1. McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Goals
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
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3. Market Structure
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
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4. Characteristics of Monopolistic Competition
Four distinguishing characteristics:
Many sellers that do not take into account rivals’ reactions
Product differentiation where the goods that are sold aren’t homogenous
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
Ease of entry of new firms in the long run because there are no significant barriers to entry
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5. Output, Price, and Profit of a Monopolistic Competitor
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
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6. Determining Profits Graphically: Monopolistic CompetitionMC
ATCLosses
ATCL
ATCBreak even
Losses
ATCProfits
Break even P
ATCP
A monopolistic firm can earn profits, losses, or break even in the short run D MR Q Q
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7. Monopolistic Competition Compared with Perfect Competition GraphMC
In monopolistic competition in the long run, P > min ATC,
In perfect competition in the long run, P = min ATC
ATC
PMC
DPC
PPC
Outcome:
Monopolistic competition output is lower and
price is higher than
perfect competition
DMC
MRMC Q
QMC
QPC
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8. Comparing Monopolistic Competition with Monopoly
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)
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9. Advertising and Monopolistic Competition
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”
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10. Characteristics of Oligopoly
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
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11. Models of Oligopoly Behavior
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
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12. The Cartel Model
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
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13. Implicit Price Collusion
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
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14. Why Are Prices Sticky?
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
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15. The Kinked Demand Curve Graph
If P increases, others won’t go along, so D is elastic
A gap in the MR curve exists
A large shift in marginal cost is required before firms will change their price
MC1 P
MC2
Gap
If P decreases, other firms match the decrease, so D is inelastic MR D Q Q
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16. The Contestable Market Model
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
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17. Comparing Contestable Market and Cartel Models
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
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18. New Entry as a Limit on the Cartelization Strategy and Price Wars
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
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19. Comparison of Market Structures
Monopoly
Oligopoly
Monopolistic Competition
Perfect Competition
No. of firms
One
Few
Many
Almost infinite
Barriers to entry
Significant
None
Pricing decisions
MC = MR
Strategic pricing
MC = MR = P
Output decisions
Most output restriction
Output restricted
Output restricted, product differentiation
No output restriction
Interdependence
No competitors
Interdependent decisions
Each firm independent
LR profit
Possible
P and MC
P > MC
P = MC
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20. Classifying Industries and Markets in Practice
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
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21. The North American Industry Classification System
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
Three to Six Digit Sectors 23
Construction 42
Wholesale Trade 51
Information
517 –Telecommunications
5172 – Wireless telecommunications carriers
– Paging 61
Education Services
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22. Empirical Measures of Industry Structure
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
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23. Concentration Ratios and the Herfindahl Index
Industry
Four Firm Concentration Ratio
Herfindahl Index
Poultry 46
773
Soft drinks 52
896
Breakfast cereal 78
2,999
Soap and detergent 38
664
Men’s footwear 44
734
Women’s footwear 64
1,556
Pharmaceuticals 34
506
Computer equipment 49
1,183
Burial caskets 73
2,965
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24. Conglomerate Firms and Bigness
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
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25. Oligopoly Models and Empirical Estimates of Market Structure
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
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26. Chapter Summary 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
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27. Chapter Summary
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
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28. Chapter Summary
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
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29. Preview of Chapter 17: Real-World Competition and Technology
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
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