1. 13.1 Ch. 13 Monopolistic Competition and Oligopoly A monopolistically competition is a form of industry (market) structure has the following characteristics: A large number of firms No barriers to entry Product differentiation An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated. There tend to be barriers to entry  The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others. Perfect Competition MonopolyMonopolist Competition Oligopoly

2. 13.2 Monopolistic Competition Monopolistic competition is 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 because they produce differentiated products. New firms can enter and established firms can exit such an industry with ease. What is product differentiation?

3. 13.3 Nine Industries with Characteristics of Monopolistic Competition Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 SIC NO. INDUSTRY DESIGNATION FOUR LARGEST FIRMS EIGHT LARGEST FIRMS TWENTY LARGEST FIRMS NUMBER OF FIRMS 3792 Travel trailers and campers 415772270 3942 Dolls 344767204 2521 Wood office furniture 263451611 2731 Book publishing 2338622504 2391 Curtains and draperies 2232481004 2092 Fresh or frozen seafood 192847600 3564 Blowers and fans 142241518 2335 Women’s dresses 1117303943 3089 Miscellaneous plastic products 58137605 Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.

4. 13.4 Product Differentiation, Advertising, and Social Welfare Total Advertising Expenditures in 2001 DOLLARS (BILLIONS) Newspapers89.5 Television54.4 Direct mail44.7 Internet5.8 Yellow pages13.6 Radio17.9 Magazines11.1 Total231.3.

5. 13.5 More Advertising Data Magazine Advertising Revenues by Category, 2001 DOLLARS (MILLIONS) Automotive$1,688 Technology Telecommunications Computers and software 223 817 Home furnishings and supplies1,196 Toiletries and cosmetics1,401 Apparel and accessories1,316 Financial, insurance and real estate962 Food and food products1,207 Drugs and remedies1,217 Retail stores692 Beer wine and liquor307 Sporting goods279

6. 13.6 The Case for Product Differentiation and Advertising The advocates of free and open competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. Product differentiation helps to ensure high quality and efficient production. Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the market place.

7. 13.7 The Case Against Product Differentiation and Advertising Critics of product differentiation and advertising argue that they amount to nothing more than 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. 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.

8. 13.8 Product Differentiation Reduces the Elasticity of Demand Facing a Firm Based on the availability of substitutes, the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, and likely to be more elastic than the demand curve faced by a monopoly.

9. 13.9 Monopolistic Competition in the Short Run A profit-maximizing monopolistically competitive firm will produce up to the point where MR = MC. This firm is earning positive profits in the short-run.

10. 13.10 Monopolistic Competition in the Short-Run Profits are not guaranteed. Here, a firm with a similar cost structure is shown facing a weaker demand and suffering short-run losses.

11. 13.11 Monopolistic Competition in the Long-Run 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. Positive economic profits in the short-run will attract entry in the long-run, shifting D inwards until…..profits are zero

12. 13.12 Economic Efficiency and Resource Allocation In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product. Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity.

13. 13.13 Oligopoly An oligopoly is a form of industry (market) structure characterized by a few dominant firms, causing a high degree of concentration. Products may be homogeneous or differentiated. The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others.

14. 13.14 Ten Highly Concentrated Industries 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 fiber100 4 Primary copper959911 Household laundry equipment909910 Cigarettes991009 Malt beverages (beer)9095494 Electric lamp bulbs899454 Cereal breakfast foods839448 Motor vehicles8392325 Small arms ammunition8994107 Household refrigerators and freezers829721

15. 13.15 The Collusion Model A group of firms that gets together and makes price and output decisions jointly is called a cartel. Collusion occurs when price- and quantity-fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when agreements are implicit.

16. 13.16 The Price-Leadership Model Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy. Assumptions of the price-leadership model: 1. The industry is made up of one large firm and a number of smaller, competitive firms; 2. The dominant firm maximizes profit subject to the constraint of market demand and subject to the behavior of the smaller firms; 3. The dominant firm allows the smaller firms to sell all they want at the price the leader has set. Outcome of the price-leadership model: 1. The quantity demanded in the industry is split between the dominant firm and the group of smaller firms. 2. This division of output is determined by dominant firm’s power 3. The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

17. 13.17 Predatory Pricing The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing. Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.

18. 13.18 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.

19. 13.19 Payoff Matrix for Advertising Game B’s STRATEGY A’s STRATEGY Do not advertiseAdvertise Do not advertise A’s profit = $50,000 B’s profit = $50,000 A’s loss = $25,000 B’s profit = $75,000 Advertise A’s profit = $75,000 B’s loss = $25,000 A’s profit = $10,000 B’s profit = $10,000 The strategy that firm A will actually choose depends on the information available concerning B’s likely strategy.

20. 13.20 Payoff Matrix for Advertising Game B’s STRATEGY A’s STRATEGY Do not advertiseAdvertise Do not advertise A’s profit = $50,000 B’s profit = $50,000 A’s loss = $25,000 B’s profit = $75,000 Advertise A’s profit = $75,000 B’s loss = $25,000 A’s profit = $10,000 B’s profit = $10,000 Regardless of what B does, it pays A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.

21. 13.21 The Prisoners’ Dilemma ROCKY GINGER Do not confessConfess Do not confess Ginger: 1 year Rocky: 1 year Ginger: 7 years Rocky: free Confess Ginger: free Rocky: 7 years Ginger: 5 years Rocky: 5 years Both Ginger and Rocky have dominant strategies: to confess. Both will confess, even though they would be better off if they both kept their mouths shut.

22. 13.22 Contestable Markets A market is perfectly contestable if entry to it and exit from it are costless (easy). 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.

23. 13.23 Oligopoly 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 essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms.

24. 13.24 Oligopoly and Economic Performance Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons: They are likely to price above marginal cost. This means that there would be underproduction from society’s point of view. Strategic behavior can force firms into deadlocks that waste resources. Product differentiation and advertising may pose a real danger of waste and inefficiency.

25. 13.25 Regulation of Mergers 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 1FIRM 2FIRM 3FIRM 4 Industry A50  50 2 + 50 2 = 5,000 Industry B8010  80 2 + 10 2 + 10 2 = 6,600 Industry C25 25 2 + 25 2 + 25 2 + 25 2 = 2,500 Industry D4020 40 2 + 20 2 + 20 2 + 20 2 = 2,800 The Celler-Kefauver Act of 1950 extended the government’s authority to ban vertical and conglomerate mergers. The Herfindahl-Hirschman Index (HHI) is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.

26. 13.26 Department of Justice Merger Guidelines ANTITRUST DIVISION ACTION HHI 1,800 1,000 0 Concentrated Challenge if Index is raised by more than 50 points by the merger Moderate Concentration Challenge if Index is raised by more than 100 points by the merger Unconcentrated No challenge