Chapter 10

1. Chapter 10 Oligopoly and Monopolistic Competition

2. 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.

3. 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.

4. 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 ratio.

5. 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%

6. 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.

7. 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 chapters.)

8. Costs 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.

9. 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.

10. Review: Barriers to Entry Barriers to entry can be economic (high start-up costs) or legal (government restrictions).

11. 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.

12. Product Prices Under imperfect competition, product prices may not equal the marginal cost of production. As a result, the firms may enjoy “supernormal” profits.

13. 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 chapter.

14. 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.

15. 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.

16. 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 together.

17. Cartel 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.

18. 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.

19. Collusive Oligopoly looks like Monopoly MC p* AC firm A profits are the pink box. d MR q*

20. 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

21. 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.

22. Examples of Monopolistic Competition Shampoos, frozen foods, detergent, cosmetics, magazines, etc. Gas stations, restaurants, grocery stores.

23. 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.”

24. 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.

25. Initial Equilibrium for Fishing Magazine -- looks like regular monopoly p* d mr q*

26. 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.

27. Equilibrium for fishing magazine after entry of new competitor(s) p* d q*

28. 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.

29. 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 test!!!!)

30. 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.

31. 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.”

32. 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.

33. 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 maintain.

34. Important Results, Continued In many situations, there is no stable equilibrium for an oligopoly.

35. Section B Control, Innovation, and Information

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. Basic Research Because some basic research is inappropriable to a certain degree, private investment would fall below a social optimum without government investment.

43. 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.

44. Section C The “Balance Sheet” on Imperfect Competition

45. 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.

46. 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.

47. Competitive Solution Consumer Surplus MC AC p* MR d q*

48. Monopoly Solution Consumer Surplus MC pm AC pc MR d qm qc

49. Monopoly Solution Consumer Surplus plus extra profits. Some of the lost area of consumer surplus goes to monopoly profits. MC pm pc MR d qc qm

50. 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.” MC pm pc MR d qc qm