1. Monopolistic Competition, Oligopoly, and Antitrust
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

2. The Effects of Market Entry
In the absence of substantial economies of scale, it is possible for additional firms to enter the market, driving down prices and profit.
Output decisions are based on the marginal principle:
Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

3. The Effects of Market Entry
When a second firm enters the market, the monopoly’s demand and marginal revenue curves shift inward.
The firm’s price and output level will have to be adjusted in order to follow the marginal principle.
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4. The Effects of Market Entry
The monopoly satisfies the marginal principle by producing and selling 300 toothbrushes at $2 each.
After entry, each of two firms produces 200 units and charges $1.85 per unit. Entry decreases price.
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5. The Effects of Market Entry
Before entry, the monopoly produces 300 units, at a cost per unit of $0.90 per toothbrush.
After entry, each of two firms produces 200 units at an average cost of $ Entry increases average cost.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

6. The Effects of Market Entry
Summary:
There are three reasons why profit decreases for the individual firm after entry of a second firm:
Lower price
Lower quantity sold
Higher AC of production
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

7. The Effects of Market Entry
2.00 e
1.85 d
1.00
Revenue or cost ( $ per tooth brush) c
0.90 AC x n D1
MC1 D2
MR1
MR2
200
300
Toothbrushes per minute
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8. Monopolistic Competition
Monopolistic Competition: A market served by dozens of firms selling slightly different products.
Characteristics of Monopolistic Competition:
Many firms
Differentiated product
No artificial barriers to entry
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

9. The Meaning of “Monopolistic Competition”
Each firm is monopolistic because it sells a unique product.
Each firm is a competitive because it sells a product that is a close but not a perfect substitute for the products sold by other firms in the market.
The availability of close substitutes makes the firm’s demand very price elastic.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

10. Product Differentiation
Firms may differentiate their product in several ways:
Physical characteristics
Location
Services
Aura or image
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

11. Short-run and Long-run Equilibrium
As long as there is profit to be made, more and more firms will enter the market.
As firms enter, each firm’s demand curve shifts to the left, decreasing market price, decreasing the quantity produced per firm, and increasing the average cost of production.
Entry will stop once the economic profit of each existing firm reaches zero. In the long run, revenue will be just enough to cover all costs, including the opportunity cost of all inputs, but not enough to cause additional firms to enter.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

12. Long-run Equilibrium Under Monopolistic Competition
In this example, the marginal principle is satisfied at 55 thousand toothbrushes per minute, selling at a price of $ The cost of producing each toothbrush is also $ Economic profit equals zero.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

13. Trade-offs with Monopolistic Competition
Monopoly
Monopolistic Competition
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

14. Trade-offs with Monopolistic Competition
Monopolistic competition brings good news and bad news relative to the monopoly outcome:
Good news: lower price and greater variety
Bad news: higher average cost
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

15. Oligopoly An oligopoly is a market served by a few firms.
The key feature of an oligopoly is that firms act strategically. Firms are interdependent—the actions of one firm affect the profits of the other firms in the market.
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16. Oligopoly and Pricing Decisions
Economists use concentration ratios to measure the degree of concentration, or just how few firms exist in a market.
For example a four firm concentration ratios is the percentage of total output in the market produced by the largest four, i.e., a 93% concentration ratio for cigarettes indicates that the largest 4 firms produced 93% of the total output.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

17. Concentration Ratios in Selected Manufacturing Industries
Industry
Four-firm Concentration Ratio (%)
Eight-firm Concentration Ratio (%)
Cigarettes 93
Not available
Guided missiles and space vehicles 99
Beer and malt beverages 90 98
Batteries 87 95
Electric bulbs 86 94
Breakfast cereals 85
Motor vehicles and car bodies 84 91
Greeting cards 88
Engines and turbines 79 92
Aircraft and parts
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

18. Barriers to Entry in an Oligopoly
Most firms in an oligopoly earn economic profit, yet additional firms do not enter the market, for three reasons:
Economies of scale large enough to generate a natural oligopoly but not a natural monopoly
Government barriers to entry
Substantial investment in an advertising campaign in order to enter the market
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

19. Oligopolistic Firms A duopoly is a market with two firms.
A cartel is a group of firms that coordinate their pricing decisions, often charging the same price for a particular good or service.
The arrangement under which two or more firms act as one, coordinating their pricing decisions, is also known as price fixing.
The equilibrium price and quantity in the oligopolistic market depend on the strategic behavior of the firms in the oligopoly.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

20. Cartel Pricing
In a cartel arrangement, two firms act as one. In this case, they split the market output—each serving 75 passengers per day, and charge $400 per ticket.
The firms also split the profit. Each firm earns $7,500 = [( ) x 150]/2.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

21. Duopoly Pricing
When two firms compete against one another, they end up serving 100 passengers each, at a price of $350.
Each firm earns a profit of $5,000, compared to a profit of $7,500 if they had acted as one firm.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

22. Duopoly Versus Cartel Pricing
The duopoly produces more output and charges a lower price than the cartel.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

23. The Game Tree
A game tree provides a visual representation of the consequences of alternative strategies. Firms can use it to develop pricing strategies.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

24. Cartel and Duopoly Outcomes in the Game Tree
Profits ($000)
Jill Jack $ $7.5
Jack:
High or
Low price?
High
High price
Jill Jack $ $1
Jill:
High or
Low price?
Low
Jill Jack $ $1
High
Jack:
High or
Low price?
Low price
Jill Jack
$ $5
Low
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

25. Cartel and Duopoly Outcomes in the Game Tree
Profits ($000)
Jill Jack $ $7.5
Jack:
High or
Low price?
High
High price
Cartel
Outcome
Jill:
High or
Low price?
Duopoly
Outcome
Jack:
High or
Low price?
Low price
Jill Jack
$ $5
Low
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

26. The Outcome of the Price-Fixing Game
Jack captures large share of market
Jill captures large share of market
Jill: Low Price
Jack: High Price
Price
$350
$400
Quantity
170 10
Average cost
$300
Profit per passenger
$50
$100
Total profit
$8,500
$1,000
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

27. The Dominant Strategy Irrational for Jack to choose high price
Jack chooses the low price when Jill chooses the high price.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

28. The Dominant Strategy
Jack chooses the low price when Jill chooses the low price.
Irrational for Jack to choose high price
Dominant Strategy: Jack chooses the low price regardless of Jill’s choice.
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29. The Duopolists’ Dilemma
Knowing that Jack will choose the low price no matter what, will Jill choose the high price or the low price?
Irrational for Jill to be underpriced.
Jill will choose the low price, and the trajectory of the game is X to Z to 4.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

30. The Duopolists’ Dilemma
The duopolists’ dilemma is that although both firms would be better off if they chose the high price, each firm chooses the low price.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

31. Retaliation for Underpricing
Schemes to punish Jack if he underprices:
Duopoly price: Jill also lowers price; abandons the idea of cartel profits, and settles for duopoly profits which are better than the profits when she is underpriced by Jack.
Tit-for-tat: Jill chooses whatever price Jack chose the preceding month.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

32. Tit-for-Tat Response to Underpricing
Jill chooses whatever price Jack chose the preceding month.
After Jack lowers price, profits sink to the duopoly level. Jack increases price in the fourth month, which restores the cartel pricing in the fifth month.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

33. Avoiding the Dilemma: Guaranteed Price Matching
To eliminate the incentive for underpricing, one firm can guarantee that it will match its competitor’s price.
How will Jack respond to Jill’s price-matching policy?
Choose the high price: Jack matches Jill’s high price in which case both will earn maximum (cartel) profits.
Choose the low price: if Jack chooses the low price, Jill will match the low price and both firms will earn minimum (duopoly) profits. Therefore, Jack has no reason to choose the low price.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

34. Guaranteed Price Matching
Price matching eliminates the duopolists’ dilemma and makes cartel profits and pricing possible, even without a formal cartel.
Guaranteed price matching leads to higher prices. It guarantees that consumers will pay the high price!
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

35. Entry Deterrence and Limit Pricing
An insecure monopolist fears the entry of a second firm, and could react in one of two ways:
A passive strategy: allow the second firm to enter the market
An entry-deterrence strategy: try to prevent the firm from entering
The threat of entry will force the monopolist to act like a firm in a market with many firms, picking a low price and earning a small profit.
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36. The Passive Strategy
If Mona adopts a passive strategy, it will allow Doug to enter the market, and each will earn the duopoly profits of $5,000 each (Duopoly Outcome).
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

37. The Entry-deterrence Strategy
Mona can prevent Doug from entering by incurring a large investment and committing herself to serving a large number of customers at a low price.
400
m: Secure Monopoly
Profit = $15,000
370
350 z
LRAC
300
Market
Demand
Passengers
per day
150
180
200
250
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

38. The Entry-deterrence Strategy
Due to economies of scale, suppose that that the minimum entry quantity is 70 passengers a day, the entry deterring quantity for Mona will be 180 passengers (250-70). If Doug enters serving 70 passengers and Mona serves 180, the price drops to $300, making entry unprofitable to Doug.
400
m: Secure Monopoly
370
i: Insecure Monopoly
Deterrence Profit =
$12,600
350
d: Duopoly z
LRAC
300
Once Mona commits to large load of passengers, the most profitable load will be 180 passengers
Market
Demand
Passengers
per day
150
180
200
250
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

39. The Entry-deterrence Strategy
Mona can prevent Doug from entering by incurring a large investment and committing herself to serving a large number of customers at a low price.
What is more profitable, entry deterrence or the passive duopoly outcome?
400
m: Secure Monopoly
370
i: Insecure Monopoly
Deterrence Profit =
$12,600
350 z
LRAC
300
Market
Demand
Passengers
per day
150
180
200
250
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

40. Antitrust Policy
The purpose of antitrust policy is to promote competition among firms. Competition leads to lower prices and better products.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

41. Antitrust Policy Under federal antitrust rules, the government can:
Break up of monopolies into several smaller companies.
Prevent corporate mergers that would reduce competition.
Regulate business practices.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

42. Brief History of Antitrust Legislation
1890
Sherman Act: made it illegal to monopolize a market or to engage in practices that resulted in a restraint of trade.
1914
Clayton Act: outlawed specific practices that discourage competition, including tying contracts, price discrimination for the purpose of reducing competition, and stock-purchase mergers that would substantially reduce competition.
Federal Trade Commission: established to enforce antitrust laws.
1936
Robinson-Patman Act: prohibited selling products at “unreasonably low prices” with the intent of reducing competition.
1950
Celler-Kefauver Act: outlawed asset-purchase mergers that would substantially reduce competition.
1980
Hart-Scott-Rodino Act: extended antitrust legislation to proprietorships and partnerships.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

43. Breaking Up Monopolies
A trust is an arrangement under which the owners of several companies transfer their decision-making powers to a small group of trustees. Firms in a trust act as a single firm.
The label “antitrust” comes from early cases involving the breakup of trusts.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

44. Blocking Mergers
A merger occurs when two firms combine their operations.
Because a merger decreases the number of firms in a market, it is likely to lead to higher prices.
A possible benefit from a merger is that the new firm could combine production, marketing, or administrative operations, and thus produce its products at a lower average cost.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

45. Blocking Mergers
New guidelines developed by the Justice Department and the Federal Trade Commission allow companies involved in a proposed merger to present evidence that the merger would reduce costs and lead to lower prices, better products, or better service.
The analysis of proposed mergers today focuses less on counting the number of firms in a market, and more on how a merger would affect price.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin

46. Regulating Business Practices
The government may intervene when specific business practices increase market concentration.
Among those practices are:
Price fixing
Tying, or forcing consumers of one product to purchase another
Price discrimination that reduces competition
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