both firms could improve their
positions if they agreed to both adopt a high-price strategy.
However, such an agreement is collusion and is a violation of
U.S.
anti-trust laws.
E.
If collusion does exist, formally or informally, there is
much incentive on the part of both parties to cheat and secretly
break the agreement.
For example, if RareAir can get Uptown to agree to a high-price
strategy, then RareAir can sneak in a low-price strategy and
increase its profit
VI.
Three oligopoly models are used to explain oligopolistic
price-output behavior.
(There is no single model that can portray this market structure due
to the wide diversity of oligopolistic situations and mutual
interdependence that makes predictions about pricing and output
quantity precarious.)
A.
The kinked-demand model assumes a noncollusive oligopoly.
(Figure 9.4)
1.
The individual firms believe that rivals will match any price
cuts. Therefore, each
firm views its demand as inelastic for price cuts, which means they
will not want to lower prices since total revenue falls when demand
is inelastic and prices are lowered.
2.
With regard to raising prices, there is no reason to believe
that rivals will follow suit because they may increase their market
shares by not raising prices.
Thus, without any prior knowledge of rivals’ plans, a firm
will expect that demand will be elastic when it increases price.
From the total-revenue test, we know that raising prices when
demand is elastic will decrease revenue.
Therefore, the noncolluding firm will not want to raise
prices.
3.
This analysis is one explanation of the fact that prices tend
to be inflexible in oligopolistic industries.
B.
Price leadership is a type of gentleman’s agreement that
allows oligopolists to coordinate their prices legally; no formal
agreements or clandestine meetings are involved.
The practice has evolved whereby one firm, usually the
largest, changes the price first and, then, the other firms follow.
1.
Several price leadership tactics are practiced by the leading
firm.
a.
Prices are changed only when cost and demand conditions have
been altered significantly and industry-wide.
b.
Impending price adjustments are often communicated through
publications, speeches, and so forth.
Publicizing the “need to raise prices” elicits a consensus
among rivals.
c.
Leaders try to avoid price wars that reduce profits.
However, leaders may sometimes reduce price below the
short-run profit-maximizing level to discourage new entrants.
2.
Applying the
Analysis: Challenges to
Price Leadership
a. Price
leadership in oligopoly occasionally breaks down and sometimes
results in a
price war. A
recent example occurred in the breakfast cereal industry in which
Kellogg had been the traditional price leader, but General Mills and
Post were attempting to gain market share.
b. In 2002,
Burger King and McDonald’s engaged in a price war between the
Whoppers and Big “N” Tasty burger.
c. Price
wars eventually end when firms realize that they can increase
profits by
reverting to price leadership.
C.
Cartels and collusion agreements constitute another oligopoly
model. (Figure 9.5)
1.
Game theory suggests that collusion is beneficial to the
participating firms.
2.
Collusion reduces uncertainty, increases profits, and may
prohibit the entry of new rivals.
3.
A cartel may reduce the chance of a price war breaking out
particularly during a general business recession.
4.
The kinked-demand curve’s tendency toward rigid prices may
adversely affect profits if general inflationary pressures increase
costs.
5.
To maximize profits jointly, the firms collude and agree to a
certain price. Assuming
the firms have identical cost, demand, and marginal-revenue date the
result of collusion is as if the firms made up a single monopoly
firm.
6.
Applying the
Analysis: Cartels and Collusion
a. A cartel
is a group of producers that creates a formal written agreement
specifying
how much each member will produce and charge.
The Organization of Petroleum
Exporting Countries (OPEC) is the most significant
international cartel.
b. Cartels
are illegal in the U.S., thus any
collusion that exists is covert and secret.
Examples of these illegal, covert agreements include the 1993
collusion between
dairy companies convicted of rigging bids for milk products
sold to schools and, in 1996, American agribusiness Archer Daniels
Midland, three Japanese firms, and a
South Korean firm were found to have conspired to fix the
worldwide price and sales
volume of a livestock feed additive.
7.
There are many obstacles to collusion:
a.
Differing demand and cost conditions among firms in the
industry;
b.
A large number of firms in the industry;
c.
The incentive to cheat;
d.
Recession and declining demand (increasing ATC);
e.
The attraction of potential entry of new firms if prices are
too high; and
VII.
Oligopoly and Advertising
A.
Product development and advertising campaigns are more difficult to
combat and match than lower prices.
B.
Oligopolists have substantial financial resources with which
to support advertising and product development.
C.
Table 9.1 lists the 10 leading
U.S.
advertisers in 2003.
D.
Advertising can affect prices, competition, and efficiency both
positively and negatively.
1.
Advertising reduces a buyers’ search time and minimizes these
costs.
2.
By providing information about competing goods, advertising
diminishes monopoly power, resulting in greater economic efficiency.
3.
By facilitating the introduction of new products, advertising
speeds up technological progress.
4.
If advertising is successful in boosting demand, increased
output may reduce long run average total cost, enabling firms to
enjoy economies of scale.
5.
Not all effects of advertising are positive.
a.
Much advertising is designed to manipulate rather than inform
buyers.
b.
When advertising either leads to increased monopoly power, or
is self-canceling, economic inefficiency results.
6.
Global Snapshot: The World’s
Top 10 Brand Names
VIII.
Oligopoly and Efficiency
A.
Allocative and productive efficiency are not realized because price
will exceed marginal cost and, therefore, output will be less than
minimum average-cost output level (Figure 9.5).
Informal collusion among
oligopolists may lead to
price and output decisions that are similar to that of a pure
monopolist while appearing to involve some competition.
B.
The economic inefficiency may be lessened because:
1.
Foreign competition has made many oligopolistic industries
much more competitive when viewed on a global scale.
2.
Oligopolistic firms may keep prices lower in the short run to
deter entry of new firms.
3.
Over time, oligopolistic industries may foster more rapid
product development and greater improvement of production techniques
than would be possible if they were purely competitive.
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