1. Monopolistic Competition and Oligopoly
Chapter 13
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.
First, monopolistic competition is defined, listing important characteristics, typical examples, and efficiency outcomes. Next we turn to oligopoly, surveying the possible courses of price, output, and advertising behavior that oligopolistic industries might follow. Finally, oligopoly is assessed as to whether it is an efficient or inefficient market structure.
The Last Word shows how a few big companies now compete with one another via the Internet as very competitive oligopolists.
Monopolistic Competition and Oligopoly
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Monopolistic Competition
Relatively large number of sellers
Product differentiation
Easy entry and exit
Nonprice competition like advertising
In monopolistic competition, firms can differentiate their products by the product attributes, by service, with location, or with brand names and packaging. There is relatively easy entry and exit, just not as easy as with perfect competition. That is why the number of sellers is not as large as in perfect competition, but it is relatively large. This type of market experiences some pricing power due to the differentiated product. If a firm goes to the trouble and expense of differentiating their product they should let people know about it. They can do this through advertising. Product differentiation and advertising are ways that firms can compete other than by offering the lowest price.
LO1

3. Monopolistically Competitive Industries
Industry concentration
Measured by 4-firm concentration ratio
Percentage of sales by 4 largest firms
Herfindahl index
Sum of squared market shares
output of four largest firms
total output in the industry
4-firm CR =
Four-firm concentration ratios are a measure of industry concentration. Four-firm concentration ratios are low in monopolistically competitive firms as in the table on the next slide. One of the cautions of using these is that they reflect national output (sales numbers) and would not be reflective of a localized monopoly.
Herfindahl index: the lower the HI, the more competitive the industry. The Herfindahl Index is another measure of industry concentration and it is the sum of the squared percentage of market shares of all firms in the industry. Generally speaking, the lower the Herfindahl, the lower the industry concentration.
HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2
LO1

4. Low Concentration Industries
(1)
Industry
(2)
4-Firm Concentration Ratio
(3)
Herfindahl
Index
Textile machinery 30
360
Wood trusses 15
102
Women’s dresses 28
328
Metal stamping 14 88
Textile bags
318
Metal windows and door 13
109
Plastic bags 27
299
Wood pallets 11 51
Ready-mix concrete 23
313
Sheet metal work 7
Jewelry
230
Signs
Asphalt paving 22
188
Stone products
Plastic pipe 21
187
Quick printing 4 8
Sawmills 98
Retail bakeries
Curtains and draperies 85
Bolts, nuts, and rivets 6
This table shows some examples of U.S. manufacturing industries that are considered monopolistically competitive. The lower the 4-firm concentration ratio, the less concentration and subsequently, the more competitive the industry. Generally speaking, the lower the Herfindahl index, the lower the industry concentration.
Source: Bureau of Census, Census of Manufacturers, 2007

5. Price and Output in Monopolistic Competition
Demand is highly elastic
Short run profit or loss
Produce where MR = MC
Long run only a normal profit
Entry and exit
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.
In the short run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly.
The profit maximizing situation is illustrated in the next slide and the loss minimizing situation is illustrated following that.
Much like in pure competition, in monopolistic competition the profits in the long run are equal to zero because of free entry and exit into and out of the industry.
LO2

6. The Short Run: Profit or Loss
ATC MC P1 A1
Price and costs
Economic
profit D1
Firms produce the quantity where MR = MC just like in other industries. It is possible to make a profit in the short run. (Price – ATC) * Q = Economic profit.
At the profit maximizing output, price is higher than ATC and the firms enjoy an economic profit in the short run.
MR = MC MR Q1
Quantity
LO2

7. The Short Run: Profit or Loss
ATC MC A2 P2
Loss
Price and costs D2
Firms will produce the quantity where MR = MC to maximize profits. It is possible to make a loss in the short run.
(Price – ATC) * Q = Economic profit or loss. At the profit maximizing output, price is below ATC and therefore a loss is incurred.
MR = MC MR Q2
Quantity
LO2

8. The Long Run: Only a Normal ProfitMC
ATC
P3= A3
Price and costs D3
In the long run firms still produce the quantity where MR = MC. In the long run firms will enter the industry if economic profits were enjoyed, shifting demand left and profits fall. In the long run firms will exit the industry if there are economic losses, shifting demand to the right and losses shrink. This will continue until the price settles where it just equals ATC at the MR=MC output. At this price, the monopolistically competitive firm earns a normal profit.
MR = MC MR Q3
Quantity
LO2

9. Monopolistic Competition and Efficiency
Monopolistic competition inefficient
Productive inefficiency because P > min ATC
Allocative inefficiency because P > MC
Excess capacity
Productive efficiency means that the firm is producing in the least costly way and is found when P = minimum ATC.
Allocative efficiency means that the firm is producing the right amount of product and is found when P = MC.
Neither condition is met in monopolistic competition. As we examine the industry, we will find that it is inefficient.
There is excess capacity in the industry which means that the plant and equipment are underutilized because firms are producing below minimum ATC output.
LO3

10. Monopolistic Competition and Efficiency
Quantity
Price and costs MC MR D3
ATC Q3
P3= A3
MR = MC P4
Price is lower
We can see the inefficiency of monopolistic competition. In long-run equilibrium a monopolistic competitor achieves neither productive nor allocative efficiency. Productive efficiency is not realized because production occurs where the average total cost A3 exceeds the minimum average total cost A4. Allocative efficiency is not achieved because the product price P3 exceeds the marginal cost. The results are an underallocation of resources as well as an efficiency loss and excess production capacity for every firm in the industry. This firm’s excess production capacity is Q4 - Q3.
Excess capacity at
minimum ATC Q4
LO3

11. Product Variety
The firm constantly manages price, product, and advertising
Better product differentiation
Better advertising
The consumer benefits by greater array of choices and better products
Types and styles
Brands and quality
Monopolistically competitive producers may be able to postpone the long-run outcome of just normal profits through product development, improvement, and advertising. Compared with pure competition, this suggests possible advantages for the consumer. Development, or improved products, can provide the consumer with a diversity of choices. The product variety that is found in monopolistic competition helps compensate for its failure to achieve economic efficiency. Consumers have a wider array of products to choose from and, presumably, they have better quality products to choose from as well.
Product differentiation is at the heart of the trade-off between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem.
LO4

12. Oligopoly Oligopoly A few large producers Homogeneous oligopoly
Differentiated oligopoly
Limited control over price
Entry barriers
Mergers
The entry barriers in oligopoly are not as great as in monopoly, thus we have a few producers. There are homogeneous or standardized oligopolies like the steel and aluminum markets. There are also be differentiated oligopolies like the markets for automobiles, electronics equipment, and breakfast cereals. Control over price is limited because there are just a few sellers in the market and rivals may respond in a way that would be detrimental to the firm that just changed the price. Entry barriers are more substantial than in monopolistic competition which is why there are just a few producers in the market. Although some firms have become dominant as a result of internal growth, others have gained dominance through mergers.
LO5

13. Oligopolistic Industries
Four-firm concentration ratio
40% or more to be an oligopoly
Shortcomings
Localized markets
Interindustry competition
Import competition
Dominant firms
To be an oligopoly, the 4-firm concentration ratio must be at least 40%. Based on this rule of thumb, about 50% of U.S. manufacturing is oligopolistic. Here are four shortcoming to be aware of when using these ratios. Localized markets may have just one producer which is a monopoly, while a low 4-firm concentration ratio indicates a lot of competition in the national industry. Interindustry competition occurs when industries like glass and plastic compete with each other. This competition is not reflected in their high 4-firm concentration ratios. Competition from imports due to world trade is not taken into account when calculating concentration ratios. There may be a dominant firm in the industry exhibiting domination that may be disguised and not reflected in the 4-firm concentration ratio.
LO5

14. High Concentration Industries
(1)
Industry
(2)
4-Firm Concentration Ratio
(3)
Herfindahl
Index
Primary copper 99 ND
Petrochemicals 80
2,535
Cane sugar refining 95
Breakfast cereals
2,426
Cigarettes 98
Small-arms ammunition 79
2,447
Household laundry equipment
Primary aluminum 77
2,250
Household refrigerators and freezers 92
Men’s slacks and jeans 76
2,015
Beer 90
Electric light bulbs 75
2,258
Glass containers 87
2,507
Tires 73
1,540
Electronic computers
Household vacuum cleaners 71
1,519
Phosphate fertilizers 83
Alcohol distilleries 70
1,915
Turbines and generators 68
1,937
Aircraft 81
Motor vehicles
1,744
This table displays a few high-concentration U.S. manufacturing industries. A 4-firm concentration ratio of 40% or more is indicative of an oligopolist.
ND represents “not disclosed”. Source: Bureau of Census, Census of Manufacturers, 2007

15. Oligopoly Behavior Oligopolies display strategic behavior
Mutual interdependence
Collusion
Incentive to cheat
Game theory
Prisoner’s dilemma
Strategic pricing behavior refers to how a firm’s decisions are based on the actions and reactions of rivals.
Mutual interdependence exists when each firm’s profit depends on its own pricing strategy and that of its rivals.
Collusion is defined as cooperating with rivals and can benefit the firm.
There is an incentive for firms to cheat on their agreement to collude because cheating can result in increased revenues for the cheater.
Game theory is the study of how people behave in strategic situations. The Prisoner’s dilemma is a classic example of mutual interdependence and game theory.
LO6

16. Game Theory Overview RareAir’s price strategy 2 competitors
2 price strategies
Each strategy has a payoff matrix
Greatest combined
profit
Independent actions
stimulate a response
High
Low A B
$12
$15
High
$12 $6
Uptown’s price strategy
This graph is a payoff matrix for a two-firm oligopoly and is used to show the payoff to each firm that would result from each combination of strategies. Each firm has two possible pricing strategies. RareAir’s strategies are shown in the top margin, and Uptown’s in the left margin. Each lettered cell of this four-cell payoff matrix represents one combination of a RareAir strategy and an Uptown strategy and shows the profit that combination would earn for each. C D $6 $8
Low
$15 $8
LO6

17. Game Theory Overview RareAir’s price strategy
Independently lowered prices in expectation of greater profit leads to worst combined outcome
Eventually low outcomes make firms return to higher prices.
High
Low A B
$12
$15
High
$12 $6
Uptown’s price strategy
Assuming no collusion, the outcome of this game is cell D, with both parties using low price strategies and earning $8 million in profits. However, this inferior profit level will eventually lead firms to higher prices. C D $6 $8
Low
$15 $8
LO6

18. Three Oligopoly Models
Kinked-demand curve
Collusive pricing
Price leadership
Reasons for 3 models
Diversity of oligopolies
Complications of interdependence
There are two reasons that there is not just a single model to explain this type of market. Oligopoly encompasses a great range and diversity of market structures. The decisions depend on the actions of the rivals, making it more difficult to explain the behaviors without several models. Each of these models are described on the following slides.
LO7

19. Kinked-Demand Theory Noncollusive oligopoly
Uncertainty about rivals reactions
Rivals match any price change
Rivals ignore any price change
Assume combined strategy
Match price reductions
Ignore price increases
The kinked demand model is used for noncollusive oligopolies to explain their behaviors and pricing strategies. Since the firms do not collude, none of the firms know with certainty what their rivals are going to do. However, the firms assume that their rivals will match any price reductions in an effort to maintain their customers. On the other hand, it is reasonable to assume that if a firm raises its price, its rivals will ignore the price change in an effort to steal customers from the firm raising its price.
LO7

20. Kinked-Demand Curve Price Price and costs Quantity Rivals ignore
Rivals ignore
price increase D2
MC1 e e P0 P0
MR2 f f D2
MC2
MR2
Rivals match
price decrease g
This graph shows the kinked-demand curve. (a) The slope of a noncollusive oligopolist’s demand and marginal-revenue curves depends on whether its rivals match (straight lines D1 and MR1) or ignore (straight lines D2 and MR2) any price changes that it may initiate from the current price P0.
(b) In all likelihood an oligopolist’s rivals will ignore a price increase but follow a price cut. This causes the oligopolist’s demand curve to be kinked (D2eD1) and the marginal-revenue curve to have a vertical break, or gap (fg). Because any shift in marginal costs between MC1 and MC2 will cut the vertical (dashed) segment of the marginal-revenue curve, no change in either price, P0, or output, Q0, will result from such a shift. In other words, competitors and rivals strategize against each other, consumers effectively have 2 partial demand curves and each part has its own marginal revenue resulting in a kinked-demand curve to the consumer; price and output are optimized at the kink. g D1 D1 Q0
MR1 Q0
MR1
LO7

21. Kinked-Demand Curve Criticisms Explains inflexibility, not price
Prices are not that rigid
Price war
There are a few criticisms of the kinked demand curve. First, the demand curve was created around the current price that was already being charged, but it never actually explained how the current price was determined. This is very similar to putting the cart before the horse. We have seen that prices are rigid for reasons on the demand and cost side, but prices in oligopolies are not nearly as rigid as this model implies. Lastly, there is always a chance that changing prices could result in a price war.
LO7

22. Cartels and Other Collusion
Price and costs
Quantity MC P0
ATC A0
MR=MC
Oligopolies tend to collude and this model shows how collusive oligopolists behave. Oligopolies are conducive to collusion and the tendency toward joint profit maximization. If oligopolistic firms face identical or highly similar demand and cost conditions, they may collude to limit their joint output and to set a single, common price. Thus, each firm acts as if it were a pure monopolist, setting output at Q0 and charging price P0. This price and output combination maximizes each oligopolist’s profit (green area) and thus, the combined or joint profit of the colluding firms. Collusion is most likely to occur when the good that is being produced is homogeneous.
Economic
profit MR D Q0
LO7

23. Overt Collusion A cartel is a group of firms or nations that collude
Formally agreeing to the price
Sets output levels for members
Collusion is illegal in the United States
OPEC
A cartel is defined as a group of firms or nations joining together and formally agreeing as to the price they will charge and the output levels of each member. It is illegal in the US; however, business with the OPEC cartel is conducted every day. In the past, OPEC has been successful in increasing the price of the oil they sell by restricting supply.
LO7

24. Global Perspective
This Global Perspective reflects the 12 OPEC Nations, Daily Oil Production, October 2012.
The OPEC nations produce about 43 percent of the world’s oil and supplies about 45 percent of the oil sold in world markets.
LO7

25. Obstacles to Collusion
Demand and cost differences
Number of firms
Cheating
Recession
New entrants
Legal obstacles
Because demand and cost differences exist between members, it will be difficult for all members to charge the same price.
The more firms who are part of the agreement, the harder it is to maintain.
There is always a tendency for members to cheat and this erodes the cartel’s power over time. See the Prisoner’s dilemma.
Overall demand declines during recessions making cheating more attractive.
New producers will be drawn to the industry because of the greater prices and profits which will increase market supply and decrease prices.
Laws prohibit cartels and price collusion in the United States.
LO7

26. Price Leadership Model
Dominant firm initiates price changes
Other firms follow the leader
Use limit pricing to block entry of new firms
Possible price war
Price Leadership is an economic model where a dominant firm initiates price changes and the others in the industry follow the leader. The leader communicates price changes through speeches, press releases, or articles in trade journals. One result is infrequent price changes since the leader is never certain that the other firms will follow and there is always the threat of a price war.
LO7

27. Oligopoly and Advertising
Oligopolies commonly compete though product development and advertising
Less easily duplicated than a price change
Financially able to advertise
In differentiated oligopolies advertising is the best way to communicate a firm’s product differences. Product improvements revealed through advertising can be successful in increasing market share and revenues because product innovations are more difficult to copy by a competitor than a price change. Oligopolists are financially able to advertise due to economic profits earned in the past.
LO8

28. Positive Effects of Advertising
Low-cost way of providing information to consumers
Enhances competition
Speeds up technological progress
Can help firms obtain economies of scale
Advertising is a low-cost way of providing information to consumers about different options and it reduces the consumer’s search time for products. Advertising also enhances competition between firms and thus aids in economic efficiency. It speeds up technological progress by introducing new products. Advertising can help firms obtain economies of scale by reducing long run average costs.
LO8

29. Oligopoly and Advertising
The Largest U.S. Advertisers, 2011
Company
Advertising Spending
Millions of $
Proctor & Gamble
$4,971.5
General Motors
3,055.7
Verizon
2,523.0
Comcast
2,465.4
AT&T
2,359.0
JP Morgan Chase
2,351.8
Ford Motor
2,141.3
American Express
2,125.3
L’Oréal
2,124.6
Walt Disney
2,112.2
Oligopolists have substantial financial resources with which to support advertising.
Source: Advertising Age
LO8

30. Negative Effects of Advertising
Can be manipulative
Contain misleading claims that confuse consumers
Consumers may pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product
When advertising either leads to increased monopoly power, or is self-canceling, economic inefficiency results.
LO8

31. Global Perspective
The brands identified here were based on the four criteria of brand’s market share, world appeal across age groups and nationalities, customer loyalty, and the ability to stretch beyond the original product.
Source: 100 Best Global Brands, Interbrand.
LO8

32. Oligopoly and Efficiency
Oligopolies are inefficient
Productively inefficient because P > min ATC
Allocatively inefficient because P > MC
Qualifications
Increased foreign competition
Limit pricing
Technological advance
Productive efficiency is achieved by producing in the least costly way and is evidenced by P = min ATC. Allocative Efficiency is achieved by producing the right amount of output and is evidenced by P = MC. Neither efficiencies occur in oligopolistic markets. Foreign competition has increased rivalry in oligopolistic industries. If the oligopolist leader practices limit pricing, we may get lower prices. Oligopolies may foster more rapid product development because of the competition in the industry and with the firm’s profits they have a means to invest in new technologies.
LO9

33. Internet Oligopolies
The Internet became accessible to the average person in the mid 1990’s
Today it is dominated by a few very large firms
Google, Facebook, Amazon, Microsoft, Apple
Not satisfied with just revenues generated in their respective sectors
Compete for advertising $s
Compete with their own electronic devices
Google grew to be a near monopoly in search; Facebook advanced to be a near monopoly in social media; Amazon has established a near monopoly in retail; Microsoft has held a near monopoly in pc operating systems and software; Apple has dominance with its devices that run on Apple operating systems. These very successful technology companies are now competing outside of their respective sectors with each other in the quest to increase revenues and satisfy invertors. They compete for revenues collected from advertising and they compete by designing new consumer electronic products; this has led to a very competitive environment.