ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
Chapter 21
“Oligopoly and
Monopolistic Competition”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
1
Learning Objectives
1. Explain the meaning and significance of
mutual interdependence.
2. Identify the models associated with
oligopoly.
3. Describe the characteristics of
monopolistic competition.
4. Define product differentiation and state
its implications.
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Learning Objectives
5. Relate how and why firms charge some
consumers more than others for the same
products.
6. Explain why oligopoly brings economic
change.
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21.1
OLIGOPLY
• Oligopoly is characterized by multiple
firms, one or more of which will produce a
significant portion of industry output.
• Oligopoly firms are mutually
interdependent, with actions of one firm
inducing other firms to take counteractions.
• Oligopoly products may be differentiated or
homogeneous.
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Oligopoly Products May Be
Differentiated or Homogeneous
• Differentiated Oligopolies: cigarettes
and automobiles
• Homogeneous Oligopolies: steel,
aluminum, and copper
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Measuring Market Power
o Market power is the ability of a firm to control
the price it charges for its output.
o Purely competitive firms have no market power, as
they are price takers.
o Monopoly firms have the most market power
because they have no competition.
o We must assess the market power of the firms
that are neither purely competitive and
monopolistic, and one method to measure
market power is the four firm concentration
ratio.
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Measuring Market Power
 To compute a four-firm concentration ratio:
= Sales by four largest firms in an industry
Sales by all firms in and industry
 The larger the concentration ratio, the more
market power the firms in the industry possess.
 Concentration ratios do not take into account
sales by foreign firms, nor do they account for
differences in size among the four firms.
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Measuring Market Power
FOUR-FIRM CONCENTRATION RATIOS FOR
SELECTED U.S. MANUFACTURING
INDUSTRIES
CONCENTRATION
INDUSTRY
RATIO (PERCENT)
Cigarettes
98.9
Aircraft
84.8
Tires
72.4
Soap and detergents
65.6
Gloves and mittens
63.8
Cookies and crackers
59.9
Dog and cat food
58.4
Luggage
51.9
Soft drinks
47.2
Boats
41.4
Mattresses
38.6
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Mergers and Spin-offs
A merger occurs when one firm combines with
another firm to form a single firm.
 Horizontal merger occurs when an firm merges
another in the same line of business.
 Vertical Integration occurs when a firm
acquires another firm that supplies it with an
input.
 Conglomerate Merger occurs when firms in
unrelated businesses merge.
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21.2
OLIGOPOLY MODELS
Oligopoly is the only market structure for
which there are a variety of models.
Contestable markets occur when new rivals
can enter or exit the market cheaply.
 Price leadership model is based on
observable oligopoly behavior. When one
firm changes its selling price, the remaining
firms in the industry.
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Oligopoly Models
A Cartel is a form of oligopoly in which
firms in an industry collude.
Collusion means that firms jointly plan price
and output.
Cartels are illegal in the United States.
 A dominant firm with a competitive fringe is
an oligopoly model that combines the
competitive and monopoly models
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Reasons for Difficulty in
Keeping Cartels Together
 Illegal in the U.S.
 Any member has the incentive to cheat
 Cartel members may drop out
 High cartel profits may induce
competition
 Higher prices can lead to the
development of substitute goods
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The Nominal and Real Price of Oil
Oil production
(percentage
of world market)
50
Price
($ per barrel)
35
OPEC oil production
30
25
40
Nominal price
20
30
15
20
10
Real price
10
5
0
0
’70
’75
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’80
’85
’90
’95
‘00
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Oligopoly Models
Marginal
Competitive
cost
supply
#3 The price#1
from
step
#2 becomes
the market
The
firm's
computes
its
price. Firmsresidual
in the competitive
are price
demand, fringe
the shortage
The dominant firm with a competitive fringe
takers at that
price.
Theoccur
total quantity
of output
that
would
in
the
chooses its output and price in three steps: equals the quantity supplied by the competitive
competitive market at each
fringe plus the
quantity
by the
price
belowsupplied
the competitive
dominant firm.
Actual market equilibrium
equilibrium.
occurs at this point, as other firms take this
Price
price competitive equilibrium.
•
•
Competitive Dominant
fringe
firm’s
quantity
quantity
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Total
quantity
Market
quantity
Dominant
firm’s
quantity
Dominant
firm’s
#2 The
dominant
firm
chooses demand
its quantity by
equating marginal
revenue to marginal
Firm’s
Marginal
cost,
which determines
quantity
revenue
the price.
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Game Theory
•Game theory employs mathematics to
analyze the behavior of parties whose
interests conflict. This method may be
employed to deepen the understanding
of oligopoly behavior.
•The tool of analysis is the payoff matrix.
•An example of game theory is the
prisoners dilemma.
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Game Theory
Decision 1
√
Decision 2
√
Al:
Confess or
keep quiet?
Happy:
Confess or
keep quiet?
Happy Al
5
5
Happy Al
1
20
√
Al:
Confess or
keep quiet?
Outcome
Prison sentence
(years)
Happy Al
20
1
Happy Al
3
3
Prisoner’s Dilemma: Happy is better off confessing no matter what Al does. The outcome of
these decisions is a prison sentence of 5 years apiece, as shown in the yellow boxes. Note that
Al and Happy's collective interest is better served by collusion, in which they both keep quiet
16
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and are
sentenced
3 years each.
Game Theory
Decision 1
Decision 2
X–co Y–co
$10 m $10 m
X-co:
High or low
price?
Y-co:
High or low
price?
Outcome
Profit (loss)
X–co Y–co
$15 m ($5 m)
√
√
X-co:
High or low
price?
X–co Y–co
($5 m) $15 m
X–co Y–co
$1 m $1 m
√ firms face the dilemma of
Prisoner’s Dilemma in a Two-Firm Oligopoly: These
whether to price high or low. Their collective interest calls for a high price. In the
17
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Prentice
Hall Publishing
absence
collusion,
however, their dominant strategies cause theAyers/Collinge,
price to be1/elow.
The Model of Kinked Demand
• Prices in oligopoly sometimes seems “sticky”,
meaning resistant to change.
• The kinked demand curve model offers an
explanation.
• In this model, any firm that raises its price,
loses a significant fraction of its customers to
other firms that are assumed to keep their
prices constant.
• However if a firm lowers its price, it does not
gain customers from other firms, because the
other firms in the industry would feel the
competitive need to lower their prices too.
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The Kinked Demand Curve
Marginal cost can shift,
yet still intersect
marginal revenue at
the same quantity.
Kink
•
Price
Marginal Cost
The
demand
curve
As a kinked
consequence,
marginal
model
assumes
that firms
revenue
is discontinuous
match
price
decreases
by their
(vertical)
at the
quantity
competitors,
butthe
dokink.
not match
associated with
price increases.
Firm’s Demand
Quantity
Profit maximizing
quantity
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Marginal
revenue
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21.3
MONOPOLISTIC COMPETITION
Monopolistic competition is a market characterized
by many firms, product differentiation, and
relatively easy entry of new firms.
Monopolistically competitive firms face a
downward sloping demand curve that is less elastic
than that of a purely competitive firm, but more
elastic than that of a monopolist.
Specifically, each firm faces a demand curve that is
highly elastic, which gives it a relatively flat
appearance.
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Monopolistic Competition
The firm’ demand curve is influenced by its
own actions , and the actions of its competitors.
Monopolistically competitive firm’s have the
incentive to advertise and vary their products
as a way of increasing their demand at the
expense of their competitors.
In the short-run monopolistically competitive
firms will continue to enter or exit a market
until a long-run equilibrium is reached in
which additional entrants would expect
additional profits.
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Output and Price in
Monopolistic Competition
Marginal Cost
•
Price
•
Marginal cost =
marginal revenue
Profitmaximizing
quantity
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Under monopolistic competition,
demand is much more elastic. As a
result, the profit-maximizing output
occurs close to the efficient output,
given by the intersection of marginal
cost and the firm’s demand.
Firm’s Demand
Marginal
revenue
Quantity
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Profit, Loss, and Breakeven in
Monopolistic Competition
Marginal Cost
Profitable firm
•
Price
Profit
•
•
Average
cost
Firm’s Demand
Marginal
revenue
Profitmaximizing
quantity
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Quantity
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Profit, Loss, and Breakeven in
Monopolistic Competition
Marginal Cost
Average
cost
Price
Loss
•
•
•
Firm with a loss
Firm’s Demand
Marginal
revenue
Profitmaximizing
quantity
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Quantity
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Profit, Loss, and Breakeven in
Monopolistic Competition
Marginal Cost
Average
cost
Firm that
breaks even
•
Price
•
Firm’s Demand
Marginal
revenue
Profitmaximizing
quantity
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Quantity
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21.4
WAYS TO COMPLETE
The key to riches
in monopolistic
competition is
successful product
differentiation in
such things as…
 Size
 Taste
 Shape
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 Style
 Color
 Texture
 Quality
 Location
 Packaging
 Advertising
 Service
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Advertising and Product
Differentiation
If the marginal revenue generated by
advertising exceeds the marginal cost of
advertising, advertising raises profits.
Otherwise it does not.
The profit-maximizing firm will adjust its
hours of operation, selection of
merchandise, and every other aspect of
product differentiation with this same
principle in mind.
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Advertising to Shift Demand
$
Advertising aims to
strengthen preferences
for the firm’s products.
Firm’s demand
Marginal Revenue
Quantity
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Price Discrimination Under Monopolistic
Competition and Oligopoly
Price discrimination is selling a good or service at
different prices when such differences are not cause
by differences in production cost.
Price discrimination is feasible when different
prices can be charged to different market segments.
A firm cannot practice price discrimination if
buyers who buy at a low price, can resell those
goods to other buyers at a higher price, which is a
practice called arbitrage.
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21.5 EXPLORE & APPLY
Oligopoly –Changing Way of Life
FOUR-FIRM CONCENTRATION RATIOS
KIND OF BUSINESS
CONCENTRATION
RATIO
Discount department
87.9
stores
Radio, television, and
other electronics stores
62.3
FOR RETAILING
COMMENT
Highly concentrated,
indicating probable
oligopoly
Relatively high
concentration ratio,
indicating
possible
Pharmacies and drug
stores
Clothing stores
Nursery and garden centers
All retail firms
retailing is highly
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competitive
46.6
25.5
12.4
7.9
oligopoly
Moderate concentration
ratio
Fairly competitive
Competitive
Low concentration ratio
indicates
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Oligopoly –Changing Way of Life
TOP TEN U.S. RETAILERS
FIRM SALES (IN BILLIONS OF DOLLARS)
1. Wal-Mart
2. Home Depot
3. Kroger
4. Sears, Roebuck, and Co.
5. Target Corp.
6. Albertson’s Inc.
7. K-Mart
8. Costco Wholesale Corp.
9. Safeway
10. J. C. Penney
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219.8
53.55
50.1
41.1
39.4
37.9
37.0
34.8
34.3
32.0
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Terms along the Way
•
•
•
•
•
oligopoly
mutually interdependent
differentiated product
monopolistic competition
four-firm concentration
ratio
• merger
• horizontal merger
©2004 Prentice Hall Publishing
•
•
•
•
•
•
vertical merger
conglomerate merger
contestable market
price leadership
cartel
dominant firm with a
contestable market
• game theory
• kinked demand curve
• monopolistic competition
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Test Yourself
1. Which is the best example of a vertical
merger?
a. A computer manufacturer merges with a
computer store.
b. Two book publishers merge.
c. A jewelry store merges with a furniture store.
d. A Cosmetics manufacturer merges with a
pizza restaurant.
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Test Yourself
2.
a.
b.
c.
d.
Price leadership describes a model of
cartel
monopoly
oligopoly
monopolistic competition
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Test Yourself
3. Cartels are difficult to maintain over time for
each of the following reasons, EXEPT that
a. Individual members cheat by charging less
than the cartel price.
b. consumers substitute other goods for the
product of the cartel.
c. new competitors that are not cartel members
may enter the market.
d. legal barriers prohibit any member of the
cartel from dropping out.
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Test Yourself
4. In the game theory model of oligopoly, prices
a. are are set with little concern for whether
profits are maximized.
b. are set strategically, as though firms are all
playing in the same game.
c. fall when cost rise, and when cost fall.
d. remain stable in response to moderate
changes in cost.
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Test Yourself
5. In which market structure do firms
ALWAYS produce differentiated
products?
a. Pure competition.
b. Monopoly.
c. Monopolistic competition.
d. Game theory.
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Test Yourself
6.
a.
b.
c.
d.
Fast food restaurants are examples of
pure competition
monopolistic competition
oligopoly
monopoly
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Test Yourself
7.
a.
b.
c.
Monopolistically competitive firms
are mutually interdependent.
are also called price takers.
maximize profits by setting marginal
revenue equal to marginal cost.
d. are few in number.
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The End!
Next Chapter 22
“Market for Labor
and Other Inputs”
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