Chapter 25

Monopolistic Competition and Oligopoly

Key characteristics of Monopolistic Competition:

1. Large number of sellers
individual firms have relatively small market share
no collusion
independent action (i.e. not significant interdependence)
2. Differentiated Products
Product Attributes
Service
location
Branding / Merchandising / significant advertising expenditures
product differentiation provides some control
over price
3. Easy entry and exit

Monopolistic Competition:
Price and Output
The firm faces highly elastic demand.
many rivals producing close
substitutes
product differentiation means
demand is not perfectly elastic
Shortrun:
MR = MC maximizes profits (or
Longrun:
minimizes losses)
the firm will tend to earn a normal profit only,
but no economic profits
Easy entry/exit
Complicating factors (theory v. practice):
Product differentiation can be strong (branding, location, etc.);
some firms are able to sustain long run profits
Always some restriction to entry (e.g. start-up costs); economic
profits may linger into the long run

Monopolistic Competition and Economic Efficiency

Review:
Allocative efficiency:
P = MC (at MC = D)
price = marginal cost
- the right amount of resources are allocated to the product
Productive efficiency: P = min. ATC (at ATC = D) price = minimum
average total cost
- production occurs using the lowest cost combination of
resources
MONOPOLISTIC COMPETITION IS NOT EFFICIENT:
Allocative Efficiency not achieved
Long run P > MC
consumers want additional units not being produced
Productive Efficiency not achieved
although long run P = ATC at the given level of output, firms do
not produce the output that coincides with the lowest ATC
costs associated with product differentiation (not incurred in

Monopolistic Competition (cont.)

A producer may be able to postpone the long-run outcome of zero
economic profit
- new product development, current product improvement,
merchandising
Although the consumer pays a higher price in monopolistic
competition (and the producers dont supply enough), one
consumer benefit exists:
-- additional product choice (close but not exact substitutes)
The monopolistically competitive firm juggles three factors in seeking
maximum profit.
product attributes
product price
advertising
Theory v. Practice:
Every possible combination of price, product, and advertising
poses a different demand and cost situation for the
individual firm.
The optimal combination cannot be easily predicted.

#1. 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.

Economic profits attract competing firms to enter:

- putting downward pressure on prices
- decreasing the portion of market demand held by the individual
firm.
This reduces economic profit for the individual firm.

http://
www.youtube.com/watch?v=6c0VtOdibcI&feature=relmfu
Spurlock on branding/advertising

Oligopoly
Key characteristics:
a few large producers
differentiated or homogeneous product
some monopoly power over price, but
limited by mutual interdependence
strong barriers to entry
Economies of scale, initial costs of capital,
control/ownership of resources
Mergers may lead to and are prevalent in oligoply.
increase monopoly power

Determining the Market Structure of an Industry

Concentration Ratio:
-- a measure of the total output produced in an industry by a given
number of firms in the industry.
-- a four firm concentration ratio is the most commonly used
-- a high concentration ratio is associated with less competition
Assume Industry A, with 10 producers that have market shares (%)
of:
30%

23%

15%

10%

8%

6%

4% 2% 1% 1%

The four firm concentration ratio is: 78%

Assume Industry B, with 10 producers that have market shares (%)
of:
12%

11%

10%

10%

10%

10%

10%

10%

9% 8%

The four firm concentration ratio is: 43%

Industry B appears much more competitive than Industry A.
0 50%: Industry ranges from perfect competition to oligopoly

Determining the Market Structure of an Industry

Herfindahl Index:
-- a measure of the size of firms in relation to the industry
-- an indicator of the amount of competition in an industry.
-- named after economist Orris C. Herfindahl
-- widely applied in competition law and antitrust inquiry
-- a relatively high Herfindahl Index is associated with low competition
defined as the sum of the squares of the market shares of all the
firms in the industry
--

Assume Industry A, with 10 producers that have market shares (%)

of:
30%

23%

15%

10%

8%

6%

4% 2% 1% 1%

The Herfindahl Index is:

Assume Industry B, with 10 producers that have market shares (%)
of:
12%

11%

10%

10%

10%

10%

10%

10%

9% 8%

Oligopoly & Game Theory

Dominant Strategy:
No matter what the opponent
does, a strategy that earns a
player a payoff better than any
other strategy.
Does not mean player gets the
best possible payoff.
Nash Equilibrium:
- set of strategies, one for each player, such that
no player has incentive to unilaterally
change his strategy
- does not mean either player gets the best possible payoff
- one example of equilibrium is if both players have a dominant
strategy
- players are in Nash equilibrium if each one is making the best decisio
that he can, taking into account the potential decisions of the other
Prisoners Dilemma:
- situation in which both players could improve the Equilibrium
outcome by collusion

1. Does either firm have a dominant strategy?

2. Is there a Nash Equilibrium?
3. Can you predict a likely outcome (no collusion)?
4. Is it a Prisoners Dilemma game?
5. Is there an incentive for collusive strategy?
If so, what is the likely result of binding collusion?

Questions for each matrix:

1. Does either firm have a dominant
strategy?
2. Is there a Nash Equilibrium?
3. Can you predict a likely outcome (no
collusion)?
4. Is it a Prisoners Dilemma game?
5. Is there an incentive for collusive
strategy?

Questions for each matrix:

airlines
Coke & Pepsi
1. Does either firm have a both maintain fare both advertise
dominant strategy?
Yes; both
Yes; both
2. Is there a Nash
maintain fare
advertise
Equilibrium?
Yes; both
Yes; both
3. Can you predict a likely
maintain fare
advertise
outcome (no collusion)?
Yes
No
4. Is it a Prisoners Dilemma
game?
Yes; both
No
raise fare
5. Is there an incentive for
collusive strategy? If so,
what is the likely result of

McDs & BK
No
No
No
No
Perhaps

#1. How does monopolistic competition differ from pure competition?

From pure monopoly?

Pure Competition Monopolistic Competition

Pure Monopoly
very large number of firms many firms
one firm
standardized product differentiated product Unique product; no close
no control over price little control over price
subs.
Price maker
no entry barriers very small barriers to entry
Blocked entry
no non-price comp. significant non-price comp.
little/no nonprice comp.
Explain fully what product differentiation involves.

Product differentiation whether based on real or perceived

differences is what the monopolistic competitor needs to gain some
monopoly power in the market.
The real differences can be in quality, in services, in location, or in
marketing.
To the extent that product differentiation exists in fact or in the mind
of the consumer, monopolistic competitors have some control over
price, because they have built up some loyalty to their brand.

#5. Critically evaluate and explain:

In monopolistically competitive industries economic profits
are competed away in the long run; hence, there is no valid
reason to criticize the performance and efficiency of such
industries.
The first part of the statement is TRUE (theoretically) .
The second part of the statement is FALSE.
The inefficiency of monopolistic competition is not related to the
profit level but to the fact that the firms do not produce at the point
of minimum ATC (not productively efficient) and do not equate price
and MC (not allocatively efficient).
This is an inevitable consequence of imperfect competition.
In the long run monopolistic competition leads to a
monopolistic price but not to monopolistic profits.
TRUE.
Competition of close substitutes tends to move price of the average
firm down to equality with ATC. Thus, there is no economic profit.
However, price is higher than in pure competition (and therefore
monopolistic) because while the P = ATC it does not equal

#6. Why do oligopolies exist?

economies of scale

(automobiles, steel industry)

ownership/control of resources (cigarettes, mining industries)
Mergers (banking)
Worcester County National, Shawmut, Fleet, Banknorth, TD
Banknorth, TD Bank
List five or six oligopolists whose products you own or regularly purchase.

Coca-Cola,
Sanford.

Chrysler,

General Electric,

Whirlpool,

What distinguishes oligopoly from monopolistic competition?

Oligopoly
Monopolistic Competition
few firms
many firms
standard or diff. productdifferentiated product
price-maker, but
little control over price
strong entry barriersvery small barriers to entry
significant non-price comp significant non-price comp.

#7a. What is the meaning of a four-firm concentration ratio of 60 percent? 90

percent?

A four-firm concentration ratio states the percentage of sales that

the largest four firms in an industry generate.
A 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.
What are the shortcomings of concentration ratios as measures of monopoly
power?

definition of industry regarding geography (regional v. national v.

international)
do not account for inter-industry competition (theater v. ballpark
entertainment)
do not reveal the dispersion of size among the top four firms.

#7b. 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

Herfindahl index for A:

302 + 302 + 202 + 102 + 102
900 + 900 + 400 + 100 + 100
2,400
Herfindahl index for B:
602 + 252 + 52 + 52 + 52
3,600 + 625 + 25 + 25 +25
4,300
and compare their likely competitiveness.

Industry A would likely be more competitive than Industry B,

where
one firm dominates and two firms control 85 percent of the
market.

8. Explain the general meaning of the following profit payoff matrix for oligopolists
C and D. All profit figures are in thousands. Use the payoff matrix to explain the
mutual interdependence that characterizes oligopolistic industries.

C and D are interdependent because their profits depend not just

on their own price, but also on the other firms price.
Assuming no collusion between C and D, what is the likely pricing 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;
Cs
profit is $55,000, Ds, $58,000.
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?

Through price collusion

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

Why is there so much advertising in monopolistic competition and

oligopoly?
25-11

Monopolistically competitive firms maintain economic profits

through:
product development and advertising.
(advertising will increase demand for the product tastes
and preferences)
The oligopolist would rather not compete on a basis of price.
Advertising can operate as a barrier to entry
How does such advertising help consumers and promote efficiency?

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.

Why might it be excessive at times?

Advertising may result in manipulation and persuasion rather

than information.
An increase in brand loyalty through advertising will increase the
producers monopoly power.

FTC:
http://www.youtube.com/watch?v=NssfPApe5iQ
Bagels price fixing:
http://www.youtube.com/watch?v=u6VHDJ4x0sI
Qantas price fixing:
http://www.youtube.com/watch?v=o_gnvHKoOX4

Prisoners dilemma:
http://www.youtube.com/watch?v=ED9gaAb2BEw
Dark Knight:
http://www.youtube.com/watch?v=TmUWRJInwhk&feature=related
Split/Steal:
http://www.youtube.com/watch?v=InDgRkn04xg