Chapter 6
IMPERFECT COMPETITION
Chapter in a Nutshell
1. Imperfect competition occurs when more than one seller competes for sales with other sellers,
each of which has some price-making ability. Imperfect competition includes the market
structures of monopolistic competition and oligopoly.
2. Economists have developed concentration ratios to tell how close an industry comes to the
extremes of competition and monopoly. A low concentration ratio suggests a high degree of
competition and a high concentration ratio implies a low degree of competition.
3. Monopolistic competition is characterized by a large number of sellers, each seller having a
relatively small share of the total market, relative freedom of entry into the market and exit
from the market, and product differentiation among sellers. Although monopolistically
competitive firms tend to earn zero economic profits in the long run, they suffer from the
problem of excess capacity.
4. The goal of persuasive advertising is to shift a firm’s demand curve to the right and make it
less sensitive to price changes. Advertising is informative when it provides trustworthy
information about the quality and price of a good or service or the location of suppliers. By
informing potential customers about alternative sources of supply and pricing policies,
advertising forces sellers to maintain low prices.
5. Price discrimination is the practice of charging some customers a lower price than others for
an identical good or service even though there is no difference in the cost to the firm of
supplying these consumers. A firm practicing price discrimination will charge a lower price
to buyers with more elastic demand and a higher price to buyers with less elastic demand.
6. In oligopoly, a small number of firms compete with each other and each firm has significant
price-making ability. Oligopolistic markets are characterized by high barriers to entry,
economies of scale, and mergers. Uncertainty about the interaction of competing firms in
oligopoly makes it virtually impossible to formulate a single theory of oligopoly behavior.
However, game theory can be used to illustrate the mutual interdependence of firms in
oligopolistic markets.
7. Oligopolies are characterized by horizontal mergers, vertical mergers, and conglomerate
mergers. Of these three types of mergers, government regulators monitor proposed
horizontal mergers most closely. The reason is that horizontal mergers can result in the
uniting of formerly competing firms, thus increasing the monopoly power of the newly
formed firm.
8. Government regulators are not necessarily the only force keeping an oligopolist in check.
The threat of potential competition can also serve as an incentive for an oligopolist to produce
a high quality product and sell it at a “competitive” price to consumers.
Chapter Objectives
After reading this chapter, you should be able to:
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Chapter 6: Imperfect Competition
1. Distinguish between monopolistic competition and oligopoly.
2. Identify the goals and effects of advertising.
3. Explain how a seller successfully practices price discrimination.
4. Discuss the major theories of oligopolistic behavior.
5. Distinguish between a horizontal merger, a vertical merger, and a conglomerate merger.
6. Explain how the threat of potential competition encourages firms to produce a high quality
product and sell it at a reasonable price to consumers.
Knowledge Check
Key Concept Quiz
1. concentration ratios
2. monopolistic competition
_____ a the market structure closest to perfect competition
4. excess capacity
_____ b the difference between the output corresponding to
minimum average total cost and the output
produced by a monopolistically competitive firm
in the long run
5. price discrimination
_____ c. a form of imperfect competition
6. oligopoly
_____ d. a form of collusion
7. game theory
_____ e. a market characterized by free entry and exit
8. cartel
_____ f. provides an explanation for oligopolistic behavior
9. horizontal merger
_____ g. the practice of charging some customers a lower
price than others for an identical product
3. product differentiation
10. contestable market
_____ h. tell us how close an industry comes to the
extremes of perfect competition and monopoly
____ i.
is a fundamental characteristic of monopolistic
competition
_____ j. when two firms selling similar products merge
Multiple Choice Questions
1. When markets are imperfectly competitive
a. there is usually only one seller in a market
Chapter 6: Imperfect Competition
59
b. firms have some price-making ability
c. firms behave exactly like monopolists
d. firms always behave like oligopolists
2. Concentration ratios typically refer to
a.
b.
c.
d.
top four firms in an industry
top two firms in an industry
top five firms in an industry
top 100 firms in an industry
3. Monopolistically competitive markets are characterized by
a.
b.
c.
d.
low concentration ratios
high concentration ratios
zero concentration ratios
marginal concentration ratios
4. Product differentiation is a fundamental characteristic of
a.
b.
c.
d.
monopolistic competition
monopoly
oligopoly
perfect competition
5. If an online grocery company, Homegrocer.com of Seattle, is operating in a monopolistically
competitive market and decides to raise prices it will
a.
b.
c.
d.
lose a relatively large share of its market
lose a small share of its sales
not lose any sales
lose all of its sales
6. The changes in the price of gas at a local Chevron station closely follow the changes in gas
prices at the BP station down the road. This implies that these gas stations are operating in
a.
b.
c.
d.
an oligopolistic market
a perfectly competitive market
a monopolistically competitive market
a monopolistic market
7. Choice in a monopolistically competitive market involves a tradeoff in the form of
a.
b.
c.
d.
excess capacity
better quality products
better quality service
chronic shortages
8. If Oral Best sells toothbrushes in a monopolistically competitive industry, then in the long
run, Oral Best will earn
a. zero economic profit
b. positive economic profits
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Chapter 6: Imperfect Competition
c. negative economic profits
d. super-normal profits
9. Persuasive advertising by Starbucks will make the demand for Starbucks’ mochas
a.
b.
c.
d.
more elastic
less elastic
perfectly elastic
perfectly inelastic
10. If Starbucks’ advertising campaign is countered by an equally effective campaign by Seattle’s
Best Coffee, such that the market share of each firm remains unchanged, one can conclude
that
a.
b.
c.
d.
the average total cost of Starbucks has increased
the average total cost of Seattle’s Best Coffee has shifted upwards
the consumer now faces a higher price
all of the above
11. If MCI, AT&T and SPRINT engage in price discrimination, they are likely to charge
a.
b.
c.
d.
a higher price to consumers with inelastic demand curves
a higher price to consumers with elastic demand
a lower price to consumers with inelastic demand curves
the lowest possible prices
12. All of the following reasons may allow for an oligopolistic market to emerge except
a.
b.
c.
d.
barriers to entry
economies of scale
mergers
price-taking behavior
13. If the Grand Central movie theater practices successful price discrimination, it will charge
a.
b.
c.
d.
the same price to all customers regardless of their elasticities of demand
different prices to various customers regardless of their elasticities of demand
higher prices to customers with more elastic demand schedules
higher prices to customers with more inelastic demand schedules
14. A high concentration ratio in an industry suggests that
a.
b.
c.
d.
the industry is perfectly competitive
the industry is monopolistically competitive
the dominant firms in the industry have negligible price-making ability
the dominant firms in the industry have substantial price-making ability
15. Suppose that Hal’s Texaco is a retailer of gasoline in a monopolistically competitive market.
In the long run, the firm will
a.
b.
c.
d.
realize substantial economic profits
provide the amount of output that minimizes average total cost
provide less than the amount of output that minimizes average total cost
have a demand curve that is perfectly inelastic
Chapter 6: Imperfect Competition
61
16. If Boeing is the only firm in a “contestable” market for commercial jetliners,
a. Boeing cannot behave as though it is a monopoly even though it is the only firm in the
market
b. as a single firm in the market, Boeing can behave as a monopoly
c. the potential entry of new firms enhances the monopoly power of Boeing
d. the potential entry of new firms has no effect on the monopoly power of Boeing
17. Boeing and Airbus compete for sales of commercial jetliners in a (an) _____market.
a.
b.
c.
d.
perfectly competitive
monopolistic
oligopolistic
monopolistically competitive
18. If the Top 4 concentration ratio equals 85 percent, the market is likely to be
a.
b.
c.
d.
monopolistic
oligopolistic
monopolistically competitive
perfectly competitive
19. In the long run, firms in a monopolistically competitive industry tend to suffer from
a.
b.
c.
d.
economic losses
excess capacity
dealing with strong labor unions
governmental price ceilings applied to their products
20. For Coca-Cola Company, successful advertising would have the effect of
a.
b.
c.
d.
21.
Because an oligopolistic market consists of a relatively small number of firms, they
a.
b.
c.
d.
22.
shifting the demand for Coke rightward and making it less elastic
shifting the demand for Coke rightward and making it more elastic
shifting the demand for Coke leftward and making it less elastic
shifting the demand for Coke leftward and making it more elastic
are mutually interdependent
have the incentive to earn only normal profits
operate similar to perfectly competitive firms
tend to operate at the low points on their average total cost curves
A merger between two competing steel companies is a
a.
b.
c.
d.
conglomerate merger
vertical merger
horizontal merger
inflationary merger
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Chapter 6: Imperfect Competition
True-False Questions
1.
T
F
Both monopolistically competitive markets and perfectly competitive
markets are characterized by price-taking behavior.
2.
T
F
Vertical mergers are monitored most closely by government regulators.
3.
T
F
An oligopolist has significant price-making ability.
4.
T
F
A monopolistically competitive firm has limited price-making ability.
5.
T
F
A price discriminating firm always charges higher prices to the
customers who have highly inelastic demand curves.
6.
T
F
Persuasive advertising makes a firm’s demand curve more elastic.
7.
T
F
Monopolistically competitive firms behave like monopolies in the long
run.
8.
T
F
Monopolistically competitive firms can earn positive economic profits in
the long run.
9.
T
F
In a monopolistically competitive market, there are relatively few sellers.
10.
T
F
Monopolistically competitive markets are characterized by product
differentiation.
11.
T
F
Game theory illustrates the mutual independence of firms.
12.
T
F
Contestable markets are ones that are susceptible to potential
competition.
13.
T
F
If Microsoft argues that it is operating in a contestable market, it may be
arguing that there area significant barriers to entry in this market.
14.
T
F
Cartels are likely to reduce output below the competitive level.
15.
T
F
Cartels are more susceptible to cheating if firms face identical costs.
16.
T
F
A monopolistically competitive firm produces more output than a
competitive firm, and this excess is known as excess capacity.
17.
T
F
A high concentration ratio implies that the industry is operating in a
perfectly competitive market.
18.
T
F
Oligopoly involves a considerable dose of competition and a small dose
of monopoly.
19.
T
F
Experience shows that cartels are quite easy to form and operate.
20.
T
F
Grocery stores in large cities likely provide an example of oligopoly.
21.
T
F
Farming and commercial fishing provide good examples of oligopoly.
22.
T
F
The acquisition of Cleveland Iron Ore Co. by U.S. Steel Co. represents a
conglomerate merger.
Chapter 6: Imperfect Competition
63
23.
T
F
When Delta Airlines charges different coach fares to different travels on
a flight from Seattle to Chicago, it engages in price discrimination.
24.
T
F
When Hollywood Video and Blockbuster Video entered the market for
rental videos, they became perfectly competitive firms.
25.
T
F
If the four largest firms control 75 percent of a market, they are regarded
as monopolistically competitive sellers.
Application Questions
1. Suppose you are the chief executive officer for the major U.S. brewing company, Soma. At
the annual Brewers Association Meetings held in Seattle, you and your fellow CEOs from
other brewing companies decide (secretly, of course) to collude on price and to allocate
shares of the market between firms. Suppose that the price is set at $30 per barrel of beer and
your share of the market is set at two million barrels per year. The demand, marginal
revenue, average total cost, and marginal cost curves for Soma are shown in the graph below.
40
MC
ATC
Price ($/barrel)
30
AT
20
Soma’s
Demand
10
MR
2
4
6
8
Quantity (millions of barrels)
Will Soma make a profit under the cartel agreement? If so, how much profit? Identify the
area of profit on the graph.
2. In the scenario presented in question 1, does Soma have an incentive to cheat on the
agreement? Why or why not? Use a graph to justify your answer.
Answers to Knowledge Check Questions
Key Concept Answers
1. i
6. c
2. a
7. g
64
3. j
4. b
5. h
Chapter 6: Imperfect Competition
8. e
9. l
10. f
Multiple Choice Answers
1. b
6. c
2. a
7. a
3. a
8. a
4. a
9. b
5. a
10. d
11.
12.
13.
14.
15.
True-False Answers
1. F
6. F
2. F
7. F
3. T
8. F
4. T
9. F
5. T
10. T
11.
12.
13.
14.
15.
Application Question Answers
a
d
d
d
c
T
T
F
T
F
16.
17.
18.
19.
20.
16.
17.
18.
19.
20.
a
c
b
b
a
F
F
F
F
F
21.
22.
21.
22.
23.
24.
25.
a
c
F
F
T
F
F
Chapter 6: Imperfect Competition
1.
65
Soma will make a profit under the cartel agreement. The area of profit under the cartel
agreement is shown in the graph by the heavy-lined rectangle. The profit is ($30 - $10) x
2 million barrels = $40 million.
40
MC
ATC
Price ($/barrel)
30
20
Soma’s
Demand
10
MR
2
4
6
8
Quantity (millions of barrels)
Soma has an incentive to cheat because the profit maximizing level of output is 4 million
barrels—MR = MC at 4 million barrels. Soma’s profits could be ($30 - $12) x 4 million
barrels = $72 million. The profit is shown below as the area inside the heavy-lined
rectangle.
40
MC
ATC
30
Price ($/barrel)
2.
20
Soma’s
Demand
10
MR
2
4
6
8
Quantity (millions of barrels)