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CHAPTER 26 & 27
MONOPOLISTIC COMPETITION, OLIGOPOLY, AND STRATEGIC
BEHAVIOR
CHAPTER OVERVIEW
In these chapters the models of monopolistic competition
and oligopoly are discussed. The key terms for each model are
defined, the major attributes of each are discussed, the profitmaximizing rate of output and long-run implications for efficiency with the perfect competition model are analyzed. The
purpose and effect of advertising, an important characteristic
of these models, is also discussed. The existence of widespread
economies of scale in certain industries is suggested as a
possible explanation of oligopoly and the concept of the
concentration ratio is introduced. Strategic behavior under
oligopolistic conditions along with game theory is introduced.
The ways oligopolists deter entry by potential competitors is
analyzed. Finally, the various market structures are compared.
CHAPTER OBJECTIVES
After studying this chapter students should be able to
1.
Discuss the key characteristics of a
monopolistically competitive industry.
2.
Contrast the output and pricing decisions of
monopolistically competitive firms with those of
perfectly competitive firms.
3.
Outline the fundamental characteristics of
oligopoly.
4.
Understand how to apply game theory to evaluate
the pricing strategies of oligopolistic firms.
5.
Explain the kinked demand theory of oligopolistic
price rigidity.
6.
Describe theories of how firms may deter entry by
potential rivals
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CHAPTER OUTLINE
I.
MONOPOLISTIC COMPETITION: A market structure where a large
number of firms produce similar but differentiated
products which they advertise and promote. There is
relatively easy entry into the industry.
A.
B.
Number of Firms: In monopolistic competition, there is
a large number of firms, but not as many as in perfect
competition. This fact has several implications for a
monopolistically competitive industry.
1.
Small Share of Market: When many firms exist in
an industry each firm has a relatively small
share of the total market. Thus, each has only a
very small amount of control over the market
clearing price.
2.
Lack of Collusion: With many firms it is difficult for them to get together to collude; that
is, to agree to cooperate to set a pure monopoly
price and output. Price rigging in a monopolistically competitive industry is virtually impossible.
3.
Independence: Because there are so many firms,
each one acts independently of the others; no
firm attempts to take into account all of its
rival firms.
Product Differentiation: Product differentiation is
the distinguishing of products by brand name, color,
minor attributes, and the like. Product differentiation occurs in other than perfectly competitive
markets where products are homogeneous. Each separate, differentiated product has numerous similar but
not perfect substitutes. The greater the number of
substitutes available, other things being equal, the
greater the price elasticity of demand. The ability of
a firm to raise price is limited, and the demand curve
slopes downward.
C.
Ease of Entry: For a monopolistic competitor, potential competition is always a threat. The easier
and less costly entry is, the more a current
monopolistic competitor must worry about losing
business.
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D.
Sales Promotion and Advertising: No individual firm
in a perfectly competitive market will advertise. It
can sell all it wants at the going market price. Since
the monopolistic competitor has some monopoly power,
advertising may result in increased profits.
Advertising should be carried to the point where
marginal revenue from advertising just equals the
marginal cost of advertising.
1.
II.
Advertising as Signaling Behavior: Signals are
compact gestures or actions that convey
information. Heavy advertising expenditures that
establish brand names or trademarks are signals
that the company plans to stay in business.
PRICE AND OUTPUT FOR THE MONOPOLISTIC COMPETITION:
A.
The Individual Firm's Demand and Cost Curves: Since
the individual firm is not a perfect competitor its
demand curve slopes downward. It faces a marginal
revenue curve that is downward-sloping and below the
demand curve. The profit-maximizing rate of output
and price, are determined where the marginal cost
curve intersects the marginal revenue curve from
below.
B.
The Short-Run Equilibrium: In the short-run it is
possible for a monopolistic competitor to make economic profits, profits equal to the normal rate of
return, or losses.
C.
The Long-Run: Zero Economic Profits: In the long-run,
because so many firms produce substitutes for the
product in question, any economic profits will disappear with competition. They will be reduced to zero
either through entry by new firms seeking a chance to
make a higher rate of return than elsewhere or by
changes in product quality and advertising outlays by
existing firms in the industry. Economic losses in
the short-run will disappear in the long-run because
firms that suffer them will leave the industry.
III. COMPARING PERFECT COMPETITION WITH MONOPOLISTIC COMPETITION: Both the monopolistic competitor and the perfect
competitor make zero economic profits in the long run. The
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perfect competitor's average total costs are at minimum in
the long run. This is not the case with the monopolistic
competitor. The equilibrium rate of output is to the left
of the minimum point on the ATC curve and price is greater
than marginal cost.
IV.
OLIGOPOLY: An oligopoly is a market situation in which
there are very few sellers. Each seller knows the other
sellers will react to its changes in prices and quantities.
An oligopoly market structure can exist for either a
homogeneous or a differentiated produce.
A.
B.
Characteristics of Oligopoly:
1.
Small Number of Firms: An oligopoly exists when
a handful of firms dominate the industry enough
to set prices.
2.
Interdependence: This is also called strategic
dependence, which is a situation in which one
firm's actions with respect to output, price, or
product differentiation may be strategically
countered by one or more other firms in the
industry. Such dependence can only exist when
there are a few major firms in an industry.
Why Oligopoly Occurs:
1.
Economies of Scale: The strongest reason that
has been offered for the existence of oligopoly
is economies of scale. Economies of scale are
defined as a production situation in which a
doubling of output results in less that a
doubling of total costs. The firm's average
total cost curve will slope downward as it
produces more and more output. Average total
cost can be reduced by continuing to expand the
scale of operation.
2.
Barriers to Entry: These barriers include legal
barriers, such as patents, and control and
ownership over critical supplies.
3.
Oligopoly by Merger: A merger is the joining of
two of more firms under a single ownership or
control. There are two types of mergers. A
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horizontal merger involves firms producing or
selling a similar product. A vertical merger
occurs when one firm merges with another from
which it purchases an input or to which it sells
an output.
V.
VI.
MEASURING INDUSTRY CONCENTRATION:
A.
Concentration Ratio: The percentage of all sales contributed by the leading four or leading eight firms in
an industry is sometimes called the industry concentration ratio.
B.
U.S. Concentration Ratios: The concept of an industry
is necessarily arbitrary. As a consequence, concentration ratios rise as we narrow the definition of an
industry and fall as we broaden it.
C.
Oligopoly, Efficiency, and Resource Allocation: While
oligopolists charge prices that are greater than
marginal cost, others exist because of economies of
scale. There is no definite evidence of serious
resource allocation in the United States because of
oligopolies largely because of increased foreign
competition.
STRATEGIC BEHAVIOR AND GAME THEORY: When there are
relatively few firms in an industry, each reacts to the
price, quantity, quality, and new product innovations that
the others undertake. Each oligopolist has a reaction
function which is the manner in which one oligopolist
reacts to a change in price (or output or quality) of
another oligopolist. Economists use game theory models to
describe the way firms rationally interact. Game theory is
the analytical framework in which two or more individuals,
companies, or nations compete for certain payoffs that
depend on the strategy that the others employ. The plans
made by these individuals are known as game strategies.
A.
Some Basic Notions About Game Theory: Games can be
cooperative and non-cooperative. They are classified
by whether the payoffs are negative, zero or positive.
A cooperative game is one in which players explicitly
collude to make themselves better off. With firms, it
involves companies colluding in order to make higher
than competitive rates of return. A non-cooperative
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game is a game in which players neither collude nor
negotiate in any way. Applied to firms, it is a
situation in which there are few firms and each firm
has some ability to change price. A zero sum game is
a game in which one player's losses are exactly offset
by the other player's gains. A negative-sum game is a
game in which both players are worse off at the end of
the game. A positive-sum game is a game in which both
players are better off at the end of the game.
1.
Strategies in Non-cooperative Games: A strategy
is any rule that is used to make a choice, e. g.,
always pick heads.. The goal is to devise a
dominant strategy. A dominant strategy will
yield the most benefit for the player using it.
These strategies are generally successful no
matter what actions other players take.
B.
Applying Game Theory to Pricing Strategies: An example
of the use of game theory is presented.
C.
Opportunistic Behavior: Actions that ignore possible
long-run benefits of cooperation and focus solely on
short run gains. This kind of behavior can be
contrasted to tit-for-tat strategic behavior when
repeat transactions are likely. Here a player will
behave well as long as others do likewise.
VII. PRICE RIGIDITY AND THE KINKED DEMAND CURVE: Assume that
rivals will match all price decreases (in order not to be
undersold) but not price increases (because they want to
capture more business). There is no collusion. The
implications of this reaction function are rigid prices and
a kinked demand curve.
A.
Nature of the Kinked Demand Curve: An oligopoly firm
will assume that if it lowers price, rivals will react
by matching that reduction to avoid losing their
respective shares of the market. The oligopolist
lowering the price will not greatly increase its
quantity demanded and total revenues will fall. If it
increases price, rivals will not follow. Thus, a
higher price will cause quantity demanded to decease
rapidly and total revenues will fall. There will be a
kink in the demand curve. The resulting marginal
revenue curve has a discontinuous portion.
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B.
Price Rigidity: The kinked demand curve analysis may
help explain why price changes might be infrequent in
an oligopolistic industry without collusion. Each
oligopolist can only expect lower revenues if it
changes price. Another theoretical reason for price
inflexibility under the kinked demand curve model has
to do with the discontinuous portion of the marginal
revenue curve. As long as the marginal cost curve
passes through the discontinuity, the firm will not
change price.
C.
Criticisms of the Kinked Demand Curve: If every
oligopolistic firm faced a kinked demand curve, it
would not pay to change prices. The problem is that
the kinked demand curve does not show us how supply
and demand originally determine the going price of an
oligopolist's product. Oligopoly prices do not appear
to be as rigid, particularly in the upward direction,
as the kinked demand curve theory implies.
VIII. STRATEGIC BEHAVIOR WITH IMPLICIT COLLUSION: A MODEL OF
PRICE LEADERSHIP: Price leadership is a model of a pricing
practice in many oligopolistic industries. The largest
firm publishes its price list ahead of its competitors, who
then follow those prices. This is also called parallel
pricing. By definition, price leadership requires one firm
to be the leader. Because of laws against collusion, firms
in an industry cannot communicate who the price leader will
be directly. That is why the largest firm often becomes
the price leader.
A.
IX.
Price Wars: Price leadership may not always work. If
the price leader ends up much better off than those
firms that follow, they may not set prices according
to the dominant firm. A price war may result. A
price war is a pricing campaign designed to drive
competing firms out of a market by repeatedly cutting
prices.
DETERRING ENTRY INTO AN INDUSTRY: An important part of
game playing has to do with how potential competitors might
react to a decision. Existing firms in an industry devise
strategies to deter entrance into that industry. By
getting a local, state or federal government to restrict
entry, or adopting certain pricing and investment strategies they may deter the entrance of new firms.
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X.
A.
Increasing Entry Costs: Any strategy undertaken by
firms in an industry with the design or effect of
raising the cost of entry into the industry by a new
firm. To sustain a long price war, existing firms
might invest in excess capacity so that they may
expand output during the price war, thus signaling
potential competitors that they will engage in a price
war. Existing domestic firms can also raise the cost
of entry by foreign firms by getting the U.S. government to pass stringent environmental or health and
safety standards.
B.
Limit-Pricing Strategies: The existing firms may
lower their market price until they sell the same
quantity as before a new firm entered the industry.
Existing firms limit their price to be above
competitive prices, but if there is a new entrant, the
new limit price will be below the one at which a new
firm can make a profit. The limit-pricing model is a
model that hypothesizes a group of colluding sellers
who together set the highest common price they believe
they can charge without new firms seeking to enter the
industry.
C.
Raising Customers' Switching Costs: If an existing
firm can make it more costly for customers to switch
from its product or service to a competitor's, the
existing firm can deter entry. In the computer
industry switching cost were high because, in the
past, computer operating systems have not been compatible across company lines.
COMPARING MARKET STRUCTURES:
compared in
Market structures are
SELECTED REFERENCES
Bain, Joe S., "Relation or Profit-Rate to Industry Concentration:
American Manufacturing, 1936-1940," Quarterly Journal of Economics,
August 1951, pp. 293-324.
Brozen, Yale, ed., The Competitive Economy, Morristown, NJ: General
Learning Press, 1975.
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Chamberlain, Edward, H., The Theory of Monopolistic Competition, 8th
Edition, Cambridge, MA: Harvard University Press, 1962.
Fellner, William, Competition Among the Few, New York: Knopf, 1950.
Kilpatrick, R.W., "Stigler on the Relationship between Industry
Profit Rates and Market Concentration," Journal of Political Economy,
May-June 1968, pp. 479-488.
MacAvoy, Paul W., et al., "High and Stable Concentration Levels,
Profitability and Public Policy: A Response," Journal of Law and
Economics, October 1971, pp. 493-500.
Meckling, William H. and Michael C. Jensen, "Reflections on the
Corporation as a Social Invention," Los Angeles International
Institute for Economic Research, Reprint Paper 18, November 1983.
Robinson, Joan, The Economics of Imperfect Competition, London:
MacMillan and Company, Ltd., 1965.
Shepherd, William C., The Economics of Industrial Organization,
Englewood Cliffs, NJ: Prentice-Hall, Inc., 1979.
Shudson, Michael, Advertising, The Uneasy Persuasion, New York: Basic
Books, 1985.
Stigler, George, "Notes on a Theory of Duopoly," Journal of
Political Economy, Vol. XLVIII, 1940, pp. 521-541.