2. 14 Monopolistic Competition and Oligopoly Chapter Outline
Monopolistic Competition Product Differentiation, Advertising, and Social Welfare Price and Output Determination in Monopolistic Competition Economic Efficiency and Resource Allocation Oligopoly Oligopoly Models Game Theory Repeated Games A Game with Many Players: Collective Action Can Be Blocked by a Prisoners’ Dilemma Oligopoly and Economic Performance Industrial Concentration and Technological Change The Role of Government Regulation of Mergers A Proper Role?

3. MONOPOLISTIC COMPETITION AND OLIGOPOLY
FIGURE Characteristics of Different Market Organizations
Although not every industry fits neatly into one of these categories, the categories do provide a useful and convenient framework for thinking about industry
structure and behavior.

4. MONOPOLISTIC COMPETITION
monopolistic competition A common form of industry (market) structure in the United States, characterized by a large number of firms, none of which can influence market price by virtue of size alone. Some degree of market power is achieved by firms producing differentiated products. New firms can enter and established firms can exit such an industry with ease.

5. MONOPOLISTIC COMPETITION
TABLE Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1997
INDUSTRY DESIGNATION
FOUR LARGEST FIRMS
EIGHT LARGEST FIRMS
TWENTY LARGEST FIRMS
NUMBER OF FIRMS
Travel trailers and campers 26 36 50
761
Dolls 31 51 66
239
Wood office furniture 34 42 55
639
Book printing 32 45 59
890
Curtains and draperies .5 .3 .1
2012
Fresh or frozen seafood 13 .6 22 .9 .2
586
Women’s dresses 14 23 .7 39 .4
747
Miscellaneous plastic products 5 8
7522
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing. Subject Series EC92m315, June, 2001.
Firms in a monopolistically competitive industry are small relative to the total market. New firms can enter the industry in pursuit of profit, and relatively good substitutes for the firms’ products are available. Firms in monopolistically competitive industries try to achieve a degree of market power by differentiating their products—by producing something new, different, or better, or by creating a unique identity in the minds of consumers.

6. MONOPOLISTIC COMPETITION
PRODUCT DIFFERENTIATION, ADVERTISING,
AND SOCIAL WELFARE
product differentiation A strategy that firms use to achieve market power. Accomplished by producing products that have distinct positive identities in consumers’ minds.

7. MONOPOLISTIC COMPETITION
TABLE Total Advertising Expenditures in 2003
DOLLARS (BILLIONS)
Newspapers
45.4
Television
62.2
Direct mail
49.1
Yellow pages
13.9
Internet
5.6
Radio
19.5
Magazines
11.8
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 2002, Table 1253.

8. MONOPOLISTIC COMPETITION
TABLE Magazine Advertising Revenues by Category, 2003
DOLLARS (MILLIONS)
Automotive
2,088
Technology Telecommunications Computers and software
Home furnishings and supplies
1,554
Toiletries and cosmetics
1,699
Apparel and accessories
1,513
Financial, insurance and real estate
896
Food and food products
1,391
Drugs and remedies
1,663
Retail stores
986
Beer wine and liquor
394
Sporting goods
253
Source: Publishers Information Bureau, Statistical Abstract of the United States, 2002, pg. 772

9. MONOPOLISTIC COMPETITION
The Case for Product Differentiation and Advertising
Restaurants and rock bands are good examples of monopolistic
competitors that face intense competition.
The advocates of spirited competition believe that differentiated products and advertising
give the market system its vitality and are the basis of its power. They are the only ways to begin to satisfy the enormous range of tastes and preferences in a modern economy. Product differentiation also helps to ensure high quality and efficient production, and advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the marketplace.

10. MONOPOLISTIC COMPETITION
The Case Against Product Differentiation and Advertising
Product differentiation and advertising waste society’s scarce resources, argue critics. They say enormous sums of money are spent to create minute, meaningless differences among products.
The bottom line, critics of product differentiation and advertising argue, is waste and
inefficiency. Enormous sums are spent to create minute, meaningless, and possibly
nonexistent differences among products. Advertising raises the cost of products and
frequently contains very little information. Often, it is merely an annoyance. Product
differentiation and advertising have turned the system upside down: People exist to
satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive
warfare and may serve as a barrier to entry, thus reducing real competition.

11. MONOPOLISTIC COMPETITION
No Right Answer
There are strong arguments on both sides of the advertising debate, and even the empirical evidence yields to conflicting conclusions. Some studies show
that advertising leads to concentration and positive profits; others, that advertising improves the functioning of the market.

12. MONOPOLISTIC COMPETITION
PRICE AND OUTPUT DETERMINATION
IN MONOPOLISTIC COMPETITION
Product Differentiation and Demand Elasticity
FIGURE Product Differentiation Reduces the Elasticity of Demand Facing a Firm
Although the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, it is likely to be more elastic than the demand curve faced by a monopoly.

13. MONOPOLISTIC COMPETITION
Price/Output Determination in the Short Run
FIGURE Monopolistic Competition in the Short Run
To maximize profit, the monopolistically competitive firm will increase production until the marginal revenue from increasing output and selling it no longer exceeds the marginal cost of producing it. This occurs at the point at which marginal revenue equals marginal cost: MR = MC.

14. MONOPOLISTIC COMPETITION
Price/Output Determination in the Long Run
FIGURE Monopolistically Competitive Firm at Long-Run Equilibrium
The firm’s demand curve must end up tangent to its average total cost curve for profits to equal zero. This is the condition for long-run equilibrium in a monopolistically competitive industry.

15. MONOPOLISTIC COMPETITION
ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION
Because entry is easy and economic profits are eliminated in the long run, we might conclude that the result of monopolistic competition is efficient. There are two problems, however.
First, once a firm achieves any degree of market power by differentiating its product (as is the case in monopolistic competition), its profit-maximizing strategy is to hold down production and charge a price above marginal cost.
Second, the final equilibrium in a monopolistically competitive firm is necessarily to the left of the low point on its average total cost curve.

16. OLIGOPOLY
oligopoly A form of industry (market) structure characterized by a few dominant firms. Products may be homogenous or
differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.

17. OLIGOPOLY INDUSTRY DESIGNATION FOUR LARGEST FIRMS EIGHT LARGEST FIRMS
TABLE Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1997
INDUSTRY DESIGNATION
FOUR LARGEST FIRMS
EIGHT LARGEST FIRMS
NUMBER OF FIRMS
Cellulosic man-made fiber
100 4
Primary copper 95 99 11
Household laundry equipment 90 10
Cigarettes 9
Malt beverages (beer)
494
Electric lamp bulbs 89 94 54
Cereal breakfast foods 83 48
Motor vehicles 92
325
Small arms ammunition
107
Household refrigerators and freezers 82 97 21
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series 2001.

18. OLIGOPOLY OLIGOPOLY MODELS
Because many different types of oligopolies exist, a number of different oligopoly models
have been developed.
All kinds of oligopoly have one thing in common:
The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly.

19. OLIGOPOLY The Collusion Model
The colluding oligopoly will face market demand and produce only up to the point at which marginal revenue and marginal cost are equal (MR = MC), and price will be set above marginal cost.
cartel A group of firms that gets together and makes joint price and output decisions to maximize joint profits.
tacit collusion Collusion occurs when price- and quantity-fixing agreements among producers are explicit. Tacit
collusion occurs when such agreements are implicit.

20. OLIGOPOLY The Cournot Model
Cournot model A model of a two-firm industry (duopoly) in which a series of output adjustment decisions leads to a
final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly.
The Cournot model of oligopoly results in a quantity of output somewhere between
output that would prevail if the market were perfectly competitive and output that
would be set by a monopoly.

21. OLIGOPOLY The Kinked Demand Curve Model
kinked demand curve model A model of oligopoly in which the demand curve facing each individual firm has a “kink”
in it. The kink results from the assumption that competitor firms will follow if a single firm cuts price but will not follow if a single
firm raises price.

22. OLIGOPOLY
FIGURE A Kinked Demand Curve Oligopoly Model

23. OLIGOPOLY The Price-Leadership Model
price leadership A form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.
As in the other oligopoly models, an oligopoly with a dominant price leader will produce a level of output between the output that would prevail under perfect competition and the output that a monopolist would choose in the same industry. It will also set a price between the monopoly price and the perfectly competitive price. Some competition is usually more efficient than none at all.

24. OLIGOPOLY
GAME THEORY
game theory Analyzes oligopolistic behavior as a complex series of strategic
moves and reactive countermoves among rival firms. In game theory, firms are
assumed to anticipate rival reactions.

25. OLIGOPOLY
FIGURE Payoff Matrix for Advertising Game

26. OLIGOPOLY
dominant strategy In game theory, a strategy that is best no matter what the
opposition does.
prisoners’ dilemma A game in which the players are prevented from cooperating and in which each has a dominant strategy that leaves them both
worse off than if they could cooperate.

27. OLIGOPOLY
FIGURE The Prisoners’ Dilemma

28. OLIGOPOLY
FIGURE Payoff Matrixes for Left/Right–Top/Bottom Strategies

29. OLIGOPOLY
Nash equilibrium In game theory, the result of all players’ playing their best strategy given what their competitors are doing.
maximin strategy In game theory, a strategy chosen to maximize the minimum gain that can be earned.

30. OLIGOPOLY REPEATED GAMES
tit-for-tat strategy A company’s strategy that lets a competitor know the company
will follow the competitor’s lead.
FIGURE Payoff Matrix for Airline Game

31. OLIGOPOLY
A GAME WITH MANY PLAYERS: COLLECTIVE ACTION CAN BE BLOCKED BY A PRISONERS’ DILEMMA
Contestable Markets
perfectly contestable market A market in which entry and exit are costless.
In contestable markets, even large oligopolistic firms end up behaving like perfectly
competitive firms. Prices are pushed to long-run average cost by competition, and positive
profits do not persist.

32. OLIGOPOLY
Review
Oligopoly is a market structure that is consistent with a variety of behaviors.
The only necessary condition of oligopoly is that firms are large enough to have some
control over price. Oligopolies are concentrated industries. At one extreme is the cartel,
in which a few firms get together and jointly maximize profits—in essence, acting as a
monopolist. At the other extreme, the firms within the oligopoly vigorously compete
for small, contestable markets by moving capital quickly in response to observed profits.
In between are a number of alternative models, all of which stress the interdependence
of oligopolistic firms.

33. OLIGOPOLY OLIGOPOLY AND ECONOMIC PERFORMANCE
Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons.
First, profit-maximizing oligopolists are likely to price above marginal cost. When
price is above marginal cost, there is underproduction from society’s point of view—in
other words, society could get more for less, but it does not. Second, strategic behavior
can lead to outcomes that are not in society’s best interest. Specifically, strategically
competitive firms can force themselves into deadlocks that waste resources. Finally, to
the extent that oligopolies differentiate their products and advertise, there is the
promise of new and exciting products. At the same time, however, there remains a real
danger of waste and inefficiency.
INDUSTRIAL CONCENTRATION AND TECHNOLOGICAL CHANGE
One of the major sources of economic growth and progress throughout history has been technological advance.

34. THE ROLE OF GOVERNMENT REGULATION OF MERGERS
Celler-Kefauver Act (1950) Extended the government’s authority to ban vertical and conglomerate mergers.
Herfindahl-Hirschman Index (HHI) A mathematical calculation that uses market
share figures to determine whether or not a proposed merger will be challenged by the government.

35. HERFINDAHL- HIRSCHMAN INDEX
THE ROLE OF GOVERNMENT
TABLE Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each with No More Than Four Firms
PERCENTAGE SHARE OF:
HERFINDAHL- HIRSCHMAN INDEX
FIRM 1
FIRM 2
FIRM 3
FIRM 4
Industry A 50 -
= 5,000
Industry B 80 10
= 6,600
Industry C 25
= 2,500
Industry D 40 20
= 2,800
If the Herfindahl-Hirschman Index is less than 1,000, the industry is considered unconcentrated, and any proposed merger will go unchallenged by the Justice Department. If the index is between 1,000 and 1,800, the department will challenge any merger that would increase the index by over 100 points. Herfindahl indexes above 1,800 mean that the industry is considered concentrated already, and the Justice Department will challenge any merger that pushes the index up more than 50 points.

36. THE ROLE OF GOVERNMENT
FIGURE Department of Justice Merger Guidelines (revised 1984)

37. THE ROLE OF GOVERNMENT A PROPER ROLE?
Certainly there is much to guard against in the behavior of large, concentrated industries. Barriers to entry, large size, and product differentiation all lead to market power and to potential inefficiency. Barriers to entry and collusive behavior stop the market from working toward an efficient allocation of resources.

38. REVIEW TERMS AND CONCEPTS
cartel
Celler-Kefauver Act
Cournot model
dominant strategy
game theory
Herfindahl-Hirschman Index (HHI)
kinked demand curve model
maximin strategy
monopolistic competition
Nash equilibrium
oligopoly
perfectly contestable market
price-leadership model
prisoners’ dilemma
product differentiation
tacit collusion
tit-for-tat strategy