Chapter 9

Pricing and Output Decisions: Monopolistic Competition and Oligopoly

Modified by Chris Ball (2009) for EC 600
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Overview
Monopolistic competition Oligopoly Pricing under oligopoly Competing in imperfectly competitive markets Strategy: the challenge for firms in imperfect competition
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Learning objectives
contrast monopolistic competition and oligopoly describe the role that mutual interdependence plays in setting prices in oligopolistic markets

Chapter Nine

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Learning objectives
explain how non-price factors help firms to differentiate their products and services understand the five forces in Porters model of competition

Chapter Nine

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Introduction
Imperfect competition some market power but not absolute market power  firms have the ability to set prices within the limits of certain constraints  mutual interdependence: interaction among competitors when making decisions

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Introduction
Perfect Competition Monopoly Monopolistic Oligopoly Competition Market power? No Yes* Yes Yes

Mutual interdependence among competing firms? Non-price competition? Easy market entry or exit ?

No

No

No

Yes

No Yes

Optional No

Yes Yes

Yes No

* subject to government regulation

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Monopolistic competition
Monopolistic competition: characteristics many firms  relatively easy entry  product differentiation: can set price at a level higher than the price established by perfect competition  use MR = MC rule to maximize profit

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Monopolistic competition
If earning above-normal profits, newcomers will enter the market market supply curve shifts out and to the right firms demand curve shifts down and to the left ultimately, in the long run, firms earn only normal profit
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Oligopoly
Oligopoly is a market dominated by a relatively small number of large firms Herfindahl-Hirschman index (HH) measures market concentration (max HH = 10,000; unconcentrated markets have HH < 1,000)
n

HH ! Si2
i !1

n = number of firms in the industry Si = firms market share

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Pricing in an oligopolistic market

Mutual interdependence: relatively few sellers create a situation where each is carefully watching the others as it sets its price

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Pricing in an oligopolistic market

Price leader: one firm in the industry takes the lead in changing prices, and assumes that other firms: will follow a price increase but will not go even lower in order not to trigger a price war Non-price leader: firm that leads the differentiation of products on other, nonprice attributes
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Competing in imperfectly competitive markets

Non-price competition: any effort made by firms in order to change the demand for their product (other than the price)
Non-price determinants of demand:  tastes and preferences  income  prices of substitutes and complements  number of buyers  future expectations of buyers  financing terms
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Competing in imperfectly competitive markets

Examples: of efforts by managers to influence non-price demand influences:  advertising and promotion  location and distribution channels  market segmentation  loyalty programs  product extensions and new products  special customer services  product lock-in or tie-in  pre-emptive new product announcements
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Competing in imperfectly competitive markets

Equalizing at the margin: economic concept which managers can use to help make an optimal decision eg MR = MC is an example of equalizing at the margin  can be used to decide the optimal expenditure level on a non-price factor  may occur over a long period of time  firm must adjust MR, MC for the time value of money
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Competing in imperfectly competitive markets

Examples: the reality of imperfect competition

auto industry small retailers global credit card issuers

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Chapter Nine

Strategy for firms in imperfect competition

How does industry concentration affect the behavior of firms competing in the industry? Strategy: the means by which an organization uses its scarce resources to relate to the competitive environment in a manner that is expected to achieve superior business performance over the long run
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Strategy for firms in imperfect competition

Strategy is important when firms are price makers and are faced with price and non-price competition as well as threats from new entrants into the market More important for firms in imperfectly competitive markets than those in perfectly competitive markets or monopoly markets
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Strategy for firms in imperfect competition

Managerial economics: the use of economic analysis to make business decisions involving the best use of an organizations scarce resources Industrial organization: studies the way that firms and markets are organized and how this organization affects the economy

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Strategy for firms in imperfect competition

Structure-Conduct-Performance (S-C-P) paradigm: says structure affects conduct which affects performance

structure: number of firms in industry, conditions of entry, product differentiation conduct: pricing strategies, advertising, product development, legal tactics, collusion performance: maximization of societys welfare
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Criticism: weak empirical evidence of relationship between observed concentration and profit levels Weak theoretical foundations. Ignores the likely option that causality runs in reverse, for example

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Strategy for firms in imperfect competition

New Theory of Industrial Organization: says there is no necessary connection between observed industry structure and performance that uniquely leads to maximum social welfare theory of contestable markets: performance by firms is ultimately influenced not by actual competition, but by the threat of potential competition
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Strategy for firms in imperfect competition

Porters Five Forces model: illustrates the various factors that affect the ability of any firm in the industry to earn a profit

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Strategy for firms in imperfect competition

Porters generic strategies for earning above-average return on investment


Differentiation approach: for a monopoly or monopolistically competitive market following MR = MC rule, firm sets a price on the demand line that is above AC

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Strategy for firms in imperfect competition

Porters generic strategies for earning above-average return on investment


Cost leadership approach: for perfect competition maintain cost structure low enough so when P = MC, there is a positive difference between P and AC
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Chapter Nine