Monopolistic Competition and Oligopoly

• Chapter 16: Monopolistic Competition
  • 16-1: Between Monopoly and Perfect Competition
  • 16-2: Competition with Differentiated Products
  • 16-3: Advertising
• Chapter 17: Oligopoly
  • 17-1: Markets with Only a Few Sellers
  • 17-2: The Economics of Cooperation
  • 17-3: Public Policy toward Oligopolies

Chapter 16: Monopolistic Competition

16-1: Between Monopoly and Perfect Competition

• Monopoly and perfect competition are two extremes; most markets fall in the middle under imperfect competition
• An oligopoly is a market with a few sellers that offer relaitively similar products offered by other sellers
  • Oligopolies can be measured using a concentration ratio, or the percent supplied by the four largest firms in a market
  • Higher concentration ratios = better described as oligopolies
• Monopolistic competition refers to markets with many firms selling similar but not identical products
  • Contains three main attributes
    • Many sellers - there are many firms selling to the same group of customers
    • Product differentiation - each firm produces a product that is unique to other firms, so each firm is not a price taker
    • Free entry and exit - firms can enter and exit the market, so the number of firms adjusts until economic profit equals zero
• Graphic showing the differences between the types of markets:

16-2: Competition with Differentiated Products

The Monopolistically Competitive Firm in the Short Run

• Each firm in a monopolistically competitive market can be treated like a monopoly; they face downward-sloping demand curves and produce the quantity at which the marginal revenue equals marignal cost
• Graphs showing the curves for two monopolitically competitive firms:

The Long-Run Equilibrium

• The situations depicted in the above graphs don’t last long, as firms making a profit encourages new firms to enter while firms taking a loss encourages firms to exit
  • Less firms = higher price and vice versa
• Firms in the market eventually reach an equilibrium where they are making zero economic profit
  • Graph showing the curves of a long-run monopolistically competitive firm:
  • Note that the demand curve is tangent to the average total cost curve at the profit-maximizing quantity
• Monopolistically competitive markets share some traits with monopolies and perfect competition
  • As in a monopoly, price exceeds marginal cost. This is because the profit-maximizing point is when marginal revenue equals marginal cost and the marginal revenue must be lower the price due to the downward-sloping demand curve
  • As in a competitive market, price equals average total cost due to the free entry and exit of firms

Monopolistic versus Perfect Competition

• Graphs showing the differences between a monopolistic competitive and a perfect competitive firm:

• Two main differences: Excess Capacity and Markup

Excess Capacity

• The slope of the demand curve is negative and the price that monopolistically competitive firms offer is when the demand curve is tangent to the average total cost curve
  • This means that firms produce less than the quantity at the efficient scale, as the efficient scale has a slope of zero
  • The difference between this lower quantity and the efficient scale quantity is known as the excess capacity, as perfectly competitive firms could produce more and lower the total average cost
  • Monopolistically competitive firms cannot produce more, as it lowers the price too much

Markup over Marginal Cost

• Price is higher than marginal cost because a monopolistically competitive firm has market power, but they don’t make profit because they are operating below their efficient scale
• Monopolistically competitive firms want more customers because that means they receive more profit (price is greater than marginal cost) while perfectly competitive firms don’t care (price is equal to marginal cost)

Monopolistic Competition and the Welfare of Society

• One source of inefficiency is the markup; some customers value a good more than the marginal cost but less than its marked up price
  • Hard to fix this issue, as legislation would need to target all firms that create different products
  • Additionally, if you remove markup, firms are forced to operate at a loss
• Another source of inefficiency is that the number of firms may be inefficient because the entry of a firm has external effects
  • The product-variety externality: Consumers get consumer surplus because there is more variety in the market
  • The business-stealing externality: Other firms in the market get a lower market share, thus lowering producer surplus
  • Based on these externalities and their magnitude, a market may have too many or too few firms
• Though there are inefficiencies associated with monopolistic competition, they are difficult to fix and improve upon

16-3: Advertising

The Debate over Advertising

• Critics argue that advertising is more psychological than informational, and advertising impedes competition by exaggerating the differences in products, thus creating a more inelastic demand curve to profit off of
• Defenders argue that advertising is a way to provide information to customers, making them more privy to their options
  • It can also enhance competition because new firms can more easily enter and customers are more informed

Advertising as a Signal of Quality

• If a firm has a bad product, then they won’t spend money on advertising because consumers won’t repurchase their product after trying it
• If a firm has a good product, then they will spend money on advertising because it establishes a customer base who repeatedly purchases their product
• Therefore, advertising can serve as a way to show customers which products are good and which are bad

Brand Names

• Some argue that brand names are detrimental because it accentuates unnoticeable differences between products
• Defenders argue that brand names provide information about the quality of a product and encourage prestigous companies to maintain the quality of said product

Chapter 17: Oligopoly

• A market with few sellers that sell identical (or similar) products is called an oligolpoly
• Because there are few sellers, each firm must use game theory to cooperate and determine how much of a product they should produce

17-1: Markets with Only a Few Sellers

A Duopoly Example

• Picture a town with two water sellers
  • Both sellers incur no marginal cost to produce another gallon of water, and the demand curve of water is downward-sloping
• The demand schedule of water for the town:

Competition, Monopolies, and Cartels

• Let’s suppose that the sellers are in a perfectly copmetitive market
  • The price would equal the marginal cost, so the price would be zero because the marginal cost is zero
  • The equilibrium quantity would be 120 gallons
• Let’s suppose that a monopoly owns the water
  • The highest profit is when the monopoly sells 60 gallons of water at $60 each
  • This result is inefficient because the monopoly produces below the efficient quantity of water
• The best decision for the duopolists is to produce at the profit maximizing quantity
  • If the sellers agree to sell 30 gallons each, this agreement is called collusion and the sellers working together are called a cartel
  • Cartels essentially act as monopolies

The Equilibrium for an Oligopoly

• Oligopolists would like to act as a cartel, but self-interest often overrides and lowers profit
• Assuming that the two water sellers start at the profit maximizing quantity, one water seller might be inclined to sell more water in order to increase their profit
  • Currently, each makes $1,800, but if one seller increases production to 40 gallons, then the price falls to $50, thus netting a profit of $2,000
• If both sellers think this way, then the total quantity of water would be 80 gallons and the price of water would be $40
• The sellers would refuse to sell more because they lose profit instead
  • Raising production to 50 gallons lowers the price to $30, meaning that the new profit is $1,500 instead of $1,600
• The outcome of 40 gallons is called the Nash equilibrium, or the point at which both firms choose the best strategy based on actions and strategies of the other firm
• Self-interest means that firms produce more than a monopoly would but less than perfectly competitive firms would
• To summarize: when firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced under perfect competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

How the Size of an Oligopoly Affects the Market Outcome

• Assume that the two water sellers grows to four, and each seller must decide on a new quantity to produce
• The decision made will be based on two effects
  • The output effect: Because price is above marginal cost, selling another gallon of water at the current price will increase profit
  • The price effect: Raising production increases the quantity sold and lowers the price of water
• The oligopolists will continue/stop producing water until the price effect and output effect balance each other out, unable to affect the other firms’ production
• The more firms in the market, the less of an impact a firm can have on the market price
  • Thus, as the number of sellers in an oligopoly grows, the more perfectly competitive the market becomes. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

17-2: The Economics of Cooperation

The Prisoners’ Dilemma

• Two convicts are given the option to either confess or stay silent
  • Payoff matrix showing the different outcomes based on confessing or staying silent:
• Regardless of the actions of the other person, the convict should always confess, as confessing will always net them a benefit (20 years vs. 8 years and 1 year vs. 0 years)
  • This strategy is a dominant strategy because it is the best strategy regardless of the actions of the other player
• Both prisoners thus confess, resulting in a Nash equilibrium where they both spend 8 years in prison
  • Worse than the optimal solution, but better than the worst case scenario

Oligopolies as a Prisoners’ Dilemma

• A payoff matrix can also be drawn for the situation of the water sellers:
• Suppose that both firms decide on a starting point of 30 gallons and have the option to either stay at 30 gallons or increase to 40 gallons
  • The situation resembles the Prisoners’ Dilemma: the dominant strategy is to raise production to 40 gallons, as it always increases profit regardless of the actions of the other firm

Other Examples of the Prisoners’ Dilemma

• Arms Races - The US and USSR both decided to stockpile weapons because it was the dominant strategy
  • Payoff matrix:
• Common Resources - Two oil companies should build more drills on shared land because it ensures the most amount of profit
  • Payoff matrix:

The Prisoners’ Dilemma and the Welfare of Society

• The equilibrium derived from the Prisoners’ Dilemma can be detrimental to society
  • The arms race caused both countries to be in danger while the abundance of drills produced less oil in the long run
• Oligopolists’ lack of cooperation in maintaining monopoly-level production is a good thing, as it means that the quantity produced is closer to the socially efficient outcome

Why People Sometimes Cooperate

• The prisoners’ dilemma situation can be won if the game is repeated over and over again
  • Suppose that the two water sellers can set their production every week
  • If they only could set it once, then they would both produce 40 gallons, as it is the dominant strategy
  • If they repeated the situation over weeks, then they would realize that producing 30 gallons is more profitable and agree to doing so
    • This requires a caveat; if the agreement is broken, then the other firm will retaliate by producing 40 gallons
  • $1,800 > $1,500, so in the long run, the firms will reach an agreement and maximize profits

17-3: Public Policy toward Oligopolies

Restraint of Trade and the Antitrust Laws

• Though contracts are typically good for an economy, a contract between competitors that makes a market less competitive has been outlawed over centuries
  • Take the Sherman and Clayton Antitrust Acts which prohibit the “restraint of trade” that increases profits for firms
  • The Justice Department and private parties can sue and enforce these antitrust laws to prevent firms from making markets less competitive

Controversies over Antitrust Policy

• The actions that antitrust policies can prohibit have been debated

Resale Price Maintenance

• A firm that sells a price to stores at $50 and forces them to sell it at $75 is engaging in resale price maintenance
• Theoretically, it reduces competition because the price cannot be lowered
• Defenders state that resale price maintenance isn’t meant to reduce competition, as the original firm would instead reduce the wholesale price instead of the selling price if it wanted to be more powerful
• Additionally, the markup in cost might have a legitimate goal; sellers might be required to have a showroom highlighting the quality of the firm’s product that is paid for by the markup
• This scenario highlights that business practices that appear to reduce competition may in fact have legitimate purposes

Predatory Pricing

• A big firm might try to force a smaller firm out by cutting its prices and incurring a loss to protect its market share
• Thought it could reduce competition, the big firm must lose money and produce more product at the new price (because a lower price causes a higher demand)
  • This could thus hurt the bigger firm more than the samller firm
• Hard to tell when a price cut is competitive and when a price cut is predatory

Tying

• A firm might try to sell two products together at a single price, an action called tying
• The Supreme Court banned the practice on the grounds that firms could exert more market power by selling more of its product (some of which might be undesirable)
• Economists argue that this argument is untrue; if consumers are willing to pay a high price for one product and lower price for the other, then the practice of tying means that the single price must be close to the price of the higher quality product anyways
• Tying could act as a form of price discrimination; if two consumers value the two products differently but have a similar willingness to pay for both of them, then firms could tie the products to maximize profit