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Chapter 11
Monopolistic
Competition and
Oligopoly
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Characteristics of monopolistic
competition
• Normal profit in the long run
• Characteristics of oligopoly
• Game theory
• The oligopolist’s kinked demand
curve
• Collusion among oligopolists
• The effects of advertising
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Monopolistic Competition
• Large number of sellers
– Small market shares
– No collusion, limited control of price
– Independent action
• Differentiated Products
– Product attributes (pizza)
– Service (Men’s Warehouse)
– Location (hotels)
– Brand names and packaging
(Air Jordan)
– Some control over price (preference)
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Monopolistic Competition
• Easy entry and exit
• Need for advertising
–Nonprice Competition
• Which industries?
–Degree of concentration
–Four-firm concentration ratio
• Less that 40%
–Herfindahl index
• Closer to 0 than 10,000
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Table 11.1
Monopolistic Competition
• Firm’s demand curve
–Highly elastic
• Short run profit or loss
–Produce where MR=MC
• Long run normal profit
–Entry and exit
• Inefficient
• Product variety
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Monopolistic Competition
Short-Run Profits
Price and Costs
MC
ATC
P1
A1
Economic
Profit
D1
MR = MC
MR
0
Q1
Quantity
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Monopolistic Competition
Short-Run Losses
Price and Costs
MC
ATC
A2
P2
Loss
D2
MR = MC
MR
0
Q2
Quantity
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Monopolistic Competition
Long-Run Equilibrium
MC
Price and Costs
ATC
P3= A3
D3
MR = MC
MR
0
Q3
Quantity
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Monopolistic Competition
P=MC=Min ATC for pure competition (recall)
Price and Costs
MC
ATC
P3= A3
P4
Price is Lower
D3
MR = MC
Excess Capacity at
Minimum ATC
0
MR
Q3
Q4
Quantity
Monopolistic competition is not efficient
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Oligopoly
• A few large producers
• Homogeneous (steel) or
differentiated products (cars)
• Control over price
–Mutual interdependence
–Strategic behavior
• Entry barriers (EOS, capital,
control of resources)
• Mergers (tv, newspapers, banks)
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Examples
• Tennis Balls: Wilson, Penn, Dunlop and
Spalding.
• Cars: GM, Ford, DaimlerChrysler
• Cereal: Quaker, Ralston Food, Kellogg, Post
and General Mills.
• Aircraft: Boeing (McDonnell Douglas) and
Lockheed Martin
• Grocery stores: (Giant Eagle, Shopn’Save,
Wal-Mart)
Most Famous Oligopoly - OPEC
Oligopoly
• Four-firm concentration ratio
–Needs to be more than 40%
–Half of U.S. manufacturing
• Localized markets
• Interindustry competition
• World trade
–Import Competition
• Herfindahl index
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Game Theory
RareAir’s Price Strategy
High
Uptown’s Price Strategy
• 2 competitors
• 2 price
strategies
• Each strategy
has a payoff
matrix
• Greatest
combined
profit
• Independent
actions
stimulate a
response
A
$12
Low
B
$15
High
$12
C
$6
$6
D
$8
Low
$15
$8
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Game Theory
RareAir’s Price Strategy
High
Uptown’s Price Strategy
• Independently
lowered prices
in expectation
of greater profit
leads to the
worst
combined
outcome
• Eventually low
outcomes make
firms return to
higher prices
A
$12
Low
B
$15
High
$12
C
$6
$6
D
$8
Low
$15
$8
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Game Theory
• Mutual interdependence
–Pricing policy
• Collusion
–Enhances profit
• Incentive to cheat
• Prisoner’s dilemma
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Three Oligopoly Models
•
•
•
•
Kinked-demand curve
Collusive pricing
Price leadership
Why three models?
–Diversity of oligopolies
–Complications of interdependence
• D, MR often unknown
• Stable economy = sticky prices
• Price shifts often occur collusively
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Kinked-Demand Curve
• Noncollusive oligopoly
(differentiated product)
• Strategies
–Match price changes
–Ignore price changes
• Combined strategy
• Price inflexibility
• The kinked-demand curve
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Kinked-Demand Curve
Competitor and rivals strategize versus each other
Consumers effectively have 2 partial demand curves
and each part has its own marginal revenue part
e
P0
f
D2
Rivals Match g
Price Decrease
0
Q0
MR1
Quantity
MR2
Price and Costs
Price
Rivals Ignore
Price Increase
MC1
D2
P0
e
MR2
f
MC2
g
D1
D1
0
Q0
MR1
Quantity
Resulting in a kinked-demand curve
to the consumer – price and output
are optimized at the kink
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Kinked-Demand Curve
• Criticisms of the model
–How does price get to P0
–Explains inflexibility, not price
–Prices are not that rigid
(unstable economy)
–Price wars
(often due to recession)
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Cartels and Other Collusion
• Price and output
– Joint profit maximization
– Easiest with standardized
product
Price and Costs
MC
Effectively Sharing
The Monopoly Profit
P0
ATC
A0
MR=MC
Economic
Profit
D
MR
Q0
Quantity
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The OPEC Cartel
Daily oil production (barrels) , November 2008
Saudi Arabia
Iran
Kuwait
Venezuela
Iraq
Nigeria
UAE
Angola
Libya
Algeria
Qatar
Indonesia
Ecuador
8,904,000
3,843,000
2,538,000
2,368,000
2,297,000
2,183,000
2,117,000
1,804,000
1,737,000
1,417,000
848,000
843,000
530,000
Source: A. T. Kearney, Foreign Policy
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Cartels and Other Collusion
• Covert collusion
–Tacit understandings
• Obstacles to collusion
–Demand and cost differences
–Number of firms
–Cheating
–Recession (increases in ATC)
–Potential entry
–Legal obstacles: antitrust law
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Price Leadership Model
Leadership tactics
• Usually largest/most efficient firm
• Infrequent price changes
• Communications
• Limit pricing to keep barriers to
entry
• Breakdowns in price leadership:
–Price wars
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Advertising
• Prevalent in monopolistic
competition and oligopoly
• Capture market share
• Better than a price cut
• Information for consumers
(HD TVs) – more competition?
• Manipulation
(Air Jordan) – less competition?
• Efficiency – more or less?
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Oligopoly and Advertising
The Largest U.S. Advertisers, 2006
Company
Advertising Spending
Millions of $
Proctor and Gamble
AT&T
General Motors
Time Warner
Verizon
Ford Motor
GlaxoSmithKline
Walt Disney
Johnson & Johnson
Unilever
$4898
3345
3296
3089
2822
2577
2444
2320
2291
2098
Source: Advertising Age
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Oligopoly and Advertising
World’s Top 10 Brand Names, 2007
Coca-Cola
Microsoft
IBM
General Electric
Nokia
Toyota
Intel
McDonald’s
Disney
Mercedes-Benz
Source: Interbrand
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Oligopoly and Efficiency
•
•
•
•
P = MC = min ATC
Not productively efficient
Not allocatively efficient
Tendency to share the monopoly
profit
• Qualifications
– Increased foreign competition (cars)
– Limit pricing to keep barriers to entry
– Technological advance (R&D)
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Oligopoly in the Beer Industry
• From hundreds to a few firms
• Demand side changes
– Taste shifts to lighter beers
– Shift from tap to cans or bottles
• Supply side changes
– Technological change increased
minimum efficient scale
– National brands enjoy cost advantages
• Consolidation into oligopoly
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Key Terms
• monopolistic
competition
• product differentiation
• nonprice competition
• four-firm concentration
ratio
• Herfindahl index
• excess capacity
• oligopoly
• homogeneous
oligopoly
• differentiated oligopoly
• strategic behavior
• mutual interdependence
• interindustry
competition
• import competition
• game theory
• collusion
• kinked-demand curve
• price war
• cartel
• price leadership
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Next Chapter Preview…
Technology, R&D,
And Efficiency
11-32