Chapter 25
Monopolistic Competition and Oligopoly
Key characteristics of Monopolistic Competition:
1.
Large number of sellers
– individual firms have relatively small market share
– no collusion
– independent action (i.e. not significant interdependence)
2.
Differentiated Products
– Product Attributes
– Service
– location
– Branding / Merchandising / significant advertising expenditures
 product differentiation provides some control over price
3.
Easy entry and exit
Monopolistic Competition:
Price and Output
The firm faces highly elastic demand.
• many rivals producing close substitutes
• product differentiation means
demand is not perfectly elastic
Short-run:
MR = MC maximizes profits (or minimizes losses)
Long-run:
the firm will tend to earn a normal profit only,
but no economic profits
• Easy entry/exit
Complicating factors (theory v. practice):
• Product differentiation can be strong (branding, location, etc.); some firms are able
to sustain long run profits
• Always some restriction to entry (e.g. start-up costs); economic profits may linger
into the long run
Monopolistic Competition and Economic Efficiency
Review:
Allocative efficiency: P = MC (at MC = D)
price = marginal cost
- the right amount of resources are allocated to the product
Productive efficiency: P = min. ATC (at ATC = D) price = minimum average total cost
- production occurs using the lowest cost combination of resources
MONOPOLISTIC COMPETITION IS NOT EFFICIENT:
Allocative Efficiency not achieved
• Long run P > MC
• consumers want additional units not being produced
Productive Efficiency not achieved
• although long run P = ATC at the given level of output, firms do not produce the
output that coincides with the lowest ATC
• costs associated with product differentiation (not incurred in pure competition)
Monopolistic Competition (cont.)
A producer may be able to postpone the long-run outcome of zero economic profit
- new product development, current product improvement, merchandising
Although the consumer pays a higher price in monopolistic competition (and the
producers don’t supply “enough”), one consumer benefit exists:
-- additional product choice (close but not exact substitutes)
The monopolistically competitive firm juggles three factors in seeking maximum profit.
• product attributes
• product price
• advertising
Theory v. Practice:
Every possible combination of price, product, and advertising
poses a different demand and cost situation for the individual firm.
The optimal combination cannot be easily predicted.
A monopolistically competitive firm uses trial and error to maximize profits.
#1. Explain how the entry of firms into its industry affects the demand curve facing a
monopolistic competitor and how that, in turn, affects its economic profit.
Economic profits attract competing firms to enter:
- putting downward pressure on prices
- decreasing the portion of market demand held by the individual firm.
This reduces economic profit for the individual firm.
http://www.youtube.com/watch?v=6c0VtOdibcI&feature=relmfu
Spurlock on branding/advertising
Oligopoly
Key characteristics:
• a “few” large producers
• differentiated or homogeneous product
• some monopoly power over price, but…
limited by mutual interdependence
• strong barriers to entry
 Economies of scale, initial costs of capital,
control/ownership of resources
Mergers may lead to and are prevalent in oligoply.
 increase monopoly power
Determining the Market Structure of an Industry
Concentration Ratio:
-- a measure of the total output produced in an industry by a given number of firms in
the industry.
-- a four firm concentration ratio is the most commonly used
-- a high concentration ratio is associated with less competition
Assume Industry A, with 10 producers that have market shares (%) of:
30%
23%
15%
10%
8%
6%
4%
2%
1%
1%
9%
8%
The four firm concentration ratio is: 78%
Assume Industry B, with 10 producers that have market shares (%) of:
12%
11%
10%
10%
10%
10%
10%
10%
The four firm concentration ratio is: 43%
Industry B appears much more competitive than Industry A.
0 – 50%: Industry ranges from perfect competition to oligopoly
50 – 80%: Industry is likely oligopoly
80 – 100%: Industry ranges from oligopoly to monopoly (or near monopoly).
Determining the Market Structure of an Industry
Herfindahl Index:
-- a measure of the size of firms in relation to the industry
-- an indicator of the amount of competition in an industry.
-- named after economist Orris C. Herfindahl
-- widely applied in competition law and antitrust inquiry
-- a relatively high Herfindahl Index is associated with low competition
-- defined
as the sum of the squares of the market shares of all the firms in the industry
Assume Industry A, with 10 producers that have market shares (%) of:
30%
23%
15%
10%
8%
6%
4%
2%
1%
1%
9%
8%
The Herfindahl Index is:
Assume Industry B, with 10 producers that have market shares (%) of:
12%
11%
10%
10%
10%
10%
10%
The Herfindahl Index is:
Industry B appears much more competitive than Industry A.
10%
Oligopoly & Game Theory
Dominant Strategy:
• No matter what the opponent does, a
strategy that earns a player a payoff
better than any other strategy.
• Does not mean player gets the best
possible payoff.
Nash Equilibrium:
- set of strategies, one for each player, such that
no player has incentive to unilaterally change his strategy
- does not mean either player gets the best possible payoff
- one example of equilibrium is if both players have a dominant strategy
- players are in Nash equilibrium if each one is making the best decision that he can,
taking into account the potential decisions of the other
Prisoner’s Dilemma:
- situation in which both players could improve the Equilibrium outcome by collusion
Price Fixing
http://www.youtube.com/watch?v=DPXTsPS-hyw
http://www.youtube.com/watch?v=u6VHDJ4x0sI
1. Does either firm have a dominant strategy?
2. Is there a Nash Equilibrium?
3. Can you predict a likely outcome (no collusion)?
4. Is it a Prisoner’s Dilemma game?
5. Is there an incentive for collusive strategy?
If so, what is the likely result of binding collusion?
Questions for each matrix:
1. Does either firm have a dominant strategy?
same prices
2. Is there a Nash Equilibrium?
3. Can you predict a likely outcome (no collusion)?
4. Is it a Prisoner’s Dilemma game?
5. Is there an incentive for collusive strategy?
If so, what is the likely result of binding collusion?
same
prices
lower
prices
lower prices
same prices lower prices
same
prices
lower
prices
Questions for each matrix:
1. Does either firm have a
dominant strategy?
airlines
both maintain fare
Coke & Pepsi
both advertise
McD’s & BK
No
2. Is there a Nash Equilibrium?
Yes; both
maintain fare
Yes; both
advertise
No
3. Can you predict a likely outcome
(no collusion)?
Yes; both
maintain fare
Yes; both
advertise
No
4. Is it a Prisoner’s Dilemma game?
Yes
No
No
5. Is there an incentive for collusive
strategy? If so, what is the likely
result of binding collusion?
Yes; both
raise fare
No
Perhaps
#1. How does monopolistic competition differ from pure competition?
Pure Competition
very large number of firms
standardized product
no control over price
no entry barriers
no non-price comp.
From pure monopoly?
Monopolistic Competition
Pure Monopoly
many firms
one firm
differentiated product Unique product; no close subs.
little control over price
Price maker
very small barriers to entry
Blocked entry
significant non-price comp.
little/no nonprice comp.
Explain fully what product differentiation involves.
Product differentiation – whether based on real or perceived differences – is what the
monopolistic competitor needs to gain some monopoly power in the market.
The real differences can be in quality, in services, in location, or in marketing.
To the extent that product differentiation exists in fact or in the mind of the consumer,
monopolistic competitors have some control over price, because they have built up
some loyalty to their brand.
#5. Critically evaluate and explain:
“In monopolistically competitive industries economic profits are competed away in
the long run; hence, there is no valid reason to criticize the performance and
efficiency of such industries.”
The first part of the statement is TRUE (theoretically) .
The second part of the statement is FALSE.
The inefficiency of monopolistic competition is not related to the profit level but to the
fact that the firms do not produce at the point of minimum ATC (not productively
efficient) and do not equate price and MC (not allocatively efficient).
This is an inevitable consequence of imperfect competition.
“In the long run monopolistic competition leads to a monopolistic price but not to
monopolistic profits.”
TRUE.
Competition of close substitutes tends to move price of the average firm down to
equality with ATC. Thus, there is no economic profit.
However, price is higher than in pure competition (and therefore “monopolistic”)
because while the P = ATC it does not equal minimum ATC.
#6. Why do oligopolies exist?
• economies of scale (automobiles, steel industry)
• ownership/control of resources (cigarettes, mining industries)
• Mergers (banking)
Worcester County National, Shawmut, Fleet, Banknorth, TD Banknorth, TD Bank
List five or six oligopolists whose products you own or regularly purchase.
Coca-Cola, Chrysler,
General Electric,
Whirlpool,
What distinguishes oligopoly from monopolistic competition?
Oligopoly
Monopolistic Competition
few firms
many firms
standard or diff. product
differentiated product
price-maker, but…
little control over price
strong entry barriers
very small barriers to entry
significant non-price comp significant non-price comp.
Sanford.
#7a. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent?
A four-firm concentration ratio states the percentage of sales that the largest four
firms in an industry generate.
A ratio of 60 percent means the largest four firms in the industry account for 60
percent of sales; a four-firm concentration ratio of 90 percent means the largest four
firms account for 90 percent of sales.
What are the shortcomings of concentration ratios as measures of monopoly power?
• definition of industry regarding geography (regional v. national v. international)
• do not account for inter-industry competition (theater v. ballpark… entertainment)
• do not reveal the dispersion of size among the top four firms.
#7b. Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10
percent of total industry sales. For the five firms in industry B the figures are 60, 25, 5, 5, and 5
percent. Calculate the Herfindahl index for each industry…
Herfindahl index for A:
302 + 302 + 202 + 102 + 102
900 + 900 + 400 + 100 + 100
2,400
Herfindahl index for B:
602 + 252 + 52 + 52 + 52
3,600 + 625 + 25 + 25 +25
4,300
…and compare their likely competitiveness.
Industry A would likely be more competitive than Industry B, where
one firm dominates and two firms control 85 percent of the market.
8. Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit
figures are in thousands. Use the payoff matrix to explain the mutual interdependence that
characterizes oligopolistic industries.
C and D are interdependent because their profits depend not just on their own
price, but also on the other firm’s price.
Assuming no collusion between C and D, what is the likely pricing outcome?
Both firms will set price at $35.
If either charged $40, it would be concerned the other would undercut the price
and its profit by charging $35. At $35 for both; C’s profit is $55,000, D’s, $58,000.
In view of your answer to 8b, explain why price
collusion is mutually profitable. Why might there be
a temptation to cheat on the collusive agreement?
Through price collusion—agreeing to
charge $40—each firm would achieve
higher profits (C = $57,000; D = $60,000).
Once both firms agree on $40, each sees
it can increase its profit even more by
secretly charging $35 while its rival
charges $40.
25-11
Why is there so much advertising in monopolistic competition and oligopoly?
Monopolistically competitive firms maintain economic profits through:
 product development and advertising.
(advertising will increase demand for the product… tastes and preferences)
The oligopolist would rather not compete on a basis of price.
Advertising can operate as a barrier to entry
How does such advertising help consumers and promote efficiency?
• Advertising provides information about new products and product improvements
to the consumer.
• Advertising may result in an increase in competition by promoting new products
and product improvements.
Why might it be excessive at times?
•
•
•
Advertising may result in manipulation and persuasion rather than information.
An increase in brand loyalty through advertising will increase the producer’s
monopoly power.
Excessive advertising may create barriers to entry into the industry … cycle of
advertising/profits/advertising
FTC:
http://www.youtube.com/watch?v=NssfPApe5iQ
Bagels price fixing:
http://www.youtube.com/watch?v=u6VHDJ4x0sI
Qantas price fixing:
http://www.youtube.com/watch?v=o_gnvHKoOX4
Prisoner’s dilemma:
http://www.youtube.com/watch?v=ED9gaAb2BEw
Dark Knight:
http://www.youtube.com/watch?v=TmUWRJInwhk&feature=related
Split/Steal:
http://www.youtube.com/watch?v=InDgRkn04xg