Monopolistic Competition and Oligopoly Chapter 12 Chapter Outline 12 1 Monopolistic Competition 12 2 Oligopoly 12 3 Price Competition 12 4 Competition versus Collusion The Prisoners Dilemma 12 5 Implications of the Prisoners Dilemma for Oligopolistic Pricing 12 6 Cartels Monopolistic Competition and Oligopoly monopolistic competition Market in which firms can enter freely each producing its own brand or version of a differentiated product oligopoly Market in which only a few firms compete with one another and entry by new firms is impeded cartel Market in which some or all firms explicitly collude coordinating prices and output levels to maximize joint profits The Makings of Monopolistic Competition A monopolistically competitive market has two key characteristics 1 Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes In other words the cross price elasticities of demand are large but not infinite 2 There is free entry and exit it is relatively easy for new firms to enter the A Monopolistically Competitive Firm in the Short and Long Run Because the firm is the only producer of its brand it faces a downwardsloping demand curve P MC and the firm has monopoly power In the short run P AC as well and the firm earns profits shown by the yellow shaded rectangle A Monopolistically Competitive Firm in the Short and Long Run In the long run profits attract new firms with competing brands The firm s market share falls and its demand curve shifts downward In long run equilibrium described in part b P AC so the firm earns zero profit even though it has monopoly power Monopolistic Competition and Economic Efficiency Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium Under perfect competition P MC The demand curve facing the firm is horizontal so the zeroprofit point occurs at the point of minimum AC Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium Under monopolistic competition P MC Thus there is a deadweight loss as shown by the yellow shaded area The demand curve is downward sloping so the zero profit point is to the left of the point of minimum average cost Any gains of monopolistic competition to consumers Monopolistic Competition in the Markets for Cola and Coffee Elasticities of Demand for Brands of Colas and Coffee Brand Colas Royal Crown Coke Ground coffee Elasticity of Demand 2 4 5 2 to 5 7 Folgers 6 4 Maxwell House 8 2 Chock Full o Nuts 3 6 With the exception of Royal Crown and Chock Full o Nuts all the colas and coffees are quite price elastic With elasticities on the order of 4 to 8 each brand has only limited monopoly power This is typical of monopolistic competition ACTIVE LEARNING 1 Advertising 1 So far we have studied three market structures perfect competition monopoly and monopolistic competition In each of these would you expect to see firms spending money to advertise their products Why or why not 2 Is advertising good or bad from society s viewpoint Try to think of at least one pro and con Advertising In monopolistically competitive industries product differentiation and markup pricing lead naturally to the use of advertising In general the more differentiated the products the more advertising firms buy Economists disagree about the social value of advertising The Critique of Advertising Critics of advertising believe Society is wasting the resources it devotes to advertising Firms advertise to manipulate people s tastes Advertising impedes competition it creates the perception that products are more differentiated than they really are allowing higher markups The Defense of Advertising Defenders of advertising believe It provides useful information to buyers Informed buyers can more easily find and exploit price differences Thus advertising promotes competition and reduces market power Results of a prominent study Eyeglasses were more expensive in states that prohibited advertising by eyeglass makers than in states that did not restrict such advertising Advertising as a Signal of Quality A firm s willingness to spend huge amounts on advertising may signal the quality of its product to consumers regardless of the content of ads Ads may convince buyers to try a product once but the product must be of high quality for people to become repeat buyers The most expensive ads are not worthwhile unless they lead to repeat buyers When consumers see expensive ads they think the product must be good if the company is willing to spend so much on advertising Brand Names In many markets brand name products coexist with generic ones Firms with brand names usually spend more on advertising charge higher prices for the products As with advertising there is disagreement about the economics of brand names The Critique of Brand Names Critics of brand names believe Brand names cause consumers to perceive differences that do not really exist Consumers willingness to pay more for brand names is irrational fostered by advertising Eliminating govt protection of trademarks would reduce influence of brand names result in lower prices The Defense of Brand Names Defenders of brand names believe Brand names provide information about quality to consumers Companies with brand names have incentive to maintain quality to protect the reputation of their brand names Comparing Perfect Monop Competition Perfect competition Monopolistic competition number of sellers many many free entry exit yes yes long run econ profits zero zero the products firms sell identical differentiated firm has market power none price taker yes D curve facing firm downwardsloping horizontal Comparing Monopoly Monop Competition Monopoly Monopolistic competition number of sellers one many free entry exit no yes long run econ profits positive zero firm has market power yes yes D curve facing firm downwarddownwardsloping sloping market demand close substitutes none many Oligopoly In oligopolistic markets the products may or may not be differentiated Only a few firms account for most or all of total production Some or all firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for new firms to enter Examples automobiles steel aluminum petrochemicals electrical equipment and computers Equilibrium in an Oligopolistic Market When a market is in equilibrium firms are doing the best they can and have no reason to change their price or