Chapter 12
Monopolistic
Competition and
Oligopoly
Monopolistic
Chapter 12 Slide 2
Topics to be Discussed
Monopolistic Competition
Oligopoly
Price Competition
Competition Versus Collusion: The
Chapter 12 Slide 3
Topics to be Discussed
Implications of the Prisoners’ Dilemma
for Oligopolistic Pricing
Chapter 12 Slide 4
Monopolistic Competition
Characteristics
1) Many firms
2) Free entry and exit
Chapter 12 Slide 5
Monopolistic Competition
The amount of monopoly power
depends on the degree of differentiation.
Examples of this very common market
structure include:
Toothpaste
Soap
Chapter 12 Slide 6
Monopolistic Competition
Toothpaste
Crest and monopoly power
Procter & Gamble is the sole producer of
Crest
Consumers can have a preference for
Crest---taste, reputation, decay preventing efficacy
The greater the preference (differentiation)
Chapter 12 Slide 7
Monopolistic Competition
Question
Does Procter & Gamble have much monopoly
Chapter 12 Slide 8
Monopolistic Competition
The Makings of Monopolistic Competition
Two important characteristics
Differentiated but highly substitutable
products
A Monopolistically Competitive
Firm in the Short and Long Run
Quantity
Chapter 12 Slide 10
Observations (short-run)
Downward sloping demand--differentiated
product
Demand is relatively elastic--good substitutes MR < P
Profits are maximized when MR = MC This firm is making economic profits
Chapter 12 Slide 11
Observations (long-run)
Profits will attract new firms to the industry
(no barriers to entry)
The old firm’s demand will decrease to DLR Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC -- some monopoly power
Deadweight loss
MC AC
Comparison of Monopolistically Competitive
Equilibrium and Perfectly Competitive Equilibrium
$/Q
Chapter 12 Slide 13
Monopolistic Competition
Monopolistic Competition and Economic
Efficiency
The monopoly power (differentiation) yields
a higher price than perfect competition. If price was lowered to the point where
Chapter 12 Slide 14
Monopolistic Competition
Monopolistic Competition and Economic
Efficiency
With no economic profits in the long run,
Chapter 12 Slide 15
Monopolistic Competition
Questions
1) If the market became competitive,
what would happen to output
and price?
Chapter 12 Slide 16
Monopolistic Competition
Questions
3) What is the degree of monopoly
power?
Chapter 12 Slide 17
Monopolistic Competition
in the Market for Colas and Coffee
The markets for soft drinks and coffee
Chapter 12 Slide 18
Elasticities of Demand for
Brands of Colas and Coffee
Colas: Royal Crown -2.4
Coke -5.2 to -5.7
Ground Coffee: Hills Brothers -7.1
Maxwell House -8.9
Chase and Sanborn -5.6
Chapter 12 Slide 19
Questions
1) Why is the demand for Royal Crown
more price inelastic than for Coke?
2) Is there much monopoly power in
these two markets?
3) Define the relationship between
elasticity and monopoly power.
Chapter 12 Slide 20
Oligopoly
Characteristics
Small number of firms
Chapter 12 Slide 21
Oligopoly
Examples
Automobiles Steel
Aluminum
Petrochemicals
Chapter 12 Slide 22
Oligopoly
The barriers to entry are:
Natural
Scale economies
Patents
Technology
Chapter 12 Slide 23
Oligopoly
The barriers to entry are:
Strategic action
Flooding the market
Chapter 12 Slide 24
Oligopoly
Management Challenges
Strategic actions Rival behavior
Question
What are the possible rival responses to a
Chapter 12 Slide 25
Oligopoly
Equilibrium in an Oligopolistic Market
In perfect competition, monopoly, and
monopolistic competition the producers did not have to consider a rival’s response
when choosing output and price.
In oligopoly the producers must consider
Chapter 12 Slide 26
Oligopoly
Equilibrium in an Oligopolistic Market
Defining Equilibrium
Firms doing the best they can and have
no incentive to change their output or price
All firms assume competitors are taking
Chapter 12 Slide 27
Oligopoly
Nash Equilibrium
Each firm is doing the best it can given
Chapter 12 Slide 28
Oligopoly
The Cournot Model
Duopoly
Two firms competing with each other
Homogenous good
The output of the other firm is assumed
Chapter 12 Slide
If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount.
Firm 1’s Output Decision
Q1 P1
What is the output of Firm 1 if Firm 2 produces 100 units?
D1(0)
MR1(0)
If Firm 1 thinks Firm 2 will produce nothing, its demand
curve, D1(0), is the market demand curve.
D1(50) MR1(50)
25
Chapter 12 Slide 30
Oligopoly
The Reaction Curve
A firm’s profit-maximizing output is a
Chapter 12 Slide 31 Firm 2’s Reaction
Curve Q*2(Q2)
Firm 2’s reaction curve shows how much it will produce as a function of how much
it thinks Firm 1 will produce.
Reaction Curves
and Cournot Equilibrium
Q2
Firm 1’s Reaction Curve Q*1(Q2)
x
x
x
x
Firm 1’s reaction curve shows how much it will produce as a function of how much
it thinks Firm 2 will produce. The x’s correspond to the previous model.
In Cournot equilibrium, each firm correctly assumes how
much its competitors will produce and thereby maximize its own profits. Cournot
Chapter 12 Slide 32
Oligopoly
Questions
1) If the firms are not producing at the
Cournot equilibrium, will they adjust
until the Cournot equilibrium is
reached?
Chapter 12 Slide 33
Oligopoly
An Example of the Cournot Equilibrium
Duopoly
Market demand is P = 30 - Q where Q =
Q1 + Q2
MC
1 = MC2 = 0
The Linear Demand Curve
Chapter 12 Slide 34
Oligopoly
An Example of the Cournot Equilibrium
Firm 1’s Reaction Curve
1
The Linear Demand Curve
Chapter 12 Slide 35
Oligopoly
An Example of the Cournot Equilibrium
1
The Linear Demand Curve
Chapter 12 Slide 36
Oligopoly
An Example of the Cournot Equilibrium
10
The Linear Demand Curve
Chapter 12 Slide 37
Duopoly Example
Q1
Q2 Firm 2’s
Reaction Curve
30
15
Firm 1’s
Reaction Curve
15
30
10
10
Cournot Equilibrium
Chapter 12 Slide
Profit Maximization with Collusion
Chapter 12 Slide 39
Oligopoly
Contract Curve
Q1 + Q2 = 15
Shows all pairs of output Q
1 and Q2 that
maximizes total profits
Q1 = Q2 = 7.5
Less output and higher profits than the
Cournot equilibrium
Profit Maximization with Collusion
Chapter 12 Slide 40
Firm 1’s
Reaction Curve Firm 2’s
Reaction Curve
Duopoly Example
Q1
Cournot Equilibrium
15
15
Competitive Equilibrium (P = MC; Profit = 0)
Collusion Curve
7.5
7.5
Collusive Equilibrium
For the firm, collusion is the best outcome followed by the Cournot
Chapter 12 Slide 41
First Mover
Advantage--The Stackelberg Model
Assumptions
One firm can set output first MC = 0
Market demand is P = 30 - Q where Q =
total output
Firm 1 sets output first and Firm 2 then
Chapter 12 Slide 42
Firm 1
Must consider the reaction of Firm 2
Firm 2
Takes Firm 1’s output as fixed and
therefore determines output with the Cournot reaction curve: Q2 = 15 - 1/2Q1
Chapter 12 Slide
therefore MR 0
Chapter 12 Slide 44
Substituting Firm 2’s Reaction Curve
for
Q
2:
Chapter 12 Slide 45
Conclusion
Firm 1’s output is twice as large as firm 2’s Firm 1’s profit is twice as large as firm 2’s
Questions
Why is it more profitable to be the first
mover?
Which model (Cournot or Shackelberg) is
more appropriate?
Chapter 12 Slide 46
Price Competition
Competition in an oligopolistic industry
may occur with price instead of output.
The Bertrand Model is used to illustrate
Chapter 12 Slide 47
Price Competition
Assumptions
Homogenous good
Market demand is P = 30 - Q where
Q = Q1 + Q2
MC = $3 for both firms and MC1 = MC2 = $3
Bertrand Model
Chapter 12 Slide 48
Price Competition
Assumptions
The Cournot equilibrium:
Assume the firms compete with price, not
quantity.
Bertrand Model
Bertrand Model
Chapter 12 Slide 49
Price Competition
How will consumers respond to a
price differential? (Hint: Consider
homogeneity)
The Nash equilibrium:
P = MC; P
1 = P2 = $3
Q = 27; Q
1 & Q2 = 13.5
Bertrand Model
Bertrand Model
0
Chapter 12 Slide 50
Price Competition
Why not charge a higher price to raise
profits?
How does the Bertrand outcome compare to
the Cournot outcome?
The Bertrand model demonstrates the
importance of the strategic variable (price versus output).
Bertrand Model
Chapter 12 Slide 51
Price Competition
Criticisms
When firms produce a homogenous good, it
is more natural to compete by setting quantities rather than prices.
Even if the firms do set prices and choose
the same price, what share of total sales will go to each one?
It may not be equally divided.
Bertrand Model
Chapter 12 Slide 52
Price Competition
Price Competition with Differentiated
Products
Market shares are now determined not just
Chapter 12 Slide 53
Price Competition
Assumptions
Duopoly FC = $20 VC = 0
Differentiated Products
Chapter 12 Slide 54
Price Competition
Assumptions
Firm 1’s demand is Q1 = 12 - 2P1 + P2 Firm 2’s demand is Q2 = 12 - 2P1 + P1
P
1 and P2 are prices firms 1 and 2
charge respectively
Q
1 and Q2 are the resulting quantities
they sell
Differentiated Products
Chapter 12 Slide 55
Price Competition
Determining Prices and Output
Set prices at the same time
20
Differentiated Products
Chapter 12 Slide 56
Price Competition
Determining Prices and Output
Firm 1: If P2 is fixed:
Differentiated Products
Chapter 12 Slide 57
Firm 1’s Reaction Curve
Nash Equilibrium in Prices
P1
P2
Firm 2’s Reaction Curve
$4
$4
Nash Equilibrium
$6
$6
Chapter 12 Slide 58
Nash Equilibrium in Prices
Does the Stackelberg model prediction
for first mover hold when price is the
variable instead of quantity?
Chapter 12 Slide 59
A Pricing Problem
for Procter & Gamble
Scenario
1) Procter & Gamble, Kao Soap, Ltd.,
and Unilever, Ltd were entering the
market for Gypsy Moth Tape.
2) All three would be choosing their
prices at the same time.
Differentiated Products
Chapter 12 Slide 60
Scenario
3) Procter & Gamble had to
consider competitors prices when
setting their price.
4) FC = $480,000/month and
VC = $1/unit for all firms
Differentiated Products
Differentiated Products
A Pricing Problem
Chapter 12 Slide 61
Scenario
5) P&G’s demand curve was:
Q = 3,375
P
-3.5(
P
U)
.25(
P
K)
.25Where P, P
U , PK are P&G’s, Unilever’s,
and Kao’s prices respectively
Differentiated Products
Differentiated Products
A Pricing Problem
Chapter 12 Slide 62
Problem
What price should P&G choose and what is
the expected profit?
Differentiated Products
Differentiated Products
A Pricing Problem
P&G’s Profit
(in thousands of $ per month)1.10 -226-215-204 -194-183-174 -165-155 1.20 -106-89 -73-58 -43-28 -15-2
1.30 -56-37 -192 1531 4762 1.40 -44-25 -612 2946 6278
1.50 -52-32 -153 2036 5268 1.60 -70-51 -34-18 -114 3044
1.70 -93-76 -59-44 -28-13 115 1.80 -118-102 -87-72 -57-44 -30-17
Competitor’s (Equal) Prices ($) P&G’s
Chapter 12 Slide 64
What Do You Think?
1) Why would each firm choose a
price of $1.40? Hint: Think Nash
Equilibrium
2) What is the profit maximizing price
with collusion?
A Pricing Problem
Chapter 12 Slide 65
Competition Versus Collusion:
The Prisoners’ Dilemma
Why wouldn’t each firm set the
Chapter 12 Slide 66
Assume:
16
Chapter 12 Slide 67
Possible Pricing Outcomes:
Chapter 12 Slide 68
Payoff Matrix for Pricing Game
Firm 2
Firm 1
Charge $4 Charge $6
Charge $4
Charge $6
$12, $12 $20, $4
Chapter 12 Slide 69
These two firms are playing a
noncooperative game.
Each firm independently does the best it
can taking its competitor into account.
Question
Why will both firms both choose $4 when
$6 will yield higher profits?
Chapter 12 Slide 70
An example in game theory, called the
Prisoners’ Dilemma
, illustrates the
problem oligopolistic firms face.
Chapter 12 Slide 71
Scenario
Two prisoners have been accused of
collaborating in a crime.
They are in separate jail cells and cannot
communicate.
Each has been asked to confess to the
crime.
Chapter 12 Slide 72
-5, -5 -1, -10
-2, -2 -10, -1
Payoff Matrix for Prisoners’ Dilemma
Prisoner A
Confess Don’t confess
Confess
Don’t confess
Prisoner B
Chapter 12 Slide 73
Payoff Matrix for
the
P & G
Prisoners’ Dilemma
Conclusions: Oligipolistic Markets
1) Collusion will lead to greater profits
2) Explicit and implicit collusion is
possible
Chapter 12 Slide 74
Charge $1.40 Charge $1.50
Charge $1.40
Unilever and Kao
Charge $1.50
P&G
$12, $12 $29, $11
$3, $21 $20, $20
Payoff Matrix for the P&G Pricing
Problem
Chapter 12 Slide 75
Implications of the Prisoners’
Dilemma for Oligipolistic Pricing
Observations of Oligopoly Behavior
1) In some oligopoly markets, pricing
behavior in time can create a
Chapter 12 Slide 76
Observations of Oligopoly Behavior
2) In other oligopoly markets, the firms
are very aggressive and collusion is not
possible.
Firms are reluctant to change price
because of the likely response of their competitors.
In this case prices tend to be relatively rigid.
Implications of the Prisoners’
Chapter 12 Slide 77
The Kinked Demand Curve
$/Q
Quantity
MR D
If the producer lowers price the competitors will follow and the
demand will be inelastic. If the producer raises price the
Chapter 12 Slide 78
The Kinked Demand Curve
$/Q
D P*
Q*
MC MC’
So long as marginal cost is in the vertical region of the marginal revenue curve, price and output
will remain constant.
MR
Chapter 12 Slide 79
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing
Price Signaling
Implicit collusion in which a firm announces
a price increase in the hope that other firms will follow suit
Price Signaling & Price Leadership
Chapter 12 Slide 80
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing
Price Leadership
Pattern of pricing in which one firm
regularly announces price changes that other firms then match
Price Signaling & Price Leadership
Chapter 12 Slide 81
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing
The Dominant Firm Model
In some oligopolistic markets, one large
firm has a major share of total sales, and a group of smaller firms supplies the
remainder of the market.
The large firm might then act as the
Chapter 12 Slide 82
Price Setting by a Dominant Firm
Price
At this price, fringe firms sell QF, so that total
SF The dominant firm’s demand curve is the difference between market demand (D) and the supply
Chapter 12 Slide 83
Cartels
Characteristics
1) Explicit agreements to set output
and
price
Chapter 12 Slide 84
Cartels
Examples of
successful cartels
OPEC
International
Bauxite
Association
Mercurio Europeo
Examples of
unsuccessful cartels
Copper
Tin
Coffee
Tea
Cocoa
Characteristics
Chapter 12 Slide 85
Cartels
Characteristics
4) Conditions for success
Competitive alternative sufficiently
deters cheating
Potential of monopoly power--inelastic
Chapter 12 Slide 86
Cartels
Comparing OPEC to CIPEC
Most cartels involve a portion of the market
Chapter 12 Slide 87
The OPEC Oil Cartel
Price
Quantity
MROPEC
DOPEC TD SC
MCOPEC
TD is the total world demand curve for oil, and SC is the competitive supply. OPEC’s
demand is the difference between the two.
QOPEC P*
OPEC’s profits maximizing quantity is found at the intersection of its MR and MC curves. At this quantity
Chapter 12 Slide 88
Cartels
About OPEC
Very low MC TD is inelastic
Chapter 12 Slide 89
The OPEC Oil Cartel
Price
Quantity
MROPEC
DOPEC TD SC
MCOPEC
QOPEC P*
The price without the cartel:
•Competitive price (PC) where DOPEC = MCOPEC
Chapter 12 Slide 90
The CIPEC Copper Cartel
Price
Quantity
MRCIPEC TD
DCIPEC
SC
MCCIPEC
QCIPEC P*
PC
QC QT
•TD and SC are relatively elastic
•DCIPECis elastic
•CIPEC has little monopoly power
Chapter 12 Slide 91
Cartels
Observations
To be successful:
Total demand must not be very price
elastic
Either the cartel must control nearly all
Chapter 12 Slide 92
The Cartelization
of Intercollegiate Athletics
Observations
1) Large number of firms (colleges)
2) Large number of consumers (fans)
Chapter 12 Slide 93
Question
How can we explain high profits in a
competitive market? (Hint: Think cartel and the NCAA)
The Cartelization
Chapter 12 Slide 94
The Milk Cartel
1990s with less government support,
the price of milk fluctuated more widely
In response, the government permitted
six New England states to form a milk
cartel (Northeast Interstate Dairy
Chapter 12 Slide 95
The Milk Cartel
1999 legislation allowed dairy farmers in
Northeastern states surrounding NIDC
to join NIDC, 7 in 16 Southern states to
form a new regional cartel.
Chapter 12 Slide 96
Summary
In a monopolistically competitive
market, firms compete by selling
differentiated products, which are highly
substitutable.
In an oligopolistic market, only a few
Chapter 12 Slide 97
Summary
In the Cournot model of oligopoly, firms
make their output decisions at the same
time, each taking the other’s output as
fixed.
In the Stackelberg model, one firm sets
Chapter 12 Slide 98
Summary
The Nash equilibrium concept can also
be applied to markets in which firms
produce substitute goods and compete
by setting price.
Firms would earn higher profits by
Chapter 12 Slide 99
Summary
The Prisoners’ Dilemma creates price
rigidity in oligopolistic markets.
Price leadership is a form of implicit
collusion that sometimes gets around
the Prisoners Dilemma.
