Monopolistic Competition and Oligopoly

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Monopolistic Competition and Monopolistic Competition and OligopolyOligopoly


Monopolistic CompetitionMonopolistic Competition

• A A monopolistically competitive monopolistically competitive industryindustry has the following has the following characteristics:characteristics:

• A large number of firmsA large number of firms

• No barriers to entryNo barriers to entry

• Product differentiationProduct differentiation


Monopolistic CompetitionMonopolistic Competition

• Monopolistic competitionMonopolistic competition is a common is a common form of industry (market) structure in the form of industry (market) structure in the United States, characterized by a large United States, characterized by a large number of firms, none of which can influence number of firms, none of which can influence market price by virtue of size alone.market price by virtue of size alone.

• Some degree of market power is achieved Some degree of market power is achieved by firms producing differentiated products.by firms producing differentiated products.

• New firms can enter and established firms New firms can enter and established firms can exit such an industry with ease.can exit such an industry with ease.


The Case for Product Differentiation The Case for Product Differentiation and Advertisingand Advertising

• The advocates of free and open The advocates of free and open competition believe that differentiated competition believe that differentiated products and advertising give the products and advertising give the market system its vitality and are the market system its vitality and are the basis of its power.basis of its power.

• Product differentiation helps to ensure Product differentiation helps to ensure high quality and efficient production.high quality and efficient production.


The Case for Product Differentiation The Case for Product Differentiation and Advertisingand Advertising

• Advertising provides consumers with Advertising provides consumers with the valuable information on product the valuable information on product availability, quality, and price that availability, quality, and price that they need to make efficient choices they need to make efficient choices in the market place.in the market place.


The Case Against Product The Case Against Product Differentiation and AdvertisingDifferentiation and Advertising

• Critics of product differentiation and Critics of product differentiation and advertising argue that they amount to advertising argue that they amount to nothing more than waste and nothing more than waste and inefficiency.inefficiency.

• Enormous sums are spent to create Enormous sums are spent to create minute, meaningless, and possibly minute, meaningless, and possibly nonexistent differences among nonexistent differences among products.products.


The Case Against Product The Case Against Product Differentiation and AdvertisingDifferentiation and Advertising

• Advertising raises the cost of products Advertising raises the cost of products and frequently contains very little and frequently contains very little information. Often, it is merely an information. Often, it is merely an annoyance.annoyance.

• People exist to satisfy the needs of the People exist to satisfy the needs of the economy, not vice versa.economy, not vice versa.

• Advertising can lead to unproductive Advertising can lead to unproductive warfare and may serve as a barrier to warfare and may serve as a barrier to entry, thus reducing real competition.entry, thus reducing real competition.


OligopolyOligopoly

• An An oligopolyoligopoly is a form of industry is a form of industry (market) structure characterized by a (market) structure characterized by a few dominant firms. Products may few dominant firms. Products may be homogeneous or differentiated.be homogeneous or differentiated.

• The behavior of any one firm in an The behavior of any one firm in an oligopoly depends to a great extent oligopoly depends to a great extent on the behavior of others.on the behavior of others.


Oligopoly ModelsOligopoly Models

• All kinds of oligopoly have one All kinds of oligopoly have one thing in common:thing in common:

• The behavior of any given The behavior of any given oligopolistic firm depends on the oligopolistic firm depends on the behavior of the other firms in the behavior of the other firms in the industry comprising the oligopoly.industry comprising the oligopoly.


The Collusion ModelThe Collusion Model

• A group of firms that gets together A group of firms that gets together and makes price and output and makes price and output decisions jointly is called a decisions jointly is called a cartelcartel..

• Collusion occurs when price- and Collusion occurs when price- and quantity-fixing agreements are quantity-fixing agreements are explicit.explicit.

• Tacit collusionTacit collusion occurs when firms occurs when firms end up fixing price without a specific end up fixing price without a specific agreement, or when agreements are agreement, or when agreements are implicit.implicit.


The Price-Leadership ModelThe Price-Leadership Model

• Price-leadershipPrice-leadership is a form of is a form of oligopoly in which one dominant firm oligopoly in which one dominant firm sets prices and all the smaller firms sets prices and all the smaller firms in the industry follow its pricing in the industry follow its pricing policy.policy.



• Assumptions of the price-leadership model:Assumptions of the price-leadership model:

1.1. The industry is made up of one large firm and a The industry is made up of one large firm and a number of smaller, competitive firms;number of smaller, competitive firms;

2.2. The dominant firm maximizes profit subject to The dominant firm maximizes profit subject to the constraint of market demand the constraint of market demand andand subject to subject to the behavior of the smaller firms;the behavior of the smaller firms;

3.3. The dominant firm allows the smaller firms to The dominant firm allows the smaller firms to sell all they want at the price the leader has set.sell all they want at the price the leader has set.



• Outcome of the price-leadership model:Outcome of the price-leadership model:

1.1. The quantity demanded in the industry is split The quantity demanded in the industry is split between the dominant firm and the group of between the dominant firm and the group of smaller firms.smaller firms.

2.2. This division of output is determined by the This division of output is determined by the amount of market power that the dominant firm amount of market power that the dominant firm has.has.

3.3. The dominant firm has an incentive to push The dominant firm has an incentive to push smaller firms out of the industry in order to smaller firms out of the industry in order to establish a monopoly.establish a monopoly.


Predatory PricingPredatory Pricing

• The practice of a large, powerful firm The practice of a large, powerful firm driving smaller firms out of the driving smaller firms out of the market by temporarily selling at an market by temporarily selling at an artificially low price is called artificially low price is called predatory pricingpredatory pricing..

• Such behavior became illegal in the Such behavior became illegal in the United States with the passage of United States with the passage of antimonopoly legislation around the antimonopoly legislation around the turn of the century.turn of the century.


Game TheoryGame Theory

• Game theoryGame theory analyzes oligopolistic analyzes oligopolistic behavior as a complex series of behavior as a complex series of strategic moves and reactive strategic moves and reactive countermoves among rival firms.countermoves among rival firms.

• In game theory, firms are assumed In game theory, firms are assumed to anticipate rival reactions.to anticipate rival reactions.


Contestable MarketsContestable Markets

• A market is A market is perfectly contestableperfectly contestable if if entry to it entry to it andand exit from it are exit from it are costless.costless.

• In contestable markets, even large In contestable markets, even large oligopolistic firms end up behaving oligopolistic firms end up behaving like perfectly competitive firms. like perfectly competitive firms. Prices are pushed to long-run Prices are pushed to long-run average cost by competition, and average cost by competition, and positive profits do not persist.positive profits do not persist.


Oligopoly is Consistent withOligopoly is Consistent witha Variety of Behaviorsa Variety of Behaviors

• The only necessary condition of oligopoly is The only necessary condition of oligopoly is that firms are large enough to have some that firms are large enough to have some control over price.control over price.

• Oligopolies are concentrated industries. At Oligopolies are concentrated industries. At one extreme is the cartel, in essence, one extreme is the cartel, in essence, acting as a monopolist. At the other acting as a monopolist. At the other extreme, firms compete for small extreme, firms compete for small contestable markets in response to contestable markets in response to observed profits. In between are a number observed profits. In between are a number of alternative models, all of which stress of alternative models, all of which stress the interdependence of oligopolistic firms.the interdependence of oligopolistic firms.


Oligopoly and Economic PerformanceOligopoly and Economic Performance

• Oligopolies, or concentrated industries, are Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons:likely to be inefficient for the following reasons:

• They are likely to price above marginal cost. This They are likely to price above marginal cost. This means that there would be underproduction from means that there would be underproduction from society’s point of view.society’s point of view.

• Strategic behavior can force firms into deadlocks Strategic behavior can force firms into deadlocks that waste resources.that waste resources.

• Product differentiation and advertising may pose a Product differentiation and advertising may pose a real danger of waste and inefficiency.real danger of waste and inefficiency.

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Monopolistic Competition and Oligopoly