1. MONOPOLISTIC COMPETITION AND OLIGOPOLY
Chapter 13
MONOPOLISTIC COMPETITION AND OLIGOPOLY

2. Today’s lecture will:
Discuss the four distinguishing characteristics of monopolistic competition.
Demonstrate graphically the equilibrium of a monopolistic competitor.
State the central element of oligopoly.

3. Today’s lecture will:
Explain why decisions in the cartel model depend on market share and decisions in the contestable market model depend on barriers to entry.
Explain two empirical methods of determining market structure.

4. Characteristics of Monopolistic Competition
Many sellers
Differentiated products
Multiple dimensions of competition
Easy entry of new firms in the long run

5. Equilibrium in Monopolistic Competition
Profit maximizing
output is where
MR=MC.
Price MC
ATC PM QM
At equilibrium
P=ATC and economic profits are zero. MR D
Quantity

6. Comparing Perfect and Monopolistic Competition
Perfect competition
Monopolistic competition
Price
Quantity
Price MC MC
ATC
ATC PM QM PC PC QC D QC MR D
Quantity

7. Comparing Monopolistic Competition with Monopoly
It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry.
No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry.

8. Advertising and Monopolistic Competition
Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do.
The goals of advertising are to increase demand and make demand more inelastic.
Advertising increases ATC.

9. Characteristics of Oligopoly
Oligopolies are made up of a small number of mutually interdependent firms.
Each firm must take into account the expected reaction of other firms.
Oligopolies can be collusive or noncollusive.

10. Models of Oligopoly Behavior
There is no single model of oligopoly behavior.
Two models of oligopoly behavior are:
The cartel model – the combination of firms acts as if it were a monopoly.
The contestable market model – existence of barriers to entry, not market structure, determine price and output decisions.

11. The Cartel Model
Oligopolies act as if they were a monopoly and set a price to maximize profit.
Output quotas are assigned to individual member firms so that total output is consistent with joint profit maximization.
If oligopolies can limit the entry of other firms, they can increase profits.

12. Implicit Price Collusion
Formal collusion is illegal in the U.S. while informal collusion is permitted.
Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another.
Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.

13. Why Are Prices Sticky?
Informal collusion is an important reason why prices are sticky.
Another is the kinked demand curve.
If a firm increases price, others won’t go along, so demand is very elastic for price increases.
If a firm lowers price, other firms match the decrease, so demand is inelastic for price decreases.

14. The Kinked Demand Curve
Price
Quantity a b
MC0 P
MR1 c
MC1 D1 d D2 Q
MR2

15. The Contestable Market Model
According to the contestable market model, barriers to entry and exit determine a firm’s price and output decisions.
Even if the industry contains only one firm, it will set a competitive price if there are no barriers to entry.

16. Comparing the Contestable Market and Cartel Models
The cartel model is appropriate for oligopolists that collude, set a monopoly price, and prevent market entry.
The contestable market model describes oligopolies that sets a competitive price and has no barriers to entry.
Oligopoly markets lie between these two extremes.
Both models use strategic pricing decisions – firms set their price based on the expected reactions of other firms.

17. New Entry and Price Wars
The threat of outside competition limits oligopolies from acting as a cartel.
Price wars are the result of strategic pricing decisions gone wild.
A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business.

18. Comparison of Market Structures
Monopoly
Oligopoly
Monopolistic
Competition
Perfect
Number of Firms
One
Few
Many
Almost infinite
Barriers to Entry
Significant
None
Pricing Decisions
MC=MR
Strategic pricing,
between monopoly
and competition
MC=MR=P
Output Decisions
Most output
restriction
Output somewhat restricted
Output somewhat restricted by product differentiation
No output restricition
Interdependence
No competitors
Interdependent decisions
Each firm independent
Long-Run Profit
Possible
P and MC
P>MC
P=MC
Structure
Characteristics

19. Classifying Industries
Cross-price elasticity measures the responsiveness of the change in demand for a good to a change in the price of a related good.
Goods with a cross-price elasticity of 3 or more are in the same industry.
North American Industry Classification System (NAICS) is an industry classification system adopted by Canada, Mexico, and the U.S. in 1997.

20. Industry Groupings in NAICS
Retail Trade
Information __
Telecommunications
5172 Wireless telecommunications and
carriers (except satellite)
Paging
Finance and insurance
53 Real estate and rental and leasing

21. Determining Industry Structure
The concentration ratio – the value of sales by the top firms of an industry as a percentage of total industry sales
The Herfindahl index – the sum of the squared value of the individual market shares of all firms in the industry

22. Concentration Ratios and the Herfindahl Index
Industry
Four -
firm
concentration
ratio
Herfindahl
index
Meat products 42
393
Breakfast cereal 78
2,445
Book printing 39
364
Stationary 28
1,128
Soap and detergent 61
1,619
Men’s footwear
857
Computer and peripherals 49
728
Burial caskets 73
2,965
Radio, TV, wireless
broadcasting

23. Conglomerate Firms and Bigness
Neither the four-firm concentration ratio nor the Herfindahl index gives a complete picture of corporations’ bigness because many firms are conglomerates.
Conglomerates – huge corporations whose activities span various unrelated industries.

24. Summary Monopolistic competition is characterized by:
Many sellers
Differentiated products
Multiple dimensions of competition
Ease of entry of new firms
The central characteristic of oligopoly is that there are a small number of interdependent firms.

25. Summary
Monopolistic competitors differ from perfect competitors in that the former face a downward sloping demand curve.
Monopolistic competitors differ from monopolists in that monopolistic competitors make zero long-run profit.
In monopolistic competition firms act independently; in an oligopoly they take account of each other’s actions.

26. Summary
An oligopolist’s price will be somewhere between the competitive price and the monopolistic price.
A contestable market theory of oligopoly judges an industry’s competitiveness more by performance and barriers to entry than by structure.
Cartel models of oligopoly concentrate on market structure.

27. Summary
Industries are classified by economic activity in the North American Industry Classification System (NAICS). Industry structures are measured by concentration ratios and Herfindahl indexes.
A concentration ratio is the sum of market shares of the largest firms in an industry.
A Herfindahl index is the sum of the squares of the market shares of all firms in an industry.

28. Review Question Explain the difference in short-run and long-run equilibrium for a monopolistic competitor.
In the short-run, a monopolistic competitor produces where MR=MC. As long as P>ATC, the firm will make an economic profit. However, other firms enter the industry and decrease the market share of the original firms. The demand curve for all firms will shift to the left until P=ATC. There are no economic profits in long-run equilibrium.
Review Question Compare long-run equilibrium in oligopoly with perfect competition and monopoly with respect to price and output .
Equilibrium output for an oligopolistic market is larger than output for a monopoly, but less than output for a perfectly competitive market. Prices in oligopoly are lower than those for monopoly, but higher than those in perfect competition.