CHAPTER
13
Monopolistic Competition and
Oligopoly
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Monopolistic Competition
• A monopolistically competitive
industry has the following
characteristics:
• A large number of firms
• No barriers to entry
• Product differentiation
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Monopolistic Competition
• Monopolistic competition is a common
form of industry (market) structure in the
United States, characterized by a large
number of firms, none of which can influence
market price by virtue of size alone.
• Some degree of market power is achieved
by firms producing differentiated products.
• New firms can enter and established firms
can exit such an industry with ease.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Nine Industries with Characteristics of
Monopolistic Competition
Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1992
FOUR
LARGEST
FIRMS
INDUSTRY
DESIGNATION
SIC NO.
EIGHT
TWENTY NUMBER
LARGEST LARGEST
OF
FIRMS
FIRMS
FIRMS
3792
Travel trailers and campers
41
57
72
270
3942
Dolls
34
47
67
204
2521
Wood office furniture
26
34
51
611
2731
Book publishing
23
38
62
2504
2391
Curtains and draperies
22
32
48
1004
2092
Fresh or frozen seafood
19
28
47
600
3564
Blowers and fans
14
22
41
518
2335
Women’s dresses
11
17
30
3943
3089
Miscellaneous plastic products
5
8
13
7605
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series
MC92-S-2, 1997.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Product Differentiation, Advertising, and
Social Welfare
Total Advertising Expenditures in 1998
DOLLARS
(BILLIONS)
Newspapers
44.2
Television
48.0
Direct mail
39.5
Other
31.7
Yellow pages
12.0
Radio
14.5
Magazines
10.4
Total
200.3
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United
States, 1999, Table 947.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Case for Product Differentiation
and Advertising
• The advocates of free and open
competition believe that differentiated
products and advertising give the
market system its vitality and are the
basis of its power.
• Product differentiation helps to ensure
high quality and efficient production.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Case for Product Differentiation
and Advertising
• Advertising provides consumers with
the valuable information on product
availability, quality, and price that
they need to make efficient choices
in the market place.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Case Against Product
Differentiation and Advertising
• Critics of product differentiation and
advertising argue that they amount to
nothing more than waste and
inefficiency.
• Enormous sums are spent to create
minute, meaningless, and possibly
nonexistent differences among
products.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Case Against Product
Differentiation and Advertising
• Advertising raises the cost of products
and frequently contains very little
information. Often, it is merely an
annoyance.
• People exist to satisfy the needs of the
economy, not vice versa.
• Advertising can lead to unproductive
warfare and may serve as a barrier to
entry, thus reducing real competition.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Monopolistic Competition in the Short Run
• In the short-run, a monopolistically competitive firm
will produce up to the point where MR = MC.
• This firm is
earning positive
profits in the
short-run.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Monopolistic Competition in the Short-Run
• Profits are not guaranteed. Here, a firm with a
similar cost structure is shown facing a weaker
demand and suffering short-run losses.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Monopolistic Competition in the Long-Run
• The firm’s demand
curve must end up
tangent to its average
total cost curve for
profits to equal zero.
This is the condition
for long-run equilibrium
in a monopolistically
competitive industry.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Economic Efficiency
and Resource Allocation
• In the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,
however:
• Price is above marginal
cost. More output could
be produced at a
resource cost below the
value that consumers
place on the product.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Economic Efficiency
and Resource Allocation
• In the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,
however:
• Average total cost is not
minimized. The typical
firm will not realize all the
economies of scale
available. Smaller and
smaller market share
results in excess capacity.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Oligopoly
• An oligopoly is a form of industry
(market) structure characterized by a
few dominant firms. Products may
be homogeneous or differentiated.
• The behavior of any one firm in an
oligopoly depends to a great extent
on the behavior of others.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Ten Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms in HighConcentration Industries, 1992
INDUSTRY
DESIGNATION
SIC NO.
FOUR
LARGEST
FIRMS
EIGHT
LARGEST
FIRMS
NUMBER
OF
FIRMS
2823
Cellulosic man-made fiber
98
100
5
3331
Primary copper
98
99
11
3633
Household laundry equipment
94
99
10
2111
Cigarettes
93
100
8
2082
Malt beverages (beer)
90
98
160
3641
Electric lamp bulbs
86
94
76
2043
Cereal breakfast foods
85
98
42
3711
Motor vehicles
84
91
398
3482
Small arms ammunition
84
95
55
3632
Household refrigerators and freezers
82
98
52
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject
Series MC92-S-2, 1997.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Oligopoly Models
• All kinds of oligopoly have one
thing in common:
• The behavior of any given
oligopolistic firm depends on the
behavior of the other firms in the
industry comprising the oligopoly.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Collusion Model
• A group of firms that gets together
and makes price and output
decisions jointly is called a cartel.
• Collusion occurs when price- and
quantity-fixing agreements are
explicit.
• Tacit collusion occurs when firms
end up fixing price without a specific
agreement, or when agreements are
implicit.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Cournot Model
• The Cournot model is a model of a
two-firm industry (duopoly) in which
a series of output-adjustment
decisions leads to a final level of
output between the output that would
prevail if the market were organized
competitively and the output that
would be set by a monopoly.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Kinked Demand Curve Model
• The kinked demand model is a
model of oligopoly in which the
demand curve facing each individual
firm has a “kink” in it. The kink
follows from the assumption that
competitive firms will follow if a
single firm cuts price but will not
follow if a single firm raises price.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Kinked Demand Curve Model
• Above P*, an increase in
price, which is not followed
by competitors, results in a
large decrease in the firm’s
quantity demanded
(demand is elastic).
• Below P*, price decreases
are followed by
competitors so the firm
does not gain as much
quantity demanded
(demand is inelastic).
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Price-Leadership Model
• Price-leadership is a form of
oligopoly in which one dominant firm
sets prices and all the smaller firms
in the industry follow its pricing policy.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Price-Leadership Model
•
Assumptions of the price-leadership model:
1. The industry is made up of one large firm and a
number of smaller, competitive firms;
2. The dominant firm maximizes profit subject to
the constraint of market demand and subject to
the behavior of the smaller firms;
3. The dominant firm allows the smaller firms to
sell all they want at the price the leader has set.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Price-Leadership Model
•
Outcome of the price-leadership model:
1. The quantity demanded in the industry is split
between the dominant firm and the group of
smaller firms.
2. This division of output is determined by the
amount of market power that the dominant firm
has.
3. The dominant firm has an incentive to push
smaller firms out of the industry in order to
establish a monopoly.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Predatory Pricing
• The practice of a large, powerful firm
driving smaller firms out of the
market by temporarily selling at an
artificially low price is called
predatory pricing.
• Such behavior became illegal in the
United States with the passage of
antimonopoly legislation around the
turn of the century.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Game Theory
• Game theory analyzes oligopolistic
behavior as a complex series of
strategic moves and reactive
countermoves among rival firms.
• In game theory, firms are assumed to
anticipate rival reactions.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Payoff Matrix for Advertising Game
B’s STRATEGY
A’s STRATEGY
Do not advertise
Advertise
Do not advertise
A’s profit = $50,000
B’s profit = $50,000
A’s loss = $25,000
B’s profit = $75,000
Advertise
A’s profit = $75,000
B’s loss = $25,000
A’s profit = $10,000
B’s profit = $10,000
• Regardless of what B does, it pays A to advertise. This is
the dominant strategy, or the strategy that is best no
matter what the opposition does.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
The Prisoners’ Dilemma
ROCKY
GINGER
Do not confess
Confess
Do not confess
Ginger: 1 year
Rocky: 1 year
Ginger: 7 years
Rocky: free
Confess
Ginger: free
Rocky: 7 years
Ginger: 5 years
Rocky: 5 years
• Both Ginger and Rocky have dominant strategies: to
confess. Both will confess, even though they would be
better off if they both kept their mouths shut.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Payoff Matrix for
Left/Right-Top/Bottom Strategies
Original Game
D’s STRATEGY
C’s
STRATEGY
Left
Right
Top
C wins $100
D wins no $
C wins $100
D wins $100
Bottom
C loses $100
D wins no $
C wins $200
D wins $100
© 2002 Prentice Hall Business Publishing
• Because D’s behavior is
predictable (he will play
the right-hand strategy), C
will play bottom.
• When all players are
playing their best strategy
given what their
competitors are doing, the
result is called Nash
equilibrium.
Principles of Economics, 6/e
Karl Case, Ray Fair
Payoff Matrix for
Left/Right-Top/Bottom Strategies
New Game
D’s STRATEGY
C’s
STRATEGY
Left
Right
Top
C wins $100
D wins no $
C wins $100
D wins $100
Bottom
C loses
$10,000
D wins no $
© 2002 Prentice Hall Business Publishing
C wins $200
D wins $100
• C is likely to play top and
guarantee herself a $100
profit instead of losing
$10,000 to win $200, even if
there is just a small chance of
D’s choosing left.
• When uncertainty and risk are
introduced, the game
changes. A maximin
strategy is a strategy chosen
to maximize the minimum
gain that can be earned.
Principles of Economics, 6/e
Karl Case, Ray Fair
Contestable Markets
• A market is perfectly contestable if
entry to it and exit from it are
costless.
• In contestable markets, even large
oligopolistic firms end up behaving
like perfectly competitive firms.
Prices are pushed to long-run
average cost by competition, and
positive profits do not persist.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Oligopoly is Consistent with
a Variety of Behaviors
• The only necessary condition of oligopoly
is that firms are large enough to have some
control over price.
• Oligopolies are concentrated industries. At
one extreme is the cartel, in essence,
acting as a monopolist. At the other
extreme, firms compete for small
contestable markets in response to
observed profits. In between are a number
of alternative models, all of which stress
the interdependence of oligopolistic firms.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Oligopoly and Economic Performance
• Oligopolies, or concentrated industries, are
likely to be inefficient for the following reasons:
• They are likely to price above marginal cost. This
means that there would be underproduction from
society’s point of view.
• Strategic behavior can force firms into deadlocks
that waste resources.
• Product differentiation and advertising may pose a
real danger of waste and inefficiency.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair
Product Differentiation Reduces the
Elasticity of Demand Facing a Firm
• Based on the availability of
substitutes, the demand
curve faced by a
monopolistic competitor is
likely to be less elastic
than the demand curve
faced by a perfectly
competitive firm, and likely
to be more elastic than the
demand curve faced by a
monopoly.
© 2002 Prentice Hall Business Publishing
Principles of Economics, 6/e
Karl Case, Ray Fair