3.4 - 3.5 - Monopolistic competition / Oligopoly / Monopoly

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Monopolistic competition 1. Draw the model 2. What happens in the short-run? 3. What happens in the long-run?

(Monopoly like model). In the SR: Abnormal profit possible. In the LR: Abnormal profit signals other firms to enter market, each with slightly differentiated products (possible bc of no major barriers to entry, good knowledge, possibility to differentiate)-> since products are very close substitutes, demand for firm's product will fall -> decrease in demand -> AR line shifts left -> MR shifts left too -> depletes abnormal profit (at MR=MC) -> only normal profit made -> no further incentive for new firms to enter market. NOTE: There is NO demand curve for the market as a whole as, in MC, each firm produces its own, slightly differentiated product -> individual demand curves, one for each differentiated product in MP market. Abnormal profit attracts new entrants, each with slightly differentiated products. Since products are very close substitutes -> demand for firm's product will fall (as overall demand for this type of product will be spread amongst a much greater number of firms)

MONOPOLISTIC COMPETITION

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OLIGOPOLY

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Oligopolies 1. Disadvantages

1) Allocatively and productively inefficient. 2) High concentration reduces consumer choice. 3) Cartel-like behaviour reduces competition and can lead to higher prices and reduced output. 4) Lack of competition -> oligopolists can make decisions more complex (e.g. financial decisions about mortgages) -> individual consumers fall back on heuristics and rule of thumb processes -> leads to decision making bias and irrational behaviour (inc. making purchases which add no utility or even harm the individual consumer) -> thus, oligopolists can manipulate consumer decision making. 5) Deliberate barriers to entry -> firms can be prevented from entering. 6) Potential loss of economic welfare.

How can monopolies develop?

1) Complete ownership of scarce resource (natural monopoly). 2) Successful internal growth. 3) Mergers and acquisitions. 4) Patents/copyright -> exclusive rights to a good/service.

Monopoly 1. What are some barriers to entry in a monopoly? 2. What effect does this have?

1) High levels of expenditure on advertising (SUNK COST). establishing branded products -> consumer loyalty -> more expensive for new entrants to be successful. 2) Economies of scale. 3) Patents. 4) High sunk costs. 5) Brand proliferation. Multi-product firms -> gives false appearance of competition -> (non-price competition). Prevents new firms entering market to share in SN profit -> no close substitutes -> greatest monopoly power.

Oligopolies 1. Advantages

1) Oligopolies may adopt a highly competitive strategy -> generate similar benefits to more competitive market structures, such as lower prices. Even though there are a few firms, making the market uncompetitive, their behaviour may be highly competitive. 2) Dynamic efficiency. Abnormal profits -> used to innovate -> new products and processes -> better quality goods -> consumer benefits. Due to sticky prices increased importance to non-price competition -> encourages firms to improve quality of goods & increase spending on R&D -> to invent new goods etc. 3) Price stability Helps consumers to plan ahead and stabilise their expenditure -> help stabilise the business cycle

Monopoly 1. Advantages

1. Economies of scale. 2. Dynamic efficiency 3. Will eventually be replaced by new markets- Creative Destruction (Joseph Schumpeter) 3. Natural monopoly -> no wasteful duplication of resources. 4. Avoids market failure (missing market). 5. Abnormal profits -> invest in R&D and allows them to fund high cost investment spending into new technology -> if successful, results in improved products and lower costs in the LR. Innovative monopoly -> dynamically efficient over long run as it reaps the reward of investment in R&D. Patents for new ideas are normally acceptable as it encourage firms to fund the initial R&D and it allows these firms to recoup their investment.

Monopoly 1. Adv: Why is monopoly power needed to create dynamic efficiency? 2. Draw model

1. High profit levels -> boost investment in R&D. 2. Large firms are more likely to innovate -> innovation can lead to lower costs than in competitive markets. 3. Firm needs a dominant position to bear the risks associated with innovation. 4. Firms need to be able to protect their intellectual property by establishing barriers to entry; otherwise, there will be a free rider problem. 5. Why spend large sums on R&D if ideas or designs are instantly copied by rivals who have not allocated funds to R&D? However, monopolies protected from competition by barriers to entry -> generate high levels of supernormal profits. 7.If some SN profit invested in new technology, -> costs are reduced via process innovation -> monopolist's supply curve shifts to the right of the industry supply curve -> lower price and higher output in LR.

Monopoly 1. Disadvantages

1. Higher price than in a more competitive market. Lower output. -> Reducing consumer surplus and economic welfare -> Deadweight welfare loss. Higher prices -> allocative inefficiency (P>MC) and abnormal profits -> reduced benefits to consumers -> unequal distribution of income. Equity. Higher prices -> exploit low income consumers -> their purchasing power might be transferred to shareholders in the form of dividends -> unequal distribution of income. 4.Restricting choice for consumers. 5.Reducing consumer sovereignty. Less motivated towards economic efficiency e.g. cutting costs or increasing productivity. X-inefficiency. Allocatively inefficient. Productively inefficient. Lack of competition -> discourages monopoly to invest in R&D -> lack of innovation -> worse products.

Efficiencies in monopolisticly competitive markets 1. Allocative efficiency 2. Productive efficiency

1. In the short-run, MC markets are not allocatively efficient because P>MC. Also in LR. 2. In the short-run, MC markets are not productively efficient because (although close) operating at MC=MR, an output level that is lower than the output level at which ATC is minimized. In the LONG-RUN productive efficiency is also not achieved (in fact, less PE than in SR)

Monopoly 1. Government intervention- Why does the government regulate monopolies? 2. Monopoly regulation (competition policy)

1. Prevent excess prices (-> which otherwise would lead to allocative inefficiency, and decline in consumer welfare. 2. Quality of service. If a firm has monopoly over the provision of a particular service, it may have little incentive to offer a good quality service -> govt regulation to ensure minimum standards of service met. 5. Promote competition. Some industries possible to promote competition -> less need for govt regulation. 4. Natural monopolies. Some industries natural monopolies due to high EoS -> most efficient number of firms is 1 -> cannot encourage competition -> essential to regulate firm to prevent abuse of monopoly power.

Cartel

A collusive agreement by firms, usually to fix prices. Sometimes also an agreement to restrict output and to deter the entry of new firms.

Monopolistic competition 1. Define

A market structure in which firms have many competitors but each one sells a slightly differentiated product. A market structure in which there are many buyers and sellers. Firms supply similar, but differentiated, goods. There is freedom of entry into the market and freedom of exit out of the market. Knowledge among buyers tends to be widespread but it is not perfect.

Monopoly 1. Define 2. Draw the model

A market structure in which there is only one firm in the market. Price maker. Firm is the market. Protected by barriers to entry. A single supplier producing a differentiated product. The demand for the product is therefore the AR line, and the MR line slopes downwards with twice the gradient of AR.

Oligopoly 1. Define 2. What is used to identify oligopoly in a highly concentrated market? 3. How are oligopolies defined?

An imperfectly competitive market structure in which there is a high level of market concentration, dominated by a few suppliers. Differentiated goods (advertising is often important) and are interdependent (their actions influence each other). High barriers to entry but less than monopoly. Abnormal profit possible in SR and LR. They are price makers (but interdependent behaviour). Non-price competition is important. There are different possible outcomes for oligopoly: 1) Stable/'sticky' prices (e.g. through kinked demand curve) 2) Price wars (e.g. competitive oligopoly). 3) Collusion for higher prices. Concentration ratios are used to identify an oligopoly (measures extent to which a market is dominated by a few leading firms. Oligopoly: top 5 firms have 50%+ total market sales.) Oligopolies are best defined not only by market structure/number of firms in market, but also by market conduct or market behaviour.

Why does one not distinguish between SR and LR profit maximization in a monopoly?

Because a monopoly is protected by barriers to entry which prevent new firms entering the market to share in the abnormal profit made by the monopolist -> no close substitutes -> greatest monopoly power -> Entry barriers allow the monopolist to keep abnormal profit in both the SR and LR

Are cartels (collusive oligopolies) stable or unstable?

Cartels are unstable.

NAME THE TYPE OF OLIGOPOLY: Firms act independently- they do not form agreements with each other

Competitive oligopoly

Oligopolistic markets: 2 types

Competitive oligopoly (compete against themselves). Collusive oligopoly (agreements made amongst themselves in order to restrict competition and maximise their own benefits).

KINKED DEMAND CURVE MODEL (competitive olgply): How are rivals assumed to react to a price fall by one firm?

Cutting price below p1: Rivals are assumed to match a price fall by one firm to avoid a loss of market share. Demand relatively inelastic and a fall in price will also lead to a fall in total revenue. May also lead to price wars (which may lead to SR increases in sales and revenues but may not be in long term interests).

Cartels (collusive oligopoly): Adv & Disadv ?

DISADV- high prices and lack of choice (same as monopoly). However without the benefits that monopoly can bring e.g. EoS and dynamic efficiency

Collusive behaviour: COSTS

Damages consumer welfare (higher prices, loss of consumer surplus, loss of allocative efficiency, hits lower income families i.e. has regressive impact). Absence of competition hits efficiency (X-inefficiencies, less incentive to innovate). Reinforces the cartel's monopoly power

Does demand tend to be price elastic or inelastic in monopolistically competitive markets?

Demand tends to be price elastic as in MC there are many small firms competing, each with a slighting differentiated product.

OLIGOPOLY: Key features

Dominated by a few large firms. High market concentration ratio. Each firm supplies branded products. Barriers to entry and exit. Interdependent strategic decisions by firms.

OLIGOPOLY: Collusive

Firms act as if joint monopoly. Collusion = high prices. All firms refrain from competition.

How can COMPETITIVE oligopolists reduce the uncertainty they face in imperfectly competitive markets? Why?

Firms colluding together e.g. by forming a cartel agreement to jointly agree to charge a price. They enable inefficient firms to stay in business, while other more efficient members to enjoy abnormal profit because they are protected from competition

Monopoly 1. How is the process of 'Creative destruction' linked to monopolies? 2. Does this lend weight to the argument whether or not monopoly needs to be regulated?

Joseph Schumpeter: the dynamics of business cycle under capitalism might destroy some large inefficient firms by smaller new entrants. New entrants would be able to exploit new technology -> gain a competitive advantage over older, larger firms that continued to use older technologies. New entrepreneurs are often willing to take risks and employ new technologies in order to enter markets (they have less to lose than established firms). Eventually, across the economy, new technologies replace older and obsolete ones. Schumpeter's analysis can be argued to be a 'defence' of monopoly, at least in terms of the whether they need to be regulated. If Schumpeter is accurate, then even natural monopolies may be subject to competition and innovation from new entrants.

What model is used for competitive oligopoly?

Kinked demand curve model

Monopolistic competition 1. Ways in which Monopolistic Competition resembles PERFECT COMPETITION (PC). 2. Ways in which Monopolistic Competition resembles a Monopoly

Large number of buyers and sellers. Few barriers to entry in the LR. As a result, entry of new firms, attracted by SR abnormal profit, brings down the price each firm can charge until only normal profits made. Product differentiation (goods provide partial but not perfect substitutes for each other so each firm possesses a degree of monopoly power over their product. Unlike in PC market if a firm raises its price it does not lose all of its customers because there is brand loyalty) . Downward facing demand curve. Not price takers (each firm makes independent decisions about price and output)

Barriers to entry in OLIGOPOLIES

Limit or predatory pricing. Advertising. Brand multiplicity. Integration. Non-price competition. Branding. R&D for innovative new products.

Monopoly power 1. Define 2. Factors which influence monopoly power. 3. What effect would having high levels of monopoly power have?

Measures the degree to which a firm or individual can influence the market. When a single firm controls 25% or more of a particular market. Monopoly power is influenced by factors such as: 1) Barriers to entry. 2) Number of competitors. 3) Advertising. 4) Degree of product differentiation. High levels of monopoly power may mean price inelastic demand -> enables firms to set high prices. (barriers to entry -> prevent entry of new firms -> no close substitutes -> inelastic demand)

Monopoly 1. Adv: Why are economies of scale an advantage of a monopoly

Monopolies = large firms. Better placed to exploit returns to scale which lead to EoS (LRAC falls as output increases) -> increased output -> average CoP fall -> lower LRAC (benefit: firms) -> lower prices (benefit: consumers) -> adv to monopoly as would increase sales and maximize EoS -> barrier to entry (will only go as low as AR=AC limit pricing esp. if contestable market). May be 'natural monopoly' -> best to remain monopolies -> avoid wasteful duplication of resources/infrastructure that would happen if competition increased as new firms would be encouraged to build their own infrastructure -> most efficient number of firms in industry is one

Monopolistic competition 1. When is monopolisticly competitive firms most likely? Give examples

Monopolistically competitive firms are most common in industries where differentiation is possible, such as: •The restaurant business •Hotels and pubs •General specialist retailing •Consumer services, such as hairdressing

What does lack of competitive pressure lead to? How should the govt deal with problems posed by this?

Monopoly abuse and consumer exploitation. Govt policies dealing with market concentration and monopoly power now deal with deregulation and removal of barriers to entry i.e. making the market more contestable. Actual competition in a market is not essential, the threat of entry by new firms is enough to ensure efficient and non-exploitative behavior by incumbent firms

When is monopoly power greater?

Monopoly power is greater if: 1) there are significant barriers to entry. 2) The firm has no, or few, competitors. 3) marketing creates high levels of brand loyalty. 4) product differentiation is high.

KINKED DEMAND CURVE MODEL (competitive olgply): As a result of price rigidity, how does it affect the type of competition?

Non-price competition becomes more important

Contestable market: Hit and run entry

Occurs when a new entrant can 'hit' the market, share in abnormal profits and then 'run' when none left, given that there are no or low barriers to entry. The threat of hit and run entry is sufficient to keep prices and profits at lowest possible level, thereby increasing consumer surplus

OLIGOPOLY: Strategic Interdependence

One firm's output and pricing decisions is influenced by the likely behaviour of competitors. Few sellers so each firm is likely to be aware of the actions of other firms. Decisions of one firm influence, and are influenced by, the decisions of other firms. Causes oligopolistic industries to be at high risk of tacit or explicit collusion which can lead to allegations of anti-competitive behaviour. High level of uncertainty.

Why do some oligopolies collude?

Profit maximisation. Small number of firms. Similar costs. High entry barriers = lack of competition. Consumer loyalty / inertia. Govt. unable to detect collusive behavior or ineffective competition policy.

Collusive oligopolies: BENEFITS

Public benefits. Profits have value (R&D- leading to dynamic efficiency. Higher wages for employees- increased consumption)

Monopoly regulation 1. How can the government regulate monopolies?

Price capping by regulators RPI-X. i.e. limit price increases. If regulator thinks a firm can make efficiency savings and is charging too much to consumers, it can set a high level of X (amount they have to cut prices by in real terms). Adv: 1. Can set price increases depending on the state of the industry and potential efficiency savings.

What type of competition exists in monopolistic competition?

Price competition and non-price competition. Price competition leads to lower prices and profits -> MC markets tend to feature non-price competition. Focusing on methods e.g. new product development and advertising -> firms can increase demand for their products, without cutting price, although this does lead to higher costs.

KINKED DEMAND CURVE MODEL (competitive olgply): What is a key prediction of this model?

Prices will be rigid or 'sticky' even when there is a change in the marginal costs of supply

KINKED DEMAND CURVE MODEL (competitive olgply): How are rivals assumed to react to a price increase by one firm?

Rising price above p1: Rivals are assumed to hold their prices -> acting firm will lose market share -> demand will be relatively elastic -> lost sales and falling total revenue.

What is the equilibrium like under MC in SR and LR?

Short-run: Abnormal profits possible. Long-run: New firms attracted into industry as low barriers to entry, good knowledge and opportunity to differentiate.

Cartels (collusive oligopolies) are quite unstable. When do cartels break down?

When one firm cheats the cartel by increasing quantity or decreasing price. Govt exposes cartel and breaks it up. Market becomes contestable. Falling demand.

OLIGOPOLY: Competitive

When rival firms are interdependent and must take account of other's reactions when forming a market strategy but without cooperation or collusion. As a result, there is uncertainty in competitive oligopolies

Monopolies 1. Are monopolistic firms X-inefficient? 2. Define X-inefficiency. 3. Why are monopolistic firms x-inefficient? 4. Examples of x-inefficiency 5. How is x-inefficiency shown on a model?

Yes. X-efficiency- requires that the lowest possible prices are paid for inputs or factors of production. However, there is less incentive for a monopoly to make full use of the available technology, mainly due to lack of competition. More likely to be technically and productively inefficient -> incurring unnecessary production costs and wasted resources. E.g. Employing too many workers or investing in machines that are never used, deeming it technically inefficient. It could be paying its workers unnecessary high wages or buying capital or raw material at unnecessary high prices. Monopolist's LRAC is above that which would be technically possible -> resources are wasted. The x-inefficiency gap, as shown in figure 3, is considered as unnecessary production costs that a firm can reduce. In a perfectly competitive market, a firm must eliminate any form of x-inefficiency in order to survive and make normal profits. However, this is not the case with monopoly, which are able to survive while incurring unnecessary production costs and making satisfactory rather than maximum profits.

Can some COLLUSIVE behaviour between oligopolistic firm have public benefits?

Yes. Some forms of collusion e.g. on joint product development or ensuring industry safety standards, are in the public interest. (Price collusion is regarded as bad- often takes place in secret)

Monopolies 1. Will they always exist?

the existence of monopolies are inevitable as long as firms seek profit maximisation as well as increased market share and ultimately market dominance. In a free market economy, the chances of supernormal profits will eventually encourage other firms to attempt to break into a monopolistic market. The threat of competition or even a financial threat of a takeover will force a monopoly to become highly economic efficient. The American economist William Baumol argues in his theory of contestable markets that a monopoly may be forced over time to make the same production and pricing decisions as a competitive market would, merely due to the possibility of future competition. (Griffiths and Ison, 2001)