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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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Chapter 10

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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.

  • Oligopoly: An industry is dominated by a few firms.

  • Monopoly: A single firm produces all the output.

Market Power

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.

Concentration Ratio

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


4-firm concentration ratios, Examples

  • Cigarettes = 93%

  • Household refrigerators = 82%

  • Electric light bulbs = 86%

  • Motor vehicles = 84%

  • Greeting Cards = 84%

  • Blast furnaces = 37%

  • Tools, dies, and jigs = 3%

Limits of these ratios

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.

The nature of Imperfect Competition

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.

Review: The U-Shaped AC Curve

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

the market.

Review: Barriers to Entry

Barriers to entry can be economic (high

start-up costs) or legal (government


New Concept: Strategic Interaction

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.

Product Prices

Under imperfect competition, product prices

may not equal the marginal cost of

production. As a result, the firms may

enjoy “supernormal” profits.

Empirical Studies

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


Research and Development

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.

Theories of Imperfect Competition

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.

Case 1: Collusive Oligopoly

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.

Rewards of 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.

Collusive Oligopoly looks like Monopoly




firm A

profits are the pink





The problem of “cheating”

Cartels may fall apart if firms are tempted

to cheat, either by undercutting prices or

producing more than their “share” of the

total output.

Example: OPEC

Case II: Monopolistic Competition

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

not identical.

Examples of Monopolistic Competition

Shampoos, frozen foods, detergent,

cosmetics, magazines, etc.

Gas stations, restaurants, grocery


Product Differentiation

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.”

Fishing Magazine Example

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.

Initial Equilibrium for Fishing Magazine -- looks like regular monopoly





But under monopolistic competition . . .

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 profits.

Equilibrium for fishing magazine after entry of new competitor(s)




Easy entry of new firms

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.

Long-Run Equilibrium under Monopolistic Competition

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


Is Monopolistic Competition “good” for consumers?

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.

Case III: Oligopoly with Rivalry

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

Game theory is a technique used to analyze

the outcomes of strategic interactions.

Game theory results have shed some light

on rivalry in oligopolies.

Important Results

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


Important Results, Continued

In many situations, there is no stable

equilibrium for an oligopoly.

Section B

Control, Innovation, and Information

Large Corporations

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.

Board of Directors

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

may arise.

Potential Conflicts

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.

A note on “bounded rationality”

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.

Joseph Schumpeter

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

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.

Basic Research

Because some basic research is inappropriable

to a certain degree, private investment would

fall below a social optimum without

government investment.

Intellectual Property and the Internet

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.

Section C

The “Balance Sheet” on Imperfect Competition

We have seen that. . .

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.

Measuring “Waste” from Imperfect Competition

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.

Competitive Solution

Consumer Surplus







Monopoly Solution

Consumer Surplus









Monopoly Solution

Consumer Surplus

plus extra profits.

Some of the lost area

of consumer surplus

goes to monopoly









Dead-Weight Loss

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.”








Empirical Studies of Costs of Monopolies

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


More thoughts on monopolies

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.

Intervention Strategies

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 Laws

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.

Encouraging Competition

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


Government Regulation

Regulation tells the business how it can

operate and how to price products. It is

government control without government


Government Ownership

This approach has been widely used outside

the U.S. for natural monopolies such as

utilities. This approach is not popular in

market economies.

Price Controls

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.

Bottom Line

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.

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