Chapter 11: Monopolistic Competition and Oligopoly

• Monopolistic competition - Relatively large number of sellers, differentiated products, easy entry/exit
• Relatively large # of sellers
  • Small market shares
  • No collusion - The presence of a relatively large number of firms ensures that collusion by a group of firms to restrict output and set prices is unlikely
  • Independent action - Each firm can determine its own pricing policy without considering the possible reactions of rival firms
• Product differentiation - Variations of particular product
  • Product attributes
  • Service
  • Location
  • Brand names + packaging
  • Some control over product prices
• Easy entry + exit
  • Few economies of scale
  • Low capital requirements
• Non-price competition - Product differentiation + advertising
• Four firm concentration ratio - Ratio of the output (sales) of the four largest firms in an industry relative to total industry sales
  • Very low in purely competitive industries
• Herfindahl index - Sum of the squared percentage market shares of all firms in the industry
  • Important to assess oligopolistic industries
  • Lower index → Greater chance of being competitive
• Monopolistic competition’s demand curve
  • Highly elastic
  • No perfect product substitutes
  • Price elasticity depends on # of rivals + degree of product differentiation
• Short run
  • Produces where MR = MC
  • May incur loss in short run

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• Long run
  • Only normal profit (break even)
  • Economic profits → Firms enter industry → Quantity increases → Economic profit decreases
  • Economic losses → Firms leave industry → Quantity decreases → Economic profit increases
  • Complications
  • Product differentiation can prevent duplication
  • In reality, entry is not as free

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• Efficiency
  • Neither productive nor allocative efficiency
  • Average total cost slightly higher than optimal
  • P > MC → Underallocation of resources
• Excess capacity - Plant and equipment that are underused because firms are producing less than the minimum-ATC output
• Product differentiation
  • Stay ahead of competitors
  • Provides more range to consumers
  • Trade-off b/w consumer choice + productive efficiency
• Oligopoly - Market dominated by a few large producers of a homogeneous or differentiated product
  • 3-5 firms
• Homogeneous oligopoly - Standardized products
• Differentiated oligopoly - Differentiated products
• Strategic behavior - Self-interested behavior that takes into account reactions of others
• Mutual interdependence - A situation in which each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms
• Entry barriers
  • Economies of scale
  • Large capital expenditures
  • Ownership + control of raw resources
• Merge 2 competing firms → Increase market share + achieve greater economies of scale + greater monopoly power
• Shortcomings of concentration ratios
  • Localized markets
  • Interindustry competition - Competition b/w 2 products associated w/ different industries
  • Import competition - Competition b/w foreign products
• Game theory - Study of how people behave in strategic situations
  • Payoff matrix shows payoff to each firm resulting from different combinations of strategies
  • Collusion - Cooperation w/ rivals rather than work competitively/independently
  • Incentive to cheat - Cheating on collusive agreement to increase own profit
• 3 oligopoly models
  • (1) the kinked-demand curve, (2) collusive pricing, and (3) price leadership
  • Why isn’t there only a single model?
  • Diversity of oligopolies - Oligopoly encompasses a greater range and diversity of market situations than do other market structures
  • Complications of interdependence - The mutual interdependence of oligopolistic firms complicates matters significantly
• Kinked demand curve - Demand is highly elastic above the going price P0 but much less elastic or even inelastic below that price
  • Rivals can either match price changes or ignore price changes
  • Prices stable in non-collusive oligopolistic industries
  • Even if costs change significantly, may not need to change price
  • Price war - Successive and continuous rounds of price cuts by rivals as they attempt to maintain their market shares

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• Cartels + other collusion

  • Cartel - A group of producers that typically creates a formal written agreement specifying how much each member will produce and charge
  • Obstacles to collusion
  • Demand + cost differences - When oligopolists face different costs and demand curves, it is difficult for them to agree on a price
  • Number of firms - Other things equal, the larger the number of firms, the more difficult it is to create a cartel or some other form of price collusion
  • Cheating - Collusive oligopolists are tempted to engage in secret price cutting to increase sales and profit
  • Long-lasting recession - Slumping markets increase average total cost
  • Potential entry of new firms - The greater prices and profits that result from collusion may attract new entrants, including foreign firms
  • Anti-trust law - U.S. antitrust laws prohibit cartels and price-fixing collusion

• Price leadership - The dominant firm initiates price changes and all other firms more or less automatically follow the leader

  • Infrequent price changes
  • Communications of price changes
  • Limit pricing

• Oligopoly + advertising

  • Product development + advertising less easily duplicated than price cuts
  • Positive effects
  • Diminishes monopoly power
  • Lowers consumers’ search costs
  • More economic efficiency
  • Negative effects
  • No info about price or quality
  • Based on misleading claims
  • Establishes brand loyalty + monopoly power

• Oligopoly + efficiency

  • Neither productive nor allocative efficiency
  • No regulation of loophole monopoly power

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