Monopolistic competition & oligopoly

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

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Prepared by: Fernando Quijano and Yvonn Quijano

Monopolistic Competition and Oligopoly


Monopolistic Competition

• A monopolistically competitive industry has the following characteristics:

• A large number of firms

• No barriers to entry

• Product differentiation


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.


Nine Industries with Characteristics of Monopolistic Competition

Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992

SIC NO.INDUSTRY

DESIGNATION

FOURLARGEST

FIRMS

EIGHTLARGES

TFIRMS

TWENTYLARGES

TFIRMS

NUMBEROF

FIRMS

3792 Travel trailers and campers 41 57 72 270

3942 Dolls 34 47 67 204

2521 Wood office furniture 26 34 51 611

2731 Book publishing 23 38 62 2504

2391 Curtains and draperies 22 32 48 1004

2092 Fresh or frozen seafood 19 28 47 600

3564 Blowers and fans 14 22 41 518

2335 Women’s dresses 11 17 30 3943

3089 Miscellaneous plastic products 5 8 13 7605Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.


Product Differentiation, Advertising, and Social Welfare

Total Advertising Expenditures in 1998

DOLLARS(BILLIONS)

Newspapers 44.2

Television 48.0

Direct mail 39.5

Other 31.7

Yellow pages 12.0

Radio 14.5

Magazines 10.4

Total 200.3Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947.


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.


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 market place.


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.


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.


Product Differentiation Reduces the Elasticity of Demand Facing a Firm

• Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.


Monopolistic Competition 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.


Monopolistic Competition in the Short-Run

• Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.


Monopolistic Competition in the Long-Run

• The firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.


Economic Efficiencyand Resource Allocation

• 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.


Economic Efficiencyand Resource Allocation

• In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:

• 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.


Oligopoly

• An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated.

• The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.


Ten Highly Concentrated Industries

Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992

SIC NO.INDUSTRY

DESIGNATION

FOURLARGEST

FIRMS

EIGHTLARGEST

FIRMS

NUMBEROF

FIRMS

2823 Cellulosic man-made fiber 98 100 5

3331 Primary copper 98 99 11

3633 Household laundry equipment 94 99 10

2111 Cigarettes 93 100 8

2082 Malt beverages (beer) 90 98 160

3641 Electric lamp bulbs 86 94 76

2043 Cereal breakfast foods 85 98 42

3711 Motor vehicles 84 91 398

3482 Small arms ammunition 84 95 55

3632 Household refrigerators and freezers 82 98 52

Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.


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 comprising the oligopoly.


The Collusion Model

• A group of firms that gets together and makes price and output decisions jointly is called a cartel.

• 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 agreements are implicit.


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.


The Kinked Demand Curve Model

• The kinked demand 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.


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).


The Price-Leadership Model

• 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.



• Assumptions of the price-leadership model:

1. The industry is made up of one large firm and a number of smaller, competitive firms;

2. The dominant firm maximizes profit subject to the constraint of market demand and subject to the behavior of the smaller firms;

3. The dominant firm allows the smaller firms to sell all they want at the price the leader has set.



• Outcome of the price-leadership model:

1. The quantity demanded in the industry is split between the dominant firm and the group of smaller firms.

2. This division of output is determined by the amount of market power that the dominant firm has.

3. The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.


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.


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.


Payoff Matrix for Advertising Game

B’s STRATEGY

A’s STRATEGY Do not advertise Advertise

Do not advertise A’s profit = $50,000B’s profit = $50,000

A’s loss = $25,000B’s profit = $75,000

AdvertiseA’s profit = $75,000B’s loss = $25,000

A’s profit = $10,000B’s profit = $10,000

• The strategy that firm A will actually choose depends on the information available concerning B’s likely strategy.


Payoff Matrix for Advertising Game

B’s STRATEGY

A’s STRATEGY Do not advertise Advertise

Do not advertise A’s profit = $50,000B’s profit = $50,000

A’s loss = $25,000B’s profit = $75,000

AdvertiseA’s profit = $75,000B’s loss = $25,000

A’s profit = $10,000B’s profit = $10,000

• Regardless of what B does, it pays A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.


The Prisoners’ Dilemma

ROCKY

GINGER Do not confess Confess

Do not confess Ginger: 1 yearRocky: 1 year

Ginger: 7 yearsRocky: free

ConfessGinger: freeRocky: 7 years

Ginger: 5 yearsRocky: 5 years

• Both Ginger and Rocky have dominant strategies: to confess. Both will confess, even though they would be better off if they both kept their mouths shut.


Payoff Matrix forLeft/Right-Top/Bottom Strategies

Original Game

D’s STRATEGY

C’s STRATEGY Left Right

Top C wins $100D wins no $

C wins $100D wins $100

BottomC loses $100D wins no $


• Because D’s behavior is predictable (he will play the right-hand strategy), C will play bottom.

• When all players are playing their best strategy given what their competitors are doing, the result is called Nash equilibrium.


Payoff Matrix forLeft/Right-Top/Bottom Strategies

• C is likely to play top and guarantee herself a $100 profit instead of losing $10,000 to win $200, even if there is just a small chance of D’s choosing left.

• 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.

New Game

D’s STRATEGY

C’s STRATEGY Left Right

Top C wins $100D wins no $


BottomC loses $10,000D wins no $



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.


Oligopoly is Consistent witha Variety of Behaviors

• The only necessary condition of oligopoly is that firms are large enough to have some control over price.

• 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.


Oligopoly and Economic Performance

• Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons:

• They are likely to price above marginal cost. This means that there would be underproduction from society’s point of view.

• Strategic behavior can force firms into deadlocks that waste resources.

• Product differentiation and advertising may pose a real danger of waste and inefficiency.


The Role of Government

• The Celler-Kefauver Act of 1950 extended the government’s authority to ban vertical and conglomerate mergers.

• 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.


Regulation of Mergers

Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms

PERCENTAGE SHARE OF: HERFINDAHL-HIRSCHMAN

INDEXFIRM 1 FIRM 2 FIRM 3 FIRM 4

Industry A 50 50 - - 502 + 502 = 5,000

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


Department of Justice Merger Guidelines (revised 1984)

ANTITRUST DIVISION ACTION

HHI

1,800

1,000

0

ConcentratedChallenge 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

UnconcentratedNo challenge

Monopolistic competition & oligopoly

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