CHAPTER
7
Monopolistic
Competition, Oligopoly,
and Antitrust
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
The Effects of Market Entry

In the absence of substantial economies of scale,
it is possible for additional firms to enter the
market, driving down prices and profit.

Output decisions are based on the marginal principle:
Marginal PRINCIPLE
Increase the level of an activity if its marginal
benefit exceeds its marginal cost, but reduce
the level if the marginal cost exceeds the
marginal benefit. If possible, pick the level at
which the marginal benefit equals the
marginal cost.
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The Effects of Market Entry
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
When a second firm
enters the market,
the monopoly’s
demand and
marginal revenue
curves shift inward.

The firm’s price and
output level will
have to be adjusted
in order to follow
the marginal
principle.
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The Effects of Market Entry


The monopoly satisfies
the marginal principle
by producing and
selling 300
toothbrushes at $2
each.
After entry, each of
two firms produces
200 units and charges
$1.85 per unit.
Entry
decreases
price.
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The Effects of Market Entry


Before entry, the
monopoly produces
300 units, at a cost
per unit of $0.90 per
toothbrush.
After entry, each of two
firms produces 200
units at an average cost
Entry
increases
average cost.
of $1.00.
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The Effects of Market Entry
Summary:

There are three reasons why profit
decreases for the individual firm
after entry of a second firm:
Lower price
 Lower quantity sold
 Higher AC of production

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Revenue or cost ( $ per tooth brush)
The Effects of Market Entry
m
2.00
1.85
e
d
1.00
0.90
c
x
AC
n
MR2
200
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MC1
D2
D1
MR1
300 Toothbrushes per minute
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Monopolistic Competition
Monopolistic Competition: A market
served by dozens of firms selling
slightly different products.
Characteristics of Monopolistic
Competition:



Many firms
Differentiated product
No artificial barriers to entry
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The Meaning of “Monopolistic
Competition”

Each firm is monopolistic because it sells
a unique product.

Each firm is a competitive because it sells a
product that is a close but not a perfect
substitute for the products sold by other
firms in the market.

The availability of close substitutes makes
the firm’s demand very price elastic.
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Product Differentiation
Firms may differentiate their product in
several ways:




Physical characteristics
Location
Services
Aura or image
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Short-run and Long-run Equilibrium

As long as there is profit to be made, more and
more firms will enter the market.

As firms enter, each firm’s demand curve shifts
to the left, decreasing market price, decreasing
the quantity produced per firm, and increasing
the average cost of production.

Entry will stop once the economic profit of each
existing firm reaches zero. In the long run,
revenue will be just enough to cover all costs,
including the opportunity cost of all inputs, but
not enough to cause additional firms to enter.
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Long-run Equilibrium Under
Monopolistic Competition

In this example, the
marginal principle
is satisfied at 55
thousand
toothbrushes per
minute, selling at a
price of $1.35. The
cost of producing
each toothbrush is
also $1.35.
Economic profit
equals zero.
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Trade-offs with Monopolistic
Competition
Monopoly
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Monopolistic Competition
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Trade-offs with Monopolistic Competition
Monopolistic competition brings
good news and bad news relative to
the monopoly outcome:

Good news: lower price and greater
variety

Bad news: higher average cost
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Oligopoly

An oligopoly is a market served by
a few firms.

The key feature of an oligopoly is
that firms act strategically. Firms
are interdependent—the actions of
one firm affect the profits of the
other firms in the market.
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Oligopoly and Pricing Decisions


Economists use concentration ratios to
measure the degree of concentration,
or just how few firms exist in a market.
For example a four firm concentration
ratios is the percentage of total output
in the market produced by the largest
four, i.e., a 93% concentration ratio for
cigarettes indicates that the largest 4
firms produced 93% of the total
output.
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Concentration Ratios in Selected
Manufacturing Industries
Industry
Four-firm
Eight-firm
Concentration Concentration
Ratio (%)
Ratio (%)
Cigarettes
93
Not available
Guided missiles and space vehicles
93
99
Beer and malt beverages
90
98
Batteries
87
95
Electric bulbs
86
94
Breakfast cereals
85
98
Motor vehicles and car bodies
84
91
Greeting cards
84
88
Engines and turbines
79
92
Aircraft and parts
79
93
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Barriers to Entry in an Oligopoly
Most firms in an oligopoly earn economic profit, yet
additional firms do not enter the market, for three
reasons:

Economies of scale large enough to
generate a natural oligopoly but not a
natural monopoly

Government barriers to entry

Substantial investment in an advertising
campaign in order to enter the market
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Oligopolistic Firms

A duopoly is a market with two firms.

A cartel is a group of firms that coordinate their
pricing decisions, often charging the same price
for a particular good or service.

The arrangement under which two or more firms
act as one, coordinating their pricing decisions, is
also known as price fixing.

The equilibrium price and quantity in the
oligopolistic market depend on the strategic
behavior of the firms in the oligopoly.
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Cartel Pricing


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In a cartel
arrangement, two
firms act as one. In
this case, they split the
market output—each
serving 75 passengers
per day, and charge
$400 per ticket.
The firms also split the
profit. Each firm earns
$7,500 = [(400-300) x 150]/2.
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Duopoly Pricing


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When two firms
compete against one
another, they end up
serving 100 passengers
each, at a price of $350.
Each firm earns a profit
of $5,000, compared to a
profit of $7,500 if they
had acted as one firm.
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Duopoly Versus Cartel Pricing

The duopoly produces more output and charges a lower price
than the cartel.
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The Game Tree

A game tree provides a visual
representation of the
consequences of alternative
strategies. Firms can use it to
develop pricing strategies.
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Cartel and Duopoly Outcomes in the Game Tree
Profits ($000)
Jill Jack
$7.5 $7.5
Jack:
High or
Low price?
Jill:
High or
Low price?
Jack:
High or
Low price?
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Jill
$1
Jack
$1
Jill
$8.5
Jack
$1
Jill
$5
Jack
$5
24
Cartel and Duopoly Outcomes in the Game Tree
Profits
($000)
Jill
Jack
$7.5 $7.5
Jack:
High or
Low price?
Cartel
Outcome
Jill:
High or
Low price?
Duopoly
Outcome
Jack:
High or
Low price?
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Jill
$5
O’Sullivan & Sheffrin
Jack
$5
25
The Outcome of the Price-Fixing Game
Jack captures large
share of market
Jill captures large
share of market
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Jill: Low Price
Jack: High
Price
Price
$350
$400
Quantity
170
10
Average cost
$300
$300
Profit per passenger
$50
$100
Total profit
$8,500
$1,000
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The Dominant Strategy
Irrational for Jack to
choose high price

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Jack chooses the
low price when
Jill chooses the
high price.
27
The Dominant Strategy

Jack chooses the
low price when
Jill chooses the
low price.
Irrational for Jack to
choose high price

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Dominant
Strategy: Jack
chooses the low
price regardless of
Jill’s choice.
28
The Duopolists’ Dilemma

Knowing that Jack will choose the low price no
matter what, will Jill choose the high price or the
low price?
Irrational for Jill to be
underpriced.

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Jill will choose the
low price, and the
trajectory of the
game is X to Z to
4.
29
The Duopolists’ Dilemma

The duopolists’ dilemma is
that although both firms would
be better off if they chose the
high price, each firm chooses
the low price.
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Retaliation for Underpricing
Schemes to punish Jack if he underprices:

Duopoly price: Jill also lowers price;
abandons the idea of cartel profits, and
settles for duopoly profits which are better
than the profits when she is underpriced by
Jack.

Tit-for-tat: Jill chooses whatever price
Jack chose the preceding month.
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Tit-for-Tat Response to Underpricing
 Jill
chooses whatever
price Jack chose the
preceding month.
 After Jack lowers price,
profits sink to the
duopoly level. Jack
increases price in the
fourth month, which
restores the cartel
pricing in the fifth
month.
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Avoiding the Dilemma: Guaranteed
Price Matching


To eliminate the incentive for underpricing,
one firm can guarantee that it will match its
competitor’s price.
How will Jack respond to Jill’s price-matching
policy?


Choose the high price: Jack matches Jill’s high price in
which case both will earn maximum (cartel) profits.
Choose the low price: if Jack chooses the low price, Jill
will match the low price and both firms will earn
minimum (duopoly) profits. Therefore, Jack has no
reason to choose the low price.
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Guaranteed Price Matching
 Price
matching eliminates the
duopolists’ dilemma and makes cartel
profits and pricing possible, even
without a formal cartel.
 Guaranteed
price matching leads
to higher prices. It guarantees that
consumers will pay the high price!
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Entry Deterrence and Limit Pricing

An insecure monopolist fears the entry of a
second firm, and could react in one of two
ways:

A passive strategy:
allow the second firm to
enter the market

An entry-deterrence strategy:
try to
prevent the firm from entering

The threat of entry will force the monopolist
to act like a firm in a market with many firms,
picking a low price and earning a small profit.
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The Passive Strategy

If Mona adopts a
passive strategy,
it will allow Doug
to enter the
market, and each
will earn the
duopoly profits
of $5,000 each
(Duopoly
Outcome).
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The Entry-deterrence Strategy
m: Secure Monopoly
400
370
350
Mona can prevent Doug
from entering by incurring a
large investment and
committing herself to serving
a large number of customers
at a low price.
Profit =
$15,000
z
300
LRAC
Market
Demand
150
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Passengers
per day
37
The Entry-deterrence Strategy
m: Secure Monopoly
400
i: Insecure Monopoly
370
350
Due to economies of scale,
suppose that that the
minimum entry quantity is 70
passengers a day, the entry
deterring quantity for Mona
will be 180 passengers (25070). If Doug enters serving 70
passengers and Mona serves
180, the price drops to $300,
making entry unprofitable to
Doug.
Deterrence Profit =
$12,600
d: Duopoly
z
300
LRAC
Market
Demand
150
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Passengers
per day
O’Sullivan & Sheffrin
Once Mona
commits to large
load of
passengers, the
most profitable
load will be 180
passengers
38
The Entry-deterrence Strategy

400
370
350
Mona can prevent Doug from entering by incurring a
large investment and committing herself to serving a
large number of customers at a low price.
 What is more
m: Secure Monopoly
profitable, entry
deterrence or the
i: Insecure Monopoly
passive duopoly
outcome?
Deterrence Profit =
$12,600
z
300
LRAC
Market
Demand
150
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Passengers
per day
39
Antitrust Policy

The purpose of antitrust policy is to
promote competition among firms.
Competition leads to lower prices
and better products.
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Antitrust Policy
Under federal antitrust rules, the government
can:

Break up of monopolies into several smaller
companies.

Prevent corporate mergers that would reduce
competition.

Regulate business practices.
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Brief History of Antitrust Legislation
1890
Sherman Act: made it illegal to monopolize a market or to engage in
practices that resulted in a restraint of trade.
1914
Clayton Act: outlawed specific practices that discourage competition,
including tying contracts, price discrimination for the purpose of
reducing competition, and stock-purchase mergers that would
substantially reduce competition.
Federal Trade Commission: established to enforce antitrust laws.
1914
1936
Robinson-Patman Act: prohibited selling products at “unreasonably
low prices” with the intent of reducing competition.
1950
Celler-Kefauver Act: outlawed asset-purchase mergers that would
substantially reduce competition.
1980
Hart-Scott-Rodino Act: extended antitrust legislation to
proprietorships and partnerships.
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Breaking Up Monopolies


A trust is an arrangement under which the
owners of several companies transfer their
decision-making powers to a small group of
trustees. Firms in a trust act as a single
firm.
The label “antitrust” comes from early
cases involving the breakup of trusts.
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Blocking Mergers

A merger occurs when two firms combine their
operations.

Because a merger decreases the number of firms
in a market, it is likely to lead to higher prices.

A possible benefit from a merger is that the new
firm could combine production, marketing, or
administrative operations, and thus produce its
products at a lower average cost.
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Blocking Mergers

New guidelines developed by the Justice
Department and the Federal Trade Commission
allow companies involved in a proposed merger to
present evidence that the merger would reduce
costs and lead to lower prices, better products, or
better service.

The analysis of proposed mergers today focuses
less on counting the number of firms in a market,
and more on how a merger would affect price.
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Regulating Business Practices

The government may intervene when specific
business practices increase market
concentration.

Among those practices are:



Price fixing
Tying, or forcing consumers of one product to
purchase another
Price discrimination that reduces competition
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