11

Monopolistic Competition and Oligopoly

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Monopolistic Competition

Relatively large number of sellers Differentiated products Easy entry and exit Advertising

LO1

11-2

Monopolistically Competitive

Industry concentration Measured by: Four-firm concentration ratios Percentage of 4 largest firms
4-Firm CR =

Herfindahl index Sum of squared market shares

HI = (%S1)2 + (%S2)2 + (%S3)2 + . + (%Sn)2
LO1

Output of four largest firms Total output in the industry

11-3

Low Concentration Industries

(1) Industry (2)
4-Firm Concentration Ratio

(3) Herfindahl Index

207 262 263 205 240 319 206 117

(1) Industry
Metal windows and doors Womens dresses Ready mix concrete Wood trusses Stone products Metal stamping Wood pallets Sheet metal work

(2)
4-Firm Concentration Ratio

(3) Herfindahl Index

114 84 63 50 59 31 24 25

Asphalt paving Plastic pipe Textile bags

25 24 24 24 23 22 20 18

14 13 11 10 10 8 7 6

Bolts, nuts, and rivets

Plastic bags Quick printing Textile machinery Sawmills

Jewelry
Curtains and draperies

16
16

117
111

Signs
Retail bakeries

5
4

19
7

LO1

11-4

Price and Output in Monopolistic Comp

Demand is highly elastic Short run profit or loss Produce where MR=MC Long run normal profit Entry and exit Inefficient Product variety
LO2

11-5

The Short Run: Profit or Loss

MC ATC

Price and Costs

P1 A1

Economic Profit
MR = MC

D1

MR
0

Quantity

Q1

LO2

11-6

The Short Run: Profit or Loss

MC ATC

Price and Costs

A2 P2

Loss
D2 MR = MC

MR
0

Quantity

Q2

LO2

11-7

The Long Run: Only a Normal Profit

MC
ATC

Price and Costs

P3= A3

D3 MR = MC

MR
0

Quantity

Q3

LO2

11-8

Monopolistic Competition: Efficiency

Inefficient Productive inefficiency P > ATC Allocative inefficiency P > MC

LO2

11-9

Monopolistic Competition: Efficiency P=MC=Min ATC for pure competition (recall)

MC

Price and Costs

ATC
P3= A3

P4
Price is Lower D3 MR = MC Excess Capacity at Minimum ATC 0 Q3

MR Q4

Quantity
11-10

Monopolistic competition is not efficient

LO2

Product Variety

The firm constantly manages price,

product, and advertising. Better product differentiation Better advertising The consumer benefits by greater array of choices and better products. Types and Styles Brands and Quality
11-11

LO2

Oligopoly

A few large producers Homogeneous or differentiated

products Limited control over price Mutual interdependence Strategic behavior Entry barriers Mergers
11-12

LO3

Oligopolistic Industries

Four-firm concentration ratio 40% or more to be oligopoly Shortcomings Localized markets Inter-industry competition World price Dominant firms
LO3

11-13

High Concentration Industries

(1) Industry
Primary copper Cane sugar refining Cigarettes Household laundry equipment Beer Electric light bulbs Glass containers Turbines and generators

(2)
4-Firm Concentration Ratio

(3) Herfindahl Index

ND ND ND ND ND 2582 2582 ND

(1) Industry
Petrochemicals Small arms ammunition Motor vehicles Mens slacks and jeans Aircraft Breakfast cereals Household vacuum cleaners Phosphate fertilizers Tires Electronic computers Alcohol distilleries

(2)
4-Firm Concentration Ratio

(3) Herfindahl Index

2662 1901 2321 2515 ND 2521 2096 1853 1807 2662 1609 11-14

99 99 95 93 91 89 88 88

85 83 81 80 81 78 78 78 77 76 71

Household refrigerators and freezers

Primary aluminum
LO1

85 85

1986 ND

Game Theory Overview

Oligopolies display strategic pricing

behavior Mutual interdependence Collusion Incentive to cheat Prisoners dilemma

LO4

11-15

Game Theory Overview

RareAirs Price Strategy 2 competitors 2 price strategies Each strategy has a payoff matrix Greatest combined profit Independent actions stimulate a response
High Low B

Uptowns Price Strategy

A High $12

$12

$15
$6

C Low $15

$6

$8 $8

LO4

11-16

Game Theory Overview

RareAirs Price Strategy Independently lowered prices in expectation of greater profit leads to worst combined outcome Eventually low outcomes make firms return to higher prices.
High Low B

Uptowns Price Strategy

A High $12

$12

$15
$6

C Low $15

$6

$8 $8

LO4

11-17

3 Oligopoly Models

Kinked Demand Curve Collusive Pricing Price Leadership Reasons for 3 models Diversity of oligopolies Complications of interdependence

LO5

11-18

Kinked-Demand Theory

Noncollusive oligopoly Uncertainty about rivals reactions Rivals match any price change Rivals ignore any price change Assume combined strategy Match price reductions Ignore price increases
LO5

11-19

Kinked Demand Curve

Rivals Ignore Price Increase Price and Costs D2 P0 e MR2 f MC2

MC1

Price

P0 f

e D2 MR2 D1

Rivals Match g Price Decrease 0 MR1 Quantity Q0

g
D1 0 Q0 MR1 Quantity

LO5

11-20

Kinked Demand Curve

Criticisms Explains inflexibility, not price Prices are not that rigid Price wars

LO6

11-21

Cartels and Other Collusion

MC

Price and Costs

P0

ATC

A0
MR=MC

Economic Profit
Q0

MR

Quantity

LO6

11-22

Global Perspective

LO6

11-23

Overt Collusion

Cartels - a group of firms or nations

that collude Formally agreeing to the price Sets output levels for members Collusion is illegal in the United States OPEC
11-24

LO6

Obstacles to Collusion

Demand and cost differences Number of firms Cheating Recession New entrants Legal obstacles

LO6

11-25

Price Leadership Model

Price Leadership Dominant firm initiates price

changes Other firms follow the leader Use limit pricing to block entry of new firms Possible price war
11-26

LO6

Oligopoly and Advertising

Prevalent to compete with product

development and advertising Less easily duplicated than a price change Financially able to advertise

LO7

11-27

Positive Effects of Advertising

Low-cost way of providing information

to consumers Enhances competition Speeds up technological progress Can help firms obtain economies of scale

LO7

11-28

Oligopoly and Advertising

The Largest U.S. Advertisers, 2008 Company Procter & Gamble Verizon AT&T Advertising Spending Millions of $ $4831 $3700 $3073

General Motors
Johnson & Johnson Unilever Walt Disney Time Warner General Electric Sears

$2901
$2529 $2423 $2218 $2208 $2019 $1865

Source: Advertising Age http://www.adage.com

LO7

11-29

Negative Effects of Advertising

Can be manipulative Contains misleading claims that

confuse consumers Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product.

LO7

11-30

Global Perspective

LO7

11-31

Oligopoly and Efficiency

Oligopolies are inefficient Productively inefficient P > minATC Allocatively inefficient P > MC Qualifications Increased foreign competition Limit pricing Technological advance
LO7

11-32

Oligopoly in the Beer Industry

The beer industry is now an oligopoly. Changes in demand Change in tastes Consumed at home and mass
produced Changes in supply Technological advance Economies of scale
11-33