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Monopolistic Competition and Oligopoly
Monopolistic Competition and Oligopoly 11
Lecture 11 Imperfect Competition
Business 5017 Managerial Economics
The Stackelberg Leadership Model
Public Interest Theory
Economic Theory of Regulation
Market for Corporate Control
Are Hostile Takeovers Ecient
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 2 / 29Introduction
Monopolistic Competition and Oligopoly
We have so far studied two extreme forms of market structure.
In perfect competition, no single rm has the market power to
uence the market price. In the long run rms make no economic
A monopolist which sells a product with no close substitute enjoy
great market power and makes economic prots in the long run.
Most market structures in our economy are something in between.
In monopolistic competition, each rm sells a dierentiated product
with its market niche. The rms enjoy some market power and face
their own downward sloping demand curves.
In an oligopoly, price, quantity, and therefore prots depend on the
interactions of the rm. The form of competition and market
outcome are indeterminate.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 3 / 29Monopolistic Competition
The market power of a monopolistic competitive rm depends on a
number of factors:
Number of competitors
Production capacity of competitors
Ease of new rms entering the market
Degree of product dierentiation
Brand name recognition and loyalty
Price dierence awareness of consumers
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 4 / 29Monopolistic Competition
A typical rm faces a
downward sloping demand
curve, with a steeper
marginal revenue curve.
Prot maximization is
achieved by setting MC =
The rm produces Q and
charges P on the demand
compared with the perfectly
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 5 / 29Monopolistic Competition
As long as the rms are making economic prots, new rms will enter
The demand and MR curves of a typical rm shift down because of
increased competitive. Demand also becomes more elastic.
This continues until all economic prots have eroded, with price P
and quantity Q on the LRAC curve.
Note that in the long run the rm is not producing at the minimum
eciency scale, meaning economic ineciency.
This occurs as long as the demand curve facing an individual rm is
not perfectly elastic.
Firms in monopolistic competitive often engage in nonprice
competitive such as advertisement and customer relationships.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 6 / 29Monopolistic Competition
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 7 / 29Oligopoly Modelling Reality
Just a Handful of Sellers
Typically just a few sellers in a market with not much product
dierentiation. Barriers to entry are high.
Demands are more inelastic than that in a monopolistic competition.
Therefore the oligopolists have more market power.
Consequently if an oligopolist behaves like a monopolist, the
deadweight loss is larger than that of a monopolistic competitive
However, this is not always the case. Pricing decisions of oligopolists
are mutually interdependent. There is a wide variety of economic
models on their behaviours.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 8 / 29Oligopoly Modelling Reality
Oligopolist as a Monopolist
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 9 / 29Oligopoly The Stackelberg Leadership Model
One Market Leader
The market is dominated by one big producer with cost advantage
(advanced technology, patents, big brand name, etc.).
The rest of the rms are followers with no market power.
The total supply curve of the followers is the sum of their MC curves.
Without the leader, this supply curve MC meets the market demand
curve D at price P and quantity Q .
m 1 2
Excess demand exists at any price below P , these excess demands
become the demand curve D for the dominant producer, with
corresponding marginal revenue MR .
The dominant producer maximizes prot by setting MC = MR with
the pricequantity combination (P ;Q ).
The followers are price takers, now face market price P . The excess
demand between the consumers and the followers is Q Q , which
is equal to Q .
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 10 / 29Oligopoly The Stackelberg Leadership Model
Price Leader and Followers
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 11 / 29Oligopoly Collusion
How Cartels are Formed
If product dierentiation is weak, consumers are more price sensitive.
Pricing becomes the main tool in competition among the oligopolists.
There are strong incentives for the rm to form a cartel and behave
collectively like a monopoly.
The cartel chooses the monopoly pricequantity combination to
maximize prot, which is shared by its members.
With the high monopoly price, however, each individual rm in the
cartel has an incentive to cheat, making even more prot by
To avoid collapse, the cartel must have a mechanism in place to
punish the cheaters.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 12 / 29Oligopoly Collusion
An Example of Duopoly
Two identical rms with
constant returns to scale
They form a cartel to maximize
joint prot with (P ;Q ). This
means each rm produces at a
level Q =Q =2.
After the collusion agreement,
each rm has the incentive to
lower price a little to P and
capture almost the whole
But total prot goes down if
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 13 / 29Oligopoly Collusion
Back to Game Theory
The above colluding duopoly can be described by a Prisoner's
Assume that the two rms, A and B, have two choices, high price or
low price. Their incentive can be analyzed with the payo matrix.
For Firm A, no matter what Firm B chooses, its best strategy is to
choose low price. The same is true for Firm B.
Therefore the dominant strategy is low price for both rms, resulting
in the inecient outcome (500; 500).
This outcome is also a Nash equilibrium, which consists of the best
strategy for every player given the action of all the other players. In
other words, no player has the incentive to change his/her choice.
Therefore in a oneshot game the collusion will fail. In a repeated
game setting, the behaviours are more complicated.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 14 / 29Oligopoly Collusion
Payo Matrix of a Duopoly
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 15 / 29Oligopoly Collusion
Cartels with Lagged Demand
Recall that when a product exhibits lagged demand due to network
eect or rational addiction, a rm has the incentive to lower price
now so that demand will be higher in the future.
This applies to a cartel as well. But individual rm has the incentive
to freeride the other rms.
Since the game is inherently dynamic, actual behaviours depends on
the mechanism design of the cartel.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 16 / 29Oligopoly Collusion
In a lot of cases the transaction costs of maintaining a cartel
(negotiating, monitoring, and enforcing the agreement) is higher than
the benets of collusion.
The problem may be resolved with a third party doing the monitoring
and enforcement task.
A good candidate for this third party is the government. With
legislative and executive power, the government can be very ecient
in maintaining a cartel.
This is why some industries lobby for government regulations or
oppose deregulation. The eects of regulations can suppress
Examples: airline regulations, liquor licence, banning Sunday
shopping, professional licensing, etc.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 17 / 29Oligopoly Regulating Monopoly
When the longrun average cost is declining within the range of
market demand, it is cost eective to have a single producer.
The natural monopoly is socially inecient, however, if it exploits
consumers with its market power. The government usually steps in to
regulate the monopoly.
Instead of the monopolist's prot maximizing (P ;Q ), the
government can impose a price ceiling at P , where the LRAC meets
the market demand curve.
This may occur naturally without government intervention in a
contestable market. Even though there is a high xed cost, some
wellnanced rms may see the monopoly prot as a sign to enter the
The threat of a price war with a new competitor keeps the natural
monopolist in check and charge a price close to the socially ecient
level at P .
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 18 / 29Oligopoly Regulating Monopoly
A Natural Monopolist
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 19 / 29Business Regulation Public Interest Theory
\The Government is the Problem"
Many sectors in the economy are subject to various degree of
In Canada the most heavily regulated sectors are health care,
education, transportation, telecommunication, agriculture, and
Common reasons for regulation are social insurance, monopoly power,
public safety, market stability, preservation of culture and languages,
Some economists think that excessive government regulation hinders
the operation of the free markets and creates ineciency.
Others try to explain regulation from an institutional economics
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 20 / 29Business Regulation Public Interest Theory
Regulating Cartels and Natural Monopoly
Cartels and natural monopoly
are common targets by
The objective is to eliminate the
deadweight welfare loss in the
Determining the exact values of
the socially ecient
(P ;Q ), however, is not a
Cost structure of a monopolist
is private to the rm. It has the
incentive to mislead the
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 21 / 29Business Regulation Public Interest Theory
Subsidizing a Monopoly
In some cases even the monopoly does not exploit the consumers and
produces at the output level that price equals LRAC, it is still not
This is because LRAC is declining so that LRMC is below it.
Consumers' willingness to pay at the margin is still higher than the
marginal cost of production.
To induce the monopolist to produce at the socially ecient output
Q , the government can provide a subsidy to the rm equals to the
This, however, gives the incentive to the managers to turn the subsidy
into perks and increased pays. Unions members of the rm have the
incentives to negotiate pay raise and more fringe benets.
LRAC and LRMC will shift upward, raising market price and reducing
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 22 / 29Business Regulation Public Interest Theory
Underproduction and Government Subsidy
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 23 / 29Business Regulation Economic Theory of Regulation
Regulation as a Marketable Product
The provision of government regulation can be viewed as a market
service, subject to the forces of supply and demand.
On the supply side: benets include campaign contributions, lucrative
consulting jobs, or sometimes outright bribery.
On the demand side:
Monitoring and enforcing cartel agreements to prevent competition
Erecting barriers to entry and establishing import restrictions
Freeriding problems exist when the industry is big and diverse.
The economic theory of regulation provides a useful conceptual
framework but is less successful in predicting the outcomes of specic
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 24 / 29Market for Corporate Control Firm Integrations
Mergers, Acquisitions, and Hostile Takeover
The economic theory of market can be applied to consumer or
industrial goods and services and provision of government regulation.
It can also be applied to the market of corporate control.
Firms can be bought and sold as investment vehicles.
When rms change hand under \friendly" agreements, it is called as
mergers (TD Bank and Canada Trust) or acquisitions (Walmart
Canada buying stores from Zellers).
Economists classify MA as horizontal or vertical integrations.
Occasionally \corporate raiders" oer a deal directly to shareholders
without management's approval. These are labelled as hostile
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 25 / 29Market for Corporate Control Firm Integrations
Internal departments of a rm can behave like a monopoly, restricting
services and requiring larger budget of operations.
Management uses outsourcing as a tool to avoid ineciency of
If the management is unable or unwilling to tackle these ineciency,
the company's stock value may become depressed.
This provides incentive for an outside to take over the rm, improve
its eciency, and resell it at a prot.
The threat of a hostile takeover keeps internal monopolistic
behaviours in check.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 26 / 29Market for Corporate Control Firm Integrations
Hostile Takeover and PrincipalAgent Problem
In a classical principalagent situation, the objective of the
management of a rm is not aligned with that of the shareholders.
In a hostile takeover, the management always oppose the rm being
taken over. The new owner of the rm threatens their pay, perks, and
privileges. Often the management team will be replaced.
The shareholders of the target rm, on the other hand, are the main
beneciaries of the takeover. They see their stock prices go up about
Following this argument, a hostile takeover bid is usually a signal that
the target rm suers from principalagent problems. Outsiders see
the opportunity to improve the operation of the rm.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 27 / 29Market for Corporate Control Are Hostile Takeovers Ecient
CostBenet Analysis of Takeovers
The shareholders of the target rm usually gain from a hostile
takeover. What about the other players
Winner's curse Imagine that bidders of a rm have their own
subjective evaluation on the value of the target rm. The one which
wins the bid has the most optimistic outlook.
The winning rm may overbid compared with the average bid. This
may potential hurt the shareholders of the acquiring rm.
Empirical studies do not support this argument, shareholders of the
acquiring rm on the average gain 1 to 3 percent in their stock prices.
Firms which actually suer the winer's curse, however, are more likely
to become the target of hostile takeovers themselves.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 28 / 29Market for Corporate Control Are Hostile Takeovers Ecient
Other Third Parties
Bondholders A hostile takeover may increase the risk the target
rms or the acquiring rm. While the shareholders of these rm get
higher expected returns on the operation, bondholders may suer
because of the additional risk.
Empirical studies nd that losses by bondholders are minimal.
Laido workers Corporate raiders are often accused of laying o
workers of the newly acquired rm.
The argument is circular because the objective of the takeover is to
improve the eciency of the rm so that it converges to its optimal
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 29 / 29