Roger LeRoy Miller
Economics Today
Chapter 25
Monopolistic Competition,
Oligopoly, and Strategic Behavior
Miller, Economics Today, © 2001 Addison Wesley Longman, Inc.
Introduction
Shoppers at the Web site of the apparel manufacturer
Eddie Bauer can use a “virtual dressing room”
to click and drag clothes together for a closer look.
By making its Web site interesting
and useful Eddie Bauer seeks to differentiate
its brand name and attract customers.
To understand the actions of firms that sell
similar but differentiated goods, you must learn
about monopolistic competition.
Slide 25-2
Learning Objectives
 Discuss the key characteristics of a
monopolistically competitive industry
 Contrast the output and pricing
decisions of monopolistically
competitive firms with those
of perfectly competitive firms
Slide 25-3
Learning Objectives
 Outline the fundamental
characteristics of oligopoly
 Understand how to apply game theory
to evaluate the pricing strategies
of oligopolistic firms
Slide 25-4
Learning Objectives
 Explain the kinked demand curve
theory of oligopolistic price rigidity
 Describe theories of how firms may
deter market entry by potential rivals
Slide 25-5
Chapter Outline
 Monopolistic Competition
 Price and Output for the Monopolistic
Competitor
 Comparing Perfect Competition
with Monopolistic Competition
 Oligopoly
Slide 25-6
Chapter Outline
 Strategic Behavior and Game Theory
 Price Rigidity and the Kinked Demand
Curve
 Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Deterring Entry into an Industry
 Comparing Market Structures
Slide 25-7
Did You Know That...
 80 percent of initial customer contacts
for General Motors Saturn division
now originate on the Internet?
 GM and other businesses leave
no stone unturned to inform people
about what they sell, where people
can buy it, and at what price?
Slide 25-8
Monopolistic Competition
 Monopolistic Competition
– A market situation in which a large
number of firms produce similar
but not identical products
– Entry into the industry is relatively easy
Slide 25-9
Monopolistic Competition
 Characteristics of monopolistic
competition
– Significant number of sellers
in a highly competitive market
– Differentiated products
– Sales promotion and advertising
– Easy entry of new firms in the long run
Slide 25-10
Monopolistic Competition
 Implications of the large number
of firms
– Small market share
– Lack of collusion
– Independence
Slide 25-11
Monopolistic Competition
 Product Differentiation
– The distinguishing of products by brand
name, color, and other minor attributes
Slide 25-12
Monopolistic Competition
 Product differentiation and price
– Differentiate perfectly
• Producer is a monopoly
– Significant influence on price
– Differentiation is not perfect
• Producer is a monopolistic competitor
– The more successful it is at differentiation
the more control over price
Slide 25-13
Monopolistic Competition
 Ease of entry
– Threat of a more efficient competitor
is always present
Slide 25-14
Monopolistic Competition
 Sales promotion and advertising
– Can increase demand for a firm
– Can differentiate a firm’s product
– Should be continued to the point
at which the additional revenue from
one more dollar of advertising just
equals that one dollar of marginal cost
Slide 25-15
Monopolistic Competition
 Advertising as signaling behavior
– Advertising over a long period
of time is a signal that a firm wants
repeat business
Slide 25-16
Monopolistic Competition
 What do you think?
– Would a perfect competitor have any
incentive to advertise?
– Why would a monopolistically
competitive firm advertise?
– Can advertising lead to efficiency?
Slide 25-17
Short-Run and Long-Run
Equilibrium with Monopolistic Competition
• Price (P1) > ATC
• Economic profit
Figure 25-1, Panel (a)
Slide 25-18
Short-Run and Long-Run
Equilibrium with Monopolistic Competition
-Price (P1) < ATC
-Economic loss
Figure 25-1, Panel (b)
Slide 25-19
Short-Run and Long-Run
Equilibrium with Monopolistic Competition
-Price (P1) = ATC
-Normal rate of return
Figure 25-1, Panel (c)
Slide 25-20
Comparing Perfect Competition
with Monopolistic Competition
 Perfect competitors and monopolistic
competitors earn zero economic profit.
 How are they different?
Slide 25-21
Comparison of the Perfect Competitor
with the Monopolistic Competitor
Figure 25-2, Panels (a) and (b)
Slide 25-22
Comparing Perfect Competition
with Monopolistic Competition
 What do you think?
– Would you want to live in a perfectly
competitive world with homogenous
products?
Slide 25-23
Oligopoly
 Oligopoly
– A market situation in which there
are very few sellers
– Each seller knows that the other sellers
will react to its changes in prices
and quantities
Slide 25-24
Oligopoly
 Characteristics of oligopoly
– Small number of firms
– Interdependence
• Strategic dependence
Slide 25-25
Oligopoly
 Strategic Dependence
– A situation in which one firm’s actions
with respect to price, quality, advertising,
and related changes may be strategically
countered by the reactions of one
or more other firms in the industry
Slide 25-26
Oligopoly
 Why oligopoly occurs
– Economies of scale
– Barriers to entry
– Mergers
• Vertical mergers
• Horizontal mergers
Slide 25-27
Oligopoly
 Vertical Merger
– The joining of a firm with another to which
it sells an output or from which it buys
an input
 Horizontal Merger
– The joining of firms that are producing
or selling a similar product
Slide 25-28
Oligopoly
 Measuring industry concentration
– Concentration Ratio
• The percentage of all sales contributed
by the leading four or leading eight firms
in an industry
Slide 25-29
Computing the Four-Firm
Concentration Ratio
Firm
Annual Sales
($ Millions)
1
2
3
4
5 through 25
150
100
80
70
50
Total
450
Total number
of firms in
Industry = 25
400
= 88.9%
Four-firm concentration ratio =
450
Slide 25-30
Computing the Four-Firm
Concentration Ratio
Industry
Percentage of Value of Total
Domestic Shipments Accounted
For By the Top Four Firms %
Domestic motor vehicles
84
Breakfast cereals
85
Soft drinks
69
Tobacco products
93
Primary aluminum
59
Household vacuum cleaners
59
Electronic computers
45
Printing and publishing
23
Source: U.S. Bureau of the Census
Slide 25-31
Oligopoly
 What do you think?
– Are oligopolies inefficient?
Slide 25-32
Strategic Behavior
and Game Theory
 Explaining the pricing and output
behavior of oligopoly markets
– Reaction Function
• The manner in which one oligopolist reacts
to a change in price, output, or quality made
by another oligopolist in the industry
Slide 25-33
Strategic Behavior
and Game Theory
 Game Theory
– A way of describing the various possible
outcomes in any situation involving two
or more interacting individuals when those
individuals are aware of the interactive
nature of their situation and plan
accordingly
Slide 25-34
Strategic Behavior
and Game Theory
 Cooperative Game
– A game in which the players explicitly
cooperate to make themselves better off
Slide 25-35
Strategic Behavior
and Game Theory
 Noncooperative Game
– A game in which the players neither
negotiate nor cooperate in any way
Slide 25-36
Strategic Behavior
and Game Theory
 Zero-Sum Game
– A game in which any gains
within the group are exactly offset
by equal losses by the end of the game
Slide 25-37
Strategic Behavior
and Game Theory
 Negative-Sum Game
– A game in which players as a group
lose at the end of the game
Slide 25-38
Strategic Behavior
and Game Theory
 Positive-Sum Game
– A game in which players as a group
are better off at the end of the game
Slide 25-39
Strategic Behavior
and Game Theory
 Strategies in noncooperative games
– Strategy
• Any rule that is used to make a choice
• Any potential choice that can be made
by players in a game
– Dominant Strategies
• Strategies that always yield the highest benefit
Slide 25-40
Prisoner’s Dilemma
 You and your partner rob a bank
and get caught.
Slide 25-41
Prisoner’s Dilemma
 You are separated
and given these options:
– Both confess and get 5 years in jail
– Neither confess and get 2 years
– One confess and the other does not
• Confessor goes free
• One who does not confess get 10 years
Slide 25-42
Prisoner’s Dilemma
 What would you do?
– Remember
• No cooperation
Slide 25-43
The Prisoners’ Dilemma
Payoff Matrix
Figure 25-3
Slide 25-44
Strategic Behavior
and Game Theory
 Applying game theory to pricing
strategies
– Would you choose a high price
or a low price?
• Remember
– No collusion
Slide 25-45
Strategic Behavior
and Game Theory
Figure 25-4
Slide 25-46
Strategic Behavior
and Game Theory
 Opportunistic Behavior
– Actions that ignore the possible long-run
benefits of cooperation and focus solely
on short-run gains
Slide 25-47
Strategic Behavior
and Game Theory
 Opportunistic behavior
– Implies a noncooperative game
– Not realistic
• We make repeat transactions
Slide 25-48
Strategic Behavior
and Game Theory
 Tit-for-Tat Strategic Behavior
– In game theory, cooperation that
continues so long as the other players
continue to cooperate
Slide 25-49
International Example:
Strategically Relating Subsidies to Nuclear Weapons
 Pakistan agreed to certain conditions
for an IMF loan
– In 1999, the IMF discovered that Pakistan
had spent much of this loan on the
development of nuclear weapons
– Soon, Pakistan had to default on its debt
 Why would Pakistan engage in this
behavior with the IMF?
Slide 25-50
Price Rigidity
and the Kinked Demand Curve
d1 is relatively elastic
• if one firm raises its
price the others will not
and it will lose market
share
d2 is relatively inelastic
• if one firm lowers its
price the others lower
their price so gain in sales
is small
Figure 25-5, Panel (a)
Slide 25-51
Price Rigidity
and the Kinked Demand Curve
The kinked demand curve
indicates the possibility
of price rigidity
Figure 25-5, Panel (b)
Slide 25-52
Price Rigidity and the
Kinked Demand Curve
Changes in cost do
not impact output
and prices as long as
MC remains in the
vertical portion of MR
Figure 25-6
Slide 25-53
Price and Marginal Revenue per Unit
Criticisms of the
Kinked Demand Curve
• Cannot determine P0
• Empirical evidence does
not confirm the kinked
demand theory
d1
P0
MR1
d2
MR2
q0
Quantity per Time Period
Slide 25-54
Strategic Behavior
 Do pet products have nine lives?
– H.J. Heinz’s Pet Products Company
• Dropped its price of 9-Lives cat food by 22%
to meet increased competition from Nestle,
Quaker, Grand Metropolitan, and Mars
• Heinz then decided to raise prices
• Its competition did not and Heinz’s market
share dropped from 23 to 15 percent
Slide 25-55
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Price Leadership
– A practice in many oligopolistic industries
in which the largest firm publishes its price
list ahead of its competitors, who then
match those announced prices
Slide 25-56
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Price War
– A pricing campaign designed to drive
competing firms out of a market
by repeatedly cutting prices
Slide 25-57
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Markets where price wars are common
– Cigarettes
– Long-distance telephone companies
– Airlines
Slide 25-58
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Markets where price wars are common
– Diapers
– Frozen foods
– PC hardware and software
Slide 25-59
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Cigarette price wars
– Philip Morris cut Marlboro
by 40 cents a pack
– RJR Nabisco matched the cut for Camel
– Marlboro’s market share rose
from 22.1% to 27.3%
– Profits and stock prices fell
Slide 25-60
Strategic Behavior with Implicit
Collusion: A Model of Price Leadership
 Cigarette price wars
– Phillip Morris reduced prices by 18%
and sales went up by only 12.5%
• Profits fell by 25%
Slide 25-61
Deterring Entry Into an Industry
 Entry Deterrence Strategy
– Any strategy undertaken by firms in an
industry, either individually or together,
with the intent or effect of raising the cost
of entry into the industry by a new firm
Slide 25-62
Deterring Entry Into an Industry
 Increasing entry cost
– Threat of price wars
– Government regulations
• Environmental regulation
• Safety standards
Slide 25-63
Deterring Entry Into an Industry
 Limit-Pricing Strategies
– A model that hypothesizes that a group
of colluding sellers will set the highest
common price that they believe they
can charge without new firms seeking
to enter that industry in search
of relatively high profits
Slide 25-64
Deterring Entry Into an Industry
 Raising customer’s switching cost
– Examples
• Non-compatible software
• Non-transferability of college courses
Slide 25-65
Comparing Market Structures
Market
Structure
Number
of
Sellers
Unrestricted
Entry and
Exit
Ability
to Set
Price
Long-Run
Economic
Profits
Possible
Product
Nonprice
Differentiation Competition Examples
Perfect
competition
Numerous
Yes
None
No
None
None Agriculture,
coal
Monopolistic
competition
Many
Yes
Some
No
Considerable
Yes
Toothpaste
toilet paper,
soap, retail
trade
Oligopoly
Few
Partial
Some
Yes
Frequent
Yes
Cigarettes,
steel
Pure
monopoly
One
No (for
entry)
Considerable
Yes
None
(product is
unique)
Yes
Some electric
companies,
some local
telephone
companies
Slide 25-66
Issues and Applications:
Product Differentiation on the Web
 Some Internet-based companies
such as Yahoo and AOL are now
in the top echelons of American
business because they forged
a recognized brand name.
 New companies copy the strategies
of successful companies
– Barnes and Noble and Books.com
copied Amazon.com
Slide 25-67
Web Links
 The following Web link appears in the
margin of this chapter in the textbook:
– http://www.csgb.ubc.ca/ccpp/simulation
Slide 25-68
Summary Discussion
of Learning Objectives
 Key characteristics
of monopolistic competition
– Large number of small firms
– Differentiated products
– Easy entry and exit
– Advertising and sales promotion
Slide 25-69
Summary Discussion
of Learning Objectives
 Contrasting the output and pricing
decisions of monopolistically
competitive firms with those
of perfectly competitive firms
– Monopolistically competitive firm
•
•
•
•
MR = MC determines output
Price set on demand curve
P > MC
P = ATC in the long-run
Slide 25-70
Summary Discussion
of Learning Objectives
 Contrasting the output and pricing
decisions of monopolistically
competitive firms with those
of perfectly competitive firms
– Perfectly competitive firm
• MR = MC determines output
• P = MR = MC
• P = minimum ATC in the long-run
Slide 25-71
Summary Discussion
of Learning Objectives
 The fundamental characteristics of oligopoly
– Economies of scale
– Barriers to entry
– Strategic dependence
 Applying game theory to evaluate
the pricing strategies of oligopolistic firms
– Game theory looks at competition for payoffs
• That depends on the strategies that others employ
Slide 25-72
Summary Discussion
of Learning Objectives
 The kinked demand theory
of oligopolistic price rigidity
– If a firm believes that rivals will follow price cuts
but not price increases, it will be reluctant
to change price.
 How firms may deter market entry
by potential rivals
– Raise entry costs
– Limit pricing
– Switching policies
Slide 25-73
End of Chapter
Chapter 25
Monopolistic Competition,
Oligopoly, and Strategic Behavior