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11 Monopolistic Competition and Oligopoly

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Learning Outcomes

After reading this chapter, you should be able to

• Discuss the importance of degree of concentration and conditions of entry with regard to industry structure.

• Describe the characteristics of monopolistic competition.

• Explain why interdependence is unique to oligopoly.

• Use game theory to understand oligopolistic behavior.

• Summarize the significant characteristics that differentiate market structures.

234

Section 11.1 Industry Structure

Introduction What’s in a brand name? Do you have a favorite soap, aspirin, breakfast food, or cola? When you get right down to it, a bar of soap is pretty much a bar of soap. An aspirin is pretty much an aspirin, and a cola is pretty much a cola. Maybe including colas is taking it too far—to some people one cola is not the same as any other cola. A few decades ago the Coca-Cola Company introduced a new cola, and some of its customers revolted; some of them even hoarded cases of the original version of the cola. The company eventually gave up and brought back the old favorite as Coca-Cola Classic. To these consumers, one cola was definitely not the same as any other.

To the owner of a brand name, the important question is how much different is the product that has the brand identification. Is it a quarter different? Would you pay 25 cents more for a bar of Dove soap? Would you pay $1 more per bar? How much would you be willing to pay to buy Tylenol over the generic acetaminophen? Perhaps $2 more? Clearly, the value of the brand disappears at some price. Even a product with a brand name is still subject to the forces of supply and demand in a competitive market.

In the 1930s, theories were developed that filled out the spectrum between monopoly and perfect competition. Market structures between the two theoretical extremes are called imperfect competition. Economists divide imperfect competition into monopolistic competi- tion and oligopoly. We will study these two market structures in this chapter.

11.1 Industry Structure Up to this point, we have been using the term industry without carefully defining it. In gen- eral, an industry is a group of firms producing the same, or at least similar, products. Once an industry has been defined, it is possible to determine its market structure, or where it lies on the spectrum from perfect competition to monopoly. The structure will depend on several characteristics of the industry. The degree of concentration and conditions of entry are espe- cially important characteristics. Entry affects concentration because high barriers to entry result in a more concentrated industry.

Economics in Action: What’s in Between?

There is a drastic difference between monopolies (one seller) and perfect competition (many sellers). Are there opportunities for any markets that fall in between these two? For an explanation of the various markets, follow the link to the Khan Academy (http://www.khanacademy.org), and then do a search for the video “Oligopolies and Monopolistic Competition.”

http://www.khanacademy.org

235

Section 11.1 Industry Structure

Concentration Ratios Concentration refers to the extent to which a certain number of firms dominate sales in a given market. A concentration ratio is used by economists to provide a measure of the dis- tribution of economic power among firms in a market. To calculate a concentration ratio, the firms in a particular industry are ranked in order of decreasing size. The next step is to cal- culate the percentage of that industry’s total sales accounted for by a certain number of the largest firms. For example, a four-firm concentration ratio measures the percentage of sales accounted for by the four largest firms in an industry. Other commonly used concentration ratios are for the largest firm, the three largest firms, the eight largest firms, and so on. Most industry studies employ four-firm ratios.

The more concentrated an industry, the more likely it is that there will be a recognized inter- dependence and joint action of either a collusive or noncollusive nature. When the four-firm concentration ratio exceeds 50%, the degree of interdependence in the industry is likely to be very high.

The Herfindahl Index The U.S. Department of Justice has been using the Herfindahl Index, a summed index of con- centration, to replace the more traditional concentration ratios. The Herfindahl Index takes into account the market shares of all of the firms in an industry, not just the market share of the few largest firms. Later in this chapter, we will look at how the Herfindahl Index has been used by the Justice Department.

The Herfindahl Index is the sum of the squares of market shares in an industry. The formula for this sum is

H = (S1)2 + (S2)2 + · · · + (Sn)2

where H is the Herfindahl Index and S1 through Sn are the market shares of individual firms 1 through n. These market shares total 100%. An industry that had 10 equal-sized firms each having 10% of the market would have a Herfindahl Index of 1,000.

Table 11.1 shows how the Herfindahl Index is calculated for two industries and compares each index to a four-firm concentration ratio. Note that both industries have four-firm con- centration ratios of 96%, but industry A has a much higher Herfindahl Index (8,116) than industry B (2,308). These Herfindahl Index values imply that industry A is 3.5 times more concentrated than is industry B. Thus, Industry A has a higher likelihood of collusion, or agreements between firms in an industry to set a certain price or share a market.

236

Section 11.2 Monopolistic Competition

Barriers to Entry Entry conditions are the second characteristic affecting market structure. If barriers to entry are high and the industry is highly concentrated, it is more likely that joint action can be undertaken to create monopoly profits. If concentration is high and entry is blocked, the exist- ing firms will be in a better position to restrict output, raise prices, and maintain persistent profits.

The rapid internationalization of world markets makes the maintenance of entry barriers very difficult. It may be possible to limit entry in a domestic economy, but if free trade is allowed or if movements to increase trade exist, these barriers will fall. One of the most effec- tive antimonopoly policies is a policy of more open international trade.

11.2 Monopolistic Competition In monopolistic competition, the industry consists of a large number of firms, each pro- ducing a differentiated product, which is a good or service that has real or imagined char- acteristics that are different from those of other goods or services. This differentiation can take many forms. The salespeople may be nicer, the packaging more sustainable, the credit terms better, or the service faster. It could even be that a famous person is associated with the product, such as Steph Curry and Under Armour. It is important to note that a product is

Table 11.1: Sample calculations of the Herfindahl index

Industry A Industry B

Firm Market share

(%) Square of

market share Firm Market share

(%) Square of

market share

1 90 8,100 1 24 576

2 2 4 2 24 576

3 2 4 3 24 576

4 2 4 4 24 576

5 1 1 5 1 1

6 1 1 6 1 1

7 1 1 7 1 1

8 1 1 8 1 1

Four-firm concentration ratio = 96% Herfindahl Index = 8,116

Four-firm concentration ratio = 96% Herfindahl Index = 2,308

237

Section 11.2 Monopolistic Competition

differentiated if consumers perceive it as different. For example, chemists tell us that aspirin is aspirin, and there is no real difference among the various brands. Yet many consumers view the brands as different, showing a preference for a brand such as Bayer, so aspirin is a differentiated product.

The market structure of monopolistic competition has some characteristics of monopoly and some of pure competition, which explains its name. A very important assumption of monopolistic competi- tion is that entry into this industry is relatively easy, similar to perfect competition. New firms can enter the industry and start selling products that are sim- ilar to those already being produced. This is impor- tant because an increase in the number of available options can increase the elasticity for any (or all) of the goods or services being sold. However, each firm has control over the price of the good or ser- vice in the market, which is similar to monopoly.

You may have recognized monopolistic competition as a familiar market structure, since retail firms often fit this model. Monopolistic competition is generally what comes to mind when people think of competitive markets.

Short-Run Equilibrium Short-run equilibrium for a monopolistically competitive firm is very similar to that of the monopolistic firm. Figure 11.1 shows the demand curve for a firm that provides grocery deliv- ery services operating in monopolistic competition. When we analyzed perfect competition, we started with the market and derived the representative firm’s demand curve. In analyzing monopolistic competition, we begin with a representative firm, rather than with the mar- ket. With product differentiation, each firm faces a unique demand curve. The firm’s demand curve in Figure 11.1 is negatively sloped, unlike the perfectly elastic demand curve faced by the perfectly competitive firm. The negative slope is a result of the differentiated nature of the firm’s product. If the product’s price is raised, the firm will not lose all its customers, because some will continue to prefer this product to substitutes that are close but not perfect. For example, when Apple increases the price of the iPhone, some previous customers will switch to a competitor, like Samsung, but many people will still purchase iPhones. Likewise, if the price is reduced, the firm will gain customers, but some customers will remain loyal to the products produced by other firms.

Daniel Gluskoter/CALSP/ASSOCIATED PRESS Sellers in a single industry attempt to differentiate their products. For exam- ple, Under Armour is associated with basketball star Steph Curry. Curry’s name and brand are part of some of Under Armour’s products.

238

Section 11.2 Monopolistic Competition

The relative elasticity of the demand curves is a measure of the degree of differentiation within the industry. If the products are only slightly differentiated, then they are close substitutes and each firm’s demand curve will be very elastic. If the products are highly differentiated, the demand curve will be less elastic, indicating that the firm can more easily raise the price with- out losing many customers. Its customers don’t change products, because they don’t view the other products as substitutes. Think again of aspirin, for example. Some people are willing to pay more for Bayer than for Brand X because they think it is different. The makers of Bayer are able to charge a higher price without losing a large number of customers. Bayer will be limited in price flexibility by the amount of differentiation it is able to create. As price goes higher and higher, fewer people will be willing to pay for the differentiation. Some people may be willing to pay 10 cents more for Bayer than for a different brand, but if the price of Bayer is increased further, more and more people will shift to the other brands.

The demand curve for the grocery delivery firm in Figure 11.1 has a negative slope, indicating product differentiation. However, demand is very elastic, indicating that there are many close substitutes. Since the demand (average revenue) curve is negatively sloped, the marginal rev- enue curve will lie below it, for the same reasons it does in the case of monopoly. The firm will, of course, maximize profits at price P1 = $4.00 and output x1 = 30 deliveries per hour, where marginal revenue is equal to marginal cost. The firm is earning an economic profit because average revenue exceeds average cost. Total revenue is $4.00 × 30 = $120 per hour, represented by rectangle 0P1Ax1, and total cost is $3.75 × 30 = $112.50, represented by rect- angle 0CBx1. Economic profit is thus $120 – $112.50 = $7.50 per hour, the area of the shaded rectangle CP1AB.

Figure 11.1: Short-run profits for a firm in monopolistic competition

In the short run, an economic profit can exist for firms in monopolistic competition. Such profits will induce new firms to enter the industry.

Price, cost

Deliveries/ hour

P 1 = 4

x 1 = 30

Economic profit

D = AR C = 3.75

239

Section 11.2 Monopolistic Competition

Firms in monopolistic competition can make profits in the short run if they are able to gener- ate enough demand for the good or service. However, a firm that is making profits will attract other entrepreneurs into the market. Without barriers to entry, in the long run, the situation may change.

Long-Run Equilibrium What about long-run equilibrium in a monopolistically competitive industry? Entry into monopolistically competitive industries is assumed to be relatively easy. Thus, new firms will enter the industry in response to the economic profits. As firms enter the industry, the demand curve faced by any representative firm will shift to the left because the new firms will be attracting customers away from firms already in the industry. This shift of buyers is what happens, for example, when a new grocery store opens in an area. It draws some customers away from the existing stores. The existing firms’ demand curves will continue to shift down and to the left as new firms enter, and new firms will enter as long as economic profits are to be made. Long-run equilibrium will occur when firms are earning zero economic profit (or normal profit). Such an equilibrium is depicted in Figure 11.2. Price is P* = $3.75, and output is x1 = 30 deliveries per hour. Total revenue and total cost are equal, represented by rectangle 0P1Ax1. There are no economic profits being earned, and no additional firms will attempt to enter this industry at this point.

Figure 11.2: Long-run equilibrium in monopolistic competition

Since entry into a monopolistically competitive industry is relatively easy, there can be no long-run economic profits. Firms will enter until all firms are earning only a normal profit.

Price, cost

Deliveries/ hour

P* = 3.75

MC AC

D = AR

x* = 30

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Section 11.2 Monopolistic Competition

Of course, too many firms might enter an industry due to a mistaken anticipation of economic profits. If this happens, firms will experience losses, and some firms will leave the industry as the long-run adjustment proceeds. Figure 11.3 shows a monopolistically competitive gro- cery delivery firm suffering a loss. Firms would respond to losses by leaving the industry. The demand curves faced by the remaining firms would shift up and to the right until the equilib- rium shown in Figure 11.2 was restored. The long-run adjustment process under monopolis- tic competition produces an equilibrium with zero economic profits.

Figure 11.3: Short-run losses for a firm in monopolistic competition

Short-run losses, indicated by the shaded area, will cause some firms to exit the industry. Firms will exit until the remaining firms are earning a normal profit, as in Figure 11.2.

Price, cost

Deliveries/ hour

C = 3.75

P 1 = 3.25

x 1 = 30

MC AC

Loss

D = AR

Monopoly and Competition As you can see, the model of monopolistic competition borrows from the model of monop- oly and the model of perfect competition. In the short run, the monopolistically competitive firm is producing the profit-maximizing output and searching for the best price that can be charged for this output. In the long run, the economic profits disappear as new firms enter the industry. The demand curve of each firm then shifts to the left because market demand is shared by more firms. This result is similar to the long-run outcome in perfect competition.

Excess Capacity In long-run equilibrium, the monopolistically competitive firm chooses an output that does not fully utilize existing plant size. The unutilized part of the production facilities, called excess capacity, is depicted in Figure 11.4. The profit-maximizing output is x1 = 30 deliv- eries per hour, where MR = MC. This level of output is not, however, the output that would

241

Section 11.2 Monopolistic Competition

have resulted under perfect competition. Under perfect competition, the firm would use the least cost combination of inputs, where average cost is at a minimum. That output would be socially optimal because it represents maximum attainable allocative efficiency, because MC = P. That output is represented by x2 = 35 deliveries per hour, as shown in Figure 11.4. In other words, in long-run equilibrium, the monopolistically competitive firm produces less than the quantity that would efficiently use its full productive capacity.

Figure 11.4: Excess capacity

Excess capacity results from a firm choosing to produce fewer deliveries in order to earn a higher price. Under perfect competition, the firm would use the least cost combination of inputs, where average cost is at a minimum, x2. In the long run, the monopolistically competitive firm produces less than the quantity that would efficiently use its full productive capacity.

Price, cost

Deliveries/ hour

MC AC

D 1

= AR 1

MR 1

x 1 = 30 x

2 = 35

P 1 = 3.50

P 2 = 3.25

Is excess capacity a bad thing? To answer this question, it is necessary to consider what causes excess capacity. The firm is producing less than the socially ideal output because it maximizes profits by producing a lower output. Excess capacity is a result of the negative slope in the demand curve. This negative slope, you recall, is a result of the product differentiation. The excess capacity, therefore, results from product differentiation.

It can be argued that excess capacity is not necessarily a bad thing. Consumers may be will- ing to incur the extra cost in return for the perceived benefits of product differentiation. It would indeed be a very boring world without product differentiation. We might all be wear- ing khaki-colored shirts, for example.

The major problem with this argument lies in separating desired from undesired product differentiation. A consumer who is faced with a wide range of product choices but little price competition is not able to choose whether to pay extra to get the differentiated product. Con- sider shampoo. There are hundreds of brands of shampoo and arguably thousands of differ- ent varieties among those brands. How much are consumers willing to pay for differentiated

242

Section 11.2 Monopolistic Competition

products? The shampoo market alone generated an estimated $4 billion in revenue in 2017. When a consumer purchases any brand other than the lowest price option, the consumer voluntarily chooses product differentiation.

Product Differentiation and Advertising The firm in monopolistic competition will try to differentiate its product in order to shift its demand curve to the right and to make demand relatively more inelastic by developing con- sumer loyalty. The firm will advertise as well as make changes in color, style, quality, and so on. Advertising can inform consumers about higher quality or develop brand loyalty. Either of these results creates product differentiation. Competing with rival firms through advertis- ing, style changes, color changes, and techniques other than lowering price is referred to as nonprice competition.

If effective use of nonprice competition differentiates a firm’s product enough that other firms’ products do not seem to be good substitutes, the firm can earn an economic profit in the long run.

The fast-food industry, for example, is often monopolistically competitive. In a small town with one fast-food option, the industry could be a monopoly. However, in metropolitan areas, there are large numbers of firms, and entry is relatively easy. If a firm is able to success- fully differentiate its product so that consumers don’t consider the products of other firms close substitutes, the firm will be able to earn a long-run economic profit because it can keep would-be competitors out of its segment of the market. For example, McDonald’s is certainly not the only fast-food restaurant to make hamburgers, but it is the only one with the Big Mac. If McDonald’s can convince customers that there is no substitute for a Big Mac, persistent brand loyalty might allow McDonald’s to maintain an economic profit in the long run.

Advertising is particularly important for firms trying to distinguish the goods and services they offer from other competing firms. This is why firms in a perfectly competitive market (or close to it) do not advertise. The goods or services in a perfectly competitive market are identical by definition, so there are no gains to be made from advertising.

Check Point: Characteristics of Monopolistic Competition

• There are many sellers of similar but differentiated products. • Economic profits can exist in the short run. • Price is equal to average cost in the long run. • Excess capacity exists in the long run (price is greater than marginal cost). • Nonprice competition increases product differentiation.

243

Section 11.3 Oligopoly

Resource Allocation in Monopolistic Competition The model of monopolistic competition has several implications for the allocation of resources. The resulting allocation will be different from the societal ideal achieved with perfect compe- tition. First, even at the long-run equilibrium with zero economic profit, there will be excess capacity with monopolistic competition. This means that price will be greater than minimum average cost. Consumers are paying only the average cost of production, but this cost is higher than it would be with more competition.

Second, if costs are the same under perfect competition and monopolistic competition, prices will be higher with monopolistic competition because price is greater than marginal cost (or marginal revenue). Third, firms in monopolistic competition will provide a wider variety of styles, colors, qualities, and brands. These choices are, unfortunately, related to the product differentiation and excess capacity that cause average cost to be higher.

Fourth, in monopolistic competition, there will be advertising and other forms of nonprice competition. This outcome is not necessarily bad. To the extent that advertising adds to cus- tomer satisfaction and the product is voluntarily purchased, it can be a good thing. Some social critics consider any advertising that does more than convey information to be a waste. Economists would argue that one must compare the marginal benefits of advertising to the marginal costs of advertising to judge its worth.

Economics in Action: Exploring Advertising in Monopolistic Competition

In economics and marketing, product differentiation is the process of distinguishing a product or offering from others, to make it more attractive to a particular target market. This involves differentiating it from competitors’ products as well as a firm’s own product offerings. Learn more at https://youtu.be/4crl90EHsdQ.

11.3 Oligopoly The last of the four market structures is oligopoly. Oligopoly is the market structure in which a few firms dominate the market. The scarcity of sellers is the key to firms’ behavior in oli- gopoly. In oligopoly, firms realize that their small number produces mutual interdependence. As a result, each firm will forecast or expect a certain response from its rivals to any price or output decision that it might make. There are many real-world examples of oligopoly mar- kets. For example, there are four primary breakfast cereal companies that dominate the U.S. market: Kellogg, General Mills, Post, and Quaker. Four music companies control 80% of the market: Universal Music Group, Sony Music Entertainment, Warner Music Group, and EMI Group. The market for jetliners is dominated by Boeing and Airbus, and so on. Since there are few firms, the actions of the firms are interdependent.

https://youtu.be/4crl90EHsdQ

244

Section 11.3 Oligopoly

Global Outlook: Commodity Cartels in the Real World

Cartels are groups of independent firms that, instead of competing, agree to act in concert to determine prices and dictate output. The United States uses antitrust laws to discourage cartel behavior, but many governments around the world actively encourage the formation of cartels. This is particularly the case with commodity cartels.

Commodity cartels have a long history of failure. In the 1950s, commodity agreements, which are essentially cartels for agricultural products and raw materials, existed for tin, coffee, sugar, and wheat. The countries forming these cartels were less developed countries of South America and Africa. The success of Arab countries with the Organization of the Petroleum Exporting Countries (OPEC) in 1973 reenergized some of these cartels because many commodity-exporting countries tried to emulate OPEC. The result was a flurry of activity that produced the following official organizations:

International Bauxite Association International Coffee Organization Intergovernmental Council of Copper Exporting Countries International Sugar Organization International Tin Council Organization of Banana Exporting Countries

In addition, there were attempts in the late 1970s and early 1980s to organize cartels in iron ore, nickel, rubber, tungsten, molybdenum, cobalt, columbium, and tantalum. Very few of these cartels, however, enjoyed the success that OPEC had in the 1970s.

Several lessons can be learned from the experience of these commodity cartels and the success of OPEC. To be successful, a commodity cartel must

1. have few members; 2. produce a product with few substitutes (have inelastic demand); 3. have buoyant world demand (have high income elasticity); 4. pursue a moderate pricing policy; 5. have at least tacit approval of consuming nations; and 6. have effective sanctions against chiselers, or sellers that cheat on a cartel agreement,

by lowering prices in an attempt to capture more of the market.

Most cartels have great difficulty with the last three requirements and as a result break down rather quickly.

The effects of commodity cartels are often mixed up with economic development and world politics. Members tend to be less developed countries, and the consuming nations tend to be developed countries. The formation of a cartel is often justified in terms of a “fair” price that will redistribute wealth from rich to poor countries.

Cartels are anticonsumer. Although some of those consumers live in high-income countries, many are poor people in poor countries. The OPEC oil price hikes in the 1970s caused greater hardship in poor countries than it did in rich countries.

245

Section 11.4 Collusion

11.4 Collusion The history of cartels is not impressive. Most have held together for only short periods of time and have then fallen apart because of cheating. The incentive to cheat, either by undercutting the agreed-upon price or by producing additional output, is magnified by the expected profits that would result from cheating on the cartel.

Cartels in the Real World Organized, collusive activity in private industry in the United States has been deemed illegal by the Sherman Antitrust Act of 1890. However, the incentive to earn monopoly profits may outweigh the expected costs of breaking the law.

One example involving a large number of firms was an attempt to form a cartel known as the National Farmers Organization (NFO), founded in 1955. The industry for milk and beef pro- duction is composed of large numbers of firms (farms), and the NFO cartel only included about 10% of them. In the late 1960s and early 1970s, the NFO attempted two separate actions: one to raise milk prices and the other to raise beef prices. The cartel tried to organize farmers to keep production from the market. In order to raise prices, cartel members were to destroy milk and keep cattle away from the market. If the NFO members had been successful in rais- ing prices, the nonmembers who continued to produce and sell would have benefited. They would have reacted to the higher prices by expanding output. Also, as prices began to rise, there would have been tremendous pressure on cartel members to cheat on the withholding action. In fact, the cheaters would have benefited much more than the members who refused to cheat. The attempt to organize the cartel resulted in violence. Cattle scales were blown up. NFO farmers sat in the roads to keep others from taking their products to market. Some farm- ers even resorted to taking cattle to market in house trailers to avoid detection. The lesson is clear: A cartel with many members will find it very difficult to succeed.

OPEC: A Decade of Success The best-known cartel of recent years is OPEC. In the 1950s international oil companies con- trolled a major portion of the world’s oil supply. These companies frequently engaged in price competition. In an attempt to stop price cutting, some Arab governments and a few non-Arab governments formed OPEC in 1960. At first, OPEC enjoyed little success. But this changed in 1973, as the Arab–Israeli War heated up and the Arab countries banded together. On January 1, 1973, the price of oil was $2.12 per barrel. Of this $2.12, $1.52 went to the OPEC govern- ments. By January 1, 1974, the price was $7.61, with $7.01 going to the governments. By Janu- ary 1975 the price was about $10.50. By 1982 the price had risen to $35.00.

How did this cartel, which had been in existence since 1960, come to flex its muscles in 1973? At that time, importing governments helped by posting prices and dealing with OPEC in open forums, so individual members were less likely to cheat. More importantly, however, Saudi Arabia was willing to cut back its production of oil to allow other members to sell all they wanted to produce at the high prices set by the cartel.

246

Section 11.4 Collusion

In 1984, after production had to be cut back by 5 million barrels a day to prevent the cartel from collapsing, Saudi Arabia’s willingness to bear this cost began to weaken. The price of oil began to fall. The January 1984 price was $29 per barrel, down from the 1982 high of $35. The slide continued. In January 1987 the price was $13 per barrel. In January 1990 it was under $12 per barrel. As prices fell, cheating became more common. The predictions made by economists in the 1970s that the cartel would eventually weaken started to come true. Some of the Persian Gulf countries—notably Kuwait, the United Arab Emirates, and Qatar—were experiencing cash flow problems. These countries started grandiose development schemes when their oil revenues were in excess of $300 billion per year. Their revenues fell signifi- cantly because of the decreased price, but the development projects still had to be paid for. Kuwait began shipping more oil than allowed by OPEC agreements—one of the factors under- lying the Gulf War.

As of 2018 there were 15 member countries, including Iraq, Iran, Kuwait, Saudi Arabia, Ven- ezuela, Qatar, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon, Angola, and Equatorial Guinea. Congo was the most recent to join in 2018.

As we pointed out earlier, all cartels face two prob- lems. The first is cheating, or secret price cut- ting. OPEC faced this problem in the presence of oil surpluses. The second problem a cartel faces is new entry. Large amounts of oil have been com- ing into the market from non-OPEC sources, such as the North Sea, Alaska, and the Alberta oil sands. In addition, other sources of energy, such as solar and nuclear energy, which were uneconomical when oil was $2 per barrel, became profitable at the much higher prices. The new entry has been slow to develop, but the future should prove even more difficult for OPEC as new firms producing oil and other competing products enter the market and challenge the cartel’s cohesiveness.

The impact of new oil supplies is evident in the statistics. In 1973 OPEC’s share of world oil production was 56%. In 1975 its share was 51%. In 1980 it was 45%, and by 1986 OPEC’s share had fallen to 28%. This declining share of production signaled the weakening of the car- tel better than any other piece of data. If a cartel is going to set prices, it must control a large share of total production. After a rebound in the 1990s and early 2000s, OPEC now produces roughly 40% of the world’s oil (Energy Information Administration, 2018).

In addition to the new oil supplies, the high oil prices have also had an effect on quantity demanded. OPEC’s dominance resulted in adjustments in consumer demand. Perhaps the most evident of these adjustments is the increased fuel efficiency of automobiles and the move to hybrid and electric cars.

tfoxfoto/iStock/Thinkstock OPEC is one of the best known cartels in recent years. The organization was formed to stop price cutting in the oil market.

247

Section 11.4 Collusion

Informal Market Coordination Informally coordinated oligopolies engage in unorganized and unstated attempts to practice joint actions. Such tacit collusion is much weaker than the collusion among members of a cartel. It is weaker because all the incentives to cheat are still present, but organized vigilance against cheating is not. Tacit collusion is found in U.S. industries because cartels are illegal under federal antitrust laws. Informal cooperation among oligopolistic firms can be viewed as an attempt to form cartels while avoiding antitrust laws. Such collusion usually takes the form of informal agreements to behave in certain ways. Often these agreements arise natu- rally, without any need for formal organization.

Economics in Action: OPEC

The fluctuating price of oil is largely decided by supply and demand and the collective actions of OPEC, an organization that provides 40% of the world’s oil. CNBC’s Tom Chitty explains at https://www.cnbc.com/video/2018/06/20/what-is-opec.html.

Check Point: Characteristics of Oligopoly

• There are only a few sellers of homogenous or differentiated products. • Interdependence leads to attempts at communication, coordination, and collusion. • Cartels may be formed to determine industry pricing and output. • Nonprice competition increases product differentiation.

Policy Focus: Oligopoly and Tit for Tat

In the real world of cartel behavior, oligopoly firms may develop a strategy to help support a collusive market in one form or another. One such example is called the tit-for-tat strategy, which is a form of tacit collusion. In tit for tat, firms begin by behaving cooperatively in time t. If the other firm cheats in time t = 1, then you engage in cheating in the next period, t = 2. Cheating results in a decrease in prices that serves one primary purpose: to reduce any profits the other firm would stand to earn from cheating on your arrangement.

However, sometimes cheating after the other player has cheated is not enough to enforce cooperation. Instead, a firm can create a punishment stage of the game, where you go beyond simply cheating and engage in extreme behavior. Although this punishment stage is harmful to the other firm, it is usually also quite harmful to the punisher. The goal is to send a signal to the other firm that there is a cost to not cooperating.

(continued)

https://www.cnbc.com/video/2018/06/20/what-is-opec.html

248

Section 11.4 Collusion

Game Theory: Strategy and Rivalry in Oligopoly Life for the entrepreneur is simple in pure monopoly and pure competition. But most firms in the real world must make strategic decisions, based on how rival firms are likely to react to their own action. The just-completed review of oligopoly and monopolistic competition demonstrated the interdependence in these market structures. Game theory is a field of mathematics that can provide insights into oligopolistic behavior. A review of some elements of game theory will show how firms might make moves that could gain a competitive edge in the marketplace. Game theory applied to economic reasoning asks how management of a firm should act if it believes that a rival firm is rational and out to maximize its profits.

Game theory, a theory of rational decision making under conditions of uncertainty, was first developed by John von Neumann (1903–1957) and Oskar Morgenstern (1902–1977) in a book entitled The Theory of Games and Economic Behavior. Game theory says that players try to reach an optimal position through strategic behavior that takes into account the antici- pated moves of other players. Game theory attempts to explain how a decision maker will make decisions based on the assumption that the competitors are rational and profit maxi- mizing. This model describes very accurately how oligopolists behave.

Standard microeconomic decision-making theory is based on the assumption that the out- comes of various decisions are known with certainty. Game theory suggests rational solutions when the outcomes are uncertain. Games are usually described as being either zero sum or non-zero sum. Zero-sum games are those in which one player’s gain is another player’s loss. Non-zero-sum games open the door to collusion or cooperative action because all players may gain (or all may lose) from a certain course of action. This aspect of game theory has proved very useful in the study of oligopolies in which each firm must take into account the reactions of its competitors.

Policy Focus: Oligopoly and Tit for Tat (continued)

Sometimes a tit-for-tat strategy results in an all-out price war. In June 2017 Southwest Airlines sparked a price war in airline fares by cutting some fares to as low as $49 each way, depending on the cities. Other airlines started offering their own “specials” immediately after the announcement was made by Southwest. Because airlines typically update fares throughout the day, they are quickly able to respond to other airlines’ price changes, speeding up the downward spiral of a price war.

OPEC is the most well-known example of an organization engaging in a fairly successful tit- for-tat strategy. When the organization suspects that one of the countries may be cheating, the reaction is to punish cheating by matching the overproduction. Although this strategy harms the cheating country, it also increases oil price volatility, which has repercussions of its own. However, if the tit-for-tat strategy helps enable the oil cartel to deter cheating and maintain high prices in the market, the countries can achieve the joint profit maximizing outcome for an oligopoly.

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Section 11.4 Collusion

Cooperative and Noncooperative Games Games can be cooperative or noncooperative. A cooperative game is a game in which a con- tract is possible. You may, for example, enter into an agreement with a rival to share risk or bring complementary technologies together to solve a customer’s problem. In both of these cases, it is possible for the parties to draw up a contract that divides the profits or losses. In a noncooperative game such a contract is not possible. An example of a noncooperative game would be a service provider like Netflix deciding to reduce prices expecting that its rivals will match the cut. Most games of interest in examining business strategic behavior are noncooperative.

One of the most famous economic games is called the prisoners’ dilemma. Two prisoners are interrogated separately. Each one knows that if neither confesses, both will go free. However, if one confesses and implicates the other, the one who confesses will receive a light sentence and the other will get a long prison term. The interrogator separately offers each prisoner the opportunity to confess and “get a better deal.” The rational course of action for the self- interested prisoner is to confess and implicate the other. Since both face the same incentive and the same uncertainty about the other’s action, both will confess. The outcome of the two rational decisions will make both of the prisoners worse off. They would both be better off if they could engage in collusion, because if neither confesses, both will go free. This same lesson holds for oligopolistic firms. Oligopolistic firms may decide to compete aggressively, attempt- ing to take their competitors’ market, or may try to cooperate and settle for the market share they have. Like the prisoners, each firm has an incentive to undercut the other, and each knows the other has the same incentive.

Does the prisoners’ dilemma mean that firms will be doomed to low profits and financial problems because they will always undercut one another? Experience in the airline industry in the past decade might lead to this conclusion. Boeing and Airbus could have tried to cooperate by reducing output and increasing prices, but instead the two com- panies have been fiercely competitive for over 20 years. But, as we saw earlier, some oligopolies exist side by side over time, and a form of price leadership or other cooperative behavior emerges. The U.S. breakfast cereal market is a perfect example. Prior to the 1990s this industry was incredibly profitable, and the price leader in the market was Kellogg. Every year, Kellogg could increase cereal prices, and the other three companies in the market would fol- low suit. This tacit noncompetition allowed these firms to generate massive revenues from selling a relatively pleasant product. Decreased demand,

Blend Images/Superstock Over time, some oligopolies exist side by side and form a price leadership. The breakfast cereal market is an example of this scenario.

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Section 11.4 Collusion

increased competition by discount producers, and an unwillingness by some firms to follow Kellogg’s lead eventually eroded profits. However, an attempt to move away from price com- petition has been seen in the market since 2001. A major difference between the prisoners’ dilemma in theory and that faced by oligopolists is that the offer to the prisoners is made only once by the interrogator. In the real world of cartel behavior, the firm faces the prison- ers’ dilemma daily. Over time the firms can learn how their rival will react—most of the time!

Nonprice Competition Oligopolists also compete in dimensions other than just price. In formulating models, econo- mists tend to treat goods as homogeneous and view competition as occurring mostly through price adjustments. In the real world, however, competition can take other forms. Firms can change the quality, color, texture, design, size, advertising, and a host of other attributes of a product. Sometimes quality or quantity changes substitute for price changes. The size of a candy bar could be decreased while the price remains the same. This change is in effect a price increase, albeit a disguised price increase. Even an apparently homogeneous product can be differentiated by the quality of customer service.

Casual observation leads to the conclusion that a great deal of the advertising on television is done by firms in oligopolistic markets. Most informational advertising is done on radio or in the print media. Most of the major ads on television appear to be aimed at a goal other than informing consumers. There may be several economic goals of this advertising. Name brand capital is the value that consumers place on a product because of experience, reputation, or image. The image of Apple, for example, is recognizable around the world. This name brand capital can be very important in terms of maintaining market share in the face of price (or quality) competition from new rivals that don’t have it. In the extreme, name brand capital is a barrier to entry that may allow the firm to behave in a monopolistic fashion. Large firms will tend to advertise more heavily, have higher prices, and have higher profits than their smaller competitors.

An oligopolistic firm may resort to nonprice competition in an attempt to increase its market share. We can apply the model of oligopoly to these other types of competition. For example, a firm contemplating a new advertising program has to consider whether the program will increase its market share or prompt a rival to undertake a similar program. In the first case, the program may be worthwhile. In the second, it would probably only increase costs without creating a larger market share. Thus, even with respect to advertising, firms in an oligopoly are interdependent and need to consider the reactions of rivals.

Factors Determining Market Coordination by Oligopolies As you have seen, there are benefits to be gained by oligopolists who can coordinate output and pricing, whether such coordination is formal or informal. There are strong forces pulling in opposite directions. It is worthwhile to review some variables that facilitate or limit such market coordination.

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Section 11.4 Collusion

The Number of Firms The number of firms in an oligopoly has the most obvious impact on the likelihood of formal or informal market coordination. As the number of firms increases, the incentive and ability to coordinate diminish. In addition, as the number of firms increases, the cost of coordinating and policing the agreement increases.

Barriers to Entry Barriers to entry play a key role in determining market coordination because they are related to the number of firms. An oligopoly will not be able to practice effective coordination if it can’t limit entry. New firms will destroy market coordination and erode any economic profit created by it. If strong barriers to entry (including barriers created by government) exist, the possibility of coordination exists. If barriers to entry are weak, coordination is highly unlikely.

The Size of Firms If the oligopolistic industry is dominated by one firm or if several of the firms are large rela- tive to the others, the possibility of market coordination is enhanced. In such a case, coordina- tion would only require agreement by the dominant firm or firms.

Secrecy Coordination requires the elimination of secrecy so that uncooperative behavior can be pun- ished. Monitoring cheating is easier in an environment in which secret deals don’t stay secret long. Government has often aided in market coordination by requiring the full disclosure of contract details.

Unstable or Fluctuating Demand If demand fluctuates or is otherwise unstable, a firm in an oligopoly will have difficulty deter- mining if changes in its demand are the result of market forces or, alternatively, the competi- tive behavior of a rival. As a result, unstable or fluctuating demand will make market coordi- nation more difficult.

Product Differentiation The more homogeneous a product is, the easier it will be to coordinate the sale of that product. As product differences increase, firms will be unable to determine whether the price concessions of rivals are attempts to cheat or are due to actual differences in product characteristics.

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Section 11.5 Market Structures in Review

Industry Social Structure As you have already seen, the maturity of an industry can affect market coordination. The social structure of an industry is also important. Do the leaders know and trust each other? Do they get together at meetings? Do they play golf or engage in other recreational pursuits? If they do, coordination might be easier.

Antitrust Activity The U.S. antitrust laws make collusion illegal. If these laws are vigorously enforced, it will make coordination more costly. The antitrust laws will serve to limit attempts at coordination.

11.5 Market Structures in Review This section concludes the discussion of the four theoretical market structures. Table 11.2 summarizes some of the important characteristics that differentiate these market structures. The key to understanding the theory of the firm is a solid understanding of monopoly and perfect competition. Oligopoly and monopolistic competition expand the models of monop- oly and perfect competition and bring those models closer to real-world situations.

Table 11.2: Summary of market structures

Type Number of firms

Product differentiation

Control over price

Type of nonprice competition Examples

Perfect competition

Many Homogenous product

None None Agriculture

Monopolistic competition

Many Slightly differentiated products

Some Advertising and product differentiation

Retail trade and service industry

Oligopoly Few Homogenous or differentiated products

Some to considerable (it depends)

Advertising and product differentiation

Auto and steel industries

Monopoly One Unique product (no close substitutes)

Considerable Public relations or advertising to increase demand

Patented goods

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Conclusion

Conclusion Now, what is the value of a brand name? The answer, of course, like all answers in econom- ics, is “it depends.” Product differentiation and brand loyalty give the owners of that brand name monopoly power in a certain range. That range is determined by how much more con- sumers are willing to pay for the brand. According to the 2017 Brand Keys Loyalty Leaders List, the number one company in customer brand loyalty was Apple. Apple’s tablets held the number one position, Apple’s smartphone came in at number three, and Apple computers were number five. That’s pretty impressive—to have three products in the top five, out of 740 brands in 83 categories (Brand Keys, 2017). As a result, Apple is able to sell its products at premium prices.

Key Ideas

1. Monopolistic competition is a market structure characterized by many firms selling differentiated products. Key assumptions in the model of monopolistic competition are a large number of producers, product differentiation, and relative ease of entry. Economic profits can exist in the short run in this market structure, but entry of new firms will ensure a long-run equilibrium with zero economic profit.

2. Oligopoly is the market structure in which there are only a few firms competing imperfectly. Because there are so few firms in an oligopoly, they are interdependent. They take this interdependence into account in their economic decision making.

3. Cartels are threatened by cheating behavior on the part of individual members and by new entry. The larger the number of firms in a cartel, the more difficult it is for the cartel to hold together. Barriers to entry are thus important in oligopoly, just as they are in monopoly. Successful cartels have often been supported by governments, which police cheating behavior.

4. Game theory is a theory of rational decision making under uncertainty. It can give valuable insights into behavior in oligopoly.

5. Economic forces that work to limit coordination in oligopoly or to facilitate it pull in opposite directions. Because of product differentiation, monopolistically competitive firms produce a smaller output at a higher price than firms (with the same costs) engaged in perfect competition. In long-run equilibrium in monopolistic competi- tion, marginal cost is not equal to average cost.

Critical-Thinking Questions

1. Compare a perfectly competitive market and a market with monopolistic competi- tion. Which assumptions are different?

2. In what sense is monopolistic competition like monopoly? In which key areas do they differ?

3. How might the expectation of entry limit cartel formation? What other factors might influence the likelihood of a successful cartel?

4. What does it mean for firms to be interdependent? How does this change the way a firm chooses to set prices?

5. What are concentration measures, and how are they used to differentiate markets?

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Conclusion

10. Calculate the Herfindahl Index for the industry in Question 9. What does this number tell you about the level of competitiveness in the market? How would these answers change if the market consisted of only the first two firms?

11. Would the National Collegiate Athletic Association be considered a cartel? Why or why not?

12. How do changes in technology affect oligopoly? How is this seen in the U.S. domestic auto industry?

13. Assume that a merger between two firms in a market would change the market com- position from a low concentration ratio to a much larger concentration ratio. Should this merger be approved by the Justice Department? Why or why not?

14. Given what has happened in the airline industry since its deregulation, should it be reregulated? Why or why not? If so, how should the regulations be set?

15. The National Football League (NFL) has an exclusive deal with Reebok so that play- ers may wear only Reebok attire. How does this deal create a barrier to entry? What does it say about the structure of individual teams within the NFL?

6. Give four examples of differentiated products. Are these differences real, imagined, or created? Why is it important that a firm be able to convince consumers that their product is different?

7. How does a firm in monopolistic competition maximize profit? How does this differ from the way a monopolist maximizes profit?

8. Suppose that advertising in an oligopolistic market does not increase the total vol- ume of sales but only the distribution of sales among the oligopoly firms. How does this fit with the prisoners’ dilemma game?

9. The following data are for a fictional soft drink industry. What is the four-firm con- centration ratio for this industry?

Firm Annual sales

1 $400,000,000

2 $300,000,000

3 $200,000,000

4 $50,000,000

5 $20,000,000

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Conclusion

Key Terms cartel A group of independent firms that agree not to compete but rather to deter- mine prices and output jointly.

cheating Violating a cartel agreement by lowering prices in an attempt to capture more of the market.

collusion The act of forming agreements between firms in an industry to set a certain price or to share a market in certain ways.

concentration ratio A measure of the dis- tribution of economic power among firms in an oligopolistic market.

differentiated product A good or service that has real or imagined characteristics that are different from those of other goods or services.

excess capacity The unutilized part of existing production facilities by a monopo- listically competitive firm.

game theory A mathematical theory about rational decision making under conditions of uncertainty that can provide insight into oligopolistic behavior.

Herfindahl Index A summed index of concentration that takes into account all the firms in an industry.

monopolistic competition The market structure in which a large number of firms sell differentiated products.

name brand capital The value that con- sumers place on a product because of expe- rience, reputation, or image.

nonprice competition Competing with rival firms through advertising, style changes, color changes, and techniques other than lowering price.

oligopoly The market structure in which a few firms compete imperfectly and recog- nize their interdependence.

tacit collusion Unorganized and unstated attempts by informally coordinated oligopo- lies to practice joint actions.