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Part III: Market Structure

12. Monopoly

13. Game Theory and Strategic Play

14. Oligopoly and Monopolistic Competition

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Chapter 14

Oligopoly and Monopolistic

Competition

2015.12.25.

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1 Two More Market Structures

2 Oligopoly

3 Monopolistic Competition

4 The “Broken” Invisible Hand

5 Summing Up: Four Market Structures

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Q:How many firms are necessary to make a

market competitive?

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• Two market structures that lie between perfect

competition and monopoly are oligopoly and

monopolistic competition.

• In both of these markets the seller must

recognize actions of competitors.

• In oligopolies, economic profits in the long run

can be positive.

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• In monopolistically competitive markets, entry

and exit drive economic profits to zero in the

long run.

• There are several important variables such as

the number of firms in the industry, the degree

of product differentiation, entry barrier, and

the presence or absence of collusion that

determine the competitiveness of a market.

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14.1 Two More Market

Structures

• Differentiated products are goods that are

similar but not identical.

• Homogeneous products are goods that are

identical, making them perfect substitutes.• Two characteristics of the classification of

market structures:1. The number of firms

2. The degree of product differentiation

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Exhibit 14.1 Characteristics of Four Market Structures

• Oligopoly: only a few suppliers, homogeneous or

differentiated products• Monopolistic competition: facing downward-sloping

demand curve (monopolistic), free entry (competitive),

many firms selling differentiated products.8 / 38

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14.2 Oligopoly

• Greek origins: oligoi meaning “a few” and

polein meaning “to sell.”

• Oligopolies sell homogeneous goods (for

example, hard drive or oil) or differentiated

goods (for example, cigarettes or soda).

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The Oligopolist’s Problem

• Due to cost advantage associated with the

economies of scale of oligopoly or other barrier

to entry, entry and exit will not necessarily

push the market to zero economic profits in the

long run.

• Because of relatively few competitors, there is

an important interaction between the few

sellers that do occupy the market.

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Oligopoly Model with Homogeneous Products

• One of the simplest cases of oligopoly is an industry with

only two competing firms— a duopoly.

• Suppose that these two firms compete against one

another by setting prices— Bertrand competition.

• Suppose that the industry of interest is landscaping and

that there are two firms: your company, Dogwood and a

competitor, Rose Petal.

• Both companies have the same marginal cost which is

$30 per landscape job.

• Consumers view services from two companies as

identical. They will hire services from the company that

sells at a lower price.

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Exhibit 14.2 Market Demand Curve for an Oligopolywith Homogeneous Products

• If both companies charge the same price, each company

will get half of the demand.

• The market has a total demand of 1,000 landscaping jobs

per week, provided that the price is $50.

• At any price above $50, the market demand is zero.

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• What is directly relevant for a firm’s

profit-maximizing decisions is its residual

demand curve, which is the demand that is not

met by other firms.

• Your residual demand curve is1000, if PDW < PR P,

10002 , if PDW = PR P,

0, if PDW > PR P

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Doing the Best You Can:

How Should You Price to Maximize Profits?

• You should choose the price that maximizes

your profits.

• Marginal cost is $30.

• How does your behavior affect Rose Petal’s

behavior?

• To start with some simple strategies, suppose

you charge a price of $50 and Rose Petal

charges $45.

• What happens? Is this a Nash Equilibrium?

Can you do better?14 / 38

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Exhibit 14.3 Dueling Duopolies and a Pricing Response

• A series of price-cutting between you and Rose Petal.

• When does all of this price-cutting end? Or, what is the

Nash equilibrium?

• PDW = PR P = MC = $30 is the unique Nash

Equilibrium.

• In this equilibrium, each company ends up supplying

half of the market and earn zero economic profits.

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Oligopoly Model with Differentiated Products

• A more realistic description of an industry is a

set of firms that make similar but not

homogeneous products.

• Because products are differentiated, the

demand function is not “all-or-nothing.”

• Firms can charge higher prices and not lose all

sales because the differentiation creates

preferences on the part of consumers.

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Example: Coke Cola and Pepsi• If Coke raises its price, it will lose sales to Pepsi, but

Coke’s sales won’t go to zero because of differentiation.

Some consumers would still rather have Coke.

• How should Coke and Pepsi decide on their prices?

• Each firm must predict how its prices will affect the

prices of its competitor.

• In Nash equilibrium, both firms set their prices as best

responses to each other.

• In a oligopoly with differentiated products, firms

typically make positive economic profits, and some

oligopolists persist in the long run with positive profits

because of barriers (such as established brands) to entry.

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• What happens if there is a third firm supplying

soda to the market?

• Price will typically be lower with three firms

competing compared to two firms competing.

• As the number of firms in an oligopolistic

market increases further, prices tend to decline

toward marginal cost.

• If enough entry occurs, it could cause the

market to turn into a monopolistically

competitive structure.

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Collusion: One Way to Keep Prices High

• Collusion occurs when rival firms conspire

among themselves to set prices or to control

production quantities rather than let the free

market determine them.

• Imagine that you and the CEO of Rose Petal

decide to collude by setting your prices jointly

rather than independently.

• Oligopolies might coordinate and collectively

act as a monopolist and then split the

monopoly profits among themselves.

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• Your firm and Rose Petal can collude and set

prices at $50. At this price, the market demand

is 1,000 jobs. Half of the consumers will go to

each firm.• Two reasons that collusion among oligopolies

might not always be formed:• Even firms agree on collusion, they have an

incentive to engage in secret price-cutting to

capture more of the profits for themselves. (For

example, you can charge $49.50 for landscaping

jobs and get the whole demand.)• Price-fixing is illegal.

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When Collusion Can Work

Two important considerations that determine

how successful a collusive arrangement is:• Detection and punishment of cheaters.

• For example: Keep my price at $50 provided that

you also keep your price at $50; if you ever cut your

price, then I will cut my price to $30, forever. This

type of punishment is called a grim strategy (冷酷

策略).

• The long-term value of the market.• A colluder who values future monopoly profits

more than current cheating profits will abide by the

collusion agreement.

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To Cheat or Not To Cheat: That Is the Question• Another type of oligopoly model where sellers compete

on quantities rather than prices is called Cournot

competition.• The most famous group that chooses to collude by

choosing quantities is OPEC (Organization of the

Petroleum Exporting Countries).• OPEC is an oil cartel that coordinates the policies of

several major oil-producing countries.

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• OPEC has a problem of keeping the price of its

good—oil— high.• This problem arises from the natural inability of

collusive arrangement: each country can increase its

profits by pumping more oil, but if they all do so they

will depress prices, reducing everybody’s profits.• In only 10 of the 83 months shown in Exhibit 14.4 is

actual production at or below the agreed-upon quota.

Exhibit 14.4 OPEC’s Production Quota Agreements and Actual Production, 2001-2007

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14.3 14.3 Monopolistic

CompetitionThe Monopolistic Competitor’s Problem

Exhibit 14.5 Dairy Queen’s (resdual) Demand Curveand Marginal Revenue Curve

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Doing the Best You Can:

How a Monopolistic Competitor Maximizing Profits

The decision rule is identical to that for the monopolist:

Exhibit 14.6 Optimal Pricing Strategy for aMonopolistic Competitor

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How a Monopolistic Competitor Calculates Profits

Exhibit 14.7 Economic Profits and Economics Losses

Profits=Total revenue-Total cost=

(P × Q)− (AT C × Q) = (P − AT C)× Q

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Long-Run Equilibrium in a Monopolistically Competitive

Industry

Exhibit 14.8 The Effect of Market Entry on an Existing Firm’s Demand Curve

• With positive profits, sellers will be attracted to this

market.

• When there are more substitutes for a good, a firm’s

residual demand curve shifts to the left and becomes

more elastic (less steep).

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Exhibit 14.9 Zero Profits in Long-Run Equilibrium

• When does entry stop?

• Entry stops when there are no longer economic profits.

• Monopolistically competitive firms have an incentive to

continually try to distinguish themselves from rivals.

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14.4 The “Broken”

Invisible Hand

• One important factor that can “break” the

powerful result of the invisible hand is market

power.

• In both market structures of monopoly and

oligopoly, firms have market power and are

able to charge prices greater than marginal

cost, reducing total surplus.

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Exhibit 14.10 Equilibria for a Perfectly Competitive Marketand a Monopolistically Competitive Market

• Is total surplus maximized under monopolistically

competition? The answer is no.• Monopolistic competitors produce at a level below the

efficient scale of production (the minimum of the AT Ccurve).• They mark up price above its marginal cost.• The monopolistic competitor produces too little

compared to the socially efficient level.30 / 38

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Regulating Market Power

• Should the government regulate oligopolistic

and monopolistically competitive markets?

• It depends.

• A clear case in which government regulation is

warranted is successful collusion.

• The Sherman Antitrust Act of 1890 and the

Clayton Act of 1914 are concerned with the

regulation of mergers (購併).

• One of the main approaches the Department of

Justice (DOJ) adopts in its analysis of mergers

is to calculate how concentrated an industry is.31 / 38

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• One of the tools that the DOJ uses to guide its

enforcement of the Sherman Act is the

Herfindahl-Hirschman Index (HHI).

• The HHI is a measure of market concentration, which is

calculated by squaring the market share of each firm

competing in the market and then summing the

resulting numbers.

• For example, if there are two firms in an industry and

one firm accounts for 75 percent of the sales and the

other 25 percent, the HHI is equal to 752+ 252=6,250.

• The higher the HHI, the more concentrated the industry.

• The HHI approaches zero when a market consists of a

large number of firms of relatively equal size.

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• There are limits to how effectively the

government can use regulation to reduce

market power, particularly in monopolistically

competitive markets with many producers.

• Imagine if the government had to regulate

prices for every product sold in

monopolistically competitive industries.

• And Imagine further that it would set the

number and type of entrants for each

production line.

• This type of intervention would border on a

command economy.

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14. Summing Up: Four

Market Structures

Exhibit 14.11 Four Market Structures34 / 38

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Q:How many firms are necessary to make a

market competitive?

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• Two economists, Timothy Bresnahan and Peter

Reiss reasoned that if a market is already

effectively competitive, the addition of one

more firm should not change prices.

• When firms have significant market power,

further entry reduces prices, while in a

competitive market, further entry should leave

prices unchanged.

• Bresnahan and Reiss obtained information on

prices and the number of tire dealers across

different towns in the western United States.

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Exhibit 14.12 Tire Prices and Tire Quality in Selected U.S. Towns

• There is practically no difference in prices

between markets with four and five dealers.

• Once the difference in tire quality (time

mileage rating) is accounted for, there is no

evidence that prices are different between

markets with three or four dealers.

• In sum, the evidence suggests that three or four

firms are sufficient for the tire market to be

(effectively) competitive.37 / 38

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• Two economists, Martin Dufwenberg and Uri Gneezy

designed an experiment in which a number of sellers

each chose a bid (selling price) between 2 and 100.

• Whichever seller made the lowest bid kept the dollar

amount equal to his or her bid.

• Dufwenberg and Gneezy found that in a duopoly,

average bids were just below 50.

• When the number of sellers increased to four, the sellers

acted much more competitively.

• In fact, with four sellers, the average winning bid at the

end of ten rounds of play was close to 2!

• Thus, it the lab too, it appears that four competitors are

sufficient to drive the equilibrium toward the competitive

outcome.

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