chapter 21 “oligopoly and monopolistic competition”

1 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e

Chapter 21Chapter 21“Oligopoly and “Oligopoly and

Monopolistic Competition”Monopolistic Competition”

ECONOMICS: ECONOMICS: EXPLORE & APPLYEXPLORE & APPLYby Ayers and Collingeby Ayers and Collinge


Learning ObjectivesLearning Objectives

1.1. Explain the meaning and significance of Explain the meaning and significance of mutual interdependence.mutual interdependence.

2.2. Identify the models associated with Identify the models associated with oligopoly.oligopoly.

3.3. Describe the characteristics of Describe the characteristics of monopolistic competition.monopolistic competition.

4.4. Define product differentiation and state Define product differentiation and state its implications.its implications.


Learning ObjectivesLearning Objectives

5.5. Relate how and why firms charge some Relate how and why firms charge some consumers more than others for the same consumers more than others for the same products.products.

6.6. Explain why oligopoly brings economic Explain why oligopoly brings economic change.change.


21.121.1OLIGOPLYOLIGOPLY• OligopolyOligopoly is characterized by multiple is characterized by multiple

firms, one or more of which will produce a firms, one or more of which will produce a significant portion of industry output.significant portion of industry output.

• Oligopoly firms are Oligopoly firms are mutually mutually interdependent,interdependent, with actions of one firm with actions of one firm inducing other firms to take counteractions.inducing other firms to take counteractions.

• Oligopoly products may be differentiated Oligopoly products may be differentiated or homogeneous. or homogeneous.


Oligopoly Products May Be Oligopoly Products May Be Differentiated or HomogeneousDifferentiated or Homogeneous

• Differentiated Oligopolies: cigarettes and automobiles• Homogeneous Oligopolies: steel,

aluminum, and copper


Measuring Market PowerMeasuring Market Power

o Market power is the ability of a firm to Market power is the ability of a firm to control the price it charges for its output.control the price it charges for its output.o Purely competitive firms have no market power, as Purely competitive firms have no market power, as

they are price takers.they are price takers.o Monopoly firms have the most market power Monopoly firms have the most market power

because they have no competition.because they have no competition.o We must assess the market power of the firms We must assess the market power of the firms

that are neither purely competitive and that are neither purely competitive and monopolistic, and one method to measure monopolistic, and one method to measure market power is the market power is the four firm concentration four firm concentration ratio. ratio.


To compute a four-firm concentration ratio:To compute a four-firm concentration ratio:= = Sales by four largest firms in an industrySales by four largest firms in an industry Sales by all firms in and industrySales by all firms in and industry The larger the concentration ratio, the more The larger the concentration ratio, the more

market power the firms in the industry possess.market power the firms in the industry possess. Concentration ratios do not take into account Concentration ratios do not take into account

sales by foreign firms, nor do they account for sales by foreign firms, nor do they account for differences in size among the four firms.differences in size among the four firms.




INDUSTRY CONCENTRATION RATIO (PERCENT)

Cigarettes 98.9Aircraft 84.8Tires 72.4Soap and detergents 65.6Gloves and mittens 63.8Cookies and crackers 59.9Dog and cat food 58.4Luggage 51.9Soft drinks 47.2Boats 41.4Mattresses 38.6

FOUR-FIRM CONCENTRATION RATIOS FOR SELECTED U.S. MANUFACTURING INDUSTRIES


Mergers and Spin-offsMergers and Spin-offs

A A merger merger occurs when one firm combines with occurs when one firm combines with another firm to form a single firm.another firm to form a single firm.

Horizontal mergerHorizontal merger occurs when an firm merges occurs when an firm merges another in the same line of business.another in the same line of business.

Vertical IntegrationVertical Integration occurs when a firm occurs when a firm acquires another firm that supplies it with an acquires another firm that supplies it with an input.input.

Conglomerate MergerConglomerate Merger occurs when firms in occurs when firms in unrelated businesses merge.unrelated businesses merge.


21.221.2OLIGOPOLY MODELSOLIGOPOLY MODELSOligopoly Oligopoly is the only market structure for is the only market structure for which there are a variety of models.which there are a variety of models. Contestable marketsContestable markets occur when new rivals occur when new rivals can enter or exit the market cheaply.can enter or exit the market cheaply. Price leadershipPrice leadership model is based on model is based on observable oligopoly behavior. When one observable oligopoly behavior. When one firm changes its selling price, the remaining firm changes its selling price, the remaining firms in the industry. firms in the industry.


Oligopoly ModelsOligopoly Models

A Cartel A Cartel is a form of oligopoly in which is a form of oligopoly in which firms in an industry collude.firms in an industry collude.

CollusionCollusion means that firms jointly plan price means that firms jointly plan price and output.and output.Cartels are illegal in the United States.Cartels are illegal in the United States.

A A dominant firm with a competitive fringedominant firm with a competitive fringe is is an oligopoly model that combines the an oligopoly model that combines the competitive and monopoly modelscompetitive and monopoly models


Reasons for Difficulty in Reasons for Difficulty in Keeping Cartels TogetherKeeping Cartels Together

Illegal in the U.S.Illegal in the U.S. Any member has the incentive to cheatAny member has the incentive to cheat Cartel members may drop outCartel members may drop out High cartel profits may induce High cartel profits may induce competitioncompetition Higher prices can lead to the Higher prices can lead to the development of substitute goodsdevelopment of substitute goods


The Nominal and Real Price of OilThe Nominal and Real Price of Oil

35

30

25

20

15

10

5

0’70 ’75 ’80 ’85 ’90 ’95 ‘00

50

40

30

20

10

0

Price ($ per barrel)

Oil production (percentage of world market)

OPEC oil production

Nominal price

Real price


Oligopoly ModelsOligopoly Models

Price • •

Total quantity

Market quantity

Dominant firm’s

quantity

Marginal revenue

Firm’squantity

Dominant firm’s demand

Marginal costCompetitive

supply

Dominant firm’s

quantity

Competitive fringe

quantity

The dominant firm with a competitive fringe chooses its output and price in three steps:

#1 The firm's computes its residual demand, the shortage that would occur in the competitive market at each price below the competitive equilibrium.

#2 The dominant firm chooses its quantity by equating marginal revenue to marginal cost, which determines the price.

#3 The price from step #2 becomes the market price. Firms in the competitive fringe are price takers at that price. The total quantity of output equals the quantity supplied by the competitive fringe plus the quantity supplied by the dominant firm. Actual market equilibrium occurs at this point, as other firms take this price competitive equilibrium.


Game TheoryGame Theory

•Game theoryGame theory employs mathematics to employs mathematics to analyze the behavior of parties whose analyze the behavior of parties whose interests conflict. This method may be interests conflict. This method may be employed to deepen the understanding employed to deepen the understanding of oligopoly behavior.of oligopoly behavior.•The tool of analysis is the The tool of analysis is the payoff matrix.payoff matrix.•An example of game theory is the An example of game theory is the prisoners dilemma.prisoners dilemma.



Happy:Confess orkeep quiet?

Al:Confess orkeep quiet?

Al:Confess orkeep quiet?

Happy Al 5 5

Happy Al 1 20

Happy Al 20 1

Happy Al 3 3

confess

confess

confessKeep quiet

Keep quiet

Keep quiet

√ √

√

Decision 1 Decision 2 OutcomePrison sentence (years)

Prisoner’s Dilemma: Happy is better off confessing no matter what Al does. The outcome of these decisions is a prison sentence of 5 years apiece, as shown in the yellow boxes. Note that Al and Happy's collective interest is better served by collusion, in which they both keep quiet and are sentenced to 3 years each.



Y-co:High or low price?

X-co:High or low price?

X-co:High or low price?

X–co Y–co$10 m $10 m

X–co Y–co$15 m ($5 m)

X–co Y–co($5 m) $15 m

X–co Y–co$1 m $1 m

High price

High price

High price

Low price

Low price

Low price√

√

√

Decision 1 Decision 2 OutcomeProfit (loss)

Prisoner’s Dilemma in a Two-Firm Oligopoly: These firms face the dilemma of whether to price high or low. Their collective interest calls for a high price. In the absence of collusion, however, their dominant strategies cause the price to be low.


The Model of Kinked DemandThe Model of Kinked Demand• Prices in oligopoly sometimes seems Prices in oligopoly sometimes seems “sticky”,“sticky”,

meaning resistant to change.meaning resistant to change.• The The kinked demand curve modelkinked demand curve model offers an offers an

explanation.explanation.• In this model, any firm that raises its price, In this model, any firm that raises its price,

loses a significant fraction of its customers to loses a significant fraction of its customers to other firms that are assumed to keep their other firms that are assumed to keep their prices constant.prices constant.

• However if a firm lowers its price, it does not However if a firm lowers its price, it does not gain customers from other firms, because the gain customers from other firms, because the other firms in the industry would feel the other firms in the industry would feel the competitive need to lower their prices too.competitive need to lower their prices too.


The Kinked Demand CurveThe Kinked Demand CurveD

o ll a

r s

Quantity

Marginal Cost

KinkPrice

Profit maximizingquantity

Marginal revenue

•

Firm’s Demand

Marginal cost can shift,yet still intersectmarginal revenue at the same quantity.

The kinked demand curve model assumes that firms match price decreases by their competitors, but do not match price increases.

As a consequence, marginal revenue is discontinuous (vertical) at the quantity associated with the kink.


21.321.3MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITIONMonopolistic competitionMonopolistic competition is a market characterized is a market characterized

by many firms, by many firms, product differentiationproduct differentiation, and , and relatively easy entry of new firms.relatively easy entry of new firms.

Monopolistically competitive firms face a Monopolistically competitive firms face a downward sloping demand curve that is less elastic downward sloping demand curve that is less elastic than that of a purely competitive firm, but more than that of a purely competitive firm, but more elastic than that of a monopolist. elastic than that of a monopolist.

Specifically, each firm faces a demand curve that is Specifically, each firm faces a demand curve that is highly elastic, which gives it a relatively flat highly elastic, which gives it a relatively flat appearance.appearance.


The firm’ demand curve is influenced by its The firm’ demand curve is influenced by its own actions , and the actions of its competitors.own actions , and the actions of its competitors.

Monopolistically competitive firm’s have the Monopolistically competitive firm’s have the incentive to advertise and vary their products incentive to advertise and vary their products as a way of increasing their demand at the as a way of increasing their demand at the expense of their competitors.expense of their competitors.

In the short-run monopolistically competitive In the short-run monopolistically competitive firms will continue to enter or exit a market firms will continue to enter or exit a market until a long-run equilibrium is reached in until a long-run equilibrium is reached in which additional entrants would expect which additional entrants would expect additional profits.additional profits.

Monopolistic CompetitionMonopolistic Competition


Output and Price in Output and Price in Monopolistic CompetitionMonopolistic Competition

Do l

l ar s

Quantity

Marginal Cost

Price

Marginal revenue

Firm’s Demand

Profit-maximizing

quantity

•

•

Marginal cost = marginal revenue

Under monopolistic competition, demand is much more elastic. As a result, the profit-maximizing output occurs close to the efficient output, given by the intersection of marginal cost and the firm’s demand.


Profit, Loss, and Breakeven in Profit, Loss, and Breakeven in Monopolistic CompetitionMonopolistic Competition

Do l

l ar s

Quantity

Marginal Cost

Price

Marginal revenue

Firm’s Demand

Profit-maximizing

quantity

ProfitProfit

•

•

Average cost

•

Profitable firm



Do l

l ar s

Quantity

Marginal Cost

Price

Marginal revenue

Firm’s Demand

Profit-maximizing

quantity

LossLoss

•

Average cost

Firm with a loss••



Do l

l ar s

Quantity

Marginal Cost

Price

Marginal revenue

Firm’s Demand

Profit-maximizing

quantity

•

Average cost

Firm that breaks even•


21.4 21.4 WAYS TO COMPLETEWAYS TO COMPLETEThe key to riches The key to riches

in monopolistic in monopolistic competition is competition is successful product successful product differentiation in differentiation in such things as…such things as…

Size Size TasteTaste ShapeShape

StyleStyle ColorColor TextureTexture QualityQuality LocationLocation Packaging Packaging AdvertisingAdvertising ServiceService


If the marginal revenue generated by If the marginal revenue generated by advertising exceeds the marginal cost of advertising exceeds the marginal cost of advertising, advertising raises profits.advertising, advertising raises profits.Otherwise it does not.Otherwise it does not.

The profit-maximizing firm will adjust The profit-maximizing firm will adjust its hours of operation, selection of its hours of operation, selection of merchandise, and every other aspect of merchandise, and every other aspect of product differentiation with this same product differentiation with this same principle in mind. principle in mind.

Advertising and Product Advertising and Product DifferentiationDifferentiation


Advertising to Shift DemandAdvertising to Shift Demand

$

Quantity

Firm’s demand

Marginal Revenue

Advertising aims tostrengthen preferencesfor the firm’s products.


Price Discrimination Under Monopolistic Price Discrimination Under Monopolistic Competition and OligopolyCompetition and Oligopoly

Price discriminationPrice discrimination is selling a good or service at is selling a good or service at different prices when such differences are not cause different prices when such differences are not cause by differences in production cost.by differences in production cost.Price discrimination is feasible when different Price discrimination is feasible when different prices can be charged to different market segments.prices can be charged to different market segments.A firm cannot practice price discrimination if A firm cannot practice price discrimination if buyers who buy at a low price, can resell those buyers who buy at a low price, can resell those goods to other buyers at a higher price, which is a goods to other buyers at a higher price, which is a practice called practice called arbitragearbitrage..


21.5 EXPLORE & APPLY21.5 EXPLORE & APPLYOligopoly –Changing Way of LifeOligopoly –Changing Way of Life

FOUR-FIRM CONCENTRATION RATIOS FOR RETAILINGKIND OF BUSINESS KIND OF BUSINESS CONCENTRATION CONCENTRATION COMMENTCOMMENT

RATIO RATIO Discount department Discount department 87.9 87.9 Highly Highly concentrated, concentrated, storesstores indicating probable indicating probable

oligopolyoligopolyRadio, television, and Radio, television, and 62.362.3 Relatively Relatively highhighother electronics storesother electronics stores concentration concentration ratio, ratio, indicating indicating possiblepossible

oligopolyoligopoly Pharmacies and drug Pharmacies and drug 46.6 46.6 Moderate Moderate concentrationconcentrationstoresstores ratioratioClothing stores Clothing stores 25.5 25.5 Fairly Fairly competitivecompetitiveNursery and garden centers Nursery and garden centers 12.4 12.4 CompetitiveCompetitiveAll retail firms All retail firms 7.9 7.9 Low Low concentration ratio concentration ratio

indicates retailing is highly indicates retailing is highly competitivecompetitive


TOP TEN U.S. RETAILERSTOP TEN U.S. RETAILERSFIRM SALES (IN BILLIONS OF DOLLARS)FIRM SALES (IN BILLIONS OF DOLLARS)

1. Wal-Mart 1. Wal-Mart 219.8219.82. Home Depot 2. Home Depot 53.5553.553. Kroger 3. Kroger 50.150.14. Sears, Roebuck, and Co. 4. Sears, Roebuck, and Co. 41.141.15. Target Corp. 5. Target Corp. 39.439.46. Albertson’s Inc. 6. Albertson’s Inc. 37.937.97. K-Mart 7. K-Mart 37.037.08. Costco Wholesale Corp.8. Costco Wholesale Corp. 34.834.89. Safeway 9. Safeway 34.334.310. J. C. Penney 10. J. C. Penney 32.032.0

Oligopoly –Changing Way of Life


Terms along the WayTerms along the Way

• oligopolyoligopoly• mutually interdependentmutually interdependent• differentiated productdifferentiated product• monopolistic competitionmonopolistic competition• four-firm concentration four-firm concentration

ratioratio• mergermerger• horizontal mergerhorizontal merger

• vertical mergervertical merger• conglomerate mergerconglomerate merger• contestable marketcontestable market• price leadershipprice leadership• cartelcartel• dominant firm with a dominant firm with a

contestable marketcontestable market• game theorygame theory• kinked demand curvekinked demand curve• monopolistic competitionmonopolistic competition


Test YourselfTest Yourself

1.1. Which is the best example of a vertical Which is the best example of a vertical merger?merger?

a.a. A computer manufacturer merges with a A computer manufacturer merges with a computer store.computer store.

b.b. Two book publishers merge.Two book publishers merge.c.c. A jewelry store merges with a furniture store.A jewelry store merges with a furniture store.d.d. A Cosmetics manufacturer merges with a A Cosmetics manufacturer merges with a

pizza restaurant.pizza restaurant.



2.2. Price leadership describes a model ofPrice leadership describes a model ofa.a. cartelcartelb.b. monopolymonopolyc.c. oligopolyoligopolyd.d. monopolistic competitionmonopolistic competition



3.3. Cartels are difficult to maintain over time for Cartels are difficult to maintain over time for each of the following reasons, each of the following reasons, EXEPTEXEPT that that

a.a. Individual members cheat by charging less Individual members cheat by charging less than the cartel price.than the cartel price.

b.b. consumers substitute other goods for the consumers substitute other goods for the product of the cartel.product of the cartel.

c.c. new competitors that are not cartel members new competitors that are not cartel members may enter the market.may enter the market.

d.d. legal barriers prohibit any member of the legal barriers prohibit any member of the cartel from dropping out.cartel from dropping out.



4.4. In the game theory model of oligopoly, pricesIn the game theory model of oligopoly, pricesa.a. are are set with little concern for whether are are set with little concern for whether

profits are maximized.profits are maximized.b.b. are set strategically, as though firms are all are set strategically, as though firms are all

playing in the same game.playing in the same game.c.c. fall when cost rise, and when cost fall.fall when cost rise, and when cost fall.d.d. remain stable in response to moderate remain stable in response to moderate

changes in cost.changes in cost.



5.5. In which market structure do firms In which market structure do firms ALWAYSALWAYS produce differentiated produce differentiated products?products?

a.a. Pure competition.Pure competition.b.b. Monopoly.Monopoly.c.c. Monopolistic competition.Monopolistic competition.d.d. Game theory.Game theory.



6.6. Fast food restaurants are examples of Fast food restaurants are examples of a.a. pure competitionpure competitionb.b. monopolistic competitionmonopolistic competitionc.c. oligopolyoligopolyd.d. monopolymonopoly



7.7. Monopolistically competitive firmsMonopolistically competitive firmsa.a. are mutually interdependent.are mutually interdependent.b.b. are also called price takers.are also called price takers.c.c. maximize profits by setting marginal maximize profits by setting marginal

revenue equal to marginal cost.revenue equal to marginal cost.d.d. are few in number.are few in number.


The End!The End!Next Chapter 22Next Chapter 22

““Market for Labor Market for Labor and Other Inputs”and Other Inputs”

chapter 21 “oligopoly and monopolistic competition”

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