Chapter 15
Monopolistic Competition
and Oligopoly
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What will you learn in this chapter?
• What the features of oligopoly and monopolistic competition are.
• How to calculate the short‐run and long‐run profit‐maximizing price and quantity for a monopolistically competitive firm.
• What the welfare costs of monopolistic competition are.
• How product differentiation motivates advertising and branding.
• What the strategic production decision of firms in an oligopoly is.
• Why firms in an oligopoly have an incentive to collude, and why they might fail to do so.
• How to compare the welfare of producers, consumers, and society as a whole in an oligopoly to monopoly and perfect competition.
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What sort of market?
What sort of market is the music industry?
• Dominated by four labels.
Sony
27.44%
Universal
31.61%
– None big enough to dominate the industry.
– Not a monopoly market.
• Products are not standard.
– Not a perfectly competitive market.
Warner
18.14%
EMI
10.21%
Other firms
12.61%
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• Two markets lie between the extreme models of monopoly and perfect competition.
–
–
Oligopoly.
Monopolistic competition.
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Oligopoly and monopolistic competition
• An oligopoly is a market with a few firms selling a similar good or service.
– Strategic interactions between a firm and its rivals have a major impact on its success.
• An individual firm’s price and quantity affect others’ profitability.
• No interaction in perfectly competitive or monopoly markets.
– Existence of some barrier to entry.
• These barriers to entry may be overcome, but it may be costly.
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Oligopoly and monopolistic competition
• Monopolistic competition describes a market with many firms that sell similar, but differentiated, goods and services.
– Able to earn a positive profit in the short run by selling a differentiated product.
– Offer goods that are similar to competitors’ products but more attractive in some ways.
• Firms have an interest in persuading customers that their products are unique, a practice known as product differentiation.
– This is the role of advertising and branding. © 2014 by McGraw‐Hill Education
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Monopolistic competition in the short run
• Monopolistically competitive firms behave like a monopolist in the short run.
– Downward‐sloping demand curve.
– U‐shaped ATC curve.
Price ($)
Consumer surplus
Producer surplus
Profit/producer surplus
Deadweight loss
MC
ATC
4.70
3
• Produce where MR = MC.
• Charge corresponding price on demand curve. • Firm earns profits by extracting consumer surplus.
• Create deadweight loss.
D
MR
0
47
Elvis records (thousands)
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Active Learning: Monopolistic competition in the short run
In the short‐run, what price and quantity should General Mills set for its ice cream, Häagen‐Dazs?
Price ($)
MC
ATC
P1
P2
P3
P4
D
MR
0
Q1
Q2
Häagen-Dazs (thousands)
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Monopolistic competition in the long run
• Monopolistic and monopolistically competitive firms are similar in the short run.
• In the long‐run, firms can enter the monopolistically competitive market.
Price ($)
Consumer surplus
Deadweight loss
Producer surplus
MC
ATC
D
MR
0
Elvis records (thousands)
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Positive economic profits:
• Firm entry causes range of substitutes.
• Existing firms’ demand curves shift left.
• Entry continues until there are zero
economic profits.
Negative economic profits: • Firm exit causes fewer substitutes.
• Existing firms’ demand curves shift right.
• Exit continues until there are zero
economic profits.
Because profits are zero, this is the same quantity as where ATC is tangent to demand.
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Monopolistic competition in the long run
• Similar to monopolists, monopolistically competitive firms operate at smaller‐than‐efficient scale.
• Firms could decrease costs by producing more.
– This would decrease profits.
Perfect competition
Monopolistic competition
Price ($)
Price ($)
In monopolistic competition,
firms produce when ATC is
still decreasing.
MC
In perfect competition,
firms produce where
ATC is lowest. This is
the efficient choice.
MC
Deadweight
loss
Consumer
surplus
Producer
surplus
ATC
ATC
P=MR
(Demand)
0
•
•
MR
D
0
Elvis records (thousands)
Sets price at P = ATC > MC.
•
Produce at smaller‐than efficient scale. •
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Elvis records (thousands)
Sets price at P = min(ATC) = MC.
Efficient scale.
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Monopolistic competition in the long run
• Monopolistically competitive firms face the same situation as perfectly competitive firms in the long‐run: Profits are driven to zero.
• Only by finding new ways to be different is it possible for a monopolistically competitive firm to generate profits in the long run.
• In contrast, a monopolist has far less incentive to innovate, because there is no danger of customers switching to a firm with newer and better products.
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The welfare costs of monopolistic competition
• Monopolistically competitive firms are inefficient.
– Firms maximize profits at a P > MC.
– Quantity is reduced.
– Deadweight loss occurs and the market does not maximize total surplus.
• Regulation to increase efficiency is difficult.
– Regulating a lower price would mean that those firms that could not produce at a lower cost would be forced to leave the market.
– Consumers would get a greater quantity of similar products at a lower price, but they would lose product variety.
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Product differentiation, advertising, and branding
• Product differentiation enables firms to maintain economic profits in the short run.
• Firms have incentives to persuade customers that their products cannot easily be substituted.
– Advertisement: Valuable if expanding information set; though it generally appeals to image over reality.
– Branding: Valuable when it signals a hard‐earned reputation; though it may perpetuate false perceptions of product differences that represent barriers to enter.
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Advertising as a signal
• It is hard to distinguish real information about a product from an ad, as firms know more about the true quality of their products than consumers.
• Advertising may be a signal of quality in itself, as it is costly to advertise.
•
Album Profits
Yes
$10 million
No
-$5 million
Yes
$2 million
For example, music companies typically only promote ‘good’ albums.
–
Fans: Do we like
this album?
Yes
Music label:
Should we promote a
new album?
No
–
•
Fans: Do we like
this album?
No
-$50,000
Music companies will find it profitable to advertise albums fans are going to enjoy.
Music companies will find it unprofitable to advertise albums fans are not going to enjoy.
Consumers can use promotion efforts as a signal of album quality.
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Oligopoly
• A firm in an oligopoly market competes against a few identifiable rivals with market power.
• Oligopolists make strategic decisions about price and quantity that take into account the expected choices of their competitors.
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Oligopolies in competition
• Suppose that there are two big music labels, Warner and Universal, selling a standardized good—an album.
– Each firm has fixed costs of $100 million.
– Each firm has marginal costs of $0.
• If they acted like joint monopolists, they would produce quantities where total revenue is maximized.
• If they acted like perfectly competitive firms, they would produce at the quantity where P = MC = 0.
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Oligopolies in competition
• Below is the market demand for albums and each firm’s demand curve.
Demand and revenue schedule
Albums
(millions)
Monopoly
Perfect
competition
Price
($)
Revenue
(millions of $)
40
20
800
50
18
900
60
16
960
70
14
980
80
12
960
90
10
900
100
8
800
110
6
660
120
4
480
130
2
260
140
0
0
Demand curve
Price ($)
14
Monopoly
equilibrium
Perfect
competition
equilibrium
0
70
140
Millions of albums
• Acting as monopolists, each sets price to maximize total profit; each produces 35M albums at $14.
• Acting as perfectly competitive firms, each sets price equal to zero; each produces 70M albums at $0.
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Oligopolies in competition
• Acting as joint monopolists, per firm profits are (35M x $14) ‐ $100M = $390M.
• Suppose Warner decides to produce another 5M albums without letting Universal know.
• Profits are no longer equal between two firms.
• The larger quantity lowers the market price to $13:
Warner profits: (40M x $13) ‐ $100M = $420M.
Universal profits: (35M x $13) ‐ $100M = $355M.
• If Universal now produces another 5M albums, market price is lowered to $12, and per firm profits are:
(40M x $12 ) – 100M = $380M
• If Warner and Universal both increased quantity again by 5M, profits would be (45M X $ 10) – 100M = $350M.
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Oligopolies in competition
• Each firm has an incentive to gain higher profits by increasing quantity, but this comes at a cost of a lower market price.
– Quantity effect: An additional unit of output sold increases a firm’s profit if price > marginal cost.
– Price effect: An additional unit of output lowers market price, and firm earns lower profit per unit sold.
• If the quantity effect is greater than the price effect, firms increase their quantity sold.
– They will continue to increase output until the quantity effect equals the price effect.
• The price effect is smaller when there are more firms.
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Compete or collude?
• The act of working together to make decisions about price and quantity is collusion.
• In the previous example:
– Compete: $350M each in profits.
– Collude: $390M each in profits.
• Why would these firms not always choose to collude?
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Compete or collude?
• The previous example of why firms don’t collude to make higher profits can be understood using the prisoner’s dilemma.
Universal Music Group
Collude
Produce 35M CDs
Collude
Compete
Produce 45M CDs
Warner Music
Produce 35M CDs
Compete
Produce 45M CDs
Profit: $390m
Profit: $440m
Q = 70m
P = $14
Q = 80m
P = $12
Profit: $390m
Profit: $320m
Profit: $320m
Profit: $350m
Q = 80m
Q = 90m
P = $12
P = $10
Profit: $440m
Profit: $350m
• Firms earn highest profits by colluding.
• Firms earn lowest profits by competing.
• Each firm has an incentive to renege on a collusion deal and compete regardless of what the other firm does.
• Reneging on collusion leads to competitive equilibrium.
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Compete or collude?
• In oligopoly markets, competing is a dominant strategy
for both firms.
– A dominant strategy is one in which it is best for a firm to follow no matter what strategy other firms choose.
• Since all firms in this game have a dominant strategy, the result is a Nash equilibrium, an equilibrium in which each party chooses an action that is optimal given the choices of rivals.
– If the output decision is made repeatedly, both firms may take an initial chance that the other will hold up its end of an initial agreement to collude.
• This strategy often holds firms together in a cartel.
– A cartel is a group of firms who collude to make collective production decisions.
– Cartels are mostly illegal.
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Oligopoly and public policy
• The United States has strict laws prohibiting anti‐competitive (colluding) behavior.
• In 1960, the U.S. government reviewed annual bids it had received to supply heavy machinery.
– Government agencies discovered that 47 manufacturers had submitted identical bids for the previous three years.
– The estimated cost of this cartel to U.S. taxpayers was $175 million per year.
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Deadweight loss under varying amounts of competition
The deadweight losses incurred can be compared under varying amounts of competition.
Perfect competition
Price ($)
Competitive oligopoly
Price ($)
S
S
12
10
D
D
90
Price ($)
80
Collusion
Price ($)
S
14
Monopoly
S
14
D
70
Albums (millions)
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D
70
Albums (millions)
Consumer Surplus
Perfectly competitive firms have zero DWL.
• Competitive oligopolies have some DWL, but less than colluding oligopolies.
• Colluding oligopolies and monopolies have identical DWL.
– The DWL is the largest.
•
Producer Surplus
Deadweight loss
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Summary
• Two market structures were explored:
– Monopolistic competition.
– Oligopoly.
• Monopolistic competition describes a market with many firms that sell goods and services that are similar, but slightly different.
• Oligopoly describes a market with only a few firms that sell a similar good or service
– Firms tend to know their competition.
– Each firm has some price‐setting power.
– No one firm has total market control.
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Summary
• In monopolistically competitive markets, firms can earn short‐run profits.
• The less substitutable a good seems, the less likely consumers are to switch to other products if the price increases
• This provides incentives to producers to differentiate their products by:
– Making them truly different.
– Convincing consumers that they are different through advertising and branding.
• Advertising and branding either explicitly gives the desired information to the consumer or signals the quality of their products.
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Summary
• In oligopoly markets, firms make strategic price and quantity decisions.
• By colluding, firms can maximize profits by producing the equivalent monopoly quantity and splitting revenues.
– Profits increase when a colluding firm deviates by increasing quantity, which is the quantity effect.
– Profits decrease when a colluding firm deviates by increasing quantity, which is the price effect.
• An oligopolist increases output until the quantity effect is equal to the price effect when MC = 0.
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