14 Monopolistic Competition

Chapter
14
Monopolistic Competition
and Oligopoly
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 14: Monopolistic Competition and Oligopoly
and Oligopoly
14
Chapter Outline
Product Differentiation, Advertising, and
Social Welfare
Price and Output Determination in
Economic Efficiency and Resource
Allocation
Oligopoly
Oligopoly Models
Game Theory
Repeated Games
A Game with Many Players: Collective
Action Can Be Blocked by a
Prisoners’ Dilemma
Oligopoly and Economic Performance
Industrial Concentration and
Technological Change
The Role of Government
Regulation of Mergers
A Proper Role?
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 38
CHAPTER 14: Monopolistic Competition and Oligopoly MONOPOLISTIC COMPETITION
AND OLIGOPOLY
FIGURE 14.1 Characteristics of Different Market Organizations
Although not every industry fits neatly into one of

these categories, the categories do provide a useful
and convenient framework for thinking about industry
structure and behavior.
MONOPOLISTIC COMPETITION
monopolistic competition A common

form of industry (market) structure in the
United States, characterized by a large
number of firms, none of which can
influence market price by virtue of size
alone. Some degree of market power is
achieved by firms producing differentiated
products. New firms can enter and
established firms can exit such an industry
with ease.
TABLE 14.1 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected
Industries, 1997
FOUR EIGHT TWENTY NUMBER
INDUSTRY LARGEST LARGEST LARGEST OF
DESIGNATION FIRMS FIRMS FIRMS FIRMS
Travel trailers and campers 26 36 50 761

Dolls 31 51 66 239
Wood office furniture 34 42 55 639
Book printing 32 45 59 890
Curtains and draperies 26.5 36.3 50.1 2012
Fresh or frozen seafood 13.6 22.9 42.2 586
Women’s dresses 14.2 23.7 39.4 747
Miscellaneous plastic products 5 8 14 7522
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing. Subject Series EC92m315, June, 2001.
Firms in a monopolistically competitive industry are small relative to the total market. New
firms can enter the industry in pursuit of profit, and relatively good substitutes for the firms’
products are available. Firms in monopolistically competitive industries try to achieve a
degree of market power by differentiating their products—by producing something new,
different, or better, or by creating a unique identity in the minds of consumers.
PRODUCT DIFFERENTIATION, ADVERTISING,

AND SOCIAL WELFARE
product differentiation A strategy that

firms use to achieve market power.
Accomplished by producing products that
have distinct positive identities in
consumers’ minds.
CHAPTER 14: Monopolistic Competition and Oligopoly Product Differentiation and Advertising
1. How many varities?: Example of grey color concrete side walk
and houses with various colors.
2. How do firms differentiate products?:
Horizontal differentiation: Improve the product for some but make it
worse for others.
Behavioral Economics: (A branch of economics that uses the insights
of psychology and economies that investigates the decision making.
Are too many varieties bad?
Example of Jam stall: One stall with six varieties and other with 24
varieties.
Package size and pricing form: Small, large and extra large packages
Some pricing with the subscription like magazine or health club
(commitment device)
3. Vertical Differentiation
The Case for Product Differentiation and

Advertising
Restaurants and rock bands are

good examples of monopolistic
competitors that face intense
competition.
The advocates of spirited competition believe that differentiated products and advertising
give the market system its vitality and are the basis of its power. They are the only ways to
begin to satisfy the enormous range of tastes and preferences in a modern economy.
Product differentiation also helps to ensure high quality and efficient production, and
advertising provides consumers with the valuable information on product availability, quality,
and price that they need to make efficient choices in the marketplace.
The Case Against Product Differentiation and

Advertising
Product differentiation and advertising waste

society’s scarce resources, argue critics. They say
enormous sums of money are spent to create
minute, meaningless differences among products.
The bottom line, critics of product differentiation and advertising argue, is waste and
inefficiency. Enormous sums are spent to create minute, meaningless, and possibly
nonexistent differences among products. Advertising raises the cost of products and
frequently contains very little information. Often, it is merely an annoyance. Product
differentiation and advertising have turned the system upside down: People exist to
satisfy the needs of the economy, not vice versa. Advertising can lead to unproductive
warfare and may serve as a barrier to entry, thus reducing real competition.
No Right Answer
There are strong arguments on both sides of the

advertising debate, and even the empirical evidence
yields to conflicting conclusions. Some studies show
that advertising leads to concentration and positive
profits; others, that advertising improves the
functioning of the market.
PRICE AND OUTPUT DETERMINATION
IN MONOPOLISTIC COMPETITION
Product Differentiation and Demand Elasticity
FIGURE 14.2 Product Differentiation Reduces the Elasticity of Demand Facing a Firm
Although the demand curve faced by a monopolistic competitor is likely to be less elastic
than the demand curve faced by a perfectly competitive firm, it is likely to be more elastic
than the demand curve faced by a monopoly.
Price/Output Determination in the Short Run
FIGURE 14.3 Monopolistic Competition in the Short Run
To maximize profit, the monopolistically competitive firm will increase production until the
marginal revenue from increasing output and selling it no longer exceeds the marginal cost
of producing it. This occurs at the point at which marginal revenue equals marginal cost:
MR = MC.
Price/Output Determination in the Long Run
FIGURE 14.4 Monopolistically Competitive Firm at Long-Run Equilibrium
The firm’s demand curve must end up tangent to its average total cost curve for profits to
equal zero. This is the condition for long-run equilibrium in a monopolistically competitive
industry.
ECONOMIC EFFICIENCY AND RESOURCE
ALLOCATION
Because entry is easy and economic profits are
eliminated in the long run, we might conclude that
the result of monopolistic competition is efficient.
There are two problems, however.
First, once a firm achieves any degree of market

power by differentiating its product (as is the case in
monopolistic competition), its profit-maximizing
strategy is to hold down production and charge a
price above marginal cost.
Second, the final equilibrium in a monopolistically

competitive firm is necessarily to the left of the low
point on its average total cost curve.
OLIGOPOLY
oligopoly A form of industry (market)

structure characterized by a few dominant
firms. Products may be homogenous or
differentiated. The behavior of any one
firm in an oligopoly depends to a great
extent on the behavior of others.
OLIGOPOLY
TABLE 14.4 Percentage of Value of Shipments Accounted for by the Largest Firms in
High-Concentration Industries, 1997
FOUR EIGHT NUMBER

INDUSTRY LARGEST LARGEST OF
DESIGNATION FIRMS FIRMS FIRMS
Cellulosic man-made fiber 100 4
Primary copper 95 99 11
Household laundry equipment 90 99 10
Cigarettes 99 100 9
Malt beverages (beer) 90 95 494
Electric lamp bulbs 89 94 54
Cereal breakfast foods 83 94 48
Motor vehicles 83 92 325
Small arms ammunition 89 94 107
Household refrigerators and freezers 82 97 21
Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series 2001.
OLIGOPOLY
OLIGOPOLY MODELS
Because many different types of oligopolies exist, a

number of different oligopoly models
have been developed.
All kinds of oligopoly have one thing in common:
The behavior of any given oligopolistic firm depends on the behavior of the other firms in the
industry comprising the oligopoly.
OLIGOPOLY
The Collusion Model
The colluding oligopoly will face market demand and produce only up to the point at which
marginal revenue and marginal cost are equal (MR = MC), and price will be set above
marginal cost.
cartel A group of firms that gets together

and makes joint price and output
decisions to maximize joint profits.
tacit collusion Collusion occurs when

price- and quantity-fixing agreements
among producers are explicit. Tacit
collusion occurs when such agreements
are implicit.
OLIGOPOLY
The Cournot Model
Cournot model A model of a two-firm

industry (duopoly) in which a series of
output adjustment decisions leads to a
final level of output between the output
that would prevail if the market were
organized competitively and the output
that would be set by a monopoly.
The Cournot model of oligopoly results in a quantity of output somewhere between

output that would prevail if the market were perfectly competitive and output that
would be set by a monopoly.
OLIGOPOLY
The Kinked Demand Curve Model
kinked demand curve model A model

of oligopoly in which the demand curve
facing each individual firm has a “kink”
in it. The kink results from the assumption
that competitor firms will follow if a single
firm cuts price but will not follow if a single
firm raises price.
OLIGOPOLY
FIGURE 14.5 A Kinked Demand Curve Oligopoly Model
OLIGOPOLY
The Price-Leadership Model
price leadership A form of oligopoly in

which one dominant firm sets prices and
all the smaller firms in the industry follow
its pricing policy.
As in the other oligopoly models, an oligopoly with a dominant price leader will produce a
level of output between the output that would prevail under perfect competition and the
output that a monopolist would choose in the same industry. It will also set a price between
the monopoly price and the perfectly competitive price. Some competition is usually more
efficient than none at all.
OLIGOPOLY
GAME THEORY
game theory Analyzes oligopolistic

behavior as a complex series of strategic
moves and reactive countermoves among
rival firms. In game theory, firms are
assumed to anticipate rival reactions.
OLIGOPOLY
FIGURE 14.6 Payoff Matrix for Advertising Game
OLIGOPOLY
dominant strategy In game theory, a

strategy that is best no matter what the
opposition does.
prisoners’ dilemma A game in which the

players are prevented from cooperating
and in which each has a dominant
strategy that leaves them both
worse off than if they could cooperate.
OLIGOPOLY
FIGURE 14.7 The Prisoners’ Dilemma
OLIGOPOLY
FIGURE 14.8 Payoff Matrixes for Left/Right–Top/Bottom Strategies
OLIGOPOLY
Nash equilibrium In game theory, the

result of all players’ playing their best
strategy given what their competitors are
doing.
maximin strategy In game theory, a

strategy chosen to maximize the
minimum gain that can be earned.
OLIGOPOLY
REPEATED GAMES
tit-for-tat strategy A company’s strategy

that lets a competitor know the company
will follow the competitor’s lead.
FIGURE 14.9 Payoff Matrix for Airline Game
OLIGOPOLY
A GAME WITH MANY PLAYERS: COLLECTIVE

ACTION CAN BE BLOCKED BY A PRISONERS’
DILEMMA
Contestable Markets
perfectly contestable market A market

in which entry and exit are costless.
In contestable markets, even large oligopolistic firms end up behaving like perfectly
competitive firms. Prices are pushed to long-run average cost by competition, and positive
profits do not persist.
OLIGOPOLY
Review
Oligopoly is a market structure that is consistent

with a variety of behaviors.
The only necessary condition of oligopoly is that firms are large enough to have some
control over price. Oligopolies are concentrated industries. At one extreme is the cartel,
in which a few firms get together and jointly maximize profits—in essence, acting as a
monopolist. At the other extreme, the firms within the oligopoly vigorously compete
for small, contestable markets by moving capital quickly in response to observed profits.
In between are a number of alternative models, all of which stress the interdependence
of oligopolistic firms.
OLIGOPOLY
OLIGOPOLY AND ECONOMIC PERFORMANCE

Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons.
First, profit-maximizing oligopolists are likely to price above marginal cost. When
price is above marginal cost, there is underproduction from society’s point of view—in
other words, society could get more for less, but it does not. Second, strategic behavior
can lead to outcomes that are not in society’s best interest. Specifically, strategically
competitive firms can force themselves into deadlocks that waste resources. Finally, to
the extent that oligopolies differentiate their products and advertise, there is the
promise of new and exciting products. At the same time, however, there remains a real
danger of waste and inefficiency.
INDUSTRIAL CONCENTRATION AND

TECHNOLOGICAL CHANGE
One of the major sources of economic growth and

progress throughout history has been technological
advance.
THE ROLE OF GOVERNMENT
REGULATION OF MERGERS
Celler-Kefauver Act (1950) Extended

the government’s authority to ban vertical
and conglomerate mergers.
Herfindahl-Hirschman Index (HHI) A

mathematical calculation that uses market
share figures to determine whether or not
a proposed merger will be challenged by
the government.
TABLE 14.5 Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical

Industries, Each with No More Than Four Firms
PERCENTAGE SHARE OF: HERFINDAHL-

HIRSCHMAN
FIRM 1 FIRM 2 FIRM 3 FIRM 4 INDEX
Industry A 50 50 - - 502 + 502 = 5,000

Industry B 80 10 10 - 802 + 102 + 102 = 6,600
Industry C 25 25 25 25 252 + 252 + 252 + 252 = 2,500
Industry D 40 20 20 20 402 + 202 + 202 + 202 = 2,800
If the Herfindahl-Hirschman Index is less than 1,000, the industry is considered

unconcentrated, and any proposed merger will go unchallenged by the Justice Department.
If the index is between 1,000 and 1,800, the department will challenge any merger that would
increase the index by over 100 points. Herfindahl indexes above 1,800 mean that the industry
is considered concentrated already, and the Justice Department will challenge any merger
that pushes the index up more than 50 points.
FIGURE 14.10 Department of Justice Merger

Guidelines (revised 1984)
A PROPER ROLE?
Certainly there is much to guard against in the

behavior of large, concentrated industries. Barriers
to entry, large size, and product differentiation all
lead to market power and to potential inefficiency.
Barriers to entry and collusive behavior stop the
market from working toward an efficient allocation of
resources.
REVIEW TERMS AND CONCEPTS
cartel monopolistic competition

Celler-Kefauver Act Nash equilibrium
Cournot model oligopoly
dominant strategy perfectly contestable
game theory market
Herfindahl-Hirschman price-leadership model
Index (HHI) prisoners’ dilemma
kinked demand curve product differentiation
model tacit collusion
maximin strategy tit-for-tat strategy

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Chapter

Fernando & Yvonn Quijano

FIGURE 14.1 Characteristics of Different Market Organizations

Although not every industry fits neatly into one of

monopolistic competition A common

Travel trailers and campers 26 36 50 761

PRODUCT DIFFERENTIATION, ADVERTISING,

product differentiation A strategy that

The Case for Product Differentiation and

Restaurants and rock bands are

The Case Against Product Differentiation and

Product differentiation and advertising waste

There are strong arguments on both sides of the

Price/Output Determination in the Short Run

FIGURE 14.3 Monopolistic Competition in the Short Run

Price/Output Determination in the Long Run

FIGURE 14.4 Monopolistically Competitive Firm at Long-Run Equilibrium

First, once a firm achieves any degree of market

Second, the final equilibrium in a monopolistically

oligopoly A form of industry (market)

FOUR EIGHT NUMBER

Because many different types of oligopolies exist, a

All kinds of oligopoly have one thing in common:

The Collusion Model

cartel A group of firms that gets together

tacit collusion Collusion occurs when

The Cournot Model

Cournot model A model of a two-firm

The Cournot model of oligopoly results in a quantity of output somewhere between

The Kinked Demand Curve Model

kinked demand curve model A model

FIGURE 14.5 A Kinked Demand Curve Oligopoly Model

The Price-Leadership Model

price leadership A form of oligopoly in

game theory Analyzes oligopolistic

FIGURE 14.6 Payoff Matrix for Advertising Game

dominant strategy In game theory, a

prisoners’ dilemma A game in which the

FIGURE 14.7 The Prisoners’ Dilemma

FIGURE 14.8 Payoff Matrixes for Left/Right–Top/Bottom Strategies

Nash equilibrium In game theory, the

maximin strategy In game theory, a

tit-for-tat strategy A company’s strategy

FIGURE 14.9 Payoff Matrix for Airline Game

A GAME WITH MANY PLAYERS: COLLECTIVE

perfectly contestable market A market

Oligopoly is a market structure that is consistent

OLIGOPOLY AND ECONOMIC PERFORMANCE

INDUSTRIAL CONCENTRATION AND

One of the major sources of economic growth and

Celler-Kefauver Act (1950) Extended

Herfindahl-Hirschman Index (HHI) A

TABLE 14.5 Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical

PERCENTAGE SHARE OF: HERFINDAHL-

Industry A 50 50 - - 502 + 502 = 5,000

If the Herfindahl-Hirschman Index is less than 1,000, the industry is considered

FIGURE 14.10 Department of Justice Merger

Certainly there is much to guard against in the

cartel monopolistic competition

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