Chapter 7
MONOPOLY, OLIGOPOLY,
AND STRATEGY
1. Monopoly and Oligopoly
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Firms that are large relative to the market are either
monopolies, in which a single firm dominates the
market, or oligopolies , where a handful of firms
dominate.
Perfectly competitive firms have no control over the
prices they charge; they are price takers.
Monopolist and oligopolists exercise more control
over price they are price searchers.
Price searchers face a downward-sloping demand
curve, if they want to increase sales they must lower
their price.
1. Monopoly and Oligopoly
– cont.
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A monopoly is one seller of a good that has no
close substitutes, with considerable control over price
and protection from competition by barriers to entry.
Historically water, electric and gas companies were
monopolies.
The most complex price searcher is the oligopolist
who must consider the reactions of competitors.
This large firm worries about the entire market for
the product as well as the reaction of its rivals.
Automobiles, breakfast cereals, refrigerators, and
cigarettes are examples.
1. Monopoly and Oligopoly
– cont.
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Barriers to entry differentiate one type of
price searcher from another; entry barriers
are any conditions that put new firms at a
disadvantage to old firms. Examples are:
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Large minimum efficient scale, requiring huge
capital investments;
Patents;
Monopoly ownership of critical raw material; and
Government restrictions on entry such as licensing
requirements.
2. Price Searching
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The behavior of each price searchers are
governed by certain general principles:
They must lower their price to sell more.
They must maximize their profits by
producing that output at which marginal
revenue equals marginal cost.
Marginal revenue, MR, is the increase in
revenue brought about by increasing output
(sales) by one unit.
2. Price Searching
For the price searcher, price is greater
than marginal revenue: P>MR.
 Selling more output “spoils the market”
on the earlier units sold because their
price is lower.
Price Searching and “Skimming the
Market” Example
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2.1 The Marginal Revenue
Curve
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The price searcher faces both a demand schedule
and a marginal revenue schedule.
Whether MR is positive or negative depends on
whether demand is elastic or inelastic at the
corresponding price:
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Elastic demand = a reduction in price raises total revenue
so MR is positive
Inelastic demand = a reduction in price lowers total
revenue so MR is negative
With straight-line demand curves, the MR curve will
be exactly halfway between the demand curve and
the vertical axis.
2.2 Profit Maximizing by a
Monopoly Producer
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The profit-maximizing level of output is
where MR = MC.
The demand curve determines the
price, and where MR and MC intersect
determines the quantity.
The monopolist can set either the
profit-maximizing price or the profitmaximizing quantity.
2.3 Oligopoly
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Oligopoly covers markets between monopoly and
monopolistic competition.
Oligopoly is characterized by a small number of
producers, barriers to entry, price searching, and
mutual interdependence.
They are more complicated than perfect
competition, pure monopolies, or monopolistic
competition because there is no one theory of
oligopoly.
The marginal revenue an oligopolistic gains from a
higher price depends on the reactions of rival firms,
which might be difficult to predict.
2.4 Mutual
Interdependence
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Mutual interdependence characterizes an industry
where it is recognized that the actions of one firm
affect other firms in the industry.
Mutual interdependence is the most important
feature of oligopoly:
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In some industries, the pattern of reaction may be well
understood by all participants it may either be dictated by
custom or by agreement;
In others, the reactions of rival firms may be unpredictable,
and participants must use strategic behavior to outguess
and outmaneuver their rivals.
2.4.1 Strategic Behavior
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Strategic behavior occurs when oligopolistic
rivals adopt strategies to outguess other
firms.
Each firm’s profit depends on the price
charged by the other.
If one charges a slightly lower price, then it
will make a large profit while the higherpriced firm makes a low profit.
Oligopolist must make a pricing decision not
knowing what the other firm will do.
2.4.1 Strategic Behavior
– cont.
The Prisoners Dilemma Example
 As equilibrium applies to supply and demand in
competitive markets, so does it applies to strategic
behavior.
 A Nash equilibrium is a set of strategies, one for
each player, such that no player has an incentive to
universally change his or her reaction.
 Players are in equilibrium if a change in strategies by
any one of them would lead the other player to earn
less remaining with the current strategy.
2.4.2 Cartel Agreements
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Some oligopolistic firms form a cartel.
A cartel is an arrangement that allows the
participating firms to coordinate their output
and pricing decisions to earn monopoly
profits.
If successful, these agreements allow the
oligopolistic firms to earn monopolistic profits
for the industry as a whole.
2.4.2 Cartel Agreements
– cont.
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In most countries, cartel agreements are
against the law and must be kept secret.
Every cartel member can gain through the
attainment of monopoly profits if each
adheres to the agreement. Each member can
gain by cheating on the agreement if the
others do not cheat.
Greed leads firms to join cartels; greed also
leads firms to break up cartels; very few
cartels are successful over the long run.
2.4.3 Conscious Parallelism
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Informal agreements and conscious
parallelism are also used by oligopositic firms
to coordinate price and output.
Rival firms follow the price leader’s price to
increase and decrease. The price leader
keeps a sharp eye on market demand and
costs. A price leader is a firm whose price
changes are consistently imitated by other
firms in the industry.
2.4.3 Conscious Parallelism
– cont.
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Conscious parallelism occurs when oligopoly
firms behave in the same way even though
they have not agreed to act in a parallel
manner.
Examples are submitting identical bids and
switching to high-season rates at the same
time without formal agreement.
Through conscious parallelism, the actions of
producers can be coordinated without formal
or even informal agreements.
3. Efficiency, Antitrust,
and Network Externalities
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In the case of monopoly, price exceeds
marginal cost (P>MC)
There is economic inefficiency when it is
possible to rearrange production so that the
benefits to gainers outweigh the costs to the
losers.
Monopoly is inefficient because it produces
where P>MC.
Consumers buy until the marginal benefit to
them equals price.
3. Efficiency, Antitrust, and
Network Externalities – cont.
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MC measures the marginal cost of the
resources used to produce another unit.
 Monopoly is costly to consumers and society
because it raises prices by the artificial
restriction of output to obtain the monopoly
price.
 Monopoly rent-seeking is the expenditure of
resources to gain monopoly rights from
government.
Campaign Finance and Monopoly Rent-Seeking
Example
3.1 Monopoly and
Antitrust
Historic monopolies are the controllers of raw
material (Alcoa Aluminum), and improved
innovation and technology (Kodak and IBM).
 The Sherman Antitrust Act of 1890 is the
cornerstone of U.S. antitrust policy. It
declared monopolies and the attempt to
create monopolies illegal.
The Department of Justice’s Case against
Microsoft Example
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3.2 Monopolies in the Long
Run
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Unlike competitive economic profits,
monopoly profits can persist for long periods.
In the U.S., it is difficult to find pure
monopolies because of actual or potential
substitutes and because absolute barriers to
entry are rarely present.
Exceptional monopoly profits have historically
promoted the development of closer
substitutes for the monopolist’s products.
(E.g. railroad and AT&T)
3.3 Monopolies and
Network Externalities
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The Internet and communications revolutions have
created a new type of monopoly based on network
externalities.
Network externalities exist when the act of joining
a network confers a benefit on all other members of
the network.
Examples are owners of fax machines, users of PCs
(use a common operating system and exchange files
easily), and users of cell phones with text messaging.
The greater the number of users, the more valuable
the network.
3.3 Monopolies and Network
Externalities – cont.
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Monopolies can be created when network
externalities exist because of the importance of
common standards. (VHS/Beta, or
Macintosh/Windows)
New entrants to the network will choose the common
standard, even if the alternative standard is in some
sense superior (e.g. the adoption of qwerty standard
for typewriters).
Network externalities explain some of today’s
monopolies, such as Microsoft Windows, the Intel
monopoly of microprocessors, and the monopoly of
word processing by MS Word.
4. Concentration Ratios
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The statistical tool commonly used to
measure the extend of competition is the
concentration ratio.
The x-firm concentration ratio is the
percentage of industry output, accounted for
by the largest x domestic firms in the
industry.
The higher the concentration ratio, the higher
the presumed degree of monopoly power in
that industry.
4. Concentration Ratios
– cont.
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Concentration ratios are an imperfect
measure of the extend of oligopoly or
monopoly for several reasons:
1.
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Some markets are worldwide, e.g. automobiles
and steel. (compare America with
Japanese/German cars)
It can give a false picture because of foreign
competition and the existence of substitutes.
It may conceal the churning forces of
competition. (Every x years the top four firms are
replaced by new upcoming firms)
4.1 Trends in
Concentration
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There is a widespread impression that
concentration has been increasing over time.
It has been created by erroneously equating
increases in the absolute size of firms with
increases in their market share.
The largest 100 American firms have
accounted for the same percentage of
manufacturing for almost a half-century.
4.1 Trends in
Concentration – cont.
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It is difficult to measure the degree of
monopolization of an entire economy
over time.
The most common measures suggest
the economy is not becoming more
monopolized.
The statistics, however, point to a
remarkable stability of concentration.