Question

a) Government motive for introducing competition policy is a positive action since the incentive to develop new production process in general is higher among competitive firms as compared to monopoly. Discuss. ( 40 marks)

b) Discuss the factors that facilitate and hinder effective collusion among oligopolistics firms. ( 40 marks)

Answer 1

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A:

MONOPOLISTIC COMPETITION

Learning Objectives

By the end of this section, you will be able to:

• Explain the significance of differentiated products
• Describe how a monopolistic competitor chooses price and quantity
• Discuss entry, exit, and efficiency as they pertain to monopolistic competition
• Analyze how advertising can impact monopolistic competition

Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell different kinds of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States. When products are distinctive, each firm has a mini-monopoly on its particular style or flavor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names. The term “monopolistic competition” captures this mixture of mini-monopoly and tough competition, and the following Clear It Up feature introduces its derivation.

Who invented the theory of imperfect competition?

The theory of imperfect competition was developed by two economists independently but simultaneously in 1933. The first was Edward Chamberlin of Harvard University who published The Economics of Monopolistic Competition. The second was Joan Robinson of Cambridge University who published The Economics of Imperfect Competition. Robinson subsequently became interested in macroeconomics where she became a prominent Keynesian, and later a post-Keynesian economist. (See the Welcome to Economics! and The Keynesian Perspective chapters for more on Keynes.)

DIFFERENTIATED PRODUCTS

A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which the product is sold, intangible aspects of the product, and perceptions of the product. Products that are distinctive in one of these ways are called differentiated products.

Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. The location of a firm can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory.

Intangible aspects can differentiate a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of beer or cigarettes if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.

The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.

PERCEIVED DEMAND FOR A MONOPOLISTIC COMPETITOR

A monopolistically competitive firm perceives a demand for its goods that is an intermediate case between monopoly and competition. Figure 1 offers a reminder that the demand curve as faced by a perfectly competitive firm is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.

Figure 1. Perceived Demand for Firms in Different Competitive Settings. The demand curve faced by a perfectly competitive firm is perfectly elastic, meaning it can sell all the output it wishes at the prevailing market price. The demand curve faced by a monopoly is the market demand. It can sell more output only by decreasing the price it charges. The demand curve faced by a monopolistically competitive firm falls in between.

The demand curve as faced by a monopolistic competitor is not flat, but rather downward-sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers. Since there are substitutes, the demand curve facing a monopolistically competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its price, some consumers will choose not to purchase its product—but they will then need to buy a completely different product. However, when a monopolistic competitor raises its price, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm. If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.

At a glance, the demand curves faced by a monopoly and by a monopolistic competitor look similar—that is, they both slope down. But the underlying economic meaning of these perceived demand curves is different, because a monopolist faces the market demand curve and a monopolistic competitor does not. Rather, a monopolistically competitive firm’s demand curve is but one of many firms that make up the “before” market demand curve. Are you following? If so, how would you categorize the market for golf balls? Take a swing, then see the following Clear It Up feature.

Are golf balls really differentiated products?

Monopolistic competition refers to an industry that has more than a few firms, each offering a product which, from the consumer’s perspective, is different from its competitors. The U.S. Golf Association runs a laboratory that tests 20,000 golf balls a year. There are strict rules for what makes a golf ball legal. The weight of a golf ball cannot exceed 1.620 ounces and its diameter cannot be less than 1.680 inches (which is a weight of 45.93 grams and a diameter of 42.67 millimeters, in case you were wondering). The balls are also tested by being hit at different speeds. For example, the distance test involves having a mechanical golfer hit the ball with a titanium driver and a swing speed of 120 miles per hour. As the testing center explains: “The USGA system then uses an array of sensors that accurately measure the flight of a golf ball during a short, indoor trajectory from a ball launcher. From this flight data, a computer calculates the lift and drag forces that are generated by the speed, spin, and dimple pattern of the ball. … The distance limit is 317 yards.”

Over 1800 golf balls made by more than 100 companies meet the USGA standards. The balls do differ in various ways, like the pattern of dimples on the ball, the types of plastic used on the cover and in the cores, and so on. Since all balls need to conform to the USGA tests, they are much more alike than different. In other words, golf ball manufacturers are monopolistically competitive.

However, retail sales of golf balls are about $500 million per year, which means that a lot of large companies have a powerful incentive to persuade players that golf balls are highly differentiated and that it makes a huge difference which one you choose. Sure, Tiger Woods can tell the difference. For the average duffer (golf-speak for a “mediocre player”) who plays a few times a summer—and who loses a lot of golf balls to the woods and lake and needs to buy new ones—most golf balls are pretty much indistinguishable.

HOW A MONOPOLISTIC COMPETITOR CHOOSES PRICE AND QUANTITY

The monopolistically competitive firm decides on its profit-maximizing quantity and price in much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a downward-sloping demand curve, and so it will choose some combination of price and quantity along its perceived demand curve.

As an example of a profit-maximizing monopolistic competitor, consider the Authentic Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice of vegetables and meats. Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants, it has a differentiated product. The firm’s perceived demand curve is downward sloping, as shown in Figure 2 and the first two columns of Table 1.

Figure 2. How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price. To maximize profits, the Authentic Chinese Pizza shop would choose a quantity where marginal revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity of 40 and a price of $16.

b:

Collusion makes allusion to the cooperation between different firms. This cooperation leads to a restrain of market competition, in any of its forms, which translates into higher profits for the firms in detriment of consumer’s welfare. A cartel is an example of firms belonging to the same industry structure which collude to some degree in setting prices and/or output levels. Agreements which have as their object or effect the prevention, restriction or distortion of perfect competition are prohibited. Such agreements include, but are not restricted to, activities such as:

-fixing purchase or selling prices or any other trading condition, directly or indirectly;

-controlling or limiting production levels, markets, technological advances or investments;

-sharing markets or resources supplies.

Legislation in different countries may consider different scenarios and penalties for such agreements, but the main idea is clear: firms behaviour shall not affect the correct functioning of market forces.

A clear example is to consider an industry where there are only two firms (duopoly). Both firms will set their levels of output and prices with the objective of maximizing their joint profits. Many strategies can be used in order to maximize profits which would lead to a multiple Nash equilibria solution. As seen in the figurebelow, collusion maximises aggregate profits for both firms, since the isoprofit curves are tangent. It’s a better equilibrium than the one in Cournot duopolies or Stackelberg duopolies.

However, cartels are not stable. There will always be incentives for each firm to trick the other, and change their output and/or price level in such a way, that they’ll increase their own profit in detriment of the other’s. To avoid this practice, any deviation by any party should be instantly punished; this is known as a trigger strategy. James W. Friedman demonstrated in his paper “A Non-cooperative Equilibrium for Supergames”, 1971, that in this context of infinite interactions, it is possible that collusion occurs due to this punishment strategy. That is, the cartel may endure as long as punishment strategies are so devastating that the benefits derived form deviation would end up being smaller than the benefits of keep colluding. J. W. Fridman put this idea in what is known in game theory as Folk theorem:

The sustainability of the equation will depend mainly in two factors: the credibility of the threat of punishment, and the discount factor. The former is easily understood as a credible threat will ensure no deviations are made, and the latter is related with how much does each party value the profits obtained from the results of following a collusive strategy, compared to the possible profits of changing their strategy.

Factors that guarantee collusion stability:

There are number of factors that affect this collusive equilibrium, such as:

-Number of firms in the market: the higher the degree of concentration in a market the higher the incentives to collude. Firms in highly concentrated markets will tend to collude since all the profits will be distributed amongst fewer firms.

-Multimarket contact: if firms compete in more than one market, the collusive agreement will be more stable. Firms that compete with other firms over many markets can establish trigger strategies that can be applied in all these markets, which will create a more devastating punishment strategy.

-Market transparency: the more transparent a market is, the easier it is to ensure that every firm is following the same strategy and is not deviating from the deal. Collusion will be more difficult in industries where it is harder to detect changes in firm’s prices or output.

-Asymmetry between firms: the bigger the asymmetry between firms, the harder it is for collusion to take place. If firms have different cost structures, the one with the lowest costs will be incentivised to lower its prices, and thus cause the other firm to have to exit the market.

Collusion agreement games:

In game theory, collusion agreements can be described using the extensive form, as depicted in the adjacent game tree. In this case, two firms share the market, already colluding and maintaining high prices. Each firm can decide to stop colluding and start a price war, in order to increase their market share, even force the other to quit the market. Firm 1 can either keep colluding with firm 2, or start a price war. If firm 1 decides to keep colluding, firm 2 will need to make a decision. If they both agree to collude, they will get 5,5. However, if one of them decides to start a price war, the set of payoffs will be either 4,3 or 3,4, depending on which one starts the war (and therefore acquires a greater market share). It’s easy to see that collude-collude is both the Nash equilibrium and a Pareto optimum situation. This result may change when considering repeated games, as seen before.