Chapter 13: Monopolistic Competition and Oligopoly

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Ch. 13 Monopolistic Competition and Oligopoly A monopolistically competition is a form of industry (market) structure has the following characteristics: A large number of firms No barriers to entry Product differentiation An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated. There tend to be barriers to entry  The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others. Perfect CompetitionMonopolyMonopolist CompetitionOligopoly


Monopolistic CompetitionMonopolistic competition is a common form of industry (market) structure in the United States, characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms because they produce differentiated products. New firms can enter and established firms can exit such an industry with ease. What is product differentiation?


Nine Industries with Characteristics of Monopolistic Competition


Product Differentiation, Advertising, and Social Welfare


More Advertising Data


The Case for Product Differentiation and AdvertisingThe advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. Product differentiation helps to ensure high quality and efficient production. Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.


The Case Against Product Differentiation and AdvertisingCritics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products. Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. People exist to satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive warfare and may serve as a barrier to entry, thus reducing real competition.


Product Differentiation Reduces the Elasticity of Demand Facing a FirmBased on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.


Monopolistic Competition in the Short RunA profit-maximizing monopolistically competitive firm will produce up to the point where MR = MC. This firm is earning positive profits in the short-run.


Monopolistic Competition in the Short-Run Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.


Monopolistic Competition in the Long-Run The firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.Positive economic profits in the short-run will attract entry in the long-run, shifting D inwards until…..profits are zero


Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product. Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity.


OligopolyAn oligopoly is a form of industry (market) structure characterized by a few dominant firms, causing a high degree of concentration. Products may be homogeneous or differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.


Ten Highly Concentrated Industries


The Collusion ModelA group of firms that gets together and makes price and output decisions jointly is called a cartel. Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit.


The Price-Leadership ModelPrice-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy. Assumptions of the price-leadership model: The industry is made up of one large firm and a number of smaller, competitive firms; The dominant firm maximizes profit subject to the constraint of market demand and subject to the behavior of the smaller firms; The dominant firm allows the smaller firms to sell all they want at the price the leader has set. Outcome of the price-leadership model: The quantity demanded in the industry is split between the dominant firm and the group of smaller firms. This division of output is determined by dominant firm’s power The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.


Predatory PricingThe practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing. Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.


Game TheoryGame theory analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms. In game theory, firms are assumed to anticipate rival reactions.


Payoff Matrix for Advertising GameThe strategy that firm A will actually choose depends on the information available concerning B’s likely strategy.


Payoff Matrix for Advertising GameRegardless of what B does, it pays A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.


The Prisoners’ DilemmaBoth Ginger and Rocky have dominant strategies: to confess. Both will confess, even though they would be better off if they both kept their mouths shut.


Contestable MarketsA market is perfectly contestable if entry to it and exit from it are costless (easy). In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.


Oligopoly is Consistent with a Variety of BehaviorsThe only necessary condition of oligopoly is that firms are large enough to have some control over price. Oligopolies are concentrated industries. At one extreme is the cartel, in essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms.


Oligopoly and Economic PerformanceOligopolies, or concentrated industries, are likely to be inefficient for the following reasons: They are likely to price above marginal cost. This means that there would be underproduction from society’s point of view. Strategic behavior can force firms into deadlocks that waste resources. Product differentiation and advertising may pose a real danger of waste and inefficiency.


Regulation of MergersThe Celler-Kefauver Act of 1950 extended the government’s authority to ban vertical and conglomerate mergers. The Herfindahl-Hirschman Index (HHI) is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.


Department of Justice Merger Guidelines

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Last Updated: 8th March 2018

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