The definition is difficult, since it means different things to different people, and there is no common legal definition. This game is shown in Figure 5. There are two players in the game: Cargill and Tyson. Each firm has two possible strategies: produce natural beef or not. In this game, profits are made from the premium associated with natural beef.
If only one firm produced natural beef,. Both firms choose to produce natural beef, no matter what, so this is a Dominant Strategy for both firms. The outcome of this game demonstrates why all beef processors have moved quickly into the production of natural beef in the past few years, and are all earning higher levels of profits. If all oligopolists in a market could agree to raise the price, they could all earn higher profits.
Collusion, or the cooperative outcome, could result in monopoly profits. In the USA, explicit collusion is illegal. For example, if gas stations in a city such as Manhattan, Kansas all matched a higher price, they could all make more money. However, there is an incentive to cheat on this implicit agreement by cutting the price and attracting more customers away from the other firms to your own gas station.
Firms in a cooperative agreement are always tempted to break the agreement to do better. The Nash Equilibrium calculated for the three oligopoly models Cournot, Bertand, and Stackelberg is a noncooperative equilibrium, as the firms are rivals and do not collude. In these models, firms maximize profits given the actions of their rivals. This is common, since collusion is illegal and price wars are costly.
Oligopolists have a strong desire for price stability. Firms in oligopolies are reluctant to change prices, for fear of a price war. If a single firm lowers its price, it could lead to the Bertrand equilibrium, where price is equal to marginal costs, and economic profits are equal to zero.
The kinked demand model asserts that a firm will have an asymmetric reaction to price changes. Rival firms in the industry will react differently to a price change, which results in different elasticities for price increases and price decreases. The kinked demand curve is shown in Figure 5. In the kinked demand curve model, MR is discontinuous, due to the asymmetric nature of the demand curve. For linear demand curves, MR has the same y-intercept and two times the slope… resulting in two different sections for the MR curve when demand has a kink.
The graph shows how price rigidity occurs: any changes in marginal cost result in the same price and quantity in the kinked demand curve model. As long as the MC curve stays between the two sections of the MR curve, the optimal price and quantity will remain the same. One important feature of the kinked demand model is that the model describes price rigidity, but does not explain it with a formal, profit-maximizing model.
The kinked demand model is criticized because it is not based on profit-maximizing foundations, as the other oligopoly models. Price signaling is common for gas stations and grocery stores, where price are posted publically. A dominant firm is defined as a firm with a large share of total sales that sets a price to maximize profits, taking into account the supply response of smaller firms.
The dominant firm model is also known as the price leadership model. The market demand for the good D mkt is equal to the sum of the demand facing the dominant firm D dom and the demand facing the fringe firms D F. Total quantity Q T is also the sum of output produced by the dominant and fringe firms.
The dominant firm model is shown in Figure 5. The supply curve for the fringe firms is given by S F , and the marginal cost of the dominant firm is MC dom. The dominant firm has the advantage of lower costs due to economies of scale. In what follows, the dominant firm will set a price, allow the fringe firms to produce as much as they desire, and then find the profit-maximizing quantity and price with the remainder of the market.
To find the profit-maximizing level of output, the dominant firm first finds the demand curve facing the dominant firm the dashed line in Figure 5. The dominant firm demand curve is found by the following procedure. At this point, the fringe firms supply the entire market, so the residual facing the dominant firm is equal to zero.
Therefore, the demand curve of the dominant firm starts at the price where fringe supply equals market demand. The second point on the dominant firm demand curve is found at the y-intercept of the fringe supply curve S F. At any price equal to or below this point, the supply of the fringe firms is equal to zero, since the supply curve represents the cost of production. At this point, and all prices below this point, the market demand D mkt is equal to the dominant firm demand D dom.
Thus, the dashed line below the y-intercept of the fringe supply is equal to the market demand curve. This is the dashed line above the S F y-intercept. Once the dominant firm demand curve is identified, the dominant firm maximizes profits by setting marginal revenue equal to marginal cost at quantity Q dom. This level of output is then substituted into the dominant firm demand curve to find the price P dom. The fringe firms take this price as given, and produce Q F.
In this way, the dominant firm takes into account the reaction of the fringe firms while making the output decision.
The model effectively captures an industry with one dominant firm and many smaller firms. A cartel is a group of firms that have an explicit agreement to reduce output in order to increase the price.
Cartels are illegal in the United States, as the cartel is a form of collusion. The success of the cartel depends upon two things: 1 how well the firms cooperate, and 2 the potential for monopoly power inelastic demand.
Cooperation among cartel members is limited by the temptation to cheat on the agreement. This cartel is legal, since it is an international agreement, outside of the American legal system. Frequently, one or more member nations increases oil production above the agreement, putting downward pressure on oil prices. A collusive agreement, or cartel, results in a circular flow of incentives and behavior.
When firms in the same industry act independently, they each have an incentive to collude, or cooperate, to achieve higher levels of profits. If the firms can jointly set the monopoly output, they can share monopoly profit levels. When firms act together, there is a strong incentive to cheat on the agreement, to make higher individual firm profits at the expense of the other members.
The business world is competitive, and as a result oligopolistic firms will strive to hold collusive agreements together, when possible. This type of strategic decisions can be usefully understood with game theory, the subject of the next two Chapters.
Skip to content Main Body. Monopolistic Competition. Homogeneous good. Numerous firms. Many firms. Few firms. One firm. Free entry and exit. Two additional models of pricing are price signaling and price leadership. Previous: Chapter 4.
Pricing with Market Power. Next: Chapter 6. Game Theory. Share This Book Share on Twitter. In the long run, firms in monopolistic competitive markets are highly inefficient and can only break even. Given a long enough time period, a firm can take the following actions in response to shifts in demand:. In the long-run, a monopolistically competitive market is inefficient.
It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus. Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run.
While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run.
Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit. Long Run Equilibrium of Monopolistic Competition : In the long run, a firm in a monopolistic competitive market will product the amount of goods where the long run marginal cost LRMC curve intersects marginal revenue MR.
The price will be set where the quantity produced falls on the average revenue AR curve. The result is that in the long-term the firm will break even. The key difference between perfectly competitive markets and monopolistically competitive ones is efficiency. One of the key similarities that perfectly competitive and monopolistically competitive markets share is elasticity of demand in the long-run. In both circumstances, the consumers are sensitive to price; if price goes up, demand for that product decreases.
The two only differ in degree. Demand curves in monopolistic competition are not perfectly elastic: due to the market power that firms have, they are able to raise prices without losing all of their customers. Demand curve in a perfectly competitive market : This is the demand curve in a perfectly competitive market. Note how any increase in price would wipe out demand. Also, in both sets of circumstances the suppliers cannot make a profit in the long-run. Ultimately, firms in both markets will only be able to break even by selling their goods and services.
Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues. One key difference between these two set of economic circumstances is efficiency. A perfectly competitive market is perfectly efficient.
This means that the price is Pareto optimal, which means that any shift in the price would benefit one party at the expense of the other. The overall economic surplus, which is the sum of the producer and consumer surpluses, is maximized.
The suppliers cannot influence the price of the good or service in question; the market dictates the price. The price of the good or service in a perfectly competitive market is equal to the marginal costs of manufacturing that good or service. In a monopolistically competitive market the price is higher than the marginal cost of producing the good or service and the suppliers can influence the price, granting them market power. Another key difference between the two is product differentiation.
In a perfectly competitive market products are perfect substitutes for each other. But in monopolistically competitive markets the products are highly differentiated.
A final difference involves barriers to entry and exit. In a monopolistic competitive market there are few barriers to entry and exit, but still more than in a perfectly competitive market. In terms of economic efficiency, firms that are in monopolistically competitive markets behave similarly as monopolistic firms.
This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity. Firms in a monopolistically competitive market are price setters, meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. In these types of markets, the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve.
This means two things:. Regardless of whether there is a decline in producer surplus, the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus.
Productive efficiency occurs when a market is using all of its resources efficiently. In a monopolistic competitive market, firms always set the price greater than their marginal costs, which means the market can never be productively efficient. Allocative efficiency occurs when a good is produced at a level that maximizes social welfare. Advertising and branding help firms in monopolistic competitive markets differentiate their products from those of their competitors.
One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products. Two ways to do this is through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services. Advertising is generally used by businesses to cultivate a brand. Listerine advertisement, : From until the mids, Listerine was also marketed as preventive and a remedy for colds and sore throats.
The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. Reputation among consumers is important to a monopolistically competitive firm because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality.
This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large.
Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information. Finally, advertising allows new firms to enter into a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.
There are some concerns about how advertising can harm consumers and society as well. The concentration ratio has several shortcomings in terms of measuring competitiveness. Interindustry competition sometimes exists, so dominance in one industry may not mean that competition from substitutes is lacking. World trade has increased competition, despite high domestic concentration ratios in some industries like the auto industry.
Concentration ratios fail to measure accurately the distribution of power among the leading firms. Concentration tells us nothing about the actual market performance of various industries in terms of how vigorous the actual competition is among existing rivals.
From the total-revenue test, we know raising prices when demand is elastic will decrease revenue. The figure above shows that marginal cost has substantial ability to increase at price P before it no longer equals MR; thus, changes in marginal cost will also not tend to affect price.
In the real world oligopoly prices are often not rigid, especially in the upward direction. Quick Quiz.
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