CHAPTER
16
Monopolistic Competition
Economics
PRINCIPLES OF
N. Gregory Mankiw
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by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
Introduction:
Between Monopoly and Competition
Two extremes
 Perfect competition: many firms, identical
products
 Monopoly: one firm
In between these extremes: imperfect competition
 Oligopoly: only a few sellers offer similar or
identical products.
 Monopolistic competition: many firms sell
similar but not identical products. (differentiated)
MONOPOLISTIC COMPETITION
1
Characteristics & Examples
of Monopolistic Competition
Characteristics:
 Many sellers
 Product differentiation
 Free entry and exit
Examples:
 apartments
 books
 bottled water
 clothing
 fast food
 night clubs
MONOPOLISTIC COMPETITION
2
Comparing Perfect & Monop. Competition
Perfect
competition
Monopolistic
competition
number of sellers
many
many
free entry/exit
yes
yes
long-run econ. profits
zero
zero
the products firms sell
identical
differentiated
firm has market power? none, price-taker
yes
D curve facing firm
downwardsloping
MONOPOLISTIC COMPETITION
horizontal
3
Comparing Monopoly & Monop. Competition
Monopoly
Monopolistic
competition
number of sellers
one
many
free entry/exit
no
yes
long-run econ. profits
positive
zero
firm has market power?
yes
yes
D curve facing firm
downwarddownwardsloping
sloping
(market demand)
close substitutes
none
MONOPOLISTIC COMPETITION
many
4
A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve.
At each Q, MR < P.
To maximize profit,
firm produces Q
where MR = MC.
The firm uses the
D curve to set P.
MONOPOLISTIC COMPETITION
Price
profit
MC
ATC
P
ATC
D
MR
Q
Quantity
5
A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC
at the output where
MR = MC.
The best this firm
can do is to
minimize its losses.
Price
MC
losses
ATC
ATC
P
D
MR
Q
MONOPOLISTIC COMPETITION
Quantity
6
Entry and Normal Profit
Monopolistic Competition and Monopoly
 Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
 Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
 If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
 If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and prices.
MONOPOLISTIC COMPETITION
8
A Monopolistic Competitor in the Long Run
Entry and exit
occurs until
P = ATC and
profit = zero.
Price
Notice that the
P = ATC
firm charges a
markup of price
markup
over marginal cost
and does not
MC
produce at
minimum ATC.
MONOPOLISTIC COMPETITION
MC
ATC
D
MR
Q
Quantity
9
Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1.
 The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
 Under perfect competition, firms produce the
quantity that minimizes ATC.
2.
 Under monopolistic competition, P > MC.
 Under perfect competition, P = MC.
MONOPOLISTIC COMPETITION
10
Monopolistic Competition and Welfare
 Monopolistically competitive markets do not
have all the desirable welfare properties of
perfectly competitive markets.
 Because P > MC, the market quantity is below
the socially efficient quantity.
 Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
to reduce prices.
MONOPOLISTIC COMPETITION
11
ACTIVE LEARNING
1
Advertising
1. So far, we have studied three market
structures: perfect competition, monopoly, and
monopolistic competition. In each of these,
would you expect to see firms spending money
to advertise their products? Why or why not?
2. Is advertising good or bad from society’s
viewpoint? Try to think of at least one “pro”
and “con.”
12
Advertising
 In monopolistically competitive industries,
product differentiation and markup pricing
lead naturally to the use of advertising.
 In general, the more differentiated the products,
the more advertising firms buy.
MONOPOLISTIC COMPETITION
13
Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts
on advertising may signal the quality of its product
to consumers, regardless of the content of ads.
 Ads may convince buyers to try a product once,
but the product must be of high quality for people
to become repeat buyers.
MONOPOLISTIC COMPETITION
14
Advertising as a Signal of Quality
 The most expensive ads are not worthwhile
unless they lead to repeat buyers.
 When consumers see expensive ads,
they think the product must be good if the
company
is willing to spend so much on advertising.
MONOPOLISTIC COMPETITION
15
Brand Names
 In many markets, brand name products coexist
with generic ones.
 Firms with brand names usually spend more on
advertising, charge higher prices for the products.
 As with advertising, there is disagreement about
the economics of brand names…
MONOPOLISTIC COMPETITION
16
The Defense of Brand Names
 Defenders of brand names believe:
 Brand names provide information about quality
to consumers.
 Companies with brand names have incentive
to maintain quality, to protect the reputation of
their brand names.
MONOPOLISTIC COMPETITION
17
CONCLUSION
 Differentiated products are everywhere;
examples of monopolistic competition abound.
MONOPOLISTIC COMPETITION
18
CHAPTER SUMMARY
 A monopolistically competitive market has
many firms, differentiated products, and free entry.
 Each firm in a monopolistically competitive market
has excess capacity – produces less than the
quantity that minimizes ATC. Each firm charges a
price above marginal cost.
19
CHAPTER
17
Oligopoly
Economics
PRINCIPLES OF
N. Gregory Mankiw
Premium PowerPoint Slides
by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
Measuring Market Concentration
 Concentration ratio: the percentage of the
market’s total output supplied by its four largest
firms.
 The higher the concentration ratio,
the less competition.
 This chapter focuses on oligopoly,
a market structure with high concentration ratios.
OLIGOPOLY
21
Concentration Ratios in Selected U.S. Industries
Industry
Video game consoles
Tennis balls
Credit cards
Batteries
Soft drinks
Web search engines
Breakfast cereal
Cigarettes
Greeting cards
Beer
Cell phone service
Autos
Concentration ratio
100%
100%
99%
94%
93%
92%
92%
89%
88%
85%
82%
79%
Oligopoly
 Oligopoly: a market structure in which only a
few sellers offer similar or identical products.
 Strategic behavior in oligopoly:
A firm’s decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making decisions.
 Game theory: the study of how people behave
in strategic situations.
OLIGOPOLY
23
A Comparison of Market Outcomes
When firms in an oligopoly individually choose
production to maximize profit,
 oligopoly Q is greater than monopoly Q
but smaller than competitive Q.
 oligopoly P is greater than competitive P
but less than monopoly P.
OLIGOPOLY
24
Game Theory
 Game theory helps us understand oligopoly and
other situations where “players” interact and
behave strategically.
 Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
 Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial
OLIGOPOLY
25
Prisoners’ Dilemma Example
 The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
 The police question each in separate rooms,
offer each the following deal:
 If you confess and implicate your partner,
you go free.
 If you do not confess but your partner implicates
you, you get 20 years in prison.
 If you both confess, each gets 8 years in prison.
OLIGOPOLY
26
Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess
Confess
Clyde’s
decision
Bonnie gets
8 years
Clyde
gets 8 years
Bonnie goes
free
Remain
silent Clyde
gets 20 years
OLIGOPOLY
Remain silent
Bonnie gets
20 years
Clyde
goes free
Bonnie gets
1 year
Clyde
gets 1 year
27
Prisoners’ Dilemma Example
 Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.
 Both would have been better off if both remained
silent.
 But even if Bonnie and Clyde had agreed before
being caught to remain silent, the logic of selfinterest takes over and leads them to confess.
OLIGOPOLY
28
Oligopolies as a Prisoners’ Dilemma
 When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
 Our earlier example:
 T-Mobile and Verizon are duopolists in
Smalltown.
 The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
 Here is the “payoff matrix” for this example…
OLIGOPOLY
29
T-Mobile & Verizon in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
T-Mobile
Q = 30
Q = 30
Verizon
Q = 40
OLIGOPOLY
T-Mobile’s
profit = $900
Verizon’s
profit = $900
T-Mobile’s
profit = $750
Verizon’s profit
= $1000
Q = 40
T-Mobile’s
profit = $1000
Verizon’s
profit = $750
T-Mobile’s
profit = $800
Verizon’s
profit = $800
30
ACTIVE LEARNING
3
The “fare wars” game
The players: American Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone
 If both airlines cut fares,
each airline’s profit = $400 million
 If neither airline cuts fares,
each airline’s profit = $600 million
 If only one airline cuts its fares,
its profit = $800 million
the other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium.
31
ACTIVE LEARNING
3
Answers
Nash equilibrium:
both firms cut fares
American Airlines
Cut fares
$400 million
Don’t cut fares
$200 million
Cut fares
United
Airlines
$400 million
$800 million
$800 million
$600 million
Don’t cut
fares
$200 million
$600 million
32
Other Examples of the Prisoners’ Dilemma
Ad Wars
Two firms spend millions on TV ads to steal
business from each other. Each firm’s ad
cancels out the effects of the other,
and both firms’ profits fall by the cost of the ads.
Organization of Petroleum Exporting Countries
Member countries try to act like a cartel, agree to
limit oil production to boost prices & profits.
But agreements sometimes break down
when individual countries renege.
OLIGOPOLY
33
Other Examples of the Prisoners’ Dilemma
Arms race between military superpowers
Each country would be better off if both disarm,
but each has a dominant strategy of arming.
Common resources
All would be better off if everyone conserved
common resources, but each person’s dominant
strategy is overusing the resources.
OLIGOPOLY
34
Another Example: Negative Campaign Ads
 Election with two candidates, “R” and “D.”
 If R runs a negative ad attacking D,
3000 fewer people will vote for D:
1000 of these people vote for R, the rest abstain.
 If D runs a negative ad attacking R,
R loses 3000 votes, D gains 1000, 2000 abstain.
 R and D agree to refrain from running attack ads.
Will each one stick to the agreement?
OLIGOPOLY
35
Another Example: Negative Campaign Ads
Each candidate’s
dominant strategy:
run attack ads.
R’s decision
Do not run attack
ads (cooperate)
Do not run
attack ads
(cooperate)
D’s decision
Run
attack ads
(defect)
OLIGOPOLY
no votes lost
or gained
no votes
lost or gained
Run attack ads
(defect)
R gains 1000
votes
D loses
3000 votes
R loses 3000
votes
D gains
1000 votes
R loses
2000 votes
D loses
2000 votes
36
Cooperation and Cartels
 If the firms in an oligopoly cooperate, they may earn
more profits than if they act independently.
 Collusion, which leads to secret cooperative
agreements, is illegal in the U.S., although it is legal and
acceptable in many other countries.
 Price-Leadership Cartels may form in which firms
simply do whatever a single leading firm in the industry
does. This avoids strategic behavior and requires no
illegal collusion.
Cartels
 A cartel is an organization of independent firms whose
purpose is to control and limit production and maintain or
increase prices and profits.
 Like collusion, cartels are illegal in the United States.
 Conditions necessary for a cartel to be stable
(maintainable):
 There are few firms in the industry.
 There are significant barriers to entry.
 An identical product is produced.
 There are few opportunities to keep actions secret.
 There are no legal barriers to sharing agreements.
OPEC as an Example of a Cartel
 OPEC: Organization of Petroleum Exporting Countries.
 Attempts to set prices high enough to earn member
countries significant profits, but not so high as to
encourage dramatic increases in oil exploration or the
pursuit of alternative energy sources.
 Controls prices by setting production quotas for
member countries.
 Such cartels are difficult to sustain because members
have large incentives to cheat, exceeding their quotas.
The Diamond Cartel
 In 1870 huge diamond mines in South Africa flooded the gem
market with diamonds.
 Investors at the time wanted to control production and created
De Beers Consolidated Mines, Ltd., which quickly took control
of all aspects of the world diamond trade.
 The Diamond Cartel, headed by DeBeers, has been
extremely successful. While other commodities’ prices, such
as gold and silver respond to economic conditions, diamonds’
prices have increased every year since the Depression.
 This success has been achieved by DeBeers’ influence on the
supply of diamonds, but also via the cartel’s influence on
demand.
 In the 1940s DeBeers’ instigated an advertising campaign
making the diamond a symbol of status and romance.