Monopolistic Competition
and Oligopoly
16
CHAPTER 16
Monopolistic Competition and Oligopoly
Competition, you know, is a lot like
chastity. It is widely praised, but alas,
too little practiced.
— Carol Tucker
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Monopolistic Competition
and Oligopoly
16
Chapter Goals
• List the four distinguishing characteristics of
monopolistic competition
• Demonstrate graphically the equilibrium of a
monopolistic competitor
• State the central element of oligopoly
• Explain why decisions in the cartel model depend
on market share and decisions in the contestable
market model depend on barriers to entry
• Describe two empirical methods of determining
market structure
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Monopolistic Competition
and Oligopoly
16
Market Structure
• Market structure refers to the physical characteristics
of the market within which firms interact
• It is determined by the number of firms in the
market and the barriers to entry
• A monopolistically competitive market is a market in
which there are many firms selling differentiated
products and few barriers to entry
• An oligopolistic market is a market in which there are
only a few firms and firms explicitly take other firms’
likely response into account
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Monopolistic Competition
and Oligopoly
16
Characteristics of Monopolistic Competition
Four distinguishing characteristics:
1. Many sellers that do not take into account rivals’
reactions
2. Product differentiation where the goods that are
sold aren’t homogenous
3. Multiple dimensions of competition make it harder
to analyze a specific industry, but these methods of
competition follow the same two decision rules as
price competition
4. Ease of entry of new firms in the long run because
there are no significant barriers to entry
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Monopolistic Competition
and Oligopoly
16
Output, Price, and Profit of a
Monopolistic Competitor
• Like a monopoly,
• The monopolistic competitive firm has some
monopoly power so the firm faces a downward
sloping demand curve
• Marginal revenue is below price
• At profit maximizing output, marginal cost will
be less than price
• Like a perfect competitor, zero economic profits exist in
the long run
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Monopolistic Competition
and Oligopoly
16
Determining Profits Graphically:
Monopolistic Competition
P
MC
ATCLosses
ATCL
ATCBreak even
Profits
Losses
ATCProfits
P
Break even
ATCP
D
MR
Q
Q
A monopolistic firm can
earn profits, losses, or
break even in the short run
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Monopolistic Competition
and Oligopoly
16
Monopolistic Competition Compared
with Perfect Competition Graph
P
MC
ATC
PMC
PPC
DPC
DMC
MRMC
QMC QPC
Q
• In monopolistic competition
in the long run, P > min ATC,
• In perfect competition in the
long run, P = min ATC
Outcome:
Monopolistic competition
output is lower and
price is higher than
perfect competition
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Monopolistic Competition
and Oligopoly
16
Comparing Monopolistic Competition with Monopoly
• It is possible for the monopolist to make economic
profit in the long run because of the existence of
barriers to entry
• No long-run economic profit is possible in
monopolistic competition because there are no
significant barriers to entry
• For a monopolistic competitor in long-run equilibrium,
(P = ATC) ≥ (MC = MR)
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Monopolistic Competition
and Oligopoly
16
Advertising and Monopolistic Competition
• Perfectly competitive firms have no incentive to
advertise, but monopolistic competitors do
• The goals of advertising are to increase demand and
make demand more inelastic
• Advertising increases ATC
• The increase in cost of a monopolistically competitive
product is the cost of “differentness”
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Monopolistic Competition
and Oligopoly
16
Characteristics of Oligopoly
• Oligopolies are made up of a small number of firms in an
industry
• In any decision a firm makes, it must take into account
the expected reaction of other firms
• Oligopolistic firms are mutually interdependent
• Oligopolies can be collusive or noncollusive
• Firms may engage in strategic decision making where
each firm takes explicit account of a rival’s expected
response to a decision it is making
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Monopolistic Competition
and Oligopoly
16
Models of Oligopoly Behavior
• There is no single model of oligopoly behavior
• An oligopoly model can take two extremes:
• The cartel model is when a combination of firms acts
as if it were a single firm and a monopoly price is set
• The contestable market model is a model of
oligopolies where barriers to entry and exit, not market
structure, determine price and output decisions and a
competitive price is set
• Other models of oligopolies give price results between the
two extremes
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Monopolistic Competition
and Oligopoly
16
The Cartel Model
• A cartel model of oligopoly is a model that assumes
that oligopolies act as if they were a monopoly and set
a price to maximize profit
• Output quotas are assigned to individual member firms
so that total output is consistent with joint profit
maximization
• If oligopolies can limit the entry of other firms, they can
increase profits
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Monopolistic Competition
and Oligopoly
16
Implicit Price Collusion
• Explicit (formal) collusion is illegal in the U.S. while
implicit (informal) collusion is permitted
• Implicit price collusion exists when multiple firms
make the same pricing decisions even though they
have not consulted with one another
• Sometimes the largest or most dominant firm takes
the lead in setting prices and the others follow
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Monopolistic Competition
and Oligopoly
16
Why Are Prices Sticky?
• One characteristic of informal collusive behavior is that
prices tend to be sticky – they don’t change frequently
• Informal collusion is an important reason why prices are
sticky
• Another is the kinked demand curve
• If a firm increases price, others won’t go along,
so demand is very elastic for price increases
• If a firm lowers price, other firms match the
decrease, so demand is inelastic for price
decreases
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Monopolistic Competition
and Oligopoly
16
The Kinked Demand Curve Graph
P
• A gap in the MR curve exists
• A large shift in marginal cost
is required before firms will
change their price
If P increases, others won’t go
along, so D is elastic
MC1
P
MC2
Gap
If P decreases, other firms
match the decrease, so D
is inelastic
MR
Q
D
Q
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Monopolistic Competition
and Oligopoly
16
The Contestable Market Model
• The contestable market model is a model of
oligopolies where barriers to entry and exit, not market
structure, determine price and output decisions and a
competitive price is set
• Even if the industry contains only one firm, it will set a
competitive price if there are no barriers to entry
• Much of what happens in oligopoly pricing is
dependent on the specific legal structure within which
firms interact
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Monopolistic Competition
and Oligopoly
16
Comparing Contestable Market and Cartel Models
• The cartel model is appropriate for oligopolists that
collude, set a monopoly price, and prevent market entry
• The contestable market model describes oligopolies that
set a competitive price and have no barriers to entry
• Oligopoly markets lie between these two extremes
• Both models use strategic pricing decisions where
firms set their price based on the expected reactions of
other firms
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Monopolistic Competition
and Oligopoly
16
New Entry as a Limit on the
Cartelization Strategy and Price Wars
• The threat of outside competition limits oligopolies from
acting as a cartel
• The threat will be more effective if the outside competitor
is much larger than the firms in the oligopoly
• Price wars are the result of strategic pricing decisions
gone wild
• A predatory pricing strategy involves temporarily
pushing the price down in order to drive a competitor
out of business
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Monopolistic Competition
and Oligopoly
16
Comparison of Market Structures
Monopoly
Oligopoly
Monopolistic
Competition
Perfect
Competition
One
Few
Many
Almost infinite
Barriers to entry
Significant
Significant
Few
None
Pricing decisions
MC = MR
Strategic
pricing
MC = MR
MC = MR = P
No output
restriction
No. of firms
Output decisions
Most output
restriction
Output
restricted
Output
restricted,
product
differentiation
Interdependence
No
competitors
Interdependent
decisions
Each firm
independent
Each firm
independent
LR profit
Possible
Possible
None
None
P and MC
P > MC
P > MC
P > MC
P = MC
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Monopolistic Competition
and Oligopoly
16
Classifying Industries and Markets in Practice
• An industry seldom fits neatly into one category or
another
• One way to classify markets in practice is by its cross
price elasticity
• Cross-price elasticity measures the responsiveness
of the change in demand for a good to a change in the
price of a related good
• Goods with a cross-price elasticity of 3 or more
are in the same industry
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Monopolistic Competition
and Oligopoly
16
The North American Industry Classification System
• North American Industry Classification System
(NAICS) is an industry classification system that
categorizes industries by the type of economic activity
and groups firms with like production processes
Two Digit Sectors
23
Construction
42
Wholesale Trade
51
Information
61
Education Services
Three to Six Digit Sectors
517 –Telecommunications
5172 – Wireless telecommunications carriers
517211 – Paging
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Monopolistic Competition
and Oligopoly
16
Empirical Measures of Industry Structure
• The concentration ratio is the value of sales by the top
firms of an industry stated as a percentage of total
industry sales
• The Herfindahl index is the sum of the squared value of
the individual market shares of all firms in the industry
• Because it squares market shares, the Herfindahl index
gives more weight to firms with large market shares than
does the concentration ratio measure
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Monopolistic Competition
and Oligopoly
16
Concentration Ratios and the Herfindahl Index
Industry
Four Firm
Concentration Ratio
Herfindahl Index
Poultry
46
773
Soft drinks
52
896
Breakfast cereal
78
2,999
Soap and detergent
38
664
Men’s footwear
44
734
Women’s footwear
64
1,556
Pharmaceuticals
34
506
Computer equipment
49
1,183
Burial caskets
73
2,965
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Monopolistic Competition
and Oligopoly
16
Conglomerate Firms and Bigness
• Neither the four-firm concentration ratio nor the
Herfindahl index gives a complete picture of
corporations’ bigness because many firms are
conglomerates
• Conglomerates are huge corporations whose
activities span various unrelated industries
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Monopolistic Competition
and Oligopoly
16
Oligopoly Models and
Empirical Estimates of Market Structure
• The cartel model fits best with empirical measurements
because it assumes that the structure of the market is
directly related to the price a firm charges
• It predicts that oligopolies charge higher prices
than monopolistic or perfect competitors
• The contestable market model gives less weight to the
empirical estimates of market structure
• Markets that look oligopolistic could be highly
competitive
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Monopolistic Competition
and Oligopoly
16
Chapter Summary
• Monopolistic competition is characterized by:
• Many sellers
• Differentiated products
• Multiple dimensions of competition
• Ease of entry of new firms
• The central characteristic of oligopoly is that there are a
small number of interdependent firms
• Monopolistic competitors differ from perfect competitors
in that the former face a downward sloping demand curve
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Monopolistic Competition
and Oligopoly
16
Chapter Summary
• Monopolistic competitors differ from monopolists in that
monopolistic competitors make zero long-run profit
• In monopolistic competition firms act independently; in
an oligopoly they take account of each other’s actions
• An oligopolist’s price will be somewhere between the
competitive price and the monopolistic price
• A contestable market theory of oligopoly judges an
industry’s competitiveness more by performance and
barriers to entry than by structure
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Monopolistic Competition
and Oligopoly
16
Chapter Summary
• Cartel models of oligopoly concentrate on market structure
• Industries are classified by economic activity in the North
American Industry Classification System (NAICS)
• Industry structures are measured by concentration ratios
and Herfindahl indexes
• A concentration ratio is the sum of market shares of the
largest firms in an industry
• A Herfindahl index is the sum of the squares of the market
shares of all firms in an industry
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Monopolistic Competition
and Oligopoly
16
Preview of Chapter 17:
Real-World Competition and Technology
• Discuss the monitoring problem and its implications for economics
• Explain how corporate takeovers can limit X-inefficiency
• Discuss why competition should be seen as a process, not a
state
• Explain two actions firms take to break down monopoly and three
they take to protect monopoly
• Discuss why oligopoly is the best market structure for technological
change
16-29