Chapter 10

Monopolistic and Oligopoly

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© 2006 Thomson/South-Western
 Monopolistic Competition

 Many producers offer products that are either

close substitutes but are not viewed as identical
 Each supplier has some power over the price it
charges : price makers
 Low barriers to entry: firms in the long run can
enter or leave the market with ease
 Act independently of each other
 Differentiate their products

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 Exhibit 1a: Maximizing Short-Run Profit
The monopolistically
competitive firm
produces the level of
output at which marginal
revenue equals marginal
cost (point e) and
charges the price
indicated by point b on
the downward-sloping
demand curve.
In panel (a), the firm
produces q units, sells
them at price p, and
earns a short-run
economic profit equal to
(p – c) multiplied by q,
shown by the blue
rectangle.
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 Exhibit 1b: Minimizing Short-Run Loss

In panel (b), the

average total cost
exceeds the price at
the output where
marginal revenue
equals marginal cost.
Thus, the firm
suffers a short-run loss
equal to (c – p)
multiplied by q, shown
by the pink rectangle.

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Zero Economic Profit in the Long Run

Low barriers to entry in monopolistic

competition: short-run economic profit
will attract new entrants in the long run
With losses some competitors will leave
the industry
Their customers will switch to the
remaining firms, increasing the demand
for each remaining firm’s demand curve
and making it less elastic
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 Exhibit 2: Long-run Equilibrium
In the long run, entry and exit MC
will shift each firm’s demand
curve until economic profit

Dollars per unit

disappears and price equals ATC
ATC
Long-run outcome occurs
where the MR curve intersects b
p
the MC curve at point a, where
the ATC curve is tangent to the
demand curve at point b and
there is no economic profit a
In the case of short-run losses, D
some firms will leave the
industry and the demand curve
shifts to the right, becoming less MR
elastic until the loss disappears
and the remaining firms earn a 0
q Quantity per period
normal profit
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 Exhibit 3: Perfect Competition versus
Monopolistic Competition

Point of tangency between d, MC and ATC in perfect competition means firm is

producing at lowest possible average cost in the long run
In monopolistic competition, the price and average cost exceed those in pure competition
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– there is excess capacity
 Comparison

 Firms in perfect competition are not producing at

minimum average cost and are said to have excess
capacity, because production falls short of the
quantity that would achieve the lowest average cost.
 Excess capacity means that each producer could
easily serve more customers and in the process would
lower average cost.
 The marginal value of increased output would exceed
its marginal cost, so greater output would increase
social welfare.

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 Comparison

Some argue that monopolistic competition

results in too many suppliers and in product
differentiation that is often artificial

Counterargument is that consumers are

willing to pay a higher price for greater
selection

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 Oligopoly

Market structure that is dominated by

just a few firms

Each must consider the effect of its own

actions on competitors’ behavior  the
firms in an oligopoly are interdependent

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 Varieties of Oligopoly

Homogeneous or differentiated products

Interdependence: the behavior of any
particular firm is difficult to analyze
Domination by a few firms can often be
traced to some form of barrier to entry

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 Exhibit 4: Economies of Scale as a Barrier to Entry

If a new entrant sells ca a

only S cars, the average
cost per unit, ca,
exceeds the average Dollars per unit
cost, cb, of a
manufacturer that sells
enough cars to reach
the minimum efficiency
scale, M.
If autos sell for a
price less than ca, a b
cb Long-run
potential entrant can
average
expect to lose money. cost

0 S M Autos per year

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 High Costs of Entry

Total investment needed to reach the

minimum size
Advertising a new product enough to
compete with established brands
High start-up costs and presence of
established brand names: the fortunes of
a new product are very uncertain

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 Models of Oligopolies

 Interdependence: no one model or approach

explains the outcomes

 At one extreme, the firms in the industry may

try to coordinate their behavior so they act
collectively as a single monopolist, forming a
cartel

 At the other extreme, they may compete so

fiercely that price wars erupt
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 Collusion

 Collusion: an agreement among firms in the

industry to divide the market and fix the price

 Cartel: a group of firms that agree to collude so

they can act as a monopolist and earn
monopoly profits

 Colluding firms usually reduce output, increase

price, and block the entry of new firms
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 Exhibit 5: Cartel as a Monopolist
D is the market
demand curve, MR
the associated
marginal revenue
curve, and MC the
horizontal sum of
the marginal cost
curves of cartel
members (assuming
all firms in the
market join the
cartel).
Cartel profits are
maximized when the
industry produces
quantity Q and
charges price p.

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 Differences in Cost

The greater the differences in average

costs across firms, the greater will be the
differences in economic profits among
firms
If cartel members try to equalize each
firm’s total profit, a high-cost firm would
need to sell more than a low-cost firm
This allocation scheme violates the cartel’s
profit-maximizing condition of finding the
output for each firm that results in
identical marginal costs across firms
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 Number of Firms in the Cartel

 The more firms in the industry, the more

difficult it is to negotiate an acceptable
allocation of output among them

 Consensus becomes harder to achieve as the

number of firms grows

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 New Entry Into the Industry

 If a cartel cannot block the entry of new firms

into the industry, new entry will eventually
force prices down, squeezing economic profit
and undermining the cartel

 The profit of the cartel attracts entry, entry

increases market supply and market price is
forced down

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 Cheating

 Perhaps the biggest obstacle to keeping the

cartel running smoothly is the powerful
temptation to cheat on the agreement

 By offering a price slightly below the

established price, a firm can usually increase its
sales and economic profit

 Because oligopolists usually operate with excess

capacity, some cheat on the established price 20
 Price Leadership

 An informal, or tacit, type of collusion occurs in

industries that contain price leaders who set the
price for the rest of the industry

 A dominant firm or a few firms establish the

market price, and other firms in the industry
follow that lead, thereby avoiding price
competition

 Price leader also initiates price changes

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 Price Leadership

 Violates U.S. antitrust laws

 The greater the product differentiation among
sellers, the less effective price leadership will be as
a means of collusion
 There is no guarantee that other firms will follow
the leader
 Some firms will try to cheat on the agreement by
cutting price to increase sales and profits
 Unless there are barriers to entry, a profitable
price will attract entrants
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 Game Theory

 Game theory examines oligopolistic behavior as

a series of strategic moves and countermoves
among rival firms

 It analyzes the behavior of decision-makers, or

players, whose choices affect one another

 Provides a general approach that allows us to

focus on each player’s incentives to cooperate
or not
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 Payoff Matrix

Payoff matrix is a table listing the rewards or

penalties that each can expect based on the
strategy that each pursues

Each prisoner pursues one of two strategies,

confessing or clamming up

The numbers in the matrix indicate the prison

sentence in years for each based on the
corresponding strategies
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 Exhibit 6: Payoff Matrix

Ben’s payoff is in
red and Jerry’s in
blue.
The incentive for
both to confess is the
dominant-strategy
equilibrium of the
game because each
player’s strategy
does not depend on
what the other does.

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 Price Setting Game

 The prisoner’s dilemma applies to a broad

range of economic phenomena such as pricing
policy and advertising strategy

 Consider the market for gasoline in a rural

community with only two gas stations: a
duopoly

 Suppose customers are indifferent between the

two brands and consider only the price
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 Price Setting Game

 Each station sets its daily price early in the

morning before knowing the price set by the
other
 Suppose only two prices are possible: a low
price and a high price
If both charge the low price, they split the market
and each earns a profit of $500 per day
If both charge the high price, they also split the
market and earn $700 profit
If one charges the high price but the other the low
one, the low-price station earns a profit of $1,000
and the high-price station earns $200
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 Exhibit 7: Price-Setting Payoff Matrix
What price for each would
maximize profits?
Texaco: If Exxon charges
the low price, Texaco earns
$500 by charging the low
price, but only $200 by
charging the high price: better
off charging the low price.
If Exxon charges the high
price, Texaco earns $1,000 by
charging the low price and
$700 by charging the high
price: Texaco earns more by
charging the low price.
Exxon faces the same
incentives
Each seller will charge the
low price, regardless of what
the other does: each earns
$500 a day.
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 One-Shot versus Repeated Games

 The outcome of a game often depends on

whether it is a one-shot game or the repeated
game

 The classic prisoner’s dilemma is a one-shot

game: the game is to be played only once

 However, if the same players repeat the

prisoner’s dilemma, as would likely occur in
the price setting game, other possibilities unfold
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 One-Shot versus Repeated Games

 In a repeated-game setting, each player has a

chance to establish a reputation for cooperation
and thereby can encourage the other player to
do the same

 The cooperative solution makes both players

better off than if they fail to cooperate

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 Exhibit 8: Cola War Payoff Matrix

Pepsi’s profit appears

in red and Coke’s in
blue
Pepsi’s decision: If
Coke adopts a big
promotional budget,
Pepsi earns $2 billion by
doing the same, but only
$1 billion by adopting a
moderate budget: Pepsi
should adopt big budget
Coke faces the same
incentives
Both will adopt the
big budget

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 Tit-for-Tat Strategy

 Experiments show that the strategy with the

highest payoff in repeated games turns out to
be the tit-for-tat strategy

 You begin by cooperating in the first round of

play
 Every round thereafter, you cooperate if your
opponent cooperated in the previous round,
and
 You cheat if your opponent cheated in the
previous round

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 Oligopoly and Perfect Competition

Price is usually higher under oligopoly

Profits are higher under oligopoly
If there are barriers to entry into the
oligopoly, profits will be higher than under
perfect competition, in the long run

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Comparison of Market Structures

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