The Econ Forum



CHAPTER 26 & 27

MONOPOLISTIC COMPETITION, OLIGOPOLY, AND STRATEGIC BEHAVIOR

CHAPTER OVERVIEW

In these chapters the models of monopolistic competition and oligopoly are discussed. The key terms for each model are defined, the major attributes of each are discussed, the profit-maximizing rate of output and long-run implications for efficiency with the perfect competition model are analyzed. The purpose and effect of advertising, an important characteristic of these models, is also discussed. The existence of widespread economies of scale in certain industries is suggested as a possible explanation of oligopoly and the concept of the concentration ratio is introduced. Strategic behavior under oligopolistic conditions along with game theory is introduced. The ways oligopolists deter entry by potential competitors is analyzed. Finally, the various market structures are compared.

CHAPTER OBJECTIVES

After studying this chapter students should be able to

1. Discuss the key characteristics of a monopolistically competitive industry.

2. Contrast the output and pricing decisions of monopolistically competitive firms with those of perfectly competitive firms.

3. Outline the fundamental characteristics of oligopoly.

4. Understand how to apply game theory to evaluate the pricing strategies of oligopolistic firms.

5. Explain the kinked demand theory of oligopolistic price rigidity.

6. Describe theories of how firms may deter entry by potential rivals

CHAPTER OUTLINE

I. MONOPOLISTIC COMPETITION: A market structure where a large number of firms produce similar but differentiated products which they advertise and promote. There is relatively easy entry into the industry.

A. Number of Firms: In monopolistic competition, there is a large number of firms, but not as many as in perfect competition. This fact has several implications for a monopolistically competitive industry.

1. Small Share of Market: When many firms exist in an industry each firm has a relatively small share of the total market. Thus, each has only a very small amount of control over the market clearing price.

2. Lack of Collusion: With many firms it is difficult for them to get together to collude; that is, to agree to cooperate to set a pure monopoly price and output. Price rigging in a monopolistically competitive industry is virtually impossible.

3. Independence: Because there are so many firms, each one acts independently of the others; no firm attempts to take into account all of its rival firms.

B. Product Differentiation: Product differentiation is the distinguishing of products by brand name, color, minor attributes, and the like. Product differentiation occurs in other than perfectly competitive markets where products are homogeneous. Each separate, differentiated product has numerous similar but not perfect substitutes. The greater the number of substitutes available, other things being equal, the greater the price elasticity of demand. The ability of a firm to raise price is limited, and the demand curve slopes downward.

C. Ease of Entry: For a monopolistic competitor, potential competition is always a threat. The easier and less costly entry is, the more a current monopolistic competitor must worry about losing business.

D. Sales Promotion and Advertising: No individual firm in a perfectly competitive market will advertise. It can sell all it wants at the going market price. Since the monopolistic competitor has some monopoly power, advertising may result in increased profits. Advertising should be carried to the point where marginal revenue from advertising just equals the marginal cost of advertising.

1. Advertising as Signaling Behavior: Signals are compact gestures or actions that convey information. Heavy advertising expenditures that establish brand names or trademarks are signals that the company plans to stay in business.

II. PRICE AND OUTPUT FOR THE MONOPOLISTIC COMPETITION:

A. The Individual Firm's Demand and Cost Curves: Since the individual firm is not a perfect competitor its demand curve slopes downward. It faces a marginal revenue curve that is downward-sloping and below the demand curve. The profit-maximizing rate of output and price, are determined where the marginal cost curve intersects the marginal revenue curve from below.

B. The Short-Run Equilibrium: In the short-run it is possible for a monopolistic competitor to make economic profits, profits equal to the normal rate of return, or losses.

C. The Long-Run: Zero Economic Profits: In the long-run, because so many firms produce substitutes for the product in question, any economic profits will disappear with competition. They will be reduced to zero either through entry by new firms seeking a chance to make a higher rate of return than elsewhere or by changes in product quality and advertising outlays by existing firms in the industry. Economic losses in the short-run will disappear in the long-run because firms that suffer them will leave the industry.

III. COMPARING PERFECT COMPETITION WITH MONOPOLISTIC COMPETITION: Both the monopolistic competitor and the perfect competitor make zero economic profits in the long run. The perfect competitor's average total costs are at minimum in the long run. This is not the case with the monopolistic competitor. The equilibrium rate of output is to the left of the minimum point on the ATC curve and price is greater than marginal cost.

IV. OLIGOPOLY: An oligopoly is a market situation in which there are very few sellers. Each seller knows the other sellers will react to its changes in prices and quantities. An oligopoly market structure can exist for either a homogeneous or a differentiated produce.

A. Characteristics of Oligopoly:

1. Small Number of Firms: An oligopoly exists when a handful of firms dominate the industry enough to set prices.

2. Interdependence: This is also called strategic dependence, which is a situation in which one firm's actions with respect to output, price, or product differentiation may be strategically countered by one or more other firms in the industry. Such dependence can only exist when there are a few major firms in an industry.

B. Why Oligopoly Occurs:

1. Economies of Scale: The strongest reason that has been offered for the existence of oligopoly is economies of scale. Economies of scale are defined as a production situation in which a doubling of output results in less that a doubling of total costs. The firm's average total cost curve will slope downward as it produces more and more output. Average total cost can be reduced by continuing to expand the scale of operation.

2. Barriers to Entry: These barriers include legal barriers, such as patents, and control and ownership over critical supplies.

3. Oligopoly by Merger: A merger is the joining of two of more firms under a single ownership or control. There are two types of mergers. A horizontal merger involves firms producing or selling a similar product. A vertical merger occurs when one firm merges with another from which it purchases an input or to which it sells an output.

V. MEASURING INDUSTRY CONCENTRATION:

A. Concentration Ratio: The percentage of all sales contributed by the leading four or leading eight firms in an industry is sometimes called the industry concentration ratio.

B. U.S. Concentration Ratios: The concept of an industry is necessarily arbitrary. As a consequence, concentration ratios rise as we narrow the definition of an industry and fall as we broaden it.

C. Oligopoly, Efficiency, and Resource Allocation: While oligopolists charge prices that are greater than marginal cost, others exist because of economies of scale. There is no definite evidence of serious resource allocation in the United States because of oligopolies largely because of increased foreign competition.

VI. STRATEGIC BEHAVIOR AND GAME THEORY: When there are relatively few firms in an industry, each reacts to the price, quantity, quality, and new product innovations that the others undertake. Each oligopolist has a reaction function which is the manner in which one oligopolist reacts to a change in price (or output or quality) of another oligopolist. Economists use game theory models to describe the way firms rationally interact. Game theory is the analytical framework in which two or more individuals, companies, or nations compete for certain payoffs that depend on the strategy that the others employ. The plans made by these individuals are known as game strategies.

A. Some Basic Notions About Game Theory: Games can be cooperative and non-cooperative. They are classified by whether the payoffs are negative, zero or positive. A cooperative game is one in which players explicitly collude to make themselves better off. With firms, it involves companies colluding in order to make higher than competitive rates of return. A non-cooperative game is a game in which players neither collude nor negotiate in any way. Applied to firms, it is a situation in which there are few firms and each firm has some ability to change price. A zero sum game is a game in which one player's losses are exactly offset by the other player's gains. A negative-sum game is a game in which both players are worse off at the end of the game. A positive-sum game is a game in which both players are better off at the end of the game.

1. Strategies in Non-cooperative Games: A strategy is any rule that is used to make a choice, e. g., always pick heads.. The goal is to devise a dominant strategy. A dominant strategy will yield the most benefit for the player using it. These strategies are generally successful no matter what actions other players take.

B. Applying Game Theory to Pricing Strategies: An example of the use of game theory is presented.

C. Opportunistic Behavior: Actions that ignore possible long-run benefits of cooperation and focus solely on short run gains. This kind of behavior can be contrasted to tit-for-tat strategic behavior when repeat transactions are likely. Here a player will behave well as long as others do likewise.

VII. PRICE RIGIDITY AND THE KINKED DEMAND CURVE: Assume that rivals will match all price decreases (in order not to be undersold) but not price increases (because they want to capture more business). There is no collusion. The implications of this reaction function are rigid prices and a kinked demand curve.

A. Nature of the Kinked Demand Curve: An oligopoly firm will assume that if it lowers price, rivals will react by matching that reduction to avoid losing their respective shares of the market. The oligopolist lowering the price will not greatly increase its quantity demanded and total revenues will fall. If it increases price, rivals will not follow. Thus, a higher price will cause quantity demanded to decease rapidly and total revenues will fall. There will be a kink in the demand curve. The resulting marginal revenue curve has a discontinuous portion.

B. Price Rigidity: The kinked demand curve analysis may help explain why price changes might be infrequent in an oligopolistic industry without collusion. Each oligopolist can only expect lower revenues if it changes price. Another theoretical reason for price inflexibility under the kinked demand curve model has to do with the discontinuous portion of the marginal revenue curve. As long as the marginal cost curve passes through the discontinuity, the firm will not change price.

C. Criticisms of the Kinked Demand Curve: If every oligopolistic firm faced a kinked demand curve, it would not pay to change prices. The problem is that the kinked demand curve does not show us how supply and demand originally determine the going price of an oligopolist's product. Oligopoly prices do not appear to be as rigid, particularly in the upward direction, as the kinked demand curve theory implies.

VIII. STRATEGIC BEHAVIOR WITH IMPLICIT COLLUSION: A MODEL OF PRICE LEADERSHIP: Price leadership is a model of a pricing practice in many oligopolistic industries. The largest firm publishes its price list ahead of its competitors, who then follow those prices. This is also called parallel pricing. By definition, price leadership requires one firm to be the leader. Because of laws against collusion, firms in an industry cannot communicate who the price leader will be directly. That is why the largest firm often becomes the price leader.

A. Price Wars: Price leadership may not always work. If the price leader ends up much better off than those firms that follow, they may not set prices according to the dominant firm. A price war may result. A price war is a pricing campaign designed to drive competing firms out of a market by repeatedly cutting prices.

IX. DETERRING ENTRY INTO AN INDUSTRY: An important part of game playing has to do with how potential competitors might react to a decision. Existing firms in an industry devise strategies to deter entrance into that industry. By getting a local, state or federal government to restrict entry, or adopting certain pricing and investment strategies they may deter the entrance of new firms.

A. Increasing Entry Costs: Any strategy undertaken by firms in an industry with the design or effect of raising the cost of entry into the industry by a new firm. To sustain a long price war, existing firms might invest in excess capacity so that they may expand output during the price war, thus signaling potential competitors that they will engage in a price war. Existing domestic firms can also raise the cost of entry by foreign firms by getting the U.S. government to pass stringent environmental or health and safety standards.

B. Limit-Pricing Strategies: The existing firms may lower their market price until they sell the same quantity as before a new firm entered the industry. Existing firms limit their price to be above competitive prices, but if there is a new entrant, the new limit price will be below the one at which a new firm can make a profit. The limit-pricing model is a model that hypothesizes a group of colluding sellers who together set the highest common price they believe they can charge without new firms seeking to enter the industry.

C. Raising Customers' Switching Costs: If an existing firm can make it more costly for customers to switch from its product or service to a competitor's, the existing firm can deter entry. In the computer industry switching cost were high because, in the past, computer operating systems have not been compatible across company lines.

X. COMPARING MARKET STRUCTURES: Market structures are compared in

SELECTED REFERENCES

Bain, Joe S., "Relation or Profit-Rate to Industry Concentration: American Manufacturing, 1936-1940," Quarterly Journal of Economics, August 1951, pp. 293-324.

Brozen, Yale, ed., The Competitive Economy, Morristown, NJ: General Learning Press, 1975.

Chamberlain, Edward, H., The Theory of Monopolistic Competition, 8th Edition, Cambridge, MA: Harvard University Press, 1962.

Fellner, William, Competition Among the Few, New York: Knopf, 1950.

Kilpatrick, R.W., "Stigler on the Relationship between Industry Profit Rates and Market Concentration," Journal of Political Economy, May-June 1968, pp. 479-488.

MacAvoy, Paul W., et al., "High and Stable Concentration Levels, Profitability and Public Policy: A Response," Journal of Law and Economics, October 1971, pp. 493-500.

Meckling, William H. and Michael C. Jensen, "Reflections on the Corporation as a Social Invention," Los Angeles International Institute for Economic Research, Reprint Paper 18, November 1983.

Robinson, Joan, The Economics of Imperfect Competition, London: MacMillan and Company, Ltd., 1965.

Shepherd, William C., The Economics of Industrial Organization, Englewood Cliffs, NJ: Prentice-Hall, Inc., 1979.

Shudson, Michael, Advertising, The Uneasy Persuasion, New York: Basic Books, 1985.

Stigler, George, "Notes on a Theory of Duopoly," Journal of Political Economy, Vol. XLVIII, 1940, pp. 521-541.

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