Oligopolistic Competition
Over the past few decades, there been an explosion in the use of game theory tools to analyze oligopolistic markets. Some of the results are interesting, and some are complicated. But a couple of general lessons have emerged from these interesting complicated findings.
One is that oligopoly markets tend to yield an outcome between the outcomes of perfect competition and monopoly. Consider prices. Unlike perfect competition, oligopolistic firms aren’t just price takers. So they can exert some market power and set a price above marginal cost but they can’t fully exert the market power of monopolies because they have to worry about other firms in their industry. So the price is above marginal cost and therefore higher than with perfect competition, but below the monopoly level, where there’s no competition. Since the price is above marginal cost, the firm is making profits.
Once again, not as many profits as the monopolist, but more than the zero profit of a firm in a perfectly competitive market. Now think about quantities. Remember that regardless of the market structure, firms must respect the demand curve. So prices are higher than those in perfect competition. Quantity sold will be lower than in perfect competition. And the prices are lower than in a monopoly. Quality sold will be higher than a monopoly.
Now let’s turn welfare. We know that a perfectly competitive firm maximizes welfare, and we know the monopolist cause deadweight loss by foregoing trade to a willingness to pay above marginal cost. An oligopoly also causes deadweight loss. Since it’s priced above marginal cost, traits that make both parties better off aren’t happening. Emerged since its prices aren’t as far above marginal Costas a monopolist, its deadweight loss is lower.
The second interesting lesson that’s emerged is that oligopoly firms do have one tool to try to escape from the competitive pressure that they face, product differentiation. The more consumers can substitute away from a firm’s product, the less profit the firm makes how do firms make it harder for people to substitute away from their products? How do they make demand more inelastic making their products more unique?
It’s tough to substitute away from more unique goods. There just aren’t many, or even any, good substitutes.
This is a fundamental force driving the creation of new products, an effort to make a profit by reducing the substitutability of your good for others. A great example is one you may have had for breakfast this morning, Apple Cinnamon Cheerios. Competition has been around for a long time.
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General Mills introduced them during World War II. Back then, Cheerio’s didn’t have much competition in the breakfast cereal market. It was Cheerios, Corn Flakes, Quaker Oats, and not much else. But after a while, many more brands entered the market. By 1970, Americans had over 150 breakfast cereals to choose from. Consumers began to see Cheerios as being high substitutable with other alternatives.
Many of these other cereals out there were also made of pulverized oats and didn’t taste all that different from Cheerio’s. So in 1989, General Mills introduced Apple CinnamonCheerios, a differentiated product for there weren’t as good substitutes. If consumers want the taste and texture
of the new brand of Apple Cinnamon Cheerio they had to buy from General Mills. A lack of good substitutes meant that the demand for Apple Cinnamon Cheerios was more inelastic than demand the more ordinary substitutable regular Cheerios. And more inelastic demand gave General Mills more market power to set an even higher price. We know that in markets where prices above marginal cost, there’s more deadweight loss, higher profits to producers, and less consumer surplus. So was the introduction of Apple Cinnamon Cheerio bad news for consumers?
Not at all. Sure, General Mills made some profit off the new differentiated cereal,
but consumers also now had a new product that provided value to them. Jerry Haussmann estimated that the introduction of Apple CinnamonCheerios increased consumer surplus by over $75 million per year in the US. That’s not bad for a single new brand of cereal. competitors impressive considering that consumers already had regular Cheerios and Honey NutCheerios as options when this new brand is released in 1989. Most product innovation in the market is driven by the efforts of oligopolistic competitors to differentiate their products to make money. Today, even though 90% of the breakfast cereal market competitors only five firms,
there are only there are over 5,000 brands of cereal to choose from.
That’s a lot of product differentiation. This highlights the fundamental tension of markets with imperfect competition. On the one hand, the prospects of profit are what drives firms to innovate and create the goods consumers want to buy. On the other hand, once these goods do exist, a firm in oligopoly competing only against a few other firms can exert its market power.
Relative to the perfect competition equilibrium, the firm sets the price too high, and the production level too low. So is this good or bad for welfare? Ultimately, it depends on how viable the product differentiation is. If this a valuable new product, then the gains from the product existing may exceed the costs of an imperfect market. But less competition for fundamentally similar products can be bad for social welfare.
Post By: Momin Faizan harun.
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