Osp6 Survey08

Prepared By Brock Williams
Chapter 8

Market Entry,
Monopolistic
Competition, and
Oligopoly

During the recession that started in
2008, some industries actually
experienced increases in demand
that caused market entry new
firms entered the markets.
Copyright 2014 Pearson Education, Inc. All rights reserved. 8-2
1. Describe and explain the effects of market entry.
2. List the conditions for equilibrium in monopolistic
competition.
3. Contrast monopolistic competition and perfect competition.
4. Explain the role of advertising in monopolistic competition.
5. Explain why a price-fixing cartel is difficult to maintain.
6. Explain the effects of a low-price guarantee on the price.
7. Explain the behavior of an insecure monopolist.
8. Define a natural monopoly and explain the average-cost
pricing policy.
9. List three features of antitrust policy.
Learning Objectives
Market Entry, Monopolistic
Competition, and Oligopoly
monopolistic competition
A market served by many firms that
sell slightly different products.
The term, monopolistic competition, actually conveys the two key
features of the market:

Each firm in the market produces a good that is slightly different from
the goods of other firms, so each firm has a narrowly defined
monopoly.

The products sold by different firms in the market are close
substitutes for one another, so there is intense competition between
firms for consumers.
8.1 THE EFFECTS OF MARKET ENTRY
M A R G I N A L P R I N C I P L E
Increase the level of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal benefit equals the
marginal cost.
FIGURE 8.1 Market Entry
Decreases Price and Squeezes
Profit
(A) A monopolist maximizes profit
at point a, where marginal
revenue equals marginal cost.
300 toothbrushes at a price of
$2.00 (point b) and an average
cost of $0.90 (point c). Profit of
$330 is shown by the shaded
rectangle.
(B) Entry of a second firm shifts
the firm-specific demand curve for
the original firm to the left. The
firm produces only 200
toothbrushes (point d) at a lower
price ($1.80, shown by point e)
and a higher average cost ($1.00,
shown by point f). Profit, shown by
the shaded rectangle, shrinks to
$160.
(cont.)
Entry Squeezes Profits from Three Sides
Entry shrinks the firms profit rectangle because it is squeezed from three
directions.

The top of the rectangle drops because the price decreases.

The bottom of the rectangle rises because the average cost increases.

The right side of the rectangle moves to the left because the quantity
decreases.
Examples of Entry: Stereo Stores, Trucking, and Tires
Empirical studies of other markets provide ample evidence that entry
decreases market prices and firms profits. In other words, consumers
pay less for goods and services, and firms earn lower profits.
(cont.)
Consider the market for television signals provided to residential
consumers. How will an existing cable-TV provider respond to the entry
of a firm that provides TV signals via satellite?

In most cases, the entry of a satellite firm causes the cable firm to
improve the quality of service and decrease its price, so consumer
surplus increases.

In some cases, the cable company improves the quality of service and
increases price. Because the service improvement is typically large
relative to the price hike, consumer surplus increases in this case too.

On average, the entry of a satellite firm increases the monthly consumer
surplus per consumer from $3.96 to $5.22, an increase of 32 percent.
SATELLITE VS. CABLE
APPLYING THE CONCEPTS #1: How does market
entry affect prices?
A P P L I C A T I O N 1
8.2 MONOPOLISTIC COMPETITION
Under a market structure called monopolistic competition, firms will
continue to enter the market until economic profit is zero. Here are the
features of monopolistic competition:

Many firms.

A differentiated product.

No artificial barriers to entry.
product differentiation
The process used by firms to
distinguish their products from the
products of competing firms.
When Entry Stops: Long-Run Equilibrium
FIGURE 8.2
Long-Run Equilibrium with
Monopolistic Competition

Under monopolistic competition, firms
continue to enter the market until
economic profit is zero.

Entry shifts the firm specific demand
curve to the left.

The typical firm maximizes profit at point
a, where marginal revenue equals
marginal cost.

At a quantity of 80 toothbrushes, price
equals average cost (shown by point b),
so economic profit is zero.
(cont.)
Differentiation by Location
FIGURE 8.3
Long-Run Equilibrium with
Spatial Competition

Book stores and other retailers
differentiate their products by
selling at different locations.

The typical book store chooses
the quantity of books at which
its marginal revenue equals its
marginal cost (point a).

Economic profit is zero
because the price equals
average cost (point b).
(cont.)
OPENING A DUNKIN DONUTS SHOP
APPLYING THE CONCEPTS #2: Are
monopolistically competitive firms profitable?
One way to get into a monopolistically competitive market is to get a franchise for a nationally advertised
product.

How much money are you likely to make in your donut shop? You will compete for donut consumers with other donut
shops, bakeries, grocery stores, and coffee shops. Given the small barriers to entering the donut business, you should
expect keen competition. You should expect to make zero economic
profit, with total revenue equal to total cost. Your total cost includes the franchise fee and royalties, as well as the
opportunity cost of your time and the opportunity cost of any funds you invest in the business.
Table 8.1 shows the franchise fees and royalty rates for several franchising opportunities. The fees
indicate how much entrepreneurs are willing to pay for the right to sell a brand-name product.
TABLE 8.1
Franchising
Fees and
Royalties
8.3 TRADE-OFFS WITH ENTRY AND
MONOPOLISTIC COMPETITION
Average Cost and Variety
There are some trade-offs associated with monopolistic competition.

Although the average cost of production is higher than the minimum,
there is also more product variety.
When firms sell the same product at different locations, the larger the
number of firms, the higher the average cost of production.

But when firms are numerous, consumers travel shorter distances to get
the product.

Therefore, higher production costs are at least partly offset by lower
travel costs.
Monopolistic Competition versus Perfect Competition
FIGURE 8.4

MONOPOLISTIC COMPETITION (cont.)
(A) In a perfectly competitive
market, the firm-specific demand
curve is horizontal at the market
price, and marginal revenue equals
price.

In equilibrium, price = marginal
cost = average cost.

Equilibrium occurs at the minimum
of the average-cost curve.

FIGURE 8.4 (contd.)
Monopolistic Competition versus
Perfect Competition

(B) In a monopolistically competitive
market, the firm- specific demand
curve is negatively sloped and
marginal revenue is less than price.

In equilibrium, marginal revenue equals
marginal cost (point b) and price
equals average cost (point c).
MONOPOLISTIC COMPETITION (cont.)
Perfect Competition
HAPPY HOUR PRICING
APPLYING THE CONCEPTS #3: How does monopolistic competition
compare with perfect competition?
Consider the phenomenon of happy hour. Many bars and restaurants near workplaces
face an increase in demand for food and drink around 5:00 p.m., and many cut
their prices for an hour or two. According to the model of perfect competition, an
increase in demand will lead to higher, not lower prices. What explains the happy hour
combination of higher demand and lower prices?

Bars are subject to monopolistic competition. Each bar has a local monopoly within
its neighborhood, but faces competition from other bars outside its neighborhood.

For an individual consumer, the higher the demand for food and drink, the greater the incentive
to consider alternatives to the nearest bar. If you expect to purchase large quantities
of bar food and drink, the savings achieved by finding a lower price at an alternative bar
will be relatively large. In other words, when individual demand increases, each bar faces
a more elastic demand for its products. In a market subject to monopolistic competition, the bars
rational response to more elastic demand (more sensitive consumers) is to decrease its price. In
graphical terms, the demand curve facing each bar becomes flatter, and the demand curve will be
tangent to the average-cost curve at a larger quantity and a lower price and average cost.
8.4 ADVERTISING FOR PRODUCT
DIFFERENTIATION
Celebrity Endorsements and Signaling
An advertisement that doesnt provide any product information may actually
help consumers make decisions.
TABLE 8.2
Advertising Profitability and Signaling
PICTURE OF MAN VERSUS PICTURE OF WOMAN
APPLYING THE CONCEPTS #4: How does advertising
affect consumer choices?
A South African consumer lender decided to use a mass mailing of 53,000 loan offers to
test the sensitivity of consumers to variations in interest rates and other features of loan
offers. The interest rates in the offer letters ranged from 3.75% to 11.75% per month.

As expected, the uptake rate (the number of consumers who accepted a particular
Loan offer) was higher for offer letters with low interest rates. The elasticity of the uptake
rate with respect to the interest rate was 0.34: a 10% decrease in the interest rate
(from say an interest rate of 7.0% to 6.3%) increased the uptake rate by 3.4%.

More surprising was the finding that the uptake rate among men was much higher
when the offer letter included a picture of a woman rather than a picture of a man.
Replacing a male model with a female model was equivalent to cutting the interest
rate by 25 percent, for example, from 7.0 percent to 5.25 percent. In contrast, the
uptake rate for women consumers was unaffected by the gender of the model.
8.5 OLIGOPOLY AND PRICING?
Oligopoly
A market served by a few firms

concentration ratio
The percentage of the market output
produced by the (4-8) largest firms.
An alternative measure of market concentration is the Herfindahl-Hirschman
Index (HHI). It is calculated by squaring the market share of each firm in the
market and then summing the resulting numbers.
An oligopoly occurs for three reasons:

1 Government barriers to entry.
2 Economies of scale in production.
3 Advertising campaigns.
(cont.)
TABLE 8.3
Concentration Ratios
in Selected
Manufacturing
Industries
duopoly
A market with two firms.

cartel
A group of firms that act in unison,
coordinating their price and quantity
decisions.

Cartel Pricing and the Duopolists Dilemma
(cont.)
price-fixing
An arrangement in which firms conspire to fix prices.
FIGURE 8.5
A Cartel Picks the Monopoly Quantity
and Price

The monopoly outcome is shown by point a,
where marginal revenue equals marginal
cost.

The monopoly quantity is 60 passengers
and the price is $400.

If the firms form a cartel, the price is $400
and each firm has 30 passengers (half the
monopoly quantity).

The profit per passenger is $300 (equal to
the $400 price minus the $100 average
cost), so the profit per firm is $9,000.
profit = (price average cost) quantity per
firm
(cont.)
FIGURE 8.6
Competing Duopolists Pick a
Lower Price

(A) The typical firm maximizes
profit at point a, where marginal
revenue equals marginal cost.
The firm has 40 passengers.

(B) At the market level, the
duopoly outcome is shown by
point d, with a price of $300 and
80 passengers.

The cartel outcome, shown by
point c, has a higher price and a
smaller total quantity.
(cont.)
FIGURE 8.7
Game Tree for the Price-Fixing
Game

The equilibrium path of the game is
square A to square C to rectangle 4:
Each firm picks the low price and
earns a profit of $8,000.

The duopolists dilemma is that each
firm would make more profit if both
picked the high price, but both firms
pick the low price.
game tree
A graphical representation of the consequences
of different actions in a strategic setting.
Price-Fixing and the Game Tree
(cont.)
Dominant Strategy -
(cont.)
TABLE 8.4
Duopolists Profits When They Choose Different Prices
Equilibrium of the Price-Fixing Game
dominant strategy
An action that is the best choice for a
player, no matter what the other
player does.
duopolists dilemma
A situation in which both firms in a
market would be better off if both
chose the high price, but each
chooses the low price.
(cont.)
Nash Equilibrium
Nash equilibrium
An outcome of a game in which each
player is doing the best he or she can,
given the action of the other players.
(cont.)
At the beginning of the nineteenth century, high overland transportation costs protected
salt producers from competition with one another, generating local salt monopolies.

Over the course of the nineteenth century, decreases in overland transportation
Costs increased competition between salt producers and decreased prices. In response to the
increased competition, salt producers colluded by forming salt pools, enterprises that
set a uniform price and distributed the salt of all participating producers. Some pools
established output quotas or paid firms not to produce salt for a year, a practice known
as dead-renting a salt furnace.

Every salt pool eventually broke down, usually within a year or two of its formation. In some
cases, individual firms cheated on the cartel by selling salt outside the cartel. In other cases the
artificially high price caused new firms to enter the market and underprice the salt pool.
FAILURE OF THE SALT CARTEL
APPLYING THE CONCEPTS #5: Why do cartels
sometimes fail to keep prices high?
Low-Price Guarantees
low-price guarantee
A promise to match a lower price of a competitor.
8.6 OVERCOMING THE
DUOPOLISTS DILEMMA
Low-Price Guarantees
FIGURE 8.8
Low-Price Guarantees Increase Prices

When both firms have a low-price guarantee, it is impossible for one firm to underprice the other. The only
possible outcomes are a pair of high prices (rectangle 1) or a pair of low prices (rectangles 2 or 4).

The equilibrium path of the game is square A to square B to rectangle 1. Each firm picks the high price
and earns a profit of $9,000.
8.6 OVERCOMING THE
DUOPOLISTS DILEMMA (cont.)
Repeated Pricing Games with Retaliation for Underpricing
grim-trigger strategy
A strategy where a firm responds to underpricing by choosing a
price so low that each firm makes zero economic profit.
tit-for-tat
A strategy where one firm chooses whatever price the
other firm chose in the preceding period.
Repetition makes price-fixing more likely because firms can punish a firm that
cheats on a price-fixing agreement, whether its formal or informal:

1 A duopoly pricing strategy.
Choosing the lower price for life.

2 A grim-trigger strategy.
3 A tit-for-tat strategy.
8.6 OVERCOMING THE
Repeated Pricing Games with Retaliation for Underpricing
FIGURE 8.9
A Tit-for-Tat Pricing Strategy (contd)

Under tit-for-tat retaliation, the first firm (Jill, the square) chooses whatever price the second firm
(Jack, the circle) chose the preceding month
8.6 OVERCOMING THE
Price-Fixing and the Law
Under the Sherman Antitrust Act of 1890 and subsequent
legislation, explicit price-fixing is illegal.

It is illegal for firms to discuss pricing strategies or
methods of punishing a firm that underprices other firms.
Price Leadership
A system under which one firm in an
oligopoly takes the lead in setting prices.
8.6 OVERCOMING THE
In two successive months (November and December), a Florida tire retailer listed
prices for 35 types of tires in newspaper advertisements. In November the average
price was $45, and in December the average price was $55.

The December advertisement was different in another way: it included a low-price guarantee
under which the retailer agreed to match any lower advertised price (and also pay the customer
some percentage of the price gap).

In fact, for each of the 35 types of tires, the December price was the same or higher than the
November price. In this case, a low-price Guarantee generated higher prices. Is the relationship
between low-price guarantees and prices apparent or real? A careful study of the retail tire
market suggests that prices are generally higher in markets where firms offer low-price
guarantees.

On average, the presence of a low price guarantee increases prices by $4 per tire, or about 10
percent of the price.
LOW PRICE GUARANTEE INCREASES TIRE PRICES
APPLYING THE CONCEPTS #6: Do low price
guarantees generate higher or lower prices?
FIGURE 8.10
Deterring Entry with Limit Pricing

Point c shows a secure monopoly, point d
shows a duopoly, and point z shows the
zero-profit outcome.

The minimum entry quantity is 20
passengers, so the entry- deterring
quantity is 100 (equal to 120 20), as
shown by point e. The limit price is $200.

The Passive Approach
8.7 THE INSECURE MONOPOLIST
AND ENTRY DETERRENCE
As long as the price is lower
than the potential entrance
average total cost of the
competing company it will be
successful.
Entry Deterrence and Limit Pricing
The quantity required to prevent the entry of the second firm is computed
as follows:

deterring quantity = zero profit quantity minimum entry quantity
AND ENTRY DETERRENCE (cont.)
FIGURE 8.11
Game Tree for the Entry-
Deterrence Game

The path of the game is square A to
square C to rectangle 4. Mona
commits to the entry-deterring
quantity of 100, so Doug stays out
of the market.

Monas profit of $10,000 is less than
the monopoly profit but more than
the duopoly profit of $8,000.
limit pricing
The strategy of reducing the price
to deter entry.

limit price
The price that is just low enough to
deter entry
Microsoft has a virtual monopoly in the market for personal-computer operating
Systems and business software. But there is a constant threat that another firm will
launch competing products, so Microsoft engages in limit pricing to deter entry into
its key markets. A recent study revealed some of the numbers behind the insecure
monopoly.

1 The pure monopoly price for a software bundle of the Windows operating system
and the Office Suite of business tools is about $354, but the actual price (the limit
price) is about $143. The estimated cost for a second firm to develop, maintain,
and market an alternative software bundle is about $38 billion, and Microsofts
actual price is just low enough to make such an investment unprofitable.

2 The pure monopoly profit would be about $191 billion, while the profit under
Microsofts limit pricing is about $153 billion. Although the profit under the
entry-deterrence strategy is less than the pure monopoly profit, it is greater than
the profit Microsoft would earn if it allowed a second firm to enter the market
($148 billion). In other words, entry deterrence is the best strategy.
MICROSOFT AS AN INSECURE MONOPOLIST
APPLYING THE CONCEPTS #7: How does a monopolist
respond to the threat of entry?
Examples: Microsoft Windows and Campus Bookstores
contestable market
A market with low entry and exit
costs.
Entry Deterrence and Contestable Markets
When Is the Passive Approach Better?
Entry deterrence is not the best strategy for all insecure monopolists.

Sharing a duopoly can be more profitable than increasing output and cutting
the price to keep the other firm out.
Microsoft picks a lower price to discourage entry and preserve its monopoly.
If your campus bookstore suddenly feels insecure about its monopoly
position, it could cut its prices to prevent online booksellers from capturing
too many of its customers.
Picking an Output Level
M A R G I N A L P R I N C I P L E
Increase the level of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal benefit equals the
marginal cost.
8.8 NATURAL MONOPOLY
FIGURE 8.12
A Natural Monopoly Uses the
Marginal Principle to Pick
Quantity and Price

Because of the indivisible input of
cable service (the cable system),
the long-run average-cost curve is
negatively sloped.

The monopolist chooses point a,
where marginal revenue equals
marginal cost.

The firm serves 70,000
subscribers at a price of $27 each
(point b) and an average cost of
$21 (point c). The profit per
subscriber is $6 ($27 $21).
Picking an Output Level
8.8 NATURAL MONOPOLY (cont.)
Will a Second Firm Enter?
FIGURE 8.13
Will a Second Firm Enter the
Market?

The entry of a second cable
firm would shift the demand
curve of the typical firm to the
left.

After entry, the firms demand
curve lies entirely below the
long-run average-cost curve.

No matter what price the firm
charges, it will lose money.
Therefore, a second firm will
not enter the market.
Price Controls for a Natural Monopoly
FIGURE 8.14
Regulators Use Average-Cost
Pricing to Pick a Monopolys
Quantity and Price

Under an average-cost pricing
policy, the government chooses
the price at which the demand
curve intersects the long-run
average-cost curve$12 per
subscriber.

Regulation decreases the price
and increases the quantity.
In the early part of the nineteenth century, public water works
could not keep up with rapidly growing demand, so cities allowed
private companies to provide water.

However, problems with competing private wager providers
caused cities to switch back to public systems
The British determined that water distribution is a natural monopoly and
allowing competition hurts rather than helps public access to water.
PUBLIC VERSUS PRIVATE WATERWORKS
APPLYING THE CONCEPTS #8: What is the rationale
for regulating a natural monopoly?
trust
An arrangement under which the
owners of several companies transfer
their decision-making powers to a
small group of trustees.
Breaking Up Monopolies
One form of antitrust policy is to break up a monopoly into several smaller
firms. The label antitrust comes from the names of the early conglomerates
that the government broke up.
8.9 ANTITRUST POLICY
Blocking Mergers
merger
A process in which two or more firms
combine their operations.
A horizontal merger involves two firms producing a similar product, for
example, two producers of pet food.

A vertical merger involves two firms at different stages of the production
process, for example, a sugar refiner and a candy producer..
8.9 ANTITRUST POLICY (cont.)
Blocking Mergers
FIGURE 8.15
Pricing by Staples in Cities with and without Competition

Using the marginal principle, Staples picks the quantity at which marginal revenue equals marginal cost.
In a city without a competing firm, Staples picks the monopoly price of $14.
In a city where Staples competes with Office Depot, the demand facing Staples is lower, so the profit-
maximizing price is only $12.
Merger Remedy for Wonder Bread
In some cases, the government allows a merger to happen
but imposes restrictions on the new company.
TABLE 8.5
A Merger Increases Prices
Regulating Business Practices: Price-Fixing, Tying, and
Cooperative Agreements
tie-in sales
A business practice under which a
business requires a consumer of one
product to purchase another product.
predatory pricing
A firm sells a product at a price below
its production cost to drive a rival out
of business and then increases the
price.
A Brief History of U.S. Antitrust Policy
TABLE 8.6
Key Antitrust Legislation
In 1998, Pennzoil Motor Oils purchased Quaker State Motor oils in an acquisition
valued at $1 billion. The merger brought together two of the five brands of premium
motor oil, with a combined market share of 38% (29% for Pennzoil and 9% for
Quaker State). The antitrust agencies approved the merger without any modifications.

A recent study of the merger concludes that the new company increased the price of
the Quaker State products by roughly 5%, but did not change the price of Pennzoil
products. The market share of Pennzoil products increased, while the market shares
of Quaker State products decreased.

The study also examines the price effects of four other mergers. In three of four
cases, the merger increased prices, with price hikes between 3 and 7 percent. The
Modest price effects might be surprising to

(1)people who expect relatively large Positive price effects as firms exploit their greater market
power and
(2)(2) people who expect negative price effects as the firms become more efficient.
MERGER OF PENNZOIL AND QUAKER STATE
APPLYING THE CONCEPTS #9: How does a merger
affect prices?
K E Y T E R M S
cartel
concentration ratio
contestable market
dominant strategy
duopolists dilemma
duopoly
game theory
game tree
grim-trigger strategy
low-price guarantee
limit price
limit pricing
merger
monopolistic competition
Nash equilibrium
oligopoly
predatory pricing
price-fixing
product differentiation
tie-in sales
tit-for-tat
trust

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