Chapter 11: Monopolistic Competition and Oligopoly - Most markets in the U.S. economy are not characterized by monopoly or pure competition. This chapter examines two models that more closely approximate reality. Monopolistic competition combines a small amount of monopoly power with a lot of competition. Oligopoly mixes a large amount of monopoly power with a small amount of competition.
I. Monopolistic Competition: See, page 218, Table 12.1 for examples of monopolistically competitive industries.
A. Characteristics:
1. Relatively large numbers of independently acting sellers
a. each seller has a small market share
b. no collusion
2. Differentiated product
a. physical attributes
b. service (carry-out; 1-hour processing; etc.)
c. location (convenience stores; motels close to interstate)
d. brand names
3. Non-price competition (advertising)
4. Relative ease of entry and exit
B. Demand for output of firms in monopolistic competition is highly but not perfectly elastic.
1. Fewer rivals than in pure competition
2. Products are not perfect substitutes
3. Therefore, price elasticity of demand depends on the number of rivals and the degree of product differentiation.
C. Short-run: Profit or Loss? See, page 213!! Note that the short run analysis does not change. If the firm is going to produce it will choose the output closest to that conforming to the MR = MC rule. It then goes to the demand curve to determine price.
1. If P > ATC, the difference will be per unit profit.
2. But, if P < ATC, the difference will be per unit loss.
3. As in pure competition, so long as P > AVC, the firm will produce in order to minimize losses.
D. In long run equilibrium, firms remaining will neither earn economic profit or loss, but will earn a normal profit. However, there are complications which may allow firms in some industries to earn an economic profit, even in the long run.
1. Entry to some monopolistically competitive industries may not be perfectly free of barriers.
2. Some firms are able to sufficiently differentiate their products that they have substantial monopoly power.
E. Monopolistic Competition and Efficiency
1. Focus on Figure 11.2. Ensure you can explain the contention that monopolistic competition provides neither productive or allocative efficiency.
2. Because firms are producing less than the minimum ATC output, firms have plants and equipment that is underutilized, i.e. they have excess capacity.
a. Society would be better off with fewer firms, each producing more output.
b. But, the tradeoff is greater choice.
II. Olipopoly
A. Characteristics:
1. A few large producers. This industry model covers the gamut between pure monopoly and monopolistic competition.
2. Firms produce either a differentiated (automobiles) or standardized (steel) product.
3. Like the monopolist, each firm is a "price maker." But, unlike the monopolist, each firm must consider how its rivals will respond to pricing decisions.
a. Strategic behavior - This refers to self-interested behavior that takes into account the reaction of others (rival sellers).
b. Mutual interdependence - This means that each firm's profit depends not entirely on its own price and sales strategies but also on those of rival firms.
4. Barriers to entry - This explains the "fewness."
5. Some monopolies have emerged mainly through growth in a few dominant firms. (the so called "urge to merge)
B. Measures of Concentration
1. The concentration ratio is the percentage of total output produced and sold by the industry's four largest firms firms.
a. When the four largest firms in an industry control 40% or more of the market, that industry is considered oligopolistic.
b. Shortcomings of concentration ratios:
(1) localized markets (ready-mix concrete)
(2) inter-industry competition (See ratio for copper in Figure 11.2. But aluminum competes with copper in many applications.)
(3) global trade (concentration ratios in Figure 11.2 are for goods produced in the U.S., but do not take into account foreign competition).
B. Measures of Concentration (continued)
2. The Herfindahl Index is the sum of the squared percentage market shares of all firms in an industry.
a. By squaring the percentage market shares of all firms, it gives much greater weight to the larger firms.
b. The larger the Herfindahl Index, the hreater the market power of the few large firms.
c. As examples, see Table 11.2 for men's slacks and tires.
C. Game Theory (The Prisoner's Dilemma)
1. The "mutual interdependence" which characterizes oligopoly creates uncertainty. One firm's decision about pricing, advertising, etc. depends on what she thinks her competitors will do. Absent collusion, each firm engages in a guessing game.
2. Be sure to work through the example provided in Figure 11.3. I have some other examples that will be provided.
D. Collusive tendencies in Oligopoly
1. The most obvious solution to the uncertainty faced by the oligopolist is "collusion." While illegal in the United States, few would suggest that it does not exist.
2. The basic problem with collusive agreements is the great temptation to "cheat." Think OPEC!
E. Two Oligopoly Models (Disregard the Kinked-Demand Model)
1. Why is there no single model as with Pure Competition and Pure Monopoly?
a. Diversity of oligopolistic industries: Some industries may be controlled by as few as four large firms, while others may have six or seven.
b. Additionally, the complications of interdependence make it impossible to settle on one theory to analyze profit maximizing behavior. However, despite the analytical difficulties, two characteristics have been observed:
(1) Prices are generally inflexible or "sticky."
(2) When prices do change, firms are likely to change prices together, suggesting some sort of collusion.
F. Collusive Pricing
a. Cartels - What can we learn from OPEC?
b. Covert collusion:
(1) Recent examples (Pet, Bordon and Dean and the school milk scandal; ADM and livestock feed)
(2) Tacit understandings; the gentleman's agreement.
c. Price leadership model
Assignment:
1. Complete Key Question #2 on Page 231. In the fourth line, omit the term "graphically."
2. Complete Question #5 on Page 231.
3. Complete Key Question #7 on Pages 231 & 232.
Out-of-class assignment for Chapters 18 and 20.
1. Key Question 9 (Chapter 18)
2. Key Question 3 (Chapter 20)
3. Key Question 8 (Chapter 20)
4. Explain the "parity" concept as it relates to U.S. agricultural policy. If in a given year the indexes of prices received and paid by farmers were 120 and 165 respectively, what would the parity ratio be?