Monopolistic Competition,

Oligopoly, and Strategic Pricing

Chapter 13

Introduction
In discussing real-world competition, the
focus quickly becomes market structure.
Market structure is the physical
characteristics of the market within
which firms interact.

Introduction
Market structure involves the number of
firms in the market and the barriers to
entry.
Perfect competition, with an infinite
number of firms, and monopoly, with a
single firm, are polar opposites.

Introduction
Monopolistic competition and oligopoly lie
between these two extremes.
Monopolistic competition is a market
structure in which there are many firms
selling differentiated products.
Oligopoly is a market structure in which
there are a few interdependent firms.

Introduction
Most U.S. industry structures fall almost
entirely between monopolistic competition
and oligopoly.
Perfectly competitive and monopolistic
industries are nearly nonexistent.

Problems Determining Market

Structure
Defining a market has problems:
What is an industry and what is its
geographic market -- local, national, or
international?
What products are to be included in the
definition of an industry?

Classifying Industries
One of the ways in which economists
classify markets is by cross-price
elasticities.
Cross-price elasticity measures the
responsiveness of the change in demand for a
good to change in the price of a related good.

Classifying Industries
Industries are classified by government
using the North American Industry
Classification System (NAICS).
The North American Industry
Classification System (NAICS) is a
classification system of industries adopted
by Canada, Mexico, and the U.S. in 1997.

Classifying Industries
When economists talk about industry
structure the general practice is to refer
to three-digit industries.
Under the NAICS, a two-digit industry
is a broadly based industry.
A three-digit industry is a specific type
of industry within a broadly defined twodigit industry.

Two- and Four- Digit Industry Groups

Determining Industry Structure

Economists use one of two methods to

measure industry structure:
1. The Concentration Ratio
2. The Herfindahl Index

Concentration Ratio
The concentration ratio is the
percentage of industry output that a
specific number of the largest firms
have.

Concentration Ratio
The most commonly used concentration
ratio is the four-firm concentration ratio.
The higher the ratio, the closer to an
oligopolistic or monopolistic type of
market structure.

The Herfindahl Index

The Herfindahl index is an alternative
method used by economists to classify
the competitiveness of an industry.
It is calculated by adding the squared
value of the market shares of all firms in
the industry.

The Herfindahl Index

Two advantages of the Herfindahl index
is that it takes into account all firms in an
industry as well as giving extra weight to
a single firm that has an especially large
market share.

The Herfindahl Index

The Herfindahl Index is important
because it is used as a marker by the
Justice Department for allowing or
disallowing mergers to take place.
If the index is less than 1,000, the industry
is considered competitive thus allowing the
merger to take place.

Concentration Ratios and the

Herfindahl Index

Conglomerate Firms and Bigness

Neither the four-firm concentration ratio
or the Herfindahl index gives a complete
picture of corporations size.

Conglomerate Firms and Bigness

This is because many firms are
conglomerateshuge corporations whose
activities span various unrelated
industries.

The Importance of Classifying

Industry Structure
Classifying industry structure is
important because structure affects firm
behavior.
The greater the number of sellers, the more
the likelihood the industry is competitive.

The Importance of Classifying

Industry Structure
The number of firms in an industry plays
a role in determining whether firms
explicitly take other firms actions into
account.
Oligopolies take into account the
reactions of other firms; monopolistic
competitors do not.

The Importance of Classifying

Industry Structure
In monopolistic competition, the large
number of firms makes it unlikely that an
individual firm will explicitly take into
account rival firms responses to their
decisions.

The Importance of Classifying

Industry Structure
In oligopoly, with fewer firms, each firm
explicitly engages in strategic decision
making.
Strategic decision making taking
explicit account of a rivals expected
response to a decision you are making.

Monopolistic Competition
The four distinguishing characteristics of
monopolistic competition are:

Many sellers.
Differentiated products.
Multiple dimensions of competition.
Easy entry of new firms in the long run.

Many Sellers
When there are many sellers as in
monopolistic competition, they do not
take into account rivals reactions.
The existence of many sellers also makes
collusion difficult.
Monopolistically competitive firms act
independently.

Differentiated Products
The many sellers characteristic gives
monopolistic competition its competitive
aspect.
Product differentiation gives monopolistic
competition its monopolistic aspect.

Differentiated Products
Differentiation exists so long as
advertising convinces buyers that it
exists.
Firms will continue to advertise as long
as the marginal benefits of advertising
exceed its marginal costs.

Multiple Dimensions of Competition

One dimension of competition is product
differentiation.
Another is competing on perceived
quality.
Competitive advertising is another.
Others include service and distribution
outlets.

Easy Entry of New Firms

in the Long Run
There are no significant barriers to
entry.
Barriers to entry prevent competitive
pressures.
Ease of entry limits long-run profit.

Output, Price, and Profit of a

Monopolistic Competitor
A monopolistically competitive firm prices
in the same manner as a monopolist
where MC = MR.
But the monopolistic competitor is not
only a monopolist but a competitor as well.

Output, Price, and Profit of a

Monopolistic Competitor
At equilibrium, ATC equals price and
economic profits are zero.
This occurs at the point of tangency
of the ATC and demand curve at the
output chosen by the firm.

Monopolistic Competition
Price

MC
ATC

PM

MR
0

QM

D
Quantity

Comparing Monopolistic Competition

with Perfect Competition
Both the monopolistic competitor and the
perfect competitor make zero economic
profit in the long run.

Comparing Monopolistic Competition

with Perfect Competition
The perfect competitors demand curve is
perfectly elastic.
Easy entry, zero economic profits, and a
uniform product means that the perfect
competitor produces at the minimum of
the ATC curve.

Comparing Monopolistic Competition

with Perfect Competition
A monopolistic competitor faces a
downward sloping demand curve, and
produces where MC = MR.
The ATC curve is tangent to the
demand curve at that level, which is not
at the minimum point of the ATC curve.

Comparing Monopolistic Competition

with Perfect Competition
Increasing market share is a relevant
concern for a monopolistic competitor but
not for a perfect competitor.

Comparing Monopolistic Competition

with Perfect Competition
In the real world of monopolistic
competition, increasing output and market
share lowers average total cost.

Comparing Perfect and Monopolistic

Competition
Perfect competition
Price

Price

MC
ATC
D

PC

Monopolistic competition

QC

Quantity

MC
ATC

PM
PC

QM

MR
D
QC Quantity

Comparing Monopolistic Competition

with Monopoly
The difference between a monopolist and
a monopolistic competitor is in the
position of the average total cost curve in
long-run equilibrium.

Comparing Monopolistic Competition

with Monopoly
For a monopolist, the average total cost
curve can be, but need not be, at a
position below price so that the
monopolist makes a long-run economic
profit.

Comparing Monopolistic Competition

with Monopoly
For a monopolistic competitor, the
average total cost curve is tangent to the
demand curve at the price and output
chose by the monopolistic competitor so
that there are zero economic profits in
the long run.

Advertising and Monopolistic

Competition
Firms in a perfectly competitive market
have no incentive to advertise: they can
sell all they produce at the market price.
Monopolistic competitors have a strong
incentive to do so.

Advertising and Monopolistic

Competition

The primary goals of the advertiser is

to
1. move the demand curve to the right and
2. make it more inelastic.

Advertising and Monopolistic

Competition
Advertising shifts the demand curve
shifts out and shifts the ATC curve up.
That way the firm can sell more,
charge more, or both.

Advertising
& the Creation of Name Brands
There is a sense of trust in buying brands we
know.
Advertising creates Name Brand Recognition.
Consumers are sometimes willing to pay more to
reduce their uncertainty about the quality of
the product.
Companies that develop name brands can often
charge more than for no name homogeneous
products.

Oligopoly
Oligopoly is a market structure where
there are a small number of mutually
interdependent firms.
Each firm must take into account the
expected reaction of other firms to its
profit maximizing output decision.

Models of Oligopoly Behavior

No single general model of oligopoly
behavior exists.
Two models of oligopoly behavior are the
cartel model and the contestable market
model.

Models of Oligopoly Behavior

In the cartel model, the firms in the
industry (oligopolies) collude to set a
monopoly price.
In the contestable market model, an
oligopolistic firm with no barriers to
entry sets a competitive price.

The Cartel Model

A cartel (sometimes called a trust) is a
combination of firms that acts as it were
a single firm.
A cartel is a shared monopoly.

The Cartel Model

If oligopolies can limit the entry of other
firms and form a cartel, they can
increase the profits going to the
combination of firms in the cartel.

The Cartel Model

The model assumes that oligopolies act as
if they were monopolists that have
assigned output quotas to individual
member firms so that total output is
consistent with joint profit maximization.

Implicit Price Collusion

Formal collusion is illegal in the U.S. while
informal collusion is permitted.
Implicit price collusion exists when
multiple firms make the same pricing
decisions even though they have not
consulted with one another.

Implicit Price Collusion

Sometimes the largest or most dominant
firm takes the lead in setting prices and
the others follow.

Cartels and Technological Change

Cartels can be destroyed by an outsider
with technological superiority.
Thus, cartels with high profits will
provide incentives for significant
technological change.

Why Are Prices Sticky?

Informal collusion is an important reason
why prices are sticky.
Another is the kinked demand curve.

Why Are Prices Sticky?

When there is a kink in the demand curve,
there has to be a gap in the marginal
revenue curve.
The kinked demand curve is not a
theory of oligopoly but a theory of
sticky prices.

The Kinked Demand Curve

Price
a
P

MC0

D1

MC1
d

MR1
D2

MR2

Quantity

The Contestable Market Model

According to the contestable market
model, barriers to entry and barriers to
exit determine a firms price and output
decisions.
Even if the industry contains only one firm, it
could still be a competitive market if entry is
open.

The Contestable Market Model

The stronger the ability of the
oligopolists to collude and prevent market
entry, the closer it is to a monopolistic
situation.
The weaker the ability to collude is,
the more competitive it is.

Strategic Pricing and Oligopoly

Both the cartel and contestable market
models use strategic pricing decisions
they set their prices based on the
expected reactions of other firms.

Strategic Pricing and Oligopoly

Cartelization strategy is limited by entry
of new firms because the newcomer may
not want to cooperate with the other
firms.

Price Wars
Price wars are the result of strategic
pricing decisions gone wild.
Sometimes a firm engages in this activity
because it hates its competitor.

Price Wars
A firm may develop a predatory pricing
strategy as a matter of policy
A predatory pricing strategy involves
temporarily pushing the price down in order
to drive a competitor out of business.

Game Theory
and Strategic Decision Making
Most oligopolistic strategic decision
making is carried out with explicit or
implicit use of game theory.
Game theory is the application of
economic principles to interdependent
situations.

The Prisoners Dilemma and a Duopoly

Example
The prisoner's dilemma can be used to
illustrate the behavior of a duopoly.
The prisoners dilemma is one well-known
game that demonstrates the difficulty of
cooperative behavior in certain
circumstances.

The Prisoners Dilemma and a Duopoly

Example
The prisoners dilemma has its simplest
application when the oligopoly consists of
only two firmsa duopoly.

The Prisoners Dilemma and a Duopoly

Example
By analyzing the strategies of both firms
under all situations, all possibilities are
placed in a payoff matrix.
A payoff matrix is a box that
contains the outcomes of a strategic
game under various circumstances.

Firm and Industry Duopoly

Cooperative Equilibrium
MC ATC
$800

700

700

600

600

500

500

400

400

Price

575

Price

$800

300

200

100

100
1

Quantity (in thousands)

(a) Firm's cost curves

MC

Competitive
solution

300

200

Monopolist
solution

MR

9 10 11

Quantity (in thousands)

(b) Industry: Competitive and monopolist solution

Firm and Industry Duopoly Equilibrium When

One Firm Cheats

MC ATC

$800

800

700

700

700

600
550
500

600
550
500

600
550
500

400
300

400

Price

A
Price

Price

$800

$900

MC ATC

300
200

200

100

100

100

2 3 4

5 6 7

Quantity (in thousands)

(a) Noncheating firms loss

2 3 4

6 7

Quantity (in thousands)

(b) Cheating firms profit

B
A

NonCheating
400 cheating
firms
firms
output
300 output

200

2 3

4 5 6

7 8

Quantity (in thousands)

(c) Cheating solution

Duopoly and a Payoff Matrix

The duopoly is a variation of the
prisoner's dilemma game.
The results can be presented in a payoff
matrix that captures the essence of the
prisoner's dilemma.

The Payoff Matrix of Strategic

Pricing Duopoly
A Does not cheat

A Cheats
A +$200,000

A $75,000
B Does not
cheat

B $75,000

B $75,000

A $75,000

A0

B Cheats
B +$200,000

B0

Oligopoly Models, Structure, and

Performance
Oligopoly models are based either on
structure or performance.
The four-fold division of markets considered
so far are based on market structure.
Structure means the number, size, and
interrelationship of firms in the industry.

Oligopoly Models, Structure, and

Performance
A monopoly is the least competitive,
perfectly competitive industries are the
most competitive.

Oligopoly Models, Structure, and

Performance
The contestable market model gives less
weight to market structure.
Markets in this model are judged by
performance, not structure.
Close relatives of it have previously been
called the barriers-to-entry model, the
stay-out pricing model, and the limitedpricing model.

Oligopoly Models, Structure, and

Performance
There is a similarity in the two
approaches.
Often barriers to entry are the reason
there are only a few firms in an industry.
When there are many firms, that suggests
that there are few barriers to entry.
In such situations, which make up the
majority of cases, the two approaches
come to the same conclusion.

Monopolistic Competition,
Oligopoly, and Strategic Pricing
End of Chapter 13