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Monopolistic Competition and Oligopoly

CHAPTER ELEVEN MONOPOLISTIC COMPETITION AND OLIGOPOLY

CHAPTER OVERVIEW

Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. In this chapter, the two market structures that fall between the extremes are discussed. Monopolistic competition contains a considerable amount of competition mixed with a small dose of monopoly power. Oligopoly, in contrast, implies a blend of greater monopoly power and less competition.

TESTING POINTS

Use these for chapter review:

1.List the characteristics of monopolistic competition.

2.Explain how product differentiation occurs in similar products.

3.Determine the profit-maximizing price and output level for a monopolistic competitor in the short run when given cost and demand data. (Remember: MR=MC; profits or losses in the short run but only normal profits [no econ. profits or losses] in the long run.)

4.Explain why a monopolistic competitor will realize only normal profit in the long run.

5.Identify the reasons for excess capacity in monopolistic competition.

6.Explain how product differentiation may offset the inefficiencies.(due to product variety)

7.Describe the characteristics of an oligopolistic industry.

8.Differentiate between homogeneous and differentiated (heterogeneous) oligopolies. (Give some examples of each.)

9.Identify and explain the most important causes of oligopoly. (Review the Barriers to entry from pure monopoly.)

10.Describe and compare the concentration ratio (CR4) and the Herfindahl index as ways to measure market dominance in an industry. (Recognize each in a verbal description. Also know what inter- industry competition is, and an example or two.)

11.Explain the mutual interdependence of two rival firms and why oligopolists might be tempted to cheat on a collusive agreement. (And why they would want to collude in the first place.)

12.Identify three possible models of oligopolistic price-output behavior.

13.Use the kinked demand curve theory to explain why prices tend to be inflexible.

14.Explain the major advantages of collusion for oligopolistic producers. (decrease in uncertainty, no price wars and …)

15.List the obstacles to collusion behavior. (Number of firms, etc.)

16.Explain price leadership as a form of tacit (unspoken) collusion. (Know what a tacit agreement is.)

17.Explain why oligopolies may prefer nonprice competition over price competition. (To avoid a price war. Also, which 2 market models use non-price competition the most?)

18.List the positive and negative effects of advertising.

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Monopolistic Competition and Oligopoly

19.Explain why some economists assert that oligopoly is less desirable than pure monopoly. (A pure monopoly can be regulated while oligopolies are less likely to be regulated. Also what is the effect if all oligopolies act together? You will have a monopoly!)

LECTURE NOTES

I.Learning objectives:

A.The characteristics of monopolistic competition.

B.Why monopolistic competitors earn only a normal profit in the long run.

C.The characteristics of oligopoly.

D.How game theory relates to oligopoly.

E.Why the demand curve of an oligopolist may be kinked.

F.The incentives and obstacles to collusion among oligopolists.

G.The potential positive and negative effects of advertising.

II.Review Table 8.1.

III.Monopolistic Competition: Characteristics and Occurrence

A.Monopolistic competition refers to a market situation in which a relatively large number of sellers offer similar but not identical products.

1.Each firm has a small percentage of the total market.

2.Collusion is nearly impossible with so many firms.

3.Firms act independently; the actions of one firm are ignored by the other firms in the industry.

B.Product differentiation and other types of nonprice competition give the individual firm some degree of monopoly power that the purely competitive firm does not possess.

1.Product differentiation may be physical (qualitative).

2.Services and conditions accompanying the sale of the product are important aspects of product differentiation.

3.Location is another type of differentiation.

4.Brand names and packaging lead to perceived differences.

5.Product differentiation allows producers to have some control over the prices of their products.

C.Similar to pure competition, under monopolistic competition firms can enter and exit these industries relatively easily. Trade secrets or trademarks may provide firms some monopoly power.

D.Firms often heavily advertise their goods to communicate product differences, and nonprice competition is significant

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Monopolistic Competition and Oligopoly

E. Monopolistically Competitive Industries (Table 11.1). Examples of real-world industries

 

that fit this model are found in

Table 11.1.

 

 

 

1. Concentration ratios are one way to measure market dominance. The four-firm

 

concentration ratio gives the percentage of total industry sales accounted for by the four

 

largest firms. The concentration ratio has several shortcomings in terms of measuring

 

competitiveness.

 

a.

Some markets are local rather than national, and a few firms may dominate within

 

 

the regional market.

 

b.

If the four-firm concentration ratio is less than 40%, it’s likely to be monopolistically

 

 

competitive.

 

 

IV.

Monopolistic Competition: Price and Output Determination

 

A.The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition, because the seller’s product is differentiated from its rivals, so the firm has some control over price.

B.In the short-run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal (MR=MC), as was true in pure competition and monopoly. The profit-maximizing situation is illustrated in Figure 11.1a, and the loss-minimizing situation is illustrated in Figure 11.1b.

C.In the long-run situation, the firm will tend to earn a normal profit only, that is, it will break even (Figure 11.1c).

1.Firms can enter the industry easily and will if the existing firms are making an economic profit (Figure 11.1A). As firms enter the industry, this decreases the demand curve facing an individual firm as buyers shift some demand to new firms; the demand curve will shift until the firm just breaks even. If the demand shifts below the break-even point (including a normal profit), some firms will leave the industry in the long run.

2.If firms were making a loss in the short run, some firms will leave the industry. This will raise the demand curve facing each remaining firm as there are fewer substitutes for buyers. As this happens, each firm will see its losses disappear until it reaches the break-even (normal profit) level of output and price.

3.Complicating factors are involved with this analysis.

a.Some firms may achieve a measure of differentiation that is not easily duplicated by rivals (brand names, location, etc.) and can realize economic profits even in the long run.

b.There is some restriction to entry, such as financial barriers that exist for new small businesses, so economic profits may persist for existing firms.

c.Long-run below-normal profits may persist, because producers like to maintain their way of life as entrepreneurs despite the low economic returns.

d.Despite complications, a normal profit in the long run is a reasonable reflection of the real world.

V.Monopolistic Competition and Economic Efficiency

A.Review the definitions of allocative and productive efficiency:

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Monopolistic Competition and Oligopoly

1.Allocative efficiency occurs when price = marginal cost, i.e., where the right amount of resources are allocated to the product.

2.Productive efficiency occurs when price = minimum average total cost, i.e., where production occurs using the least-cost combination of resources.

3.The gap between price and marginal cost for each firm creates an efficiency (or deadweight) loss industry-wide.

4.Monopolistic Competition is not efficient.

B.Excess capacity will tend to be a feature of monopolistically competitive firms (Figure 11.2 or Figure 11.1c).

1.Price exceeds marginal cost in the long run, suggesting that society values additional units that are not being produced.

2.Firms do not produce the lowest average-total-cost level of output (Figure 11.2).

3.Average costs may also be higher than under pure competition, due to advertising and other costs involved in differentiation.

VI.

Monopolistic Competition: Product Variety

 

A. A monopolistically competitive producer may be able to postpone the long-run outcome of

 

 

 

just normal profits through product development and improvement and advertising.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

B.

Compared with pure competition, this suggests possible

advantages to the consumer.

 

 

 

 

1.

Developing or improving a product can provide the consumer with a diversity of choices.

 

 

2.

Product differentiation is at the heart of the tradeoff between consumer choice and

 

 

 

 

 

productive efficiency. The greater number of choices the consumer has, the greater the

 

 

 

 

 

excess capacity problem.

 

 

3.

Average costs may also be higher than under pure competition, due to advertising and

 

 

 

 

 

other costs involved in differentiation.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

C.

The monopolistically competitive firm juggles three factors—

product attributes, product

 

 

 

price, and advertising

—in seeking maximum profit.

 

 

1.

This complex situation is not easily expressed in a simple economic model such as

 

 

 

 

 

Figure 11.1. Each possible combination of price, product, and advertising poses a

 

 

 

 

 

different demand and cost situation

for the firm.

 

 

2.

In practice, the optimal combination cannot be readily forecast but must be found by trial

 

 

 

 

 

and error.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

VII.

Oligopoly:

Characteristics and Occurrence

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A.

Oligopoly exists where a few large firms producing a homogeneous or differentiated product

 

 

 

dominate a market.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1.

There

are few enough firms

in the industry that firms are

mutually interdependent

—each

 

 

 

 

 

must

consider its rivals’

reactions in response to its decisions about prices, output, and

 

 

 

 

 

advertising.

 

 

 

 

 

 

 

 

 

 

2.

Some oligopolistic industries produce

standardized products

(steel, zinc, copper,

 

 

 

 

 

cement). These are examples of

homogeneous oligopolies

. Other industries produce

 

 

 

 

 

differentiated products

(automobiles, detergents, greeting cards). These are examples of

 

 

 

 

 

heterogeneous oligopolies

.

B. Barriers to entry (see also Ch 10 material):

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Monopolistic Competition and Oligopoly

1.Economies of scale may exist due to technology and market share.

2.The capital investment requirement may be very large.

3.Other barriers to entry may exist, such as patents, control of raw materials, preemptive and retaliatory pricing, substantial advertising budgets, and traditional brand loyalty.

C.Although some firms have become dominant as a result of internal growth, others have gained this dominance through mergers. (“The urge to merge.”)

D.Measuring industry concentration (Table 11.2):

1.Concentration ratios are one way to measure market dominance. The four-firm concentration ratio (CR4) gives the percentage of total industry sales accounted for by the four largest firms. This concentration ratio has several shortcomings in terms of measuring competitiveness. If the concentration ratio is greater than or equal to 40%, then it is considered an oligopoly.

a.Some markets are local rather than national, and a few firms may dominate within the regional market.

b.Interindustry competition sometimes exists, so dominance in one industry may not mean that competition from substitutes is lacking.

c.World trade has increased competition, despite high domestic concentration ratios in some industries like the auto industry. The ratios are for domestic production and do not include the international trade.

d.Concentration ratios fail to measure accurately the distribution of power among the leading firms.

2.The Herfindahl index is another way to measure market dominance. It measures the sum of the squared market shares of each firm in the industry, so that much larger weight is given to firms with high market shares. A high Herfindahl index number indicates a high degree of concentration in one or two firms. A lower index might mean that the top four firms have rather equal shares of the market, for example, 25 percent each (25 squared x 4 = 2,500). A high index might be where one firm has 80 percent of the industry and the others have 6 percent each for a total of 6400 + (6 squared x 3) = 6,508.

3.Concentration tells us nothing about the actual market performance of various industries in terms of how vigorous the actual competition is among existing rivals.

E.Consider This … Creative Strategic Behavior

Strategic behavior can come in the form of pricing decisions, product differentiation, or through creative marketing (creating perceived product differences). It can apply to either competitive or collusive behavior (including cheating on collusive agreements).

VIII. Oligopoly Behavior: A Game Theory Overview

A.Oligopoly behavior is similar to a game of strategy, such as poker, chess, or bridge. Each player’s action is interdependent with other players’ actions. Game theory can be applied to analyze oligopoly behavior. A two-firm model or duopoly will be used.

B.Figure 11.3 (or see the PowerPoint) illustrates the profit payoffs for firms in a duopoly in an imaginary athletic-shoe industry. Pricing strategies are classified as high-priced or low- priced, and the profits in each case will depend on the rival’s pricing strategy.

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Monopolistic Competition and Oligopoly

 

C.

Mutual interdependence is demonstrated by the following: RareAir’s best strategy is to have

 

 

a low-price strategy if Uptown follows a high-price strategy. However, Uptown will not

 

 

remain there, because it is better for Uptown to follow a low-price strategy when RareAir has

 

 

a low-price strategy.

Each possibility points to the interdependence of the two firms

. This is

 

 

a major characteristic of oligopoly.

 

D.

Another conclusion is that oligopoly can lead to collusive behavior. In the athletic-shoe

 

 

example, both firms

could improve their positions if they agreed to both adopt a high-price

 

 

strategy.

 

However, such an agreement is collusion and is a violation of U.S. anti-trust laws.

 

E.

If collusion does exist, formally or informally, there is much incentive on the part of both

 

 

parties to cheat and secretly break the agreement. For example, if RareAir can get Uptown to

 

 

agree to a high-price strategy, then RareAir can sneak in a low-price strategy and increase its

 

 

profits.

(Look at the current situation with OPEC)

 

 

 

 

 

 

 

F. CONSIDER THIS … The Prisoner’s Dilemma

 

 

In the game in Figure 11.3, both firms realize they would make higher profits if each used a

 

 

high price strategy. But each firm ends up choosing a low price strategy because it fears that

 

 

it will be worse off if the other firm uses a low price strategy against it.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

IX.

Three oligopoly models

are used to explain oligopolistic price-output behavior. (There is

 

no single model that can portray this market structure due to the wide diversity of

 

oligopolistic situations and mutual interdependence that makes predictions about pricing

 

and output quantity precarious.)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A. The

kinked-demand model

assumes a noncollusive oligopoly. (See Key Graph 11.4)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1. The individual firms believe that rivals will

match any price cuts.

 

Therefore, each firm

 

 

 

views its demand

as inelastic for price cuts,

which means they will not want to lower

 

 

 

prices since total revenue falls when demand is inelastic and prices are lowered.

 

 

2. With regard to raising prices, there is no reason to believe that rivals will follow suit

 

 

 

because they may increase their market shares by not raising prices. Thus, without any

 

 

 

prior knowledge of rivals’ plans, a firm will expect that demand will be

elastic when it

 

 

 

increases price

. From the total-revenue test, we know that raising prices when demand is

 

 

 

elastic will decrease revenue. Therefore, the noncolluding firm will not want to raise

 

 

 

prices.

 

 

 

 

 

 

 

 

3. This analysis is one explanation of the fact that prices

tend to be inflexible

in

 

 

 

oligopolistic industries.

 

 

4. Figure 11.4a illustrates the situation relative to an initial price level of P. It also shows

 

 

 

that marginal cost has substantial ability to increase at price P before it no longer equals

 

 

 

MR; thus,

changes in marginal cost will also not tend to affect price.

 

 

 

5. There are criticisms of the kinked-demand theory.

 

 

 

a. There is no explanation of why P is the original price.

 

 

 

b. In the real world oligopoly prices are often not rigid, especially in the upward

 

 

 

 

direction.

 

 

 

 

B.

Cartels and collusion agreements

constitute another oligopoly model. (See Figure 11.5)

 

 

1. Game theory suggests that collusion is beneficial to the participating firms.

2. Collusion reduces uncertainty, increases profits, and may prohibit the entry of new rivals.

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Monopolistic Competition and Oligopoly

3.A cartel may reduce the chance of a price war breaking out particularly during a general business recession.

4.The kinked-demand curve’s tendency toward rigid prices may adversely affect profits if general inflationary pressures increase costs.

5.To maximize profits, the firms collude and agree to a certain price. Assuming the firms have identical cost, demand, and marginal-revenue date the result of collusion is as if the firms made up a single monopoly firm.

6.A cartel is a group of producers that creates a formal written agreement specifying how much each member will produce and charge. The Organization of Petroleum Exporting Countries (OPEC) is the most significant international cartel.

7.Cartels are illegal in the U.S., thus any collusion that exists is covert and secret. Examples of these illegal, covert agreements include the 1993 collusion between dairy companies convicted of rigging bids for milk products sold to schools and, in 1996, American agribusiness Archer Daniels Midland, three Japanese firms, and a South Korean firm were found to have conspired to fix the worldwide price and sales volume of a livestock feed additive.

8.Tacit understandings or “gentlemen’s agreements,” often made informally, are also illegal but difficult to detect.

9.There are many obstacles to collusion:

a.Differing demand and cost conditions among firms in the industry;

b.A large number of firms in the industry;

c.The incentive to cheat;

d.Recession and declining demand (increasing ATC);

e.The attraction of potential entry of new firms if prices are too high; and

f.Antitrust laws that prohibit collusion.

C.Price leadership is a type of gentleman’s agreement (a tacit or unspoken agreement) that allows oligopolists to coordinate their prices legally; no formal agreements or clandestine meetings are involved. The practice has evolved whereby one firm, usually the largest, changes the price first and, then, the other firms follow.

1.Several price leadership tactics are practiced by the leading firm.

a.Prices are changed only when cost and demand conditions have been altered significantly and industry-wide.

b.Impending price adjustments are often communicated through publications, speeches, and so forth. Publicizing the “need to raise prices” elicits a consensus among rivals.

c.The new price may be below the short-run profit-maximizing level to discourage new entrants.

2.Price leadership in oligopoly occasionally breaks down and sometimes results in a price war. A recent example occurred in the breakfast cereal industry in which Kellogg had been the traditional price leader (in competition with General Mills).

X.Oligopoly and Advertising

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Monopolistic Competition and Oligopoly

A.Product development and advertising campaigns are more difficult to combat and match than lower prices.

B.Oligopolists have substantial financial resources with which to support advertising and product development.

C.Advertising can affect prices, competition, and efficiency both positively and negatively.

1.Advertising reduces a buyers’ search time and minimizes these costs.

2.By providing information about competing goods, advertising diminishes monopoly power, resulting in greater economic efficiency.

3.By facilitating the introduction of new products, advertising speeds up technological progress.

4.If advertising is successful in boosting demand, increased output may reduce long run average total cost, enabling firms to enjoy economies of scale.

5.Not all effects of advertising are positive.

a.Much advertising is designed to manipulate rather than inform buyers.

b.When advertising either leads to increased monopoly power, or is self-canceling, economic inefficiency results.

XI.

The economic efficiency of an oligopolistic industry is hard to evaluate.

 

 

 

 

 

 

 

 

A. Allocative and productive efficiency are

not realized

because price will exceed marginal

 

 

 

cost

and, therefore, output will be less than minimum average-cost output level (Figure

 

 

 

11.5). Informal collusion among oligopolists may lead to price and output decisions that are

 

 

 

similar to that of a pure monopolist

while appearing to involve some competition.

 

B.

The economic inefficiency may be lessened because:

 

 

1.

Foreign competition has made many oligopolistic industries much more competitive

 

 

 

 

when viewed on a global scale.

 

 

2.

Oligopolistic firms may keep prices lower in the short run to deter entry of new firms.

 

 

3.

Over time, oligopolistic industries may foster more rapid product development and

 

 

 

 

greater improvement of production techniques than would be possible if they were purely

 

 

 

 

competitive. (See Chapter 24)

 

 

XII.

LAST WORD:

The Beer Industry:

Oligopoly Brewing?

 

A. In 1947 there were 400 independent brewers in the U.S.; by 1967 the number had declined to

 

 

 

124; by 1980 the number was 33.

 

B.

In 1947, the five largest brewers sold 19 percent of the nation’s beer; currently, the big three

 

 

 

brewers sell 76 percent of the total. Anheuser-Busch and SABMiller alone sell 66 percent.

 

C.

Demand has changed.

 

 

1.

Tastes have shifted from stronger-flavored beers to lighter, dryer products.

 

 

2.

Consumption has shifted from taverns to homes, which has meant a different kind of

 

 

 

 

packaging and distribution.

 

D.

Supply-side changes have also occurred.

 

 

1.

Technology has changed, speeding up bottling and can closing.

 

 

2.

Large plants can reduce labor costs by automation.

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Monopolistic Competition and Oligopoly

3.Large fixed costs are spread over larger outputs.

4.Mergers have occurred but are not the fundamental cause of increased concentration.

5.Advertising and product differentiation have been important in the growth of some firms, especially Miller.

E.There continues to be some competition from imported beers (about 15 percent of the market) and, to a lesser extent, microbreweries (about 6 percent of the market).

COMMENTS

1.Mutual interdependence is a key concept to understand in this chapter. It may be the most important determinant in deciding to which market structure a particular business belongs.

2.Refer again to the three-step process outlined in Chapter 9 (Pure Competition) to determine a firm’s situation in the short run. Using MC, ATC, and AVC consistently to determine the same information: (1) MC = MR determines the best quantity of production; (2) comparing ATC and price determines per unit profit or loss; and (3) if a loss is occurring should the firm shutdown? Compare AVC and price.

3.Review allocative and productive efficiency and compare the long run equilibrium outcome of pure competition with the corresponding models of monopolistic competition and oligopoly.

4.The OPEC cartel’s changing strength is an excellent case study for demonstrating the factors that lead to successful collusive agreements and the factors that lead to their demise.

5.The beer industry (see Last Word section) and the soft-drink industry provide other good examples of familiar industries characterized by high concentration ratios. The influence of microbreweries and imports complicate analysis of the beer industry.

7.The Wall Street Journal, Advertising Age, and Business Week, among other business periodicals, frequently have articles on industries that lend themselves to good topics for an Article review. Other industries that are in the news frequently and would be suitable for an Article Review on whether they have become too concentrated are airlines, professional sports (any or all), college athletics, private colleges, and meatpacking.

8.You may find the following “Concept Illustration” useful in the discussion of collusion.

Concept Illustration: Collusion

One of the most famous cases of collusion in the United States involved some very unusual methods of conspiracy. In 1960 an extensive price-fixing and market-sharing scheme involving heavy electrical equipment such as transformers, turbines, circuit breakers, and switch gear was uncovered. Such participants as General Electric, Westinghouse, and Allis-Chalmers had developed elaborate covert schemes to rig prices and divide the market. Consider switch gear equipment:

At . . . periodic meetings, a scheme or formula for quoting nearly identical prices to electric utility companies, private industrial corporations and contractors was used by defendant corporations, designated by their representatives as a “phase of the moon” or “light of the moon” formula. Through cyclic rotating positioning inherent in the formula one defendant corporation would quote the low price, others would quote intermediate prices and another would quote the high price; these positions would be periodically rotated among the defendant corporations … This formula was designed to permit each

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Monopolistic Competition and Oligopoly

defendant corporation to know the exact price it and every other defendant corporation would quote on each prospective sale.

At these periodic meetings, a cumulative list of sealed bid business secured by all of the defendant corporations was also circulated and the representatives present would compare the relative standing of each corporation according to its agreed upon percentage of the total sales pursuant to sealed bids. The representatives present would then discuss particular future bid invitations and designate which defendant corporation should submit the lowest bid therefore, the amount of such bid, and the amounts of the bid to be submitted by others.1

1Jules Backman, The Economics of the Electrical Equipment Industry (New York: New York University Press, 1962), pp. 135-138, abridged. Reprinted by permission.

9.Because the term “monopolistic competition” suggests monopoly, you may have a difficult time recalling that monopolistic competition is the market structure closest to pure competition. Note that monopolistic competition is an “oxymoron”; look up the term and have fun thinking of others: e.g., jumbo shrimp, pretty ugly, awfully good, etc. This may help you to understand the combination term; while the market structure is competitive there is also an element of monopoly present. Alternatively, note that “monopolistic” is the adjective and that “competition” is the subject.

10.In attempting to categorize firms into their appropriate market structure, some of the examples may not fit clearly into a single market structure. Firms such as McDonald’s, Burger King, and Wendy’s behave as oligopolists in terms of their strategic behavior toward each other. Furthermore, in some markets (Interstate highway or Turnpike food stops), there may only be two or three fast-food restaurants. In other locations there will be numerous competitors offering a wide array of potential substitutes to consumers. Is McDonald’s an oligopolist or monopolistic competitor, the answer may be “yes,” because in some cases it will be an oligopoly firm (perhaps even a local monopoly), and other times a monopolistic competitor.

END-OF-CHAPTER QUESTIONS

11-1 How does monopolistic competition differ from pure competition in its basic characteristics? From pure monopoly? Explain fully what product differentiation may involve. Explain how the entry of firms into its industry affects the demand curve facing a monopolistic competitor and how that, in turn, affects its economic profit.

11-2 (Key Question) Compare the elasticity of the monopolistically competitor’s demand curve with that of a pure competitor and a pure monopolist. Assuming identical long-run costs, compare graphically the prices and output that would result in the long run under pure competition and under monopolistic competition. Contrast the two market structures in terms of productive and allocative efficiency. Explain: “Monopolistically competitive industries are characterized by too many firms, each of which produces too little.”

11-6 Why do oligopolies exist? List five or six oligopolists whose products you own or regularly purchase (Find out and list what make is your car, your stove and oven, your microwave, your refrigerator, etc. What distinguishes oligopoly from monopolistic competition?

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Monopolistic Competition and Oligopoly

11-7 (Key Question) Answer the following questions, which relate to measures of concentration:.

a.What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent? What are the shortcomings of concentration ratios as measures of monopoly power?

11-9 (Key Question) What assumptions about a rival’s response to price changes underlie the kinked-demand curve for oligopolists? Why is there a gap in the oligopolists’ marginal- revenue curve? How does the kinked demand curve explain price rigidity in oligopoly? What are the shortcomings of the kinked-demand model?

11-10 Why might price collusion occur in oligopolistic industries? Assess the economic desirability of collusive pricing. What are the main obstacles to collusion? Speculate as to why price leadership is legal in the United States, whereas price fixing is not.

11-11 (Key Question) Why is there so much advertising in monopolistic competition and oligopoly? How does such advertising help consumers and promote efficiency? Why might it be excessive at times?

11-13 (Last Word) What firm dominates the beer industry? What demand and supply factors have contributed to “fewness” in this industry?

ANSWERS

11-1 In monopolistic competition there are many firms but not the very large numbers of pure competition. The products are differentiated, not standardized. There is some control over price in a narrow range, whereas the purely competitive firm has none. There is relatively easy entry; in pure competition, entry is completely without barriers. In monopolistic competition, there is much nonprice competition, such as advertising, trademarks, and brand names. In pure competition, there is no nonprice competition.

In pure monopoly there is only one firm. Its product is unique and there are no close substitutes. The firm has much control over price, being a price maker. Entry to its industry is blocked. Its advertising is mostly for public relations.

(Read this and edit it since it is so wordy.) Product differentiation may well only be in the eye of the beholder, but that is all the monopolistic competitor needs to gain an advantage in the market—provided, of course, the consumer looks upon the assumed difference favorably. The real differences can be in quality, in services, in location, or even in promotion and packaging, which brings us back to where we started: possibly nonexistent differences. To the extent that product differentiation exists in fact or in the mind of the consumer, monopolistic competitors have some limited control over price, for they have built up some loyalty to their brand.

When economic profits are present, additional rivals will be attracted to the industry because entry is relative easy. As new firms enter, the demand curve faced by the typical firm will shift to the left (fall). Because of this, each firm has a smaller share of total demand and now faces a larger number of close-substitute products. This decline firm’s demand reduces its economic profit.

11-2 The monopolistic competitor’s demand curve is less elastic than a pure competitor and more elastic than a pure monopolist. Price is higher and output lower for the monopolistic competitor. Pure competition: P = MC (allocative efficiency); P = minimum ATC (productive efficiency). Monopolistic competition: P > MC (allocative efficiency) and P > minimum ATC (productive inefficiency). Monopolistic competitors have excess capacity; meaning that fewer firms operating at capacity (where P = minimum ATC) could supply the industry output.

11-3 “Monopolistic competition is monopoly up to the point at which consumers become willing to buy close-substitute products and competitive beyond that point.” Explain.

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As long as consumers prefer one product over another regardless of relative prices, the seller of the product is a monopolist. But in monopolistic competition this happy state is limited because there are many other firms producing similar products. When one firm’s prices get “too high” (as viewed by consumers), people will switch brands. At this point, our firm has entered the competitive zone unwillingly, which is why monopolistically competitive firms are forever trying to find ways to differentiate their products more thoroughly and thus to gain more monopoly price-setting power.

11-4 “Competition in quality and in service may be just as effective as price competition in giving buyers more for their money.” Do you agree? Why? Explain why monopolistically competitive firms frequently prefer nonprice to price competition.

This can certainly be true. It depends on how much consumers value quality and service, and are willing to pay for it through higher product prices. In a monopolistically competitive market the consumer can buy a substitute brand for a lower price, if the consumer prefers a lower price to better quality and service.

The monopolistically competitive firm frequently prefers nonprice competition to price competition, because the latter can lead to the firm producing where P = ATC and thus making no economic profit or, worse, producing in the short run where P < ATC and thus losing money, with the possibility of eventually going out of business.

Nonprice competition, on the other hand, if successful, results in more monopoly power: The firm’s product has become more differentiated from now less-similar competitors in the industry. This increase in monopoly power allows the firm to raise its price with less fear of losing customers. Of course, the firm must still follow the MR = MC rule, but its success in nonprice competition has shifted both the demand and MR curves upward to the right. This results in simultaneously a larger output, a higher price, and more economic profits.

11-6 Oligopolies exist for several reasons, the most common probably being economies of scale. If these are substantial, as they are in the automobile industry, for example, only very large firms can produce at minimum average cost. This makes it virtually impossible for new firms to enter the industry. A small firm could not produce at minimum cost and would soon be competed out of the business; yet to start at the required very large scale would take far more money than an unestablished firm is likely to be able to raise before proving it will be profitable.

Other barriers to entry include ownership of patents by the oligopolists and, possibly, massive advertising that gives would-be newcomers no chance to establish a presence in the public’s mind. Finally, there is the urge to merge. Mergers have the clear advantage of reducing competition—of giving the emerging oligopolists more monopoly power. Also, they may result in more economies of scale and thereby increase that barrier to new entry.

Oligopolies with which we deal include manufacturers of automobiles, ovens, refrigerators, personal computers, gasoline, and courier services.

Oligopoly is distinguished from monopolistic competition by being composed of few firms (not many); by being mutually interdependent with regard to price (instead of control within narrow limits); by having differentiated or homogeneous products (not all differentiated); and by having significant obstacles to entry (not easy entry). Both engage in much nonprice competition.

11-7 A four-firm concentration ratio of 60 percent means the largest four firms in the industry account for 60 percent of sales; a four-firm concentration ratio of 90 percent means the largest four firms account for 90 percent of sales. Shortcomings: (1) they pertain to the nation as a whole, although relevant markets may be localized; (2) they do not account for interindustry competition; (3) the data are for U.S. products—imports are excluded; and

(4) they don’t reveal the dispersion of size among the top four firms.

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b. Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent of total industry sales. For the five firms in industry B the figures are 60, 25, 5, 5, and 5 percent. Calculate the Herfindahl index for each industry and compare their likely competitiveness.

Herfindahl index for A: 2,400 (= 900 + 900 + 400 + 100 + 100). For B: 4,300 (= 3,600 + 625 + 25 + 25 +25). We would expect industry A to be more competitive than Industry B, where one firm dominates and two firms control 85 percent of the market.

11-8 (Key Question) Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit figures are in thousands.

a.Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries.

b.Assuming no collusion between C and D, what is the likely pricing outcome?

c.In view of your answer to 8b, explain why price collusion is mutually profitable. Why might there be a temptation to cheat on the collusive agreement?

The matrix shows the four possible profit outcomes for each of two firms, depending on which of the two price strategies each follows. Example: If C sets price at $35 and D at $40, C’s profits will be $59,000, and D’s $55,000.

(a)C and D are interdependent because their profits depend not just on their own price, but also on the other firm’s price.

(b)Likely outcome: Both firms will set price at $35. If either charged $40, it would be concerned the other would undercut the price and its profit by charging $35. At $35 for both; C’s profit is $55,000, D’s, $58,000.

(c)Through price collusion—agreeing to charge $40—each firm would achieve higher profits (C = $57,000; D = $60,000). But once both firms agree on $40, each sees it can increase its profit even more by secretly charging $35 while its rival charges $40.

11-9 Assumptions: (1) Rivals will match price cuts: (2) Rivals will ignore price increases. The gap in the MR curve results from the abrupt change in the slope of the demand curve at the going price. Firms will not change their price because they fear that if they do their total revenue and profits will fall. Shortcomings of the model: (1) It does not explain how the going price evolved in the first place; (2) it does not allow for price leadership and other forms of collusion.

11-10 Price wars are a form of competition that can benefit the consumer but can be highly detrimental to producers. As a result, oligopolists are naturally drawn to the idea of price-fixing among

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themselves, i.e., colluding with regard to price. In a recession, it is nice to know whether one’s rivals will cut prices or quantity, so that a mutually satisfactory solution can be reached. It is also convenient to be able to agree on what price to set to bankrupt any would-be interloper in the industry.

From the viewpoint of society, collusive pricing is not economically desirable. From the oligopoly’s viewpoint it is highly desirable since, when entirely successful, it allows the oligopoly to set price and quantity as would a profit-maximizing monopolist.

The main obstacles to collusion are demand and cost differences (which result in different points of equality of MR and MC); the number of firms (the more firms, the lower the possibility of getting together and reaching sustainable agreement); cheating (it pays to cheat by selling more below the agreed-on price—provided the other colluders do not find out); recession (when demand slumps, the urge to shave prices—to cheat—becomes much greater); potential entry (the above-equilibrium price that is the reason for collusion may entice new firms into this profitable industry—and it may be hard to get new entrants into the combine, quite apart from the unfortunate increase in supply they will cause); legal obstacles (for a century, antitrust laws have made collusion illegal).

Price leadership is legal because although the firms may follow the dominant firm’s price, they are not compelled to. Also, the tacit agreement on price does not also include an agreement to control quantity and to divide up the market.

11-11 Two ways for monopolistically competitive firms to maintain economic profits are through product development and advertising. Also, advertising will increase the demand for the firm’s product. The oligopolist would rather not compete on a basis of price. Oligopolists can increase their market share through advertising that is financed with economic profits from past advertising campaigns. Advertising can operate as a barrier to entry.

Advertising provides information about new products and product improvements to the consumer. Advertising may result in an increase in competition by promoting new products and product improvements. It may also result in increased output for a firm, pushing it down its ATC curve and closer to productive efficiency (P = minimum ATC).

Advertising may result in manipulation and persuasion rather than information. An increase in brand loyalty through advertising will increase the producer’s monopoly power. Excessive advertising may create barriers to entry into the industry.

11-13 Anheuser-Busch is the dominant firm in the industry.

On the demand side, there is evidence that by the 1970s tastes had changed in favor of lighter, drier beers produced by the larger brewers. Second, there has been a shift from consumption in taverns to home consumption, which means higher sales of packaged containers that can be shipped long distances.

On the supply side, technological advances have increased bottling lines, so that the number of cans filled per hour rose from 900 in 1965 to over 2000 in 1990s; large plants have been able to take advantage of economies of scale; television advertising also favors the large producers; and extensive product differentiation exists despite the smaller number of firms, which has enabled these firms to expand still further.

QUIZ

1.Nonprice competition refers to:

A.competition between products of different industries, for example, competition between aluminum and steel in the manufacture of automobile parts.

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B.price increases by a firm that are ignored by its rivals.

C.advertising, product promotion, and changes in the real or perceived characteristics of a product.

D.reductions in production costs that are not reflected in price reductions.

Answer: C

2.In the short-run, a profit-maximizing monopolistically competitive firm sets it price:

A.equal to marginal revenue.

B.equal to marginal cost.

C.above marginal cost.

D.below marginal cost.

Answer: C

3.In the long run, new firms will enter a monopolistically competitive industry:

A.provided economies of scale are being realized.

B.even though losses are incurred in the short run.

C.until minimum average total cost is achieved.

D.until economic profits are zero.

Answer: D

4.A monopolistically competitive firm in the short run is producing where price is $3.00 and marginal cost is $1.50. To maximize profits:

A.The firm should continue to produce this quantity

B.The firm should increase output and decrease price

C.The firm should decrease output and increase price

D.It is unclear what the firm should do without knowing marginal revenue

Answer: D

5.Which of the following statements is true?

A.Nash equilibriums exist only in games with dominant strategies.

B.Dominant strategies do not exist in repeated games.

C.Collusive agreements will always break down in repeated games.

D.Games with a known ending date undermine reciprocity strategies. Answer: D

6.In a duopoly, if one firm increases its price, then the other firm can:

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A.Keep its price constant and thus increase its market share

B.Keep its price constant and thus decrease its market share

C.Increase its price and thus increase its market share

D.Decrease its price and thus decrease its market share Answer: A

7.The term oligopoly indicates:

A.a one-firm industry.

B.many producers of a differentiated product.

C.a few firms producing either a differentiated or a homogeneous product.

D.an industry whose four-firm concentration ratio is low.

Answer: C

8.Game theory:

A.is the analysis of how people (or firms) behave in strategic situations.

B.is best suited for analyzing purely competitive markets.

C.reveals that mergers between rival firms are self-defeating.

D.reveals that price-fixing among firms reduces profits.

Answer: A

9.The kinked-demand curve of an oligopolist is based on the assumption that:

A.competitors will follow a price cut but ignore a price increase.

B.competitors will match both price cuts and price increases.

C.competitors will ignore a price cut but follow a price increase.

D.there is no product differentiation.

Answer: A

10.If oligopolistic firms facing similar cost and demand conditions successfully collude, price and output results in this industry will be most accurately predicted by which of the following models?

A.The kinked demand curve model of oligopoly

B.The price-leadership model of oligopoly

C.The pure monopoly model

D.The monopolistic competition model

Answer: C

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