copyright 2002, pearson education canada1 monopolistic competition and oligopoly chapter 14

Copyright 2002, Pearson Education Canada1

Monopolistic Competition and Oligopoly

Chapter 14


Monopolistic Competition

Monopolistic competition is a common form of industry structure in Canada, characterized by: a large number of firms, none of which can

influence market price by virtue of size alone some degree of market power achieved

through the production of differentiated products

no barriers to entry or exit


Concentration Ratios in Selected Industries, 1988 (Table 14.1)

CR4 and CR8 refer to the percentage of revenue controlled by the largest 4 and the largest 8 enterprises.


Product Differentiation

Product differentiation refers to a strategy that firms use to achieve market power.

Achieved by producing products that have distinct positive identities in the minds of consumers


The Case for Product Differentiation & Advertising

Provides consumers with variety in marketsEnsures that the quality of products remains

highSatisfies a wide range of consumer tastesProvides for product innovationEncourages competition among firms,

providing for efficiencyAdvertising provides information for

consumers


The Case Against Product Differentiation & Advertising

Society’s scarce resources are wasted as firms attempt to make small changes in products

Information content of advertising is minimal and often misleading

High advertising costs may serve as a barrier to entry in some industries

Advertising imposes costs on society because it is bothersome


Product Differentiation Reduces the Elasticity of Demand Facing a Firm (Figure 14.1)


Price / Output Determination in the Short Run

To maximize profit, the monopolistically competitive firm will increase production until the marginal revenue from increasing output and selling it, no longer exceeds the marginal cost of producing it. This occurs at the point where MC = MR.

It is therefore possible for the monopolistically competitive firm to earn short-run profits or suffer short-run losses.


A Monopolistically Competitive Firm Earning Short-Run Profits (Figure 14.2a)


A Monopolistically Competitive Firm Suffering Short-Run Losses (Figure 14.2b)


Monopolistically Competitive Firm at Long-Run Equilibrium (Figure 14.3)

As new firms enter the monopolistically competitive industry the demand curves of profit-making firms begin to shift left.

The process continues until profits are eliminated and the demand curve is just tangent to the average total cost curve.


Economic Efficiency and Resource Allocation for Monopolistic Competition

Price is greater than marginal cost, greater than the perfectly competitive solution.

The long-run equilibrium quantity of output is to the left of the minimum of ATC.


Oligopoly

Oligopoly is a form of industry structure characterized by: a few firms, each large enough to influence

market price differentiated or homogeneous products firms behaving in a way that depends to a

great extent on the behaviour of other firms


Concentration Ratios in Selected Industries, 1988 (Table 14.5)


Oligopoly Models

The Collusion ModelThe Cournot ModelThe Kinked Demand ModelThe Price Leadership ModelGame Theoretic Models


Collusion Model

Cartel refers to a group of firms that gets together and makes joint price and output decisions in order to maximize joint profits.

A modern example is OPEC.Collusion occurs when price and quantity

fixing agreements among producers are explicit.

Tacit collusion occurs when such agreements are implicit.


Assumptions of the Cournot Model

There are two firms in the industry - a duopoly.

Each firm takes the output of the other firm as given.

Both firms maximize profits.


Cournot Model

The Cournot Model is model of a two-firm industry (duopoly) in which a series of output adjustment decisions leads to a final level of output that is between that which would prevail if the market were organized competitively and that which would be set by a monopoly.


The Kinked Demand Curve Model

The kinked demand curve model is a model of oligopoly in which the demand curve facing each individual firm has a kink in it.

The kink follows from the assumption that competitive firms will follow suit if a single firm cuts price, but will not follow suit it a single firm raises price.


The Kinked Demand Curve Oligopoly Model (Figure 14.4)

If the firm increases its price the demand will fall off quite quickly.

If the firm drops its price the other firms follow and quantity demanded does not change as much.

Demand is elastic above P* and inelastic below P*.


The Price Leadership Model

The price leadership model is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.


The Price Leadership Model (Figure 14.5)

The leading firm maximizes profits by assuming that the demand it will face is the total market demand minus the amount supplied by the firms that are expected to follow its leadership.


Results 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 the amount of market power that the dominant firm has.

The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.


Game Theory

Game theory analyzes oligopolistic behaviour as a complex series of strategic moves and reactive countermoves among rival firms.

In game theory, firms are assumed to anticipate rival reactions.


Dominant Strategy and Nash Equilibrium

A dominant strategy in game theory is a strategy that is best no matter what the opposition does.

Nash equilibrium is the result in game theory, when all players play their best strategy given what their competitors are doing.


Payoff Matrix for an Advertising Game (Figure 14.6)

The dominant strategy for A and B is to advertise.


The Prisoner’s Dilemma (Figure 14.7)

The dominant strategy is for both Rocky and Ginger to confess.


Payoff Matrixes for Left / Right - Top / Bottom Strategies (Figure 14.8a)

In this game C does not have a dominant strategy but D does, right.

Since D’s behaviour is predictable C will play accordingly, in this case bottom.


Payoff Matrixes for Left / Right - Top / Bottom Strategies (Figure 14.8b)

In this game C does not have a dominant strategy but D does, right.

Since C stands to lose such a large amount, uncertainty and risk will probably cause C to choose top rather than risk bottom, despite knowledge of D’s dominant strategy.


Maximin Strategy

A maximin strategy in game theory is a strategy chosen to maximize the minimum gain that can be earned.


Contestable Markets

A market in which entry and exit are costless.

Because entry is cheap, firms are continually faced with competition or the threat of competition.

In contestable markets, firms behave like perfectly competitive firms.


Oligopoly and Economic Performance

Market concentration leads to pricing above marginal cost and output below the efficient level.

Entry barriers prevent the efficient flow of resources between firms and industries.

Product differentiation may lead to efficiency losses.


Review Terms & Concepts

cartel cournot model dominant strategy game theory kinked demand curve

model maximin strategy monopolistic

competition

Nash equilibrium oligopoly perfectly contestable

market price leadership product differentiation tacit collusion

copyright 2002, pearson education canada1 monopolistic competition and oligopoly chapter 14

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