11

Monopolistic Competition and Oligopoly

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Four Market Models

Characteristics of the Four Basic Market Models
Characteristic

Pure
Competition

Monopolistic
Competition

Oligopoly

Monopoly

Number of firms

A very large
number

Many

Few

One

Type of product

Standardized

Differentiated

Standardized or
differentiated

Unique; no
close subs.

Control over
price

None

Some, but within rather

narrow limits

Limited by mutual
inter-dependence;
considerable with
collusion

Considerable

Conditions of
entry

Very easy, no
obstacles

Relatively easy

Significant
obstacles

Blocked

Nonprice
competition

None

Considerable emphasis
on advertising, brand
names, trademarks

Typically a great
deal, particularly
with product
differentiation

Mostly public
relation
advertising

Examples

Agriculture

Retail trade, dresses,

shoes

Steel, auto, farm

implements

Local utilities

LO1

11-2

Monopolistic Competition

Relatively large number of sellers

Differentiated products
Easy entry and exit
Advertising

LO1

11-3

Monopolistically Competitive

Industry concentration
Measured by:
Four-firm concentration ratios
Percentage of 4 largest firms
4-Firm CR =

Output of four largest firms

Total output in the industry

Herfindahl index
Sum of squared market shares
HI = (%S1)2 + (%S2)2 + (%S3)2 + . +
(%Sn)2
LO1

11-4

Price and Output in Monopolistic Comp

Demand is highly elastic

Short run profit or loss
Produce where MR=MC
Long run normal profit
Entry and exit
Inefficient
Product variety
LO2

11-5

The Short Run: Profit or Loss

Price and Costs

MC

ATC

P1
A1
Economic
Profit

D1
MR = MC
MR

Q1

Quantity

LO2

11-6

The Short Run: Profit or Loss

Price and Costs

MC

ATC

A2
P2

Loss
D2
MR = MC
MR
0

Q2

Quantity

LO2

11-7

The Long Run: Only a Normal Profit

MC

Price and Costs

ATC
P3= A3

D3
MR = MC
MR
0

Q3

Quantity

LO2

11-8

Monopolistic Competition: Efficiency

Inefficient
Productive inefficiency
P > ATC
Allocative inefficiency
P > MC

LO2

11-9

Monopolistic Competition: Efficiency

P=MC=Min ATC for pure competition (recall)
Price and Costs

MC
ATC

P3= A3
P4

Price is Lower
D3
MR = MC
Excess Capacity at
Minimum ATC
0

Q3

MR
Q4

Quantity

Monopolistic competition is not efficient

LO2

11-10

Product Variety

The firm constantly manages price,

LO2

product, and advertising

Better product differentiation
Better advertising
The consumer benefits by greater
array of choices and better products
Types and styles
Brands and quality
11-11

Oligopoly

A few large producers

Homogeneous or differentiated

LO3

products
Limited control over price
Mutual interdependence
Strategic behavior
Entry barriers
Mergers
11-12

Oligopolistic Industries

Four-firm concentration ratio

40% or more to be oligopoly
Shortcomings
Localized markets
Inter-industry competition
World price
Dominant firms
LO3

11-13

Game Theory Overview

Oligopolies display strategic pricing

behavior
Mutual interdependence
Collusion
Incentive to cheat
Prisoners dilemma

LO4

11-14

Game Theory Overview

RareAirs Price Strategy

LO4

High

Uptowns Price Strategy

2 competitors
2 price
strategies
Each strategy
has a payoff
matrix
Greatest
combined
profit
Independent
actions
stimulate a
response

$12

Low
B

$15

High
$12

$6

$6

$8

Low
$15

$8

11-15

Game Theory Overview

RareAirs Price Strategy

LO4

High

Uptowns Price Strategy

Independently
lowered prices in
expectation of
greater profit
leads to worst
combined
outcome
Eventually low
outcomes make
firms return to
higher prices.

$12

Low
B

$15

High
$12

$6

$6

$8

Low
$15

$8

11-16

Three Oligopoly Models

Kinked-demand curve
Collusive pricing
Price leadership
Reasons for 3 models
Diversity of oligopolies
Complications of interdependence

LO5

11-17

Kinked-Demand Curve

Rivals Ignore
Price Increase
MC1

P0
f

D2

Q0
Quantity

LO5

P0

e
MR2

MC2

MR2

Rivals Match g
Price Decrease
0

Price

Price

D2

g
D1

MR1

D1
0

Q0

MR1

Quantity

11-18

Kinked-Demand Curve

Criticisms
Explains inflexibility, not price
Prices are not that rigid
Price wars

LO6

11-19

Cartels and Other Collusion

Price and Costs

MC

P0

ATC

A0
MR=MC
Economic
Profit

Q0

LO6

MR

Quantity

11-20

Overt Collusion

Cartels - a group of firms or nations

LO6

that collude
Formally agreeing to the price
Sets output levels for members
Collusion is illegal in the United
States
OPEC
11-21

Obstacles to Collusion

Demand and cost differences

Number of firms
Cheating
Recession
New entrants
Legal obstacles

LO6

11-22

Price Leadership Model

Price Leadership
Dominant firm initiates price

LO6

changes
Other firms follow the leader
Use limit pricing to block entry of new
firms
Possible price war
11-23

Oligopoly and Advertising

Prevalent to compete with product

development and advertising
Less easily duplicated than a price
change
Financially able to advertise

LO7

11-24

Advertising
Positive Effects

Negative Effects

Low-cost way of providing

information to consumers

Can be manipulative

Enhances competition

Contains misleading claims that

confuse consumers

Speeds up technological progress Consumers pay high prices for a

good while forgoing a better, lower
priced, unadvertised version of the
product
Can help firms obtain economies
of scale

LO7

11-25

Oligopoly and Efficiency

Oligopolies are inefficient

Productively inefficient P > minATC
Allocatively inefficient P > MC
Qualifications
Increased foreign competition
Limit pricing
Technological advance
LO7

11-26