Monopolistic Competition and Oligopoly

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 1313
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
Monopolistic Competition andMonopolistic Competition and
OligopolyOligopoly

Monopolistic CompetitionMonopolistic Competition
• AA monopolistically competitivemonopolistically competitive
industryindustry has the followinghas the following
characteristics:characteristics:
• A large number of firmsA large number of firms
• No barriers to entryNo barriers to entry
• Product differentiationProduct differentiation

• Monopolistic competitionMonopolistic competition is a commonis a common
form of industry (market) structure in theform of industry (market) structure in the
United States, characterized by a largeUnited States, characterized by a large
number of firms, none of which can influencenumber of firms, none of which can influence
market price by virtue of size alone.market price by virtue of size alone.
• Some degree of market power is achievedSome degree of market power is achieved
by firms producing differentiated products.by firms producing differentiated products.
• New firms can enter and established firmsNew firms can enter and established firms
can exit such an industry with ease.can exit such an industry with ease.

Nine Industries with Characteristics ofNine Industries with Characteristics of
Percentage of Value of Shipments Accounted for by the Largest Firms inPercentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1992Selected Industries, 1992
SIC NO.SIC NO.
INDUSTRYINDUSTRY
DESIGNATIONDESIGNATION
FOURFOUR
LARGESTLARGEST
FIRMSFIRMS
EIGHTEIGHT
LARGESTLARGEST
FIRMSFIRMS
TWENTYTWENTY
LARGESTLARGEST
FIRMSFIRMS
NUMBERNUMBER
OFOF
FIRMSFIRMS
37923792 Travel trailers and campersTravel trailers and campers 4141 5757 7272 270270
39423942 DollsDolls 3434 4747 6767 204204
25212521 Wood office furnitureWood office furniture 2626 3434 5151 611611
27312731 Book publishingBook publishing 2323 3838 6262 25042504
23912391 Curtains and draperiesCurtains and draperies 2222 3232 4848 10041004
20922092 Fresh or frozen seafoodFresh or frozen seafood 1919 2828 4747 600600
35643564 Blowers and fansBlowers and fans 1414 2222 4141 518518
23352335 Women’s dressesWomen’s dresses 1111 1717 3030 39433943
30893089 Miscellaneous plastic productsMiscellaneous plastic products 55 88 1313 76057605
Source:Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers,U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing,Concentration Ratios in Manufacturing, Subject SeriesSubject Series
MC92-S-2, 1997.MC92-S-2, 1997.

Product Differentiation, Advertising,Product Differentiation, Advertising,
and Social Welfareand Social Welfare
Total Advertising Expenditures in 1998Total Advertising Expenditures in 1998
DOLLARSDOLLARS
(BILLIONS)(BILLIONS)
NewspapersNewspapers 44.244.2
TelevisionTelevision 48.048.0
Direct mailDirect mail 39.539.5
OtherOther 31.731.7
Yellow pagesYellow pages 12.012.0
RadioRadio 14.514.5
MagazinesMagazines 10.410.4
TotalTotal 200.3200.3
Source:Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census,McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the UnitedStatistical Abstract of the United
StatesStates, 1999, Table 947., 1999, Table 947.

The Case for Product DifferentiationThe Case for Product Differentiation
and Advertisingand Advertising
• The advocates of free and openThe advocates of free and open
competition believe that differentiatedcompetition believe that differentiated
products and advertising give theproducts and advertising give the
market system its vitality and are themarket system its vitality and are the
basis of its power.basis of its power.
• Product differentiation helps to ensureProduct differentiation helps to ensure
high quality and efficient production.high quality and efficient production.

The Case for Product DifferentiationThe Case for Product Differentiation
and Advertisingand Advertising
• Advertising provides consumers withAdvertising provides consumers with
the valuable information on productthe valuable information on product
availability, quality, and price thatavailability, quality, and price that
they need to make efficient choicesthey need to make efficient choices
in the market place.in the market place.

The Case Against ProductThe Case Against Product
Differentiation and AdvertisingDifferentiation and Advertising
• Critics of product differentiation andCritics of product differentiation and
advertising argue that they amount toadvertising argue that they amount to
nothing more than waste andnothing more than waste and
inefficiency.inefficiency.
• Enormous sums are spent to createEnormous sums are spent to create
minute, meaningless, and possiblyminute, meaningless, and possibly
nonexistent differences amongnonexistent differences among
products.products.

The Case Against ProductThe Case Against Product
Differentiation and AdvertisingDifferentiation and Advertising
• Advertising raises the cost of productsAdvertising raises the cost of products
and frequently contains very littleand frequently contains very little
information. Often, it is merely aninformation. Often, it is merely an
annoyance.annoyance.
• People exist to satisfy the needs of thePeople exist to satisfy the needs of the
economy, not vice versa.economy, not vice versa.
• Advertising can lead to unproductiveAdvertising can lead to unproductive
warfare and may serve as a barrier towarfare and may serve as a barrier to
entry, thus reducing real competition.entry, thus reducing real competition.

Product Differentiation Reduces theProduct Differentiation Reduces the
Elasticity of Demand Facing a FirmElasticity of Demand Facing a Firm
• Based on the availability ofBased on the availability of
substitutes, the demandsubstitutes, the demand
curve faced by acurve faced by a
monopolistic competitor ismonopolistic competitor is
likely to belikely to be less elasticless elastic
than the demand curvethan the demand curve
faced by a perfectlyfaced by a perfectly
competitive firm, and likelycompetitive firm, and likely
to beto be more elasticmore elastic than thethan the
demand curve faced by ademand curve faced by a
monopoly.monopoly.

Monopolistic Competition in the Short RunMonopolistic Competition in the Short Run
• In the short-run, a monopolistically competitiveIn the short-run, a monopolistically competitive
firm will produce up to the point wherefirm will produce up to the point where MR = MCMR = MC..
• This firm isThis firm is
earning positiveearning positive
profits in theprofits in the
short-run.short-run.

Monopolistic Competition in the Short-RunMonopolistic Competition in the Short-Run
• Profits are not guaranteed. Here, a firm with aProfits are not guaranteed. Here, a firm with a
similar cost structure is shown facing a weakersimilar cost structure is shown facing a weaker
demand and suffering short-run losses.demand and suffering short-run losses.

Monopolistic Competition in the Long-RunMonopolistic Competition in the Long-Run
• The firm’s demandThe firm’s demand
curve must end upcurve must end up
tangent to its averagetangent to its average
total cost curve fortotal cost curve for
profits to equal zero.profits to equal zero.
This is the condition forThis is the condition for
long-run equilibrium inlong-run equilibrium in
a monopolisticallya monopolistically
competitive industry.competitive industry.

Economic EfficiencyEconomic Efficiency
and Resource Allocationand Resource Allocation
• In the long-run, economic profits are eliminated; thus, weIn the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,might conclude that monopolistic competition is efficient,
however:however:
• Price is above marginalPrice is above marginal
cost.cost. More output couldMore output could
be produced at abe produced at a
resource cost below theresource cost below the
value that consumersvalue that consumers
place on the product.place on the product.

Economic EfficiencyEconomic Efficiency
and Resource Allocationand Resource Allocation
• In the long-run, economic profits are eliminated; thus, weIn the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,might conclude that monopolistic competition is efficient,
however:however:
• Average total cost is notAverage total cost is not
minimized.minimized. The typicalThe typical
firm will not realize all thefirm will not realize all the
economies of scaleeconomies of scale
available. Smaller andavailable. Smaller and
smaller market sharesmaller market share
results in excess capacity.results in excess capacity.

OligopolyOligopoly
• AnAn oligopolyoligopoly is a form of industryis a form of industry
(market) structure characterized by a(market) structure characterized by a
few dominant firms. Products mayfew dominant firms. Products may
be homogeneous or differentiated.be homogeneous or differentiated.
• The behavior of any one firm in anThe behavior of any one firm in an
oligopoly depends to a great extentoligopoly depends to a great extent
on the behavior of others.on the behavior of others.

Ten Highly Concentrated IndustriesTen Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms in High-Percentage of Value of Shipments Accounted for by the Largest Firms in High-
Concentration Industries, 1992Concentration Industries, 1992
SIC NO.SIC NO.
INDUSTRYINDUSTRY
DESIGNATIONDESIGNATION
FOURFOUR
LARGESTLARGEST
FIRMSFIRMS
EIGHTEIGHT
LARGESTLARGEST
FIRMSFIRMS
NUMBERNUMBER
OFOF
FIRMSFIRMS
28232823 Cellulosic man-made fiberCellulosic man-made fiber 9898 100100 55
33313331 Primary copperPrimary copper 9898 9999 1111
36333633 Household laundry equipmentHousehold laundry equipment 9494 9999 1010
21112111 CigarettesCigarettes 9393 100100 88
20822082 Malt beverages (beer)Malt beverages (beer) 9090 9898 160160
36413641 Electric lamp bulbsElectric lamp bulbs 8686 9494 7676
20432043 Cereal breakfast foodsCereal breakfast foods 8585 9898 4242
37113711 Motor vehiclesMotor vehicles 8484 9191 398398
34823482 Small arms ammunitionSmall arms ammunition 8484 9595 5555
36323632 Household refrigerators and freezersHousehold refrigerators and freezers 8282 9898 5252
Source:Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers,U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing,Concentration Ratios in Manufacturing, SubjectSubject
Series MC92-S-2, 1997.Series MC92-S-2, 1997.

Oligopoly ModelsOligopoly Models
• All kinds of oligopoly have oneAll kinds of oligopoly have one
thing in common:thing in common:
• The behavior of any givenThe behavior of any given
oligopolistic firm depends on theoligopolistic firm depends on the
behavior of the other firms in thebehavior of the other firms in the
industry comprising the oligopoly.industry comprising the oligopoly.

The Collusion ModelThe Collusion Model
• A group of firms that gets togetherA group of firms that gets together
and makes price and outputand makes price and output
decisions jointly is called adecisions jointly is called a cartelcartel..
• Collusion occurs when price- andCollusion occurs when price- and
quantity-fixing agreements arequantity-fixing agreements are
explicit.explicit.
• Tacit collusionTacit collusion occurs when firmsoccurs when firms
end up fixing price without a specificend up fixing price without a specific
agreement, or when agreements areagreement, or when agreements are
implicit.implicit.

The Cournot ModelThe Cournot Model
• TheThe Cournot modelCournot model is a model of ais a model of a
two-firm industry (duopoly) in which atwo-firm industry (duopoly) in which a
series of output-adjustmentseries of output-adjustment
decisions leads to a final level ofdecisions leads to a final level of
output between the output that wouldoutput between the output that would
prevail if the market were organizedprevail if the market were organized
competitively and the output thatcompetitively and the output that
would be set by a monopoly.would be set by a monopoly.

The Kinked Demand Curve ModelThe Kinked Demand Curve Model
• TheThe kinked demand modelkinked demand model is ais a
model of oligopoly in which themodel of oligopoly in which the
demand curve facing each individualdemand curve facing each individual
firm has a “kink” in it. The kinkfirm has a “kink” in it. The kink
follows from the assumption thatfollows from the assumption that
competitive firms will follow if acompetitive firms will follow if a
single firm cuts price but will notsingle firm cuts price but will not
follow if a single firm raises price.follow if a single firm raises price.

The Kinked Demand Curve ModelThe Kinked Demand Curve Model
• Above P*, an increase inAbove P*, an increase in
price, which is not followedprice, which is not followed
by competitors, results in aby competitors, results in a
large decrease in the firm’slarge decrease in the firm’s
quantity demandedquantity demanded
(demand is elastic).(demand is elastic).
• Below P*, price decreasesBelow P*, price decreases
are followed byare followed by
competitors so the firmcompetitors so the firm
does not gain as muchdoes not gain as much
quantity demandedquantity demanded
(demand is inelastic).(demand is inelastic).

The Price-Leadership ModelThe Price-Leadership Model
• Price-leadershipPrice-leadership is a form ofis a form of
oligopoly in which one dominant firmoligopoly in which one dominant firm
sets prices and all the smaller firmssets prices and all the smaller firms
in the industry follow its pricingin the industry follow its pricing
policy.policy.

• Assumptions of the price-leadership model:Assumptions of the price-leadership model:
1.1. The industry is made up of one large firm and aThe industry is made up of one large firm and a
number of smaller, competitive firms;number of smaller, competitive firms;
2.2. The dominant firm maximizes profit subject toThe dominant firm maximizes profit subject to
the constraint of market demandthe constraint of market demand andand subject tosubject to
the behavior of the smaller firms;the behavior of the smaller firms;
3.3. The dominant firm allows the smaller firms toThe dominant firm allows the smaller firms to
sell all they want at the price the leader has set.sell all they want at the price the leader has set.

• Outcome of the price-leadership model:Outcome of the price-leadership model:
1.1. The quantity demanded in the industry is splitThe quantity demanded in the industry is split
between the dominant firm and the group ofbetween the dominant firm and the group of
smaller firms.smaller firms.
2.2. This division of output is determined by theThis division of output is determined by the
amount of market power that the dominant firmamount of market power that the dominant firm
has.has.
3.3. The dominant firm has an incentive to pushThe dominant firm has an incentive to push
smaller firms out of the industry in order tosmaller firms out of the industry in order to
establish a monopoly.establish a monopoly.

Predatory PricingPredatory Pricing
• The practice of a large, powerful firmThe practice of a large, powerful firm
driving smaller firms out of thedriving smaller firms out of the
market by temporarily selling at anmarket by temporarily selling at an
artificially low price is calledartificially low price is called
predatory pricingpredatory pricing..
• Such behavior became illegal in theSuch behavior became illegal in the
United States with the passage ofUnited States with the passage of
antimonopoly legislation around theantimonopoly legislation around the
turn of the century.turn of the century.

Game TheoryGame Theory
• Game theoryGame theory analyzes oligopolisticanalyzes oligopolistic
behavior as a complex series ofbehavior as a complex series of
strategic moves and reactivestrategic moves and reactive
countermoves among rival firms.countermoves among rival firms.
• In game theory, firms are assumedIn game theory, firms are assumed
to anticipate rival reactions.to anticipate rival reactions.

Payoff Matrix for Advertising GamePayoff Matrix for Advertising Game
B’s STRATEGYB’s STRATEGY
A’s STRATEGYA’s STRATEGY Do not advertiseDo not advertise AdvertiseAdvertise
Do not advertiseDo not advertise
A’s profit = $50,000A’s profit = $50,000
B’s profit = $50,000B’s profit = $50,000
A’s loss = $25,000A’s loss = $25,000
AdvertiseAdvertise
B’s loss = $25,000B’s loss = $25,000
• The strategy that firm A will actually choose depends on
the information available concerning B’s likely strategy.

Payoff Matrix for Advertising GamePayoff Matrix for Advertising Game
B’s STRATEGYB’s STRATEGY
A’s STRATEGYA’s STRATEGY Do not advertiseDo not advertise AdvertiseAdvertise
Do not advertiseDo not advertise
A’s loss = $25,000A’s loss = $25,000
AdvertiseAdvertise
B’s loss = $25,000B’s loss = $25,000
• Regardless of what B does, it pays A to advertise. This is
the dominant strategy, or the strategy that is best no
matter what the opposition does.

The Prisoners’ DilemmaThe Prisoners’ Dilemma
ROCKYROCKY
GINGERGINGER Do not confessDo not confess ConfessConfess
Do not confessDo not confess
Ginger: 1 yearGinger: 1 year
Rocky: 1 yearRocky: 1 year
Ginger: 7 yearsGinger: 7 years
Rocky: freeRocky: free
ConfessConfess
Ginger: freeGinger: free
Rocky: 7 yearsRocky: 7 years
Ginger: 5 yearsGinger: 5 years
Rocky: 5 yearsRocky: 5 years
• Both Ginger and Rocky have dominant strategies: to
confess. Both will confess, even though they would be
better off if they both kept their mouths shut.

Payoff Matrix forPayoff Matrix for
Left/Right-Top/Bottom StrategiesLeft/Right-Top/Bottom Strategies
Original GameOriginal Game
D’s STRATEGYD’s STRATEGY
C’sC’s
STRATEGYSTRATEGY LeftLeft RightRight
TopTop C wins $100C wins $100
D wins no $D wins no $
C wins $100C wins $100
D wins $100D wins $100
BottomBottom
C loses $100C loses $100
• Because D’s behavior is
predictable (he will play
the right-hand strategy), C
will play bottom.
• When all players are
playing their best strategy
given what their
competitors are doing, the
result is called Nash
equilibrium.

Payoff Matrix forPayoff Matrix for
Left/Right-Top/Bottom StrategiesLeft/Right-Top/Bottom Strategies
• C is likely to play top and
guarantee herself a $100
profit instead of losing
$10,000 to win $200, even if
there is just a small chance of
D’s choosing left.
• When uncertainty and risk are
introduced, the game
changes. A maximin
strategy is a strategy chosen
to maximize the minimum
gain that can be earned.
New GameNew Game
D’s STRATEGYD’s STRATEGY
C’sC’s
STRATEGYSTRATEGY LeftLeft RightRight
TopTop C wins $100C wins $100
BottomBottom
C losesC loses
$10,000$10,000

Contestable MarketsContestable Markets
• A market isA market is perfectly contestableperfectly contestable ifif
entry to itentry to it andand exit from it areexit from it are
costless.costless.
• In contestable markets, even largeIn contestable markets, even large
oligopolistic firms end up behavingoligopolistic firms end up behaving
like perfectly competitive firms.like perfectly competitive firms.
Prices are pushed to long-runPrices are pushed to long-run
average cost by competition, andaverage cost by competition, and
positive profits do not persist.positive profits do not persist.

Oligopoly is Consistent withOligopoly is Consistent with
a Variety of Behaviorsa Variety of Behaviors
• The only necessary condition of oligopoly isThe only necessary condition of oligopoly is
that firms are large enough to have somethat firms are large enough to have some
control over price.control over price.
• Oligopolies are concentrated industries. AtOligopolies are concentrated industries. At
one extreme is the cartel, in essence,one extreme is the cartel, in essence,
acting as a monopolist. At the otheracting as a monopolist. At the other
extreme, firms compete for smallextreme, firms compete for small
contestable markets in response tocontestable markets in response to
observed profits. In between are a numberobserved profits. In between are a number
of alternative models, all of which stressof alternative models, all of which stress
the interdependence of oligopolistic firms.the interdependence of oligopolistic firms.

Oligopoly and Economic PerformanceOligopoly and Economic Performance
• Oligopolies, or concentrated industries, areOligopolies, or concentrated industries, are
likely to be inefficient for the following reasons:likely to be inefficient for the following reasons:
• They are likely to price above marginal cost. ThisThey are likely to price above marginal cost. This
means that there would be underproduction frommeans that there would be underproduction from
society’s point of view.society’s point of view.
• Strategic behavior can force firms into deadlocksStrategic behavior can force firms into deadlocks
that waste resources.that waste resources.
• Product differentiation and advertising may pose aProduct differentiation and advertising may pose a
real danger of waste and inefficiency.real danger of waste and inefficiency.

The Role of GovernmentThe Role of Government
• TheThe Celler-Kefauver Act of 1950Celler-Kefauver Act of 1950
extended the government’s authorityextended the government’s authority
to ban vertical and conglomerateto ban vertical and conglomerate
mergers.mergers.
• TheThe Herfindahl-Hirschman IndexHerfindahl-Hirschman Index
(HHI)(HHI) is a mathematical calculationis a mathematical calculation
that uses market share figures tothat uses market share figures to
determine whether or not a proposeddetermine whether or not a proposed
merger will be challenged by themerger will be challenged by the
government.government.

Regulation of MergersRegulation of Mergers
Calculation of a Simple Herfindahl-Hirschman Index for Four HypotheticalCalculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical
Industries, Each With No More Than Four FirmsIndustries, Each With No More Than Four Firms
PERCENTAGE SHARE OF:PERCENTAGE SHARE OF: HERFINDAHL-HERFINDAHL-
HIRSCHMANHIRSCHMAN
INDEXINDEXFIRM 1FIRM 1 FIRM 2FIRM 2 FIRM 3FIRM 3 FIRM 4FIRM 4
Industry AIndustry A 5050 5050 −− −− 505022
+ 50+ 5022
= 5,000= 5,000
Industry BIndustry B 8080 1010 1010 −− 808022
+ 10+ 1022
+ 10+ 1022
= 6,600= 6,600
Industry CIndustry C 2525 2525 2525 2525 252522
+ 25+ 2522
+ 25+ 2522
+ 25+ 2522
= 2,500= 2,500
Industry DIndustry D 4040 2020 2020 2020 404022
+ 20+ 2022
+ 20+ 2022
+ 20+ 2022
= 2,800= 2,800

Department of Justice MergerDepartment of Justice Merger
Guidelines (revised 1984)Guidelines (revised 1984)
ANTITRUST DIVISION ACTIONANTITRUST DIVISION ACTION
HHIHHI
1,8001,800
1,0001,000
00
ConcentratedConcentrated
Challenge if Index isChallenge if Index is
raised by more than 50raised by more than 50
points by the mergerpoints by the merger
ModerateModerate
ConcentrationConcentration
Challenge if Index isChallenge if Index is
raised by more than 100raised by more than 100
points by the mergerpoints by the merger
UnconcentratedUnconcentrated
No challengeNo challenge

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