Monopolistic Competition and Product
Differentiation
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Monopolistic Competition
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Outline for Lectures 19 and 20. Read Chapter 12 and
the assigned class reading.
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Monopolistic competition is a market structure where:
There are many competing producers in an industry,
Each producer sells a differentiated product, and
† There is free entry into and exit from the industry in the long
run.
†
Announcements
What is Monopolistic Competition?
†
Why oligopolists and monopolistically competitive firms differentiate
their prod
products.
cts
Prices and profits under monopolistic competition in the short- and
long-run.
Why monopolistic competition poses a tradeoff between lower prices
and greater product diversity.
Advertising and brand names.
„
Examples of monopolistically competitive industries might include fast
food, gas stations, coffee shops.
What is an oligopoly and why it occurs.
Collusion.
Game theory and the “prisoners’ dilemma”
Tacit collusion
Antitrust policy.
Monopolistically Competitive Firm in
the Short Run
Product Differentiation
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4
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There are several ways in which companies
differentiate their product:
†
Differentiation by style of type: Clothing stores; different
types of cars; books; etc.
„
As long
g as people
p p differ in their tastes,, producers
p
will find it
profitable to produce a range of varieties.
†
Differentiation by location:
†
Differentiation by quality:
„
„
†
Example #2
Loss
Example #1
Profit
MC
P
ATC
MC
ATC
P
Dry cleaners, gas stations
Ordinary and gourmet chocolate; fancy and other types of
restaurants.
D
D
Sellers of differentiated products have some market power.
Q
MR
Q
MR
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Entry and Exit in Monopolistic
Competition (remaining firms)
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Entry, if profits exist
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Exit, if losses exist
P, MR
P, MR
D’
MR’
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The Long-Run Zero-Profit Equilibrium
MR
D
Q
D
MR
MR’
Monopolistic Competition versus Perfect
Competition
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D’
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Comparing Long-Run Equilibrium in
Perfect Competition and Monopolistic
Competition
Price exceeds marginal cost.
So selling more at the going price appeals to the producer,
so they might, for example, advertise.
† P>MC is inefficient from the vantage point of society. There
are people who are willing to pay more than the cost of
producing a product,
product but the transaction does not occur
occur.
†
…
Like perfect competition, in the long-run equilibrium of
a monopolistically competitive industry, there are
many firms, all earning zero profit.
†
But the perfectly competitive and monopolistically
competitive firms produce at different points on the long-run
average total cost curve.
„
The monopolistically competitive firm does not produce at the
minimum of the LRAC curve.
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Advertising and Brand Names
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Oligopoly
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Price exceeds MC, so advertising might increase
profit.
†
Do ads change behavior (manipulate the weak-minded)?
† Some ads provide information.
† Why would a celebrity spokesperson influence buying
decisions.
†
„
…
†
„
A signal of the product quality?
†
Convey information about product quality?
Create market power (aspirin is an identical product, so
branding creates market power for no good reason).
Understanding Oligopoly
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It is a common market structure.
„
Brand names
†
An oligopoly is an industry with only a small number of
producers.
Cigarettes, batteries, breweries, breakfast cereals, autos, and airlines,
among others.
It arises from the same forces that lead to monopoly, but in weaker
form.
When no one firm has a monopoly, but producers
nonetheless realize that they can affect market prices, an
industry is characterized by imperfect competition,
Cartels
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Formal models of oligopoly are difficult.
Strategic interactions include a vast range of different
possibilities, so there isn’t a single “workhorse” model of
oligopoly.
† The p
possibilities include:
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†
„
„
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Cartels: act collectively like monopolists and split the economic
profits.
Non-cooperative behavior.
„
„
„
Compete on prices (end up looking similar to a competitive industry).
Compete on quantities.
Interact strategically in the market, seeking the greatest advantage.
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“Seldom do members of the same trade meet
together but the conversation turns to conspiring to
raise prices” (Adam Smith).
“Any time 30 of the wealthiest and most influential
individuals get together behind closed doors and
agree to reduce output, that cannot be a good thing
for anyone but the monopolists” (Rep. John Conyers, D,
MI).
Three problems facing cartels.
Illegal in the U.S.
It is hard to restrict entry.
† It is hard to enforce output restrictions.
†
†
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The Incentive to Cheat for a Member
of a Cartel
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Firm incentives
Market equilibrium
MC
S
PM
PM
PC
PC
QC
The outcomes in oligopolistic markets will equal those
in perfectly competitive markets.
†
ATC
Needless to sa
say, firms with market power will generally
generall try
tr to a
avoid
oid
this outcome.
The fact that firm’s decisions are likely to be
interrelated opens up the opportunity for a wide
range of possible interactions.
†
Qfirm 1
Firms will be willing to cut prices (to acquire market share)
up to the point where price equals marginal costs. But this is
the perfectly competitive outcome.
„
…
D
MR
QM
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If Oligopolistic Firms Compete on Price
(the Bertrand Model)
We will study some simple models of interactions using
elementary ideas from game theory.
Qfirm 1 cheat
The Prisoners’ Dilemma
Clearly better
Definitions
Best response:
highest payoff given
other player’s
strategies
Dominant
strategy: always
the best response
Nash equilibrium
Nash equilibrium:
all players play
their best
responses, given
other player’s
actions.
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Strategic interactions of Duopolists:
the market for Lysine
A Couple Further Words on Prisoners
Dilemma Games
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Not all games have dominant strategies – it depends
on the structure of the game.
The two previous games were one-shot games. Most
oligopolists will interact repeatedly in the market.
A titi for
f tat strategy involves
i l
playing
l i cooperatively
i l at first,
fi
and then doing whatever the other player did in the
previous period.
† Firms can make greater short-term profits by cheating, but
long-term profits will be higher if they cooperate implicitly.
†
„
This is referred to as “tacit collusion.”
Nash outcome
How Repeated Interaction Can Support Collusion
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The Kinked Demand Curve
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Raise prices, others
won’t, so you lose
lots of sales
(elastic demand).
Lower prices,
others retaliate, so
demand is very
steep to the right
of Q*.
Changes in MC
may have little
effect on output!
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So What Should You Make of
Oligopoly?
Oligopoly in Practice
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22
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Antitrust laws.
Sherman Act of 1890 (forbids conspiring to restrict trade
and forbids attempts at monopolization).
† Clayton Act (1914) allows private suits, restricts mergers.
†
„
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Abundant case law (complex area).
Life can be hard for would-be colluders
Hard with many firms.
Hard with complex products and pricing schemes.
† Differences in “seniority” or costs.
† Bargaining power of buyers (like Walmart…)
†
†
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In economics we typically ask how self-interested
individuals would behave and analyze their
interactions.
Limited in the case of oligopoly, because we do not know
the extent (and nature) of noncooperative interactions or
whether the
they will coll
collude.
de
† The perfectly competitive model and the logic of supply and
demand can be very useful in analyzing oligopolistic
markets.
†
„
In cases where this isn’t enough, economists write down models of the
strategic interactions of firms, recognizing complications the arise from
price wars, anti-trust policy and other issues. These models can be
complicated!
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