Monopolistic Competition and Oligopoly

Monopolistic Competition and Oligopoly

  • Markets are neither perfectly competitive nor monopolies.
  • Firms compete in market structures between these extremes.

Introduction to Monopolistic Competition and Oligopoly

  • Monopolistic Competition: Many firms compete, but products aren't identical.
    • Example: Retail clothing stores in a mall.
  • Oligopoly: Dominated by a small number of firms.
    • Examples: Commercial aircraft (Boeing and Airbus), U.S. soft drink industry (Coca-Cola and Pepsi).
  • Oligopolies have high barriers to entry.
  • Firms strategically decide output, pricing based on other firms' actions.
  • Oligopolies can exhibit traits of monopolies or perfect competition.
  • Firms face a dilemma: collaborate like a monopoly or compete individually.

10.1 | Monopolistic Competition

  • Monopolistic competition involves many firms selling differentiated products.
  • Examples: Clothing styles, restaurants, grocery stores and even golf balls or beer.
  • Firms have a mini-monopoly on their specific style, flavor, or brand.
  • They also face competition from other styles, flavors, and brands.
Differentiated Products
  • Firms differentiate products through:
    • Physical aspects
    • Location
    • Intangible aspects
    • Perceptions
  • Physical Aspects: Features advertised (e.g., unbreakable bottle, non-stick surface).
  • Location: A gas station at a busy intersection has an advantage.
  • Intangible Aspects: Guarantees, reputation, services (free delivery), or financing.
  • Perceptions: Shaped by advertising and habits (e.g., brand preferences in beer or cigarettes).
  • Product differentiation relates to variety.
  • More variety leads to more product differentiation and monopolistic competition.
Perceived Demand for a Monopolistic Competitor
  • Demand is between monopoly and competition.
  • Perfectly competitive firm: perfectly elastic (flat) demand curve.
  • Monopoly: downward-sloping market demand curve.
  • Monopolistic competitor: downward-sloping demand curve, more elastic than a monopoly.
  • Monopolistic competitors can raise prices without losing all customers or lower prices to gain customers.
  • Demand curve is one of many that make up the "before" market demand curve
Are golf balls really differentiated products?
  • Golf balls must meet USGA standards (weight, diameter, distance).
    • Weight cannot exceed 1.620 ounces ( 45.93 grams).
    • Diameter cannot be less than 1.680 inches ( 42.67 millimeters).
    • Distance limit is 317 yards.
  • Balls differ in dimple pattern, plastic types, etc.
  • Retail sales are about 500 million per year.
  • Manufacturers try to convince players that golf balls are highly differentiated.
  • For average players, most golf balls are indistinguishable.
How a Monopolistic Competitor Chooses Price and Quantity

  • Similar to a monopolist, but with competition.

  • Firm faces a downward-sloping demand curve.

  • Example: Authentic Chinese Pizza store offering differentiated pizza.

  • Step 1: Determine the profit-maximizing level of output where Marginal Revenue (MR) = Marginal Cost (MC).

    • Produce more if MR > MC. Stop when MR = MC.
    • Reduce production if MC > MR. Stop when MR = MC.

  • Step 2: Decide what price to charge based on the demand curve for the chosen quantity.

  • Calculate Total Revenue, Total Cost, and Profit.

    • Profit = Total\ Revenue - Total\ Cost

  • Two key differences from a monopolist:

    1. Demand curve is based on product differentiation and number of competitors.
    2. New firms can enter the market with similar products.
Monopolistic Competitors and Entry

  • If firms earn positive economic profits, new firms enter the market.

  • Entry shifts the firm’s demand curve and marginal revenue curve to the left.

  • Profit-maximizing quantity decreases as MR = MC at a lower quantity.

  • Long-run equilibrium occurs when the demand curve touches the average cost curve (zero economic profits).

  • Zero economic profit means accounting profit equals what resources could earn elsewhere.

  • In the short run, monopolistic competitors can make a profit or loss and in the long run there is a zero economic profit outcome.

Monopolistic Competition and Efficiency

Entry/exit leads to:

  • Perfect competition: firms sell at the lowest point on the average cost curve (productive efficiency).
  • Monopolistic competition: price lies on the downward-sloping portion of the average cost curve, not at the bottom and isn't productively efficient.
  • Perfect competition: price = marginal cost (allocative efficiency).
  • Monopolistic competition: price > marginal revenue, so price > marginal cost and isn't allocatively efficient.
  • Monopolistic competition: lower quantity, higher price compared to perfect competition.
The Benefits of Variety and Product Differentiation
  • Monopolistic competition offers variety and innovation.
  • Consumers benefit from diverse choices and firms seeking to attract customers.
  • Critics argue that high product differentiation costs are socially wasteful.
  • Defenders argue consumers aren't forced to buy differentiated products and benefit from them.
How does advertising impact monopolistic competition?
  • Advertising aims to differentiate products.
  • Advertising can make demand more inelastic or increase demand.
  • Successful campaigns increase quantity sold, price, and profits.
  • However, advertising may simply offset other advertising.

10.2 | Oligopoly

  • Oligopoly: Few large firms dominate an industry.
    • Examples: Auto industry, cable television, commercial air travel.
  • Oligopolistic firms can compete or collude.
    • Hard competition leads to perfect competitor behavior and zero profits.
    • Collusion leads to acting like a monopoly with high prices and profits.
  • Firms are mutually interdependent and decisions depend on the decisions of other firm(s).
Why Do Oligopolies Exist?
  • Combination of barriers to entry (monopolies) and product differentiation (monopolistic competition).
  • Patents granted to a few firms (e.g., pharmaceutical companies).
  • Natural monopoly: Only one firm can operate at minimum long-run average cost.
  • Economies of scale and market demand limit the number of firms.
    • Example Boeing-Airbus oligopoly for large passenger aircraft
  • Product differentiation requires large advertising and marketing spending.
    • Difficult to compete with established brands like Coca-Cola or Pepsi.
Collusion or Competition?
  • Oligopolies tempted to act like a monopoly.
  • Collusion: Firms act together to reduce output and raise prices.
  • Cartel: Formal agreement to collude e.g., to produce the monopoly output and restrict sales at the monopoly price.
Collusion versus cartels: How can I tell which is which?
  • Collusion is illegal in the U.S. and other countries.
  • Cartels are formal (and rare) agreements to collude.
  • Most collusion is tacit (implicit understanding).
  • Firms may produce slightly more, counting on others to hold down production.
  • Fierce competition can result in zero economic profits.
The Prisoner’s Dilemma
  • Game theory analyzes decisions and payoffs.
  • Prisoner's Dilemma: Cooperation yields greater gains than self-interest.
Oligopoly Version
  • Oligopolists face a prisoner’s dilemma.
  • Cooperation (holding down output) leads to high profits.
  • Each firm tempted to increase output for higher profits.
  • Table 10.3 shows the prisoner’s dilemma for a duopoly.
    If both cooperate, high profits for each.
    If one cheats, the cheater gains more profit.
    If both cheat, profits are lower for each.
  • Result: Firms end up increasing output, earning lower profits.
What is the Lysine cartel?
  • Lysine cartel: Archer Daniels Midland (ADM) and other firms fixed prices.
  • Executives agreed on sales volume and prices.
  • FBI recorded conversations, leading to convictions.
  • Price of lysine doubled during the cartel's operation.
  • ADM slogan: "Our competitors are our friends. Our customers are the enemy."
How to Enforce Cooperation

  • Penalize those who don't cooperate.

  • Contracts are illegal for U.S. companies.

  • OPEC (Organization of Petroleum Exporting Countries) has international agreements.

  • Agreements are not legally enforceable (gray area of international law).

  • Firms keep tabs on each other's production/pricing.

  • Kinked Demand Curve: Firms match price cuts but not price increases.

  • Discourages price changes since gains are minimal.

  • Acts as a silent form of cooperation.

  • Real-world oligopolies experience cooperation and competition.

Tradeoffs of Imperfect Competition
  • Monopolistic competition common in the U.S. economy.
  • Incentives for innovation but no long-run economic profits.
  • Firms don't produce at the lowest point on average cost curves.
  • Excessive advertising and marketing spending.
  • Oligopoly common.
  • Benefits from patented innovations and economies of scale.
  • Barriers to entry allow long-term profits.
  • Lack of competition may reduce innovation and service quality.
  • Public policy aims to encourage beneficial behavior and discourage harmful behavior.
The Temptation to Defy the Law
  • Oligopolistic firms are called “cats in a bag.”
  • French detergent firms colluded but price wars broke out.
  • Soap cartel disintegrated due to individual profit maximization.
  • Authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble €361 million (484 million).
  • Icemakers carved up the market, controlling territory and setting prices.
  • Fines totaled about 600,000.
  • Temptation to earn higher profits leads to defying the law.