Monopolistic Competition and Oligopoly

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & Yvonn Quijano

14Chapter

Monopolistic Competitionand Oligopoly

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2 of 38© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Chapter Outline

14Monopolistic Competitionand Oligopoly

Monopolistic CompetitionProduct Differentiation, Advertising, and Social WelfarePrice and Output Determination in Monopolistic CompetitionEconomic Efficiency and Resource AllocationOligopolyOligopoly ModelsGame TheoryRepeated GamesA Game with Many Players: Collective Action Can Be Blocked by a Prisoners’ DilemmaOligopoly and Economic PerformanceIndustrial Concentration and Technological ChangeThe Role of GovernmentRegulation of MergersA Proper Role?

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MONOPOLISTIC COMPETITIONAND 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 industrystructure and behavior.

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MONOPOLISTIC COMPETITION

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

INDUSTRYDESIGNATION

FOURLARGEST

FIRMS

EIGHTLARGEST

FIRMS

TWENTYLARGEST

FIRMS

NUMBEROF

FIRMS

Travel trailers and campers 26 36 50 761Dolls 31 51 66 239Wood office furniture 34 42 55 639Book printing 32 45 59 890Curtains and draperies 26.5 36.3 50.1 2012Fresh or frozen seafood 13.6 22.9 42.2 586Women’s dresses 14.2 23.7 39.4 747Miscellaneous 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 11.8Source: 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

243729

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 253Source: Publishers Information Bureau, Statistical Abstract of the United States, 2002, pg. 772

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Restaurants and rock bands are good examples of monopolisticcompetitors that face intense competition.

The advocates of spirited competition believe that differentiated products and advertisinggive 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.

The Case for Product Differentiation and Advertising

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The bottom line, critics of product differentiation and advertising argue, is waste andinefficiency. Enormous sums are spent to create minute, meaningless, and possiblynonexistent differences among products. Advertising raises the cost of products andfrequently contains very little information. Often, it is merely an annoyance. Productdifferentiation and advertising have turned the system upside down: People exist tosatisfy the needs of the economy, not vice versa. Advertising can lead to unproductivewarfare and may serve as a barrier to entry, thus reducing real competition.

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.

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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 showthat advertising leads to concentration and positive profits; others, that advertising improves the functioning of the market.

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Product Differentiation and Demand Elasticity

PRICE AND OUTPUT DETERMINATIONIN MONOPOLISTIC COMPETITION

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.

FIGURE 14.2 Product Differentiation Reduces the Elasticity of Demand Facing a Firm

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Price/Output Determination 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.

FIGURE 14.3 Monopolistic Competition in the Short Run

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Price/Output Determination in the Long Run

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.

FIGURE 14.4 Monopolistically Competitive Firm at Long-Run Equilibrium

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MONOPOLISTIC COMPETITIONECONOMIC 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 ordifferentiated. 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

INDUSTRYDESIGNATION

FOURLARGEST

FIRMS

EIGHTLARGEST

FIRMS

NUMBEROF

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 21Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series 2001.

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OLIGOPOLY

OLIGOPOLY MODELS

The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly.

Because many different types of oligopolies exist, a number of different oligopoly modelshave been developed.

All kinds of oligopoly have one thing in common:

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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. Tacitcollusion occurs when such agreements are implicit.

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OLIGOPOLY

The Cournot Model

The Cournot model of oligopoly results in a quantity of output somewhere betweenoutput that would prevail if the market were perfectly competitive and output thatwould be set by a monopoly.

Cournot model A model of a two-firm industry (duopoly) in which a series of output adjustment decisions leads to afinal 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.

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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 singlefirm raises price.

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OLIGOPOLY

FIGURE 14.5 A Kinked Demand Curve Oligopoly Model

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OLIGOPOLY

The Price-Leadership Model

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.

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.

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OLIGOPOLY

game theory Analyzes oligopolistic behavior as a complex series of strategicmoves and reactive countermoves among rival firms. In game theory, firms areassumed to anticipate rival reactions.

GAME THEORY

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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 theopposition does.

prisoners’ dilemma A game in which the players are prevented from cooperating and in which each has a dominant strategy that leaves them bothworse 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

tit-for-tat strategy A company’s strategy that lets a competitor know the companywill follow the competitor’s lead.

REPEATED GAMES

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

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

perfectly contestable market A market in which entry and exit are costless.

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OLIGOPOLY

Review

The only necessary condition of oligopoly is that firms are large enough to have somecontrol 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 amonopolist. At the other extreme, the firms within the oligopoly vigorously competefor 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 interdependenceof oligopolistic firms.

Oligopoly is a market structure that is consistent with a variety of behaviors.

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OLIGOPOLY

Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons.First, profit-maximizing oligopolists are likely to price above marginal cost. Whenprice is above marginal cost, there is underproduction from society’s point of view—inother words, society could get more for less, but it does not. Second, strategic behaviorcan lead to outcomes that are not in society’s best interest. Specifically, strategicallycompetitive firms can force themselves into deadlocks that waste resources. Finally, tothe extent that oligopolies differentiate their products and advertise, there is thepromise of new and exciting products. At the same time, however, there remains a realdanger of waste and inefficiency.

OLIGOPOLY AND ECONOMIC PERFORMANCE

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 marketshare figures to determine whether or not a proposed merger will be challenged by the government.

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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

INDEXFIRM 1 FIRM 2 FIRM 3 FIRM 4

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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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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cartelCeller-Kefauver ActCournot modeldominant strategygame theoryHerfindahl-Hirschman

Index (HHI)kinked demand curve

modelmaximin strategy

REVIEW TERMS AND CONCEPTS

monopolistic competition

Nash equilibrium

oligopoly

perfectly contestable market

price-leadership model

prisoners’ dilemma

product differentiation

tacit collusion

tit-for-tat strategy

Education

Monopolistic Competition and Oligopoly