Two Market Structures
Two market structures between perfect competition and monopoly: oligopoly and monopolistic competition.
In both markets, the seller must recognize and react to the actions of competitors.
In oligopolies, long-run economic profits can be positive.
In monopolistically competitive markets, entry and exit drive economic profits to zero in the long run.
Important determinants of competitiveness include: the number of firms, the degree of product differentiation, entry barriers, and the presence or absence of collusion.
Oligopoly
Oligopolies can sell either homogeneous or differentiated products.
Homogeneous products examples: steel, oil, gasoline, computer hard drives.
Differentiated products examples: cereal, automobiles, laundry detergent, cigarettes.
Key characteristics:
Market with only a few firms competing.
Products can be either homogeneous or differentiated.
Significant barriers to entry and exit.
Each firm’s decisions depend on the actions of other firms (interdependence).
Long-run economic profits can be positive.
Duopoly (two firms) and Bertrand competition:
Two firms price for a homogeneous service/product; assumption: services are perfect substitutes.
If both firms set the same price, they share the market.
If one firm undercuts the other, it can capture the entire market until profits vanish.
Market demand and residual demand concepts:
Residual demand: the demand not met by the other firm(s) and is influenced by the prices of all firms in the industry.
Example: Dogwood vs. Rose Petal (two landscapers, MC = $30):
If Dogwood charges $50 and Rose Petal charges $45, and both MC = $30, which would a consumer pick?
If prices are set, is this a Nash equilibrium?
Observation: Dogwood has an incentive to lower price to capture more demand; thus the initial charge is not a Nash equilibrium.
Pricing dynamics and responses:
In response to a rival undercutting, firms must decide how to respond; this leads to a pricing game with potentially iterative undercutting.
Exhibit 14.2 shows the Market Demand Curve for an oligopoly with homogeneous products and demonstrates how a price above a threshold (e.g., $50) could destroy demand for one firm if the other offers a lower price.
Long-run outcome with homogeneous products:
Long-run equilibrium tends toward P = MC, which resembles a competitive outcome.
Oligopoly with differentiated products:
Differentiation means demand isn’t all-or-nothing: firms can charge higher prices and still retain some sales due to product preferences.
Coke vs. Pepsi example: raising price may still retain some customers; lowering price may shift some demand, but not all, because of imperfect substitutability.
Strategic pricing and the MR = MC rule:
In general, firms try to equate marginal revenue to marginal cost (MR = MC) when deciding prices.
If a competitor lowers its price, a firm must consider how much to lower or whether to maintain price given residual demand and competitor reactions.
How to avoid a price war:
Collusion: firms conspire to set quantity or price.
Collusion is illegal in many jurisdictions (antitrust concerns).
If collusion were legal, a cartel (e.g., OPEC) could coordinate to control prices by limiting production.
Conditions for collusion to be stable:
Enforcement mechanism to punish cheating.
Long-run profits from not cheating must outweigh short-run gains from cheating.
Why firms profess willingness to match prices:
Firms claim they will match competitors to prevent undercutting, but the strategic reality involves MR = MC optimization and possible price wars.
Exhibit 14.2 (Oligopoly with homogeneous products):
If one firm charges above $50, demand for its service would be zero in the example market.
Exhibit 14.3 (Dueling Duopolies and a Pricing Response):
Illustrates how duopolies respond to rival pricing, leading to a sequence of strategic moves.
Key takeaway: Oligopoly combines strategic interaction and potential for positive long-run profits, especially with differentiated products or collusion mechanisms.
Monopolistic Competition
Characteristics:
Many firms compete.
Products are similar but slightly differentiated (monopolistic differentiation).
No barriers to entry or exit.
Long-run profits are driven to zero due to free entry and exit.
Demand and pricing:
Each firm faces a downward-sloping demand curve due to product differentiation.
The profit-maximizing rule is the same as for a monopolist: MR = MC.
Pricing strategy and profitability:
Because of differentiation, firms may charge prices above marginal cost.
Exhibits show a variety of pricing strategies and how profits arise or disappear as entry occurs.
Long-run equilibrium:
Firms earn zero economic profits in the long run as new entrants erode profits.
Exhibit 14.10 shows zero profits in long-run equilibrium; Exhibit 14.9 demonstrates the effect of market entry on an existing firm’s demand curve; Exhibit 14.8 shows economic profits and losses (a) profits, (b) losses.
The “Broken” Invisible Hand and monopolistic competition:
Although social surplus is not maximized as in perfect competition, product variety can be socially beneficial (e.g., R&D, advertising, variety effects).
The “Broken” Invisible Hand
Market power interrupts the perfectly competitive efficiency story.
Equilibria comparison:
Exhibit 14.11 compares equilibria for a perfectly competitive market and a monopolistically competitive market.
Efficiency implications:
When firms do not operate at their minimum ATC, there is a loss of efficiency, reflecting a trade-off between product variety and allocative/ productive efficiency.
Regulation considerations:
Should the government regulate market power?
It depends on:
Suspected collusion
Benefit-cost analysis
Industry concentration levels
Herfindahl-Hirschman Index (HHI):
Definition: A measure of market concentration to determine degree of competition.
Formula: where $s_i$ is the market share of firm i (in percentage points).
Higher HHI implies more concentrated industry.
Example with two firms: if one firm has 75% and the other 25% of sales,
Interpretation: The HHI approaches zero as the number of firms grows with relatively equal shares.
Exhibit 14.11: Four Market Structures (summary table)
Perfect Competition:
Number of Firms: Many
Type of Product: Homogeneous
Barriers to Entry: None; free entry and exit
Price-Taker or Price-Maker?: Price-taker; price given by market
Residual Demand: Horizontally sloped; perfectly elastic demand
Social Surplus: Maximized
Long-run Profits: Zero
Monopolistic Competition:
Number of Firms: Many
Product Type: Slightly differentiated
Barriers to Entry: None; free entry and exit
Price-Taker or Price-Maker?: Price-maker; with recognition of other sellers
Residual Demand: Downward-sloping; slightly differentiated products are available
Social Surplus: Not maximized
Long-run Profits: Zero
Oligopoly:
Number of Firms: A few
Product Type: Identical or differentiated
Barriers to Entry: Yes
Price-Taker or Price-Maker?: Price-maker; with a strong recognition of other sellers
Residual Demand: Downward-sloping
Social Surplus: Not maximized
Long-run Profits: More than zero
Monopoly:
Number of Firms: One
Product Type: Single, undifferentiated product or service or highly differentiated with patent/ exclusive control
Barriers to Entry: Yes
Price-Taker or Price-Maker?: Price-maker; no competitors, no perfect substitutes
Residual Demand: Downward-sloping
Social Surplus: Not maximized
Long-run Profits: More than zero
Price rules summarized:
Perfect Competition:
Monopolistic Competition: P > MR = MC
Oligopoly: P > MR = MC or depending on the degree of competition and product differentiation
Monopoly: P > MR = MC
Evidence-Based Economics
How many firms are necessary to make a market competitive?
Research indicates some local markets can be competitive with 3 or 4 firms (varies by industry).
Evidence-based problem sets suggest different numbers in different contexts.
Evidence-Based Economics Problem (1–6)
Problem setup (tire dealers A and B): A has MC = $55, B has MC = $60.
(a) Bertrand competition with identical products: what is the equilibrium price and market shares?
With identical products and Bertrand competition, the equilibrium price is driven down to the lowest marginal cost, $P = $55.
Market share: Dealer A (the lower-cost firm) captures the entire market; Dealer B earns zero profits and may exit or earn zero profits; A earns zero economic profit at the price equal to its MC, assuming constant MC.
(b) A third firm, dealer C, enters with MC = $50: what happens?
Equilibrium price falls to the new lowest MC, $P = $50.
Market share: The firm(s) with the lowest MC(s) capture the market; typically dealer C would supply the entire market if A and B cannot profitably supply at $50.
(c) Now allow product differentiation: each dealer sells a slightly different tire and can charge a bit more than MC while maintaining market share. Given equilibrium prices and quantities:
Dealer A: Price $61, Quantity 50
Dealer B: Price $62, Quantity 25
Dealer C: Price $60, Quantity 25
Compute Herfindahl-Hirschman Index (HHI) for the industry with these three firms:
Total quantity = 50 + 25 + 25 = 100; shares: A 0.50, B 0.25, C 0.25
HHI: (or in percentage points: )
(d) A fourth firm enters (Dealer D) with price/demands such that quantities are: A 25, B 25, C 25, D 25
Total quantity = 100; shares each 0.25
HHI: (or in percentage points: )
(e) Difference in the average price paid by a consumer between markets in (c) and (d):
(c) Average price = \frac{61\cdot 50 + 62\cdot 25 + 60\cdot 25}{100} = \frac{3050 + 1550 + 1500}{100} = \frac{6100}{100} = 61
(d) Average price = \frac{60\cdot 25 + 61\cdot 25 + 59\cdot 25 + 60\cdot 25}{100} = \frac{1500 + 1525 + 1475 + 1500}{100} = \frac{6000}{100} = 60
Difference: 61 − 60 = 1. The average price paid is $1 higher in the market with three firms (c) than in the market with four firms (d).
Key Notation and Concepts (Summary)
MR = MC rule applies to monopolists and monopolistic competitors; in perfect competition and many oligopolies, the price relates to MC in the long run.
Residual demand: the portion of market demand not satisfied by other firms, dependent on all firms’ pricing.
Bertrand competition: price-based competition with homogeneous products; the price tends toward the lowest cost; potentially a price war.
Nash equilibrium: a strategic outcome where no player wants to deviate given others’ actions (illustrated in pricing games like duopolies).
Cartels: formal agreements among producers to collude; require enforcement and can be illegal in many jurisdictions.
HHI (Herfindahl-Hirschman Index): a measure of market concentration given by where are market shares (as fractions or percentages).
Four Market Structures (at a glance):
Perfect Competition: many, homogeneous, no barriers, price-taker, zero long-run profits, maximum social surplus.
Monopolistic Competition: many, differentiated, no barriers, price-maker, zero long-run profits.
Oligopoly: few, identical or differentiated, barriers present, price-maker (with interdependence), profits can be positive in the long run.
Monopoly: one, unique product, high barriers, price-maker, profits positive in the long run.