Monopolistic Competition and Product Differentiation
Announcements 2
Outline for Lectures 20 and 21. Read Chapters 12 and 13 and the assigned class reading.
Did you like your introductory Econ class? Are you considering a major in Economics, but are unsure of how to declare it as your major or what you can do with it as your major?
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.
The Economics Student Association is having the Career Development p Coordinator, C , Bethany y Nelson,, talk to freshman and sophomores interested in Economics about what it takes to complete the degree, the differences in the types of Economics majors, and the career opportunities after college. The possibilities are endless!
Tuesday, November 10th 2650 Humanities 4:00pm
What is an oligopoly and why it occurs. Collusion. Game theory and the “prisoners’ dilemma” Tacit collusion Antitrust policy.
*REFRESHMENTS WILL BE PROVIDED* (Questions? Contact Sanchi at
[email protected])
Monopolistically Competitive Firm in the Short Run
Monopolistic Competition 3
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Monopolistic competition is a market structure where:
Differentiation by style or type: Differentiation D ff b by location: l Differentiation by quality:
Example #2 Loss
Example #1
There are many competing producers in an industry, Each producer sells a differentiated product,
Profit
MC
P
ATC
MC
P
Sellers of a differentiated product have some market power.
There is free entry into and exit from the industry in the long run.
ATC
D
D
Examples of monopolistically competitive industries might include fast food, gas stations, coffee shops.
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
D’
MR’
Comparing Long-Run Equilibrium in Perfect Competition and Monopolistic Competition
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Monopolistic Competition versus Perfect 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 9
Oligopoly 10
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 11
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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:
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.
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,
One Possibility: Try to Act Like a Monopoly by Forming a Cartel
It is a common market structure.
Brand names
An oligopoly is an industry with only a small number of producers.
“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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Archer-Daniels-Midland (ADM) and Ajinomoto Lysine price-fixing conspiracy
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The Vice Chairman of ADM spent time in prison.
As a consequence of the ADM actions, anti-trust experts understood that price i fi fixing i was ffar more pervasive i than h was widely id l understood. d d The Th was subsequent prosecution on vitamins, fax paper, graphite electrodes.
PM
PC
PC
The outcomes in oligopolistic markets will equal those in perfectly competitive markets. 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
http://theinformantmovie.warnerbros.com/
Another possibility: Oligopolistic Firms Compete on Price (the Bertrand Model)
ATC
A loosely based account is “The Informant”
PM
He also lost whistleblower immunity as a result of $9 million in fraud. My brief reading is that he is a flawed, tragic, but somewhat heroic character.
MC
S
Like any good story, Mark Whitacre was the President of the bio-products division of ADM and turned Government informant.
Firm incentives
Market equilibrium
ADM was fined $100 million (in 1997 – the largest fine to date) and paid hundreds of millions more in class action suits ($400 million alone in a high fructose corn syrup class action).
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Lysine is an essential amino acid that is fed to animals.
The Incentive to Cheat for a Member of a Cartel
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QC
Qfirm 1
Qfirm 1 cheat
A Third Possibility: Firms interact strategically
The fact that firm’s decisions are likely to be interrelated opens up the opportunity for a wide range of possible interactions.
We will study some simple models of interactions using elementary ideas from game theory.
Needless to say, firms with market power will generally try to avoid this outcome.
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The Prisoners’ Dilemma
http://www.youtube.com/watch?v=aS_d0Ayjw4o
Clearly better
Definitions Best response: highest payoff given other player’s strategies Dominant strategy: always the best response
Nash equilibrium
Strategic interactions of Duopolists: the market for Lysine
Nash equilibrium: all players play their best responses, given other player’s actions.
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.
Today’s homework gives an example.
The two previous games were one-shot games. Most oligopolists li li t will ill iinteract t t repeatedly t dl in i th the market. k t A tit for tat strategy involves playing cooperatively at first, 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
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How Repeated Interaction Can Support Collusion 21
The Kinked Demand Curve 22
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!
So What Should You Make of Oligopoly?
Oligopoly in Practice 23
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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.
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…)
In economics we typically ask how self-interested individuals would behave and analyze their interactions. This approach is unfortunately limited in the case of oligopoly, because we do not know the extent (and nature) of noncooperati noncooperative e interactions or whether oligopolists will collude. The perfectly competitive model and the logic of supply and demand can be very useful in analyzing oligopolistic markets, however.
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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Public Policy and Competition 25
Common issues of market structure and competition.
Exxon-Mobil wants to merge. Exxon is the 4th largest and Mobil is the 13th largest U.S. company (measured in sales). Will
the merger allow the companies to operate more efficiently, creating benefits for consumers? Or will the merger hinder competition?
Many issues arise when considering these questions.
Cartels hinder competition 26
Therefore, cartels are illegal. But firms will engage in other practices that may be anti-competitive. Minimum resale price maintenance agreements. Exclusive dealings g Tie-in sales (bundling) Predatory pricing.
Size of the market – 4-firm concentration ratios, or the Herfindahl-Hirshman index (sum of shares, squared). What is the market? Globalization and the internet has expanded markets.
Office
Depot and Staples – what is the effect of competition on
prices?
Two final competition thoughts 27
Recall when we talked about regulating a natural monopoly? We described “cost-plus” regulation.
An alternative is to establish a price cap (better incentives to improve efficiency).
Throughout the world, there has been a wave of deregulation. This has delivered important benefits to consumers. But some regulation is necessary – airline safety, bank soundness, food safety. We need to be constantly vigilant about “regulatory capture.”
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