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C H APTER
13
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Monopolistic Competition
and Oligopoly
___________________________________
___________________________________
Prepared by: Fernando Q uijano
and Yvonn Q uijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
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Karl Case, Ray Fair
C H A P T E R 13: M onopolistic C om petition and O ligopoly
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Characteristics of
Different Market Organizations
Products
Price a
Number
differentiated
decision Free
of firms or homogeneous variable entry
Perfect
competition
Many
Homogeneous
No
Yes
Monopoly
One
A single,
unique product
Yes
No
Monopolistic
competition
Many
Differentiated
Yes, but
limited
Oligopoly
Few
Either
Yes
Yes
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Distinguished
by
Examples
Price competition
only
Wheat farmer
Textile firm
Still constrained
Public utility
by market demand Patented Drug
Price and quality
competition
Limited Strategic behavior
Restaurants
Hand soap
Automobiles
Aluminum
• Not every industry fits neatly into one of these
categories; however, this is a useful framework for
thinking about industry structure and behavior.
© 2004 Prentice Hall Business Publishing
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Karl Case, Ray Fair
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Monopolistic Competition
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• A monopolistically competitive
industry has the following
characteristics:
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• A large number of firms
• No barriers to entry
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• Product differentiation
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
Monopolistic Competition
___________________________________
• 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.
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Monopolistic Competition
___________________________________
Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1992
INDUSTRY
DESIGNATION
FOUR
LARGEST
FIRMS
EIGHT
TWENTY
LARGEST LARGEST
FIRMS
FIRMS
Travel trailers and campers
26
36
50
761
Dolls
31
51
66
239
Wood office furniture
34
42
55
639
Book printing
32
45
59
890
Curtains and draperies
26.5
36.3
50.1
2012
Fresh or frozen seafood
13.6
22.9
42.2
586
Women’s dresses
14.2
23.7
39.4
747
5
8
Miscellaneous plastic products
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NUMBER
OF
FIRMS
14
___________________________________
___________________________________
___________________________________
7522
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing. Subject Series EC92m315, June, 2001.
© 2004 Prentice Hall Business Publishing
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Product Differentiation,
Advertising, and Social Welfare
___________________________________
• Product differentiation is a strategy
that firms use to achieve market
power. Accomplished by producing
products that have distinct positive
identities in consumers’ minds. This
differentiation is often accomplished
through advertising.
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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Product Differentiation,
Advertising, and Social Welfare
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Total Advertising Expenditures in 2001
___________________________________
DOLLARS
(BILLIONS)
Newspapers
89.5
Television
54.4
Direct mail
44.7
Internet
___________________________________
5.8
Yellow pages
Radio
13.6
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17.9
Magazines
11.1
Total
231.3
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Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United
States, 2002, Table 1253.
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Product Differentiation,
Advertising, and Social Welfare
___________________________________
Magazine Advertising Revenues by Category, 2001
DOLLARS
(MILLIONS)
Automotive
Technology
Telecommunications
Computers and software
Home furnishings and supplies
Toiletries and cosmetics
Apparel and accessories
Financial, insurance and real estate
Food and food products
Drugs and remedies
Retail stores
Beer wine and liquor
Sporting goods
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$1,688
223
817
1,196
1,401
1,316
962
1,207
1,217
692
307
279
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Source: Publishers Information Bureau, Statistical Abstract of the United States, 2002, pg. 772
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Karl Case, Ray Fair
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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.
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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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 marketplace.
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___________________________________
___________________________________
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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.
___________________________________
___________________________________
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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.
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Price and Output Determination
in Monopolistic Competition
___________________________________
• The demand curve
faced by a monopolistic
competitor is likely to be
less elastic than the
demand curve faced by
a perfectly competitive
firm, but more elastic
than the demand curve
faced by a monopoly.
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___________________________________
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Price/Output
Determination 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.
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Price/Output
Determination in the Short Run
___________________________________
• Profits are not
guaranteed. A firm
with a similar cost
structure is shown
facing a weaker
demand and suffering
short-run losses.
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___________________________________
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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Price/Output
Determination in the Long Run
© 2004 Prentice Hall Business Publishing
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• As new firms enter a
monopolistically competitive
industry, the demand curves
of existing firms shift to the
left, pushing MR with them.
___________________________________
• In the long run, profits are
eliminated. This occurs for a
firm when its demand curve
is just tangent to its average
cost curve.
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Principles of Economics, 7/e
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Economic Efficiency
and Resource Allocation
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• 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.
___________________________________
• 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.
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Karl Case, Ray Fair
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Oligopoly
___________________________________
• An oligopoly is a form of
industry (market) structure
characterized by a few
dominant firms. Products may
be homogeneous or
differentiated.
___________________________________
___________________________________
___________________________________
___________________________________
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Oligopoly
___________________________________
Percentage of Value of Shipments Accounted for by the Largest Firms
in High-Concentration Industries, 1997
INDUSTRY
DESIGNATION
Cellulosic man-made fiber
Primary copper
Household laundry equipment
Cigarettes
Malt beverages (beer)
Electric lamp bulbs
Cereal breakfast foods
Motor vehicles
Small arms ammunition
Household refrigerators and freezers
FOUR
LARGEST
FIRMS
EIGHT
LARGEST
FIRMS
NUMBER
OF
FIRMS
100
95
90
99
90
89
83
83
89
100
99
99
100
95
94
94
92
94
4
11
10
9
494
54
48
325
107
82
97
21
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___________________________________
___________________________________
___________________________________
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject
Series 2001.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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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.
___________________________________
___________________________________
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The Collusion Model
___________________________________
• A group of firms that gets
together and makes price and
output decisions to maximize
joint profits is called a cartel.
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___________________________________
___________________________________
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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The Collusion Model
___________________________________
• 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 such
agreements are implicit.
___________________________________
___________________________________
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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.
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The Kinked Demand Curve Model
___________________________________
• The kinked demand curve 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.
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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The Kinked Demand Curve Model
___________________________________
• Above P*, an increase in
price, which is not followed
by competitors, results in a
large decrease in the firm’s
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).
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Karl Case, Ray Fair
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The Price-Leadership Model
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• 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.
___________________________________
___________________________________
___________________________________
___________________________________
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The Price-Leadership Model
___________________________________
• The price-leadership model outcome:
___________________________________
• The quantity demanded in the industry
is split between the dominant firm and
the group of smaller firms.
___________________________________
• This division of output is determined by
the amount of market power of the
dominant firm.
___________________________________
• The dominant firm has an incentive to
push smaller firms out of the industry in
order to establish a monopoly.
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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.
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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.
___________________________________
___________________________________
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Payoff Matrix for Advertising Game
___________________________________
___________________________________
___________________________________
___________________________________
• The strategy that firm A will actually choose
depends on the information available about
B’s likely strategy.
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Game Theory
___________________________________
___________________________________
• Regardless of what B does, it pays
for A to advertise. This is the
dominant strategy, or the strategy
that is best no matter what the
opposition does.
___________________________________
___________________________________
___________________________________
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Game Theory
___________________________________
• The Prisoners’ Dilemma is a game
in which:
___________________________________
• The players are prevented from
cooperating with each other;
___________________________________
• Each player in isolation has a dominant
strategy;
___________________________________
• The dominant strategy makes each
player worse off than in the case in
which they could cooperate.
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The Prisoners’ Dilemma
___________________________________
___________________________________
___________________________________
___________________________________
• Ginger and Rocky have dominant strategies
to confess even though they would be better
off if they both kept their mouths shut.
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Payoff Matrixes for
Left/Right-Top/Bottom Strategies
___________________________________
• In game theory, when
all players are playing
their best strategy
given what their
competitors are doing,
the result is called
Nash equilibrium.
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___________________________________
___________________________________
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Payoff Matrix for
Left/Right-Top/Bottom Strategies
___________________________________
• When uncertainty and
risk are introduced, the
game changes. A
maximin strategy is a
strategy chosen to
maximize the minimum
gain that can be
earned.
___________________________________
___________________________________
___________________________________
___________________________________
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Repeated Games
___________________________________
• While explicit collusion violates the
antitrust statutes, strategic reaction
does not.
___________________________________
___________________________________
• Strategic reaction in a repeated
game may still have the same effect
as tacit collusion.
___________________________________
___________________________________
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Repeated Games
___________________________________
• The strategy to respond
in a way that lets your
competitors know you
will follow their lead is
called tit-for-tat
strategy. If one leads
and the competitor
follows, both will be
better off.
___________________________________
___________________________________
___________________________________
___________________________________
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Repeated Games
___________________________________
• Game theory has been
used to help understand
many phenomena –
from the provision of
local public goods and
services to nuclear war.
___________________________________
___________________________________
___________________________________
___________________________________
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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.
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Contestable Markets
___________________________________
• The only necessary condition of
oligopoly is that firms are large
enough to have some control over
price.
___________________________________
___________________________________
___________________________________
___________________________________
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Contestable Markets
___________________________________
• 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.
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Oligopoly and Economic Performance
___________________________________
• Oligopolies, or concentrated industries,
are likely to be inefficient for the
following reasons:
___________________________________
___________________________________
• Profit-maximizing oligopolists are likely to
price above marginal cost.
• Strategic behavior can force firms into
___________________________________
deadlocks that waste resources.
• Product differentiation and advertising
may pose a real danger of waste and
inefficiency.
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
The Role of Government
___________________________________
• The Celler-Kefauver Act of
1950 extended the
government’s authority to ban
vertical and conglomerate
mergers.
___________________________________
___________________________________
___________________________________
___________________________________
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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The Role of Government
___________________________________
• 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.
___________________________________
___________________________________
___________________________________
___________________________________
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Regulation of Mergers
___________________________________
Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical
Industries, Each With No More Than Four Firms
HERFINDAHLHIRSCHMAN
INDEX
PERCENTAGE SHARE OF:
FIRM 1 FIRM 2 FIRM 3 FIRM 4
Industry A
50
50
−
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
502
+
502
= 5,000
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___________________________________
___________________________________
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C H A P T E R 13: M onopolistic C om petition and O ligopoly
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Department of Justice
Merger Guidelines (revised 1984)
___________________________________
ANTITRUST DIVISION ACTION
HHI
1,800
1,000
___________________________________
Concentrated
Challenge if Index is
raised by more than 50
points by the merger
___________________________________
Moderate
Concentration
Challenge if Index is
raised by more than 100
points by the merger
___________________________________
Unconcentrated
No challenge
___________________________________
0
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Review Terms and Concepts
___________________________________
cartel
monopolistic competition
CellerCeller-Kefauver Act
Nash equilibrium
Cournot model
oligopoly
dominant strategy
perfectly contestable market
___________________________________
price leadership
game theory
HerfindahlHerfindahl-Hirschman Index
(HHI)
prisoners’ dilemma
___________________________________
tittit-forfor-tat strategy
Kinked demand curve model
product differentiation
maximin strategy
tacit collusion
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
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