Monopolistic Competition and Oligopoly
16
16
Competition, you know, is a lot like chastity. It is widely praised, but alas, too little practiced.
— Carol Tucker
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Monopolistic Competition and Oligopoly
16
• List the four distinguishing characteristics of monopolistic competition
• Demonstrate graphically the equilibrium of a monopolistic competitor
• State the central element of oligopoly
• Explain why decisions in the cartel model depend on market share and decisions in the contestable market model depend on barriers to entry
• Describe two empirical methods of determining market structure
16-2

Monopolistic Competition and Oligopoly
16
• Market structure refers to the physical characteristics of the market within which firms interact
• It is determined by the number of firms in the market and the barriers to entry
• A monopolistically competitive market is a market in which there are many firms selling differentiated products and few barriers to entry
• An oligopolistic market is a market in which there are only a few firms and firms explicitly take other firms’ likely response into account
16-3

Monopolistic Competition and Oligopoly
16
Four distinguishing characteristics:
1. Many sellers that do not take into account rivals’ reactions
2. Product differentiation where the goods that are sold aren’t homogenous
3. Multiple dimensions of competition make it harder to analyze a specific industry, but these methods of competition follow the same two decision rules as price competition
4. Ease of entry of new firms in the long run because there are no significant barriers to entry
16-4

Monopolistic Competition and Oligopoly
16
• Like a monopoly,
• The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve
• Marginal revenue is below price
• At profit maximizing output, marginal cost will be less than price
• Like a perfect competitor, zero economic profits exist in the long run
16-5

ATC
L
P
P
ATC
P
Monopolistic Competition and Oligopoly
16
MR
MC
ATC
Losses
ATC
Break even
ATC
Profits
D
Q
Profits
Losses
Break even
A monopolistic firm can earn profits, losses, or break even in the short run
Q
16-6

P
MC
P
PC
P
Monopolistic Competition and Oligopoly
16
Q
MC
Q
PC
MC
MR
MC
ATC
• In monopolistic competition in the long run, P > min ATC,
• In perfect competition in the long run, P = min ATC
D
PC
D
MC
Q
Outcome:
Monopolistic competition
output is lower and
price is higher than perfect competition
16-7

Monopolistic Competition and Oligopoly
16
• It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry
• No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry
• For a monopolistic competitor in long-run equilibrium,
(P = ATC)
(MC = MR)
16-8

Monopolistic Competition and Oligopoly
16
• Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do
• The goals of advertising are to increase demand and make demand more inelastic
• Advertising increases ATC
• The increase in cost of a monopolistically competitive product is the cost of “differentness”
16-9

Monopolistic Competition and Oligopoly
16
• Oligopolies are made up of a small number of firms in an industry
• In any decision a firm makes, it must take into account the expected reaction of other firms
• Oligopolistic firms are mutually interdependent
• Oligopolies can be collusive or noncollusive
• Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making
16-10

Monopolistic Competition and Oligopoly
16
• There is no single model of oligopoly behavior
• An oligopoly model can take two extremes:
• The cartel model is when a combination of firms acts as if it were a single firm and a monopoly price is set
• The contestable market model is a model of oligopolies where barriers to entry and exit, not market structure, determine price and output decisions and a competitive price is set
• Other models of oligopolies give price results between the two extremes
16-11

Monopolistic Competition and Oligopoly
16
• A cartel model of oligopoly is a model that assumes that oligopolies act as if they were a monopoly and set a price to maximize profit
• Output quotas are assigned to individual member firms so that total output is consistent with joint profit maximization
• If oligopolies can limit the entry of other firms, they can increase profits
16-12

Monopolistic Competition and Oligopoly
16
• Explicit (formal) collusion is illegal in the U.S. while implicit (informal) collusion is permitted
• Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another
• Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow
16-13

Monopolistic Competition and Oligopoly
16
• One characteristic of informal collusive behavior is that prices tend to be sticky – they don’t change frequently
• Informal collusion is an important reason why prices are sticky
• Another is the kinked demand curve
• If a firm increases price, others won’t go along, so demand is very elastic for price increases
• If a firm lowers price, other firms match the decrease, so demand is inelastic for price decreases
16-14

Monopolistic Competition and Oligopoly
16
P
P
If P increases, others won’t go along, so D is elastic
Gap
Q
MR
• A gap in the MR curve exists
• A large shift in marginal cost is required before firms will change their price
MC
1
MC
2
D
If P decreases, other firms match the decrease, so D is inelastic
Q
16-15

Monopolistic Competition and Oligopoly
16
• The contestable market model is a model of oligopolies where barriers to entry and exit, not market structure, determine price and output decisions and a competitive price is set
• Even if the industry contains only one firm, it will set a competitive price if there are no barriers to entry
• Much of what happens in oligopoly pricing is dependent on the specific legal structure within which firms interact
16-16

Monopolistic Competition and Oligopoly
16
• The cartel model is appropriate for oligopolists that collude, set a monopoly price, and prevent market entry
• The contestable market model describes oligopolies that set a competitive price and have no barriers to entry
• Oligopoly markets lie between these two extremes
• Both models use strategic pricing decisions where firms set their price based on the expected reactions of other firms
16-17

Monopolistic Competition and Oligopoly
16
• The threat of outside competition limits oligopolies from acting as a cartel
• The threat will be more effective if the outside competitor is much larger than the firms in the oligopoly
• Price wars are the result of strategic pricing decisions gone wild
• A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business
16-18

Monopolistic Competition and Oligopoly
16
No. of firms
Barriers to entry
Pricing decisions
Output decisions
Interdependence
LR profit
P and MC
Monopoly
One
Significant
MC = MR
Most output restriction
No competitors
Possible
P > MC
Oligopoly
Few
Monopolistic
Competition
Many
Perfect
Competition
Almost infinite
Significant Few
Strategic pricing
MC = MR
Output restricted
Interdependent decisions
Possible
Output restricted, product differentiation
Each firm independent
None
P > MC P > MC
None
MC = MR = P
No output restriction
Each firm independent
None
P = MC
16-19

Monopolistic Competition and Oligopoly
16
• An industry seldom fits neatly into one category or another
• One way to classify markets in practice is by its cross price elasticity
• Cross-price elasticity measures the responsiveness of the change in demand for a good to a change in the price of a related good
• Goods with a cross-price elasticity of 3 or more are in the same industry
16-20

Monopolistic Competition and Oligopoly
16
• North American Industry Classification System
(NAICS) is an industry classification system that categorizes industries by the type of economic activity and groups firms with like production processes
Two Digit Sectors
23 Construction
42 Wholesale Trade
Three to Six Digit Sectors
51 Information
61 Education Services
517 –Telecommunications
5172
– Wireless telecommunications carriers
517211 – Paging
16-21

Monopolistic Competition and Oligopoly
16
• The concentration ratio is the value of sales by the top firms of an industry stated as a percentage of total industry sales
• The Herfindahl index is the sum of the squared value of the individual market shares of all firms in the industry
• Because it squares market shares, the Herfindahl index gives more weight to firms with large market shares than does the concentration ratio measure
16-22

Monopolistic Competition and Oligopoly
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Industry
Poultry
Soft drinks
Breakfast cereal
Soap and detergent
Men’s footwear
Women’s footwear
Pharmaceuticals
Computer equipment
Burial caskets
Four Firm
Concentration Ratio
46
52
78
38
44
64
34
49
73
Herfindahl Index
773
896
2,999
664
734
1,556
506
1,183
2,965
16-23

Monopolistic Competition and Oligopoly
16
• Neither the four-firm concentration ratio nor the
Herfindahl index gives a complete picture of corporations’ bigness because many firms are conglomerates
• Conglomerates are huge corporations whose activities span various unrelated industries
16-24

Monopolistic Competition and Oligopoly
16
• The cartel model fits best with empirical measurements because it assumes that the structure of the market is directly related to the price a firm charges
• It predicts that oligopolies charge higher prices than monopolistic or perfect competitors
• The contestable market model gives less weight to the empirical estimates of market structure
• Markets that look oligopolistic could be highly competitive
16-25

Monopolistic Competition and Oligopoly
16
• Monopolistic competition is characterized by:
• Many sellers
• Differentiated products
• Multiple dimensions of competition
• Ease of entry of new firms
• The central characteristic of oligopoly is that there are a small number of interdependent firms
• Monopolistic competitors differ from perfect competitors in that the former face a downward sloping demand curve
16-26

Monopolistic Competition and Oligopoly
16
• Monopolistic competitors differ from monopolists in that monopolistic competitors make zero long-run profit
• In monopolistic competition firms act independently; in an oligopoly they take account of each other’s actions
• An oligopolist’s price will be somewhere between the competitive price and the monopolistic price
• A contestable market theory of oligopoly judges an industry’s competitiveness more by performance and barriers to entry than by structure
16-27

Monopolistic Competition and Oligopoly
16
• Cartel models of oligopoly concentrate on market structure
• Industries are classified by economic activity in the North
American Industry Classification System (NAICS)
• Industry structures are measured by concentration ratios and Herfindahl indexes
• A concentration ratio is the sum of market shares of the largest firms in an industry
• A Herfindahl index is the sum of the squares of the market shares of all firms in an industry
16-28

Monopolistic Competition and Oligopoly
16
• Discuss the monitoring problem and its implications for economics
• Explain how corporate takeovers can limit X-inefficiency
• Discuss why competition should be seen as a process, not a state
• Explain two actions firms take to break down monopoly and three they take to protect monopoly
• Discuss why oligopoly is the best market structure for technological change
16-29