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11 Chapter - Monopolistic Competition and Oligopoly CHAPTER ELEVEN MONOPOLISTIC COMPETITION AND OLIGOPOLY CHAPTER OVERVIEW Pure competition and pure monopoly are the exceptions, not the rule, in the U.S. economy. In this chapter, the two market structures that fall between the extremes are discussed. Monopolistic competition contains a considerable amount of competition mixed with a small dose of monopoly power. Oligopoly, in contrast, implies a blend of greater monopoly power and less competition. First, monopolistic competition is defined, listing important characteristics, typical examples, and efficiency outcomes. Next we turn to oligopoly, surveying the possible courses of price, output, and advertising behavior that oligopolistic industries might follow. Finally, oligopoly is assessed as to whether it is an efficient or inefficient market structure. INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. List the characteristics of monopolistic competition. Explain how product differentiation occurs in similar products. Determine the profit-maximizing price and output level for a monopolistic competitor in the short run when given cost and demand data. Explain why a monopolistic competitor will realize only normal profit in the long run. Identify the reasons for excess capacity in monopolistic competition. Explain how product differentiation may offset these inefficiencies. Describe the characteristics of an oligopolistic industry. Differentiate between homogeneous and differentiated oligopolies. Identify and explain the most important causes of oligopoly. Describe and compare the concentration ratio and the Herfindahl index as ways to measure market dominance in an industry. Use a profit-payoffs matrix (game theory) to explain the mutual interdependence of two rival firms and why oligopolists might tempt to cheat on a collusive agreement. Identify three possible models of oligopolistic price-output behavior. Use the kinked demand curve theory to explain why prices tend to be inflexible. Explain the major advantages of collusion for oligopolistic producers. List the obstacles to collusion behavior. Explain price leadership as a form of tacit collusion. Explain why oligopolies may prefer nonprice competition over price competition. List the positive and negative effects of advertising. Explain why some economists assert that oligopoly is less desirable than pure monopoly. Explain the three ways that the power of oligopolists may be diminished. 11-1 Chapter 11 - Monopolistic Competition and Oligopoly 21. Define and explain the terms and concepts listed at the end of the chapter. LECTURE NOTES I. Learning objectives In this chapter students will learn: A. The characteristics of monopolistic competition. B. Why monopolistic competitors earn only a normal profit in the long run. C. The characteristics of oligopoly. D. How game theory relates to oligopoly. E. Why the demand curve of an oligopolist may be kinked. F. The incentives and obstacles to collusion among oligopolists. G. The potential positive and negative effects of advertising. II. Review Table 11.1. III. Monopolistic Competition: Characteristics and Occurrence A. Monopolistic competition refers to a market situation in which a relatively large number of sellers offer similar but not identical products. 1. Each firm has a small percentage of the total market. 2. Collusion is nearly impossible with so many firms. 3. Firms act independently; the actions of one firm are ignored by the other firms in the industry. B. Product differentiation and other types of nonprice competition give the individual firm some degree of monopoly power that the purely competitive firm does not possess. 1. Product differentiation may be physical (qualitative). 2. Services and conditions accompanying the sale of the product are important aspects of product differentiation. 3. Location is another type of differentiation. 4. Brand names and packaging lead to perceived differences. 5. Product differentiation allows producers to have some control over the prices of their products. C. Similar to pure competition, under monopolistic competition firms can enter and exit these industries relatively easily. Trade secrets or trademarks may provide firms some monopoly power. D. Examples of real-world industries that fit this model are found in Table 11.1. IV. Monopolistic Competition: Price and Output Determination 11-2 Chapter 11 - Monopolistic Competition and Oligopoly A. The firms demand curve is highly, but not perfectly, elastic. It is more elastic than the monopolys demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition, because the sellers product is differentiated from its rivals, so the firm has some control over price. B. In the short-run situation, the firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The profit-maximizing situation is illustrated in Figure 11.1a (Key Graph), and the loss-minimizing situation is illustrated in Figure 11.1b (Key Graph). C. In the long-run situation, the firm will tend to earn a normal profit only, that is, it will break even (Figure 11.1c Key Graph). 1. Firms can enter the industry easily and will if the existing firms are making an economic profit. As firms enter the industry, this decreases the demand curve facing an individual firm as buyers shift some demand to new firms; the demand curve will shift until the firm just breaks even. If the demand shifts below the break-even point (including a normal profit), some firms will leave the industry in the long run. 2. If firms were making a loss in the short run, some firms will leave the industry. This will raise the demand curve facing each remaining firm as there are fewer substitutes for buyers. As this happens, each firm will see its losses disappear until it reaches the break-even (normal profit) level of output and price. 3. Complicating factors are involved with this analysis. a. Some firms may achieve a measure of differentiation that is not easily duplicated by rivals (brand names, location, etc.) and can realize economic profits even in the long run. b. There is some restriction to entry, such as financial barriers that exist for new small businesses, so economic profits may persist for existing firms. c. Long-run below-normal profits may persist, because producers like to maintain their way of life as entrepreneurs despite the low economic returns. V. Monopolistic Competition and Economic Efficiency A. Review the definitions of allocative and productive efficiency: 1. Allocative efficiency occurs when price = marginal cost, i.e., where the right amount of resources are allocated to the product. 2. Productive efficiency occurs when price = minimum average total cost, i.e., where production occurs using the least-cost combination of resources. 3. The gap between price and marginal cost for each firm creates an efficiency (or deadweight) loss industry-wide. B. Excess capacity will tend to be a feature of monopolistically competitive firms (Figure 11.2 or Figure 11.1c Key Graph). 1. Price exceeds marginal cost in the long run, suggesting that society values additional units that are not being produced. 2. Firms do not produce the lowest average-total-cost level of output (Figure 11.2). 3. Average costs may also be higher than under pure competition, due to advertising and other costs involved in differentiation. VI. Monopolistic Competition: Product Variety 11-3 Chapter 11 - Monopolistic Competition and Oligopoly A. A monopolistically competitive producer may be able to postpone the long-run outcome of just normal profits through product development and improvement and advertising. B. Compared with pure competition, this suggests possible advantages to the consumer. 1. Developing or improving a product can provide the consumer with a diversity of choices. 2. Product differentiation is at the heart of the tradeoff between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem. C. The monopolistically competitive firm juggles three factorsproduct attributes, product price, and advertisingin seeking maximum profit. 1. This complex situation is not easily expressed in a simple economic model such as Figure 11.1. Each possible combination of price, product, and advertising poses a different demand and cost situation for the firm. 2. In practice, the optimal combination cannot be readily forecast but must be found by trial and error. VII. Oligopoly: Characteristics and Occurrence A. Oligopoly exists where a few large firms producing a homogeneous or differentiated product dominate a market. 1. There are few enough firms in the industry that firms are mutually interdependenteach must consider its rivals reactions in response to its decisions about prices, output, and advertising. 2. Some oligopolistic industries produce standardized products (steel, zinc, copper, cement), whereas others produce differentiated products (automobiles, detergents, greeting cards). B. Barriers to entry: 1. Economies of scale may exist due to technology and market share. 2. The capital investment requirement may be very large. 3. Other barriers to entry may exist, such as patents, control of raw materials, preemptive and retaliatory pricing, substantial advertising budgets, and traditional brand loyalty. C. Although some firms have become dominant as a result of internal growth, others have gained this dominance through mergers. D. Measuring industry concentration (Table 11.2): 1. Concentration ratios are one way to measure market dominance. The four-firm concentration ratio gives the percentage of total industry sales accounted for by the four largest firms. The concentration ratio has several shortcomings in terms of measuring competitiveness. a. Some markets are local rather than national, and a few firms may dominate within the regional market. b. Interindustry competition sometimes exists, so dominance in one industry may not mean that competition from substitutes is lacking. c. World trade has increased competition, despite high domestic concentration ratios in some industries like the auto industry. 11-4 Chapter 11 - Monopolistic Competition and Oligopoly d. Concentration ratios fail to measure accurately the distribution of power among the leading firms. 2. The Herfindahl index is another way to measure market dominance. It measures the sum of the squared market shares of each firm in the industry, so that much larger weight is given to firms with high market shares. A high Herfindahl index number indicates a high degree of concentration in one or two firms. A lower index might mean that the top four firms have rather equal shares of the market, for example, 25 percent each (25 squared x 4 = 2,500). A high index might be where one firm has 80 percent of the industry and the others have 6 percent each for a total of 6400 + (6 squared x 3) = 6,508. 3. Concentration tells us nothing about the actual market performance of various industries in terms of how vigorous the actual competition is among existing rivals. VIII. Oligopoly Behavior: A Game Theory Overview A. Oligopoly behavior is similar to a game of strategy, such as poker, chess, or bridge. Each players action is interdependent with other players actions. Game theory can be applied to analyze oligopoly behavior. A two-firm model or duopoly will be used. B. Figure 11.3 illustrates the profit payoffs for firms in a duopoly in an imaginary athletic-shoe industry. Pricing strategies are classified as high-priced or low-priced, and the profits in each case will depend on the rivals pricing strategy. C. Mutual interdependence is demonstrated by the following: RareAirs best strategy is to have a low-price strategy if Uptown follows a high-price strategy. However, Uptown will not remain there, because it is better for Uptown to follow a low-price strategy when RareAir has a low-price strategy. Each possibility points to the interdependence of the two firms. This is a major characteristic of oligopoly. D. Another conclusion is that oligopoly can lead to collusive behavior. In the athletic-shoe example, both firms could improve their positions if they agreed to both adopt a high-price strategy. However, such an agreement is collusion and is a violation of U.S. anti-trust laws. E. If collusion does exist, formally or informally, there is much incentive on the part of both parties to cheat and secretly break the agreement. For example, if RareAir can get Uptown to agree to a high-price strategy, then RareAir can sneak in a low-price strategy and increase its profits. F. CONSIDER THIS Creative Strategic Behavior Strategic behavior can come in the form of pricing decisions, product differentiation, or through creative marketing (creating perceived product differences). It can apply to either competitive or collusive behavior (including cheating on collusive agreements). G. CONSIDER THIS The Prisoners Dilemma In the game in Figure 11.3, both firms realize they would make higher profits if each used a high price strategy. Bet each firm ends up choosing a low price strategy because it fears that it will be worse off if the other firm uses a low price strategy against it. IX. Three oligopoly models are used to explain oligopolistic price-output behavior. (There is no single model that can portray this market structure due to the wide diversity of oligopolistic situations and mutual interdependence that makes predictions about pricing and output quantity precarious.) A. The kinked-demand model assumes a noncollusive oligopoly. (See Key Graph 11.4) 11-5 Chapter 11 - Monopolistic Competition and Oligopoly 1. The individual firms believe that rivals will match any price cuts. Therefore, each firm views its demand as inelastic for price cuts, which means they will not want to lower prices since total revenue falls when demand is inelastic and prices are lowered. 2. With regard to raising prices, there is no reason to believe that rivals will follow suit because they may increase their market shares by not raising prices. Thus, without any prior knowledge of rivals plans, a firm will expect that demand will be elastic when it increases price. From the total-revenue test, we know that raising prices when demand is elastic will decrease revenue. Therefore, the noncolluding firm will not want to raise prices. 3. This analysis is one explanation of the fact that prices tend to be inflexible in oligopolistic industries. 4. Figure 11.4a (Key Graph) illustrates the situation relative to an initial price level of P. It also shows that marginal cost has substantial ability to increase at price P before it no longer equals MR; thus, changes in marginal cost will also not tend to affect price. 5. There are criticisms of the kinked-demand theory. a. There is no explanation of why P is the original price. b. In the real world oligopoly prices are often not rigid, especially in the upward direction. B. Cartels and collusion agreements constitute another oligopoly model. (See Figure 11.5) 1. Game theory suggests that collusion is beneficial to the participating firms. 2. Collusion reduces uncertainty, increases profits, and may prohibit the entry of new rivals. 3. A cartel may reduce the chance of a price war breaking out particularly during a general business recession. 4. The kinked-demand curves tendency toward rigid prices may adversely affect profits if general inflationary pressures increase costs. 5. To maximize profits, the firms collude and agree to a certain price. Assuming the firms have identical cost, demand, and marginal-revenue date the result of collusion is as if the firms made up a single monopoly firm. 6. A cartel is a group of producers that creates a formal written agreement specifying how much each member will produce and charge. The Organization of Petroleum Exporting Countries (OPEC) is the most significant international cartel. 7. Cartels are illegal in the U.S., thus any collusion that exists is covert and secret. Examples of these illegal, covert agreements include the 1993 collusion between dairy companies convicted of rigging bids for milk products sold to schools and, in 1996, American agribusiness Archer Daniels Midland, three Japanese firms, and a South Korean firm were found to have conspired to fix the worldwide price and sales volume of a livestock feed additive. 8. Tacit understandings or gentlemens agreements, often made informally, are also illegal but difficult to detect. 9. There are many obstacles to collusion: a. Differing demand and cost conditions among firms in the industry; b. A large number of firms in the industry; c. The incentive to cheat; 11-6 Chapter 11 - Monopolistic Competition and Oligopoly d. Recession and declining demand (increasing ATC); e. The attraction of potential entry of new firms if prices are too high; and f. Antitrust laws that prohibit collusion. C. Price leadership is a type of gentlemans agreement that allows oligopolists to coordinate their prices legally; no formal agreements or clandestine meetings are involved. The practice has evolved whereby one firm, usually the largest, changes the price first and, then, the other firms follow. 1. Several price leadership tactics are practiced by the leading firm. a. Prices are changed only when cost and demand conditions have been altered significantly and industry-wide. b. Impending price adjustments are often communicated through publications, speeches, and so forth. Publicizing the need to raise prices elicits a consensus among rivals. c. The new price may be below the short-run profit-maximizing level to discourage new entrants. 2. Price leadership in oligopoly occasionally breaks down and sometimes results in a price war. A recent example occurred in the breakfast cereal industry in which Kellogg had been the traditional price leader. X. Oligopoly and Advertising A. Product development and advertising campaigns are more difficult to combat and match than lower prices. B. Oligopolists have substantial financial resources with which to support advertising and product development. C. Advertising can affect prices, competition, and efficiency both positively and negatively. 1. Advertising reduces a buyers search time and minimizes these costs. 2. By providing information about competing goods, advertising diminishes monopoly power, resulting in greater economic efficiency. 3. By facilitating the introduction of new products, advertising speeds up technological progress. 4. If advertising is successful in boosting demand, increased output may reduce long run average total cost, enabling firms to enjoy economies of scale. 5. Not all effects of advertising are positive. a. Much advertising is designed to manipulate rather than inform buyers. b. When advertising either leads to increased monopoly power, or is self-canceling, economic inefficiency results. 11-7 Chapter 11 - Monopolistic Competition and Oligopoly XI. The economic efficiency of an oligopolistic industry is hard to evaluate. A. Allocative and productive efficiency are not realized because price will exceed marginal cost and, therefore, output will be less than minimum average-cost output level (Figure 23.5). Informal collusion among oligopolists may lead to price and output decisions that are similar to that of a pure monopolist while appearing to involve some competition. B. The economic inefficiency may be lessened because: 1. Foreign competition has made many oligopolistic industries much more competitive when viewed on a global scale. 2. Oligopolistic firms may keep prices lower in the short run to deter entry of new firms. 3. Over time, oligopolistic industries may foster more rapid product development and greater improvement of production techniques than would be possible if they were purely competitive. (See Chapter 24) XII. LAST WORD: The Beer Industry: Oligopoly Brewing? A. In 1947 there were 400 independent brewers in the U.S.; by 1967 the number had declined to 124; by 1987 the number was 33. B. In 1947, the five largest brewers sold 19 percent of the nations beer; currently, the big four brewers sell 87 percent of the total. Anheuser-Busch and Miller alone sell 69 percent. C. Demand has changed. 1. Tastes have shifted from stronger-flavored beers to lighter, dryer products. 2. Consumption has shifted from taverns to homes, which has meant a different kind of packaging and distribution. D. Supply-side changes have also occurred. 1. Technology has changed, speeding up bottling and can closing. 2. Large plants can reduce labor costs by automation. 3. Large fixed costs are spread over larger outputs. 4. Mergers have occurred but are not the fundamental cause of increased concentration. 5. Advertising and product differentiation have been important in the growth of some firms, especially Miller. E. There continues to be some competition from imported beers (about 9 percent of the market) and, to a lesser extent, microbreweries (about 3 percent of the market). APPENDIX TO CHAPTER 11: ADDITIONAL GAME THEORY APPLICATIONS I. A One-Time Game: Strategies and Equilibrium A. A one-time game is one where the firms select their optimal strategies in a single time period without regard to possible interactions in subsequent time periods. A simultaneous game is one where firms choose their strategies at the same time. B. A positive-sum game is one where the sum of the two firms outcomes is positive, a zerosum game is one where the sum of the two firms outcomes is zero, and a negative-sum game is one where the sum of the two firms outcomes is negative. 11-8 Chapter 11 - Monopolistic Competition and Oligopoly C. A dominant strategy is an option that is better than any alternative option regardless of what the other firm does. D. A Nash Equilibrium is an outcome of a game from which neither rival wants to deviate. That is, neither of the firms have an incentive to change their behavior. D. Figure 1 is an example of a one-time, positive-sum game II. Credible and Empty Threats A. A credible threat is a statement of coercion by one firm that is believable by the other firm. A threatening statement may induce the other firm to deviate from its optimal strategy without the credible threat. B. An empty threat (non-credible threat) is a statement of coercion that is not believable. III. Repeated Games and Reciprocity Strategies A. A repeated game is one that recurs more than once. In this case the optimal strategy may be to cooperate and restrain oneself from competing as hard as possible so long as the other firm reciprocates by also not competing as hard as possible. B. See Figure 2 for an example. IV. First-Mover Advantages and Preemption of Entry A. A sequential game is one where one of the firms moves first and commits to a strategy. other The firm can then base its decision on the choice made by the first-mover. B. The final outcome of the game ma depend critically upon which firm moves first since the first mover may have the opportunity to establish a Nash equilibrium that works in its favor. This is referred to as the first-mover advantage. (Figure 3) C. However, this first-mover advantage in the real world is typically risky in nature. For example, the benefit may not materialize if the forecast of future profit does not materialize. See the Wal-Mart and Krispy-Cream examples in the text. ANSWERS TO END-OF-CHAPTER QUESTIONS 11-1 How does monopolistic competition differ from pure competition in its basic characteristics? From pure monopoly? Explain fully what product differentiation may involve. Explain how the entry of firms into its industry affects the demand curve facing a monopolistic competitor and how that, in turn, affects its economic profit. In monopolistic competition there are many firms but not the very large numbers of pure competition. The products are differentiated, not standardized. There is some control over price in a narrow range, whereas the purely competitive firm has none. There is relatively easy entry; in pure competition, entry is completely without barriers. In monopolistic competition, there is much nonprice competition, such as advertising, trademarks, and brand names. In pure competition, there is no nonprice competition. In pure monopoly there is only one firm. Its product is unique and there are no close substitutes. The firm has much control over price, being a price maker. Entry to its industry is blocked. Its advertising is mostly for public relations. 11-9 Chapter 11 - Monopolistic Competition and Oligopoly Product differentiation may well only be in the eye of the beholder, but that is all the monopolistic competitor needs to gain an advantage in the marketprovided, of course, the consumer looks upon the assumed difference favorably. The real differences can be in quality, in services, in location, or even in promotion and packaging, which brings us back to where we started: possibly nonexistent differences. To the extent that product differentiation exists in fact or in the mind of the consumer, monopolistic competitors have some limited control over price, for they have built up some loyalty to their brand. When economic profits are present, additional rivals will be attracted to the industry because entry is relative easy. As new firms enter, the demand curve faced by the typical firm will shift to the left (fall). Because of this, each firm has a smaller share of total demand and now faces a larger number of close-substitute products. This decline firms demand reduces its economic profit. 11-2 (Key Question) Compare the elasticity of the monopolistically competitors demand curve with that of a pure competitor and a pure monopolist. Assuming identical long -run costs, compare graphically the prices and output that would result in the long run under pure competition and under monopolistic competition. Contrast the two market structures in terms of productive and allocative efficiency. Explain: Monopolistically competitive industries are characterized by too many firms, each of which produces too little. The monopolistic competitors demand curve is less elastic than a pure competitor and more elastic than a pure monopolist. Your graphs should look like Figures 11.12 and 11.1 in the chapters. Price is higher and output lower for the monopolistic competitor. Pure competition: P = MC (allocative efficiency); P = minimum ATC (productive efficiency). Monopolistic competition: P > MC (allocative efficiency) and P > minimum ATC (productive inefficiency). Monopolistic competitors have excess capacity; meaning that fewer firms operating at capacity (where P = minimum ATC) could supply the industry output. 11-3 Monopolistic competition is monopoly up to the point at which consumers become willing to buy close-substitute products and competitive beyond that point. Explain. As long as consumers prefer one product over another regardless of relative prices, the seller of the product is a monopolist. But in monopolistic competition this happy state is limited because there are many other firms producing similar products. When one firms prices get too high (as viewed by consumers), people will switch brands. At this point, our firm has entered the competitive zone unwillingly, which is why monopolistically competitive firms are forever trying to find ways to differentiate their products more thoroughly and thus to gain more monopoly price-setting power. 11-4 Competition in quality and in service may be just as effective as price competition in giving buyers more for their money. Do you agree? Why? Explain why monopolistically competitive firms frequently prefer nonprice to price competition. This can certainly be true. It depends on how much consumers value quality and service, and are willing to pay for it through higher product prices. In a monopolistically competitive market the consumer can buy a substitute brand for a lower price, if the consumer prefers a lower price to better quality and service. The monopolistically competitive firm frequently prefers nonprice competition to price competition, because the latter can lead to the firm producing where P = ATC and thus making no economic profit or, worse, producing in the short run where P < ATC and thus losing money, with the possibility of eventually going out of business. 11-10 Chapter 11 - Monopolistic Competition and Oligopoly Nonprice competition, on the other hand, if successful, results in more monopoly power: The firms product has become more differentiated from now less-similar competitors in the industry. This increase in monopoly power allows the firm to raise its price with less fear of losing customers. Of course, the firm must still follow the MR = MC rule, but its success in nonprice competition has shifted both the demand and MR curves upward to the right. This results in simultaneously a larger output, a higher price, and more economic profits. 11-5 Critically evaluate and explain: a. In monopolistically competitive industries, economic profits are competed away in the long run; hence, there is no valid reason to criticize the performance and efficiency of such industries. b. In the long run, monopolistic competition leads to a monopolistic price but not to monopolistic profits. (a). The first part of the statement may well be true, but it does not lead logically to the second part. The criticism of monopolistic competition is not related to the profit level but to the fact that the firms do not produce at the point of minimum ATC and do not equate price and MC. This is the inevitable consequence of imperfect competition and its downward sloping demand curves. With P > minimum ATC, productive efficiency is not attained. The firm is producing too little at too high a cost; it is wasting some of its productive capacity. With P > MC, the firm is not allocating resources in accordance with societys desires; the value society sets on the product (P) is greater than the cost of producing the last item (MC). (b) The statement is often true, since competition of close substitutes tends to compete price of the average firm down to equality with ATC. Thus, there is no economic profit. However, the firm is producing where its (moderately) monopolistically downward-sloping demand curve is tangent to the ATC curve, short of the point of minimum ATC and thus at a higher than purely competitive price. In other words, it is at a monopolistic price. 11-6 Why do oligopolies exist? List five or six oligopolists whose products you own or regularly purchase. What distinguishes oligopoly from monopolistic competition? Oligopolies exist for several reasons, the most common probably being economies of scale. If these are substantial, as they are in the automobile industry, for example, only very large firms can produce at minimum average cost. This makes it virtually impossible for new firms to enter the industry. A small firm could not produce at minimum cost and would soon be competed out of the business; yet to start at the required very large scale would take far more money than an unestablished firm is likely to be able to raise before proving it will be profitable. Other barriers to entry include ownership of patents by the oligopolists and, possibly, massive advertising that gives would-be newcomers no chance to establish a presence in the publics mind. Finally, there is the urge to merge. Mergers have the clear advantage of reducing competitionof giving the emerging oligopolists more monopoly power. Also, they may result in more economies of scale and thereby increase that barrier to new entry. Oligopolies with which we deal include manufacturers of automobiles, ovens, refrigerators, personal computers, gasoline, and courier services. Oligopoly is distinguished from monopolistic competition by being composed of few firms (not many); by being mutually interdependent with regard to price (instead of control within narrow limits); by having differentiated or homogeneous products (not all differentiated); and by having significant obstacles to entry (not easy entry). Both engage in much nonprice competition. 11-11 Chapter 11 - Monopolistic Competition and Oligopoly 11-7 (Key Question) Answer the following questions, which relate to measures of concentration: a. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent? What are the shortcomings of concentration ratios as measures of monopoly power? b. Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent of total industry sales. For the five firms in industry B, the figures are 60, 25, 5, 5, and 5 percent. Calculate the Herfindahl index for each industry and compare their likely competitiveness. A four-firm concentration ratio of 60 percent means the largest four firms in the industry account for 60 percent of sales; a four-firm concentration ratio of 90 percent means the largest four firms account for 90 percent of sales. Shortcomings: (1) they pertain to the nation as a whole, although relevant markets may be localized; (2) they do not account for interindustry competition; (3) the data are for U.S. productsimports are excluded; and (4) they dont reveal the dispersion of size among the top four firms. Herfindahl index for A: 2,400 (= 900 + 900 + 400 + 100 + 100). For B: 4,300 (= 3,600 + 625 + 25 + 25 +25). We would expect industry A to be more competitive than Industry B, where one firm dominates and two firms control 85 percent of the market. 11-8 (Key Question) Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit figures are in thousands. a. Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries. b. Assuming no collusion between C and D, what is the likely pricing outcome? c. In view of your answer to 8b, explain why price collusion is mutually profitable. Why might there be a temptation to cheat on the collusive agreement? The matrix shows the four possible profit outcomes for each of two firms, depending on which of the two price strategies each follows. Example: If C sets price at $35 and D at $40, Cs profits will be $59,000, and Ds $55,000. (a) C and D are interdependent because their profits depend not just on their own price, but also on the other firms price. (b) Likely outcome: Both firms will set price at $35. If either charged $40, it would be concerned the other would undercut the price and its profit by charging $35. At $35 for both; Cs profit is $55,000, Ds, $58,000. 11-12 Chapter 11 - Monopolistic Competition and Oligopoly (c) Through price collusionagreeing to charge $40each firm would achieve higher profits (C = $57,000; D = $60,000). But once both firms agree on $40, each sees it can increase its profit even more by secretly charging $35 while its rival charges $40. 11-9 (Key Question) What assumptions about a rivals response to price changes underlie the kinkeddemand curve for oligopolists? Why is there a gap in the oligopolists marginal-revenue curve? How does the kinked demand curve explain price rigidity in oligopoly? What are the shortcomings of the kinked-demand model? Assumptions: (1) Rivals will match price cuts: (2) Rivals will ignore price increases. The gap in the MR curve results from the abrupt change in the slope of the demand curve at the going price. Firms will not change their price because they fear that if they do their total revenue and profits will fall. Shortcomings of the model: (1) It does not explain how the going price evolved in the first place; (2) it does not allow for price leadership and other forms of collusion. 11-10 Why might price collusion occur in oligopolistic industries? Assess the economic desirability of collusive pricing. What are the main obstacles to collusion? Speculate as to why price leadership is legal in the United States, whereas price fixing is not. Price wars are a form of competition that can benefit the consumer but can be highly detrimental to producers. As a result, oligopolists are naturally drawn to the idea of price-fixing among themselves, i.e., colluding with regard to price. In a recession, it is nice to know whether ones rivals will cut prices or quantity, so that a mutually satisfactory solution can be reached. It is also convenient to be able to agree on what price to set to bankrupt any would-be interloper in the industry. From the viewpoint of society, collusive pricing is not economically desirable. From the oligopolys viewpoint it is highly desirable since, when entirely successful, it allows the oligopoly to set price and quantity as would a profit-maximizing monopolist. The main obstacles to collusion are demand and cost differences (which result in different points of equality of MR and MC); the number of firms (the more firms, the lower the possibility of getting together and reaching sustainable agreement); cheating (it pays to cheat by selling more below the agreed-on priceprovided the other colluders do not find out); recession (when demand slumps, the urge to shave pricesto cheatbecomes much greater); potential entry (the above-equilibrium price that is the reason for collusion may entice new firms into this profitable industryand it may be hard to get new entrants into the combine, quite apart from the unfortunate increase in supply they will cause); legal obstacles (for a century, antitrust laws have made collusion illegal). Price leadership is legal because although the firms may follow the dominant firms price, they are not compelled to. Also, the tacit agreement on price does not also include an agreement to control quantity and to divide up the market. 11-11 (Key Question) Why is there so much advertising in monopolistic competition and oligopoly? How does such advertising help consumers and promote efficiency? Why might it be excessive at times? Two ways for monopolistically competitive firms to maintain economic profits are through product development and advertising. Also, advertising will increase the demand for the firms product. The oligopolist would rather not compete on a basis of price. Oligopolists can increase their market share through advertising that is financed with economic profits from past advertising campaigns. Advertising can operate as a barrier to entry. Advertising provides information about new products and product improvements to the consumer. Advertising may result in an increase in competition by promoting new products and product improvements. It may also result in increased output for a firm, pushing it down its ATC curve and closer to productive efficiency (P = minimum ATC). 11-13 Chapter 11 - Monopolistic Competition and Oligopoly Advertising may result in manipulation and persuasion rather than information. An increase in brand loyalty through advertising will increase the producers monopoly power. Excessive advertising may create barriers to entry into the industry. 11-12 (Advanced analysis) Construct a game-theory matrix involving two firms and their decisions on high versus low advertising budgets and the effects of each on profits. Show a circumstance in which both firms select high advertising budgets even though both would be more profitable with low advertising budgets. Why wont they unilaterally cut their advertising budgets? Firm As Advertising Low High Budget Budget Firm Bs Advertising Low Budget $100 $100 $60 $120 High Budget $120 $60 $80 $80 Profits from each advertising strategy appear in the cells In the payoff matrix above, each firm can choose between a low and high advertising budget. If, for example, Firm A chooses a high budget and Firm B a low budget, Firm As profit will be $120, and Firm Bs only $60. The payoff matrix suggests that both firms should have high advertising budgets, but if both choose to do so, they will both be worse off relative to if they both had low budgets. Neither firm will reduce its budget because if it does and its rival doesnt, the firm reducing will lose profits to the other firm. Unless they collude, the firms will both end up with large advertising budgets and reduced profits. 11-13 (Last Word) What firm dominates the beer industry? What demand and supply factors have contributed to fewness in this industry? Anheuser-Busch is the dominant firm in the industry. On the demand side, there is evidence that by the 1970s tastes had changed in favor of lighter, drier beers produced by the larger brewers. Second, there has been a shift from consumption in taverns to home consumption, which means higher sales of packaged containers that can be shipped long distances. On the supply side, technological advances have increased bottling lines, so that the number of cans filled per hour rose from 900 in 1965 to over 2000 in 1990s; large plants have been able to take advantage of economies of scale; television advertising also favors the large producers; and extensive product differentiation exists despite the smaller number of firms, which has enabled these firms to expand still further. Chapter 11-Appendix Questions 11-14 Chapter 11 - Monopolistic Competition and Oligopoly 11A-1 Is the game shown by Figure 11.3 in the chapter (not this appendix) a zero-sum game or is it a positive-sum game? How can you tell? Are there dominant strategies in this game? If so, what are they? What cell represents a Nash equilibrium and why? Explain why it is so difficult for Uptown and RareAir to achieve and maintain a more favorable cell than the Nash equilibrium in this single-period pricing game. This is a positive-sum game since the sum of the payoffs for each firm is positive. Yes, the dominant strategy is for both firms to use a low price strategy. This strategy will provide the highest payoff regardless of what the other firm does. The Nash equilibrium is for both firms to play the low price strategy (low-low cell) since neither firm has an incentive to deviate from this strategy given the strategy of the competing firm. The more favorable outcome would be for both firms to collude and use the high price strategy. Both firms would earn a profit of $12 rather than $8 in this case. The problem is that both firms have an incentive to deviate from this strategy given that the other firm is playing the high price strategy. By pricing low, given the other firm is pricing high, profits increase to $15 (rather than $12 through cooperation). 11A-2 Refer to the payoff matrix in question 8 at the end of this chapter. First, assume this is a one-time game. Explain how the $60/$57 outcome might be achieved through a credible threat. Next, assume this is a repeated game (rather than a one-time game) and that the interaction between the two firms occurs indefinitely. Why might collusion with a credible threat not be necessary to achieve the $60/$57 outcome? Either firm could threaten to flood the market to induce the other firm to choose the $40 pricing strategy. This threat is likely to be credible since both firms benefit from the $40 pricing strategy. In a repeated game setting this threat may not be necessary since the present value of cooperation may exceed the one time gains from deviating from the $40-$40 pricing strategy. Thus, each firm may have incentive not to deviate from the $40-$40 strategy out of fear of lower profits in the future. 11A-3 Refer to the payoff matrix below. Assuming this is a sequential game with no collusion, what is the outcome if Firm A moves first to build a new type of commercial aircraft? Explain why first-mover strategies in the real world are only as good as the profit projections on which they are based. How could a supposed win from moving first turn out to be a big loss, whereas the loss of being preempted turn out to be a blessing in disguise? 11-15 Chapter 11 - Monopolistic Competition and Oligopoly The dominant strategy for firm B is to build. The payoff from this build-strategy is greater than the alternative not build, regardless of what firm A does. Since firm A will recognize this strategy, they will choose not to build, thus minimizing their losses. Thus, even as a first mover firm A will choose not to build. A win for firm B may not materialize if the projections about profits are incorrect. For example, if there is a global downturn that reduces the demand for aircraft and firm B has already built the aircraft, then this may result in a loss for firm B. 11A-4 (Advanced) Suppose you are playing a game in which you and one other person each picks a number between 1 and 100, with the person closest to some randomly selected number between 1 and 100 winning the jackpot. (Ask your instructor to fund the jackpot.) Your opponent picks first. What number do you expect her to choose? Why? What number would you then pick? Why are the two numbers so close? How might this example relate to why Home Depot and Lowes, Walgreens and Rite-Aid, McDonalds and Burger King, Borders and Barnes & Noble, and other major pairs of rivals locate so close to each other in many well-defined geographical markets that are large enough for both firms to be profitable? As the first player it is optimal to choose 50. The reasoning is that your opponent could choose a number that significantly reduces your chances of winning if you didnt choose 50. For example, if you choose 1, the next player could choose 2. Thus, the only way you win is if the number 1 is drawn. How about picking 25? Your opponent would pick 26. Thus you only have a 25% chance of winning. How about 49? The same logic applies. The logic applies to companies that market similar (identical products). All of these companies choose a central location to maximize their share of costumers, assuming consumers base their behavior on distance alone. But even if this isnt a valid assumption the theory still applies for a homogeneous population. 11-16 ... View Full Document

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