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
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.
Nine Industries with Characteristics of
Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1992
FOUR EIGHT TWENTY NUMBER
INDUSTRY LARGEST LARGEST LARGEST OF
SIC NO. DESIGNATION FIRMS FIRMS FIRMS FIRMS
3792 Travel trailers and campers 41 57 72 270
3942 Dolls 34 47 67 204
2521 Wood office furniture 26 34 51 611
2731 Book publishing 23 38 62 2504
2391 Curtains and draperies 22 32 48 1004
2092 Fresh or frozen seafood 19 28 47 600
3564 Blowers and fans 14 22 41 518
2335 Womens dresses 11 17 30 3943
3089 Miscellaneous plastic products 5 8 13 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 48.0
Direct mail 39.5
Other 31.7
Yellow pages 12.0
Radio 14.5
Magazines 10.4
Total 200.3
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United
States,
States, 1999, Table 947.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Ten Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms in High-
Concentration Industries, 1992
FOUR EIGHT NUMBER
INDUSTRY LARGEST LARGEST OF
SIC NO. DESIGNATION FIRMS FIRMS FIRMS
2823 Cellulosic man-made fiber 98 100 5
3331 Primary copper 98 99 11
3633 Household laundry equipment 94 99 10
2111 Cigarettes 93 100 8
2082 Malt beverages (beer) 90 98 160
3641 Electric lamp bulbs 86 94 76
2043 Cereal breakfast foods 85 98 42
3711 Motor vehicles 84 91 398
3482 Small arms ammunition 84 95 55
3632 Household refrigerators and freezers 82 98 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.
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.
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.
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.
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.
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.
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.
Payoff Matrix for Advertising Game
Bs STRATEGY
As STRATEGY Do not advertise Advertise
As profit = $50,000 As loss = $25,000

Do not advertise
Bs profit = $50,000 Bs profit = $75,000
As profit = $75,000 As profit = $10,000

Advertise
Bs loss = $25,000 Bs profit = $10,000
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 Advertise
As profit = $50,000 As loss = $25,000

Do not advertise
Bs profit = $50,000 Bs profit = $75,000
As profit = $75,000 As profit = $10,000

Advertise
Bs loss = $25,000 Bs 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 Dilemma
ROCKY
GINGER Do not confess Confess
Ginger: 1 year Ginger: 7 years

Do not confess
Rocky: 1 year Rocky: free
Ginger: free Ginger: 5 years

Confess
Rocky: 7 years Rocky: 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 for
Left/Right-Top/Bottom Strategies
Original Game Because Ds behavior is

Ds STRATEGY predictable (he will play
Cs the right-hand strategy), C
STRATEGY Left Right will play bottom.
Top C wins $100 C wins $100 When all players are

D wins no $ D wins $100
playing their best strategy
given what their
C loses $100 C wins $200
Bottom D wins no $ D wins $100 competitors are doing, the
result is called Nash
equilibrium.
Payoff Matrix for
Left/Right-Top/Bottom Strategies
New Game C is likely to play top and

Ds STRATEGY guarantee herself a $100
Cs profit instead of losing
STRATEGY Left Right $10,000 to win $200, even if
there is just a small chance of
C wins $100 C wins $100
Top D wins no $ D wins $100 Ds choosing left.
C loses
When uncertainty and risk are
C wins $200
Bottom
$10,000
D wins no $
D wins $100 introduced, the game
changes. A maximin
strategy is a strategy chosen
to maximize the minimum
gain that can be earned.
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.
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: HERFINDAHL-

HIRSCHMAN
FIRM 1 FIRM 2 FIRM 3 FIRM 4 INDEX
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
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
1,800
Moderate
Concentration
Challenge if Index is
raised by more than 100
points by the merger
1,000
Unconcentrated
No challenge
0

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CHAPTER 13

Monopolistic Competition and

Prepared by: Fernando

Monopolistic competition is a common

Some degree of market power is achieved

New firms can enter and established firms

The advocates of free and open

Product differentiation helps to ensure

Advertising provides consumers with

Critics of product differentiation and

Enormous sums are spent to create

Advertising raises the cost of products

People exist to satisfy the needs of the

Advertising can lead to unproductive

Based on the availability of

In the short-run, a monopolistically competitive

Profits are not guaranteed. Here, a firm with a similar

The firms demand

In the long-run, economic profits are eliminated; thus, we

In the long-run, economic profits are eliminated; thus, we

An oligopoly is a form of industry

The behavior of any one firm in an

All kinds of oligopoly have one

A group of firms that gets together

The Cournot model is a model of a

The kinked demand model is a

Above P*, an increase in

Assumptions of the price-leadership model:

Outcome of the price-leadership model:

The practice of a large, powerful firm

Such behavior became illegal in the

Game theory analyzes oligopolistic

In game theory, firms are assumed

As profit = $50,000 As loss = $25,000

As profit = $75,000 As profit = $10,000

The strategy that firm A will actually choose depends on

As profit = $50,000 As loss = $25,000

As profit = $75,000 As profit = $10,000

Regardless of what B does, it pays A to advertise. This is

Ginger: 1 year Ginger: 7 years

Ginger: free Ginger: 5 years

Both Ginger and Rocky have dominant strategies: to

Original Game Because Ds behavior is

Top C wins $100 C wins $100 When all players are

New Game C is likely to play top and

A market is perfectly contestable if

In contestable markets, even large

The only necessary condition of oligopoly is

Oligopolies are concentrated industries. At

Oligopolies, or concentrated industries, are

The Celler-Kefauver Act of 1950

Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical

PERCENTAGE SHARE OF: HERFINDAHL-

ANTITRUST DIVISION ACTION

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