CHAPTER

13
Monopolistic Competition and
Oligopoly

Prepared by: Fernando

Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Monopolistic Competition
A monopolistically competitive
industry has the following
characteristics:
A large number of firms
No barriers to entry
Product differentiation

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Monopolistic Competition
Monopolistic competition is a common
form of industry (market) structure in the
United States, characterized by a large
number of firms, none of which can influence
market price by virtue of size alone.
Some degree of market power is achieved
by firms producing differentiated products.
New firms can enter and established firms
can exit such an industry with ease.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case for Product Differentiation

and Advertising
The advocates of free and open
competition believe that differentiated
products and advertising give the
market system its vitality and are the
basis of its power.
Product differentiation helps to ensure
high quality and efficient production.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case for Product Differentiation

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

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case Against Product

Differentiation and Advertising
Critics of product differentiation and
advertising argue that they amount to
nothing more than waste and
inefficiency.
Enormous sums are spent to create
minute, meaningless, and possibly
nonexistent differences among
products.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Case Against Product

Differentiation and Advertising
Advertising raises the cost of products
and frequently contains very little
information. Often, it is merely an
annoyance.
People exist to satisfy the needs of the
economy, not vice versa.
Advertising can lead to unproductive
warfare and may serve as a barrier to
entry, thus reducing real competition.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Oligopoly
An oligopoly is a form of industry
(market) structure characterized by a
few dominant firms. Products may
be homogeneous or differentiated.
The behavior of any one firm in an
oligopoly depends to a great extent
on the behavior of others.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Oligopoly Models
All kinds of oligopoly have one
thing in common:
The behavior of any given

oligopolistic firm depends on the

behavior of the other firms in the
industry comprising the oligopoly.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Collusion Model

A group of firms that gets together
and makes price and output
decisions jointly is called a cartel.
Collusion occurs when price- and
quantity-fixing agreements are
explicit.
Tacit collusion occurs when firms
end up fixing price without a specific
agreement, or when agreements are
implicit.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Price-Leadership Model

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

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Price-Leadership Model

Assumptions of the price-leadership model:

1. The industry is made up of one large firm and a

number of smaller, competitive firms;

2. The dominant firm maximizes profit subject to

the constraint of market demand and subject to

the behavior of the smaller firms;
3. The dominant firm allows the smaller firms to

sell all they want at the price the leader has set.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Price-Leadership Model

Outcome of the price-leadership model:

1. The quantity demanded in the industry is split

between the dominant firm and the group of

smaller firms.
2. This division of output is determined by the

amount of market power that the dominant firm

has.
3. The dominant firm has an incentive to push

smaller firms out of the industry in order to

establish a monopoly.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Predatory Pricing
The practice of a large, powerful firm
driving smaller firms out of the
market by temporarily selling at an
artificially low price is called
predatory pricing.
Such behavior became illegal in the
United States with the passage of
antimonopoly legislation around the
turn of the century.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Game Theory
Game theory analyzes oligopolistic
behavior as a complex series of
strategic moves and reactive
countermoves among rival firms.
In game theory, firms are assumed
to anticipate rival reactions.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Contestable Markets
A market is perfectly contestable if
entry to it and exit from it are
costless.
In contestable markets, even large
oligopolistic firms end up behaving
like perfectly competitive firms.
Prices are pushed to long-run
average cost by competition, and
positive profits do not persist.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Oligopoly is Consistent with

a Variety of Behaviors
The only necessary condition of oligopoly is
that firms are large enough to have some
control over price.
Oligopolies are concentrated industries. At
one extreme is the cartel, in essence,
acting as a monopolist. At the other
extreme, firms compete for small
contestable markets in response to
observed profits. In between are a number
of alternative models, all of which stress
the interdependence of oligopolistic firms.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Oligopoly and Economic Performance

Oligopolies, or concentrated industries, are
likely to be inefficient for the following reasons:
They are likely to price above marginal cost. This

means that there would be underproduction from

societys point of view.
Strategic behavior can force firms into deadlocks

that waste resources.

Product differentiation and advertising may pose a

real danger of waste and inefficiency.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair