Chapter 12:
Monopolistic
Competition,
Oligopoly, and
Strategic Pricing
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Introduction

Market structure is the focus of real-world
competition.

Market structure refers to the physical
characteristics of the market within which
firms interact.
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2
Introduction

Market structure involves the number of firms
in the market and the barriers to entry.
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3
Introduction

Perfect competition, with an infinite number of
firms, and monopoly, with a single firm, are
polar opposites.

Monopolistic competition and oligopoly lie
between these two extremes.
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4
Introduction

Monopolistic competition is a market
structure in which there are many firms
selling differentiated products.

There are few barriers to entry.
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5
Introduction

Oligopoly is a market structure in which
there are a few interdependent firms.

There are often significant barriers to entry.
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6
Defining a Market

Defining a market has problems:

What is an industry and what is its
geographic market?


Local, national, or international?
What products are to be included in the
definition of an industry?
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7
Classifying Industries

One of the ways in which economists classify
markets is by cross-price elasticities.

Cross-price elasticity measures the
responsiveness of the change in demand for
a good to change in the price of a related
good.
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8
Classifying Industries

Industries are classified by government using
the North American Industry Classification
System (NAICS).

The North American Industry
Classification System (NAICS) is a
classification system of industries adopted by
Canada, Mexico, and the U.S. in 1997.
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9
Classifying Industries

Under the NAICS, all firms are placed into 20
broadly defined two-digit sectors.

Two-digit sectors are further subdivided into
three-digit subsectors, four-digit industry
groupings, five-digit industries and six-digit
national industry groupings.
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10
Classifying Industries

When economists talk about industry
structure the general practice is to refer to
three-digit industries.


Under the NAICS, a two-digit industry is a broadly
based industry.
A three-digit industry is a specific type of industry
within a broadly defined two-digit industry.
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11
Classifying Industries
Two-Digit Sectors
Three-Digit Subsectors
44-45 Retail trade
48-49 Transportation
and warehousing
51 Information
513 Broadcasting and
telecommunications
52 Finance and
Insurance
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12
Determining Industry Structure

Economists use one of two methods to
measure industry structure:

The concentration ratio.

The Herfindahl index.
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13
Concentration Ratio

The concentration ratio is the percentage of
industry sales by the top few firms.
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14
Concentration Ratio

The most commonly used concentration ratio
is the four-firm concentration ratio, the CR4.

The higher the ratio, the closer to an
oligopolistic or monopolistic type of market
structure.
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15
Herfindahl Index

The Herfindahl index is an index of market
concentration calculated by adding the
squared values of the individual market
shares of all the firms in the industry.
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16
Herfindahl Index

Two advantages of the Herfindahl index is
that it takes into account all firms in an
industry, and that it gives extra weight to a
single firm that has an especially large
market share.
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17
Herfindahl Index

The Herfindahl Index is important because it
is used as a rule of thumb in determining
whether an industry is sufficiently competitive
to allow a merger between two large firms in
the industry.

If the index is less than 1,000, the industry is
considered to be sufficiently competitive.
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18
Conglomerate Firms and Bigness

Neither the four-firm concentration ratio nor
the Herfindahl index gives a complete picture
of corporations’ bigness.

This is because many firms are
conglomerates.
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19
Conglomerate Firms and Bigness

Conglomerates are huge corporations
whose activities span various unrelated
industries.
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20
Importance of Industry Structure

The less concentrated industries are more
likely to resemble perfectly competitive
markets.
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21
Importance of Industry Structure

The number of firms in an industry plays an
important role in determining whether firms
explicitly take other firms’ actions into
account.

Oligopolies take into account the reactions of
other firms; monopolistic competitors do not.
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22
Importance of Industry Structure

In monopolistic competition, there are so
many firms that firms do not take into account
their rivals’ responses to their decisions.

Collusion is difficult due to a large number of
firms.
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23
Importance of Industry Structure

In oligopoly, with fewer firms, each firm is
more likely to engage in strategic decision
making.

Strategic decision making – taking explicit
account of a rival’s expected response to a
decision you are making.
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24
Monopolistic Competition

The four distinguishing characteristics of
monopolistic competition are:

Many sellers.

Differentiated products.

Multiple dimensions of competition.

Easy entry of new firms in the long run.
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25
Many Sellers

There are many sellers in monopolistic
competition, but each of them is able to
identify its own small market segment.

Monopolistically competitive firms act
independently of their rivals.

The existence of many sellers also makes
collusion difficult.
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26
Differentiated Products

The “many sellers” characteristic gives
monopolistic competition its competitive
aspect.

Product differentiation gives monopolistic
competition its monopolistic aspect.

Competitors produce many close substitutes.
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27
Differentiated Products

Differentiation may be based on real
differences in product characteristics, or can
be based on consumers’ perceptions about
product differences.

Generally, monopolistic competition is
characterized by significant expenditures on
advertising, which acts as an important barrier
to entry.
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28
Differentiated Products

Differentiation exists so long as advertising
convinces buyers that it exists.

Firms will continue to advertise as long as the
marginal benefits of advertising exceed its
marginal costs.
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29
Differentiated Products

Any industry where brand proliferation is
present is likely to be monopolistically
competitive.

Some examples are soap, jeans, cookies and
games.
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30
Multiple Dimensions of Competition

Competition takes many forms in a
monopolistically competitive industry:

Product differentiation.

Perceived quality.

Competitive advertising.

Service and distribution outlets.
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31
Easy Entry

The existence of economic profits induces
other firms to enter, bringing long-run profit
down to zero.
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32
Output, Price, and Profit

A monopolistically competitive firm produces
in the same manner as a monopolist—to
maximize profit, it chooses the quantity where
MC = MR.

Having determined output, the firm will
charge what consumers are willing to pay
(determined by the demand curve).
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33
Output, Price, and Profit

If price exceeds ATC, the firm will earn
positive economic profits.

These profits attract entry.

Some customers of the existing firms switch
to become customers of the new firm.
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34
Output, Price, and Profit

Entry causes the existing firms’ demand
curve to shift left (decrease) as they lose
customers.

Competition, therefore, implies zero
economic profit in the long run.
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35
Output, Price, and Profit

At the long-run equilibrium, ATC equals price
and economic profits are zero.

This occurs at the point of tangency of the
ATC and demand curve at the output chosen
by the firm.
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36
Monopolistic Competition: Short Run
Price
P1
C1
MC

MR
0
Q1
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D1
Quantity
37
Monopolistic Competition: Short Run
Price
MC
P1
P2
C2
C1
0
Q2 Q1
MR1
D2
D1
Quantity
MR2
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38
Monopolistic Competition: Long Run
Price
MC
P1
P2
P3 =C3
C2
C1
ATC3
ATC2
MR2
MR3
0
Q3
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D2
D3
Quantity
39
Comparing Monopolistic Competition
and Perfect Competition

Both the monopolistic competitor and the
perfect competitor make zero economic profit
in the long run.
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40
Comparing Monopolistic Competition
and Perfect Competition

The perfect competitor’s demand curve is
perfectly elastic.

Zero economic profit means that it produces
at the minimum of the ATC curve.
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41
Comparing Monopolistic Competition
and Perfect Competition

A monopolistic competitor faces a downward
sloping demand curve, and produces where
MC = MR, not where MC = P.

The ATC curve is tangent to the demand
curve at that level, which is not at the
minimum point of the ATC curve.
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42
Comparing Monopolistic Competition
and Perfect Competition

A monopolistic competitor produces less than
a perfect competitor.
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43
Comparing Monopolistic Competition
and Perfect Competition
Perfect Competition
Price
Price
MC
ATC
D
PC
0
Monopolistic Competition
QC
Quantity
MC
ATC
PM
PC
0
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QM
MR
D
QC Quantity
44
Excess Capacity

The Excess Capacity theorem indicates
that a monopolistically competitive firm will
have excess capacity in long-run equilibrium.

It occurs because of product differentiation.
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45
Monopolistic Competition and
Advertising

Firms in a perfectly competitive market have
no incentive to advertise

Monopolistic competitors have a strong
incentive to do so.
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46
Monopolistic Competition and
Advertising

The goals of advertising are to increase
demand for the firm’s product and to increase
customer loyalty to the product.

The firm’s demand increases, and becomes
more inelastic.
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47
Monopolistic Competition and
Advertising

Advertising shifts the demand curve to the
right, and it increases firm’s costs, shifting the
ATC up.
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48
Does Advertising Help or Hurt
Society?

There is a sense of trust in buying brands we
know.

If consumers are willing to pay for
“differentness,” it’s a benefit to them.
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49
Comparing Monopolistic Competition
and Monopoly

It is possible for the monopolist to make
economic profit in the long-run.

No long-run economic profit is possible in
monopolistic competition.
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50
Characteristics of Oligopoly

Oligopolies are made up of a small number of
very large firms.

Products may be homogeneous or
differentiated

Firms are mutually interdependent.

Each firm must take into account the
expected reaction of other firms.
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51
Models of Oligopoly Behaviour

No single general model of oligopoly
behaviour exists because each oligopolistic
industry is different.

Two models of oligopoly behaviour are the
cartel model and the contestable market
model.
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52
Models of Oligopoly Behaviour

In the cartel model, an oligopoly sets a
monopoly price.

In the contestable market model, an oligopoly
with no barriers to entry sets a competitive
price.
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53
Cartel Model

A cartel is a combination of firms that acts as
it were a single firm.

A cartel is a shared monopoly.

In the cartel model, an oligopoly sets a
monopoly price.
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54
Cartel Model

If oligopolies can limit entry, they have a
strong incentive to collude.

To collude is to get together with other firms
to set price or allocate market share.
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55
Cartel Model

In the cartel model of oligopoly,

Oligopolies act as if they were monopolists

That have assigned output quotas to individual
member firms

So that total output is consistent with joint profit
maximization.
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56
Implicit Price Collusion

Formal collusion is illegal in Canada, but
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.
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57
Implicit Price Collusion

Sometimes the largest or most dominant firm
takes the lead in setting prices and the others
follow.
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58
Cartels and Technological Change

Cartels can be destroyed by an outsider with
technological superiority.

Thus, cartels with high profits will provide
incentives for significant technological
change.
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59
Why Are Prices Sticky?

Sticky prices are prices that don’t change
very much.

Informal collusion is an important reason why
prices are sticky.

Another is the kinked demand curve.
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60
Kinked Demand Curve Model of
Oligopoly

Firms have expectations about how the other
firms in the industry will behave.

A firm’s assumptions about the other firm’s
behaviour creates the kink in the demand
curve.
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61
Kinked Demand Curve Model

Assumption 1:
If a firm raises its price, no other firms will
raise their prices.

This make the firm’s own demand curve very
elastic.
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62
Kinked Demand Curve Model

Assumption 2:
If a firm lowers its price, all the other firms will
lower their prices too.

This make the firm’s own demand curve very
inelastic.
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63
Kinked Demand Curve Model

When there is a kink in the demand curve,
there has to be a gap in the marginal revenue
curve.

The kinked demand curve is not a theory of
oligopoly but a theory of sticky prices.
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64
Kinked Demand Curve Model
No-one follows a price increase.
Price
a
P
b
MC0
c
MC1
Q
D1
MR1
d
0
All firms lower price.
MR2
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D2
Quantity
65
Kinked Demand Curve Model

If a firm’s MC curve crosses MR in the
vertical portion between c and d, it will
produce the quantity Q and charge a price
equal to P.
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66
Kinked Demand Curve Model

A high-cost firm and a low-cost firm will both
produce the same quantity and charge the
same price.

If a firm’s costs decrease, consumers will not
see any change.


Price will not decrease.
The firm’s profits will increase.
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67
Contestable Market Model

According to the contestable market model,
barriers to entry and barriers to exit
determine a firm’s price and output decisions.

Even if the industry contains a very small number
of firms, it could still be a competitive market if
entry is open.
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68
Contestable Market Model

In the contestable market model, an oligopoly
with no barriers to entry sets a competitive
price.
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69
Comparing the Contestable Market
and Cartel Models

The stronger the ability of oligopolists to
collude and prevent market entry, the closer it
is to a monopolistic situation.

The weaker the ability to collude is, the more
competitive it is.

Oligopoly markets lie between these two
extremes.
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70
Strategic Pricing and Oligopoly

Both the cartel and contestable market
models use strategic pricing decisions –
firms set their prices based on the expected
reactions of other firms.
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71
New Entry Limits Cartelization

Creation of cartels is limited by threat of
outside competition.

In many industries the outside competition
comes from international firms.

For a cartel with few barriers to entry, the
long run demand curve is very elastic.
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72
Price Wars

Price wars are the result of strategic pricing
decisions breaking down.
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73
Price Wars

A firm may develop predatory pricing
strategy, which involves temporarily pushing
the price down below cost in order to drive a
competitor out of business.
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74
Game Theory and Strategic Decision
Making

Most oligopolistic strategic decision making is
carried out with explicit or implicit use of
game theory.

Game theory is the application of economic
principles to interdependent situations.
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75
Game Theory and Strategic Decision
Making

The prisoner’s dilemma is a well-known
game that demonstrates the difficulty of
cooperative behaviour in certain
circumstances.
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76
Game Theory and Strategic Decision
Making

In the prisoner’s dilemma, it’s mutual trust
that gets each one out of the dilemma,
however, confessing is the rational choice.
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77
Prisoner’s Dilemma and Duopoly

The prisoners dilemma has its simplest
application when the oligopoly consists of
only two firms—a duopoly.
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78
Prisoner’s Dilemma and Duopoly

By analyzing the strategies of both firms
under all situations, all possibilities are placed
in a payoff matrix.

A payoff matrix is a box that contains the
outcomes of a strategic game under various
circumstances.
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79
Cooperative Equilibrium
MC ATC
$800
700
700
600
600
500
500
Price
575
Price
$800
400
300
D
100
100
2
3
4
5
6
7
8
Competitive
solution
300
200
1
0
MR
1
2
Quantity (in thousands)
(a) Firm's cost curves
MC
400
200
0
Monopolist
solution
3
4
5
6
7
8
9 10 11
Quantity (in thousands)
(b) Industry: Competitive and monopolist solution
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80
One Firm Cheats
$900
$800
$800
800
700
700
700
600
550
500
600
550
500
600
550
500
400
300
A
400
Price
A
Price
Price
MC ATC
MC ATC
300
200
200
100
100
100
1
2 3 4
5 6 7
Quantity (in thousands)
(a) Noncheating firm’s loss
0
1
2 3 4
5
6 7
Quantity (in thousands)
(b) Cheating firm’s profit
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B
A
NonCheating
400 cheating
firm’s
firm’s
output
300 output
200
0
C
0
1
2 3
4 5 6
7 8
Quantity (in thousands)
(c) Cheating solution
81
Duopoly and a Payoff Matrix

The duopoly is a variation of the prisoner's
dilemma game.

The results can be presented in a payoff
matrix that captures the essence of the
prisoner's dilemma.
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82
Payoff Matrix
A Does not cheat
A Cheats
A +$200,000
A $75,000
B Does not
cheat
B $75,000
B – $75,000
A – $75,000
A $0
B Cheats
B +$200,000
B $0
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83
Payoff Matrix

If both firms cooperate, they can both get
higher profits.


$75,000 each.
However, both firms have an incentive to
cheat on their agreement.

$200,000 for the one that cheats.
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84
Payoff Matrix

A dominant strategy is one which always
yields the highest payoff, no matter what the
other player does.

The dominant strategy is to not cooperate.

i.e. to cheat.
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85
Payoff Matrix

If both firms choose to cheat on their
agreement, the outcome will be a Nash
equilibrium, a non-cooperative equilibrium in
which no player can achieve a better
outcome by switching strategies, given the
strategy of the other player.
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86
Oligopoly, Structure, and Performance

Oligopoly models are based either on
structure or performance.

The four types of markets considered so far are
based on market structure.

Structure means the number, size, and
interrelationship of firms in the industry.
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87
Oligopoly, Structure, and Performance

A monopoly is the least competitive, while
perfectly competitive industries are the most
competitive.
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88
Oligopoly, Structure, and Performance

The contestable market model gives less
weight to market structure.

Markets are judged by performance, not
structure.
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89
Oligopoly, Structure, and Performance

Performance includes:

ratio of price to marginal cost
output
allocative and productive efficiency
product variety
innovation rate
profits





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90
Oligopoly, Structure, and Performance

There is a similarity in the two approaches.

Often barriers to entry are the reason there
are only a few firms in an industry.

When there are many firms, that suggests
that there are few barriers to entry.

In the majority of cases, the two approaches
come to the same conclusion.
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Monopolistic Competition,
Oligopoly, and Strategic
Pricing
End of Chapter 12
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