Monopolistic

Competition and
Oligopoly
Chapter 11
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 oligopolists kinked demand
curve
Collusion among oligopolists
The effects of advertising
11-2
Monopolistic Competition
Large number of sellers
Small market shares
No collusion
Independent action
Differentiated Products
Product attributes
Service
Location
Brand names and packaging
Some control over price
11-3
Easy entry and exit
Need for advertising
Nonprice Competition
Which industries?
Degree of concentration
Four-firm concentration ratio
Herfindahl index
Monopolistic Competition
Monopolistic Competition
11-4
Firms demand curve
Highly elastic
Short run profit or loss
Produce where MR=MC
Long run normal profit
Entry and exit
Inefficient
Product variety
Monopolistic Competition
11-5
Short-Run Profits
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D
1
ATC
Economic
Profit
Q
1
A
1
P
1
0

Monopolistic Competition
11-6
Short-Run Losses
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D
2
ATC
Loss
Q
2
A
2
P
2
0

Monopolistic Competition
11-7
Long-Run Equilibrium
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D
3
ATC
Q
3
P
3
=A
3
0

Monopolistic Competition
11-8
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D
3
ATC
Q
3
0

P
3
=A
3
P=MC=Min ATC for pure competition (recall)
P
4
Q
4
Price is Lower
Excess Capacity at
Minimum ATC
Monopolistic competition is not efficient
Monopolistic Competition
11-9
Oligopoly
A few large producers
Homogeneous or
differentiated products
Control over price
Mutual interdependence
Strategic behavior
Entry barriers
Mergers
11-10
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
11-11
Game Theory
RareAirs Price Strategy
U
p
t
o
w
n

s

P
r
i
c
e

S
t
r
a
t
e
g
y

A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
2 competitors
2 price
strategies
Each strategy
has a payoff
matrix
Greatest
combined
profit
Independent
actions
stimulate a
response
11-12
Game Theory
RareAirs Price Strategy
U
p
t
o
w
n

s

P
r
i
c
e

S
t
r
a
t
e
g
y

A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
Independently
lowered prices
in expectation
of greater profit
leads to the
worst
combined
outcome
Eventually low
outcomes make
firms return to
higher prices
11-13
Game Theory
Mutual interdependence
Pricing policy
Collusion
Enhances profit
Incentive to cheat
Prisoners dilemma

11-14
Three Oligopoly Models
Kinked-demand curve
Collusive pricing
Price leadership
Why three models?
Diversity of oligopolies
Complications of interdependence
11-15
Kinked-Demand Curve
Noncollusive oligopoly
Strategies
Match price changes
Ignore price changes
Combined strategy
Price inflexibility
The kinked-demand curve

11-16
P
r
i
c
e

P
r
i
c
e

a
n
d

C
o
s
t
s

Quantity Quantity
0 0
P
0
MR
2
D
2
D
1
MR
1
e
f
g
Rivals Ignore
Price Increase
Rivals Match
Price Decrease
Q
0
Competitor and rivals strategize versus each other
Consumers effectively have 2 partial demand curves
and each part has its own marginal revenue part
MR
2
D
2
D
1
MR
1
Q
0
MC
1
MC
2
P
0
Resulting in a kinked-demand curve
to the consumer price and output
are optimized at the kink
e
f
g
Kinked-Demand Curve
11-17
Criticisms of the model
How does price get to P
0
Explains inflexibility, not price
Prices are not that rigid
Price wars
Kinked-Demand Curve
11-18
P
r
i
c
e

a
n
d

C
o
s
t
s

Quantity
Cartels and Other Collusion
Price and output
Joint profit maximization
D
MR=MC
ATC
MC
MR
P
0
A
0
Q
0
Economic
Profit
Effectively Sharing
The Monopoly Profit
11-19
The OPEC Cartel
Source: A. T. Kearney, Foreign Policy
Iran 3,843,000
Kuwait 2,538,000
Venezuela 2,368,000
Iraq 2,297,000
Nigeria 2,183,000
UAE 2,117,000
Angola 1,804,000
Libya 1,737,000
Algeria 1,417,000
Qatar 848,000
Indonesia 843,000
Ecuador 530,000
Daily oil production (barrels) , November 2008
Saudi Arabia 8,904,000
11-20
Cartels and Other Collusion
Covert collusion
Tacit understandings
Obstacles to collusion
Demand and cost differences
Number of firms
Cheating
Recession
Potential entry
Legal obstacles: antitrust law
11-21
Price Leadership Model
Leadership tactics
Infrequent price changes
Communications
Limit pricing
Breakdowns in price leadership:
Price wars
11-22
Advertising
Prevalent in monopolistic
competition and oligopoly
Capture market share
Better than a price cut
Information for consumers
Manipulation
11-23
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
11-24
Worlds Top 10 Brand Names, 2007
Source: Interbrand
Coca-Cola
Microsoft
IBM
General Electric
Nokia
Toyota
Intel
McDonalds
Disney
Mercedes-Benz
Oligopoly and Advertising
11-25
Oligopoly and Efficiency
Not productively efficient
Not allocatively efficient
Tendency to share the monopoly
profit
Qualifications
Increased foreign competition
Limit pricing
Technological advance
11-26
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
11-27
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
11-28
Next Chapter Preview
Technology, R&D,
And Efficiency
11-29