Lecture Essentials of economics (3/e): Chapter 9 - Brue, McConnell, Flynn

Chapter 9

Monopolistic
Competition and
Oligopoly

McGraw­Hill/Irwin

Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved
1­1


Monopolistic Competition

• Relatively large number of sellers
• Differentiated products
• Easy entry and exit
• Advertising

9­2


Price and Output in Monopolistic 
Competition

• Demand is highly elastic
• Short-run profit or loss
• Produce where MR = MC
• Long-run normal profit
• Entry and exit
• Inefficient

• Product variety
LO2

9­3


The Short Run: Profit or Loss

Price and Costs

MC

ATC

P1
A1
Economic
Profit

D1
MR = MC
MR

0

Q1

Quantity

LO2

9­4


The Short Run: Profit or Loss

Price and Costs

MC

ATC

A2
P2

Loss
D2
MR = MC
MR
0

Q2

Quantity

LO2

9­5

The Long Run: Only a Normal Profit
MC

Price and Costs

ATC
P3= A3

D3
MR = MC
MR
0

Q3

Quantity

LO2

9­6


Monopolistic Competition: Efficiency

• Inefficient
• Productive inefficiency
• P > ATC
• Allocative inefficiency
• P > MC

LO2

9­7


Monopolistic Competition: Efficiency
P = MC = min ATC for pure competition (recall)

P4
Price is lower

Excess capacity at
minimum ATC
Q4

Monopolistic competition is not efficient
LO2

9­8


Product Variety

•

•

LO2

The firm constantly manages price, product,

and advertising
• Better product differentiation
• Better advertising
The consumer benefits by greater array of
choices and better products
• Types and styles
• Brands and quality
9­9


Oligopoly

•
•
•
•
•
LO3

A few large producers
Homogeneous or differentiated products
Limited control over price
• Mutual interdependence
• Strategic behavior
Entry barriers
Mergers

9­10

Game Theory Overview

• Oligopolies display strategic pricing
behavior
• Mutual interdependence
• Collusion
• Incentive to cheat
• Prisoner’s dilemma
LO4

9­11


Game Theory Overview

LO4

High

Uptown’s Price Strategy

• 2 competitors
• 2 price strategies
• Each strategy has a
payoff matrix
• Greatest combined
profit
• Independent
actions stimulate a
response

RareAir’s Price Strategy

A

$12

Low
B

$15

High
$12

C

$6

$6

D

$8

Low
$15

$8

9­12


Game Theory Overview

LO4

High

Uptown’s Price Strategy

• Independently
lowered prices in
expectation of
greater profit leads
to worst combined
outcome
• Eventually low
outcomes make
firms return to
higher prices

RareAir’s Price Strategy

A

$12

Low
B

$15

High
$12

C

$6

$6

D

$8

Low
$15

$8

9­13


Kinked­Demand Theory

• Noncollusive oligopoly
• Uncertainty about rivals’ reactions
• Rivals match any price change
• Rivals ignore any price change

• Assume combined strategy
• Match price reductions
• Ignore price increases
LO5

9­14


Kinked­Demand Curve
MC1

D2
P0

e

MR2

MC2

f
g
D1

Q0
LO5

MR1
9­15

Kinked­Demand Curve

• Criticisms
• Explains inflexibility, not price
• Prices are not that rigid
• Price wars

LO6

9­16


Price Leadership Model

• Price leadership
• Dominant firm initiates price
•
•
LO6

changes
• Other firms follow the leader
Use limit pricing to block entry of new
firms
Possible price war
9­17


Collusion

• Cartel
• Overt collusion
• Covert collusion
• Joint-profit maximization

LO6

9­18


Collusion
MC

P0

ATC

A0
MR=MC
Economic
profit

MR

D

Q0

LO6

9­19


Overt Collusion

• Cartels: a group of firms or nations

•
•
LO6

that collude
• Formally agree to the price
• Set output levels for members
Collusion is illegal in the United
States
OPEC
9­20


Obstacles to Collusion

• Demand and cost differences
• Number of firms
• Cheating
• Recession
• New entrants
• Legal obstacles
LO6

9­21


Oligopoly and Advertising

• Prevalent to compete with product
development and advertising
• Less easily duplicated than a price
change
• Financially able to advertise

LO7

9­22


Positive Effects of 
Advertising

• Low-cost way of providing information
•
•
•

LO7

to consumers
Enhances competition
Speeds up technological progress

Can help firms obtain economies of
scale

9­23


Oligopoly and Advertising
The Largest U.S. Advertisers, 2010
Company
Procter & Gamble

Advertising Spending
Millions of $
$3124

General Motors

2131

AT&T

2093

Verizon

1823

News Corp.

1368

Pfizer

1229

Time Warner

1194

Johnson & Johnson

1140

Ford Motor

1132

L’Oreal

1112

LO7
McGraw-Hill/Irwin

Source: Advertising Age, www.adage.com
9­24


Negative Effects of Advertising

• Can be manipulative
• Contains misleading claims that
•

LO7

confuse consumers
Consumers pay high prices for a
good while forgoing a better, lowerpriced, unadvertised version of the
product
9­25