CHAPTER 24

Monopolistic Competition and Oligopoly

In addition to monopoly, the subject of Chapter 23, there are two other forms of “structural market failure” that we need to discuss. The first, monopolistic competition, deals with markets that are basically competitive but have the extra twist of product differentiation, which makes each good slightly different from its substitutes. The second, oligopoly, often referred to as “monopoly of the few,” occurs when a small number of firms control a large enough share of the market that, if they were to band together, they could act like a monopoly. Chapter 24 begins with the theory of monopolistic competition, thenbriefly explains short-run pricing and output behavior and the problem of excess capacity, which plagues monopolistically competitive firms. The chapter then moves into the theory of oligopoly and looks at short-run oligopoly pricing and output decisions according to four different theories: the kinked demand curve, price leadership, cartel, and game theory. The chapter concludes with a brief look at the theory of contestable markets and its impact on our perceptions of noncompetitive market structures.

n CHAPTER OBJECTIVES

Upon completing this chapter, you should be able to:

1.  Explain the details of the theories of monopolistic competition and oligopoly.

2.  Discuss the excess capacity theorem.

3.  Explain why some monopolistic competitors would rather be monopolists.

5.  Discuss the problems associated with forming, implementing, and maintaining a cartel.

6.  Discuss contestable markets theory.

7.  Explain the details of prisoner’s dilemma, a well-known game examined in game theory.

 KEY TERMS

•  monopolistic competition            •price leadership theory

• excess capacity theorem                • cartel theory

• oligopoly                                          •cartel

• concentration ratio                          •  game theory

•  kinked demand curve theory         •  contestable market
 

 CHAPTER OUTLINE

I.  THE THEORY OF MONOPOLISTIC COMPETITION

A.  Basic Assumptions—The theory of MONOPOLISTIC COMPETITION is built on three basic assumptions:
 

1. There Are Many Sellers and Buyers—Much as in perfect competition, there are many sellers and many buyers; however, unlike perfect competition, monopolistically competitive firms have some control over price for the following reason.

 
2. Each Firm (in the Industry) Produces and Sells a Slightly Differentiated Product—Differences among products may be due to brand names,

• packaging,
• location,
• advertising,
• service, etc.

Product differentiation may be real or imagined—that is, the perceived difference between products may or may not actually exist.

Example: Coca Cola vs Pepsi Cola

 
3. There Is Easy Entry and Exit—  Again, as in a perfectly competitive market, new firms can enter the market easily, and existing firms may exit the market easily as well.

 Example: neighborhood convenience stores

Given our knowledge of perfect competition and monopoly, understanding monopolistic competition is fairly simple.

the monopolistically competitive firm faces a downward-sloping demand curve and is a price searcher.

However, the easy entry into the market prevents the monopolistically competitive firm from exercising as much control over price as the monopolist.

As a result, while downward-sloping, the monopolistically competitive firm’sdemand curve tends to be more elastic than the monopolist’s.

C.  The Relationship Between Price and Marginal Revenue for the Monopolistically Competitive Firm—Similarly to the Monopolist, instead of producing a quantity where P = MR (as in the case of perfect competition), the monopolistically competitive firm will produce a quantity where P > MR.

D.  How Much Output Will the Monopolistically Competitive Firm Produce? What Price Will It Charge? —The monopolistically competitive firm is no different from perfect competition or monopoly in that it will price where MC = MR.

It will charge the highest price it can to sell the quantity selected.

. E.  The Relationship Between  Price and Marginal Cost for the Monopolistically Competitor—Does the monopolistically competitive firm produce a quantity where P = MC, meaning that all resources are allocated efficiently?

No. Since all firms maximize profits by producing where MR = MC, and the monopolistically competitive firm sells at P > MR, then it must be true that P > MC at that quantity.
 
 
 
 

F.  Will There Be Economic Profits In the Long Run?—Some economists argue yes and some argue no. Given that the monopolistically competitive firm has some control over price, it is quite possible that it will make economic profits in the short run.
 
 
 
 
 
 
 
 
 
 
 
 
 
 

II.  OLIGOPOLY: ASSUMPTIONS AND REAL-WORLD BEHAVIOR

A.Basic Assumptions— Although  we will discuss several different views of oligopoly behavior, three basic assumptions are integral to a definition of Oligoploly:
 

1.  There Are Few Sellers and Many Buyers—Oligopoly is characterized by a small number of firms controlling a large share of the market. Furthermore, these firms are considered to be mutually interdependent, meaning that each is aware that its actions will influence the other firms in the market and that the actions of those other firms will affect it.

2.  Firms Produce and Sell Either Homogeneous or Differentiated Products—Firms in an oligopoly may sell either homogeneous or differentiated products. Regardless of that decision, limited competition gives the oligopolist limited control over price.

3.  There Are Significant Barriers to Entry— Like  the monopolist, the oligopolist is generally protected by barriers to entry. In the case of oligopoly, economies of scale are likely to be the most important barrier, though legal barriers may exist and/or existing firms may control vital inputs.

C. If the percentage is fairly high (usually over 50 percent), then we would say that the industry is “concentrated.” Whether it is a true oligopoly will depend upon how it behaves and on the presence of alternative suppliers, such as foreign competitors or substitute domestic goods.

IV.  PRICE AND OUTPUT UNDER OLIGOPOLY—When interdependence exists among firms, the significant question becomes how one firm reacts to the actions of one or more other firm(s) in the market.

A.The Cartel Theory—In a CARTEL, several firms band together in order to act as if they were a monopolist, so that they may capture the benefits that would accrue to a monopolist in that market.

As a group, the cartel will reduce output and increase price compared to what the members would produce as individuals in order to increase total profits.

The profits will then be distributed among the cartel members according to some agreed-upon system. As

Cartel members earn monopoly profits that they otherwise would not, assuming that members act as agreed,

 
1.  Problems with Cartels—Unfortunately for the firms involved, several problems are associated with forming and maintaining a cartel.

a.  The Problem of Forming the Cartel—Forming a cartel poses two major problems.

First, in many parts of the world, cartels are illegal.

Second, even if the cartel is legal, they are expensive to set up (especially when the number of producers is fairly large), and many potential cartel members may resist the cost when they may benefit from the cartel as “free riders.”

b.  The Problem of Formulating Cartel Policy—Once the cartel is formed, each member is likely to have its own priorities. So, making policy for the whole cartel is difficult.

c.  The Problem of Entry into the Industry—Even  if cartel members manage to agree upon policy and achieve monopoly profits, those high profits may attract new firms into the industry.

 If profits are high enough, potential barriers to entry are easy to overlook.

If cartel members cannot prevent entry, then their production targets will be upset by the presence of additional suppliers.

d.  The Problem of Cheating— Once the cartel agreement has been made, cartel members have an incentive to cheat on the agreement and sell additional output.

As Exhibit 5 in the text shows, as long as the cartel price remains intact, the cheating firm may sell additional output at the cartel price and, thus, reap additional profits.

 

 
 

e.  Are Oligopoly Firms that Form Cartels in a Prisoner’s Dilemma Setting?—

  Exhibit 7 restates the dilemma in terms of two firms whose potential profits depend on each firm’s decision as to whether it should abide by a pricing agreement.

Most economists feel that the two firms are more likely to act so as to avoid the worst result for themselves, rather than acting cooperatively; as a result, they will earn much lower profits than they could have if they had cooperated.

f.  An Enforcer of the Cartel Agreement—

Although the government is in the business of breaking up cartels, it also helps create and maintain some cartels.

Examples include farmers and the acreage allotment program and, in the past, airlines through the Civil Aeronautics Board and railroads through the Interstate Commerce Commission.
 
 

Two men accused of crime by the DA

	Nathan doesn't confess	Nathan confesses
Bob doesn't confess	Nathan pays $2,0000 Bob pays $2,000	Nathan pays $500 Bob pays   $5,000
Bob does confess	Nathan pays $5,000 Bob pays $500	Nathan pays $3,000 Bob pays $3,000

two oligopolist with a cartel agreement

	firm A hold to aggreemnt	firm A break agreement
firm B hold to aggreemnt	A earns $50,000 B earns  $50,000	A earns $100,000 B earns $5,000
firm B break agreement	A earns $5,000 B earns  $100,000	A earns $10,000 B earns $10,000

V.  THE THEORY OF CONTESTABLE MARKETS: CHALLENGING ORTHODOXY— Over the past several years, the focus of market structure theory has shifted away from the number of firms in the industry to the issue of entry into and exit from an industry. In this light, economist William Baumol and others have developed the theory of contestable markets.

A.  What Is a Contestable Market?— A contestable market is one in which the following conditions are met:
 

(1) there is extremely easy entry into the market and virtually costless exit from the market;

(2) new firms entering the market can produce at the same (per-unit) costs as existing firms; and

(3)firms exiting the market can easily dispose of their fixed assets by selling or using them elsewhere.

One widely used example of a contestable market is any given domestic airline route. Suppose that only two airlines currently serve the  Omaha to Denver route. While this might result in oligopoly behavior, a number of other air carriers could easily transfer planes from another route to the  Omaha to Denver route if it became unusually profitable. Similarly, they could take those planes off of that route should it become less profitable.

1.  Noncompetitive Behavior—Even if an industry is composed of a small number of firms, the presence of potential entrants may keep existing firms from behaving in a noncompetitive way.

2.  Economic Profits— By  preventing noncompetitive behavior, the presence of potential entrants may cause economic profits to be zero, even in a highly concentrated industry where the product is in great demand.

3.  Contestability Endangers Inefficient Producers—Market concentration often allows producers to act inefficiently in an effort to maximize profits. If existing firms fail to produce at minimum ATC, new firms will likely enter, driving prices down and forcing existing firms to either become efficient or leave the market.

4.  P = MC— Since the presence of potential entrants encourages firms to produce at the lowest possible ATC, then it follows that their P = MC; therefore, contestability encourages resource allocative efficiency.

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