Chapter 7

MONOPOLY, OLIGOPOLY, AND STRATEGY

1. Monopoly and Oligopoly Firms that are large relative to the market are

either monopolies, in which a single firm dominates the market, or oligopolies , where a handful of firms dominate.

Perfectly competitive firms have no control over the prices they charge; they are price takers.

Monopolist and oligopolists exercise more control over price they are price searchers.

Price searchers face a downward-sloping demand curve, if they want to increase sales they must lower their price.

1. Monopoly and Oligopoly – cont. A monopoly is one seller of a good that has no

close substitutes, with considerable control over price and protection from competition by barriers to entry.

Historically water, electric and gas companies were monopolies.

The most complex price searcher is the oligopolist who must consider the reactions of competitors.

This large firm worries about the entire market for the product as well as the reaction of its rivals.

Automobiles, breakfast cereals, refrigerators, and cigarettes are examples.

1. Monopoly and Oligopoly – cont. Barriers to entry differentiate one type of

price searcher from another; entry barriers are any conditions that put new firms at a disadvantage to old firms. Examples are: Large minimum efficient scale, requiring huge

capital investments; Patents; Monopoly ownership of critical raw material; and Government restrictions on entry such as

licensing requirements.

2. Price Searching The behavior of each price searchers

are governed by certain general principles:

They must lower their price to sell more. They must maximize their profits by

producing that output at which marginal revenue equals marginal cost.

Marginal revenue, MR, is the increase in revenue brought about by increasing output (sales) by one unit.

2. Price Searching

For the price searcher, price is greater than marginal revenue: P>MR.

Selling more output “spoils the market” on the earlier units sold because their price is lower.

Price Searching and “Skimming the Market” Example

2.1 The Marginal Revenue Curve The price searcher faces both a demand

schedule and a marginal revenue schedule. Whether MR is positive or negative depends on

whether demand is elastic or inelastic at the corresponding price:

Elastic demand = a reduction in price raises total revenue so MR is positive

Inelastic demand = a reduction in price lowers total revenue so MR is negative

With straight-line demand curves, the MR curve will be exactly halfway between the demand curve and the vertical axis.

2.2 Profit Maximizing by a Monopoly Producer The profit-maximizing level of

output is where MR = MC. The demand curve determines the

price, and where MR and MC intersect determines the quantity.

The monopolist can set either the profit-maximizing price or the profit-maximizing quantity.

2.3 Oligopoly Oligopoly covers markets between monopoly

and monopolistic competition. Oligopoly is characterized by a small number

of producers, barriers to entry, price searching, and mutual interdependence.

They are more complicated than perfect competition, pure monopolies, or monopolistic competition because there is no one theory of oligopoly.

The marginal revenue an oligopolistic gains from a higher price depends on the reactions of rival firms, which might be difficult to predict.

2.4 Mutual Interdependence Mutual interdependence characterizes an

industry where it is recognized that the actions of one firm affect other firms in the industry.

Mutual interdependence is the most important feature of oligopoly:

In some industries, the pattern of reaction may be well understood by all participants it may either be dictated by custom or by agreement;

In others, the reactions of rival firms may be unpredictable, and participants must use strategic behavior to outguess and outmaneuver their rivals.

2.4.1 Strategic Behavior Strategic behavior occurs when

oligopolistic rivals adopt strategies to outguess other firms.

Each firm’s profit depends on the price charged by the other.

If one charges a slightly lower price, then it will make a large profit while the higher-priced firm makes a low profit.

Oligopolist must make a pricing decision not knowing what the other firm will do.

2.4.1 Strategic Behavior – cont.

The Prisoners Dilemma Example As equilibrium applies to supply and demand

in competitive markets, so does it applies to strategic behavior.

A Nash equilibrium is a set of strategies, one for each player, such that no player has an incentive to universally change his or her reaction.

Players are in equilibrium if a change in strategies by any one of them would lead the other player to earn less remaining with the current strategy.

2.4.2 Cartel Agreements Some oligopolistic firms form a cartel. A cartel is an arrangement that allows

the participating firms to coordinate their output and pricing decisions to earn monopoly profits.

If successful, these agreements allow the oligopolistic firms to earn monopolistic profits for the industry as a whole.

2.4.2 Cartel Agreements – cont.

In most countries, cartel agreements are against the law and must be kept secret.

Every cartel member can gain through the attainment of monopoly profits if each adheres to the agreement. Each member can gain by cheating on the agreement if the others do not cheat.

Greed leads firms to join cartels; greed also leads firms to break up cartels; very few cartels are successful over the long run.

2.4.3 Conscious Parallelism Informal agreements and conscious

parallelism are also used by oligopositic firms to coordinate price and output.

Rival firms follow the price leader’s price to increase and decrease. The price leader keeps a sharp eye on market demand and costs. A price leader is a firm whose price changes are consistently imitated by other firms in the industry.

2.4.3 Conscious Parallelism – cont. Conscious parallelism occurs when

oligopoly firms behave in the same way even though they have not agreed to act in a parallel manner.

Examples are submitting identical bids and switching to high-season rates at the same time without formal agreement.

Through conscious parallelism, the actions of producers can be coordinated without formal or even informal agreements.

3. Efficiency, Antitrust, and Network Externalities In the case of monopoly, price exceeds

marginal cost (P>MC) There is economic inefficiency when it is

possible to rearrange production so that the benefits to gainers outweigh the costs to the losers.

Monopoly is inefficient because it produces where P>MC.

Consumers buy until the marginal benefit to them equals price.

3. Efficiency, Antitrust, and Network Externalities – cont. MC measures the marginal cost of the

resources used to produce another unit. Monopoly is costly to consumers and

society because it raises prices by the artificial restriction of output to obtain the monopoly price.

Monopoly rent-seeking is the expenditure of resources to gain monopoly rights from government.

Campaign Finance and Monopoly Rent-Seeking Example

3.1 Monopoly and Antitrust Historic monopolies are the controllers of

raw material (Alcoa Aluminum), and improved innovation and technology (Kodak and IBM).

The Sherman Antitrust Act of 1890 is the cornerstone of U.S. antitrust policy. It declared monopolies and the attempt to create monopolies illegal.

The Department of Justice’s Case against Microsoft Example

3.2 Monopolies in the Long Run Unlike competitive economic profits,

monopoly profits can persist for long periods.

In the U.S., it is difficult to find pure monopolies because of actual or potential substitutes and because absolute barriers to entry are rarely present.

Exceptional monopoly profits have historically promoted the development of closer substitutes for the monopolist’s products. (E.g. railroad and AT&T)

3.3 Monopolies and Network Externalities The Internet and communications revolutions

have created a new type of monopoly based on network externalities.

Network externalities exist when the act of joining a network confers a benefit on all other members of the network.

Examples are owners of fax machines, users of PCs (use a common operating system and exchange files easily), and users of cell phones with text messaging.

The greater the number of users, the more valuable the network.

3.3 Monopolies and Network Externalities – cont. Monopolies can be created when network

externalities exist because of the importance of common standards. (VHS/Beta, or Macintosh/Windows)

New entrants to the network will choose the common standard, even if the alternative standard is in some sense superior (e.g. the adoption of qwerty standard for typewriters).

Network externalities explain some of today’s monopolies, such as Microsoft Windows, the Intel monopoly of microprocessors, and the monopoly of word processing by MS Word.

4. Concentration Ratios The statistical tool commonly used to

measure the extend of competition is the concentration ratio.

The x-firm concentration ratio is the percentage of industry output, accounted for by the largest x domestic firms in the industry.

The higher the concentration ratio, the higher the presumed degree of monopoly power in that industry.

4. Concentration Ratios – cont.

Concentration ratios are an imperfect measure of the extend of oligopoly or monopoly for several reasons:

1. Some markets are worldwide, e.g. automobiles and steel. (compare America with Japanese/German cars)

2. It can give a false picture because of foreign competition and the existence of substitutes.

3. It may conceal the churning forces of competition. (Every x years the top four firms are replaced by new upcoming firms)

4.1 Trends in Concentration There is a widespread impression that

concentration has been increasing over time.

It has been created by erroneously equating increases in the absolute size of firms with increases in their market share.

The largest 100 American firms have accounted for the same percentage of manufacturing for almost a half-century.

4.1 Trends in Concentration – cont. It is difficult to measure the degree

of monopolization of an entire economy over time.

The most common measures suggest the economy is not becoming more monopolized.

The statistics, however, point to a remarkable stability of concentration.