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

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

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

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