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Monopolistic Competition and Oligopoly

Survey of ECON

Robert L. Sexton

Chapter 9

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Chapter 9 Sections

– Monopolistic Competition

– Price and Output Determination in Monopolistic Competition

– Monopolistic Competition versus Perfect Competition

– Oligopoly

– Collusion and Cartels

– Game Theory and Strategic Behavior

Monopolistic Competition

Section 1

SECTION 1 QUESTIONS

Monopolistic Competition

MONOPOLISTIC COMPETITION

a market structure with many firms selling differentiated products

Monopolistic competition has features in common with both monopoly and perfect competition.
Like monopoly, individual sellers believe that they have some market power.

Monopolistic Competition

Monopolistic competition is similar to perfect competition.
Relatively free entry of new firms
Long-run price and output behavior
Zero long-run economic profits
However, the monopolistically competitive firm produces a differentiated product, which leads to some degree of monopoly power.

Monopolistic Competition:

Characteristics

In a sense, each seller in a market of monopolistic competition may be regarded as a “monopolist” of its own particular brand of the commodity.
Unlike a firm in the monopoly model, there is competition by many firms selling similar (but not identical) brands.

Monopolistic Competition

The Three Basic Characteristics of
Monopolistic Competition

Product differentiation is the accentuation of unique product qualities, real or perceived, to develop a specific product identity.
With differentiation, buyers believe that the products of the various sellers are not the same, whether the products are actually different or not.

Product Differentiation

Product differentiation leads to preferences among buyers to deal with particular sellers or to purchase the products of particular sellers.
Sources of differentiation:
Physical differences
Prestige considerations
Location
Service considerations

Product Differentiation

When many firms compete for the same customers, any particular firm has little control over or interest in what other firms do.

Impact of Many Sellers

Entry in monopolistic competition is relatively unrestricted.
New firms may easily start the production of close substitutes for existing products.
Economic profits tend to be eliminated in the long run, as is the case in perfect competition.

Significance of Free Entry

Section 1

Price and Output Determination in Monopolistic Competition

Section 2

SECTION 2 QUESTIONS

Monopolistically competitive sellers are price makers rather than price takers, they do not regard price as a given by market conditions like perfectly competitive firms.
The cost and revenue curves of a typical seller are shown in Exhibit 9.1.

Determining Short-Run Equilibrium

Exhibit 9.1: Short-Run Equilibrium in Monopolistic Competition

The intersection of the marginal revenue and marginal cost curves indicates that the short-run profit-maximizing output will be q*.
By observing how much will be demanded at that output level, we find our profit-maximizing price, P*.
That is, at the equilibrium quantity, q*, we go vertically to the demand curve and read the corresponding price on the vertical axis, P*.

Determining Short-Run Equilibrium

1. Find where MR = MC and proceed straight down to the horizontal quantity axis to find q*, the profit-maximizing output level.

2. Go up to the demand curve then to the left to find the market price. Once P* and q* are identified, total revenue can be found, TR = P × q.

3. To find total costs, go straight up from q* to the ATC curve, then left to the vertical axis to compute the ATC per unit. (TC = ATC × q).

If TR > TC at q*, the firm is generating total economic profits.
If TR < TC at q*, the firm is generating total economic losses.

Three-Step Method for
Monopolistic Competition

If we take the product price at P* and subtract the average cost at q*, this will give us per-unit profit.
If we multiply this by output, we will arrive at total economic profit, that is, (P* − ATC) × q* = total profit.
The cost curves include implicit and explicit costs—that is, even at zero economic profits the firm is covering the total opportunity costs of its resources and earning a normal profit or rate of return.

Three-Step Method for
Monopolistic Competition

Short-Run Profits and Losses in Monopolistic Competition

In Exhibit 9.1(a), the total revenue is greater than total cost so the firm has a total economic profit.
In Exhibit 9.1(b), price is below average total cost, so the firm is minimizing its economic loss.

Determining Long-Run Equilibrium

The short-run equilibrium situation, whether involving profits or losses, will probably not last long, because there is entry and exit in the long run.
If market entry and exit are sufficiently free:
New firms will enter when there are economic profits.
Some firms will exit when there are economic losses.

Determining Long-Run Equilibrium

If existing firms are earning economic profits, new firms enter to take advantage of the economic profits. The demand curves for each of the existing firms will fall and become more elastic due to increasing substitutes.

Long‑run equilibrium will occur when demand is equal to average total cost for each firm at a level of output at which each firm’s demand curve is just tangent to its ATC curve.

Achieving Long-Run Equilibrium

The point of tangency will always occur at the same level of output as where MR = MC.
At this equilibrium point, there are:
Zero economic profits
No incentives for firms to either enter or exit the industry

Achieving Long-Run Equilibrium

Exhibit 9.2: Long-Run Equilibrium for a Monopolistically Competitive Firm

Section 2

Monopolistic Competition versus Perfect Competition

Section 3

SECTION 3 QUESTIONS

Monopolistic Competition versus Perfect Competition

Both monopolistic competition and perfect competition have many buyers and sellers and relatively free entry.
However, product differentiation allows a monopolistic competitor the ability to have some influence over price.

A monopolistic competitive firm has a downward-sloping demand curve, but it tends to be more elastic than the demand curve for a monopolist because of the large number of good substitutes for its product.

Monopolistic Competition versus Perfect Competition

The Significance of Excess Capacity

Because of the downward slope of the demand curve, its point of tangency with ATC will not and cannot be at the lowest level of average cost.
Therefore, even when long-run adjustments are complete, firms will not be operating at a level that permits the lowest average cost of productionthe efficient scale of the firm.

The existing plant, even though optimal for the equilibrium volume of output, will not be used to capacity.

The Significance of Excess Capacity

EXCESS CAPACITY

occurs when the firm produces below the level at which average total cost is minimized

Unlike a perfectly competitive firm, a monopolistically competitive firm could increase output and lower its average total costs.
However, increasing output to attain lower average costs would be unprofitable. The price reduction necessary to sell the greater output would cause MR to fall below MC of the increased output.

The Significance of Excess Capacity

Consequently, in monopolistic competition, there is a tendency toward too many firms in the industry, each producing a volume of output less than that which would allow lowest cost.
Economists call this tendency a failure to reach productive efficiency.

The Significance of Excess Capacity

Failing to Meet Allocative
Efficiency, Too

In monopolistic competition, firms are not operating where P = MC.
At the intersection of MC and MR, curves (q*), P > MC .
This means that society is willing to pay more for the product (the price, P*) than it costs society to produce it (MC at q*).
The firm is not allocatively efficient, (where P = MC).
Too many firms are producing at output levels that are less than full capacity.

Perfectly competitive firms reach
Productive efficiency (P = ATC at the minimum point on the ATC curve).
Allocative efficiency (P = MC).

Failing to Meet Allocative
Efficiency, Too

In monopolistic competition, the higher average costs and the slightly higher price and lower output may just be the price we pay for differentiated productsvariety.
Just because we have not met the conditions of productive and allocative efficiencies, it is not obvious that society is better off.

Failing to Meet Allocative
Efficiency, Too

Exhibit 9.3: Comparing Long-Run Perfect Competition and Monopolistic Competition

What are the Real Costs of Monopolistic Competition?

Perfect competition meets the test of allocative and productive efficiency and monopolistic competition does not.
A remedy for a monopolistically competitive firm to look more like an efficient, perfectly competitive firm might entail using government regulation, as in the case of a natural monopoly.

However, this process would be costly because a monopolistically competitive firm makes no economic profits in the long run.
Therefore, asking monopolistically competitive firms to equate price and marginal cost would lead to economic losses, because long-run ATC would be greater than price at P = MC.
Consequently, the government would have to subsidize the firm.

What are the Real Costs of Monopolistic Competition?

The monopolistically competitive firm does not operate at the minimum point of the ATC curve, whereas the perfectly competitive firm does.
The excess capacity that exists in monopolistic competition is the price we pay for product differentiation.
In short, the inefficiency of monopolistic competition is a result of product differentiation.

What are the Real Costs of Monopolistic Competition?

Because consumers value variety—the ability to choose from competing products and brands—the loss in efficiency must be weighed against the gain in increased product variety.
The gains from product diversity can be large and may easily outweigh the inefficiency associated with a downward-sloping demand curve.
Firms differentiate their products to meet consumers’ demand.

What are the Real Costs of Monopolistic Competition?

Section 3

Oligopoly

Section 4

SECTION 4 QUESTIONS

Oligopoly

The products may be homogeneous or differentiated, but the barriers to entry are often very high, which makes it very difficult for firms to enter into the industry. Firms in the industry may earn long-run economic profits.

OLIGOPOLY

a market structure in which relatively few firms control all or most of the production and sale of a product

Mutual Interdependence

Oligopolists must strategize, much like good chess or bridge players, constantly observing and anticipating the moves of their rivals.

MUTUAL INTERDEPENDENCE

when a firm shapes its policy with an eye to the policies of competing firms

Oligopoly occurs when the number of firms in an industry is so small that any change in output or price by one firm appreciably impacts the sales of competing firms, so competitors respond directly to these actions in determining their own policy.

Mutual Interdependence

Why Do Oligopolies Exist?

Primarily, oligopoly is a result of the relationship between technological conditions of production and potential sales volumes.
For many products, a reasonably low cost of production cannot be obtained unless a firm is producing a large fraction of the market output.
In other words, substantial economies of scale are present.

Measuring Industry Concentration

Oligopolies exist, by definition, when relatively few firms control most of the production and sale of a given product or class of products.
A way of measuring the extent of oligopoly power in various industries is by using concentration ratios.

A concentration ratio indicates the proportion of total industry shipments (sales) of goods that a specified number of the largest firms in the industry produced, or the proportion of total industry assets held by those largest firms.

Measuring Industry Concentration

The extent of oligopoly power is indicated by the four-firm concentration ratio for the U.S. (Exhibit 9.4).
Concentration ratios of 70 to 100 percent are common in oligopolies.
That is, a high concentration ratio means that a few sellers dominate the market.

Measuring Industry Concentration

Exhibit 9.4: Four-Firm Concentration Ratios, U.S. Manufacturing

SOURCE: U.S. Census Bureau, 2002 Economic Census, Concentration Ratios, 2002.

Washington, D.C. (Issued May, 2006). Available at http://www.census.gov/epcd/

www/concentration.html, (accessed April, 16, 2010).

SOURCE: U.S. Census Bureau, 2002 Economic Census, Concentration Ratios, 2002. Washington, D.C. (Issued May, 2006). Available at http://www.census.gov/epcd/www/concentration.html, (accessed April, 16, 2010).

However, concentration ratios are not a perfect guide to industry concentration.
One problem is that they do not take into consideration foreign competition.

Measuring Industry Concentration

Economies of Scale as a
Barrier to Entry

Economies of large‑scale production make operation on a small scale during a new firm’s early years extremely unprofitable.
A firm cannot build up a large market overnight; in the interim, ATC is so high that losses are heavy. Recognition of this fact discourages new firms from entering the market.

Exhibit 9.5: Economies of Scale as a Barrier to Entry

Equilibrium Price and Quantity in Oligopoly

With mutual interdependence, an oligopolist generally faces considerable uncertainty as to the shape of its demand and marginal revenue curves. In order to know anything about its demand curve, a firm must know how other firms will react to its prices and other policies.

Thus, in the absence of additional assumptions, equating marginal revenue and marginal cost is relegated to guesswork.
Thus, it is difficult for an oligopolist to determine its profit-maximizing price and output.

Equilibrium Price and Quantity in Oligopoly

Section 4

Collusion and Cartels

Section 5

SECTION 5 QUESTIONS

Collusion and Cartels

The uncertainties of pricing decisions are substantial in oligopoly, so the implications of misjudging the behavior of competitors could prove to be disastrous.
Because of this uncertainty, some believe that oligopolists change their prices less frequently than perfect competitors, whose prices may change almost continuously.

The empirical evidence, however, does not clearly indicate that prices are in fact always slow to change in oligopoly situations.

Collusion and Cartels

Collusion

Because the actions and profits of oligopolists are so dominated by mutual interdependence, the temptation is great for firms to colludeto get together and agree to act jointly in pricing and other matters.

If firms believe they can increase their prices by coordinating their actions, they will be tempted to collude.
Collusion reduces uncertainty and increases the potential for monopoly profits.

Collusion

From society’s point of view, collusion has the same disadvantages as monopoly.
Goods are overpriced.
Goods are under-produced.
Consumers lose out from a misallocation of resources.

Collusion

Joint Profit Maximization

Agreements between firms on sale, pricing, and other decisions are usually called cartel agreements.
A cartel is a collection of firms making an agreement.
Cartels may lead to joint profit maximization, which requires the determination of price based on the marginal revenue function derived from the total (or market) demand schedule for the product and the marginal cost schedules of the various firms.

Exhibit 9.6: Collusion in Oligopoly

With outright agreements—necessarily secret because of antitrust laws—firms that make up the market will attempt to estimate demand and cost schedules, and will set optimum price and output levels accordingly.

Joint Profit Maximization

Equilibrium quantity and price for a collusive oligopoly, like those of a monopoly, are determined according to the intersection of the marginal revenue curve derived from the market demand curve and the horizontal sum of the short-run marginal cost curves for the oligopolists.

Joint Profit Maximization

Collusion facilitates joint profit maximization for an oligopoly.
Like monopoly, if the oligopoly is maintained in the long run:
It charges a higher price.
It produces less output.
It fails to maximize social welfare relative to perfect competition.

Joint Profit Maximization

The manner in which total profits are shared among firms in the industry depends in part upon the relative costs and sales of the various firms.

Joint Profit Maximization

Firms with low costs and large supply capability will obtain the largest profits because they have great bargaining power. With outright collusion, firms may agree upon market shares and the division of profits.

Joint Profit Maximization

Division of total profits depends on:
Relative bargaining strength of the firms
Relative financial strength
Ability to inflict damage (through price wars) on other firms
Ability to withstand similar action on the part of other firms
Relative costs
Consumer preferences
Bargaining skills

Joint Profit Maximization

Why are Most Collusive Oligopolies Short Lived?

Fortunately, most strong collusive oligopolies are rather short lived for two reasons.
First, in the United States and in some other nations, collusive oligopolies are strictly illegal under antitrust laws.
Second, for collusion to work, firms must agree to restrict output to a level that will support the profit-maximizing price.

At profit-maximizing prices, firms can earn positive economic profits.
Yet a great temptation exists for firms to cheat on the agreement of the collusive oligopoly.
And because collusive agreements are illegal, the other parties have no way to punish the offender.

Why are Most Collusive Oligopolies Short Lived?

Why do oligopolists have a strong incentive to cheat?
Any individual firm could lower its price slightly and increase sales and profits, as long as it is undetected.
Undetected price cuts could bring in new customers, including rivals’ customers.
In addition, there are non-price forms of spurring defection.

Why are Most Collusive Oligopolies Short Lived?

Price Leadership

Over time, an implied understanding may develop in an oligopoly market that a large firm is the price leader.
Competitors that go along with the pricing decisions of the price leader are called price followers.

What Happens in the Long Run if Entry is Easy?

Mutual interdependence in itself is no guarantee of economic profits, even if the firms in the industry succeed in maximizing joint profits.
The extent to which economic profits disappear depends on the ease with which new firms can enter the industry.

When entry is easy, excess profits attract newcomers.
New firms may break down existing price agreements by cutting prices in an attempt to establish themselves in the industry.
Older firms may reduce prices to avoid excessive sales losses.
As a result, the general level of prices will begin to approach average total cost.

What Happens in the Long Run if Entry is Easy?

How Do Oligopolists Deter Market Entry?

The profit-maximizing level of profits in oligopoly could be quite high, which would encourage entry.
But oligopolists often initiate pricing policies that reduce the entry incentive for new firms, holding prices below the maximum‑profit point.
This lower-than-profit-maximizing price may discourage newcomers from entering.

Because new firms would likely have higher costs than existing firms, the lower price may not be high enough to cover their costs.
However, once the threat of entry subsides, the market price may return to the profit-maximizing price.

How Do Oligopolists Deter Market Entry?

Exhibit 9.7: Long-Run Equilibrium and Deterring Entry

Antitrust and Mergers

The Justice Department and the Federal Trade Commission use the Herfindahl-Hirshman Index (HHI) to determine if a potential merger would result in an oligopoly.

Antitrust and Mergers:
Three Types of Mergers

If the price is deliberately kept low (below AVC) to drive a competitor out of the market, it is called predatory pricing.
It is difficult to distinguish predatory pricing from vigorous competition.

Predatory Pricing

Section 5

Game Theory and Strategic Behavior

Section 6

SECTION 6 QUESTIONS

Game Theory and Strategic Behavior

Noncollusive oligopoly resembles a military campaign or a poker game.
Firms take certain actions not because they are necessarily advantageous in themselves but because they improve the position of the oligopolist relative to its competitors and may ultimately improve its financial position.

A firm may deliberately cut prices, sacrificing profits either to drive competitors out of business or to discourage them from undertaking actions contrary to the interests of the other firms.

Game Theory and Strategic Behavior

What is Game Theory?

Some economists have suggested that the entire approach to oligopoly equilibrium price and output should be recast. They replace the analysis that assumes that firms attempt to maximize profits with one that examines firm behavior in terms of a strategic game.

GAME THEORY

firms attempt to maximize profits by acting in ways that minimize damage from competitors

With the game theory approach, there is a set of alternative actions, and the action that would be taken in a particular case depends on the specific policies followed by each firm.
The firm may try to figure out its competitors’ most likely countermoves to its own policies and then formulate alternative defense measures.

What is Game Theory?

Cooperative and Noncooperative Games

Interactions can either be cooperative or noncooperative.
A cooperative game would be two firms that decide to collude in order to improve their profit maximization position.
Consequently, most games are noncooperative games, in which each firm sets its own price without consulting other firms.

The primary difference between cooperative and noncooperative games is the contract.
Players in a cooperative game can talk and set binding contracts.
Those in noncooperative games are assumed to act independently, with no communication and no binding contracts.

Cooperative and Noncooperative Games

Because antitrust laws forbid firms to collude, we will assume that most strategic behavior in the marketplace is noncooperative.

Cooperative and Noncooperative Games

The Prisoners’ Dilemma

A firm’s decision makers must map out a pricing strategy based on a wide range of information.
They also must decide whether their strategy will be effective only under certain conditions regarding the actions of competitors or if the strategy will work regardless of the competitors’ actions.

Dominant Strategy

DOMINANT STRATEGY

strategy that will be optimal regardless of opponents’ actions

The prisoners’ dilemma is a famous game that has a dominant strategy and demonstrates the basic problem confronting noncolluding oligopolists.
Two bank robbery suspects are caught.
The suspects are placed in separate jail cells and are not allowed to talk with each other.

The Prisoners’ Dilemma

There are four possible results in this situation:
Both prisoners confess.
Neither confesses.
Prisoner A confesses but Prisoner B doesn’t.
Prisoner B confesses but Prisoner A doesn’t.

The Prisoners’ Dilemma

The payoff matrix summarizes these possibilities.
If each prisoner confesses, they will each serve two years in jail.
If neither confesses, each prisoner may only get one year because of insufficient evidence.
If one prisoner confesses and the other does not, the confessor gets six months and the other prisoner gets six years.

The Prisoners’ Dilemma:
The Payoff Matrix

Exhibit 9.8: The Prisoners’ Dilemma Payoff Matrix

Looking at the payoff matrix, if one prisoner confesses, it is in the best interest of the other prisoner to confess.
Since both know the temptation of the other to confess, the dominant strategy is to confess.
That is, the prisoners know that confessing is the way to make the best of a bad situation.

The Prisoners’ Dilemma

Firms in oligopoly often behave like the prisoners in the prisoners’ dilemma, carefully anticipating the moves of their rivals in an uncertain environment.

The Prisoners’ Dilemma

Profits Under Different
Pricing Strategies

To demonstrate how the prisoners’ dilemma can shed light on oligopoly theory, let us consider the pricing strategy of two firms.
In Exhibit 9.9, we present the payoff matrix—the possible profits that each firm would earn under different pricing strategies.

Exhibit 9.9: The Profit Payoff Matrix

At a Nash equilibrium, each firm is doing as well as it can, given the actions of its competitor. Each will make the choice that minimizes the risk of the worst scenario.
The Nash equilibrium is also the dominant strategy.

Nash Equilibrium

The Nash equilibrium takes on particular importance because it is a self-enforcing equilibrium.
Once this equilibrium is established, there is no incentive for either firm to move.

Nash Equilibrium

If two firms were to collude, it would be in their best interest.
However, each firm has a strong incentive to lower its price if this pricing strategy goes undetected by its competitor.

Profits under Different
Pricing Strategies

However, if both firms defect by lowering their prices from the joint profit-maximization level, both will be worse off than if they had colluded, but at least each will have minimized its potential loss if it cannot trust its competitor.
This situation is the oligopolist’s dilemma.

Profits under Different
Pricing Strategies

Advertising: Prisoners’ Dilemma Example

Advertising can lead to a situation like the prisoners’ dilemma.
Perhaps the decision makers of a large firm are deciding whether or not to launch an advertising campaign against a rival firm.

According to the payoff matrix in Exhibit 9.10, if neither company advertises, the two companies split the market, each making $100 million in profits.

Advertising

Exhibit 9.10: The Advertising Payoff Matrix

They also split the market if they both advertise, but their net profits are smaller ($75 million) because they would both incur advertising costs that are greater than any gains in additional revenues from advertising.

Advertising

However, if one advertises and the other does not, the company that advertises takes customers away from the rival.
The dominant strategy—the optimal strategy regardless of the rival’s actions—is to advertise.

Advertising

Arms Race: Prisoners’ Dilemma Example

The arms race provides a classic example of prisoner’s dilemma.
For each country, the dominant strategy is to build arms.
Self interest drives each participant into a noncooperative game that is worse for both.

Exhibit 9.11: The Arms Race Payoff Matrix

Repeated Games

TIT-FOR-TAT STRATEGY

used in repeated games, the strategy in which one player follows the other player’s move in the previous round; leads to greater cooperation

Exhibit 9.12: Characteristics of the Four Major Market Structures

Section 6