Chapter 12 Monopolistic Competition
Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. This chapter examines the first of two market structures that fall between the extremes, monopolistic competition. This market type contains a considerable amount of competition mixed with a small dose of monopoly power. First, monopolistic competition is defined, listing important characteristics, typical examples, and efficiency outcomes. The Last Word shows how increases in the minimum wage are putting mom and pop restaurants out of business while having little affect on the big chain restaurant.
Monopolistic Competition
In monopolistic competition, firms can differentiate their products by the product attributes, by service, with location, or with brand names and packaging. There is relatively easy entry and exit, just not as easy as with perfect competition. That is why the number of sellers is not as large as in perfect competition, but it is still relatively large. This type of market experiences some pricing power due to the differentiated product. If a firm goes to the trouble and expense of differentiating their product, they should let people know about it. They can do this through advertising and attain greater pricing power. Product differentiation and advertising are ways that firms can compete other than by offering the lowest price.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition
Four-firm concentration ratios are a measure of industry concentration. Four-firm concentration ratios are low in monopolistically competitive firms as in the table on the next slide. One of the cautions of using these is that they reflect national output (sales numbers) and would not be reflective of a localized monopoly. Herfindahl index: The lower the HI, the more competitive the industry. The Herfindahl Index is another measure of industry concentration, and it is the sum of the squared percentage of market shares of all firms in the industry. Generally speaking, the lower the Herfindahl, the lower the industry concentration.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition
Check Your Understanding
There are 10 firms in an industry, and each firm has a market share of 10 percent. The industry's Herfindahl index is ______?____________.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition > Chapter 12 Exercises
Price and Output in Monopolistic Competition
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.
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 a later slide, and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of relatively free entry and exit into and out of the industry.
A Monopolistically Competitive Firm: Short Run Profits
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Firms produce the quantity where MR = MC just like in other industries. It is possible to make a profit in the short run. (Price - ATC) * Q = Economic profit. At the profit maximizing output, price is higher than ATC, and the firms enjoy an economic profit in the short run.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition
A Monopolistically Competitive Firm: Long Run Equilibrium
In the long run, firms still produce the quantity where MR = MC. In the long run, firms will enter the industry if economic profits were enjoyed, shifting demand left and causing profits to fall. In the long run, firms will exit the industry if there are economic losses, shifting demand to the right and causing losses to shrink. This will continue until the price settles where it equals ATC at the MR = MC output. At this price, the monopolistically competitive firm earns a normal profit, and long run equilibrium is established.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition
Monopolistic Competition and Efficiency
We can see the inefficiency of monopolistic competition. In long-run equilibrium, a monopolistic competitor achieves neither productive nor allocative efficiency. Productive efficiency is not realized because production occurs where the average total cost (A3) exceeds the minimum average total cost (A4). Allocative efficiency is not achieved because the product price (P3) exceeds the marginal cost. There is an underallocation of resources as well as an efficiency loss and excess production capacity for every firm in the industry. This firm’s excess production capacity is Q4 - Q3.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition
True or False
"Competition in quality and service may be just as effective as price competition in giving buyers more for their money."
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition > Chapter 12 Exercises
Product Variety
Monopolistically competitive producers may be able to postpone the long-run outcome of just normal profits through product development, improvement, and advertising. Compared with pure competition, this suggests possible advantages for the consumer. Development, or improved products, can provide the consumer with diversity of choices. The product variety that is found in monopolistic competition helps compensate for its failure to achieve economic efficiency. Consumers have a wider array of products to choose from and, presumably, they have better quality products to choose from as well.
Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater the number of choices the consumer has, the greater the excess capacity problem.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 12 - Monopolistic Competition
Chapter 13 Oligopoly and Strategic Behavior
Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. In this chapter, oligopoly, one of the two market structures that fall between the extremes is discussed. Oligopoly is a blend of greater monopoly power and less competition than we find in monopolistic competition. Oligopoly is examined on possible choices of price, output, and advertising behavior that oligopolistic industries might follow. Then, oligopoly is assessed as to whether it is an efficient or inefficient market structure. The Last Word shows how a few big companies now compete with one another via the Internet as very competitive oligopolists.
Oligopoly
The entry barriers in oligopoly are not as great as in monopoly, thus we have a few producers. There are homogeneous or standardized oligopolies like the steel and aluminum markets. There are also differentiated oligopolies like the markets for automobiles, electronics equipment, and breakfast cereals. Control over price is limited because there are just a few sellers in the market and rivals may respond in a way that would be detrimental to the firm that just changed the price. So, firms use strategic pricing behavior which is how a firm’s decisions are based on the actions and reactions of rivals.
Mutual interdependence exists when each firm’s profit depends on its own pricing strategy and that of its rivals.
Entry barriers are more substantial than in monopolistic competition which is why there are just a few producers in the market. Although some firms have become dominant as a result of internal growth, others have gained dominance through mergers.
Oligopoly and Cartel Market
A cartel is defined as a group of firms or nations joining together and formally agreeing as to the price they will charge and the output levels of each member. Cartels are illegal in the US; however, business with the OPEC cartel is conducted every day. In the past, OPEC has been successful in increasing the price of the oil they sell by restricting supply.
Natural resources are classified as renewable resources and non-renewable resources. Petroleum or crude oil is a fossil fuel first discovered in the United States of America before discoveries occurred in the African, Asian and South American continents. The Organization of the Petroleum Exporting Countries (or OPEC)was formed as a cartel of thirteen countries to regulate the supply of petroleum sold in old markets worldwide. Refined petroleum has a variety of uses overtime that humans have become heavily dependent on. Examples include gasoline, kerosene, and diesel used in the transportation sector. However, it is a non-renewable resource with supply expected to be depleted in the next fifty years, and it is also known to be a big contributor to pollution affecting the global climate. While oil industrialists and lobbyists are pushing to open more restricted areas for oil exploration (e.g. the Arctic), developed countries are pushing for Green New Deals to help reduce the heavy reliance on petroleum to combat the widespread environmental concerns being felt worldwide. Examples include Euro pushing for electric vehicles by 2035 and Biden seeks to make half of new U.S. auto fleet electric by 2030.
Source: https://econeveryday.com/modern-history-of-oil/
Discussion:
By 2035, do you see yourself driving a gas-emitting vehicle or an electric vehicle or a hybrid? Explain your choice.
Oligopoly Behavior
Game theory is the study of how people behave in strategic situations. The Prisoner’s dilemma is a classic example of mutual interdependence and game theory.
Collusion is defined as cooperating with rivals and can benefit the firm. There is an incentive for firms to cheat on their agreement to collude because cheating can result in increased revenues for the cheater.
This graph is a payoff matrix for a two-firm oligopoly and is used to show the payoff to each firm that would result from each combination of strategies. Each firm has two possible pricing strategies. RareAir’s strategies are shown in the top margin, and Uptown’s in the left margin. Each lettered cell of this four-cell payoff matrix represents one combination of a RareAir strategy and an Uptown strategy and shows the profit that combination would earn for each. See next slide.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 13 - Oligopoly and Strategic Behavior
Assuming no collusion, the outcome of this game is cell D, with both parties using low price strategies and earning $8 million in profits. However, this inferior profit level will eventually lead firms to higher prices.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 13 - Oligopoly and Strategic Behavior
Example: Uber
If you were a consumer of Uber and/or Yellow Taxi service, would you be riding more Uber cabs, or riding more Yellow Taxis, or whichever responded to your App request the fastest?
Discussion:
Read the hypothetical Game Theory scenario from Cornell University, which of the following options do you think will work towards an equitable payment/earning structure for the drivers of Uber and Yellow Taxis: More collaboration (or collusive oligopoly) with respect to setting the same fare by both Uber and Yellow Taxi to deter other ride hailing/cab companies from entering the industry, OR More fare cutting with respect to Uber and Yellow Taxi each offering lower fares to lure consumers to their respective services i.e., fighting for monopoly power?
Source: https://econeveryday.com/a-partnership-in-new-york-city-uber-joining-hands-with-yellow-taxi/
A One-Time Game: Equilibrium
A Nash equilibrium is an outcome from which neither firm wants to deviate. And is described as where rivals see their respective current strategy as the optimal choice, given the other firm’s strategy, and is the only outcome that is considered stable and that will persist. If the outcome is not at the Nash equilibrium, then the firms will continue to modify their strategies until they reach the Nash equilibrium.
Kinked-Demand Theory
The kinked-demand model is used for non-collusive oligopolies to explain their behaviors and pricing strategies. Since the firms do not collude, none of the firms know with certainty what their rivals are going to do. However, the firms assume that their rivals will match any price reductions in an effort to maintain their customers. On the other hand, it is reasonable to assume that if a firm raises its price, its rivals will ignore the price change in an effort to steal customers from the firm raising its price.
This graph shows the kinked-demand curve. (a) The slope of a noncollusive oligopolist’s demand and marginal-revenue curves depends on whether its rivals match (straight lines D1 and MR1) or ignore (straight lines D2 and MR2) any price changes that it may initiate from the current price P0. (b) In all likelihood an oligopolist’s rivals will ignore a price increase but follow a price cut. This causes the oligopolist’s demand curve to be kinked (D2eD1) and the marginal-revenue curve to have a vertical break, or gap (fg). Because any shift in marginal costs between MC1 and MC2 will cut the vertical (dashed) segment of the marginal-revenue curve, no change in either price, P0, or output, Q0, will result from such a shift. In other words, competitors and rivals strategize against each other, consumers effectively have 2 partial demand curves and each part has its own marginal revenue resulting in a kinked-demand curve to the consumer; price and output are optimized at the kink.
Source: Economics (McConnell, 23e, ISBN 126528797x) > Chapter 13 - Oligopoly and Strategic Behavior
There are a few criticisms of the kinked-demand theory. First, the demand curve was created around the current price that was already being charged, but it never actually explained how the current price was determined. This is very similar to putting the cart before the horse. We have seen that prices are rigid for reasons on the demand and cost side, but prices in oligopolies are not nearly as rigid as this model implies. And, there is always a chance that changing prices could result in a price war.
Check Your Understanding
The following graph refers to a situation wherein an oligopolistic firm faces a kinked demand curve. An oligopoly firm might face this kinked demand curve if _?__
a. the oligopoly is adopting a price skimming strategy.
b. the oligopoly is acting as a firm in a monopolistic competition.
c. the oligopoly is adopting a price matching strategy: match a competitor price decrease and do not respond to a price increase.
Collusion
An agreement among firms to charge the same price or otherwise not to compete.
Price leadership
A practice where one firm initiates a price change and all other firms more or less automatically follow the leader.
Oligopoly and Efficiency
Recall that productive efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Neither efficiencies occur in oligopolistic markets. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have the financial means to invest in new technologies.
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