Chapter 11 Monopolistic Competition and Oligopoly

QUESTIONS

1. How does monopolistic competition differ from pure competition in its basic characteristics? From pure monopoly?
Explain fully what product differentiation may involve. Explain how the entry of firms into its industry affects the
demand curve facing a monopolistic competitor and how that, in turn, affects its economic profit. LO1

Answer: In monopolistic competition there are many firms but not the very large numbers of pure
competition. The products are differentiated, not standardized. There is some control over price in a narrow
range, whereas the purely competitive firm has none. There is relatively easy entry; in pure competition,
entry is completely without barriers. In monopolistic competition, there is much nonprice competition, such
as advertising, trademarks, and brand names. In pure competition, there is no nonprice competition.
In pure monopoly there is only one firm. Its product is unique and there are no close substitutes. The firm
has much control over price, being a price maker. Entry to its industry is blocked. Its advertising is mostly
for public relations.
Product differentiation may well only be in the eye of the beholder, but that is all the monopolistic competitor
needs to gain an advantage in the market—provided, of course, the consumer looks upon the assumed
difference favorably. The real differences can be in quality, in services, in location, or even in promotion and
packaging, which brings us back to where we started: possibly nonexistent differences. To the extent that
product differentiation exists in fact or in the mind of the consumer, monopolistic competitors have some
limited control over price, for they have built up some loyalty to their brand.
When economic profits are present, additional rivals will be attracted to the industry because entry is relative
easy. As new firms enter, the demand curve faced by the typical firm will shift to the left (fall). Because of
this, each firm has a smaller share of total demand and now faces a larger number of close-substitute
products. This decline firm’s demand reduces its economic profit.

2. Compare the elasticity of a monopolistic competitor’s demand with that of a pure competitor and a pure monopolist.
Assuming identical long-run costs, compare graphically the prices and outputs that would result in the long run under
pure competition and under monopolistic competition. Contrast the two market structures in terms of productive and
allocative efficiency. Explain: “Monopolistically competitive industries are populated by too many firms, each of
which produces too little.” LO2

Answer: The monopolistic competitor’s demand curve is less elastic than a pure competitor and more elastic
than a pure monopolist. Your graphs should look like Figure 9.6 (pure competition) and Figure 11.1
(monopolistic competition). Price is higher and output lower for the monopolistic competitor. Pure
competition: P = MC (allocative efficiency); P = minimum ATC (productive efficiency). Monopolistic
competition: P > MC (allocative inefficiency) and P > minimum ATC (productive inefficiency).
Monopolistic competitors have excess capacity; meaning that fewer firms operating at capacity (where P =
minimum ATC) could supply the industry output.
3. “Monopolistic competition is monopolistic up to the point at which consumers become willing to buy close-
substitute products and competitive beyond that point.” Explain. LO2

Answer: As long as consumers prefer one product over another regardless of relative prices, the seller of the
product is a monopolist. But in monopolistic competition this happy state is limited because there are many
other firms producing similar products. When one firm’s prices get “too high” (as viewed by consumers),
people will switch brands. At this point, our firm has entered the competitive zone unwillingly, which is why
monopolistically competitive firms are forever trying to find ways to differentiate their products more
thoroughly and thus to gain more monopoly price-setting power.

4. “Competition in quality and service may be just as effective as price competition in giving buyers more for their
money.” Do you agree? Why? Explain why monopolistically competitive firms frequently prefer nonprice competition
to price competition. LO2

Answer: This can certainly be true. It depends on how much consumers value quality and service, and are
willing to pay for it through higher product prices. In a monopolistically competitive market the consumer
can buy a substitute brand for a lower price, if the consumer prefers a lower price to better quality and
service.
 The monopolistically competitive firm frequently prefers nonprice competition to price competition, because
the latter can lead to the firm producing where P = ATC and thus making no economic profit or, worse,
producing in the short run where P < ATC and thus losing money, with the possibility of eventually going out
of business.
Nonprice competition, on the other hand, if successful, results in more monopoly power: The firm’s product
has become more differentiated from now less-similar competitors in the industry. This increase in
monopoly power allows the firm to raise its price with less fear of losing customers. Of course, the firm must
still follow the MR = MC rule, but its success in nonprice competition has shifted both the demand and MR
curves upward to the right. This results in simultaneously a larger output, a higher price, and more economic
profits.

5. Critically evaluate and explain: LO2

(a) In monopolistically competitive industries, economic profits are competed away in the long run; hence, there is no
valid reason to criticize the performance and efficiency of such industries.
(b) In the long run, monopolistic competition leads to a monopolistic price but not to monopolistic profits.

Answer:
(a) The first part of the statement may well be true, but it does not lead logically to the second part. The
criticism of monopolistic competition is not related to the profit level but to the fact that the firms do not
produce at the point of minimum ATC and do not equate price and MC. This is the inevitable
consequence of imperfect competition and its downward sloping demand curves. With P > minimum
ATC, productive efficiency is not attained. The firm is producing too little at too high a cost; it is
wasting some of its productive capacity. With P > MC, the firm is not allocating resources in
accordance with society’s desires; the value society sets on the product (P) is greater than the cost of
producing the last item (MC).

(b) The statement is often true, since competition of close substitutes tends to compete price of the average
firm down to equality with ATC. Thus, there is no economic profit. However, the firm is producing where its
(moderately) monopolistically downward-sloping demand curve is tangent to the ATC curve, short of the
point of minimum ATC and thus at a higher than purely competitive price. In other words, it is at a
“monopolistic” price.

6. Why do oligopolies exist? List five or six oligopolists whose products you own or regularly purchase. What
distinguishes oligopoly from monopolistic competition? LO3

Answer: Oligopolies exist for several reasons, the most common probably being economies of scale. If these
are substantial, as they are in the automobile industry, for example, only very large firms can produce at
minimum average cost. This makes it virtually impossible for new firms to enter the industry. A small firm
could not produce at minimum cost and would soon be competed out of the business; yet to start at the
required very large scale would take far more money than an unestablished firm is likely to be able to raise
before proving it will be profitable.
Other barriers to entry include ownership of patents by the oligopolists and, possibly, massive advertising
that gives would-be newcomers no chance to establish a presence in the public’s mind. Finally, there is the
urge to merge. Mergers have the clear advantage of reducing competition—of giving the emerging
oligopolists more monopoly power. Also, they may result in more economies of scale and thereby increase
that barrier to new entry.
Oligopolies with which we deal include manufacturers of automobiles, ovens, refrigerators, personal
computers, gasoline, and courier services.
Oligopoly is distinguished from monopolistic competition by being composed of few firms (not many); by
being mutually interdependent with regard to price (instead of control within narrow limits); by having
differentiated or homogeneous products (not all differentiated); and by having significant obstacles to entry
(not easy entry). Both engage in much nonprice competition.

7. Answer the following questions, which relate to measures of concentration: LO3

(a) What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent? What are the shortcomings of
concentration ratios as measures of monopoly power?
(b) Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent of total industry sales.
For the five firms in industry B, the figures are 60, 25, 5, 5, and 5 percent. Calculate the Herfindahl index for each
industry and compare their likely competitiveness.

Answer: A four-firm concentration ratio of 60 percent means the largest four firms in the industry account
for 60 percent of sales; a four-firm concentration ratio of 90 percent means the largest four firms account for
90 percent of sales (just add the percentage of sales for the largest four firms). Shortcomings: (1) they
pertain to the nation as a whole, although relevant markets may be localized; (2) they do not account for
interindustry competition; (3) the data are for U.S. products—imports are excluded; and (4) they don’t reveal
the dispersion of size among the top four firms.
To calculate the Herfindahl index square the percentages for all firms in the industry (do NOT use decimal
form) and add them together.

For industry A we have:

Herfindahl index = 302+302+202+102+102= 900+900+400+100+100= 2400
For industry B we have:
Herfindahl index = 602+252+52+52+52= 3600+625+25+25+25= 4300
We would expect industry A to be more competitive than Industry B because the largest two firms in industry
B control a greater percentage of the market. If all firms controlled an equal share of the market (20% for the
five firms above ) the Herfindahl index would equal 2000. If one firm (out of the five) controlled the entire
market (100%) the Herfindahl index would equal 10,000. The latter case is obviously a monopoly. The closer
the Herfindahl index is to the monopoly case the less competition there will be in the market.

8. Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit figures are in
thousands. LO4

(a) Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries.
(b) Assuming no collusion between X and Y, what is the likely pricing outcome?
(c) In view of your answer to 8b, explain why price collusion is mutually profitable. Why might there be a temptation
to cheat on the collusive agreement?

Answer:
(a) X and Y are interdependent because their profits depend not just on their own price, but also on the other
firm’s price. Note that Y's profits are in the lower corner and X's profits are in the upper corner.
 (b) Likely outcome: Both firms will set price at $35. If either charged $40, it would be concerned the other
would undercut the price and its profit by charging $35. For example, if firm X chooses a price of $40
and firm Y chooses a price of $40 then firm X's profits are $57,000 and firm Y's profits are $60,000.
However, if firm Y chooses to charge $35 it can increase its profit to $69,000. In effect, firm Y has an
incentive to deviate from the price of $40. The same logic applies to firm X. If firm X deviates from the
price of $40 it can increase profits to $59,000. The catch is that both firms recognize this incentive
structure and realize that if they continue to charge $40 and the other firm deviates from this price their
profits will fall (If firm X continues to charge $40 and firm Y charges $35, rather than $40, to capture
higher profits then firm X's profits will fall to $50,000. If firm X also charged $35 its profits would be
$55,000, which is better than $50,000). Thus, both firms charge a price $35; X’s profit is $55,000, Y’s,
$58,000.
(c) Through price collusion—agreeing to charge $40—each firm would achieve higher profits (X =
$57,000; Y = $60,000). But once both firms agree on $40, each sees it can increase its profit even more
by secretly charging $35 while its rival charges $40, which was discussed above.

9. What assumptions about a rival’s response to price changes underlie the kinked-demand curve for oligopolists? Why
is there a gap in the oligopolist’s marginal-revenue curve? How does the kinked-demand curve explain price rigidity in
oligopoly? What are the shortcomings of the kinked-demand model? LO5

Answer: Assumptions: (1) Rivals will match price cuts: (2) Rivals will ignore price increases. The gap in
the MR curve results from the abrupt change in the slope of the demand curve at the going price. Firms will
not change their price because they fear that if they do their total revenue and profits will fall. Shortcomings
of the model: (1) It does not explain how the going price evolved in the first place; (2) it does not allow for
price leadership and other forms of collusion.

10. Why might price collusion occur in oligopolistic industries? Assess the economic desirability of collusive pricing.
What are the main obstacles to collusion? Speculate as to why price leadership is legal in the United States, whereas
price-fixing is not. LO6

Answer: Price wars are a form of competition that can benefit the consumer but can be highly detrimental to
producers. As a result, oligopolists are naturally drawn to the idea of price-fixing among themselves, i.e.,
colluding with regard to price. In a recession, it is nice to know whether one’s rivals will cut prices or
quantity, so that a mutually satisfactory solution can be reached. It is also convenient to be able to agree on
what price to set to bankrupt any would-be interloper in the industry.
From the viewpoint of society, collusive pricing is not economically desirable. From the oligopoly’s
viewpoint it is highly desirable since, when entirely successful, it allows the oligopoly to set price and
quantity as would a profit-maximizing monopolist.

The main obstacles to collusion are demand and cost differences (which result in different points of equality of MR and
MC); the number of firms (the more firms, the lower the possibility of getting together and reaching sustainable
agreement); cheating (it pays to cheat by selling more below the agreed-on price—provided the other colluders do not
find out); recession (when demand slumps, the urge to shave prices—to cheat—becomes much greater); potential entry
(the above-equilibrium price that is the reason for collusion may entice new firms into this profitable industry—and it
may be hard to get new entrants into the combine, quite apart from the unfortunate increase in supply they will cause);
legal obstacles (for a century, antitrust laws have made collusion illegal).
Price leadership is legal because although the firms may follow the dominant firm’s price, they are not
compelled to. Also, the tacit agreement on price does not include an agreement to control quantity and to
divide up the market.

11. Why is there so much advertising in monopolistic competition and oligopoly? How does such advertising help
consumers and promote efficiency? Why might it be excessive at times? LO7

Answer: Two ways for monopolistically competitive firms to maintain economic profits are through product
development and advertising. Also, advertising will increase the demand for the firm’s product. The
oligopolist would rather not compete on a basis of price. Oligopolists can increase their market share through
 advertising that is financed with economic profits from past advertising campaigns. Advertising can operate
as a barrier to entry.
Advertising provides information about new products and product improvements to the consumer.
Advertising may result in an increase in competition by promoting new products and product improvements.
It may also result in increased output for a firm, pushing it down its ATC curve and closer to productive
efficiency (P = minimum ATC).
Advertising may result in manipulation and persuasion rather than information. An increase in brand loyalty
through advertising will increase the producer’s monopoly power. Excessive advertising may create barriers
to entry into the industry.

12. ADVANCED ANALYSIS Construct a game-theory matrix involving two firms and their decisions on high versus
low advertising budgets and the effects of each on profits. Show a circumstance in which both firms select
high advertising budgets even though both would be more profitable with low advertising budgets. Why
won’t they unilaterally cut their advertising budgets? LO7

Answer: Consider the following example, where Firm B's profits are in the lower corner and Firm A's profits
are in the upper corner :

Firm A’s Advertising

Low High
Budget Budget

Low
Firm B’s Budget $100 $120
Advertising
$100 $60

High
Budget $60 $80

$120 $80

Profits from each advertising strategy appear in the cells

In the payoff matrix above, each firm can choose between a low and high advertising budget. If, for
example, Firm A chooses a high budget and Firm B a low budget, Firm A’s profit will be $120, and Firm B’s
only $60.
 The payoff matrix suggests that both firms should have high advertising budgets, but if both choose to do so,
they will both be worse off relative to if they both had low budgets. Neither firm will reduce its budget
because if it does and its rival doesn’t, the firm reducing will lose profits to the other firm. Unless they
collude, the firms will both end up with large advertising budgets and reduced profits. (This argument is
similar to the one found in problem 8b and 8c.)
Also note that any values with the ordering above can serve as an answer to this question:

Firm A’s Advertising

Low High
Budget Budget

Low
Firm B’s Budget $Q $X
Advertising
$Q $Y

High
Budget $Y $Z

$X $Z

The restrictions are $X > $Q > $Z > $Y.

13. LAST WORD What firm dominates the U.S. beer industry? What demand and supply factors have contributed to
“fewness” in this industry?

Answer: Anheuser-Busch is the dominant firm in the industry.

On the demand side, there is evidence that by the 1970s tastes had changed in favor of lighter, drier beers
produced by the larger brewers. Second, there has been a shift from consumption in taverns to home
consumption, which means higher sales of packaged containers that can be shipped long distances.
On the supply side, technological advances have increased bottling lines, so that the number of cans filled per
hour rose from 900 in 1965 to over 2000 in 1990s; large plants have been able to take advantage of
economies of scale; television advertising also favors the large producers; and extensive product
differentiation exists despite the smaller number of firms, which has enabled these firms to expand still
further.
PROBLEMS

1. Suppose that a small town has seven burger shops whose respective shares of the local hamburger market are (as
percentages of all hamburgers sold): 23%, 22%, 18%, 12%, 11%, 8%, and 6%. What is the four‐firm concentration
ratio of the hamburger industry in this town? What is the Herfindahl index for the hamburger industry in this town? If
the top three sellers combined to form a single firm, what would happen to the four‐firm concentration ratio and to the
Herfindahl index? LO3

Answers: The four-firm concentration ratio is 75%; the Herfindahl Index is 1702 (= 529 + 484 + 324 +144 + 121
+ 64 + 36); The new four-firm concentration ratio would be 94%; the new Herfindahl Index would be 4334 =
(3969 + 144 +121 + 64 + 36).

Feedback: Consider the following example: Suppose that a small town has seven burger shops whose
respective shares of the local hamburger market are (as percentages of all hamburgers sold): 23%, 22%, 18%,
12%, 11%, 8%, and 6%.

The four-firm concentration ratio is found by adding together the top four firm's percentage of sales. For the
values above, the four-firm concentration ratio equals 75% (= 23% + 22% + 18% + 12%).

The Herfindahl index is found by squaring the percentages for all of the firms in the industry (not the decimal
form) and then adding these values together. For the values above, the Herfindahl index equals 1702 (= 232 +
222 +182 +122 + 112 + 82 + 62 = 529 + 484 + 324 + 144 + 121 + 64 + 36).

If the top three sellers combine to form a single firm, this combined firm will control 63% of the market (=
23% + 22% + 18%). Thus, we now have five firms in the industry whose respective shares of the local
hamburger market are now 63%, 12%, 11%, 8%, and 6%.

The new four-firm concentration ratio is 94% (= 63% + 12% + 11% + 8%).

The new Herfindahl index is 4334 ( = 632 + 122 + 112 + 82 + 62 = 3969 + 144 + 121 + 64 + 36).

2. Suppose that the most popular car dealer in your area sells 10 percent of all vehicles. If all other car dealers sell
either the same number of vehicles or fewer, what is the largest value that the Herfindahl index could possibly take for
car dealers in your area? In that same situation, what would the four‐firm concentration ratio be? LO3

Answers: To maximize the Herfindahl Index means to have an industry with as much concentration as possible.
That calls for firms that are as big as possible. With the largest firm controlling only 10%, the way to have the
rest of the industry be as concentrated as possible would be for there to be 9 other firms that each also
controlled 10% of the market (for a total of 10 firms each controlling 10%). In that situation, the Herfindahl
index would be 1000 (= 10*(102)) and the four-firm concentration ratio would be 40% (= 4*10%).

Feedback: Consider the following example: Suppose that the most popular car dealer in your area sells 10 percent of
all vehicles. If all other car dealers sell either the same number of vehicles or fewer in the market then the largest
number of dealers possible is 10. This follows from the fact that the largest share any dealer can have is 10%, and the
sum of all dealer shares must equal 100% of the market, we therefore have a maximum number of firms at 10 (=
100%/10%).

Given that the maximum number of firms in the market equals 10, at a maximum concentration share of 10%
for all firms, the largest Herfindahl index possible is 1000 (=10 (number of firms) x 102 (percentage squared
for each firm)).

This logic also implies that the four-firm concentration ratio (largest possible) is 40% (= 4 (largest four firms,
could be any of the ten) x 10% (share of the market)).

3. Suppose that an oligopolistically competitive restaurant is currently serving 230 meals per day (the output where MR
= MC). At that output level, ATC per meal is $10 and consumers are willing to pay $12 per meal. What is the size of
this firm’s profit or loss? Will there be entry or exit? Will this restaurant’s demand curve shift left or right? In long‐run
equilibrium, suppose that this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th
meal is $8. What is the size of the firm’s profit? Suppose that the allocatively efficient output level in long-run
equilibrium is 200 meals. Is the deadweight loss for this firm greater than or less than $60? LO3
Answers: The firm will earn a profit of $460 [= ($12-$10)*230]; there will be entry, shifting the firm’s individual
demand curve to the left; In long-run equilibrium, this firm will be earning zero profit so the information about
what the firm is charging and what the MC is for the 180th meal are irrelevant pieces of information for this
particular question; The deadweight loss will be less than $60—students can see this by noting that $60 must be
an upper bound because even if the $3 per unit difference between marginal benefit as given by the demand
curve ($11) and marginal cost as given by the MC curve ($8) continued for all units between the 180th and the
200th, the deadweight loss would only amount to $60 (= $3 per unit times 20 units). But with MC rising for all of
these units and the demand curve falling, the deadweight loss would have to be smaller.

Feedback: Consider the following example: An oligopolistically competitive restaurant is currently serving
230 meals per day (the output where MR = MC). At that output level, ATC per meal is $10 and consumers
are willing to pay $12 per meal.

Since the restaurant's ATC per meal is $10 and the restaurant receives $12 per meal, the restaurant's profit per
meal is $2 (= $12 - $10). Given that the restaurant sells 230 meals at this price its profit is $460 (= $2x230).

Given that this restaurant is making an economic profit there will be entry into this industry since other firms
will try to capture some of this economic profit. The entry of other firms will reduce demand for the
restaurant causing its demand schedule to shift to the left.

Now assume that in long‐run equilibrium this restaurant charges $11 per meal for 180 meals and that the
marginal cost of the 180th meal is $8. Also assume that the allocatively efficient output level in long-run
equilibrium is 200 meals in the long-run.

The economic profit in the long-run is always zero in this type of market (monopolistic competition).

The deadweight loss will be less than $60—students can see this by noting that $60 must be an upper bound
because even if the $3 per unit difference between marginal benefit as given by the demand curve ($11) and
marginal cost as given by the MC curve ($8) continued for all units between the 180th and the 200th, the
deadweight loss would only amount to $60 (= $3 per unit times 20 units). But with MC rising for all of these
units and the demand curve falling, the deadweight loss would have to be smaller.