Monopolistic Competition,

Oligopoly, and Strategic Pricing

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 two-
digit industry.
Two- and Four- Digit Industry Groups
Two-Digit Sectors Three-Digit Subsectors
44-45 Retail trade
48-49
Transportation
and warehousing
51 Information 513
Broadcasting and
telecommunications
52
Finance and
Insurance
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
Industry
Four-firm
concentration
ratio
Herfindahl
index
Meat packing 29 325
Book publishing 17 190
Greeting card publishing 84 2,840
Soap and detergent 60 1,306
Mens footwear 28 378
Computing equipment 43 793
Burial caskets 52 1,247
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
MC
ATC
MR D
Q
M
P
M

Price
0 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.
Perfect competition Monopolistic competition
Comparing Perfect and Monopolistic
Competition
MC
P
C
D
Q
C
Price
0 Quantity
ATC
P
M
MC
ATC
D MR
Q
M
Quantity 0
Price
Q
C
P
C

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.
D
2
The Kinked Demand Curve
D
1
MR
2
MR
1
Price
Quantity
0
Q
P
a
b
c
d
MC
0
MC
1
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
P
r
i
c
e

P
r
i
c
e

575
$800
700
600
500
400
300
200
100
0
(a) Firm's cost curves
1 2 3 4 5 6 7 8
Quantity (in thousands)
MC
ATC
$800
700
600
500
400
300
200
100
0
1 2 3 4 5 6 7 8 9 10 11
Monopolist
solution
MR
D
Competitive
solution
MC
(b) Industry: Competitive and monopolist solution
Quantity (in thousands)
Firm and Industry Duopoly Equilibrium When
One Firm Cheats
P
r
i
c
e

P
r
i
c
e

P
r
i
c
e

$800
700
600
500
400
300
200
100
0
$800
700
600
500
400
300
200
100
0
$900
800
700
600
500
400
300
200
100
0
550 550 550
1 2 3 4 5 6 7 1 2 3 4 5 6 7
A
MC
A TC
Quantity (in thousands)
(a) Noncheating firms loss
A
MC
A TC
Quantity (in thousands)
(b) Cheating firms profit
A
B
C
1 2 3 4 5 6 7 8
Quantity (in thousands)
(c) Cheating solution
Non-
cheating
firms
output
Cheating
firms
output
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.
B Cheats
B Does not
cheat
A Does not cheat A Cheats
B +$200,000
B 0
A 0
A +$200,000
B $75,000
A $75,000
A $75,000
B $75,000
The Payoff Matrix of Strategic
Pricing Duopoly
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 limited-
pricing 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.