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Chap 10

Chap 10

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Published by: Syed Hamdan on Dec 11, 2010
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CHAPTER 10OLIGOPOLY AND MONOPOLISTIC COMPETITION
I.  CHAPTER OVERVIEW
Chapter 10 explores various sources of monopoly power and the effect of imperfect competition on themarketplace.  Although the measured degree of industrial concentration has declined in the United States inrecent years, the ability of firms to differentiate their products produces monopoly power that has an importantimpact on market participants.  Perfect competition provides consumers with the lowest prices and the highestlevels of output, but concentration may lead to increases in research and innovation.  Thus, evaluating theimpact of imperfect competition is not an easy task.As you work through this chapter, you will find that analysis of imperfect competition requires a solidunderstanding of both the perfectly competitive model and the monopoly model.  Depending upon the nature of the firms in the industry, behavior may more closely follow one model than the other.  For example, the marketfor personal computers is more like a perfectly competitive environment, while the market for automobiles ismore like a monopoly environment.  In any case, most “real world” markets can be placed somewhere along acontinuum between the perfectly competitive and monopoly extremes.Over the past century, policymakers in the United States have protected and served the interests of competition in most instances.  A major question that must be considered as you work through this chapter is asfollows: Do the benefits to competitive markets outweigh the costs of protecting and preserving them?  Later chapters in the text will help you to develop a complete answer to this question.
II.  LEARNING OBJECTIVES
After you have read Chapter 10 in your text and completed the exercises in this
Study Guide
chapter, you shouldbe able to:1. List the determinants of market power, and understand how cost structure, barriers to entry, and thepotential for collusion influence the translation of that market power into a particular market structure of imperfect competition.2. Understand the spectrum of imperfect competition, stretching from perfect competition at one extremeto monopoly at the other, and identify examples of industries that appear at various spots along the lengthof this spectrum.3. Understand the potential risks and gains involved when a few firms collude to determine industry priceand/or output.  Use the model of cartel behavior to illustrate the effects of 
tacit collusion
on markets.4. Describe the importance of 
game theory
for modeling firm behavior in noncollusive imperfectlycompetitive markets.5. Conceptualize how profit-maximizing behavior in large firms might be compromised by the divorce of ownership from control.  Translate profit-maximizing behavior from the theoretical models to the “realworld” using
rules of thumb
like
cost-plus markup
, or using price discrimination.6. Evaluate to your own satisfaction the Schumpeterian hypothesis that significant market power leads toextensive and socially desirable programs of research and development that would otherwise not beforthcoming.7. Understand how imperfect competition leads to prices which exceed marginal cost, and use
deadweight loss
to evaluate the associated welfare cost.8. Compare and contrast alternative intervention strategies that governments might pursue in order either to promote the emergence of competitive markets or to manage big business where it must exist due to theimportance of economies of scale in production.
III.  REVIEW OF KEY CONCEPTS
Match the following terms from column A with their definitions in column B.
A B
__ Market power 1. The analysis of situations involving two or more decision makers who haveconflicting objectives.__ Concentration- 2. Pricing strategy in which firms take the expected average cost of a product andratio mark it up by a percentage.__ Herfindahl- 3. The loss in real income to both buyers and sellers that arises due to the existence
 
176
Hirschman of monopoly, tariffs, taxes, or other distortions.Index__ Strategic 4. The percent of total industry output that is accounted for by the four (or eight)interaction largest firms.__ Tacit collusion 5. Denotes a situation in which two or more firms jointly set their prices or outputs,divide the market among them, or make other business decisions jointly.__ Game theory 6. Laws that prohibit certain kinds of anticompetitive behavior or restrict the emergenceof highly concentrated industries.__ Price 7. Occurs in large businesses in which the owners have given decision-makingdiscrimination authority over to managers.__ Separation of 8. Refers to the ability of a firm to control price and dominate other competitors in aownership from market.control__ Markup 9. General term that describes how each firm’s business strategy depends upon itspricing rivals’ business behaviors.__ Schumpeterian l0. The inability of firms to capture the full monetary value of their inventions.hypothesis__ Inappropriability 11. Argues that the innovation produced by large firms more than offsets the lossesbrought about by too high prices.__ Deadweight loss 12. Allows specialized agencies to oversee the prices, outputs, entry, and exit of firms incertain industries.__ Regulation 13. Occurs when firms refrain from competition without explicit agreements.__ Antiturst policy 14. The sum of the squares of the percentage market shares of all participants in amarket.__ Collusive 15. Occurs when the same product is sold to different consumers for different prices.oligopoly
IV.  SUMMARY AND CHAPTER OUTLINE
This section summarizes the key concepts from the chapter.
A.  Behavior of Imperfect Competitors
l. Declining costs and artificial or collusive barriers to entry can give firms operating in a particular marketsome degree of market power and thus some discretion over both quantity and price.  One possible result ismonopoly—a single seller of a particular commodity.  Another possibility is oligopoly—a few sellers of thesame product.  Oligopolists need to be aware of the actions and reactions of other firms when they contemplatechanges in their behavior.  Monopolistic competition is a third possible structure, involving many sellers of close substitutes; long-run equilibrium here presents zero pure economic profit but inefficient cost allocations.Market power can also be measured by the Herfindahl-Hirschman Index.  The index is the sum of thesquared market shares of all participants in the market.  It differs from the concentration ratio in that it better reflects the existence of a single dominant firm in an industry with many smaller, or “fringe”, producers.  Asthis index approaches 10,000, the industry approaches monopoly.  Both the CR and the HHI can be useful if oneis trying to understand the degree of monopoly power that exists in an industry.2. Market power in an industry can be measured by
concentration ratios
, which define the percentage of totalindustry output that is controlled by the largest firms.  (Concentration ratios are usually based on the largest four or eight firms, but can be calculated based upon any number of competitors.)  As this percentage gets larger, theindustry moves away from competition and toward monopoly.3. Oligopolists can try to collude in a way that mimics a monopoly supplier, but there are risks.  Collusion isillegal in the United States, and in many other countries.  Collusion presents circumstances in which it isprofitable to cheat, but if all partners cheat, then every firm can end up worse off.
Cartels
, such as DeBeers inthe diamond industry and OPEC in the oil industry, are collusive oligopoly arrangements that exist ininternational markets.4. Colluding oligopolists maximize their joint profits by producing where the marginal cost of each firm is setequal to the marginal revenue of market demand.5. Monopolistic competitors maximize profits where marginal cost equals the marginal revenue for theispecific variant of product.  Product differentiation occurs as each firm tries to design a product that has someunique characteristics, guaranteeing it some degree of monopoly power.  Free entry and exit drive long-runequilibrium profits to zero, but because the monopolistic competitors’ demand curves are downward-sloping,production will not occur at minimum average cost.
 
177
6. Rivalry exists in oligopolistic industries due to mutual interdependence.  Modeling this rivalry is verydifficult; industries tend to develop their own standards of behavior depending on the particular nature of theproduction and distribution process and on the demand for the product itself.  Game theory is a method of analysis that is used in situations involving two or more decision makers who have conflicting objectives.
Game theory
can help us to understand and even to predict, in some cases, the behavior of rivals in an industry.7. Price discrimination is a technique used by firms with monopoly power to extract additional consumer surplus.  Price discrimination schemes occur when firms charge different consumers different prices for thesame product.  Firms want to charge higher prices to consumers whose demand is more inelastic.
B.  Innovation and Information
l. In large firms, ownership is often divorced from control.  This means that the owners of the firm have givendecision-making authority over to a group of managers, who may or may not be operating in the best interest of the owners.  Managers might be more interested in increasing their own salaries or improving their ownworking conditions than maximizing profits.  Managers have less incentive to pay dividends; often it is in their own best interest to plow retained earnings back into the firm rather than to distribute them to owners.2. Because of the difficulty in assessing actual market demand and cost structures a priori, firms approximatethe profit-maximizing strategies that we have developed in theory by using
rules of thumb
.  For example,
markup pricing 
rules are strategies that set price at a percentage over estimated average production costs.  Thismay land us exactly on the demand curve; the rules can be adjusted with experience to converge toward profit-maximizing pricing behavior in a world where managers do not operate with perfect information or certainty.3. The Schumpeterian hypothesis suggests that large firms support valuable research and development thatwould not otherwise be forthcoming.  However, in recent years small businesses have forged ahead, increasingtheir share of R&D advances.  The real issue involves incentives for firms to innovate and to take risks.  If firmsbelieve that they will be unable to appropriate a significant portion of the benefits to R&D, they will beunwilling to make sufficient investments.  Because information is costly to produce but cheap to reproduce,markets in information are subject to severe market failure.  For example, markets for “bootlegged” computer programs exist in most countries around the world, making it more difficult for firms to justify largeinvestments in new software.
C.  The Balance Sheet on Imperfect Competition
l. Imperfect competitors generally produce too little and charge prices in excess of marginal cost.  Thewelfare cost of their approach can be measured in terms of diminished consumer surplus—the
deadweight 
lossthat results from their exploiting whatever market power is available.  The notion that big business exploitsconsumers is pervasive and so governments and policy-makers in the United States are encouraged to supportcompetitive behavior.2. Intervention strategies are used by governments as they attempt to preserve competitive markets.  Theseinclude antitrust laws, regulation, government ownership or nationalization, price controls, and taxation.Regardless of their form, these actions all indicate a desire on the part of governments to encourage theefficiencies brought about by competition.
V.  HELPFUL HINTS
l. As you learned in Chapter 9, entry barriers are important to the emergence of imperfect competition.However, notice that these barriers evolve over time.  For example, IBM had a near monopoly in the market for computers throughout the 1960s and 1970s.  Their economic profits encouraged entry by competitors; “BigBlue” was able to hold them at bay for years due to the fact that it was heavily invested in research anddevelopment.  This led to large numbers of patents on new products.  However, with the emergence of thepersonal computer around 1980, rivals burst into the market with a passion.  Economic profits were soon erodedby fierce competition among firms in the industry, and IBM now sees itself fighting for market share.2. Oligopoly behavior is very difficult to model, posing great challenges for economists.  In oligopolisticindustries, firms must explicitly recognize and react to their competitors.  This mutual interdependence is one of the factors that makes modeling difficult.  If you think about big industries in the U.S. economy, you canimagine why.  Domestic airlines have a system of pricing that is mystifying to even the most knowledgeabletravelers, auto producers use a complex and ever-changing system of rebates and financing incentives, andproducers of breakfast cereals have an endless variety of products on the grocery store shelves.  All of theseindustries are dominated by domestic oligopolies, requiring that firms be aware of the responses of competitorsto changes in prices and output.  Because of this mutual interdependence, economists have a wide class of models from which they can pick and choose when describing oligopoly behavior.  There is no single modelthat can accurately generalize the actions and reactions of rivals.

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