Ch.

10 & 11 – Pure and

Monopolistic
Competition and
Monopoly
Managerial Economics Applications Strategy and
Tactics p. 275

Slide 1
Michael Porter’s Five Forces of Competitive Advantage

The forces that determine competitive advantage are:

1. Substitutes (threat of substitutes can be offset by brands
and special functions served by the product).
2. Potential Entrants (threat of entrants can be reduced by
high fixed costs, scale economies, restriction of access to
distribution channels, or product differentiation).
3. Buyer Power (threat of concentration of buyers).
4. Supplier Power (threats from concentrated suppliers of key
inputs affect profitability).
5. Intensity of Rivalry (market concentration, price
competition tactics, exit barriers, amount of fixed costs, and
industry growth rates impact profitability).
Slide 2
 Figure 10.2 on Page 433
Potential entrants
High capital requirements
Substitutes Economies of scale
Value-price gap Absolute cost advantages
Branded vs. generic High switching costs
Lack of access to distribution
Sustainable channels
industry Product differentiation
profitability Public policy constraints

Intensity of rivalry Buyer power

Industrial concentration Buyer concentration
Pricing tactics Overcapacity
Switching costs Supplier power Homogeneity of buyers
Exit barriers Unique suppliers Potential of integration
Cost fixity Number of suppliers Outside alternatives
Industrial growth rates Supply shortages or surplus
Degree of vertical integration Slide 3
Michael Porter’s Five Forces of Competitive Advantage

Slide 4
 What Went Wrong
With Xerox?
• After inventing chemical paper copiers, Xerox
enjoyed 15% growth rates in the 1960s and 70’s.
• As their patents expired, new rivals such as
Ricoh and Cannon aimed their copiers at smaller
businesses and smaller volume users.
• Xerox continued to build all parts in-house and
suffered from serious price competition. Xerox’s
strategy led to erosion of its once dominant status
to that of an also-ran.
Slide 5
 The Relevant Market Concept
• A market is a group of economic agents that interact in a
buyer-seller relationship. The number and size of the
buyers and sellers affect the nature of that relationship.
• A popular measure of concentration is the percentage of an
industry comprised of the top 4 firms. Similarly, the
market share held by the top 4 buyers is a popular measure
of buyer concentration.
• The relationship among firms is affected by:
a. the number of firms and their relative sizes.
b. whether the product is differentiated or standardized.
c. whether decisions by firms are independent or
coordinated (collusion).
Slide 6
 Pure Competition and
Monopolistic Competition
Chapter 10
• Pure competition is a standard against which other
market structures are compared. The product is
perfectly undifferentiated.
• When there are many firms, but the product is
differentiated, the market is monopolistically
competitive.
» This brand competition may involve advertising
campaigns and large promotional expenditures to
stress often minor distinctions among products
2005 South-Western Publishing Slide 7
A Continuum of Market Structures:
Competition
Pure Competition assumes:
1. a very large number of buyers and sellers
2. homogeneous product (standardized)
3. complete knowledge of all relevant market
information
4. free entry and exit (no barriers)

These assumptions imply several things about

competitive markets, including price equals
marginal cost.

Slide 8
 A Continuum of Market Structures:
Monopoly
Monopoly is characterized by 1 firm producing a
highly differentiated product in a market with
significant barriers to entry.

Monopoly assumes:
1. Only one firm in the market area
2. Low cross price elasticity with other products.
3. No interdependence with other competitors.
4. Substantial entry barriers

These assumptions imply several things about

monopolies, including that the monopoly price is well
above marginal cost.
Slide 9
A Continuum of Market Structures:
Monopolistic Competition
Monopolistic Competition is like Pure Competition
but with the existence of a differentiated product.
Monopolistic competition assumes:
1. A large number of firms, some of which may be
dominant in size
2. Differentiated products
3. Independent decision making by individual firms
4. Easy entry and exit
These assumptions imply several things about
monopolistic competition, including that the price in
the long run is equal to average cost.
Slide 10
A Continuum of Market Structures:
Oligopoly
Oligopoly is a market structure wherein the number
of firms is too small that the action of any one
firm are likely to have noticeable impact on the
performance of other firms in the industry.

Oligopoly assumes:
1. Only a few firms in the market area
2. Products may be differentiated or
undifferentiated
3. There is a large degree of interdependence with
other competitors

Chapter 12 discusses oligopoly markets. Slide 11

 Price-Output Determination
Under Pure Competition
Competitive firms attempt to maximize profits.
Competitive firms cannot charge more than the market
price of others, since their product is identical to all
others.
Hence, competitive firms are price takers.
Total revenue, TR, is P x Q, where price is given.
Therefore, marginal revenue, MR, is price, P.
Profit is total revenue minus total cost  = (TR - TC).

Slide 12
Profit maximization implies that each firm produces an
output where Price = Marginal Cost (P = MC).
» To produce more than this quantity implies that P
< MC, which is not the most profitable decision.
» To produce less than where P=MC, implies that
P > MC, and the firm could increase profits by
expanding output.
• In short run, a competitive firm may earn
economic profits.
• In long run, entry pushes price down to the minimum
point of the average cost curve, so that economic
profits are zero.

Slide 13
Equilibrium Price in a Competitive Market

• Equilibrium for each firm if

P = MC. Each firm is MCMC
“happy”
• Equilibrium for the industry
AC
if: Demand equals Supply at D
the going price
» When both occur, the market is a firm the industry
in a Competitive Equilibrium
CAN EARN ECON PROFITS
IN THE SHORT RUN
Slide 14
 A Competitive Equilibrium Implies:
1. Competitive firm can earn positive
economic profits in the SR
2. If Price < AVC, firm will shut down
so-called “shut down price” is lowest AVC
MC

AC
Pmin AC
shut down price

AVC
3. In LR, entry forces price down to the minimum
of the AC curve
Slide 15
PROBLEM: The following is given:
For the industry:
QS = 3000 + 200 P and
QD = 13500 - 500 P

For the firm:

FC = 50
MC = 3 Q

FIND OPTIMAL output for this firm.

Slide 16
Answer: Find equilibrium price. Set D = S
we see 3,000 + 200 P = 13,500 - 500 P. This
implies:

10,500 / 700 = P = $15.

At this price, the firm produces where

P = MC, so

15 = 3 Q Q=5

Slide 17
 Monopolistic Competition
• Monopolistic Competition
» MARKET STRUCTURE
• Many Firms and Many Buyers
• Easy Entry & Exit
• PRODUCT DIFFERENTIATION ! ! !
• Historical Background Product
» Joan Robinson “Economics of Imperfect Differentiation
Competition,” 1933 Among Gas
» Edward Chamberlin, “Theory of Stations
Monopolistic Competition, 1933
• Small Groups & Large Groups
Slide 18
 Product Differentiation
• Differentiation occurs when consumers perceive that a
product differs from its competition on any physical or
nonphysical characteristic, including price.
• Examples: restaurants, dealer-owned gas stations, book &
convenience stores, etc.
• Assumptions of the Model:
» Large number of firms
» Differentiated Product
» Conditions of Cost and Demand are Similar
» Easy Entry & Exit

Slide 19
 Basic Model of
Monopolistic Competition
• In the Short Run MC
» produce where MR= MC
» price on the demand curve
PM AC
• NOTICE:
» P > MC
» economic profits exist
P > AC
» there exists incentives for D
entry into this industry
SHORT RUN DIAGRAM QM
MR
Slide 20
 Profits in the SR Induces Entry
• Entry in this industry “steals” MC
customers.
• Demand curve shifts inward
• RESULTS AC
» MR = MC (like monopoly)
P
» P = AC (like competition)
» Profits in LR are zero (like D
competition)
» not at Least Cost Point of AC curve D’
(like monopoly)
Q MR
LONG RUN DIAGRAM
Slide 21
 Properties of Monopolistic Competition
• Kroger Salt & Morton
• Inefficient Production
Salt at same plant
» EXCESS CAPACITY
• Sears’ Kenmore and
• not at least cost Whirlpool built at same
point of AC curve factory.
» Could Avoid Excess • Does the expectation of
Capacity by JOINTLY zero profits in the future
PRODUCING at the stifle innovation?
same plant • Is there too much
product differentiation?

Slide 22
 Selling and Promotional Expenses
• Suppose that the price is determined outside of the model, as with
liquor prices in some States.
• We will expand promotional activities until the extra profit
associated with the activity equals the extra cost of the promotion.
• This decision rule for Optimal Advertising is when:

Contribution Margin = Marginal Cost of Advertising

or
P – MC = k • DA/DQ
• or expand advertising whenever (P – MC)( DQ/DA) > k

• where, contribution (P – MC) is the marginal profit contribution

of an additional sale, and the marginal cost of advertising is
( k • DA/DQ).
Slide 23
 Example
• To sell one more unit of output will cost the price of the
added message, k, divided by the marginal product of
a dollar of advertising (DQ/DA).
• If a radio message costs $1000, and if that message
yields 5 new items sold, then the marginal cost of
advertising is $200, ($1000 /marginal product of
advertising).
• If it costs $200 to sell one more car (MCA=$200), and
if the contribution of another car sold is $300 to profits,
then we should expand promotional expenses.

Slide 24
 What Went Wrong With
Amazon.com
• Stocks only 1,000 books but displays 2.5
million
• Barnes & Noble and Borders are profitable,
but Amazon didn’t earn a profit
• Classic example of a business with low
barriers to entry
• Internet buyers are very price conscience, as
they can shop multiple sites with
MySimon.com and others Slide 25
 Competitive Markets Under
Asymmetric Information
• Used car: who knows what about it?

• Asymmetric Information -- unequal or dissimilar

knowledge among market participants.
• Incomplete Information -- uncertain knowledge
of payoffs, choices, or types of opponents a
market player faces.
• Lemons markets where asymmetric information
exchange leads to low quality products and
services driving out the higher quality products
and services.
Slide 26
 Search Goods versus Experience Goods
• Search goods are products or services whose quality is
best detected through a market search.
• Experience goods are products and services whose quality
is undetected when purchased.
• Warranties and firm reputations are used to assure quality.
• But if someone is selling his or her car, isn't it likely that
the car is no good? Is it a lemon?
» This is an explanation why used car prices are
so much lower than new car prices.
• If one firm defrauds customers, how do the reputable firms
signal that they are NOT like the fraudulent firm?

Slide 27
 Adverse Selection
and the Notorious Firm
• Suppose that a firm may decide to produce a High
Quality or Low Quality product, and the buyer
may decide to offer a High Price or a Low Price.
• Since the firm fears that if it offers a High Quality
product but that buyers only offer a Low Price,
they only produce Low Quality products and
receive Low Prices.
• This is the problem of adverse selection, which is
a limited choice of lower-quality alternatives
due to asymmetric information.
Slide 28
 Payoffs in the boxes
Notorious Firm Analysis are for the seller only

• Simultaneous decisions BUYER

of buyer & seller Hi Price Low Price
• A risk averse decision
High
by the firm is to make a Quality 130 70
Low Quality product SELLER
• Best for the buyer is a Low
150 90
low price, but a high Quality
quality good. Worst for
the buyer is a high price We end in a trap of only
but a low quality good. poor quality goods at
low prices.
Slide 29
 Solutions to the Problem of
Adverse Selection
• Regulation (Disclosure Laws, Truth in Lending)
• Long term relationships, or reliance
relationships
• Brand names (a form of a “hostage” to quality)
• Nonredeployable assets are assets that have
little value in another other use
b Example: Dixie Cups made with paper-cup machinery
which cannot be used for other purposes — if Dixie Cups
leak, the company is in trouble
Slide 30
Solutions to the Problem of
Adverse Selection

Slide 31
Exercise/Guide Question

Slide 32
 Monopoly and Dominant Firms
Chapter 11

"Monopoly" conjures images of huge profits,

great wealth, and indiscriminate power,
labeled robber barons.
• But some monopolies are not very profitable
• Others dominate their industry
• Still others are regulated by State Public Service or
Utility Commissions, and may have very low rates
of return on invested capital.
• Regulated monopolies are known as utilities.
2005 -South-Western Publishing Slide 33
Sources of Market Power for a Monopolist
• Legal restrictions -- copyrights & patents.
• Control of critical resources creates market
power.
• Government-authorized franchises, such as
provided to cable TV companies.
• Economies of size allow larger firms to produce at
lower cost than smaller firms.
• Brand loyalty and extensive advertising
makes entry highly expensive.
• Increasing returns in network-based
businesses - compatibilities increase market
penetration. Slide 34
The Mickey Mouse Monopoly:
Disney

Slide 35
 Regulated Monopolies
• Electric Power Companies
• Natural Gas Companies
• Communication Companies
• Often, Water Companies
» All are examples of regulated companies
» They are all “naturally monopolistic” as they all
have significant declining cost curves.
» Suppose we examine railroads before regulation
as an example of a nature monopoly.

Slide 36
 Natural Monopolies
• Declining Cost
Industries
» economies in
distribution DEMAND
» economies of scale
PM
• Without Regulation AC
they face Cyclical
Competition with PR = AC MC
prices gyrating PC = MC
between PM and PC.
QR QC
» railroad history includes QM
periods of huge profits MR
then bankruptcies
Slide 37
 Solutions to the
Problem of Natural Monopolies
• PREVENT ENTRY, set P• REGULATE, prevent
= MC and subsidize. entry, & set P = AC
» subsidies require some form of » common in US for local
taxation, which will tend to distort telephone, electricity,
work effort. water
» subsidies to AMTRAK • FRANCHISE through
• NATIONALIZE, prevent entry, a bidding war, likely
set price typically low P = AC
» governments find changing price a » Cable T.V.
highly political event » concessions at various
» once popular solution in Europe stadiums
Slide 38
 Peak Load Pricing
• Examples: Long Distance Calls,
Electrical Prices, Seasonally Pricing
at Amusement Parks
• Conditions
» Not Storable
» Same Facilities
» Demand Variation

Slide 39
 Peak and Off-Peak Demand
price What price
should we
charge for peak
and off-peak
Pp
users?

Po Off Peak
Demand Peak Load Demand
Q0 QP
Slide 40
 General Solution
• P(peak) = variable costs + capital costs
• P(off-peak) = variable costs only
• Some argue that off-peak users benefit from
capacity
» Electrical Case: Less chance of a brown out
» Amusement Park: Off peak users enjoy more
space
» Then off-peak users should pay for some
part of the capacity

Slide 41