Chapters 9, 13

CHAPTERS
10, 14, 15
Concentration,
Monopolistic
Competition, and
Oligopoly
Varieties of Market
Structure
 We have studied the two extremes of
market structure — perfect
competition and monopoly.
 Most industries fall somewhere
between those two, differing along
two significant scales:
 Number of suppliers of output
 The degree of product differentiation
Monopolistic Competition
 Monopolistic competition is a market
structure in which a large number of
firms compete with each other by
making similar but slightly different
products.
 Making a product slightly different
from the product of a competing firm
is called product differentiation.
Oligopoly
 Oligopoly is a market structure in
which a small number of producers
compete with each other.
 Some oligopolies (aluminum can
manufacturing) produce identical
products.
 Others (automobiles) produce
differentiated products.
Measures of Concentration
 Industries in which only a few firms
supply all the output are said to be
concentrated.
 Economists have developed two
measures of concentration:
 The four-firm concentration ratio
 The Herfindahl-Hirschman Index
The Four-Firm Concentration Ratio
 The four-firm concentration ratio is
the percentage of total industry sales
(in dollars) made by the four largest
firms.
 The range of this measure is from 0
to 100.
 0 is perfect competition
 100 means there are four or fewer firms
in the industry
 Ratio < 60 considered competitive
Concentration Ratio Calculations
Smartphone OS Market Share
Firm
Percentage of Industry Sales
2009 2010 2011 Jan 2012
RIM Blackberry
37%
Apple iPhone
21%
Microsoft Windows Mobile 27%
Android
1%
Palm
8%
Linux
3%
Symbian
3%
27%
28%
14%
23%
2%
3%
3%
23%
26%
9%
36%
1%
3%
2%
6%
43%
2%
47%
0%
1%
1%
Top 4 sales
85%
92%
94%
98%
Other firms
15%
8%
6%
2%
Concentration Ratio Calculations
PCs (Excluding Tablets)
Firm
Worldwide Market Share
2006 2009
2013
Dell
HP
Acer
Lenovo
Toshiba
Asus
Others
15.9%
15.9%
7.6%
7.0%
3.8%
1.2%
48.6%
12.1%
19.1%
12.9%
8.0%
5.0%
2.3%
40.6%
11.6%
16.2%
8.1%
16.9%
3.4%
6.3%
37.5%
Top 4
46.4% 52.1%
52.8%
Concentration Ratio Calculations
Printers
Sales
Firm
Fran’s
Ned’s
Tom’s
Jill’s
Top 4 sales
Other 1,000 firm’s sales
Industry sales
Four-firm concentration ratios:
(millions of dollars)
2.5
2.0
1.8
1.7
8.0
1,592.0
1,600.0
Printers: 8/1,600  100 = 0.5%
The HerfindahlHirschman Index (HHI)
 The Herfindahl-Hirschman Index
(HHI) is the sum of the squared
market shares of the largest 50 firms
in an industry.
 For example, if there are four firms in
an industry with market shares of
50%, 25%, 15%, and 10%, the HHI is:
502+252+152+102 = 3,450
Using the HHI
 A monopoly will have an HHI of 10,000 (1002).
 The Justice Department defines a competitive
market as one with an HHI less than 1,000 (<100
is regarded as highly competitive).
 Markets with HHI values between 1,000 and 1,800
are regarded as moderately competitive.
 Markets with HHI values above 1,800 are regarded
as uncompetitive.
 The Federal Trade Commission (FTC) uses the
HHI to evaluate potential mergers.
 If the original HHI is between 1,000 and 1,800, any
merger that raises the HHI by 100 or more is challenged.
 If the original HHI is greater than 1,800, any merger that
raises the HHI by more than 50 is challenged.
Antitrust Law
Antitrust law provides an alternative way in
which the government may influence the
marketplace.
Antitrust law is the law that regulates
oligopolies and prevents them from becoming
monopolies or behaving like monopolies.
The Antitrust Laws
The two main antitrust laws are
 The Sherman Act, 1890
 The Clayton Act, 1914
Antitrust Law
The Sherman Act outlawed any “combination,
trust, or conspiracy that restricts interstate trade,”
and prohibited the “attempt to monopolize.”
Antitrust Law
A wave of merger activities at the
beginning of the 20th century produced a
stronger antitrust law, the Clayton Act, and
created the Federal Trade Commission.
The Clayton Act made illegal specific
business practices such as price
discrimination, interlocking directorships,
and acquisition of a competitor’s shares if
the practices “substantially lessen
competition or create monopoly.”
Antitrust Law
Table 15.6 (next slide) summarizes the
Clayton Act and its amendments, the
Robinson-Patman Act passed in 1936 and
the Cellar-Kefauver Act passed in 1950.
The Federal Trade Commission, formed in
1914, looks for cases of “unfair methods of
competition and unfair or deceptive
business practices.”
Antitrust Law
Antitrust Law
Price Fixing Always Illegal
Price fixing is always a violation of the
antitrust law.
If the Justice Department can prove the
existence of price fixing, there is no
defense.
Antitrust Law
Three Antitrust Policy Debates
But some practices are more
controversial and generate debate. Three
of them are
Resale price maintenance

 Tying arrangements
 Predatory pricing
Antitrust Law
Resale Price Maintenance
Most manufacturers sell their product to the final
consumer through a wholesale and retail
distribution chain.
Resale price maintenance occurs when a
manufacturer agrees with a distributor on the
price at which the product will be resold.
Resale price maintenance is inefficient if it
promotes monopoly pricing.
But resale price maintenance can be efficient if it
provides retailers with an incentive to provide an
efficient level of retail service in selling a product.
Antitrust Law
Tying Arrangements
A tying arrangement is an agreement to
sell one product only if the buyer agrees to
buy another different product as well.
Some people argue that by tying, a firm
can make a larger profit.
Where buyers have a differing willingness
to pay for the separate items, a firm can
price discriminate and take a larger
amount of the consumer surplus by tying.
Antitrust Law
Predatory Pricing
Predatory pricing is setting a low price to drive
competitors out of business with the intention of
then setting the monopoly price.
Economists are skeptical that predatory pricing
actually occurs.
A high, certain, and immediate loss is a poor
exchange for a temporary, uncertain, and future
gain.
No case of predatory pricing has been
definitively found.
Antitrust Law
Mergers and Acquisitions
The Federal Trade Commission (FTC) uses
guidelines to determine which mergers to
examine and possibly block.
The Herfindahl-Hirschman index (HHI) is one of
those guidelines.
As indicated earlier
 If the original HHI is between 1,000 and 1,800,
any merger that raises the HHI by 100 or more is
challenged.
 If the original HHI is greater than 1,800, any
merger that raises the HHI by more than 50 is
challenged.
Historical Example of Using the HHI to Evaluate Mergers
Carbonated Soft Drink Merger Proposals in 1986
Market Share
Firm
No Mergers Pepsi/7-Up Coke/Dr. Pepper Both Mergers
Coca Cola
Pepsi Cola
Dr. Pepper
7-Up
RJR
Others (assume 15
equal share firms)
39%
28%
7%
6%
5%
15%
39%
34%
7%
5%
15%
46%
28%
6%
5%
15%
46%
34%
5%
15%
HHI
2,430
2,766
2,976
3,312
Market Structure
Characteristic
# Firms in
Industry
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Many
Many
Few
One
Identical or
Differentiated
No Close
Substitutes
Product
Identical
Differentiated
Barriers to
Entry
None
(Free Enty)
None
(Free Entry)
Considerable
Considerable
or Legal
Barriers
Firm’s Control
over Price
None
Some
Considerable
Considerable
or Regulated
Concentration
Ratio
0
Low
(<50)
High
(>50)
100
HHI
<100
100 to 1,000
>1,000
10,000
(cont.)
Market Structure (Cont.)
Perfect
Characteristic Competition
Monopolistic
Competition
Oligopoly
Monopoly
Long Run
Profits
No
(P=ATC)
No
(P=ATC)
Yes
(P>ATC)
Yes
(P>ATC)
Allocative
Efficiency
Yes
(P=MC)
No
(P>MC)
No
(P>MC)
No
(P>MC)
Examples
Wheat, Corn
Food, Clothing,
Restaurants,
Shoes,
Computers
Autos (Domestic),
Cereals
Local Phone
Service,
CableTV,
Electric and
Gas Utilities
Limitations of
Concentration Measures
 There are three main reasons why
concentration ratios may be
misleading as measures of market
structure:
 The geographical scope of the market
 Barriers to entry and firm turnover
 The correspondence between a market
and an industry
Geographical Scope
of Market
 Concentration ratio calculations are
based on national market data.
 Some goods (such as newspapers)
are sold in regional markets.
 Other goods and services
(automobiles) are sold in global
markets.
 In either case, concentration ratios
are misleading.
Limitations of
Concentration Measures
 Market and Industry
 Markets are narrower than industries
 Firms make many different products
 Firms switch from one market to
another
Market and Industry
 Concentration ratios are calculated
using the Standard Industrial
Classification (SIC) codes of the U.S.
Department of Commerce.
 Markets often do not correspond
neatly to industries.
 Westinghouse is classified as an
electrical goods and equipment
producer. They actually produce
many other non-electrical items.
Barriers to Entry
and Turnover
 Measures of concentration do not tell
us anything about the extent and
severity of barriers to entry in an
industry.
 Even in markets that are highly
concentrated, there may be
competition if entry and exit cause a
large amount of turnover.
Concentration Measures for
the U.S. Economy
 Motor vehicles, light bulbs, household
laundry equipment, chewing gum, and
breakfast cereals are highly concentrated
oligopolies.
 Pet food, computers, and soft drinks, are
moderately competitive
 Women’s clothing, ice cream, concrete
blocks and bricks, and commercial
printing are highly competitive.
Concentration Measures in
the United States
Market Structures in the
U.S. Economy
 Between 1939 and 1980, the U.S. economy
became increasingly competitive.
 In 1980, three-fourths of the value of goods
and services produced in the U.S. was sold in
markets that are highly competitive.
 Monopolies accounted for only about 5% of
total sales.
 Since 1980, there has been even more
competition (due to global trading), but there
have also been many mergers of oligopolies
leading to greater concentration in certain
oligopolistic industries (such as
telecommunications)
Monopolistic Competition
 Monopolistic competition is a market with
the following characteristics:
 A large number of firms.
 Each firm produces a differentiated
product.
 Firms compete on product quality,
price, and marketing.
 Firms are free to enter and exit the
industry.
Monopolistic Competition
 Large Number of Firms
 The presence of a large number of firms in the
market implies:
 Each firm has only a small market share and
therefore has limited market power to
influence the price of its product.
 Each firm is sensitive to the average market
price, but no firm pays attention to the actions
of the other, and no one firm’s actions directly
affect the actions of other firms.
 Collusion, or conspiring to fix prices, is
impossible.
Monopolistic Competition
 Product Differentiation
 Firms in monopolistic competition
practice product differentiation, which
means that each firm makes a product
that is slightly different from the
products of competing firms.
Monopolistic Competition
Competing on Quality, Price, and Marketing
 Product differentiation enables firms to compete
in three areas: quality, price, and marketing.
 Quality includes design, reliability, and service.
 Because firms produce differentiated products,
each firm has a downward-sloping demand
curve for its own product.
 But there is a tradeoff between price and quality.
 Differentiated products must be marketed using
advertising and packaging.
Monopolistic Competition
 Entry and Exit
 There are no barriers to entry in monopolistic
competition, so firms cannot earn an economic
profit in the long run.
 Examples of Monopolistic Competition
 Figure 13.1 on the next slide shows market
share of the largest four firms and the HHI for
each of ten industries that operate in
monopolistic competition.
Monopolistic Competition
 The red bars
refer to the 4
largest firms.
 Green is the
next 4.
 Blue is the next
12.
 The numbers
are the HHI.
Output and Price in
Monopolistic Competition
 Short-Run Economic Profit
 A firm that has decided the quality of its
product and its marketing program produces
the profit maximizing quantity at which its
marginal revenue equals its marginal cost
(MR = MC).
 Price is determined from the demand curve for
the firm’s product and is the highest price the
firm can charge for the profit-maximizing
quantity.
Output and Price in
Monopolistic Competition
 Figure 13.2(a)
shows a short-run
equilibrium for a
firm in monopolistic
competition.
 It operates much
like a single-price
monopolist.
Output and Price in
Monopolistic Competition
 The firm produces
the quantity at which
price equals
marginal cost and
sells that quantity for
the highest possible
price.
 It earns an
economic profit (as
in this example)
when P > ATC.
Output and Price in
Monopolistic Competition
 Long Run: Zero Economic Profit
 In the long run, economic profit induces entry.
 And entry continues as long as firms in the
industry earn an economic profit—as long as
(P > ATC).
 In the long run, a firm in monopolistic
competition maximizes its profit by producing
the quantity at which its marginal revenue
equals its marginal cost, MR = MC.
Output and Price in
Monopolistic Competition
 As firms enter the industry, each existing firm
loses some of its market share. The demand
for its product decreases and the demand
curve for its product shifts leftward.
 The decrease in demand decreases the
quantity at which MR = MC and lowers the
maximum price that the firm can charge to sell
this quantity.
 Price and quantity fall with firm entry until P =
ATC and firms earn zero economic profit.
Output and Price in
Monopolistic Competition
 This figure shows a
firm in monopolistic
competition moving
from short-run
equilibrium to longrun equilibrium.
 If firms incur an
economic loss, firms
exit to restore the
long-run equilibrium
just described.
Output and Price in
Monopolistic Competition
 Monopolistic Competition and
Efficiency
 Firms in monopolistic competition are
inefficient and operate with excess
capacity.
 Figure 13.3 on the next slide illustrates
these propositions.
Output and Price in
Monopolistic Competition
 Because they
product- differentiate
and face a downwardsloping demand curve
for their products,
firms in monopolistic
competition receive a
marginal revenue that
is less than price for
all levels of output.
Output and Price in
Monopolistic Competition
 Firms maximize profit
by setting marginal
revenue equal to
marginal cost, so with
marginal revenue less
than price, marginal
cost is also less than
price.
Output and Price in
Monopolistic Competition
 Because price
equals the
marginal benefit,
marginal cost is
less than marginal
benefit.
 Underproduction
in monopolistic
competition
creates
deadweight loss.
Output and Price in
Monopolistic Competition
 A firm’s capacity
output is the output
at which average
total cost is at its
minimum.
 At the long-run profit
maximizing output,
price equals average
total cost.
 But recall that MR < P,
which means that MC
< ATC.
Output and Price in
Monopolistic Competition
 If MC < ATC, then the
ATC curve is falling.
 With output in the
range of falling ATC,
output is less than
capacity output.
 Goods are not
produced at the
minimum unit cost of
production in the long
run.
Product Development and
Marketing
 Innovation and Product Development
 We’ve looked at a firm’s profit-maximizing
output decision in the short run and the long
run of a given product and with given
marketing effort.
 To keep earning an economic profit, a firm in
monopolistic competition must be in a state of
continuous product development.
 New product development allows a firm to gain
a competitive edge, if only temporarily, before
competitors imitate the innovation.
Product Development and
Marketing
 Innovation is costly, but it increases total
revenue.
 Firms pursue product development until the
marginal revenue from innovation equals the
marginal cost of innovation.
 Production development may benefit the
consumer by providing an improved product,
or it may only create the appearance of a
change in product quality.
 Regardless of whether a product improvement
is real or imagined, its value to the consumer
is its marginal benefit, which is the amount the
consumer is willing to pay for it.
Product Development and
Marketing
 Marketing
 A firm’s marketing program uses advertising
and packaging as the two principal methods to
market its differentiated products to
consumers.
 Firms in monopolistic competition incur heavy
marketing and advertising expenditures to
enhance the perception of quality differences
between their product and rival products.
These costs make up a large portion of the
price for the product.
Product Development and
Marketing
 Figure 13.4 shows
estimates of the
percentage of sale
price for different
monopolistic
competition markets.
 Cleaning supplies
and toys top the list
at almost 15 percent.
Product Development and
Marketing
 Selling Costs and Total Costs
 Selling costs, like advertising expenditures,
fancy retail buildings, etc. are fixed costs.
 Average fixed costs decrease as production
increases, so selling costs increase average
total costs at any given level of output but do
not affect the marginal cost of production.
 Selling efforts such as advertising are
successful if they increase the demand for the
firm’s product.
Product Development and
Marketing
 Advertising costs might
lower the average total
cost by increasing
equilibrium output and
spreading their fixed
costs over the larger
quantity produced.
 Here, with no
advertising, the firm
produces 25 units of
output at an average
total cost of $170.
Product Development and
Marketing
 With advertising, the firm
produces 130 units of output
at an average total cost of
$160.
 The advertising expenditure
shifts the average total cost
curve upward, but the firm
operates at a higher output
and lower ATC than it would
without advertising.
Product Development and
Marketing
 Advertising might also
decrease the markup.
 Figure (a) shows that with
no advertising, the
demand for a firm’s
output is not very elastic
and its markup is large.
 Profits are approximately
(55-35)x75=1500
Product Development and
Marketing
 Figure (b) shows that if all firms
advertise, the demand for a
firm’s output becomes more
elastic.
 The firm produces a larger
quantity, its price falls, and its
markup shrinks.
 However, its profits fall.
 On the other hand, if all firms do
not advertise, then demand may
stay relatively inelastic and
profits would most likely rise
with advertising.
 However, in the long run all
firms will need to advertise in
order to survive.
Product Development and
Marketing
 Therefore, advertising can increase a firm’s demand and
profits in the short run only.
 Economic profit leads to entry, which decreases the
demand for each firm’s product in the long run.
 And most firms advertise so each firm’s demand
becomes more elastic and profits will fall in the long run,
even if each firm’s output increases.
 To the extent that advertising and selling costs provide
consumers with information and services that they
value more highly than their cost, these activities are
efficient.
Oligopoly
 An oligopoly is a market in which a
small number of producers compete
with each other.
 The quantity sold by any one
producer depends on that producer’s
price and on the other producers’
prices and quantities sold.
What is Oligopoly?
 Examples of
Oligopoly
 The red bars
refer to the 4
largest firms.
 Green is the
next 4.
 Blue is the next
12.
 The numbers
are the HHI.
Models of Oligopoly
 A variety of models have been
developed to explain the
determination of price and quantity
in oligopoly markets.
 No one theory explains the behavior
we see in different oligopoly markets.
 The most recent approach to
studying oligopoly behavior is game
theory
Oligopoly Games
 Game theory is a tool for studying strategic
behavior, which is behavior that takes into
account the expected behavior of others and
the mutual recognition of interdependence.
 What Is a Game?





All games share four features:
Rules
Strategies
Payoffs
Outcome
Oligopoly Games
 The Prisoners’ Dilemma
 The prisoners’ dilemma game illustrates the
four features of a game.
 The rules describe the setting of the game, the
actions the players may take, and the
consequences of those actions.
 In the prisoners’ dilemma game, two prisoners
(Art and Bob) have been caught committing a
petty crime.
 Each is held in a separate cell and cannot
communicate with the other.
Oligopoly Games
 Each is told that both are suspected of
committing a more serious crime.
 If one of them confesses, he will get a 1-year
sentence for cooperating while his
accomplice get a 10-year sentence for both
crimes.
 If both confess to the more serious crime,
each receives 3 years in jail for both crimes.
 If neither confesses, each receives a 2-year
sentence for the minor crime only.
Oligopoly Games
In game theory, strategies are all the possible actions
of each player.
Art and Bob each have two possible actions:
 Confess to the larger crime
 Deny having committed the larger crime
Because there are two players and two actions for each
player, there are four possible outcomes:
 Both confess
 Both deny
 Art confesses and Bob denies
 Bob confesses and Art denies
Oligopoly Games
 Each prisoner can work out what happens to him—
can work out his payoff—in each of the four
possible outcomes.
 We can tabulate these outcomes in a payoff matrix.
 A payoff matrix is a table that shows the payoffs for
every possible action by each player for every
possible action by the other player.
 The next slide shows the payoff matrix for this
prisoners’ dilemma game.
Payoff
Matrix
Oligopoly Games
Oligopoly Games
 If a player makes a rational choice in pursuit of
his own best interest, he chooses the action
that is best for him, given any action taken by
the other player.
 If both players are rational and choose their
actions in this way, the outcome is an
equilibrium called Nash equilibrium—first
proposed by John Nash.
 The following slides show how to find the Nash
equilibrium.
Bob’s
view
of the
world
Bob’s
view
of the
world
Art’s
view
of the
world
Art’s
view
of the
world
Equilibrium
Another Example of The
Prisoners’ DilemmaAdvertising Decisions
 Two firms, A & B, are deciding whether to devote
more resources to advertising.
 Advertising can increase demand at both the
industry (new customers for the product) and firm
specific level (consumers switching from one
brand to another).
 Advertising yields the following payoff matrix.
Prisoners’ Dilemma Payoff
Payoff Matrix
Firm A’s Strategies
Advertises
Does not advertise
Firm A
70
Firm A
40
Advertises
Firm B’
Strategies
Does not
advertise
Firm B
80
Firm A
100
Firm B
50
Firm B
100
Firm A
80
Firm B
90
Advertising Decisions
 In this case, the Nash equilibrium is that both
firm’s advertise. Firm A’s payoff is 70 and Firm
B’s payoff is 80.
 But, both firms would have been better off if
neither had advertised. Firm A’s payoff would
have been 80 and Firm B’s payoff would have
been 90. The costs of advertising outweighed the
gains for both firms.
 Of course, the firms could cooperate and agree
not to advertise. But there is always an incentive
to cheat to increase profits. It might be possible
to devise a penalty system for cheating that will
lead to the desired outcome. However,
cooperation between the firms might cause the
Justice Department to investigate possible
antitrust violations.
Pricing Decisions
 Another example of the Prisoner’s
Dilemma has to do with pricing
decisions.
 Suppose there are two firms and
each must decide whether to charge
a low price or a high price for their
product.
 The profit payoff matrix is as follows.
Pricing Decisions
Profit Payoff Matrix
Firm A’s Strategies
Low Price
High Price
Firm A
9000
Firm A
12000
High Price
Firm B’
Strategies
Low Price
Firm B
9000
Firm A
3000
Firm B
12000
Firm B
3000
Firm A
8000
Firm B
8000
Pricing Decisions
 In this case, the Nash equilibrium is that both
firm’s charge low prices.
 However, both firms would have been better off if
they had charged high prices. Their profits would
have been 9000 instead of 8000. Fear of price
cutting by their competitor leads them to a
suboptimal solution.
 Of course, the firms could cooperate and agree to
charge high prices. But there is always an
incentive to cheat to increase profits. Also,
cooperation between the firms might cause the
Justice Department to investigate possible
antitrust violations.
 It is possible to devise a pricing scheme that will
lead to the desired outcome – matching lower
prices of competitors.
Pricing Decisions
Matching Prices
Target
Best Buy
Pricing Decisions
Profit Payoff Matrix
Firm A’s Strategies
Low Price
High Price
Firm A
9000
Firm A
12000
High Price
Firm B’
Strategies
Low Price
Firm B
9000
Firm A
3000
Firm B
12000
Firm B
3000
Firm A
8000
Firm B
8000
Other Applications of Game
Theory
 The ideas just discussed can be used
to understand a host of other real
world economic situations, such as




product modification
price discrimination
entering and leaving an industry
investing in R&D (research and
development)

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