Monopolistic Competition and Oligopoly 16 Monopolistic Competition and Oligopoly Competition, you...

Monopolistic Competition and Oligopoly

16


Competition, you know, is a lot like chastity. It is widely praised, but alas, too little practiced.

— Carol Tucker

CHAPTER

16

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Chapter Goals

• List the four distinguishing characteristics of monopolistic competition

• State the central element of oligopoly

• Demonstrate graphically the equilibrium of a monopolistic competitor

• 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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Market Structure

• Market structure refers to the physical characteristics of the market within which firms interact

• An oligopolistic market is a market in which there are only a few firms and firms explicitly take other firms’ likely response into account

• A monopolistically competitive market is a market in which there are many firms selling differentiated products and few barriers to entry

• It is determined by the number of firms in the market and the barriers to entry

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Characteristics of Monopolistic Competition

Four distinguishing characteristics:

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

2. Product differentiation where the goods that are sold aren’t homogenous

1. Many sellers that do not take into account rivals’ reactions

4. Ease of entry of new firms in the long run because there are no significant barriers to entry

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Output, Price, and Profit of a Monopolistic Competitor

• Like a monopoly,

• At profit maximizing output, marginal cost will be less than price

• Marginal revenue is below price

• Like a perfect competitor, zero economic profits exist in the long run

• The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve

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Q

P

ATCBreak even

Q

MC

D

MR

A monopolistic firm can earn profits, losses, or

break even in the short run

Determining Profits Graphically: Monopolistic Competition

Losses

Break even

Profits

P

ATCLosses

ATCProfits

ATCL

ATCP

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Monopolistic Competition Compared with Perfect Competition Graph

Outcome: Monopolistic competition

output is lower and price is higher than perfect competition

• In monopolistic competition in the long run, P > min ATC,

• In perfect competition in the long run, P = min ATC

Q

P

ATC

QMC

MC

DMC

MRMC

PMC

PPCDPC

QPC

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Comparing Monopolistic Competition with Monopoly

• For a monopolistic competitor in long-run equilibrium, (P = ATC) ≥ (MC = MR)

• No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry

• It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry

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Advertising and Monopolistic Competition

• Advertising increases ATC

• The goals of advertising are to increase demand and make demand more inelastic

• Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do

• The increase in cost of a monopolistically competitive product is the cost of “differentness”

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Characteristics of Oligopoly

• Oligopolies are made up of a small number of firms in an industry

• Oligopolistic firms are mutually interdependent

• In any decision a firm makes, it must take into account the expected reaction of other firms

• 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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Models of Oligopoly Behavior

• There is no single model of oligopoly behavior

• The cartel model is when a combination of firms acts as if it were a single firm and a monopoly price is set

• An oligopoly model can take two extremes:

• 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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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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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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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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The Kinked Demand Curve Graph

• A gap in the MR curve exists

• A large shift in marginal cost is required before firms will change their price

Q

P

Q

MC1

DMR

P

If P increases, others won’t go along, so D is elastic

If P decreases, other firms match the decrease, so D

is inelastic

MC2

Gap

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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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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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New Entry as a Limit on the Cartelization Strategy and Price Wars

• 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

• 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

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Comparison of Market Structures

Monopoly OligopolyMonopolistic Competition

Perfect Competition

No. of firms One Few Many Almost infinite

Barriers to entry Significant Significant Few None

Pricing decisions MC = MRStrategic pricing

MC = MR MC = MR = P

Output decisionsMost output restriction

Output restricted

Output restricted, product

differentiation

No output restriction

InterdependenceNo

competitorsInterdependent

decisions Each firm

independentEach firm

independent

LR profit Possible Possible None None

P and MC P > MC P > MC P > MC P = MC

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Classifying Industries and Markets in Practice

• An industry seldom fits neatly into one category or another

• Cross-price elasticity measures the responsiveness of the change in demand for a good to a change in the price of a related good

• One way to classify markets in practice is by its cross price elasticity

• Goods with a cross-price elasticity of 3 or more are in the same industry

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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 Three to Six Digit Sectors

23 Construction

42 Wholesale Trade

51 Information517 –Telecommunications5172 – Wireless telecommunications carriers517211 – Paging

61 Education Services

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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

• Because it squares market shares, the Herfindahl index gives more weight to firms with large market shares than does the concentration ratio measure

• The Herfindahl index is the sum of the squared value of the individual market shares of all firms in the industry

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Concentration Ratios and the Herfindahl Index

IndustryFour 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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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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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

• The contestable market model gives less weight to the empirical estimates of market structure

• It predicts that oligopolies charge higher prices than monopolistic or perfect competitors

• Markets that look oligopolistic could be highly competitive

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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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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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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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Preview of Chapter 17: Real-World Competition and Technology

• Discuss the monitoring problem and its implications for economics

• Discuss why competition should be seen as a process, not a state

• Explain how corporate takeovers can limit X-inefficiency

• 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

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Monopolistic Competition and Oligopoly 16 Monopolistic Competition and Oligopoly Competition, you...

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