Monopolistic Competition and Product Monopolistic Competition Differentiation 2

Outline for Lectures 19 and 20. Read Chapter 12 and Monopolistic competition is a market structure where: the assigned class reading. † There are many competing producers in an industry, Announcements What is Monopolistic Competition? † Each producer sells a differentiated product, and Why oligopolists and monopolistically competitive firms differentiate † There is free entry into and exit from the industry in the long their produ cts. Prices and profits under monopolistic competition in the short- and run. long-run. „ Examples of monopolistically competitive industries might include fast Why monopolistic competition poses a tradeoff between lower prices food, gas stations, coffee shops. and greater product diversity. Advertising and brand names. What is an oligopoly and why it occurs. Collusion. Game theory and the “prisoners’ dilemma” Tacit collusion Antitrust policy.

Monopolistically Competitive Firm in Product Differentiation the Short Run 3 4

There are several ways in which companies Example #1 Example #2 MC differentiate their product: Loss ATC † Differentiation by style of type: Clothing stores; different MC types of cars; books; etc. Profit P „ As longgpp as people differ in their tastes, ,p producers will find it P profitable to produce a range of varieties. ATC † Differentiation by location: „ Dry cleaners, gas stations † Differentiation by quality: „ Ordinary and gourmet chocolate; fancy and other types of restaurants. D D † Sellers of differentiated products have some market power. Q Q MR MR

1 Entry and Exit in Monopolistic The Long-Run Zero-Profit Equilibrium Competition (remaining firms) 5 6

Entry, if profits exist Exit, if losses exist P, M R P, M R

D’ D D D’ Q MR’ MR’ MR MR

Monopolistic Competition versus Perfect Comparing Long-Run Equilibrium in Competition Perfect Competition and Monopolistic 7 8 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, but the transaction does not 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.

2 Advertising and Brand Names Oligopoly

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An oligopoly is an industry with only a small number of Price exceeds MC, so advertising might increase producers. profit. † It is a common market structure. † Do ads change behavior (manipulate the weak-minded)? „ Cigarettes, batteries, breweries, breakfast cereals, autos, and airlines, † Some ads provide information. among others. † Why would a celebrity spokesperson influence buying „ It arises from the same forces that lead to monopoly, but in weaker decisions. form. „ A signal of the product quality? † When no one firm has a monopoly, but producers Brand names nonetheless realize that they can affect market prices, an † Convey information about product quality? industry is characterized by imperfect competition, † Create market power (aspirin is an identical product, so branding creates market power for no good reason).

Understanding Oligopoly Cartels

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Formal models of oligopoly are difficult. “Seldom do members of the same trade meet † Strategic interactions include a vast range of different together but the conversation turns to conspiring to possibilities, so there isn’t a single “workhorse” model of raise prices” (Adam Smith). oligopoly. “Any time 30 of the wealthiest and most influential † The possibilities include: individuals get together behind closed doors and „ Cartels: act collectively like monopolists and split the economic agree to reduce output, that cannot be a good thing profits. for anyone but the monopolists” (Rep. John Conyers, D, „ Non-cooperative behavior. MI). „ Compete on prices (end up looking similar to a competitive industry). Three problems facing cartels. „ Compete on quantities. † „ Interact strategically in the market, seeking the greatest advantage. Illegal in the U.S. † It is hard to restrict entry. † It is hard to enforce output restrictions.

3 The Incentive to Cheat for a Member If Oligopolistic Firms Compete on Price of a Cartel (the Bertrand Model) 13 14

Firm incentives The outcomes in oligopolistic markets will equal those Market equilibrium in perfectly competitive markets. MC † Firms will be willing to cut prices (to acquire market share) S up to the point where price equals marginal costs. But this is the perfectly competitive outcome. PM PM ATC „ Needless to say, firms with market power will generally try to av oid this outcome. The fact that firm’s decisions are likely to be P C PC interrelated opens up the opportunity for a wide range of possible interactions. † We will study some simple models of interactions using MR D elementary ideas from game theory.

Q Q Q M C Qfirm 1 firm 1 cheat

The Prisoners’ Dilemma Clearly better Definitions

Best response: highest payoff given other player’s strategies

Dominant strategy: always the best response

Nash equilibrium: all players play their best responses, given other player’s Nash equilibrium actions.

4 Strategic interactions of Duopolists: A Couple Further Words on Prisoners the market for Lysine Dilemma Games 18

Not all games have dominant strategies – it depends on the structure of the game. The two previous games were one-shot games. Most oligopolists will interact repeatedly in the market. † A ti t for tat strategy invol ves pl ayi ng cooperati vel y 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

How Repeated Interaction Can Support Collusion The Kinked Demand Curve

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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!

5 So What Should You Make of Oligopoly in Practice Oligopoly? 21 22

Antitrust laws. In economics we typically ask how self-interested † Sherman Act of 1890 (forbids conspiring to restrict trade individuals would behave and analyze their and forbids attempts at monopolization). interactions. † Limited in the case of oligopoly, because we do not know † Clayton Act (1914) allows private suits, restricts mergers. the extent (and nature) of noncooperative interactions or „ Abundant case law (complex area). whether they will collu de. Life can be hard for would-be colluders † The perfectly competitive model and the logic of supply and † Hard with many firms. demand can be very useful in analyzing oligopolistic markets. † Hard with complex products and pricing schemes. „ In cases where this isn’t enough, economists write down models of the † Differences in “seniority” or costs. strategic interactions of firms, recognizing complications the arise from price wars, anti-trust policy and other issues. These models can be † Bargaining power of buyers (like Walmart…) complicated!

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