Monopolistic Competition and Oligopoly

Monopolistic Competition
and Oligopoly
Prepared by:
Chapter
14
Fernando & Yvonn
Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Chapter Outline Monopolistic Competition 14
and Oligopoly
Product Differentiation, Advertising, and
Social Welfare
Price and Output Determination in
Economic Efficiency and Resource
Allocation
Oligopoly
Oligopoly Models
Game Theory
Repeated Games
A Game with Many Players: Collective
Action Can Be Blocked by a
Prisoners’ Dilemma
Oligopoly and Economic Performance
Industrial Concentration and
Technological Change
The Role of Government
Regulation of Mergers
A Proper Role?
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38 © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

MONOPOLISTIC COMPETITION
AND OLIGOPOLY
FIGURE 14.1 Characteristics of Different Market Organizations
Although not every industry fits neatly into one of
these categories, the categories do provide a useful
and convenient framework for thinking about industry
structure and behavior.
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monopolistic competition A common
form of industry (market) structure in the
United States, characterized by a large
number of firms, none of which can influence
market price by virtue of size alone. Some
degree of market power is achieved by firms
producing differentiated products. New firms
can enter and established firms can exit
such an industry with ease.
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TABLE 14.1 Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1997
INDUSTRY
DESIGNATION
FOUR
LARGEST
FIRMS
EIGHT
LARGEST
FIRMS
TWENTY
LARGEST
FIRMS
NUMBER
OF
FIRMS
Travel trailers and campers 26 36 50 761
Dolls 31 51 66 239
Wood office furniture 34 42 55 639
Book printing 32 45 59 890
Curtains and draperies 26.5 36.3 50.1 2012
Fresh or frozen seafood 13.6 22.9 42.2 586
Women’s dresses 14.2 23.7 39.4 747
Miscellaneous plastic products 5 8 14 7522
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing. Subject Series EC92m315, June, 2001.
Firms in a monopolistically competitive industry are small relative to the total market. New
firms can enter the industry in pursuit of profit, and relatively good substitutes for the firms’
products are available. Firms in monopolistically competitive industries try to achieve a
degree of market power by differentiating their products—by producing something new,
different, or better, or by creating a unique identity in the minds of consumers.
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PRODUCT DIFFERENTIATION, ADVERTISING,
AND SOCIAL WELFARE
product differentiation A strategy that
firms use to achieve market power.
Accomplished by producing products that
have distinct positive identities in
consumers’ minds.
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TABLE 14.2 Total Advertising Expenditures in 2003
DOLLARS
(BILLIONS)
Newspapers 45.4
Television 62.2
Direct mail 49.1
Yellow pages 13.9
Internet 5.6
Radio 19.5
Magazines 11.8
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States,
2002, Table 1253.
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TABLE 14.3 Magazine Advertising Revenues by Category,
2003
DOLLARS
(MILLIONS)
Automotive 2,088
Technology
Telecommunications
Computers and software
243
729
Home furnishings and supplies 1,554
Toiletries and cosmetics 1,699
Apparel and accessories 1,513
Financial, insurance and real estate 896
Food and food products 1,391
Drugs and remedies 1,663
Retail stores 986
Beer wine and liquor 394
Sporting goods 253
Source: Publishers Information Bureau, Statistical Abstract of the United States, 2002, pg. 772
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The Case for Product Differentiation and
Advertising
Restaurants and rock bands are
good examples of monopolistic
competitors that face intense
competition.
The advocates of spirited competition believe that differentiated products and advertising
give the market system its vitality and are the basis of its power. They are the only ways to
begin to satisfy the enormous range of tastes and preferences in a modern economy.
Product differentiation also helps to ensure high quality and efficient production, and
advertising provides consumers with the valuable information on product availability,
quality, and price that they need to make efficient choices in the marketplace.
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The Case Against Product Differentiation and
Advertising
Product differentiation and advertising waste
society’s scarce resources, argue critics. They say
enormous sums of money are spent to create
minute, meaningless differences among products.
The bottom line, critics of product differentiation and advertising argue, is waste and
inefficiency. Enormous sums are spent to create minute, meaningless, and possibly
nonexistent differences among products. Advertising raises the cost of products and
frequently contains very little information. Often, it is merely an annoyance. Product
differentiation and advertising have turned the system upside down: People exist to
satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive
warfare and may serve as a barrier to entry, thus reducing real competition.

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No Right Answer
There are strong arguments on both sides of the
advertising debate, and even the empirical evidence
yields to conflicting conclusions. Some studies show
that advertising leads to concentration and positive
profits; others, that advertising improves the
functioning of the market.

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PRICE AND OUTPUT DETERMINATION
IN MONOPOLISTIC COMPETITION
Product Differentiation and Demand Elasticity
FIGURE 14.2 Product Differentiation Reduces the Elasticity of Demand Facing a Firm
Although the demand curve faced by a monopolistic competitor is likely to be less elastic
than the demand curve faced by a perfectly competitive firm, it is likely to be more elastic
than the demand curve faced by a monopoly.

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Price/Output Determination in the Short Run
FIGURE 14.3 Monopolistic Competition in the Short Run
To maximize profit, the monopolistically competitive firm will increase production until the
marginal revenue from increasing output and selling it no longer exceeds the marginal cost
of producing it. This occurs at the point at which marginal revenue equals marginal cost:
MR = MC.

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Price/Output Determination in the Long Run
FIGURE 14.4 Monopolistically Competitive Firm at Long-Run Equilibrium
The firm’s demand curve must end up tangent to its average total cost curve for profits to
equal zero. This is the condition for long-run equilibrium in a monopolistically competitive
industry.

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ECONOMIC EFFICIENCY AND RESOURCE
ALLOCATION
Because entry is easy and economic profits are
eliminated in the long run, we might conclude that
the result of monopolistic competition is efficient.
There are two problems, however.
First, once a firm achieves any degree of market
power by differentiating its product (as is the case in
monopolistic competition), its profit-maximizing
strategy is to hold down production and charge a
price above marginal cost.
Second, the final equilibrium in a monopolistically
competitive firm is necessarily to the left of the low
point on its average total cost curve.

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OLIGOPOLY
oligopoly A form of industry (market)
structure characterized by a few dominant
firms. Products may be homogenous or
differentiated. The behavior of any one
firm in an oligopoly depends to a great
extent on the behavior of others.

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OLIGOPOLY
TABLE 14.4 Percentage of Value of Shipments Accounted for by the Largest
Firms in High-Concentration Industries, 1997
INDUSTRY
DESIGNATION
FOUR
LARGEST
FIRMS
EIGHT
LARGEST
FIRMS
NUMBER
OF
FIRMS
Cellulosic man-made fiber 100 4
Primary copper 95 99 11
Household laundry equipment 90 99 10
Cigarettes 99 100 9
Malt beverages (beer) 90 95 494
Electric lamp bulbs 89 94 54
Cereal breakfast foods 83 94 48
Motor vehicles 83 92 325
Small arms ammunition 89 94 107
Household refrigerators and freezers 82 97 21
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series 2001.

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Because many different types of oligopolies exist, a
number of different oligopoly models
have been developed.
All kinds of oligopoly have one thing in common:
The behavior of any given oligopolistic firm depends on the behavior of the other firms in the
industry comprising the oligopoly.
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OLIGOPOLY
OLIGOPOLY MODELS

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OLIGOPOLY
The Collusion Model
The colluding oligopoly will face market demand and produce only up to the point at which
marginal revenue and marginal cost are equal (MR = MC), and price will be set above
marginal cost.
cartel A group of firms that gets together
and makes joint price and output
decisions to maximize joint profits.
tacit collusion Collusion occurs when
price- and quantity-fixing agreements
among producers are explicit. Tacit
collusion occurs when such agreements
are implicit.

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OLIGOPOLY
The Cournot Model
Cournot model A model of a two-firm
industry (duopoly) in which a series of
output adjustment decisions leads to a
final level of output between the output
that would prevail if the market were
organized competitively and the output
that would be set by a monopoly.
The Cournot model of oligopoly results in a quantity of output somewhere between
output that would prevail if the market were perfectly competitive and output that
would be set by a monopoly.

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OLIGOPOLY
The Kinked Demand Curve Model
kinked demand curve model A model
of oligopoly in which the demand curve
facing each individual firm has a “kink”
in it. The kink results from the assumption
that competitor firms will follow if a single
firm cuts price but will not follow if a single
firm raises price.

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OLIGOPOLY
FIGURE 14.5 A Kinked Demand Curve Oligopoly Model

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price leadership A form of oligopoly in
which one dominant firm sets prices and
all the smaller firms in the industry follow
its pricing policy.
As in the other oligopoly models, an oligopoly with a dominant price leader will produce a
level of output between the output that would prevail under perfect competition and the
output that a monopolist would choose in the same industry. It will also set a price between
the monopoly price and the perfectly competitive price. Some competition is usually more
efficient than none at all.
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OLIGOPOLY
The Price-Leadership Model

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OLIGOPOLY
GAME THEORY
game theory Analyzes oligopolistic
behavior as a complex series of strategic
moves and reactive countermoves among
rival firms. In game theory, firms are
assumed to anticipate rival reactions.

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OLIGOPOLY
FIGURE 14.6 Payoff Matrix for Advertising Game

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OLIGOPOLY
dominant strategy In game theory, a
strategy that is best no matter what the
opposition does.
prisoners’ dilemma A game in which
the players are prevented from
cooperating and in which each has a
dominant strategy that leaves them both
worse off than if they could cooperate.

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OLIGOPOLY
FIGURE 14.7 The Prisoners’ Dilemma

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OLIGOPOLY
FIGURE 14.8 Payoff Matrixes for Left/Right–Top/Bottom Strategies

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OLIGOPOLY
Nash equilibrium In game theory, the
result of all players’ playing their best
strategy given what their competitors are
doing.
maximin strategy In game theory, a
strategy chosen to maximize the
minimum gain that can be earned.

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OLIGOPOLY
REPEATED GAMES
tit-for-tat strategy A company’s strategy that lets a
competitor know the company
will follow the competitor’s lead.
FIGURE 14.9 Payoff Matrix for Airline Game

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OLIGOPOLY
A GAME WITH MANY PLAYERS:
COLLECTIVE ACTION CAN BE BLOCKED BY
A PRISONERS’ DILEMMA
Contestable Markets
perfectly contestable market A market in which entry and
exit are costless.
In contestable markets, even large oligopolistic firms end up behaving like perfectly
competitive firms. Prices are pushed to long-run average cost by competition, and positive
profits do not persist.

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OLIGOPOLY
Review
Oligopoly is a market structure that is consistent
with a variety of behaviors.
The only necessary condition of oligopoly is that firms are large enough to have some
control over price. Oligopolies are concentrated industries. At one extreme is the cartel,
in which a few firms get together and jointly maximize profits—in essence, acting as a
monopolist. At the other extreme, the firms within the oligopoly vigorously compete
for small, contestable markets by moving capital quickly in response to observed profits.
In between are a number of alternative models, all of which stress the interdependence
of oligopolistic firms.

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OLIGOPOLY
OLIGOPOLY AND ECONOMIC PERFORMANCE
Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons.
First, profit-maximizing oligopolists are likely to price above marginal cost. When
price is above marginal cost, there is underproduction from society’s point of view—in
other words, society could get more for less, but it does not. Second, strategic behavior
can lead to outcomes that are not in society’s best interest. Specifically, strategically
competitive firms can force themselves into deadlocks that waste resources. Finally, to
the extent that oligopolies differentiate their products and advertise, there is the
promise of new and exciting products. At the same time, however, there remains a real
danger of waste and inefficiency.
INDUSTRIAL CONCENTRATION AND
TECHNOLOGICAL CHANGE
One of the major sources of economic growth and
progress throughout history has been technological
advance.

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THE ROLE OF GOVERNMENT
REGULATION OF MERGERS
Celler-Kefauver Act (1950)
Extended the government’s authority to
ban vertical and conglomerate mergers.
Herfindahl-Hirschman Index (HHI) A
mathematical calculation that uses market
share figures to determine whether or not a
proposed merger will be challenged by the
government.

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Industry A 50 50 - - 502 + 502 = 5,000
Industry B 80 10 10 - 802 + 102 + 102 = 6,600
Industry C 25 25 25 25 252 + 252 + 252 + 252 = 2,500
Industry D 40 20 20 20 402 + 202 + 202 + 202 = 2,800
If the Herfindahl-Hirschman Index is less than 1,000, the industry is considered
unconcentrated, and any proposed merger will go unchallenged by the Justice Department.
If the index is between 1,000 and 1,800, the department will challenge any merger that would
increase the index by over 100 points. Herfindahl indexes above 1,800 mean that the
industry is considered concentrated already, and the Justice Department will challenge any
merger that pushes the index up more than 50 points.
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TABLE 14.5 Calculation of a Simple Herfindahl-Hirschman Index for Four
Hypothetical Industries, Each with No More Than Four Firms
PERCENTAGE SHARE OF: HERFINDAHL-HIRSCHMAN
FIRM 1 FIRM 2 FIRM 3 FIRM 4 INDEX

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FIGURE 14.10 Department of Justice Merger Guidelines
(revised 1984)

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A PROPER ROLE?
Certainly there is much to guard against in the
behavior of large, concentrated industries. Barriers
to entry, large size, and product differentiation all
lead to market power and to potential inefficiency.
Barriers to entry and collusive behavior stop the
market from working toward an efficient allocation of
resources.

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REVIEW TERMS AND CONCEPTS
cartel
Celler-Kefauver Act
Cournot model
dominant strategy
game theory
Herfindahl-Hirschman
Index (HHI)
kinked demand curve
model
maximin strategy
monopolistic competition
Nash equilibrium
oligopoly
perfectly contestable
market
price-leadership model
prisoners’ dilemma
product differentiation
tacit collusion
tit-for-tat strategy

Monopolistic Competition and Oligopoly

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