Monopolistic Competition

1
Monopolistic Competition

• A monopolistically competitive industry has the
  following characteristics
• A large number of firms
• No barriers to entry
• Product differentiation

2
Monopolistic Competition

• Monopolistic competition is 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.

3
Nine Industries with Characteristics of
Monopolistic Competition
Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1992
SIC NO. INDUSTRYDESIGNATION FOURLARGESTFIRMS FOURLARGESTFIRMS EIGHTLARGESTFIRMS EIGHTLARGESTFIRMS TWENTYLARGESTFIRMS TWENTYLARGESTFIRMS NUMBEROFFIRMS NUMBEROFFIRMS
3792 Travel trailers and campers 41 57 72 270
3942 Dolls 34 47 67 204
2521 Wood office furniture 26 34 51 611
2731 Book publishing 23 38 62 2504
2391 Curtains and draperies 22 32 48 1004
2092 Fresh or frozen seafood 19 28 47 600
3564 Blowers and fans 14 22 41 518
2335 Womens dresses 11 17 30 3943
3089 Miscellaneous plastic products 5 8 13 7605
Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.
4
Product Differentiation, Advertising, and Social
Welfare
Total Advertising Expenditures in 1998 Total Advertising Expenditures in 1998 Total Advertising Expenditures in 1998 Total Advertising Expenditures in 1998
DOLLARS(BILLIONS) DOLLARS(BILLIONS)
Newspapers 44.2
Television 48.0
Direct mail 39.5
Other 31.7
Yellow pages 12.0
Radio 14.5
Magazines 10.4
Total 200.3
Source McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947. Source McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947. Source McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947. Source McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States, 1999, Table 947.
5
The Case for Product Differentiation and
Advertising

• The advocates of free and open competition
  believe that differentiated products and
  advertising give the market system its vitality
  and are the basis of its power.
• Product differentiation helps to ensure high
  quality and efficient production.

6
The Case for Product Differentiation and
Advertising

• Advertising provides consumers with the valuable
  information on product availability, quality, and
  price that they need to make efficient choices in
  the market place.

7
The Case Against Product Differentiation and
Advertising

• Critics of product differentiation and
  advertising argue that they amount to nothing
  more than waste and inefficiency.
• Enormous sums are spent to create minute,
  meaningless, and possibly nonexistent differences
  among products.

8
The Case Against Product Differentiation and
Advertising

• Advertising raises the cost of products and
  frequently contains very little information.
  Often, it is merely an annoyance.
• 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.

9
Product Differentiation Reduces the Elasticity of
Demand Facing a Firm

• Based on the availability of substitutes, the
  demand curve faced by a monopolistic competitor
  is likely to be less elastic than the demand
  curve faced by a perfectly competitive firm, and
  likely to be more elastic than the demand curve
  faced by a monopoly.

10
Monopolistic Competition in the Short Run

• In the short-run, a monopolistically competitive
  firm will produce up to the point where MR MC.

• This firm is earning positive profits in the
  short-run.

11
Monopolistic Competition in the Short-Run

• Profits are not guaranteed. Here, a firm with a
  similar cost structure is shown facing a weaker
  demand and suffering short-run losses.

12
Monopolistic Competition in the Long-Run

• The firms 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.

13
Economic Efficiencyand Resource Allocation

• In the long-run, economic profits are eliminated
  thus, we might conclude that monopolistic
  competition is efficient, however

• Price is above marginal cost. More output could
  be produced at a resource cost below the value
  that consumers place on the product.

14
Economic Efficiencyand Resource Allocation

• In the long-run, economic profits are eliminated
  thus, we might conclude that monopolistic
  competition is efficient, however

• Average total cost is not minimized. The typical
  firm will not realize all the economies of scale
  available. Smaller and smaller market share
  results in excess capacity.

15
Oligopoly

• An oligopoly is a form of industry (market)
  structure characterized by a few dominant firms.
  Products may be homogeneous or differentiated.
• The behavior of any one firm in an oligopoly
  depends to a great extent on the behavior of
  others.

16
Ten Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1992
SIC NO. INDUSTRYDESIGNATION FOURLARGESTFIRMS FOURLARGESTFIRMS EIGHTLARGESTFIRMS EIGHTLARGESTFIRMS NUMBEROFFIRMS NUMBEROFFIRMS
2823 Cellulosic man-made fiber 98 100 5
3331 Primary copper 98 99 11
3633 Household laundry equipment 94 99 10
2111 Cigarettes 93 100 8
2082 Malt beverages (beer) 90 98 160
3641 Electric lamp bulbs 86 94 76
2043 Cereal breakfast foods 85 98 42
3711 Motor vehicles 84 91 398
3482 Small arms ammunition 84 95 55
3632 Household refrigerators and freezers 82 98 52
Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997. Source U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series MC92-S-2, 1997.
17
Oligopoly Models

• 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.

18
The Collusion Model

• A group of firms that gets together and makes
  price and output decisions jointly is called a
  cartel.
• Collusion occurs when price- and quantity-fixing
  agreements are explicit.
• Tacit collusion occurs when firms end up fixing
  price without a specific agreement, or when
  agreements are implicit.

19
The Cournot Model

• The Cournot model is 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.

20
The Kinked Demand Curve Model

• The kinked demand model is a model of oligopoly
  in which the demand curve facing each individual
  firm has a kink in it. The kink follows from
  the assumption that competitive firms will follow
  if a single firm cuts price but will not follow
  if a single firm raises price.

21
The Kinked Demand Curve Model

• Above P, an increase in price, which is not
  followed by competitors, results in a large
  decrease in the firms quantity demanded (demand
  is elastic).
• Below P, price decreases are followed by
  competitors so the firm does not gain as much
  quantity demanded (demand is inelastic).

22
The Price-Leadership Model

• Price-leadership is a form of oligopoly in which
  one dominant firm sets prices and all the smaller
  firms in the industry follow its pricing policy.

23
The Price-Leadership Model

• Assumptions of the price-leadership model
• The industry is made up of one large firm and a
  number of smaller, competitive firms
• The dominant firm maximizes profit subject to the
  constraint of market demand and subject to the
  behavior of the smaller firms
• The dominant firm allows the smaller firms to
  sell all they want at the price the leader has
  set.

24
The Price-Leadership Model

• Outcome of the price-leadership model
• The quantity demanded in the industry is split
  between the dominant firm and the group of
  smaller firms.
• This division of output is determined by the
  amount of market power that the dominant firm
  has.
• The dominant firm has an incentive to push
  smaller firms out of the industry in order to
  establish a monopoly.

25
Predatory Pricing

• The practice of a large, powerful firm driving
  smaller firms out of the market by temporarily
  selling at an artificially low price is called
  predatory pricing.
• Such behavior became illegal in the United States
  with the passage of antimonopoly legislation
  around the turn of the century.

26
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.

27
Payoff Matrix for Advertising Game
Bs STRATEGY Bs STRATEGY
As STRATEGY Do not advertise Advertise
Do not advertise As profit 50,000Bs profit 50,000 As loss 25,000Bs profit 75,000
Advertise As profit 75,000Bs loss 25,000 As profit 10,000Bs profit 10,000

• The strategy that firm A will actually choose
  depends on the information available concerning
  Bs likely strategy.

28
Payoff Matrix for Advertising Game
Bs STRATEGY Bs STRATEGY
As STRATEGY Do not advertise Advertise
Do not advertise As profit 50,000Bs profit 50,000 As loss 25,000Bs profit 75,000
Advertise As profit 75,000Bs loss 25,000 As profit 10,000Bs profit 10,000

• Regardless of what B does, it pays A to
  advertise. This is the dominant strategy, or the
  strategy that is best no matter what the
  opposition does.

29
The Prisoners Dilemma
ROCKY ROCKY ROCKY ROCKY
GINGER Do not confess Confess Confess
Do not confess Ginger 1 yearRocky 1 year Ginger 7 yearsRocky free
Confess Ginger freeRocky 7 years Ginger 5 yearsRocky 5 years

• Both Ginger and Rocky have dominant strategies
  to confess. Both will confess, even though they
  would be better off if they both kept their
  mouths shut.

30
Payoff Matrix forLeft/Right-Top/Bottom Strategies
Original Game Original Game Original Game Original Game
Ds STRATEGY Ds STRATEGY
Cs STRATEGY Left Right
Top C wins 100D wins no C wins 100D wins 100
Bottom C loses 100D wins no C wins 200D wins 100
Bottom

• Because Ds behavior is predictable (he will play
  the right-hand strategy), C will play bottom.
• When all players are playing their best strategy
  given what their competitors are doing, the
  result is called Nash equilibrium.

31
Payoff Matrix forLeft/Right-Top/Bottom Strategies

• C is likely to play top and guarantee herself a
  100 profit instead of losing 10,000 to win
  200, even if there is just a small chance of Ds
  choosing left.
• When uncertainty and risk are introduced, the
  game changes. A maximin strategy is a strategy
  chosen to maximize the minimum gain that can be
  earned.

New Game New Game New Game New Game
Ds STRATEGY Ds STRATEGY
Cs STRATEGY Left Right
Top C wins 100D wins no C wins 100D wins 100
Bottom C loses 10,000D wins no C wins 200D wins 100
Bottom
32
Contestable Markets

• A market is perfectly contestable if entry to it
  and exit from it 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.

33
Oligopoly is Consistent witha 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 essence, acting as a
  monopolist. At the other extreme, firms compete
  for small contestable markets in response to
  observed profits. In between are a number of
  alternative models, all of which stress the
  interdependence of oligopolistic firms.

34
Oligopoly and Economic Performance

• Oligopolies, or concentrated industries, are
  likely to be inefficient for the following
  reasons
• They are likely to price above marginal cost.
  This means that there would be underproduction
  from societys point of view.
• Strategic behavior can force firms into deadlocks
  that waste resources.
• Product differentiation and advertising may pose
  a real danger of waste and inefficiency.

35
The Role of Government

• The Celler-Kefauver Act of 1950 extended the
  governments authority to ban vertical and
  conglomerate mergers.
• The Herfindahl-Hirschman Index (HHI) is a
  mathematical calculation that uses market share
  figures to determine whether or not a proposed
  merger will be challenged by the government.

36
Regulation of Mergers
Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each With No More Than Four Firms
PERCENTAGE SHARE OF PERCENTAGE SHARE OF PERCENTAGE SHARE OF PERCENTAGE SHARE OF HERFINDAHL-HIRSCHMANINDEX
FIRM 1 FIRM 2 FIRM 3 FIRM 4 HERFINDAHL-HIRSCHMANINDEX
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
37
Department of Justice Merger Guidelines (revised
1984)
ANTITRUST DIVISION ACTION ANTITRUST DIVISION ACTION ANTITRUST DIVISION ACTION
HHI 1,800 1,000 0 ConcentratedChallenge if Index is raised by more than 50 points by the merger
HHI 1,800 1,000 0 Moderate ConcentrationChallenge if Index is raised by more than 100 points by the merger
HHI 1,800 1,000 0 UnconcentratedNo challenge
HHI 1,800 1,000 0