Chapter 11

 Monopolistic competition is a market structure in which:  There are a large number of firms  The products produced by the different firms are differentiated  Entry and exit occur easily  Product differentiation implies that the products are different enough that the producing firms exercise a “mini-monopoly” over their product.  The firms compete more on product differentiation than on price.  Entering firms produce close substitutes, not an identical or standardized product. 2

3

4

5

6

7

 The firm attempts to establish its product as a different product from that offered by its rivals.  Differentiation means that in the consumer’s mind, the product is not the same. Marketing is often the key to successful differentiation.  Firms may differentiate products by perceived quality, reliability, color, style, safety features, packaging, purchase terms, warranties and guarantees, location, availability (hours of operation) or any other features.  Brand names may signal information regarding the product, reducing consumer risk. 8

9 Product differentiation reduces the price elasticity of demand, which appears as a steeper demand curve. Successful product differentiation enables the firm to charge a higher price.

10

 An oligopoly is a market structure characterized by:  Few firms  Either standardized or differentiated products  Difficult entry  All the firms may be the same size, or a few large firms may dominate the industry while coexisting with several small firms.  A key characteristic of oligopolies is that each firm can affect the market, making each firm’s choices dependent on the choices of the other firms. They are interdependent. 11

 A concentration ratio gives the percentage of all sales in a market that are accounted for by a specified number of firms in that market.  The most commonly used such ratio is the four-firm concentration ratio, which shows the combined market share of the top four firms as a percent of sales in the market as a whole.  The Herfindahl-Hirschmann index (HHI) is calculated by squaring the percentage market shares of each firm in the market and summing the squares.  For an industry with n competing firms, the formula is H = p p p n 2

13

 The importance of interdependence is that it leads to strategic behavior.  Strategic behavior is the behavior that occurs when what is best for A depends upon what B does, and what is best for B depends upon what A does.  Such behavior has been analyzed using the mathematical techniques of game theory.  Game theory provides a description of oligopolistic behavior as a series of strategic moves and countermoves. 14

 Considers two actors (prisoners, firms, competitors), each trying to achieve a dominant strategy—a strategy that produces better results no matter what strategy the opposing firm follows. 15

16 Dominant Strategy: Both Confess

17 Dominant Strategy: Both Advertize

18 Dominant Strategy: Both Cheat

 If the firms in an oligopoly cooperate, they may earn more profits than if they act independently.  Collusion, which leads to secret cooperative agreements, is illegal in the U.S., although it is legal and acceptable in many other countries.  Price-Leadership Cartels may form in which firms simply do whatever a single leading firm in the industry does. This avoids strategic behavior and requires no illegal collusion. 19

 A cartel is an organization of independent firms whose purpose is to control and limit production and maintain or increase prices and profits.  Like collusion, cartels are illegal in the United States.  Conditions necessary for a cartel to be stable (maintainable):  There are few firms in the industry.  There are significant barriers to entry.  An identical product is produced.  There are few opportunities to keep actions secret.  There are no legal barriers to sharing agreements. 20

 OPEC: Organization of Petroleum Exporting Countries.  Attempts to set prices high enough to earn member countries significant profits, but not so high as to encourage dramatic increases in oil exploration or the pursuit of alternative energy sources.  Controls prices by setting production quotas for member countries.  Such cartels are difficult to sustain because members have large incentives to cheat, exceeding their quotas. 21

 Facilitating practices are actions by oligopolistic firms that can contribute to cooperation and collusion even thought the firms do not formally agree to cooperate. For example:  cost-plus/mark-up pricing can lead to similar or identical pricing behavior  most-favored customer policies lead to prices remaining higher than they would otherwise. 22

 Cost-plus or mark-up pricing is a pricing policy whereby a firm computes its average costs of producing a product and then sets the price at some percentage above this cost.  Most-favored customer: a consumer who is guaranteed the best price and any improvements in features for a period of time. This practice creates a disincentive for producers to lower prices even in the face of flagging demand. 23

 Tit-for-Tat: A strategy for ongoing interaction where one player (firm) follows the other firm’s play from the previous round. You cheat this time, I cheat next time. …  Trigger: Strategy where one player threatens to defect on the collaboration for an extended period if the other player defects once. 24

25

26