Chapter 11
MONOPOLISTIC COMPETITION
AND OLIGOPOLY
WHAT IS MONOPOLISTIC COMPETITION?
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Monopolistic competition is a market structure in which:
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There are a large number of firms
The products produced by the different firms are differentiated
Entry and exit occur easily
Product differentiation implies that the products are different enough that
the producing firms exercise a “mini-monopoly” over their product.
The firms compete more on product differentiation than on price.
Entering firms produce close substitutes, not an identical or standardized
product.
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A MONOPOLISTICALLY COMPETITIVE FIRM:
ABOVE NORMAL PROFIT
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A MONOPOLISTICALLY COMPETITIVE FIRM:
NORMAL PROFIT
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A MONOPOLISTICALLY COMPETITIVE FIRM:
ECONOMIC LOSS
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ENTRY AND NORMAL PROFIT
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PERFECT COMPETITION AND
MONOPOLISTIC COMPETITION COMPARED
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NONPRICE COMPETITION
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The firm attempts to establish its product as a different product
from that offered by its rivals.
Differentiation means that in the consumer’s mind, the product
is not the same. Marketing is often the key to successful
differentiation.
Firms may differentiate products by perceived quality, reliability,
color, style, safety features, packaging, purchase terms,
warranties and guarantees, location, availability (hours of
operation) or any other features.
Brand names may signal information regarding the product,
reducing consumer risk.
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ADVERTISING, PRICES, AND PROFITS
Product differentiation
reduces the price
elasticity of demand,
which appears as a
steeper demand
curve.
Successful product
differentiation enables
the firm to charge a
higher price.
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LOCATION UNDER
MONOPOLISTIC COMPETITION
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OLIGOPOLY
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An oligopoly is a market structure characterized by:
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Few firms
Either standardized or differentiated products
Difficult entry
All the firms may be the same size, or a few large firms may
dominate the industry while coexisting with several small firms.
A key characteristic of oligopolies is that each firm can affect
the market, making each firm’s choices dependent on the
choices of the other firms. They are interdependent.
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MEASURING CONCENTRATION:
THE DISTINGUISHING FACTOR FOR OLIGOPOLY
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A concentration ratio gives the percentage of all sales in a
market that are accounted for by a specified number of firms in
that market.
The most commonly used such ratio is the four-firm
concentration ratio, which shows the combined market share
of the top four firms as a percent of sales in the market as a
whole.
The Herfindahl-Hirschmann index (HHI) is calculated by
squaring the percentage market shares of each firm in the
market and summing the squares.
For an industry with n competing firms, the formula is
H = p 12 + p 22 + . . . + p n2
THE KINKED DEMAND CURVE
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INTERDEPENDENCE
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The importance of interdependence is that it leads to strategic
behavior.
Strategic behavior is the behavior that occurs when what is
best for A depends upon what B does, and what is best for B
depends upon what A does.
Such behavior has been analyzed using the mathematical
techniques of game theory.
Game theory provides a description of oligopolistic behavior as
a series of strategic moves and countermoves.
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GAME THEORY:
PRISONER’S DILEMMA
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Considers two actors (prisoners, firms,
competitors), each trying to achieve a dominant
strategy—a strategy that produces better
results no matter what strategy the opposing
firm follows.
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GAME
THEORY
Dominant Strategy: Both Confess
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GAME THEORY:
PRISONER’S DILEMMA
Dominant Strategy: Both Advertize
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GAME
THEORY:
PRISONER’S
DILEMMA
Dominant Strategy:
Both Cheat
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COOPERATION AND CARTELS
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If the firms in an oligopoly cooperate, they may earn more
profits than if they act independently.
Collusion, which leads to secret cooperative agreements, is
illegal in the U.S., although it is legal and acceptable in many
other countries.
Price-Leadership Cartels may form in which firms simply do
whatever a single leading firm in the industry does. This avoids
strategic behavior and requires no illegal collusion.
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CARTELS
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A cartel is an organization of independent firms whose purpose
is to control and limit production and maintain or increase
prices and profits.
Like collusion, cartels are illegal in the United States.
Conditions necessary for a cartel to be stable (maintainable):
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There are few firms in the industry.
There are significant barriers to entry.
An identical product is produced.
There are few opportunities to keep actions secret.
There are no legal barriers to sharing agreements.
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OPEC AS AN EXAMPLE OF A CARTEL
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OPEC: Organization of Petroleum Exporting Countries.
Attempts to set prices high enough to earn member countries
significant profits, but not so high as to encourage dramatic
increases in oil exploration or the pursuit of alternative energy
sources.
Controls prices by setting production quotas for member
countries.
Such cartels are difficult to sustain because members have
large incentives to cheat, exceeding their quotas.
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FACILITATING PRACTICES:
OLIGOPOLISTIC COLLUSION
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Facilitating practices are actions by oligopolistic firms
that can contribute to cooperation and collusion even
thought the firms do not formally agree to cooperate.
For example:
 cost-plus/mark-up pricing can lead to similar or
identical pricing behavior
 most-favored customer policies lead to prices
remaining higher than they would otherwise.
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FACILITATING PRACTICES
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Cost-plus or mark-up pricing is a pricing policy whereby a firm
computes its average costs of producing a product and then
sets the price at some percentage above this cost.
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Most-favored customer: a consumer who is guaranteed the
best price and any improvements in features for a period of
time. This practice creates a disincentive for producers to
lower prices even in the face of flagging demand.
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MORE STRATEGIES
TO ENCOURAGE COOPERATION (COLLUSION)
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Tit-for-Tat: A strategy for ongoing interaction where
one player (firm) follows the other firm’s play from the
previous round. You cheat this time, I cheat next time.
…
Trigger: Strategy where one player threatens to defect
on the collaboration for an extended period if the
other player defects once.
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BEHAVIOR OF A CARTEL:
FIRMS AGREE TO ACT AS A MONOPOLIST
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BEHAVIOR OF A CARTEL:
FIRMS ACT ALONE
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