And Monopolistic Competition Monopolistic Competition

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12/15/2016Chapter OutlineChapter 14OligopolyandMonopolisticCompetition14. 1.14. 2.14. 3.14. 4.14.5.Two More Market StructuresOligopolyMonopolistic CompetitionThe "Broken" Invisible HandSumming Up: Four Market StructuresModified by Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi WangKey Ideas2016/12/15Imperfect Competition(s)Joseph Tao-yi WangKey Ideas1.Two market structures that lie betweenperfect competition and monopoly areoligopoly and monopolistic competition.4.In monopolistically competitive markets,entry and exit drive economic profits tozero in the long run.2.In both of these markets the seller mustrecognize actions of competitors.5.3.In oligopolies, economic profits in the longrun can be positive.There are several important variables suchas the number of firms in the industry,the degree of product differentiation,entry barrier, and the presence or absenceof collusion that determine thecompetitiveness of a market.2016/12/15Imperfect Competition(s)Joseph Tao-yi WangEvidence-Based Economics ExampleHow many firms are necessary to make amarket competitive?2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly and Monopolistic CompetitionWhy do firms say they will match acompetitor's price?2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang1

12/15/2016Two More Market StructuresTwo More Market StructuresBetween the two extremes.Differentiated productsGoods that are similar but not identicalMonopolistic CompetitionOligopolyHomogeneous productsGoods that are identical, making them perfectsubstitutesPerfect Competition2016/12/15Imperfect Competition(s)MonopolyJoseph Tao-yi WangTwo characteristics of markets:1. The number of firms AND2. The degree of product differentiation2016/12/15Imperfect Competition(s)Joseph Tao-yi WangTwo More Market Structures:OligopolyTwo More Market StructuresMarket where there are only a few firmscompetingProducts can be either homogeneous ordifferentiatedSignificant barriers to entry and exitEach firm's decisions are dependent uponother firms' actionsPositive economic profits in the long runExhibit 14.1 Characteristics of Four Market Structures2016/12/15Imperfect Competition(s)Joseph Tao-yi WangTwo More Market Structures:Monopolistic CompetitionJoseph Tao-yi WangOligopoly can sell either.SteelOilGasolineComputer hard drivesProducts are similar but slightlydifferentiatedNo barriers to entry or exitDifferentiated products—examples:Zero economic profits in the long runImperfect Competition(s)Imperfect Competition(s)Homogeneous products—examples:Many competing firms2016/12/152016/12/15Joseph Tao-yi WangCerealAutomobilesLaundry detergentCigarettes2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang2

12/15/2016OligopolyOligopolist's problemOligopoly: Oligopoly Model withHomogeneous ProductsDuopoly: Industry with two firms1.Like a monopolist, hassignificant barriers to entry,resulting in long-run economic profits2.High degree of interdependencebetween the few firms that occupy the marketExample: two landscaping companies, Dogwoodand Rose Petal (sell homogeneous products)How much market power do thesecompanies have?Because products are perfect substitutes, if theycharge the same price, they will split the market.What if one firm lowers its price?2016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly: Oligopoly Model withHomogeneous Products2016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly: Oligopoly Model withHomogeneous ProductsResidual demandThe demand not met by the other firm(s) anddependent on the prices of all the firms in theindustryExhibit 14.2 Market Demand Curve for an Oligopoly with Homogeneous Products2016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly: Oligopoly Model withHomogeneous ProductsBoth have a MC of 30Who would you pick to do your landscaping?2.3.Is this a Nash equilibrium?What should Dogwood do?What should Rose Petal do?2016/12/15Imperfect Competition(s)Imperfect Competition(s)Joseph Tao-yi WangOligopoly: Oligopoly Model withHomogeneous ProductsWhere does the madness end?Dogwood is charging 50Rose Petal is charging 451.2016/12/15At P 30!Long runequilibrium:P MCDoes thislook familiar?Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang3

12/15/2016Oligopoly: Oligopoly Model withDifferentiated ProductsBecause products are differentiated,Oligopoly: Oligopoly Model withDifferentiated ProductsExample: Coke and Pepsithe demand function is not all-or-nothing.Firms can charge higher prices and not loseall sales becausethe differentiation creates preferences on thepart of consumers.If Coke raises its price, it will lose sales to Pepsi,but (unlike sales of homogeneous products)Coke's sales won't go to zerobecause of differentiation.Some consumers would still rather have Coke,for example.2016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly: Oligopoly Model withDifferentiated ProductsHow should Coke and Pepsi decide on theirprices?It depends.Imperfect Competition(s)Joseph Tao-yi WangOligopoly:Collusion: One Way to Keep Prices HighHow could oligopolists avoid a price war?CollusionWhether Coke thinks Pepsi will match alower priceWhether Coke thinks Pepsi will match ahigher price2016/12/152016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly:Collusion: One Way to Keep Prices HighCollusion is not illegal in some places!CartelA formal organization of producers who colludeOPEC (Organization of the PetroleumExporting Countries)Firms conspiring to set the quantity or themarket priceThis is illegal! But what if it weren't illegal?Could Rose Petal and Dogwood agree to charge 50, divide the market, and each do 500 jobs?2016/12/15Imperfect Competition(s)Joseph Tao-yi WangOligopoly:Collusion: One Way to Keep Prices HighWhen can collusion work?If there is an enforcement mechanismIf the long-run profits associated with notcheating outweigh the short-run gains ofcheatingComprised of oil-producing nations that colludeto control the price of oil by limiting production2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang4

12/15/2016Oligopoly:Collusion: One Way to Keep Prices HighWhy do firms say they will match acompetitor's price?Monopolistic CompetitionShares all of the characteristics of perfectcompetition exceptmonopolistic competitors sell products thatare slightly different.Examples:Clothing firmsRestaurantsOver-the-counter medicationsFood manufacturers2016/12/15Imperfect Competition(s)Joseph Tao-yi WangMonopolistic CompetitionThe Monopolistic Competitor's ProblemExhibit 14.5 Dairy Queen's Demand Curve and Marginal Revenue Curve2016/12/15Imperfect Competition(s)Joseph Tao-yi WangMonopolistic CompetitionThe Monopolistic Competitor's ProblemExhibit 14.7 Economic Profits and Economic Losses2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi WangMonopolistic CompetitionThe Monopolistic Competitor's ProblemExhibit 14.6 Optimal Pricing Strategy for a Monopolistic Competitor2016/12/15Imperfect Competition(s)Joseph Tao-yi WangMonopolistic CompetitionThe Monopolistic Competitor's ProblemExhibit 14.8 The Effect of Market Entry on an Existing Firm's Demand Curve2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang5

12/15/2016Monopolistic CompetitionThe Monopolistic Competitor's ProblemThe "Broken" Invisible HandMarket power breaks the hand.Exhibit 14.6 Optimal Pricing Strategy for a Monopolistic Competitor2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi WangThe "Broken" Invisible HandRegulating Market PowerThe "Broken" Invisible HandShould the government regulate, in thecase of market power?It depends.It might ifThere is suspected collusionThe benefits exceed the costsThe industry is too concentratedExhibit 14.10 Equilibria for a Perfectly Competitive Market and a Monopolistically Competitive Market2016/12/15Imperfect Competition(s)Joseph Tao-yi WangThe "Broken" Invisible HandRegulating Market Power2016/12/15Imperfect Competition(s)Joseph Tao-yi WangSumming Up: Four Market StructuresHerfindahl-Hirschman Indexmeasure of market concentration to determinedegree of competitionHHI is sum of square of market share ofeach firm.The higher the HHI, the more concentrated theindustry.Exhibit 14.11Four MarketStructures2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang6

12/15/2016Evidence-Based Economics ExampleHow many firms are necessary to make amarket competitive?HomeworkALL Chap.14, Problem 2, 4, 8, 10Bonus Question (See next slide)Challenge Questions (from Past Finals)2007 2008 2009 2010 2012 2013 2014 2015 -2016/12/15Imperfect Competition(s)Joseph Tao-yi WangBonus Question 1 (ALL 14-6)Suppose there were just two cigarettemanufacturers, Jones and Smith.Each can either advertise or not advertise.If neither advertises, they each capture 50percent of the market and each earns 10million.Imperfect Competition(s)Joseph Tao-yi WangBonus Question 1 (ALL 14-6)1.2.Suppose the government proposes a banon cigarette ads.Should the two cigarette companies favor theban or should they oppose the banif advertising did not persuade some people tobecome smokers?Imperfect Competition(s)Joseph Tao-yi WangIf they both advertise, they again split themarket evenly, but each spends 2 millionon ads and so each earns just 8 million(remember, advertising is not supposed toencourage more people to smoke).If one company advertises but the otherdoes not, then the company that advertisesattracts many of its rival's customers.As a result, the advertising company earns 12million and the other earns just 6 million.2016/12/15Imperfect Competition(s)Joseph Tao-yi WangBonus Question 1 (ALL 14-11)Show that advertising is a dominantstrategy.2016/12/15Imperfect Competition(s)Bonus Question 1 (ALL 14-6)Tobacco companies have often argued thatthey advertise to attract more people whoalready smoke and not to persuade morepeople to begin smoking.2016/12/152016/12/15Essay Q1, Q3Multi-Choice Q6-Q8, Essay CMulti-Choice Q6, Q8, Essay A, B, CMulti-Choice Q1, Q7, Q8Essay IIIEssay II, IIIEssay A, CEssay C & DJoseph Tao-yi WangMajor league baseball teams have imposedthe "luxury tax" on themselves.A team is subject to the tax if its payrollexceeds a specific level. The annual thresholdfor the luxury tax is 189 million for 2014-16.A team that exceeds the threshold must pay17.5% to 50% of the amount by whichits payroll is above the threshold, where the"tax rate" depends on the number of years theteam is over.2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang7

12/15/2016Bonus Question 1 (ALL 14-11)Bonus Question 1 (ALL 14-11)This question looks at why teams mightsubject themselves to this tax.Suppose there are two MLB teams,Yankees and Red Socks.If one chooses high & the other chooses low,the high team will attract the best players andearn 600, but the low team will earn just 300.1.They will both choose to offer either highsalaries to players or low salaries.They will make their decisions simultaneously.If both choose low, each will earn 0;if both choose high each will earn 400.2016/12/15Imperfect Competition(s)Joseph Tao-yi WangShow that high is a dominant strategy butboth would be better off if both chose low.Under a 1922 Supreme Court decision, MLB isnot subject to many antitrust laws.2.Suppose these two teams agree to a luxurytax so whoever chooses high must pay atax of 250. Find the new equilibrium.2016/12/15Imperfect Competition(s)Joseph Tao-yi WangBonus Question 1 (ALL 14-11)Some people might argue that the luxury tax inMLB is not an important determinant of majorleague salaries.As evidence, they show that team payrollsrarely exceed the threshold level and soteams rarely pay the tax.3. What does your answer to this questionsuggest about the logic of this claim?2016/12/15Imperfect Competition(s)Joseph Tao-yi Wang8

Each can either advertise or not advertise. attracts many of its rival's customers. If neither advertises, they each capture 50 percent of the market and each earns 10 million. 2016/12/15 Imperfect Competition(s) Joseph Tao-yiWang Bonus Question1 (ALL 14-6) If they both advertise, they again split the market evenly, but each spends 2 million

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