2. Chapter Outline 14 Monopolistic Competition and Oligopoly Monopolistic Competition Product Differentiation, Advertising, and Social Welfare Price and Output Determination in Monopolistic Competition Economic Efficiency and Resource Allocation Oligopoly Oligopoly Models Game Theory Repeated Games A Game with Many Players: Collective Action Can Be Blocked by a Prisoners’ Dilemma Oligopoly and Economic Performance Industrial Concentration and Technological Change The Role of Government Regulation of Mergers A Proper Role?

3. MONOPOLISTIC COMPETITION AND OLIGOPOLY FIGURE 14.1 Characteristics of Different Market Organizations Although not every industry fits neatly into one of these categories, the categories do provide a useful and convenient framework for thinking about industry structure and behavior.

4. MONOPOLISTIC COMPETITION monopolistic competition 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.

5. MONOPOLISTIC COMPETITION Firms in a monopolistically competitive industry are small relative to the total market. New firms can enter the industry in pursuit of profit, and relatively good substitutes for the firms’ products are available. Firms in monopolistically competitive industries try to achieve a degree of market power by differentiating their products—by producing something new, different, or better, or by creating a unique identity in the minds of consumers. 7522 14 8 5 Miscellaneous plastic products Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing . Subject Series EC92m315, June, 2001. 747 .4 39 .7 23 .2 14 Women’s dresses 586 .2 42 .9 22 .6 13 Fresh or frozen seafood 2012 .1 50 .3 36 .5 26 Curtains and draperies 890 59 45 32 Book printing 639 55 42 34 Wood office furniture 239 66 51 31 Dolls 761 50 36 26 Travel trailers and campers NUMBER OF FIRMS TWENTY LARGEST FIRMS EIGHT LARGEST FIRMS FOUR LARGEST FIRMS INDUSTRY DESIGNATION TABLE 14.1 Percentage of Value of Shipments Accounted for by the Largest Firms in Selected Industries, 1997

6. MONOPOLISTIC COMPETITION PRODUCT DIFFERENTIATION, ADVERTISING, AND SOCIAL WELFARE product differentiation A strategy that firms use to achieve market power. Accomplished by producing products that have distinct positive identities in consumers’ minds.

7. MONOPOLISTIC COMPETITION 13.9 Yellow pages Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United States , 2002, Table 1253. 11.8 Magazines 19.5 Radio 5.6 Internet 49.1 Direct mail 62.2 Television 45.4 Newspapers DOLLARS (BILLIONS) TABLE 14.2 Total Advertising Expenditures in 2003

8. MONOPOLISTIC COMPETITION 253 Sporting goods 394 Beer wine and liquor 986 Retail stores 1,699 Toiletries and cosmetics Source: Publishers Information Bureau, Statistical Abstract of the United States , 2002, pg. 772 1,663 Drugs and remedies 1,391 Food and food products 896 Financial, insurance and real estate 1,513 Apparel and accessories 1,554 Home furnishings and supplies 243 729 Technology Telecommunications Computers and software 2,088 Automotive DOLLARS (MILLIONS) TABLE 14.3 Magazine Advertising Revenues by Category, 2003

9. MONOPOLISTIC COMPETITION Restaurants and rock bands are good examples of monopolistic competitors that face intense competition. The advocates of spirited competition believe that differentiated products and advertising give the market system its vitality and are the basis of its power. They are the only ways to begin to satisfy the enormous range of tastes and preferences in a modern economy. Product differentiation also helps to ensure high quality and efficient production, and advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the marketplace. The Case for Product Differentiation and Advertising

10. MONOPOLISTIC COMPETITION The bottom line, critics of product differentiation and advertising argue, is waste and inefficiency. Enormous sums are spent to create minute, meaningless, and possibly nonexistent differences among products. Advertising raises the cost of products and frequently contains very little information. Often, it is merely an annoyance. Product differentiation and advertising have turned the system upside down: 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. The Case Against Product Differentiation and Advertising Product differentiation and advertising waste society’s scarce resources, argue critics. They say enormous sums of money are spent to create minute, meaningless differences among products.

11. MONOPOLISTIC COMPETITION No Right Answer There are strong arguments on both sides of the advertising debate, and even the empirical evidence yields to conflicting conclusions. Some studies show that advertising leads to concentration and positive profits; others, that advertising improves the functioning of the market.

12. MONOPOLISTIC COMPETITION Product Differentiation and Demand Elasticity PRICE AND OUTPUT DETERMINATION IN MONOPOLISTIC COMPETITION Although the demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, it is likely to be more elastic than the demand curve faced by a monopoly. FIGURE 14.2 Product Differentiation Reduces the Elasticity of Demand Facing a Firm

13. MONOPOLISTIC COMPETITION Price/Output Determination in the Short Run To maximize profit, the monopolistically competitive firm will increase production until the marginal revenue from increasing output and selling it no longer exceeds the marginal cost of producing it. This occurs at the point at which marginal revenue equals marginal cost: MR = MC . FIGURE 14.3 Monopolistic Competition in the Short Run

14. MONOPOLISTIC COMPETITION Price/Output Determination in the Long Run The firm’s 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. FIGURE 14.4 Monopolistically Competitive Firm at Long-Run Equilibrium

15. MONOPOLISTIC COMPETITION ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION Because entry is easy and economic profits are eliminated in the long run, we might conclude that the result of monopolistic competition is efficient. There are two problems, however. First, once a firm achieves any degree of market power by differentiating its product (as is the case in monopolistic competition), its profit-maximizing strategy is to hold down production and charge a price above marginal cost. Second, the final equilibrium in a monopolistically competitive firm is necessarily to the left of the low point on its average total cost curve.

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

17. OLIGOPOLY 107 94 89 Small arms ammunition 21 97 82 Household refrigerators and freezers Source: U.S. Department of Commerce, Bureau of the Census, 1997 Census of Manufacturers, Concentration Ratios in Manufacturing , Subject Series 2001. 325 92 83 Motor vehicles 48 94 83 Cereal breakfast foods 54 94 89 Electric lamp bulbs 494 95 90 Malt beverages (beer) 9 100 99 Cigarettes 10 99 90 Household laundry equipment 11 99 95 Primary copper 4 100 Cellulosic man-made fiber NUMBER OF FIRMS EIGHT LARGEST FIRMS FOUR LARGEST FIRMS INDUSTRY DESIGNATION TABLE 14.4 Percentage of Value of Shipments Accounted for by the Largest Firms in High-Concentration Industries, 1997

18. OLIGOPOLY OLIGOPOLY MODELS The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly. Because many different types of oligopolies exist, a number of different oligopoly models have been developed. All kinds of oligopoly have one thing in common:

19. OLIGOPOLY The Collusion Model The colluding oligopoly will face market demand and produce only up to the point at which marginal revenue and marginal cost are equal ( MR = MC ), and price will be set above marginal cost. cartel A group of firms that gets together and makes joint price and output decisions to maximize joint profits. tacit collusion Collusion occurs when price- and quantity-fixing agreements among producers are explicit. Tacit collusion occurs when such agreements are implicit.

20. OLIGOPOLY The Cournot Model The Cournot model of oligopoly results in a quantity of output somewhere between output that would prevail if the market were perfectly competitive and output that would be set by a monopoly. Cournot model 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.

21. OLIGOPOLY The Kinked Demand Curve Model kinked demand curve model A model of oligopoly in which the demand curve facing each individual firm has a “kink” in it. The kink results from the assumption that competitor firms will follow if a single firm cuts price but will not follow if a single firm raises price.

22. OLIGOPOLY FIGURE 14.5 A Kinked Demand Curve Oligopoly Model

23. OLIGOPOLY The Price-Leadership Model As in the other oligopoly models, an oligopoly with a dominant price leader will produce a level of output between the output that would prevail under perfect competition and the output that a monopolist would choose in the same industry. It will also set a price between the monopoly price and the perfectly competitive price. Some competition is usually more efficient than none at all. price leadership A form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.

24. OLIGOPOLY 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. GAME THEORY

25. OLIGOPOLY FIGURE 14.6 Payoff Matrix for Advertising Game

26. OLIGOPOLY dominant strategy In game theory, a strategy that is best no matter what the opposition does. prisoners’ dilemma A game in which the players are prevented from cooperating and in which each has a dominant strategy that leaves them both worse off than if they could cooperate.

27. OLIGOPOLY FIGURE 14.7 The Prisoners’ Dilemma

28. OLIGOPOLY FIGURE 14.8 Payoff Matrixes for Left/Right–Top/Bottom Strategies

29. OLIGOPOLY Nash equilibrium In game theory, the result of all players’ playing their best strategy given what their competitors are doing. maximin strategy In game theory, a strategy chosen to maximize the minimum gain that can be earned.

30. OLIGOPOLY tit-for-tat strategy A company’s strategy that lets a competitor know the company will follow the competitor’s lead. REPEATED GAMES FIGURE 14.9 Payoff Matrix for Airline Game

31. OLIGOPOLY A GAME WITH MANY PLAYERS: COLLECTIVE ACTION CAN BE BLOCKED BY A PRISONERS’ DILEMMA Contestable Markets 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. perfectly contestable market A market in which entry and exit are costless.

32. OLIGOPOLY Review 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 which a few firms get together and jointly maximize profits—in essence, acting as a monopolist. At the other extreme, the firms within the oligopoly vigorously compete for small, contestable markets by moving capital quickly in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolistic firms. Oligopoly is a market structure that is consistent with a variety of behaviors.

33. OLIGOPOLY Oligopolistic, or concentrated, industries are likely to be inefficient for several reasons. First, profit-maximizing oligopolists are likely to price above marginal cost. When price is above marginal cost, there is underproduction from society’s point of view—in other words, society could get more for less, but it does not. Second, strategic behavior can lead to outcomes that are not in society’s best interest. Specifically, strategically competitive firms can force themselves into deadlocks that waste resources. Finally, to the extent that oligopolies differentiate their products and advertise, there is the promise of new and exciting products. At the same time, however, there remains a real danger of waste and inefficiency. OLIGOPOLY AND ECONOMIC PERFORMANCE INDUSTRIAL CONCENTRATION AND TECHNOLOGICAL CHANGE One of the major sources of economic growth and progress throughout history has been technological advance.

34. THE ROLE OF GOVERNMENT REGULATION OF MERGERS Celler-Kefauver Act (1950) Extended the government’s authority to ban vertical and conglomerate mergers. Herfindahl-Hirschman Index (HHI) A mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.

35. THE ROLE OF GOVERNMENT If the Herfindahl-Hirschman Index is less than 1,000, the industry is considered unconcentrated, and any proposed merger will go unchallenged by the Justice Department. If the index is between 1,000 and 1,800, the department will challenge any merger that would increase the index by over 100 points. Herfindahl indexes above 1,800 mean that the industry is considered concentrated already, and the Justice Department will challenge any merger that pushes the index up more than 50 points. HERFINDAHL- HIRSCHMAN INDEX PERCENTAGE SHARE OF: 40 2 + 20 2 + 20 2 + 20 2 = 2,800 20 20 20 40 Industry D 25 2 + 25 2 + 25 2 + 25 2 = 2,500 25 25 25 25 Industry C 80 2 + 10 2 + 10 2 = 6,600  10 10 80 Industry B 50 2 + 50 2 = 5,000   50 50 Industry A FIRM 4 FIRM 3 FIRM 2 FIRM 1 TABLE 14.5 Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical Industries, Each with No More Than Four Firms

36. THE ROLE OF GOVERNMENT FIGURE 14.10 Department of Justice Merger Guidelines (revised 1984)

37. THE ROLE OF GOVERNMENT A PROPER ROLE? Certainly there is much to guard against in the behavior of large, concentrated industries. Barriers to entry, large size, and product differentiation all lead to market power and to potential inefficiency. Barriers to entry and collusive behavior stop the market from working toward an efficient allocation of resources.