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.