At price p1 the firm in figure 11.1 would produce

iS to

ck ph

ot o/

Th in

ks to

ck Learning Objectives

By the end of this chapter, you will be able to:

• Describe the characteristics of monopolistic competition.

• Explain why interdependence is unique to oligopoly.

• Understand why government policy is often necessary to assure the success of a cartel.

• Use game theory to understand oligopolistic behavior.

• Describe how and why equilibrium price and output under monopolistic competition and oligop- oly differ from that of perfect competition.

Monopolistic Competition and Oligopoly

11

ama80571_11_c11_305-330.indd 305 1/28/13 9:50 AM

Section 11.1 What Is an Industry? CHAPTER 11

Introduction

Consider this. . . What’s in a brand name? Do you have a favorite soap, aspirin, breakfast food, or cola? When you get right down to it, a bar of soap is pretty much a bar of soap. An aspirin is pretty much an aspirin and a cola is pretty much a cola. Maybe including colas is taking it too far—to some people one cola is not the same as any other cola. A few decades ago Coke introduced a new cola, and some of its customers revolted; some of them even hoarded cases of the original version of the cola. Coke even- tually gave up and brought back the old favorite as Coca-Cola Classic. To these consumers, one cola was definitely not the same as any other.

To the owner of a brand name, the important question is how much different is the prod- uct that has the brand identification. Is it a quarter different? Would you pay 25 cents more for a bar of Dove soap? Would you pay a dollar more per bar? How much would you be willing to pay to buy Tylenol over the generic acetaminophen? Perhaps two dollars more? Clearly the value of the brand disappears at some price. Even a product with a brand name is still subject to the forces of supply and demand in a competitive market.

We have just seen in Chapters 9 and 10 that there are no perfect real-world examples of either perfect competition or monopoly. For many years, however, all real-world indus- tries were analyzed in terms of these two models. In the 1930s, theories were developed that filled out the spectrum between monopoly and perfect competition. Market struc- tures between the two theoretical extremes are called imperfect competition. Economists divide imperfect competition into monopolistic competition and oligopoly. We will study these two market structures in this chapter.

11.1 What Is an Industry?

We have, up to this point, been using the term industry without carefully defin-ing it. In general, an industry is a group of firms producing the same, or at least similar, products. The difficulty with this definition is that it does not specify how dissimilar products must be before they are thought of as being produced in differ- ent industries. Consider containers. Are firms producing glass bottles and aluminum cans similar enough to be included in the container industry? How about firms making paper cups or even pewter mugs? Most consumers regard pewter mugs and paper cups as quite different. If you are willing to pay substantially more for a pewter mug than for a paper cup, you regard them as being distinct products. What about a plastic Ronald McDonald glass? Is it closer to a paper cup or a pewter mug? These questions demonstrate that what- ever scope is assigned to an industry will be arbitrary to some extent. Some people, even some economists, may disagree with a classification of two products as belonging to the same industry or to different industries.

Cross elasticity of demand, a concept we discussed earlier, can be useful in determining whether products belong to the same industry. If the cross elasticity of demand between two products is positive, the goods are substitutes. Goods that are close substitutes have

ama80571_11_c11_305-330.indd 306 1/28/13 9:50 AM

Section 11.2 Industry Structure CHAPTER 11

Concentration Ratios

Concentration refers to the extent to which a certain number of firms dominate sales in a given market. Measures of concentration have, for many years, been a major tool of industry studies. A concentration ratio is used by economists to provide a measure of the distribution of economic power among firms in an oligopolistic market. To calculate a concentration ratio, the economist lists all the firms in a particular industry in order of decreasing size. The next step is to calculate the percentage of that industry’s total sales accounted for by a certain number of the largest firms. For example, a four-firm concen- tration ratio measures the percentage of sales accounted for by the four largest firms in an industry. Other commonly used concentration ratios are for the largest firm, the three largest firms, the eight largest firms, and so on. Most industry studies employ four-firm ratios. Table 11.1 gives four-firm concentration ratios for a few industries.

Economics in Action: What’s in Between? There is a drastic difference between monopolies (one seller) and perfect competition (many sell- ers). Are there opportunities for any markets that fall in between these two? Follow the link to the Khan Academy (http://www.khanacademy.org), and then do a search for the video "Oligopolies and Monopolistic Competition" to learn more about the various markets.

a positive and very high cross elasticity of demand. If economists could agree on a value of this cross elasticity that would define goods as belonging to the same industry—again an arbitrary decision—they could use that number to draw the boundaries between industries.

The problem of assigning firms to industries is made even more difficult by the fact that some multiproduct firms produce a variety of goods that might be included in different industries. In which industry is a firm that produces coffee in addition to soap and cake mixes? General Electric produces goods as unrelated as jet engines and toasters. Informed judgments and somewhat arbitrary definitions are necessary in order to move from the world of theory into the real world of industry studies.

11.2 Industry Structure

Once an industry has been defined, it is possible to determine its market structure, or where it lies on the spectrum from perfect competition to monopoly. The structure will depend on several characteristics of the industry. The degree of concentration and conditions of entry are especially important characteristics. Entry affects concentra- tion because high barriers to entry result in a more concentrated industry.

ama80571_11_c11_305-330.indd 307 6/21/13 10:35 AM

http://www.khanacademy.org/finance-economics/microeconomics/v/oligopolies-and-monopolisitc-competition
http://www.khanacademy.org/finance-economics/microeconomics/v/oligopolies-and-monopolisitc-competition
Section 11.2 Industry Structure CHAPTER 11

Table 11.1: Four-firm concentration ratios for selected industries Product Concentration ratio

Automobiles 94%

Chewing gum 93

Window glass 89

Sewing machines 82

Detergent (household) 80

Tires 71

Canned beer 66

Federal Trade Commission. (1990). Selected statistical series. Washington, DC: U.S. Government Printing Office.

It could be argued that the percentage of sales accounted for by the largest firms is not the best measure of concentration in an industry. Concentration ratios might instead be calculated using percentage of assets, percentage of employees, or value of shipments. The various measures of concentration are all closely related, however, so the choice of a ratio isn’t crucial.

The more concentrated an industry, the more likely it is that there will be a recognized interdependence and joint action of either a collusive or noncollusive nature. When the four-firm concentration ratio exceeds 50%, the degree of interdependence in the industry is likely to be very high.

Barriers to Entry

Entry conditions are the second characteristic affecting market structure. If barriers to entry are high and the industry is highly concentrated, it is more likely that joint action can be undertaken to create monopoly profits. You saw earlier that cartels are very unsta- ble and that economic profits will strongly attract new firms into the industry. If concen- tration is high and entry is blocked, the existing firms will be in a better position to restrict output, raise prices, and maintain persistent profits.

The rapid internationalization of world markets makes the maintenance of entry barriers very difficult. It may be possible to limit entry in a domestic economy, but if free trade is allowed or if movements to increase trade exist, these barriers will fall. Almost all argu- ments against more liberal trade policies, such as the North American Free Trade Agree- ment (NAFTA), come from those firms and labor unions in those firms that enjoy some economic rents from the barriers to more open trade. One of the most effective antimo- nopoly policies is a policy of more open international trade.

The Herfindahl Index

The U.S. Justice Department has been using the Herfindahl Index, a summed index of concentration, to replace the more traditional concentration ratios. The Herfindahl Index, which was developed in 1950 by Orris Herfindahl in his Ph.D. dissertation at Columbia University, takes into account the market shares of all of the firms in an industry, not just

ama80571_11_c11_305-330.indd 308 1/28/13 9:50 AM

Section 11.2 Industry Structure CHAPTER 11

the market share of the few largest firms. Later in this chapter, we will look at how the Herfindahl Index was used by the Justice Department in the 1980s.

The Herfindahl Index is the sum of the squares of market shares in an industry. The for- mula for this sum is

H 5 (S1)2 1 (S2)2 1 . . . 1 (Sn)2,

where H is the Herfindahl Index and S1 through Sn are the market shares of individual firms 1 through n. These market shares total 100%. An industry that had 10 equal-sized firms each having 10% of the market would have a Herfindahl Index of 1,000.

Table 11.2 shows how the Herfindahl Index is calculated for two industries and compares each index to a four-firm concentration ratio. Note that both industries have four-firm concentration ratios of 96%, but industry A has a much higher Herfindahl Index (8,116) than industry B (2,308). These Herfindahl Index values imply that industry A is 3.5 times more concentrated than is industry B. The table demonstrates that the Herfindahl Index has a much higher value for industries that have a firm or group of firms that are rela- tively large. This higher value is the result of squaring the individual market shares to construct the index.

Table 11.2: Sample calculations of the Herfindahl index Industry A Industry B

Firm Market share (%)

Square of market share

Firm Market share (%)

Square of market share

1 90 8,100 1 24 576

2 2 4 2 24 576

3 2 4 3 24 576

4 2 4 4 24 576

5 1 1 5 1 1

6 1 1 6 1 1

7 1 1 7 1 1

8 1 1 8 1 1

Four-firm concentration ratio = 96%. Herfindahl Index = 8,116.

Four-firm concentration ratio = 96%. Herfindahl Index = 2,308.

The Number Equivalent

M. A. Adelman has developed another way to interpret the Herfindahl Index. The num- ber equivalent is the reciprocal of the Herfindahl Index (1 divided by the value of the Herfindahl Index times 10,000). It shows the theoretical number of equal-sized firms that should be found in an industry. Industry A in Table 11.2 should have 1.2 equal-sized firms, and industry B should have 4.3. Adelman would conclude that, ceteris paribus, industry B would be more competitive than industry A because A has a higher likelihood of collu- sion, or agreements between firms in an industry to set a certain price or share a market.

ama80571_11_c11_305-330.indd 309 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

11.3 Monopolistic Competition

The model of monopolistic competition describes an industry composed of a large number of sellers. Each of these sellers offers a differentiated product, which is a good or service that has real or imagined characteristics that are different from those of other goods or services. This differentiation can take many forms. The salespeople may be nicer, the packaging prettier, the credit terms better, or the service faster. It could even be that a famous person is associated with the product, like Bill Cosby and Jell-O or Michael Jordan and Nike. It is important to note that a product is differentiated if consum- ers perceive it as different. For example, chemists tell us that aspirin is aspirin, and there is no real difference among the various brands. Yet many con- sumers view the brands as dif- ferent, showing a preference for a brand such as Bayer, so aspirin is a differentiated product.

In monopolistic competition, the industry consists of a large number of firms, each produc- ing a differentiated product. A very important assumption is that entry into this industry is relatively easy. New firms can enter the industry and start sell- ing products that are similar to those already being produced. In Edward Chamberlin’s origi- nal description of monopolistic competition, a market for a set of goods that were differentiated but had a large number of close substitutes was called a product group. Chamberlin characterized monopolistic competition as the large-group case where there was rivalry between many firms in a product group.

You may have recognized monopolistic competition as a familiar market structure, since retail firms often fit this model. Monopolistic competition is generally what comes to mind when people think of competition. Perfect competition, with its homogeneous products, simply does not fit the popular idea of competition in which firms are scrambling to make their products different.

Short-Run Equilibrium

Short-run equilibrium of the monopolistically competitive firm is very similar to that of the monopolistic firm. Figure 11.1 shows the demand curve for a representative firm in monopolistic competition. When we depicted perfect competition, we started with the market and derived the representative firm’s demand curve. In analyzing monopolistic competition, we begin with a representative firm, rather than with the market. With prod- uct differentiation, each firm faces a unique demand curve. The firm’s demand curve in

Doug Pensinger/Getty Images

Sellers in a single industry attempt to differentiate their products. Nike, for example, is associated with basketball star Michael Jordan.

ama80571_11_c11_305-330.indd 310 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

Figure 11.1 is negatively sloped, unlike the perfectly elastic demand curve faced by the perfectly competitive firm. The negative slope is a result of the differentiated nature of the firm’s product. If the product’s price is raised, the firm will not lose all its customers because some will continue to prefer this product to substitutes that are close but not per- fect. Likewise, if the price is reduced, the firm will gain customers, but some customers will remain loyal to the products produced by other firms.

Figure 11.1: Short-run profits in monopolistic competition

In the short run, an economic profit can exist for firms in monopolistic competition. Such profits will cause new firms to enter the industry.

The relative elasticity of the demand curves is a measure of the degree of differentiation within the industry. If the products are only slightly differentiated, then they are close substitutes and each firm’s demand curve will be very elastic. If the products are highly differentiated, the demand curve will be less elastic, indicating that the firm can more eas- ily raise the price without losing many customers. Its customers don’t change products because they don’t view them as substitutes. Think again of aspirin, for example. Some people are willing to pay more for Bayer than for Brand X because they think it is differ- ent. The makers of Bayer are able to charge a higher price without losing a large number of customers. Bayer will be limited in price flexibility by the amount of differentiation it is able to create. As price goes higher and higher, fewer people will be willing to pay for the differentiation. Some people may be willing to pay 10 cents more for Bayer than for a

0

Price, Cost

Quantity/ Time Period

C

P1

x1

MR

MC

AC

A

B

Economic Profit

D = AR

ama80571_11_c11_305-330.indd 311 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

different brand, but if the price of Bayer is increased further, more and more people will shift to the other brands.

The demand curve in Figure 11.1 has a negative slope, indicating product differentiation. However, demand is very elastic, indicating that there are many good substitutes. Since the demand (average revenue) curve is negatively sloped, the marginal revenue curve will lie below it, for the same reasons it does in the case of monopoly. The firm will, of course, maximize profits at price P1 and output x1, where marginal revenue is equal to marginal cost. The firm in Figure 11.1 is earning an economic profit because average rev- enue, P1, exceeds average cost, C. Total revenue is represented by rectangle 0P1Ax1, and total cost is represented by rectangle 0CBx1. Economic profit is thus the area of the shaded rectangle CP1AB.

This analysis is very similar to the one developed in the preceding chapter for monopoly in the short run. The most important difference is that the demand curve here is very flat. The key to whether it is more like a perfectly competitive firm or more like a monopoly depends on what happens in the long run in response to the economic profit.

Long-Run Equilibrium

What about long-run equilibrium in a monopolistically competitive industry? Figure 11.1 shows that a short-run equilibrium results in an economic profit.

Suppose, instead, that new firms can respond to these economic profits. Entry into monopolistically competitive industries is assumed to be relatively easy. Thus, new firms will enter the industry in response to the economic profits. As firms enter the industry, the demand curve faced by any representative firm will shift to the left because the new firms will be attracting customers away from firms already in the industry. This shift of buyers is what happens, for example, when a new grocery store opens in an area. It draws some customers away from the existing stores. The existing firms’ demand curves will continue to shift down and to the left as new firms enter, and new firms will enter as long as economic profits are to be made. Long-run equilibrium will occur when firms are earning zero economic profit (or normal profit). Such an equilibrium is depicted in Figure 11.2. Price is P1 and output is x1. Total revenue and total cost are represented by rectangle 0P1Ax1. There are no economic profits being earned, and no additional firms will attempt to enter this industry.

ama80571_11_c11_305-330.indd 312 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

Figure 11.2: Long-run equilibrium in monopolistic competition

Since entry into a monopolistically competitive industry is relatively easy, there can be no long-run economic profits. Firms will enter until all firms are earning only a normal profit.

Of course, too many firms might enter an industry due to a mistaken anticipation of eco- nomic profits. If this happens, firms will experience losses, and some firms will leave the industry as the long-run adjustment proceeds. Figure 11.3 shows a monopolistically competitive firm suffering a loss equal to rectangle P1CBA. Firms would respond to such losses by leaving the industry. The demand curves faced by the remaining firms would shift up and to the right until the equilibrium shown in Figure 11.2 was restored. The long- run adjustment process under monopolistic competition produces an equilibrium with zero economic profits.

0

Price, Cost

Quantity/ Time Period

P1

x1

MR

MC AC

A

D = AR

ama80571_11_c11_305-330.indd 313 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

Figure 11.3: Short-run losses in monopolistic competition

Short-run losses, indicated by the shaded area, will cause some firms to exit the industry. Firms will exit until the remaining firms are earning a normal profit, as in Figure 11.2.

Monopoly and Competition

As you can see, the model of monopolistic competition borrows from the model of monop- oly and the model of perfect competition. In the short run, the monopolistically competi- tive firm is producing the profit-maximizing output and searching for the best price that can be charged for this output. In the long run, the economic profits disappear as new firms enter the industry. The demand curve of each firm then shifts to the left because market demand is shared by more firms. This result is similar to the long-run outcome in perfect competition. The market structure of monopolistic competition has some charac- teristics of monopoly and some of pure competition, which explains its name.

Excess Capacity

In long-run equilibrium, the monopolistically competitive firm chooses an output that does not fully utilize existing plant size. The unutilized part of the production facili- ties, called excess capacity, is depicted in Figure 11.4. The profit-maximizing output is x1, where MR = MC. This level of output is not, however, the output that would have resulted under perfect competition. Under perfect competition, the firm would use the

0

Price, Cost

Quantity/ Time Period

C

P1

x1

MR

MC AC

B

A

Loss

D = AR

ama80571_11_c11_305-330.indd 314 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

least-cost combination of inputs, where average cost is at a minimum. That output would be socially optimal because represents maximum attainable allocative efficiency because MC = P. That output is represented by x2 in Figure 11.4. In other words, in long-run equi- librium, the monopolistically competitive firm produces less than the quantity that would efficiently use its full productive capacity.

Figure 11.4: Excess capacity

Excess capacity results from the negative slope of the demand curve. As the demand curve becomes more elastic, the excess capacity diminished. It disappears when the curve becomes perfectly elastic.

Is excess capacity a bad thing? To answer this question, it is necessary to consider what causes excess capacity. The firm is producing less than the socially ideal output because it maximizes profits by producing a lower output. This lower output results from the fact that the demand curve for the monopolistically competitive firm slopes downward. You can see this result by examining Figure 11.4. Begin with demand curve D1. The monopo- listically competitive firm is producing quantity x1 at price P1. Now make the demand curve more elastic by rotating it counterclockwise. As the demand curve becomes more and more elastic and finally perfectly elastic, at D2 in Figure 11.4, the output will increase toward the socially efficient output x2. Excess capacity is a result of the negative slope in the demand curve. This negative slope, you recall, is a result of the product differentiation. The excess capacity, therefore, results from product differentiation.

0

Price, Cost

Quantity/ Time Period

P2

P1

x1 x2

MC AC

D 1 1= AR

D 2 2= AR 2= MR

1MR

ama80571_11_c11_305-330.indd 315 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

It can be argued that excess capacity is not necessarily a bad thing. Consumers may be willing to incur the extra cost in return for the perceived benefits of product differentia- tion. It would indeed be a very boring world without product differentiation. We might all be wearing khaki-colored shirts, for example.

The major problem with this argument lies in separating desired from undesired product differentiation. A consumer who is faced with a wide range of product choices but little price competition is not able to choose whether or not to pay extra to get the differenti- ated product. This problem isn’t likely to be too important, however, when there are many firms, as in monopolistic competition. Consider aspirin. If the only products in the indus- try were Anacin, Bayer, Bufferin, and Excedrin, the consumer would probably not have a low-price choice, since these brands compete almost exclusively by advertising rather than by cutting prices. But the consumer actually does have a choice of lower-priced generic brands of aspirin. So in choosing Anacin over Brand X, the consumer voluntarily chooses product differentiation. In this case, product differentiation seems to be a good thing because the consumer making the choice is maximizing individual utility. If, on the other hand, there are no lower-priced products and the consumer must choose among products that compete only through advertising, then the consumer does not really have a choice about bearing the cost of the differentiation (unless, of course, he or she simply does without the product altogether).

Product Differentiation and Advertising

The firm in monopolistic competition will try to differentiate its product in order to shift its demand curve to the right and to make demand relatively more inelastic by developing consumer loyalty. The firm will advertise as well as make changes in color, style, qual- ity, and so on. Advertising can inform consumers about higher quality or develop brand loyalty. Either of these results creates product differentiation. Competing with rival firms through advertising, style changes, color changes, and techniques other than lowering price is referred to as nonprice competition.

If effective use of nonprice competition differentiates a firm’s product enough that other firms’ products do not seem to be good substitutes, the firm can earn an economic profit in the long run. Nonprice competition will often be gradual, so the firm can avoid a price war in which all firms will lose. A firm that is successful in such nonprice competition has in essence turned its share of the monopolistically competitive market into production with long-run economic profit. The profit of such a firm could exist in the long run and not be driven to zero by new entrants.

Fast-food preparation is usually a monopolistically competitive industry. In a small town, fast food could be a monopoly or an oligopoly. However, in metropolitan areas, there are large numbers of firms, and entry is relatively easy. If a firm is able to successfully dif- ferentiate its product so that consumers don’t consider the products of other firms close substitutes, the firm will be able to earn a long-run economic profit because it can keep would-be competitors out of its segment of the market. For example, McDonald’s can’t keep firms out of the hamburger market, but it can keep firms out of the Big Mac mar- ket. If enough people believe there’s nothing like a Big Mac, this persistent brand loyalty might allow McDonald’s to maintain an economic profit in the long run.

ama80571_11_c11_305-330.indd 316 1/28/13 9:50 AM

Section 11.3 Monopolistic Competition CHAPTER 11

Resource Allocation in Monopolistic Competition

The model of monopolistic competition has several implications for the allocation of resources. The resulting allocation will be different from the societal ideal achieved with perfect competition. First, even at the long-run equilibrium with zero economic profit, there will be excess capacity with monopolistic competition. This means that price will be greater than minimum average cost. Consumers are paying only the average cost of production, but this cost is higher than it would be with more competition.

Second, if costs are the same under perfect competition and monopolistic competition, prices will be higher with monopolistic competition because price is greater than marginal cost (or marginal revenue). Third, firms in monopolistic competition will provide a wider variety of styles, colors, qualities, and brands. These choices are, unfortunately, related to the product differentiation and excess capacity that cause average cost to be higher.