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© 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

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Monopolistic Competition and Monopolistic Competition and OligopolyOligopoly


Monopolistic CompetitionMonopolistic Competition

• A A monopolistically competitive monopolistically competitive industryindustry has the following has 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

• Monopolistic competitionMonopolistic competition is a common is a common form of industry (market) structure in the form of industry (market) structure in the United States, characterized by a large United States, characterized by a large number of firms, none of which can influence number 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 achieved Some degree of market power is achieved by firms producing differentiated products.by firms producing differentiated products.

• New firms can enter and established firms New firms can enter and established firms can exit such an industry with ease.can exit such an industry with ease.


Nine Industries with Characteristics of Nine Industries with Characteristics of Monopolistic CompetitionMonopolistic Competition

Percentage of Value of Shipments Accounted for by the Largest Firms in Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992Selected Industries, 1992

SIC NO.SIC NO.INDUSTRYINDUSTRY

DESIGNATIONDESIGNATION

FOURFOURLARGESTLARGEST

FIRMSFIRMS

EIGHTEIGHTLARGESTLARGEST

FIRMSFIRMS

TWENTYTWENTYLARGESTLARGEST

FIRMSFIRMS

NUMBERNUMBEROFOF

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 76057605Source: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 Series Subject 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 200.3200.3Source: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 United Statistical Abstract of the United StatesStates, 1999, Table 947., 1999, Table 947.


The Case for Product Differentiation The Case for Product Differentiation and Advertisingand Advertising

• The advocates of free and open The advocates of free and open competition believe that differentiated competition believe that differentiated products and advertising give the products and advertising give the market system its vitality and are the market system its vitality and are the basis of its power.basis of its power.

• Product differentiation helps to ensure Product differentiation helps to ensure high quality and efficient production.high quality and efficient production.


The Case for Product Differentiation The Case for Product Differentiation and Advertisingand Advertising

• Advertising provides consumers with Advertising provides consumers with the valuable information on product the valuable information on product availability, quality, and price that availability, quality, and price that they need to make efficient choices they need to make efficient choices in the market place.in the market place.


The Case Against Product The Case Against Product Differentiation and AdvertisingDifferentiation and Advertising

• Critics of product differentiation and Critics of product differentiation and advertising argue that they amount to advertising argue that they amount to nothing more than waste and nothing more than waste and inefficiency.inefficiency.

• Enormous sums are spent to create Enormous sums are spent to create minute, meaningless, and possibly minute, meaningless, and possibly nonexistent differences among nonexistent differences among products.products.


The Case Against Product The Case Against Product Differentiation and AdvertisingDifferentiation and Advertising

• Advertising raises the cost of products Advertising raises the cost of products and frequently contains very little and frequently contains very little information. Often, it is merely an information. Often, it is merely an annoyance.annoyance.

• People exist to satisfy the needs of the People exist to satisfy the needs of the economy, not vice versa.economy, not vice versa.

• Advertising can lead to unproductive Advertising can lead to unproductive warfare and may serve as a barrier to warfare and may serve as a barrier to entry, thus reducing real competition.entry, thus reducing real competition.


Product Differentiation Reduces the Product Differentiation Reduces the Elasticity of Demand Facing a FirmElasticity of Demand Facing a Firm

• Based on the availability of Based on the availability of substitutes, the demand substitutes, the demand curve faced by a curve faced by a monopolistic competitor is monopolistic competitor is likely to be likely to be less elasticless elastic than the demand curve than the demand curve faced by a perfectly faced by a perfectly competitive firm, and likely competitive firm, and likely to be to be more elasticmore elastic than the than the demand curve faced by a demand curve faced by a monopoly.monopoly.


Monopolistic Competition in the Short RunMonopolistic Competition in the Short Run

• In the short-run, a monopolistically competitive firm In the short-run, a monopolistically competitive firm will produce up to the point where will produce up to the point where MR = MCMR = MC. .

• This firm is This firm is earning positive earning positive profits in the profits 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 a Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker similar 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 demand The firm’s demand curve must end up curve must end up tangent to its average tangent to its average total cost curve for total cost curve for profits to equal zero. profits to equal zero. This is the condition for This is the condition for long-run equilibrium in long-run equilibrium in a monopolistically a monopolistically competitive industry.competitive industry.


Economic EfficiencyEconomic Efficiencyand Resource Allocationand Resource Allocation

• In the long-run, economic profits are eliminated; thus, we In 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 marginal Price is above marginal cost.cost. More output could More output could be produced at a be produced at a resource cost below the resource cost below the value that consumers value that consumers place on the product.place on the product.


Economic EfficiencyEconomic Efficiencyand Resource Allocationand Resource Allocation

• In the long-run, economic profits are eliminated; thus, we In 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 not Average total cost is not minimized.minimized. The typical The typical firm will not realize all the firm will not realize all the economies of scale economies of scale available. Smaller and available. Smaller and smaller market share smaller market share results in excess capacity.results in excess capacity.


OligopolyOligopoly

• An An oligopolyoligopoly is a form of industry is a form of industry (market) structure characterized by a (market) structure characterized by a few dominant firms. Products may few dominant firms. Products may be homogeneous or differentiated.be homogeneous or differentiated.

• The behavior of any one firm in an The behavior of any one firm in an oligopoly depends to a great extent oligopoly 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

FOURFOURLARGESTLARGEST

FIRMSFIRMS

EIGHTEIGHTLARGESTLARGEST

FIRMSFIRMS

NUMBERNUMBEROFOF

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, Subject Subject Series MC92-S-2, 1997.Series MC92-S-2, 1997.


Oligopoly ModelsOligopoly Models

• All kinds of oligopoly have one All kinds of oligopoly have one thing in common:thing in common:

• The behavior of any given The behavior of any given oligopolistic firm depends on the oligopolistic firm depends on the behavior of the other firms in the behavior 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 together A group of firms that gets together and makes price and output and makes price and output decisions jointly is called a decisions jointly is called a cartelcartel..

• Collusion occurs when price- and Collusion occurs when price- and quantity-fixing agreements are quantity-fixing agreements are explicit.explicit.

• Tacit collusionTacit collusion occurs when firms occurs when firms end up fixing price without a specific end up fixing price without a specific agreement, or when agreements are agreement, or when agreements are implicit.implicit.


The Cournot ModelThe Cournot Model

• The The Cournot modelCournot model is a model of a is a model of a two-firm industry (duopoly) in which two-firm industry (duopoly) in which a series of output-adjustment a series of output-adjustment decisions leads to a final level of decisions leads to a final level of output between the output that would output between the output that would prevail if the market were organized prevail if the market were organized competitively and the output that competitively 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

• The The kinked demand modelkinked demand model is a is a model of oligopoly in which the model of oligopoly in which the demand curve facing each individual demand curve facing each individual firm has a “kink” in it. The kink firm has a “kink” in it. The kink follows from the assumption that follows from the assumption that competitive firms will follow if a competitive firms will follow if a single firm cuts price but will not single 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 in Above P*, an increase in price, which is not followed price, which is not followed by competitors, results in a by competitors, results in a large decrease in the firm’s large decrease in the firm’s quantity demanded quantity demanded (demand is elastic).(demand is elastic).

• Below P*, price decreases Below P*, price decreases are followed by are followed by competitors so the firm competitors so the firm does not gain as much does not gain as much quantity demanded quantity demanded (demand is inelastic).(demand is inelastic).


The Price-Leadership ModelThe Price-Leadership Model

• Price-leadershipPrice-leadership is a form of is a form of oligopoly in which one dominant firm oligopoly in which one dominant firm sets prices and all the smaller firms sets prices and all the smaller firms in the industry follow its pricing in 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 a The 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 to The dominant firm maximizes profit subject to the constraint of market demand the constraint of market demand andand subject to subject to the behavior of the smaller firms;the behavior of the smaller firms;

3.3. The dominant firm allows the smaller firms to The 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 split The quantity demanded in the industry is split between the dominant firm and the group of between the dominant firm and the group of smaller firms.smaller firms.

2.2. This division of output is determined by the This division of output is determined by the amount of market power that the dominant firm amount of market power that the dominant firm has.has.

3.3. The dominant firm has an incentive to push The dominant firm has an incentive to push smaller firms out of the industry in order to smaller firms out of the industry in order to establish a monopoly.establish a monopoly.


Predatory PricingPredatory Pricing

• The practice of a large, powerful firm The practice of a large, powerful firm driving smaller firms out of the driving smaller firms out of the market by temporarily selling at an market by temporarily selling at an artificially low price is called artificially low price is called predatory pricingpredatory pricing..

• Such behavior became illegal in the Such behavior became illegal in the United States with the passage of United States with the passage of antimonopoly legislation around the antimonopoly legislation around the turn of the century.turn of the century.


Game TheoryGame Theory

• Game theoryGame theory analyzes oligopolistic analyzes oligopolistic behavior as a complex series of behavior as a complex series of strategic moves and reactive strategic moves and reactive countermoves among rival firms.countermoves among rival firms.

• In game theory, firms are assumed In 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 = $50,000B’s profit = $50,000B’s profit = $50,000

A’s loss = $25,000A’s loss = $25,000B’s profit = $75,000B’s profit = $75,000

AdvertiseAdvertise A’s profit = $75,000A’s profit = $75,000B’s loss = $25,000B’s loss = $25,000

A’s profit = $10,000A’s profit = $10,000B’s profit = $10,000B’s profit = $10,000

• 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 profit = $50,000A’s profit = $50,000B’s profit = $50,000B’s profit = $50,000

A’s loss = $25,000A’s loss = $25,000B’s profit = $75,000B’s profit = $75,000

AdvertiseAdvertise A’s profit = $75,000A’s profit = $75,000B’s loss = $25,000B’s loss = $25,000

A’s profit = $10,000A’s profit = $10,000B’s profit = $10,000B’s profit = $10,000

• 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 yearRocky: 1 yearRocky: 1 year

Ginger: 7 yearsGinger: 7 yearsRocky: freeRocky: free

ConfessConfess Ginger: freeGinger: freeRocky: 7 yearsRocky: 7 years

Ginger: 5 yearsGinger: 5 yearsRocky: 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 forLeft/Right-Top/Bottom StrategiesLeft/Right-Top/Bottom Strategies

Original GameOriginal Game

D’s STRATEGYD’s STRATEGY

C’s C’s STRATEGYSTRATEGY LeftLeft RightRight

TopTop C wins $100C wins $100D wins no $D wins no $

C wins $100C wins $100D wins $100D wins $100

BottomBottomC loses $100C loses $100D wins no $D wins no $


• 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 forLeft/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’s C’s STRATEGYSTRATEGY LeftLeft RightRight

TopTop C wins $100C wins $100D wins no $D wins no $


BottomBottomC loses C loses $10,000$10,000D wins no $D wins no $



Contestable MarketsContestable Markets

• A market is A market is perfectly contestableperfectly contestable if if entry to it entry to it andand exit from it are exit from it are costless.costless.

• In contestable markets, even large In contestable markets, even large oligopolistic firms end up behaving oligopolistic firms end up behaving like perfectly competitive firms. like perfectly competitive firms. Prices are pushed to long-run Prices are pushed to long-run average cost by competition, and average cost by competition, and positive profits do not persist.positive profits do not persist.


Oligopoly is Consistent withOligopoly is Consistent witha Variety of Behaviorsa Variety of Behaviors

• The only necessary condition of oligopoly is The only necessary condition of oligopoly is that firms are large enough to have some that firms are large enough to have some control over price.control over price.

• Oligopolies are concentrated industries. At Oligopolies are concentrated industries. At one extreme is the cartel, in essence, one extreme is the cartel, in essence, acting as a monopolist. At the other acting as a monopolist. At the other extreme, firms compete for small extreme, firms compete for small contestable markets in response to contestable markets in response to observed profits. In between are a number observed profits. In between are a number of alternative models, all of which stress of 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, are Oligopolies, 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. This They are likely to price above marginal cost. This means that there would be underproduction from means that there would be underproduction from society’s point of view.society’s point of view.

• Strategic behavior can force firms into deadlocks Strategic behavior can force firms into deadlocks that waste resources.that waste resources.

• Product differentiation and advertising may pose a Product 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

• The The Celler-Kefauver Act of 1950Celler-Kefauver Act of 1950 extended the government’s authority extended the government’s authority to ban vertical and conglomerate to ban vertical and conglomerate mergers.mergers.

• The The Herfindahl-Hirschman Index Herfindahl-Hirschman Index (HHI)(HHI) is a mathematical calculation is a mathematical calculation that uses market share figures to that uses market share figures to determine whether or not a proposed determine whether or not a proposed merger will be challenged by the merger will be challenged by the government.government.


Regulation of MergersRegulation of Mergers

Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Calculation 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 Merger Department of Justice Merger Guidelines (revised 1984)Guidelines (revised 1984)

ANTITRUST DIVISION ACTIONANTITRUST DIVISION ACTION

HHIHHI

1,8001,800

1,0001,000

00

ConcentratedConcentratedChallenge if Index is Challenge if Index is

raised by more than 50 raised by more than 50 points by the mergerpoints by the merger

Moderate Moderate ConcentrationConcentration

Challenge if Index is Challenge if Index is raised by more than 100 raised by more than 100

points by the mergerpoints by the merger

UnconcentratedUnconcentratedNo challengeNo challenge

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