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Nov 29, 2014
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Which cell phone? Are two cell phone makers
two too few?
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Monopolistic Competitionand Oligopoly
13When you have completed your study of this chapter, you will be able to
1 Explain how price and quantity are determined in monopolistic competition.
2 Explain why selling costs are high in monopolistic competition.
3 Explain the dilemma faced by firms in oligopoly.
4 Use game theory to explain how price and quantity are determined in oligopoly.
CHAPTER CHECKLIST
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13.1 MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure in which
• A large number of firms compete.• Each firm produces a differentiated product.• Firms compete on price, product quality, and
marketing.• Firms are free to enter and exit.
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13.1 MONOPOLISTIC COMPETITION
Large Number of Firms
Like perfect competition, the market has a large number of firms. Three implications are
• Small market share
• No market dominance
• Collusion impossible
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13.1 MONOPOLISTIC COMPETITION
Product Differentation
Product differentiation is making a product that is slightly different from the products of competing firms.
A differentiated product has close substitutes but it does not have perfect substitutes.
When the price of one firm’s product rises, the quantity demanded of that firm’s product decreases.
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13.1 MONOPOLISTIC COMPETITION
Competing on Quality, Price, and Marketing
QualityDesign, reliability, after-sales service, and buyer’s ease of access to the product.
PriceBecause of product differentiation, the demand curve for the firms’ product is downward sloping.
MarketingMarketing has two main forms: Advertising and packaging.
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13.1 MONOPOLISTIC COMPETITION
Entry and Exit
No barriers to entry.
So the firm cannot make economic profit in the long run.
Identifying Monopolistic Competition
Two indexes:
• The four-firm concentration ratio
• The Herfindahl-Hirschman Index
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13.1 MONOPOLISTIC COMPETITION
The Four-Firm Concentration Ratio
The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry.
The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly.
• A ratio that exceeds 60 percent is an indication of oligopoly.
• A ratio of less than 40 percent is an indication of a competitive market—monopolistic competition.
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13.1 MONOPOLISTIC COMPETITION
The Herfindahl-Hirschman Index
The Herfindahl-Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms in a market.
Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent.
HHI = 502 + 252 + 152 + 102 = 3,450
A market with an HHI less than 1,000 is regarded as competitive and between 1,000 and 1,800 is moderately competitive.
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13.1 MONOPOLISTIC COMPETITION
How, given its costs and the demand for its jeans, does Lucky Brands decide the quantity of jeans to produce and the price at which to sell them?
The Firm’s Profit-Maximizing Decision
The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.
Figure 13.1 on the next slide illustrates this decision.
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1. Profit is maximized when MR = MC.
3. The profit-maximizing price is $100 per pair.
4. The firm makes an economic profit of $6,250 a day.
2. The profit-maximizing output is 125 pairs of Lucky jeans per day.
ATC is $50 per pair, so...
13.1 MONOPOLISTIC COMPETITION
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13.1 MONOPOLISTIC COMPETITION
Long Run: Zero Economic ProfitEconomic profit induces entry and economic loss induces exit, as in perfect competition.
Entry decreases the demand for the product of each firm.
Exit increases the demand for the product of each firm.
In the long run, economic profit is competed away and firms make zero economic profit.
Figure 13.2 on the next slide illustrates long-run equilibrium.
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1. The output that maximizes profit is 75 pairs of Lucky jeans a day.
2. The price is $70 per pair. Average total cost is also $70 per pair.
3. Economic profit is zero.
13.1 MONOPOLISTIC COMPETITION
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13.1 MONOPOLISTIC COMPETITION
Monopolistic Competition and Perfect Competition
The two key differences between monopolistic competition and perfect competition are that in monopolistic competition, there is
• Excess capacity
• Price exceeds marginal cost
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13.1 MONOPOLISTIC COMPETITION
Excess Capacity
A firm has excess capacity if the quantity it produces is less that the quantity at which average total cost is a minimum.
A firm’s efficient scale is the quantity of production at which average total cost is a minimum.
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1. The efficient scale is 100 pairs of Lucky jeans a day.
2. The firm produces less than the efficient scale and has excess capacity.
3. Price exceeds 4. marginal cost.
5. Deadweight loss is created.
13.1 MONOPOLISTIC COMPETITION
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13.2 PRODUCT DEVELOPMENT AND MARKETING
Innovation and Product Development
Wherever economic profits are earned, imitators emerge.
To maintain economic profit, a firm must seek out new products.
Cost Versus Benefit of Product Innovation
The firm must balance the cost and benefit at the margin.
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13.2 PRODUCT DEVELOPMENT AND MARKETING
Efficiency and Product Innovation
Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which equals the amount the consumer is willing to pay.
The marginal benefit to the producer is the marginal revenue, which in equilibrium equals marginal cost.
Because price exceeds marginal cost, product improvement is not pushed to its efficient level.
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13.2 PRODUCT DEVELOPMENT AND MARKETING
Marketing
Firms in monopolistic competition spend a large amount on advertising and packaging their products.
Marketing Expenditures
A large proportion of the prices that we pay cover the cost of selling a good.
Eye On Your Life shows the selling costs that you pay when you buy a new pair of running shoes.
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13.2 PRODUCT DEVELOPMENT AND MARKETING
Selling Costs and Total Costs
Marketing expenditures increase the costs of a monopolistically competitive firm above those of a perfectly competitive firm or a monopoly.
Selling costs such as advertising costs are fixed costs.
Advertising costs per unit decrease as production increases.
Figure 13.4 on the next slide illustrates the effects of selling costs on total cost.
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2. The average total cost of production,
3. Average total cost increases by a greater amount at small outputs than at large outputs.
13.2 PRODUCT DEVELOPMENT AND MARKETING
1. When advertising costs are added to
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13.2 PRODUCT DEVELOPMENT AND MARKETING
4. If advertising enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, …
the average total cost falls from $60 a pair to $40 a pair.
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13.2 PRODUCT DEVELOPMENT AND MARKETING
Selling Costs and Demand
Advertising and other selling efforts change the demand for a firm’s product.
The effects are complex:
• A firm’s own advertising increases the demand for its product.
• Advertising by all firms might decrease the demand for any one firm’s product and might make demand more elastic.
The price and markup might fall.
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13.2 PRODUCT DEVELOPMENT AND MARKETING
Efficiency: The Bottom Line
The bottom line on the question of efficiency of monopolistic competition is ambiguous.
Do the gains from extra product variety offset the selling costs and the extra cost arising from excess capacity?
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There is a lot of product differentiation in cell phones:
Samsung makes 38 versions; HTC makes 35; Nokia makes 30; and Sony makes 25.
In the three months from April through June 2013, dozens of new varieties of cell phones were announced by the top 20 firms in this market.
Why is there so much variety in cell phones?
The answer is that preferences are diverse and the cost of matching the diversity of preference is low.
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Think about the ways in which cell phones differ.
Just a few examples are its dimensions, weight, navigation tools, talk time, standby time, screen, camera features, audio features, memory, connectivity, processor speed, storage, and network capability.
Each one of these features comes in dozens of varieties.
How many possible designs?
For example, if a phone had 10 features and each feature comes in 6 varieties, there are 1 million different possible cell-phone designs.
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Firms produce variety only when the marginal cost of doing so is less than the marginal benefit.
The marginal cost of some cell-phone variety is not large.
But a technology exists for adding variety at almost zero cost that increases product differentiation to make each cell phone unique to the preferences of each individual.
This technology is the app.
Apple has only six versions of the iPhone, but with a large and growing number of apps, each iPhone owner can load their phone with exactly the apps they want.
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In the long-run equilibrium, entry and innovation by each competitor will drive the economic profit toward zero.
Each cell-phone maker will offer a degree of product differentiation that equates the marginal cost of variety with its marginal benefit.
But the pursuit of economic profit will spur ever more innovation.
Consumers will be confronted with ever wider choice.
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13.3 OLIGOPOLY
Oligopoly is another market type that stands between perfect competition and monopoly.
In oligopoly:
• A small number of firms compete.
• Natural or legal barriers prevent the entry of new firms.
Because oligopoly consists of a small number of firms:
• Each firm has a large market share.
• The firms are interdependent.
• The firms have an incentive to collude.
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13.3 OLIGOPOLY
Collusion
When a small number of firms share a market, they can increase their profit by forming a cartel and acting like a monopoly.
A cartel is a group of firms acting together to limit output, raise price, and increase economic profit.
A duopoly is a market in which there are only two producers.
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13.3 OLIGOPOLY
Cartels are illegal but they do operate in some markets.
Despite the temptation to collude, cartels tend to collapse.
Oligopoly might operate like monopoly, like perfect competition, or somewhere between these two extremes.
Monopoly Outcome
The firm would operate as a single-price monopoly.
Figure 13.5 on the next slide shows the monopoly outcome.
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13.3 OLIGOPOLY
With the market demand, D, marginal revenue curve, MR, and marginal cost, MC, …
a monopoly airplane maker maximizes profit by producing 6 airplanes a week and selling them for $13 million an airplane.
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13.3 OLIGOPOLY
The Duopolist’s Dilemma
To achieve the monopoly profit Airbus and Boeing might attempt to form a cartel.
If the firms can agree to produce the monopoly output of 6 airplanes a week, joint profits will be $72 million .
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13.3 OLIGOPOLY
Would it be in the self-interest of Airbus and Boeing to stick to the agreement and limit production to 3 planes a week each?
With price exceeding marginal cost, one firm can an increase its profit by increasing its output.
If both firms increased output when price exceeds marginal cost, the end of the process would be the same as perfect competition.
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13.3 OLIGOPOLY
Perfect Competition
Equilibrium occurs where the marginal revenue curve intersects the demand curve.
The quantity produced is 12 planes a week and the price would be $1 million a plane.
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Boeing can increase its economic profit by $4 million and cause the economic profit of Airbus to fall by $6 million to $30 million.
Boeing Increases Output to 4 Airplanes a Week
13.3 OLIGOPOLY
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Airbus Increases Output to 4 Airplanes a Week
For Airbus, this outcomeis an improvement on the previous one by $2 milliona week (up from $30 million).
For Boeing, the outcomeis worse than the previous one by $8 million a week (down from $40 million).
13.3 OLIGOPOLY
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13.3 OLIGOPOLY
Boeing Increases Output to 5 Airplanes a Week
If Boeing increases output to 5 airplanes a week, its economic profit falls.Similarly, if Airbus increases output to 5 airplanes a week, its economic profit falls.
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13.3 OLIGOPOLY
A cartel might achieve the monopoly equilibrium, break down and result in the perfect competition equilibrium,
or operate somewhere between these two extreme outcomes.
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13.3 OLIGOPOLY
• If both firms stick to the monopoly output, they each produce 3 airplanes and make $36 million.
• If they both increase production to 4 airplanes a week, they make $32 million each.
• If only one firm increases production to 4 airplanes a week, that firm makes $40 million.
• What do they do?
Game theory provides an answer.
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13.4 GAME THEORY
Game theory is the tool used to analyze strategic behavior—behavior that recognizes mutual interdependence and takes account of the expected behavior of others.
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13.4 GAME THEORY
What Is a Game?
All games involve three features:• Rules• Strategies• Payoffs
Prisoners’ dilemma is a game between two prisoners that shows why it is hard to cooperate, even when it would be beneficial to both players to do so.
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13.4 GAME THEORY
The Prisoners’ Dilemma
Art and Bob been caught stealing a car: sentence is 2 years in jail.
DA wants to convict them of a big bank robbery: sentence is 10 years in jail.
DA has no evidence and to get the conviction, he makes the prisoners play a game.
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13.4 GAME THEORY
Rules
Players cannot communicate with one another.
• If both confess to the larger crime, each will receive a sentence of 3 years for both crimes.
• If one confesses and the accomplice does not,the one who confesses will receive a 1-year sentence, while the accomplice receives a10-year sentence.
• If neither confesses, both receive a 2-year sentence.
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13.4 GAME THEORY
Strategies
The strategies of a game are all the possible actions of each player.
The strategies in the prisoners’ dilemma are
• Confess to the bank robbery.
• Deny the bank robbery.
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13.4 GAME THEORY
Payoffs
Four outcomes:
• Both confess.
• Both deny.
• Art confesses and Bob denies.
• Bob confesses and Art denies.
A payoff matrix is a table that shows the payoffs for every possible action by each player given every possible action by the other player.
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Table 13.5 shows the prisoners’ dilemma payoff matrix for Art and Bob.
13.4 GAME THEORY
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13.4 GAME THEORY
Equilibrium
Occurs when each player takes the best possible action given the action of the other player.
Nash equilibrium is an equilibrium in which each player takes the best possible action given the action of the other player.
The Nash equilibrium for Art and Bob is to confess.
The equilibrium of the prisoners’ dilemma is not the best outcome for the players.
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13.4 GAME THEORY
The Duopolists’ Dilemma
The dilemma of Boeing and Airbus is similar to that of Art and Bob.
Each firm has two strategies. It can produce airplanes at the rate of:
• 3 a week
• 4 a week
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13.4 GAME THEORY
Because each firm has two strategies, there are four possible combinations of actions:
• Both firms produce 3 a week (monopoly outcome).
• Both firms produce 4 a week.
• Airbus produces 3 a week and Boeing produces 4 a week.
• Boeing produces 3 a week and Airbus produces 4 a week.
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The Payoff Matrix
Table 13.6 shows the payoff matrix as the economic profits for each firm in each possible outcome.
13.4 GAME THEORY
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Equilibrium of the Duopolists’ Dilemma
Both firms produce 4 a week.
Like the prisoners, the duopolists fail to cooperate and get a worse outcome than the one that cooperation would deliver.
13.4 GAME THEORY
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13.4 GAME THEORY
Collusion Is Profitable but Difficult to Achieve
The duopolists’ dilemma explains why it is difficult for firms to collude and achieve the maximum monopoly profit.
Even if collusion were legal, it would be individually rational for each firm to cheat on a collusive agreement and increase output.
In an international oil cartel, OPEC, countries frequently break the cartel agreement and overproduce.
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13.4 GAME THEORY
Advertising and Research Games in Oligopoly
Advertising campaigns by Coke and Pepsi, and research and development (R&D) competition between Procter & Gamble and Kimberly-Clark are like the prisoners’ dilemma game.
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Coke and Pepsi have two strategies: advertise or not advertise.
Advertising Game
Table 13.8 shows the payoff matrix as the economic profits for each firm in each possible outcome.
13.4 GAME THEORY
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The Nash equilibrium for this game is for both firms advertise.
But they could earn a larger joint profit if they could collude and not advertise.
13.4 GAME THEORY
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P&G and Kimberly-Clark have two strategies: spend on R&D or do no R&D.
Table 13.9 shows the payoff matrix as the economic profits for each firm in each possible outcome.
Research and Development Game
13.4 GAME THEORY
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The Nash equilibrium for this game is for both firms to undertake R&D.
But they could earn a larger joint profit if they could collude and not do R&D.
13.4 GAME THEORY
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13.4 GAME THEORY
Repeated Games
Most real-world games get played repeatedly.
Repeated games have a larger number of strategies because a player can be punished for not cooperating.
This suggests that real-world duopolists might find a way of learning to cooperate so they can enjoy monopoly profit.
The next slide shows the payoffs with a “tit-for-tat” response.
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Week 1: Suppose Boeing contemplates producing 4 planes instead of the agreed 3 planes.
Boeing’s profit will increase from $36 million to $40 million, and Airbus’s profit will decrease from $36 million to $30 million.
13.4 GAME THEORY
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13.4 GAME THEORY
Week 2: Airbus punishes Boeing and produces 4 planes.
But Boeing must go back to producing 3 planes to induce Airbus to cooperate in week 3.
In week 2, Boeing’s profit falls to $30 million and Airbus’s profit increases to $40 million.
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13.4 GAME THEORY
Over the two-week period,
Boeing’s profit would have been $72 million if it had cooperated, but it was only $70 million with Airbus’s tit-for-tat response.
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13.4 GAME THEORY
In reality, whether a duopoly works like a one-play game or a repeated game depends on the number of players and the ease of detecting and punishing overproduction.
The larger the number of players, the harder it is to maintain the monopoly outcome.
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13.4 GAME THEORY
Is Oligopoly Efficient?
In oligopoly, price usually exceeds marginal cost.
So the quantity produced is less than the efficient quantity.
Oligopoly suffers from the same source and type of inefficiency as monopoly.
Because oligopoly is inefficient, antitrust laws and regulations are used to try to reduce market power and move the outcome closer to that of competition and efficiency.
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The cell phone combines two products: hardware and software.
Two firms dominate the cell-phone market: Apple and Samsung.
Apple powers its iPhone with its own operating system whereas Samsung installs the Android operating system.
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Figure 1 shows that Android is the most popular operating system with 75 percent share.
Figure 2 shows that Samsung competes with other Android smart-phone producers.
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Is the cell-phone market efficient?
Profit is one test of efficiency.
The large profit made suggest that the market is closer to monopoly than perfect competition.
Producer surplus is maximized.
Consumer surplus is less than it would be in a competitive market.
There is underproduction and a deadweight loss.
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Some firms (Apple, Microsoft, Google) seek maximum profit by controlling both hardware and software.
Others ( Samsung, LG and other) focus on hardware only.
In either case, hardware is the key to profit.
Economies of scale in the design and production of hardware mean that this market is likely to remain a highly concentrated oligopoly.
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