Monopolistic Competition and Oligopoly

CHAPTER
13
Monopolistic Competition and Oligopoly
Prepared by: Fernando Quijano and Yvonn Quijano
2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Monopolistic Competition
A monopolistically competitive industry has the following characteristics:
A large number of firms No barriers to entry Product differentiation
Karl Case, Ray Fair
Monopolistic Competition
Monopolistic competition is 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.
Karl Case, Ray Fair
Nine Industries with Characteristics of Monopolistic Competition

Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992
INDUSTRY DESIGNATION
Travel trailers and campers Dolls Wood office furniture Book publishing Curtains and draperies Fresh or frozen seafood Blowers and fans Womens dresses Miscellaneous plastic products
SIC NO.
FOUR LARGEST FIRMS
EIGHT TWENTY NUMBER LARGEST LARGEST OF FIRMS FIRMS FIRMS
3792 3942 2521 2731 2391 2092 3564 2335 3089
41 34 26 23 22 19 14 11 5
57 47 34 38 32 28 22 17 8
72 67 51 62 48 47 41 30 13
Karl Case, Ray Fair
270 204 611 2504 1004 600 518 3943 7605
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.
Product Differentiation, Advertising, and Social Welfare

Total Advertising Expenditures in 1998 DOLLARS (BILLIONS) Newspapers 44.2
Television
Direct mail Other Yellow pages
48.0
39.5 31.7 12.0
Radio
Magazines Total
14.5
10.4 200.3
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947.
Karl Case, Ray Fair
The Case for Product Differentiation and Advertising

The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. Product differentiation helps to ensure high quality and efficient production.
Karl Case, Ray Fair
The Case for Product Differentiation and Advertising

Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.
Karl Case, Ray Fair
The Case Against Product Differentiation and Advertising

Critics of product differentiation and advertising argue that they amount to nothing more than waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products.
Karl Case, Ray Fair
The Case Against Product Differentiation and Advertising

Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Product Differentiation Reduces the Elasticity of Demand Facing a Firm

Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.
Karl Case, Ray Fair
Monopolistic Competition in the Short Run

In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC. This firm is earning positive profits in the short-run.
Karl Case, Ray Fair
Monopolistic Competition in the Short-Run

Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.
Karl Case, Ray Fair
Monopolistic Competition in the Long-Run
The firms 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.
Economic Efficiency and Resource Allocation

In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:
Price is above marginal
cost. More output could be produced at a resource cost below the value that consumers place on the product.
Karl Case, Ray Fair
Economic Efficiency and Resource Allocation

In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:
Average total cost is not
minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity.
Karl Case, Ray Fair
Oligopoly
An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.
Karl Case, Ray Fair
Ten Highly Concentrated Industries

Percentage of Value of Shipments Accounted for by the Largest Firms in HighConcentration Industries, 1992 INDUSTRY DESIGNATION
Cellulosic man-made fiber Primary copper
SIC NO.
2823 3331
FOUR LARGEST FIRMS

98 98
EIGHT LARGEST FIRMS

100 99
NUMBER OF FIRMS
5 11
3633
2111 2082 3641 2043
Household laundry equipment

Cigarettes Malt beverages (beer) Electric lamp bulbs Cereal breakfast foods
94
93 90 86 85
99
100 98 94 98
10
8 160 76 42
3711
3482 3632
Motor vehicles
Small arms ammunition Household refrigerators and freezers
84
84 82
91
95 98
398
55 52
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.
Karl Case, Ray Fair
Oligopoly Models
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.
Karl Case, Ray Fair
The Collusion Model

A group of firms that gets together and makes price and output decisions jointly is called a cartel. Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit.
The Cournot Model

The Cournot model is 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.
Karl Case, Ray Fair
The Kinked Demand Curve Model

The kinked demand model is a model of oligopoly in which the demand curve facing each individual firm has a kink in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price.
Karl Case, Ray Fair
The Kinked Demand Curve Model

Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firms quantity demanded (demand is elastic). Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).
The Price-Leadership Model

Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.
Karl Case, Ray Fair

Assumptions of the price-leadership model:
1. The industry is made up of one large firm and a
number of smaller, competitive firms;

2. The dominant firm maximizes profit subject to
the constraint of market demand and subject to the behavior of the smaller firms;
3. The dominant firm allows the smaller firms to
sell all they want at the price the leader has set.
Karl Case, Ray Fair

Outcome of the price-leadership model:
1. The quantity demanded in the industry is split
between the dominant firm and the group of smaller firms.

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

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

Predatory Pricing
The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing. Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.
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.
Karl Case, Ray Fair
Payoff Matrix for Advertising Game

Bs STRATEGY As STRATEGY Do not advertise Do not advertise As profit = $50,000 Bs profit = $50,000 As profit = $75,000 Bs loss = $25,000 Advertise As loss = $25,000 Bs profit = $75,000 As profit = $10,000 Bs profit = $10,000
Advertise
The strategy that firm A will actually choose depends on the information available concerning Bs likely strategy.
Payoff Matrix for Advertising Game

Bs STRATEGY As STRATEGY Do not advertise Do not advertise As profit = $50,000 Bs profit = $50,000 As profit = $75,000 Bs loss = $25,000 Advertise As loss = $25,000 Bs profit = $75,000 As profit = $10,000 Bs profit = $10,000
Advertise
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 Dilemma

ROCKY GINGER Do not confess Do not confess Ginger: 1 year Rocky: 1 year Ginger: free Rocky: 7 years Confess Ginger: 7 years Rocky: free Ginger: 5 years Rocky: 5 years
Confess
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 for Left/Right-Top/Bottom Strategies

Original Game Ds STRATEGY
Cs STRATEGY
Left
C wins $100 D wins no $
Right
C wins $100 D wins $100
Because Ds 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.
Top
Bottom
C loses $100 D wins no $
Karl Case, Ray Fair
Payoff Matrix for Left/Right-Top/Bottom Strategies

New Game Ds STRATEGY
Cs STRATEGY
Left
C wins $100 D wins no $ C loses $10,000 D wins no $
Right
Top
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 Ds 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.
Karl Case, Ray Fair
Bottom
Contestable Markets
A market is perfectly contestable if entry to it and exit from it 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.
Oligopoly 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 essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms.
Oligopoly and Economic Performance

Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons:
They are likely to price above marginal cost. This
means that there would be underproduction from societys point of view.

Strategic behavior can force firms into deadlocks
that waste resources.

Product differentiation and advertising may pose a
real danger of waste and inefficiency.
Karl Case, Ray Fair
The Role of Government

The Celler-Kefauver Act of 1950 extended the governments authority to ban vertical and conglomerate mergers.
The Herfindahl-Hirschman Index (HHI) is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.
Regulation of Mergers
Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms PERCENTAGE SHARE OF: FIRM 1 Industry A Industry B Industry C Industry D 50 80 25 40 FIRM 2 50 10 25 20 FIRM 3 10 25 20 FIRM 4 25 20 HERFINDAHLHIRSCHMAN INDEX 502 + 502 = 5,000 802 + 102 + 102 = 6,600 252 + 252 + 252 + 252 = 2,500 402 + 202 + 202 + 202 = 2,800
Karl Case, Ray Fair
Department of Justice Merger Guidelines (revised 1984)

ANTITRUST DIVISION ACTION HHI
Concentrated Challenge if Index is raised by more than 50 points by the merger Moderate Concentration Challenge if Index is raised by more than 100 points by the merger Unconcentrated No challenge
1,800
1,000
0

Monopolistic Competition and Oligopoly

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CHAPTER

Prepared by: Fernando Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Nine Industries with Characteristics of Monopolistic Competition

FOUR LARGEST FIRMS

EIGHT TWENTY NUMBER LARGEST LARGEST OF FIRMS FIRMS FIRMS

3792 3942 2521 2731 2391 2092 3564 2335 3089

270 204 611 2504 1004 600 518 3943 7605

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Product Differentiation, Advertising, and Social Welfare

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case for Product Differentiation and Advertising

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case for Product Differentiation and Advertising

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case Against Product Differentiation and Advertising

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case Against Product Differentiation and Advertising

Product Differentiation Reduces the Elasticity of Demand Facing a Firm

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Monopolistic Competition in the Short Run

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Monopolistic Competition in the Short-Run

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Monopolistic Competition in the Long-Run

Economic Efficiency and Resource Allocation

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Economic Efficiency and Resource Allocation

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Ten Highly Concentrated Industries

FOUR LARGEST FIRMS

EIGHT LARGEST FIRMS

Household laundry equipment