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Chapter 15 - Monopolistic competition and oligopoly. In this chapter you will learn: What the features of oligopoly and monopolistic competition are? How to calculate the short‐run and long‐run profit‐maximizing price and quantity for a monopolistically competitive firm? What the welfare costs of monopolistic competition are?...
Chapter15 MonopolisticCompetition andOligopoly â2014byMcGrawHillEducation Whatwillyoulearninthischapter? ã Whatthefeaturesofoligopolyandmonopolisticcompetition are ã How to calculate the short‐run and long‐run profit‐maximizing price and quantity for a monopolistically competitive firm • What the welfare costs of monopolistic competition are • How product differentiation motivates advertising and branding • What the strategic production decision of firms in an oligopoly is • Why firms in an oligopoly have an incentive to collude, and why theymightfailtodoso ã Howtocomparethewelfareofproducers,consumers,and societyasawholeinanoligopolytomonopolyandperfect competition â2014byMcGrawHillEducation Whatsortofmarket? Whatsortofmarketisthemusicindustry? ã Dominated by four labels Sony 27.44% Universal 31.61% – None big enough to dominate the industry – Not a monopoly market • Products are not standard – Not a perfectly competitive market Warner 18.14% EMI 10.21% Other firms 12.61% â2014byMcGrawHillEducation ã Twomarketsliebetweenthe extrememodelsofmonopoly andperfectcompetition Oligopoly Monopolistic competition Oligopoly and monopolistic competition • An oligopoly is a market with a few firms selling a similar good or service – Strategic interactions between a firm and its rivals have a major impact on its success • An individual firm’s price and quantity affect others’ profitability • No interaction in perfectly competitive or monopoly markets – Existence of some barrier to entry • Thesebarrierstoentrymaybeovercome,butitmaybe costly â2014byMcGrawHillEducation Oligopolyandmonopolisticcompetition ã Monopolisticcompetition describesamarketwith manyfirmsthatsellsimilar,butdifferentiated, goodsandservices – Able to earn a positive profit in the short run by selling a differentiated product – Offer goods that are similar to competitors’ products but more attractive in some ways • Firms have an interest in persuading customers that their products are unique, a practice known asproductdifferentiation Thisistheroleofadvertisingandbranding. â2014byMcGrawHillEducation Monopolisticcompetitionintheshortrun ã Monopolisticallycompetitivefirmsbehavelikea monopolistintheshortrun Downward‐sloping demand curve – U‐shaped ATC curve Price ($) Consumer surplus Producer surplus Profit/producer surplus Deadweight loss MC ATC 4.70 • Produce where MR = MC • Charge corresponding price on demand curve. • Firm earns profits by extracting consumer surplus • Create deadweight loss D MR 47 Elvis records (thousands) © 2014 by McGraw‐Hill Education Active Learning: Monopolistic competition in the short run In the short‐run, what price and quantity should General Mills set for its ice cream, Häagen‐Dazs? Price ($) MC ATC P1 P2 P3 P4 D MR Q1 Q2 Họagen-Dazs (thousands) â2014byMcGrawHillEducation Monopolisticcompetitioninthelongrun ã Monopolistic and monopolistically competitive firms are similar in the short run • In the long‐run, firms can enter the monopolistically competitive market Price ($) Consumer surplus Deadweight loss Producer surplus MC ATC D MR Elvis records (thousands) â2014byMcGrawHillEducation Positiveeconomicprofits: ã Firmentry causesrangeofsubstitutes ã Existingfirmsdemandcurvesshiftleft ã Entrycontinuesuntiltherearezero economic profits Negative economic profits: • Firm exit causes fewer substitutes • Existing firms’ demand curves shift right • Exit continues until there are zero economic profits Because profits are zero, this is the same quantity as where ATC is tangent to demand Monopolistic competition in the long run • Similar to monopolists, monopolistically competitive firms operate at smaller‐than‐efficient scale • Firms could decrease costs by producing more – This would decrease profits Perfect competition Monopolistic competition Price ($) Price ($) In monopolistic competition, firms produce when ATC is still decreasing MC In perfect competition, firms produce where ATC is lowest This is the efficient choice MC Deadweight loss Consumer surplus Producer surplus ATC ATC P=MR (Demand) • • MR D Elvis records (thousands) SetspriceatP=ATC>MC ã Produceatsmallerthanefficientscale ã â2014byMcGrawHillEducation Elvis records (thousands) Sets price at P = min(ATC) = MC Efficient scale Monopolistic competition in the long run • Monopolistically competitive firms face the same situation as perfectly competitive firms in the long‐run: Profits are driven to zero • Only by finding new ways to be different is it possible for a monopolistically competitive firm to generate profits in the long run • In contrast, a monopolist has far less incentive to innovate, because there is no danger of customers switching to a firm with newer and better products © 2014 by McGraw‐Hill Education 10 The welfare costs of monopolistic competition • Monopolistically competitive firms are inefficient – Firms maximize profits at a P > MC – Quantity is reduced – Deadweight loss occurs and the market does not maximize total surplus • Regulation to increase efficiency is difficult – Regulating a lower price would mean that those firms that could not produce at a lower cost would be forced to leave the market – Consumerswouldgetagreaterquantityofsimilar productsatalowerprice,buttheywouldlose product variety â2014byMcGrawHillEducation 11 Productdifferentiation,advertising,and branding ã Productdifferentiationenablesfirmstomaintain economic profits in the short run • Firms have incentives to persuade customers that their products cannot easily be substituted – Advertisement: Valuable if expanding information set; though it generally appeals to image over reality – Branding: Valuable when it signals a hard‐earned reputation; though it may perpetuate false perceptions ofproductdifferencesthatrepresentbarrierstoenter â2014byMcGrawHillEducation 12 Advertisingasasignal ã Itishardtodistinguishrealinformationabouta productfromanad,asfirmsknowmoreabout thetruequalityoftheirproductsthanconsumers ã Advertising may be a signal of quality in itself, as it is costly to advertise • Album Profits Yes $10 million No -$5 million Yes $2 million For example, music companies typically only promote ‘good’ albums – Fans: Do we like this album? Yes Music label: Should we promote a new album? No – • Fans: Do we like this album? No -$50,000 Music companies will find it profitable to advertise albums fans are going to enjoy Music companies will find it unprofitable to advertise albumsfansarenotgoingto enjoy Consumerscanuse promotioneffortsasa signalofalbumquality â2014byMcGrawHillEducation 13 Oligopoly ã Afirminanoligopolymarketcompetesagainst afewidentifiablerivalswithmarketpower ã Oligopolists makestrategicdecisionsabout priceandquantitythattakeintoaccountthe expectedchoicesoftheircompetitors â2014byMcGrawHillEducation 14 Oligopoliesincompetition ã Suppose that there are two big music labels, Warner and Universal, selling a standardized good—an album – Each firm has fixed costs of $100 million – Each firm has marginal costs of $0 • If they acted like joint monopolists, they would produce quantities where totalrevenueis maximized ã Iftheyactedlikeperfectlycompetitivefirms,they wouldproduceatthequantitywhereP=MC=0 â2014byMcGrawHillEducation 15 Oligopoliesincompetition ã Below is the market demand for albums and each firm’s demand curve Demand and revenue schedule Albums (millions) Monopoly Perfect competition Price ($) Revenue (millions of $) 40 20 800 50 18 900 60 16 960 70 14 980 80 12 960 90 10 900 100 800 110 660 120 480 130 260 140 0 Demand curve Price ($) 14 Monopoly equilibrium Perfect competition equilibrium 70 140 Millions of albums • Acting as monopolists, each sets price to maximize total profit; each produces 35M albums at $14 • Actingasperfectlycompetitivefirms,eachsetspriceequaltozero;eachproduces70M albumsat$0 â2014byMcGrawHillEducation 16 Oligopoliesincompetition ã Actingasjointmonopolists,perfirmprofitsare(35Mx$14) $100M=$390M ã Suppose Warner decides to produce another 5M albums without letting Universal know • Profits are no longer equal between two firms • The larger quantity lowers the market price to $13: Warner profits: (40M x $13) ‐ $100M = $420M Universal profits: (35M x $13) ‐ $100M = $355M • If Universal now produces another 5M albums, market price is lowered to $12, and per firm profits are: (40M x $12 ) – 100M = $380M • If Warner and Universal both increased quantity again by 5M, profits would be (45M X $ 10) – 100M = $350M © 2014 by McGraw‐Hill Education 17 Oligopolies in competition • Each firm has an incentive to gain higher profits by increasing quantity, but this comes at a cost of a lower market price – Quantity effect: An additional unit of output sold increases a firm’s profit if price > marginal cost – Price effect: An additional unit of output lowers market price, and firm earns lower profit per unit sold • If the quantity effect is greater than the price effect, firms increase their quantity sold – They will continue to increase output until the quantity effect equals the price effect • The price effect is smaller when there are more firms © 2014 by McGraw‐Hill Education 18 Compete or collude? • The act of working together to make decisions about price and quantity is collusion • In the previous example: – Compete: $350M each in profits – Collude: $390M each in profits • Why would these firms not always choose to collude? © 2014 by McGraw‐Hill Education 19 Compete or collude? • The previous example of why firms don’t collude to make higher profits can be understood using the prisoner’s dilemma Universal Music Group Collude Produce 35M CDs Collude Compete Produce 45M CDs Warner Music Produce 35M CDs Compete Produce 45M CDs Profit: $390m Profit: $440m Q = 70m P = $14 Q = 80m P = $12 Profit: $390m Profit: $320m Profit: $320m Profit: $350m Q = 80m Q = 90m P = $12 P = $10 Profit: $440m Profit: $350m • Firms earn highest profits by colluding • Firms earn lowest profits by competing • Each firm has an incentive to renege on a collusion deal and compete regardless of what the other firm does • Reneging on collusion leads to competitive equilibrium © 2014 by McGraw‐Hill Education 20 Compete or collude? • In oligopoly markets, competing is a dominant strategy for both firms – A dominant strategy is one in which it is best for a firm to follow no matter what strategy other firms choose • Since all firms in this game have a dominant strategy, the result is a Nash equilibrium, an equilibrium in which each party chooses an action that is optimal given the choices of rivals – If the output decision is made repeatedly, both firms may take an initial chance that the other will hold up its end of an initial agreement to collude • This strategy often holds firms together in a cartel – A cartel is a group of firms who collude to make collective production decisions – Cartels are mostly illegal © 2014 by McGraw‐Hill Education 21 Oligopoly and public policy • The United States has strict laws prohibiting anti‐competitive (colluding) behavior • In 1960, the U.S. government reviewed annual bids it had received to supply heavy machinery – Government agencies discovered that 47 manufacturers had submitted identical bids for the previous three years – The estimated cost of this cartel to U.S. taxpayers was $175 million per year © 2014 by McGraw‐Hill Education 22 Deadweight loss under varying amounts of competition The deadweight losses incurred can be compared under varying amounts of competition Perfect competition Price ($) Competitive oligopoly Price ($) S S 12 10 D D 90 Price ($) 80 Collusion Price ($) S 14 Monopoly S 14 D 70 Albums (millions) © 2014 by McGraw‐Hill Education D 70 Albums (millions) Consumer Surplus Perfectly competitive firms have zero DWL • Competitive oligopolies have some DWL, but less than colluding oligopolies • Colluding oligopolies and monopolies have identical DWL – The DWL is the largest • Producer Surplus Deadweight loss 23 Summary • Two market structures were explored: – Monopolistic competition – Oligopoly • Monopolistic competition describes a market with many firms that sell goods and services that are similar, but slightly different • Oligopoly describes a market with only a few firms that sell a similar good or service – Firms tend to know their competition – Each firm has some price‐setting power – No one firm has total market control © 2014 by McGraw‐Hill Education 24 Summary • In monopolistically competitive markets, firms can earn short‐run profits • The less substitutable a good seems, the less likely consumers are to switch to other products if the price increases • This provides incentives to producers to differentiate their products by: Makingthemtrulydifferent Convincingconsumersthattheyaredifferentthrough advertisingandbranding ã Advertisingandbrandingeitherexplicitlygivesthe desiredinformationtotheconsumerorsignalsthe qualityoftheirproducts â2014byMcGrawHillEducation 25 Summary • In oligopoly markets, firms make strategic price and quantity decisions • By colluding, firms can maximize profits by producing the equivalent monopoly quantity and splitting revenues – Profitsincreasewhenacolludingfirmdeviatesby increasingquantity,whichisthequantityeffect Profitsdecreasewhenacolludingfirmdeviatesby increasingquantity,whichisthepriceeffect ã Anoligopolist increasesoutputuntilthequantity effectisequaltothepriceeffectwhenMC=0 â2014byMcGrawHillEducation 26 ... â2014byMcGrawHillEducation Oligopoly? ?and? ?monopolistic? ?competition • Monopolistic? ?competition describes a market with many firms that sell similar, but differentiated, goods? ?and? ?services – Able to earn a positive... Price ($) MC ATC P1 P2 P3 P4 D MR Q1 Q2 Họagen-Dazs (thousands) â2014byMcGrawHillEducation Monopolisticcompetitioninthelongrun ã Monopolisticandmonopolisticallycompetitive firmsaresimilarintheshortrun... â2014byMcGrawHillEducation 15 Oligopoliesincompetition ã Belowisthemarketdemandforalbumsandeachfirms demandcurve Demand and revenue schedule Albums (millions) Monopoly Perfect competition Price ($) Revenue