Chapter 10. Oligopoly and Monopolistic Competition. Behavior of Imperfect Competitors. Perfect Competition: Many firms produce an identical output. No firm can affect market price. Monopolistic competition: A large number of firms produce slightly differentiated products.
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Oligopoly and Monopolistic Competition
Market power signifies the degree of
control that a single firm or a small number
of firms has over the price and production
decisions in an industry.
The four-firm concentration ratio is
defined as the percent of total industry
output that is accounted for by the largest
four firms. Similarly, one can define
an eight-firm (or other number) concentration
Concentration ratios do not include the
effect of international competition or
structural change. The top four U.S.
auto makers have 84% of U.S. output,
but if imports are included, the figure
drops to 67% of U.S. sales.
Three major factors are present in imperfectly
competitive markets: costs, barriers to
entry, and strategic interactions.
(Two of these are familiar from the previous
When the minimum “efficient” size of
operation for a firm occurs at a sizable
proportion of the total industry output,
only a few firms can profitably survive.
Remember that the Average Cost curve is
U-shaped. If the minimum point occurs at
a large output level, relative to the size of the
market, there will likely be only a few firms in
Barriers to entry can be economic (high
start-up costs) or legal (government
When only a few firms operate in market,
they will probably recognize their
interdependence. Strategic interaction
occurs when each firm’s business plan
depends on the behavior of its rivals. We’ll
return to this concept later in this chapter.
Under imperfect competition, product prices
may not equal the marginal cost of
production. As a result, the firms may
enjoy “supernormal” profits.
Empirical studies show that profits in
many concentrated industries are
only slightly higher than in
unconcentrated ones. We’ll see
why this is the case later in this
R&D expenditures tend to be high in
concentrated industries as each firm tries
to get an edge on its rivals. By contrast,
small firms in unconcentrated industries
usually see little purpose in such
investments. High investments in R&D
are generally seen as a mitigating
advantage of concentrated industries.
Industrial organization is the study of
the behavior of imperfectly competitive
industries. In this class, we will look
at only three of the possible organizations.
When firms in an oligopoly actively
cooperate with each other, they engage
in collusion. Two or more firms jointly
set their prices or outputs, divide the
market, or make other business decisions
One type of collusive oligopoly is a cartel.
A cartel is an organization of independent
firms, producing similar products, that work
together to raise prices and restrict output.
Cartels are illegal in the U.S., but firms
are often tempted to engage in tacit collusion.
Imagine four firms that decide to maximize
their joint profits. In such a situation, the
firms seek the collusive oligopoly equilibrium.
This solution looks like the monopoly case.
profits are the pink
Cartels may fall apart if firms are tempted
to cheat, either by undercutting prices or
producing more than their “share” of the
Under monopolistic competition, there are
many firms and entry into the industry is
relatively easy. The difference between
perfect competition and monopolistic
competition is that the product is
Shampoos, frozen foods, detergent,
cosmetics, magazines, etc.
Gas stations, restaurants, grocery
Because of product differentiation, each
firm in monopolistic competition faces a
downward sloping demand curve, as in a
monopoly. The difference is that new firms
can easily enter the market if the profits
earned by one firm are “too high.”
A fishing magazine would face a downward
sloping demand because it is somewhat
differentiated from other magazines.
Initially, the market equilibrium might
lead to high profits.
The high profits enjoyed by the magazine
will entice other people to put together a
new fishing magazine. Another firm can
enter this industry by hiring an editor, some
writers, and other workers, and locating a
printer. The competition will decrease the
demand for the original magazine, eroding
The easy entry of new firms into an industry
characterized by monopolistic competition
explains why economists do not find excess
profits in most firms in this situation. New
firms will enter the industry until economic
profits (which account for opportunity costs)
fall to zero.
In the long-run equilibrium position for a
firm in monopolistic competition, price
is above MC, but economic profits are
driven to zero.
(Remember this condition for the next
Under monopolistic competition, price is
above MC and output per firm is reduced
below the ideal competitive level. Thus,
price is probably higher than it would be
for a non-differentiated product.
However, monopolistic competition gives
people more choices and greater variety.
In this case, a firm competes with a
few other firms and tries to “guess” its
rivals reactions to its business decisions.
The firm will maximize profits by taking
into account its rivals likely reactions.
This is called “strategic interaction.”
Game theory is a technique used to analyze
the outcomes of strategic interactions.
Game theory results have shed some light
on rivalry in oligopolies.
As the number of noncooperative or competing
oligopolists becomes “large,” industry price and
quantity tend toward the competitive equilibrium.
If firms collude, rather than compete, the
market tends toward the monopoly price and
output. But as the number of firms increases,
collusive agreements are more difficult to
In many situations, there is no stable
equilibrium for an oligopoly.
Control, Innovation, and Information
Most large companies are publicly owned.
Corporate shares (stock) can be bought
by anyone with enough money.
Because ownership of stock in many large
companies is widely dispersed, ownership
is usually divorced from control.
Stock-holders of a company elect a board
of directors, but most of the decisions are
made by salaried managers. Most of the
time there is no conflict between the board
and the management, but conflicts of interest
1) Insiders may vote themselves large
salaries, expense accounts, bonuses, etc.,
at the expense of stockholders.
2) Managers may want to hold onto profits
to expand and build the company, while
directors may want them paid out as dividends
or used to invest elsewhere.
3) Managers may not want to take risks.
Page 178. Your textbook notes that in real
life consumers and producers operate with
imperfect information and limited time. They
may not exactly maximize utility or profit,
but instead settle for a reasonable approximation.
Schumpeter’s writings emphasized the
importance of the entrepreneur or
innovator. He saw in the entrepreneur
the “hero” of capitalism, and viewed
capitalism itself as a dynamic process.
The market for information presents a special
challenge. Information is difficult to produce
but easy to reproduce. The inability of a
firm to capture the full value of its inventions
is called inappropriability, and it is a problem
in the information industry and in other
areas, as well.
Because some basic research is inappropriable
to a certain degree, private investment would
fall below a social optimum without
The marginal cost of reproducing material
on the internet is close to zero. However,
the total cost of producing the material
in the first place might be high. Intellectual
property rights allow creators to benefit from
their creations. Enforcing such rights can
be difficult in some situations, however.
The “Balance Sheet” on Imperfect Competition
We have seen that imperfect competition
can result in higher prices and lower output
of products. Even though a monopoly, for
example, follows the same profit-maximization
rule as a perfectly competitive firm (MR=MC),
because of the market structure, market price
in a monopoly will be higher than MC.
We can measure the “efficiency loss” from
imperfect competition by looking
at consumer surplus. If the industry could
be competitive, then price is set where
supply (representing MC) equals demand.
plus extra profits.
Some of the lost area
of consumer surplus
goes to monopoly
The orange triangle
is dead-weight loss.
This area of former
consumer surplus does
not go into profits to the
monopoly. It is just “lost.”
Economists have measured the dead-weight
loss of imperfect competition in the U.S.
Recent studies have found the loss to be
between 0.5 and 2% of GNP.
It is also important to remember that imperfect
competition can promote innovation and
discovery. Also, the cost structure of an industry
could lead to higher prices if there were many
Some economists maintain that monopolies
become complacent, paying little attention
to product quality or consumer desires
because there are no rivals. An example
involves AT&T, which provided only plain
black phones while it enjoyed monopoly status.
Governments can use six major tools to
deal with imperfect competition:
legislating antitrust policy, encouraging
competition, regulating the monopoly,
taking ownership of the monopoly, setting
price controls, and taxing monopoly profits.
Antitrust policies are laws that prohibit
certain kinds of behavior, such as collusion.
Antitrust policies are discussed in detail
in chapter 17 of your book.
Allowing imports is one means of
encouraging competition. Removing any
domestic legal barriers to entry is another.
(Remember that communities may have
social reasons to limit certain types of
Regulation tells the business how it can
operate and how to price products. It is
government control without government
This approach has been widely used outside
the U.S. for natural monopolies such as
utilities. This approach is not popular in
Price controls lead to market distortions.
The gas shortage of the 1970s occurred
because price could not fully adjust to
reflect the new supply and demand
Taxation can reduce monopoly profits (and
presumably direct those earnings toward
socially desirable outcomes), but it does
not alleviate the price and output distortions.
It is too simplistic to say that perfect
competition is always better than
imperfect competition. Firms tend toward
a certain size and structure because of
technology and market conditions.