Chapter 11

Monopolistic
Competition and
Oligopoly

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
• Characteristics of monopolistic
competition
• Normal profit in the long run
• Characteristics of oligopoly
• Game theory
• The oligopolist’s kinked demand
curve
• Collusion among oligopolists
• The effects of advertising
11-2
 Monopolistic Competition
• Large number of sellers
–Small market shares
–No collusion
–Independent action
• Differentiated Products
–Product attributes
–Service
–Location
–Brand names and packaging
–Some control over price 11-3
 Monopolistic Competition
• Easy entry and exit
• Need for advertising
–Nonprice Competition
• Which industries?
–Degree of concentration
–Four-firm concentration ratio
–Herfindahl index
11-4
 Monopolistic Competition
• Firm’s demand curve
–Highly elastic
• Short run profit or loss
–Produce where MR=MC
• Long run normal profit
–Entry and exit
• Inefficient
• Product variety
11-5
 Monopolistic Competition
Short-Run Profits
ATC
MC
Price and Costs

P1
A1

Economic D1
Profit
MR = MC

MR

0 Q1
Quantity
11-6
 Monopolistic Competition
Short-Run Losses
ATC
MC

A2
Price and Costs

P2

Loss
D2

MR = MC

MR

0 Q2
Quantity
11-7
 Monopolistic Competition
Long-Run Equilibrium
MC
ATC
Price and Costs

P3= A3

D3

MR = MC

MR

0 Q3
Quantity
11-8
 Monopolistic Competition
P=MC=Min ATC for pure competition (recall)
MC

ATC
Price and Costs

P3= A3
P4

Price is Lower
D3

MR = MC
Excess Capacity at
Minimum ATC MR
0 Q3 Q4
Quantity
Monopolistic competition is not efficient
11-9
 Oligopoly
• A few large producers
• Homogeneous or
differentiated products
• Control over price
–Mutual interdependence
–Strategic behavior
• Entry barriers
• Mergers
11-10
 Oligopoly
• Four-firm concentration ratio
–Needs to be more than 40%
–Half of U.S. manufacturing
• Localized markets
• Interindustry competition
• World trade
–Import Competition
• Herfindahl index
11-11
 Game Theory

RareAir’s Price Strategy

• 2 competitors High Low
• 2 price

Uptown’s Price Strategy

strategies A B
$12 $15
• Each strategy
has a payoff High
matrix $12 $6
• Greatest
combined
C D
profit $6 $8
• Independent Low
actions $15 $8
stimulate a
response

11-12
 Game Theory

RareAir’s Price Strategy

• Independently High Low
lowered prices

Uptown’s Price Strategy

in expectation A B
$12 $15
of greater profit
leads to the High
worst $12 $6
combined
outcome
C D
• Eventually low $6 $8
outcomes make Low
firms return to $15 $8
higher prices

11-13
 Game Theory

• Mutual interdependence
–Pricing policy
• Collusion
–Enhances profit
• Incentive to cheat
• Prisoner’s dilemma

11-14
 Three Oligopoly Models
• Kinked-demand curve
• Collusive pricing
• Price leadership
• Why three models?
–Diversity of oligopolies
–Complications of interdependence

11-15
 Kinked-Demand Curve
• Noncollusive oligopoly
• Strategies
–Match price changes
–Ignore price changes
• Combined strategy
• Price inflexibility
• The kinked-demand curve
11-16
 Kinked-Demand Curve
Competitor and rivals strategize versus each other
Consumers effectively have 2 partial demand curves
and each part has its own marginal revenue part

Rivals Ignore
Price Increase

Price and Costs

D2 MC1
e e
P0 P0
Price

MR2 f
f
D2 MC2

MR2
Rivals Match g
Price Decrease g
D1 D1
0 Q0 MR1 0 Q0 MR1
Quantity Quantity
Resulting in a kinked-demand curve
to the consumer – price and output
are optimized at the kink
11-17
 Kinked-Demand Curve

• Criticisms of the model

–How does price get to P0
–Explains inflexibility, not price
–Prices are not that rigid
–Price wars

11-18
 Cartels and Other Collusion
• Price and output
–Joint profit maximization

MC Effectively Sharing
The Monopoly Profit
Price and Costs

P0 ATC

A0

MR=MC
Economic
Profit MR D

Q0
Quantity
11-19
 The OPEC Cartel
Daily oil production (barrels) , November 2008
Saudi Arabia 8,904,000
Iran 3,843,000
Kuwait 2,538,000
Venezuela 2,368,000
Iraq 2,297,000
Nigeria 2,183,000
UAE 2,117,000
Angola 1,804,000
Libya 1,737,000
Algeria 1,417,000
Qatar 848,000
Indonesia 843,000
Ecuador 530,000
Source: A. T. Kearney, Foreign Policy
11-20
 Cartels and Other Collusion
• Covert collusion
–Tacit understandings
• Obstacles to collusion
–Demand and cost differences
–Number of firms
–Cheating
–Recession
–Potential entry
–Legal obstacles: antitrust law
11-21
 Price Leadership Model

• Leadership tactics
• Infrequent price changes
• Communications
• Limit pricing
• Breakdowns in price leadership:
–Price wars

11-22
 Advertising

• Prevalent in monopolistic
competition and oligopoly
• Capture market share
• Better than a price cut
• Information for consumers
• Manipulation

11-23
Oligopoly and Advertising
The Largest U.S. Advertisers, 2006
Advertising Spending
Company Millions of $
Proctor and Gamble $4898
AT&T 3345
General Motors 3296
Time Warner 3089
Verizon 2822
Ford Motor 2577
GlaxoSmithKline 2444
Walt Disney 2320
Johnson & Johnson 2291
Unilever 2098
Source: Advertising Age
11-24
 Oligopoly and Advertising
World’s Top 10 Brand Names, 2007
Coca-Cola
Microsoft
IBM
General Electric
Nokia
Toyota
Intel
McDonald’s
Disney
Mercedes-Benz
Source: Interbrand
11-25
 Oligopoly and Efficiency
• Not productively efficient
• Not allocatively efficient
• Tendency to share the monopoly
profit
• Qualifications
–Increased foreign competition
–Limit pricing
–Technological advance
11-26
 Oligopoly in the Beer Industry
• From hundreds to a few firms
• Demand side changes
– Taste shifts to lighter beers
– Shift from tap to cans or bottles
• Supply side changes
– Technological change increased
minimum efficient scale
– National brands enjoy cost advantages
• Consolidation into oligopoly
11-27
 Key Terms
• monopolistic • strategic behavior
competition • mutual interdependence
• product differentiation • interindustry
• nonprice competition competition
• four-firm concentration • import competition
ratio
• game theory
• Herfindahl index
• collusion
• excess capacity
• oligopoly • kinked-demand curve
• homogeneous • price war
oligopoly • cartel
• differentiated oligopoly • price leadership
11-28
Next Chapter Preview…

Technology, R&D,
And Efficiency

11-29