Monopolistic

Competition, Oligopoly,
and Strategic Pricing

Chapter 13

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 Laugher Curve
In Canada, there is a small radical group
that refuses to speak English and no one
can understand them.
They are called “separatists.”

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 Laugher Curve
In the United States we have the same
kind of group.
They are called “economists.”
— Nations Business

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 Introduction
■ Market structure is the focus real-world
competition.
■ Market structure refers to the physical
characteristics of the market within which
firms interact.

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 Introduction
■ Market structure involves the number of
firms in the market and the barriers to
entry.

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 Introduction
■ Perfect competition, with an infinite
number of firms, and monopoly, with a
single firm, are polar opposites.
■ Monopolistic competition and oligopoly lie
between these two extremes.

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 Introduction
■ Monopolistic competition is a market
structure in which there are many firms
selling differentiated products.
■ There are few barriers to entry.

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 Introduction
■ Oligopoly is a market structure in which
there are a few interdependent firms.
■ There are often significant barriers to
entry.

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 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?

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 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.

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 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.

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 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.

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 Two- and Four- Digit
Industry Groups

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 Determining Industry
Structure
■ Economists use one of two methods to
measure industry structure:
● The concentration ratio.
● The Herfindahl index.

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 Concentration Ratio
■ The concentration ratio is the value of
sales by the top firms of an industry stated
as a percentage of total industry sales.

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 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.

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 The Herfindahl Index
■ The Herfindahl index is an index of
market concentration calculated by adding
the squared value of the individual market
shares of all firms in the industry.

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 The Herfindahl Index
■ The Herfindahl index gives higher weights
to the largest firms in the industry because
it squares market shares.

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 The Herfindahl Index
■ The Herfindahl Index is used as a rule of
thumb by the Justice Department to
determine whether a merger be allowed to
take place.
● If the index is less than 1,000, the industry
is considered competitive thus allowing the
merger to take place.

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 Concentration Ratios and
the Herfindahl Index

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 Conglomerate Firms and
Bigness
■ Neither the four-firm concentration ratio or
the Herfindahl index gives a complete
picture of corporations’ bigness.

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 Conglomerate Firms and
Bigness
■ This is because many firms are
conglomerates – huge corporations
whose activities span various unrelated
industries.

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 The Importance of
Classifying Industry
Structure
■ The less concentrated industries are more
likely to resemble perfectly competitive
markets.

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 The Importance of
Classifying Industry
Structure
■ The number of firms in an industry play a
role in determining whether firms explicitly
take other firms’ actions into account.

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 The Importance of
Classifying Industry
Structure
■ It is unlikely that an monopolistically
competitive firm will explicitly take into
account rival firms’ responses to its
decisions.

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 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 rival’s expected
response to a decision you are making.

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 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.

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 Many Sellers
■ When there are many sellers, they do not
take into account rivals’ reactions.
■ The existence of many sellers makes
collusion difficult.
■ Monopolistically competitive firms act
independently.

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 Differentiated Products
■ The “many sellers” characteristic gives
monopolistic competition its competitive
aspect.
■ Product differentiation gives monopolistic
competition its monopolistic aspect.

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 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.

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 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.

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 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.

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 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.

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 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.

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 Monopolistic Competition
Price
MC

ATC
PM

MR D
0 QM Quantity

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 Comparing Perfect and
Monopolistic Competition
■ Both the monopolistic competitor and the
perfect competitor make zero economic
profit in the long run.

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 Comparing Perfect and
Monopolistic Competition
■ The perfect competitors demand curve as
perfectly elastic.
■ Zero economic profit means that it
produces at the minimum of the ATC
curve.

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 Comparing Perfect and
Monopolistic 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.

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 Comparing Perfect and
Monopolistic Competition
■ Increasing market share is a relevant
concern for a monopolistic competitor but
not for a perfect competitor.

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 Comparing Perfect and
Monopolistic Competition
Perfect competition Monopolistic competition
Price Price
MC MC
ATC ATC

PM
PC D PC

MR D
0 QC Quantity 0 QM QQuantity
C

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 Comparing Monopolistic
Competition with
Monopoly
■ It is possible for the monopolist to make
economic profit in the long-run.
■ No long-run economic profit is possible in
monopolistic competition.

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 Advertising and
Monopolistic Competition
■ Firms in a perfectly competitive market
have no incentive to advertise
■ Monopolistic competitors have a strong
incentive to do so.

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 Goals of Advertising
■ The goals of advertising include shifting
the demand curve to the right and making
it more inelastic.
■ Advertising shifts the ATC curve up.

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 Does Advertising Help or
Hurt Society?
■ There is a sense of trust in buying brands
we know.
■ If consumers are willing to pay for
“differentness,” it’s a benefit to them.

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 Characteristics Oligopoly
■ Oligopolies are made up of a small number
of mutually interdependent firms.
■ Each firm must take into account the
expected reaction of other firms.

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 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.

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 The Cartel Model
■ A cartel is a combination of firms that acts
as it were a single firm.
■ A cartel is a shared monopoly.
■ In the cartel model, an oligopoly sets a
monopoly price.

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 The Cartel Model
■ If oligopolies can limit the entry of other
firms and form a cartel, they can increase
the profits going to the firms in the cartel.

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 The Cartel Model
■ The cartel model of oligopoly:
● 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.

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 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.

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 Implicit Price Collusion
■ Sometimes the largest or most dominant
firm takes the lead in setting prices and the
others follow.

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 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.

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 Why Are Prices Sticky?
■ Informal collusion is an important reason
why prices are sticky.
■ Another is the kinked demand curve.

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 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.

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 The Kinked Demand
Curve
Price
a
b MC0
P
c
MC1 D1

d MR1
D2
0 Quantity
Q MR2

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 The Contestable Market
Model
■ According to the contestable market
model, barriers to entry and barriers to exit
determine a firm’s price and output
decisions.
● Even if the industry contains only one
firm, it could still be a competitive
market if entry is open.

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 The Contestable Market
Model
■ In the contestable market model, an
oligopoly with no barriers to entry sets a
competitive price.

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 Comparing the
Contestable Market and
Cartel Models
■ The stronger the ability of 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.
■ Oligopoly markets lie between these two
extremes.

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 Strategic Pricing and
Oligopoly
■ Both the cartel and contestable market
models use strategic pricing decisions –
firms set their price based on the expected
reactions of other firms.

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 New Entry as a Limit on
the Cartelization
Strategy
■ The threat from outside competition limits
oligopolies from acting as a cartel.
■ The newcomer may not want to cooperate
with the other firms.

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 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.

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 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.

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 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.

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 Game Theory and
Strategic Decision
Making
■ The prisoner’s dilemma is a well-known
game that demonstrates the difficulty of
cooperative behavior in certain
circumstances.

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 Game Theory and
Strategic Decision
Making
■ In the prisoner’s dilemma, where mutual
trust gets each one out of the dilemma,
confessing is the rational choice.

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 Prisoner’s Dilemma and a
Duopoly Example
■ The prisoners dilemma has its simplest
application when the oligopoly consists of
only two firms—a duopoly.

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 Prisoner’s 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.

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 Firm and Industry Duopoly
Cooperative Equilibrium
MC ATC
MC
$800 $800 Monopolist
solution
700 700

600 600 Competitive

575
solution
500 500

400 400
Price

Price
D
300 300

200 200
MR
100 100

0 0
1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 9 10 11
Quantity (in thousands) Quantity (in thousands)

(a) Firm's cost curves (b) Industry: Competitive and monopolist solution

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 Firm and Industry Duopoly
Equilibrium When One Firm
Cheats
$900
MC ATC MC ATC
$800 $800 800

700 700 700

C
600 600 600 B
550 550 550 A
500 500 500
A A Non- Cheating
400 400 400 cheating firm’s
Price

Price

Price
firm’s output
300 300 300 output

200 200 200

100 100 100

0 0 0
1 2 3 4 5 6 7 1 2 3 4 5 6 7 1 2 3 4 5 6 7 8
Quantity (in thousands) Quantity (in thousands) Quantity (in thousands)

(a) Noncheating firm’s loss (b) Cheating firm’s profit (c) Cheating solution

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 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.

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 The Payoff Matrix of
Strategic Pricing Duopoly
A Does not cheat A Cheats

A $75,000 A +$200,000
B Does not
cheat B $75,000 B – $75,000

A – $75,000 A0
B Cheats
B +$200,000 B0

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 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.

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 Oligopoly Models,
Structure, and
Performance
■ A monopoly is the least competitive,
perfectly competitive industries are the
most competitive.

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 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.

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 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 the majority of cases, the two approaches
come to the same conclusion.

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 Monopolistic
Competition, Oligopoly,
and Strategic Pricing

End of Chapter 13

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