Macroeconomics Principles and

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 CHAPTER 11

MONOPOLISTIC COMPETITION AND OLIGOPOLY

MASTERY GOALS

The objectives of this chapter are to:

1. Identify the characteristics of the four basic market structures, and discuss how
economists decide which model to use to analyze different real-world markets.
2. Describe the constraints and goal of an individual monopolistic competitor.
3. Explain how a monopolistic competitor maximizes profit.
4. Explain why long-run economic profits will be zero under monopolistic competition.
5. Explain why monopolistic competitors operate with excess capacity.
6. Describe how nonprice competition can affect the market equilibrium in a
monopolistically competitive industry.
7. Describe the different types of barriers to entry that can lead to oligopoly.
8. Explain the prisoner’s dilemma model.
9. Show how game theory can be useful in analyzing the behavior of oligopolists.
10. Explain how the equilibrium in a game with repeated plays may differ from the
equilibrium in a game played only once.
11. Discuss the difference between explicit and implicit collusion.
12. Describe the forces operating to restrict and reduce the extent of oligopoly in the
economy.

THE CHAPTER IN A NUTSHELL

Imperfect competition refers to market structures between perfect competition and monopoly.
In imperfectly competitive markets, there is more than one seller, but still too few to create a
perfectly competitive market. In addition, these markets often violate other conditions of
perfect competition, such as the requirement of a standardized product or free entry and exit.
Monopolistic competition and oligopoly are two types of imperfectly competitive markets.
A monopolistically competitive market has three fundamental characteristics:
1. many small buyers and sellers;
2. sellers offer a differentiated product; and
3. sellers can easily enter or exit the market.

124
 Chapter 11 Monopolistic Competition and Oligopoly 125

The individual monopolistic competitor faces a downward-sloping demand curve that

should be flatter than the demand curve faced by a monopolist, since closer substitutes are
available under monopolistic competition. Profit is maximized by producing where marginal
revenue equals marginal cost, and may be positive or negative in the short run. Entry and
nonprice competition (that is, any action, other than price cutting, taken to increase the
demand for a firm’s output) should drive profits to zero in the long run. In the long run, a
monopolistic competitor will operate with excess capacity—that is, it will produce too little
output to achieve the minimum cost per unit.
An oligopoly is a market dominated by a small number of strategically interdependent
firms. Oligopoly is a matter of degree, depending on the number of reasonably close
substitutes a product has, and on whether there is market domination by a few large
strategically interdependent firms. Oligopolists can produce either standardized or
differentiated products. They may earn economic profit in the long run due to barriers to
entry. Barriers to entry may take several forms: substantial economies of scale, the
favorable reputations of early entrants, strategic barriers designed by existing firms to
deter entry, or legal barriers.
Game theory is a useful approach for learning how oligopolists behave. Several
examples are covered in this chapter in order to emphasize the interdependence of firms in
an oligopoly market. The outcomes of these games depend on whether the game is played
only once or repeatedly. One possible result of repeated trials is cooperative behavior, in the
form of explicit or tacit collusion. The ability of oligopolists to collude is limited by their
ability to cheat. The future of oligopoly depends on antitrust legislation and enforcement,
the globalization of markets, and technological change.
Advertising frequently occurs in monopolistic competition and oligopoly. Under
monopolistic competition, advertising increases the size of the market. But in the long run,
each firm earns zero economic profit, just as it would if no firms were advertising. The price
to the consumer, however, may either rise or fall. The type and extent of advertising under
oligopoly may be determined by collusive behavior.
Perfect competition, monopolistic competition, oligopoly, and monopoly are the four
market structures studied in this textbook. These models are useful for analyzing real-world
markets, but markets in the real world typically have characteristics of more than one kind of
market structure. Our choice of model depends on the questions we are trying to answer.

TEACHING TIPS

1. The local Yellow Pages can come in handy to help spark some class discussion. Try
passing out photocopies of the relevant sections in class or have your students go to
yellowpages.com if they bring their own laptops to class.
a. Ask your students to look at the entries under the “restaurants” heading of the
Yellow Pages. Use the entries to discuss the degree of competition in your town.
Unless it is a very small town, the restaurant industry will be monopolistically
competitive. Pick two restaurants with which students may be familiar. Why is
there no strategic interaction between them? Is there evidence that they are earning
zero profit?
126 Instructor’s Manual for Economics: Principles and Applications, 5e

b. Give students the following assignment: Look over the Yellow Pages or
yellowpages.com at home, find an interesting category, and analyze the degree of
competition in that field. Remember to consider substitutes for the product or
service in question, as well as whether the market is local or national.
2. Here is an exercise on advertising and collusion in oligopoly:
Assume there are two firms in this industry, one owned by Bart and the other by Lisa.
Assume that neither firm advertises, and that each sells 100,000 units of output at $2
per unit. Assume that each unit cost $1 to produce. By conducting a $20,000
advertising campaign, either firm can lure 50,000 customers from its competitor, as
long as the other firm does not respond with its own campaign. (Assume that costs per
unit, excluding advertising, remain at $1 per unit, and that price per output remains at
$2 per unit.) If both firms advertise, there will be no change in market share. Show the
payoff matrix for Bart’s and Lisa’s strategies and discuss the likely outcome with and
without collusive behavior.
Answer:
Bart Advertises Bart Does Not Advertise

Lisa Advertises Bart earns $80,000, Bart earns $50,000,

Lisa earns $80,000 Lisa earns $130,000

Lisa Does Not Advertise Bart earns $130,000, Bart earns $100,000,
Lisa earns $50,000 Lisa earns $100,000

DISCUSSION STARTERS

1. See “Move to Drop Coupons Puts Procter & Gamble in Sticky PR Situation,” The
Wall Street Journal, April 17, 1997, A1, for a real-world example of a prisoner’s
dilemma concerning advertising.
Money-off coupons are a form of advertising. P&G claims that coupons are
inefficient: coupon issuers spend about $6.5 billion a year on them but consumers
redeem only about $3.6 billion worth. (They also claim that 8 million trees are needed
to produce the unredeemed coupons alone.)
In January 1996, P&G decided to test this claim by replacing coupons with
everyday lower prices in three New York cities.
Construct a payoff matrix for P&G and its competitors showing the payoffs
associated with the following strategies: P&G and the competitors offer coupons,
neither P&G nor the competitors offer coupons, only the competitors offer coupons,
and only P&G offers coupons. Which strategy maximizes profits for P&G and its
competitors? Could this strategy result in lower prices for consumers?
Unfortunately for P&G, their test resulted in boycotts, public hearings, and an
investigation by the New York state’s attorney general’s office into possible antitrust
violations, claiming that P&G conspired to persuade other companies to drop coupons.
 Chapter 11 Monopolistic Competition and Oligopoly 127

Why would consumers protest so vehemently against the end of couponing?

Explain how coupons are a form of price discrimination.
2. An interesting example of cheating on a cartel is the case involving Major League
Baseball and the New York Yankees. Major League Baseball has been trying to
negotiate a sponsorship package with Nike Inc. and Reebok International Ltd. A deal
with the companies that would have given $350,000 annually to each of the 30 clubs
in the league was rejected in 1996 by the club owners.
Now, George Steinbrenner and the New York Yankees have signed their own $95
million, 10-year, sponsorship deal with Adidas. In response, Major League Baseball
ordered the Yankees not to sell merchandise with the Yankees and Adidas logo at
Yankee Stadium. Steinbrenner countered by serving an antitrust suit against Major
League Baseball and the other 29 clubs. He accuses the defendants of conspiring to
form a merchandise cartel that favors weak teams.
Discuss how cheating on the cartel (in the form of negotiating an independent
merchandising deal) undercut the power of the cartel. Are the New York Yankees
victims of a merchandise monopoly?
3. Conduct the following experiment to show the advantages and difficulties of forming
cartels. It will cost you some money (a maximum of $20 in this example, but usually
the outcome will cost you much less). However, it will drive the point home.
a. Select 5 students. Tell them that you are going to have them each write the letter “A”
or “B” on secret ballots. State that you will pay $4 to each student if they all write
“A.” Explain that if 1 student “cheats” by writing “B,” that student will receive $8,
while the 4 who don’t cheat will only receive $1 each. Ask them to study the
payment table below, which shows the payments for other possible outcomes, and to
reach an agreement about what letter they will all choose. Explain that this game
will not be repeated, then provide secret ballots for their answers. After collecting
their ballots, ask their classmates to predict the outcome. Chances are that the group
will agree that all members chose “A,” but that at least one student will cheat and
choose “B.”
b. Discuss how the outcome might change with repeated plays.
c. Discuss how the outcome might change if there were only two players, or if the
whole class were allowed to play.
d. Show how total payments to the group are largest if there is no cheating on the
cartel, but that individuals can expect to maximize their personal rewards by
cheating.
e. Save information about the outcome of this game to compare with outcomes in
other classes in the future.
128 Instructor’s Manual for Economics: Principles and Applications, 5e

Payment Table
Payment per “A” Payment per “B” Total Payments
Payments if all 5
students choose “A” $4.00 — $20.00

Payments if 4 choose
“A” and 1 chooses “B” $1.00 $8.00 $12.00

Payments if 3 choose
“A” and 2 choose “B” $0.50 $4.00 $9.50

Payments if 2 choose
“A” and 3 choose “B” $0.25 $0.50 $2.00

Payments if 1 chooses
“A” and 4 choose “B” $0.10 $0.25 $1.10

Payments if all 5
choose “B” — $0.10 $0.50

ANSWERS, SOLUTIONS, AND EXERCISES

ANSWERS TO ONLINE REVIEW QUESTIONS

1. Like perfectly competitive markets, monopolistically competitive markets have many

buyers and sellers as well as easy entry and exit. Like monopolies, monopolistically
competitive firms face a downward-sloping demand curve.
2. False. In the long run, a monopolistic competitor will not produce at minimum ATC. In
long-run equilibrium, there are too many firms producing too little output to achieve
minimum ATC.
3. False. A monopolistic competitor can also increase its sales by using nonprice
competition (such as advertising, packaging, quality of service, etc.).
4. In oligopoly there are fewer firms than in perfect competition or monopolistic
competition, but more than in monopoly. Unlike perfectly or monopolistically
competitive markets, there are barriers to entry and exit.
5. a. Oligopolistic. Within the U.S. market, three U.S. firms and perhaps half a dozen
foreign firms dominate the market, and they follow each other’s pricing and
nonprice practices closely.
b. Perfectly competitive. There are many farmers who produce the same product and
there are few barriers to entry.
 Chapter 11 Monopolistic Competition and Oligopoly 129

c. Monopolistically competitive. Probably the city has many other copy shops in
addition to Kinko’s, each offering slightly different services.

d. Monopolistic. Within the two-mile radius of the campus, it is the only firm. There
are no close substitutes, unless the college has its own facilities.
e. Monopolistically competitive. There are many ice cream manufacturers and few
barriers to entry, but each manufacturer has a slightly different product. But the
market could be considered an oligopoly if it is defined more narrowly (“the
market for premium ice cream”).
f. Oligopolistic. There are few firms, each able to observe and react to the other’s
activities.
g. Monopolistic. The newspaper is the only seller in the market, with no close
substitutes.
6. In a natural monopoly, economies of scale extend over a wide-enough range of output
that the lowest cost per unit is attained when a single firm produces for the entire
market. In a natural oligopoly, economies of scale do not extend over as wide a range
of output, allowing more than one competitor to enter.
7. Barriers to entry include economies of scale, favorable reputation of early entrants,
strategic barriers, and legal barriers. Strategic barriers created by oligopolistic firms
include maintaining excess capacity and making special arrangements with customers
or distributors. Possible legal barriers include tariffs, quotas, and zoning regulations.
8. Difficulty observing other firms’ prices, unstable market demand, and a large number
of firms promote cheating—since they lessen the probability of detection. In addition,
unstable market demand means new terms for collusion must be periodically
renegotiated, giving firms the opportunity to cheat in the interim. Finally, if many
firms are involved in collusion, any individual firm may face a smaller chance of
getting caught and facing punishment, thereby increasing the probability of cheating.
9. In addition to the MES, we need to know the size of the market. It is the MES relative
to the approximate size of the market that determines the industry structure.
10. New technologies limit the degree of concentration in an industry by creating new
substitute goods and by breaking down barriers to entry. Two examples are cable
television and local phone companies; both face new competition made possible by
technological advances (satellite dishes in the case of cable TV, and cell phones in the
case of local phone companies).
11. a. Since the cable provider is a monopoly, it will do little if any advertising. If it does
advertise, it will do so to convince people to get cable, not to steal business from
its competitors (since there are no competitors).
b. The dairy farm is in a perfectly competitive market and won’t advertise at all.
c. Blockbuster is a monopolistically competitive firm. It will try to shift its demand
curve rightward and make demand for its output less elastic through advertising.
We expect heavy advertising.
130 Instructor’s Manual for Economics: Principles and Applications, 5e

d. Assuming Homestake is in a perfectly competitive market, it will not advertise at

all.
e. Dell Computer Co. is in a monopolistically competitive market. Like Blockbuster,
it will advertise to increase demand for its product and make that demand less
elastic. We expect heavy advertising.
12. It is difficult to apply the definition of oligopoly to real-world markets since doing so
involves defining the relevant market, deciding what number qualifies as “a few,” and
deciding whether market domination by a few firms occurs.

PROBLEM SET
1.

The firm produces where MR = MC, but at this price, the firm suffers a loss (because
the price – read off the demand curve – is less than average total cost). If the situation
does not improve, the firm will exit the market in the long run. When it exits,
producers of similar goods will likely see their demand curves shift rightward as
customers of the firm depicted here seek out other firms from which to buy the
product.
2.
Price

MC

P1
ATC
E
P2

D2 MR1 D1
MR2
Quantity
Q2 Q1
 Chapter 11 Monopolistic Competition and Oligopoly 131

Initially, the monopolist earns an economic profit by producing where MR = MC, i.e.
producing quantity Q1 at price P1. Entry will occur, shifting the firm’s demand and
marginal revenue curves leftward (to D2 and MR2). Long-run equilibrium will occur at
point E, where the firm earns zero economic profit.

3. a.
Price per Eye Exams Total Cost Total Revenue Marginal Marginal
Eye Exam per Week per Week per Week Revenue Cost
$100 100 $10,500 $10,000 -- --
$30 $7.50
$80 140 $10,800 $11,200
$13.33 $8.33
$60 200 $11,300 $12,000
$3.64 $9.00
$40 310 $12,290 $12,400
-$5.83 $10.29
$20 550 $14,760 $11,000
b. An optometry practice might face a downward-sloping demand curve if it could
differentiate its product through location, hours of operation, ambiance, quality of
service, or frame selection.
c. The profit-maximizing price is $60 and the profit-maximizing number of eye
exams per week is 200.
4. a.
Price per Taco Plates Total Cost Total Marginal Marginal
Taco Plate per Week per Week Revenue Revenue Cost
per Week
$5 50 $30 $250
$2.33 $0.67
4 80 $50 $320
$1.86 $1.80
3 150 $176 $450
$1.77 $2.00
2 800 $1476 $1600
-$1.67 $2.20
1 1100 $2136 $1100
Tino should expand his output as long as MR exceeds MC. His profit-maximizing
price is $3 and his profit-maximizing number of taco plates is 150.
132 Instructor’s Manual for Economics: Principles and Applications, 5e

b.
Price per Taco Plates Total Cost Total Marginal Marginal
Taco Plate per Week per Week Revenue Revenue Cost
per Week
$5 60 $130 $300
$2.33 $0.55
4 96 $150 $384
$1.86 $1.50
3 180 $276 $540
$1.76 $1.67
2 960 $1576 $1920
-$1.67 $1.83
1 1320 $2236 $1320
Tino’s profit-maximizing price is $2, and his profit-maximizing number of taco plates
is 960. Since Tino earns an economic profit of $344 with this combination, entry will
occur until Tino’s economic profit falls to $0.
5. He should not shut down in the short run, because he is covering his average variable
cost (P = $60, AVC = $56.50).

6. a.

The typical plastics firm produces the output level where MC = MR, charges the
corresponding price given by the demand curve, and earns zero economic profit.
 Chapter 11 Monopolistic Competition and Oligopoly 133

b.

Oil is a variable input, so if oil prices increase, the ATC curve and the MC curve of
all firms shift upward. In the short run, the typical plastics firm suffers an
economic loss.
c. If price remained high, and profits remained negative, some firms would exit.
Other firms would experience a rightward shift of their demand curves, and in
long-run equilibrium, the remaining firms would earn zero economic profit.

7. a.
134 Instructor’s Manual for Economics: Principles and Applications, 5e

b.

8. a. In the payoff matrices below, Road Kill’s payoffs are listed first:

Sal Monella
Clean up Don't Cleanup

5,000 -3,000
Clean up

5,000 12,000
Road Kill
Café

12,000 7,000
Don't
Cleanup
-3,000 7,000

b. Both Road Kill Café and Sal Monella have a dominant strategy: to clean up.
c. If Road Kill Café and Sal Monella act independently, they’ll both clean up and earn
$5,000.

d. When facing the same decision repeatedly, Sal Monella and Road Kill Café might
decide to cooperate. By both agreeing to not clean up, they can increase their
income to $7,000 each.

e.
 Chapter 11 Monopolistic Competition and Oligopoly 135

Sal Monella
Clean up Don't Cleanup

5,000 -3,000
Clean up

5,000 6,000
Road Kill
Café

6,000 7,000
Don't
Cleanup
-3,000 7,000

The restaurants no longer have dominant strategies. For example, Road Kill’s best
action now depends on what Sal Monella chooses. Without cooperation, we would
need a more sophisticated analysis to predict an outcome. With cooperation,
however, the firms will decide not to clean up, and each will earn $7000.

9. a.

Study
Huck
Don’t Study

B F
Study
B A
Tom
Don’t C
Study
A
F C

b. Both Tom’s and Huck’s dominant strategy is to study.

c. Tom and Huck will employ their dominant strategies and will study for Professor
Clemens’ course. They will each pass their final exam and will be given “B’s.”
d. In this game, cooperation could not improve on the non-cooperative outcome, in
which both get Bs. Any agreement made by Huck and Tom to cooperate and change
the outcome would lower the grade for one or both of them.
136 Instructor’s Manual for Economics: Principles and Applications, 5e

e. Now the payoff table looks like this:

Huck
Study Don’t Study

B F
Study
B A
C
Tom

C C
Don’t
Study
F C

Tom still has the same dominant strategy as before (to study). Huck, however, no
longer has a dominant strategy, because if Tom doesn’t study, Huck is indifferent
between studying and not studying. However, because Huck knows that Tom will
always study (because that is Tom’s dominant strategy), Huck will also always study
in order to get a payoff of B. Colluding to not study would never be in anyone’s
interest.
10. a. Nike has a dominant strategy to go “high.” Adidas does not have a dominant
strategy.
b. This game will still have an outcome: Adidas can determine that Nike will go high,
so it will go high also.
c. Nike would choose the outrageously high price if it believed that Adidas would
follow. Nike would earn $1.2 million in profits and Adidas would earn $600,000
in profits. While Nike would have an incentive to charge the high price if Adidas
charged the outrageously high price, Nike would know that Adidas would follow
Nike’s pricing, and this would reduce Nike’s profit. Therefore, the outcome of the
game with Nike as price leader is that both charge the outrageously high price.
 Chapter 11 Monopolistic Competition and Oligopoly 137

MORE CHALLENGING
11. In the short run, the tax will shift each firm’s ATC curve upward but will have no
effect on their MC or MR curves. Therefore, price and output levels will remain the
same, but profit will be reduced by the amount of the tax. However, the tax will cause
the typical firm to go from earning zero economic profit to suffering a loss. In the long
run, exit will occur, shifting each remaining firm’s demand curve rightward, until each
firm is earning zero economic profit. This will occur at a higher price than without the
tax.
12. a. Neither player has a dominant strategy.
b. The outcome of the game cannot be determined from the information in the payoff
matrix using the tools learned in this chapter.
c. Player 2 has a dominant strategy; it is to choose “B”. When one player has a
dominant strategy, we can predict the outcome. Since Player 1 knows that Player 2
will choose “B,” Player 1 will maximize his payoff by also choosing “B.”

EXPERIENTIAL EXERCISE

If you look carefully, you can often find evidence of price leadership. For example, the Wall
Street Journal frequently runs stories about airfares. Typically, one airline will change its
fares—on certain routes or across the board—and other airlines will match those changes
within a day or two. When you find such a story, check back over the next few days. Did
other airlines match the leader, or was the leader forced to back off the price changes?