Which market structure is characterized by a few interdependent firms

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.

Check Point: Characteristics of Monopolistic Competition

• There are many sellers of similar but differentiated products. • Economic profits can exist in the short run. • Price is equal to average cost in the long run. • Excess capacity exists in the long run (price is greater than marginal cost). • Nonprice competition increases product differentiation.

It is easy to determine how suc- cessful a firm is at product dif- ferentiation by examining the difference between its prices and its competitors’ prices. The consumer may go to McDon- ald’s if a Big Mac costs $0.15 more than the competition, but what if it cost $0.55 more or $1.15 more? There is some price at which the other products will become good substitutes. That price is a measure of the success of product differentiation. It may be that a Big Mac is worth more to the consumer because of higher quality or because McDonald’s has a very success- ful advertising and public rela- tions program. The point is that

it doesn’t matter what causes the differentiation. The economic impact is that McDonald’s may be able to earn an economic profit in the long run.

Exactostock/SuperStock

Fast food is a monopolistically competitive market. For example, McDonald’s can’t keep other firms out of the hamburger market, but it can keep firms out of the Big Mac market.

ama80571_11_c11_305-330.indd 317 1/28/13 9:50 AM

Section 11.4 Oligopoly CHAPTER 11

Fourth, in monopolistic competition, there will be advertising and other forms of nonprice competition. This outcome is not necessarily bad. To the extent that advertising adds to customer satisfaction and the product is voluntarily purchased, it can be a good thing. Some social critics consider any advertising that does more than convey information to be a bad thing. Economists would argue that one must compare the marginal benefits of advertising to the marginal costs of advertising to judge its worth.

11.4 Oligopoly

The last of the four market structures is oligopoly. In 1934, German economist Hein-rich von Stackelberg published a book entitled Market Structure and Equilibrium. It discussed the idea of firms’ interdependence and formed the basis of the model of oligopoly. Oligopoly is the market structure in which a few firms compete imperfectly. The scarcity of sellers is the key to firms’ behavior in oligopoly. In oligopoly, firms real- ize that their small number produces mutual interdependence. As a result, each firm will forecast or expect a certain response from its rivals to any price or output decision that it might make. Oligopoly is the market structure in which there are only a few firms or a few firms dominate the market. Oligopoly is important because there are so many real- world examples of it. For example, there are four primary breakfast cereal manufactur- ers: Kellogg, General Mills, Post, and Quaker. There are two major producers in the beer industry: Anheuser-Busch and MillerCoors. Four music companies control 80% of the market: Universal Music Group, Sony Music Entertainment, Warner Music Group, and EMI group. The market for jetliners is dominated by Boeing and Airbus, and so on. Since there are few firms, the actions of the firms are interdependent.

In some people’s minds, oligopoly and monopoly are essentially the same. This view was expressed by John Kenneth Galbraith. Galbraith argued, “So long as there are only a few massive firms in an industry, each must act with a view of the welfare of all.” (Galbraith, 1956, p.83) This view, which is not widely held among economists, regards oligopoly as shared monopoly. Shared monopoly is the model of oligopoly that says that oligopolists coordinate decisions and share markets to act as a monopoly.

Most economists view oligopoly as more complex and more difficult to analyze than monopoly. There is no single model of oligopoly, as there is for the other three market structures. The difficulty stems from the interdependence that characterizes oligopoly. Because of the complexity of oligopoly, economic analysis of it often includes heavy doses of descriptive economics rather than formal models with graphs. We will follow this tradi- tion and describe several types of oligopoly and forms of oligopolistic behavior.

Oligopolies are sometimes categorized by the type of product they produce: homoge- neous or differentiated. An oligopolistic industry that produces a homogeneous product is referred to as a pure oligopoly or a standardized oligopoly. The distinction is important because in pure oligopolies a single price is charged for the output of all the firms. An example of a pure oligopoly is the aluminum industry. As a manufacturer making alumi- num furniture, you would be indifferent about which firm produced the bar of aluminum you purchase as an input.

In contrast, a differentiated oligopoly produces products that are different. The auto industry is a good example. In differentiated oligopolies, there are price clusters, which

ama80571_11_c11_305-330.indd 318 1/28/13 9:50 AM

Section 11.4 Oligopoly CHAPTER 11

Global Outlook: Commodity Cartels in the Real World Cartels are groups of independent firms that, instead of competing, agree to act in concert to deter- mine prices and dictate output . The United States uses anti-trust laws to discourage cartel behavior, but many governments around the world actively encourage the formation of cartels. This is particu- larly the case with commodity cartels.

Commodity cartels have a long history of failure. In the 1950s, commodity agreements, which are essentially cartels for agricultural products and raw materials, existed for tin, coffee, sugar, and wheat. The countries forming these cartels were less developed countries of South America and Africa. The success of the Arab countries with OPEC in 1973 reenergized some of these cartels as many commodity-exporting countries tried to emulate OPEC. The result was a flurry of activity that produced the following official organizations:

International Bauxite Association (IBA) International Coffee Organization (ICO) Intergovernmental Council of Copper-Exporting Countries (CIPEC) International Sugar Association (ISA) International Tin Council (ITC) Organization of Banana Exporting Countries (OBEC)

In addition, there were attempts in the late 1970s and early 1980s to organize cartels in iron ore, nickel, rubber, tungsten, molybdenum, cobalt, columbium, and tantalum. Very few of these cartels, however, enjoyed the success that OPEC had in the 1970s.

Several lessons can be learned from the experience of these commodity cartels and the success of OPEC. To be successful, a commodity cartel must:

1. have few members, 2. produce a product with few substitutes (have inelastic demand), 3. have buoyant world demand (have high income elasticity), 4. pursue a moderate pricing policy, 5. have at least tacit approval of consuming nations, and 6. have effective sanctions against chiselers, or sellers that cheat on a cartel agreement, by lower-

ing prices in an attempt to capture more of the market.

Most cartels have great difficulty with the last three requirements and, as a result, break down rather quickly.

The effects of commodity cartels are often mixed up with economic development and world politics. Members tend to be less developed countries, and the consuming nations tend to be developed countries. The formation of a cartel is often justified in terms of a “fair” price that will redistribute wealth from rich to poor countries.

Cartels are anti-consumer. Although some of those consumers live in high-income countries, many are poor people in poor countries. The OPEC oil price hikes in the 1970s caused greater hardship in poor countries than it did in rich countries.

are groupings of prices for similar, but not homogeneous, products. The range of prices within a cluster will depend on the amount of product differentiation. The more differ- entiated the products, the greater the price divergence. Tight price clusters indicate very little product differentiation.

ama80571_11_c11_305-330.indd 319 1/28/13 9:50 AM

Section 11.5 Collusion and Oligopolies CHAPTER 11

11.5 Collusion and Oligopolies

The history of cartels is not impressive. Most have held together for only short peri-ods of time, and have then fallen apart because of cheating. In the few cases where cartels have had long-term success, there has usually been direct government sup- port. Once a government is involved, it becomes more difficult to cheat because the gov- ernment can police and penalize this behavior.

Cartels in the Real World

Organized, collusive activity in private industry in the United States has usually been invalidated by the courts. However, General Electric and Westinghouse engaged in a conspiracy in the late 1950s to act as a cartel. They decided on a scheme that allowed them to submit low bids alternately on government contracts. The scheme depended on the phases of the moon. At either full or new moon (every two weeks), the firm desig- nated to be the low bidder would gain the contract because the other firm would submit an uncompetitively high bid. This plan worked well because there were only two firms dealing with one buyer, the federal government. Each firm would know if the other was cheating because the bids were later made public. In this case, the government was inad- vertently helping the cartel overcome the cheating problem.

Another example, involving a large number of firms, was an attempt to form a cartel known as the National Farm Organization (NFO). The industry for milk and beef pro- duction is composed of large numbers of firms (farms), and the NFO cartel only included about 10% of them. In 1967 and 1968, the NFO attempted two separate actions: one to raise milk prices and the other to raise beef prices. The cartel tried to organize farmers to keep production from the market. In order to raise prices, cartel members were to destroy milk and keep cattle away from the market. If the NFO members had been successful in raising prices, the nonmembers who continued to produce and sell would have ben- efited. They would have reacted to the higher prices by expanding output. Also, as prices began to rise, there would have been tremendous pressure on cartel members to cheat on the withholding action. In fact, the cheaters would have benefited much more than the members who refused to cheat. The attempt to organize the cartel resulted in violence. Cattle scales were blown up. NFO farmers sat in the roads to keep others from taking their products to market. Some farmers even resorted to taking cattle to market in house trailers to avoid detection. The lesson is clear: A cartel with many members will find it very difficult to succeed.

Cartels are much more common in Europe than they are in the United States. In Europe, cartels are permitted and often encouraged by governments. Before the 1950s, all major German industries operated as cartels. Currently in Western Europe, the Common Market Commission is actively promoting cartels in steel, textiles, and shipbuilding. In contrast, cartels are—with one exception—illegal in the United States. The one exception, based on the Webb–Pomerene Act of 1921, allows the formation of cartels when they are necessary to participate in foreign trade. These Webb–Pomerene cartels have not been successful in raising prices, primarily because of the large number of firms participating.

ama80571_11_c11_305-330.indd 320 1/28/13 9:50 AM

Section 11.5 Collusion and Oligopolies CHAPTER 11

OPEC: A Decade of Success

The best-known cartel of recent years is the Organization of Petroleum Exporting Coun- tries, known as OPEC. In the 1950s, international oil companies controlled a major portion of the world’s oil supply. These companies frequently engaged in price competition. In an attempt to stop price cutting, some Arab governments and a few non-Arab governments formed OPEC in 1960. At first, OPEC enjoyed little success. But this changed in 1973, as the Arab-Israeli war heated up and the Arab countries banded together. On January 1, 1973, the price of oil was $2.12 per barrel. Of this $2.12, $1.52 went to the OPEC govern- ments. By January 1, 1974, the price was $7.61 with $7.01 going to the governments. By January 1975, the price was about $10.50. By 1982, the price had risen to $35.00.

How did this cartel, which had been in existence since 1960, come to flex its muscles in 1973? At that time, importing governments helped by posting prices and dealing with OPEC in open forums, so individual members were less likely to cheat. More importantly, however, Saudi Arabia was willing to cut back its production of oil to allow other mem- bers to sell all they wanted to produce at the high prices set by the cartel.

In 1984, after production had to be cut back by 5 million barrels a day to prevent the cartel from collapsing, Saudi Arabia’s willingness to bear this cost began to weaken. The price of oil began to fall. The January 1984 price was $29 per barrel, down from the 1982 high of $35. The slide continued. In January 1987, the price was $13 per barrel. In January 1990, it was under $12 per barrel. As prices fell, cheating became more common. The predictions made by economists in the 1970s that the cartel would eventually weaken started to come true. Some of the Persian Gulf countries, notably Kuwait, the United Arab Emirates, and Qatar, were experiencing cash flow problems. These countries started grandiose development schemes when their oil revenues were in excess of $300 billion per year. Their revenues fell significantly because of the decreased price, but the development projects still had to be paid for. Kuwait began shipping more oil than allowed by OPEC agreements—one of the factors underlying the Gulf War. In 1986, Nobel Prize win- ner Milton Friedman wrote an editorial entitled, “Right at Last, an Expert’s Dream,” reminding readers that he had predicted in 1974 that OPEC would not last very long (Friedman, 1986, p.8).

As we pointed out earlier, all cartels face two problems. The first is cheating, or secret price cutting. OPEC faced this prob- lem in the presence of oil sur- pluses. The second problem a cartel faces is new entry. Large amounts of oil have been com- ing into the market from non- OPEC sources, such as the North Sea, Alaska, and the Alberta oil

Exactostock/SuperStock

The Organization of Petroleum Exporting Countries (OPEC) is one of the best-known cartels in recent years. The organization was formed to stop price cutting in the oil market.

ama80571_11_c11_305-330.indd 321 1/28/13 9:50 AM

Section 11.5 Collusion and Oligopolies CHAPTER 11

No Market Coordination

Unorganized, uncollusive oligopolies are characterized by independent action. Firms in these oligopolies practice profit maximization independently but are affected by the actions and responses of their rivals. Each firm tries to anticipate the response of its rivals and then takes that prediction into account when making decisions. Economists tried to develop a model for this behavior in the early 19th century. In 1838, A. Augustin Cournot (1801–1877) published a theory of duopoly (a market with only two firms). His theory and those that followed (up to the post-World War II period) were unsatisfac- tory because they assumed that the rival firm would not react to the action of the firm

Check Point: Characteristics of Oligopoly

• There are only a few sellers of homogenous or differentiated products. • Interdependence leads to attempts at communication, coordination, and collusion. • Cartels may be formed to determine industry pricing and output. • Nonprice competition increases product differentiation.

sands. In addition, other sources of energy, such as solar and nuclear energy, which were uneconomical when oil was $2 per barrel, became profitable at the much higher prices. The new entry has been slow to develop, but the future should prove even more difficult for OPEC as new firms producing oil and other competing products enter the market and challenge the cartel’s cohesiveness.

The impact of new oil supplies is evident in the statistics. In 1973, OPEC’s share of world oil production was 56%. In 1975, its share was 51%. In 1980, it was 45% and by 1986, OPEC’s share had fallen to 28%. This declining share of production signaled the weaken- ing of the cartel better than any other piece of data. If a cartel is going to set prices, it must control a large share of total production. After a rebound in the 1990s and 2000s, OPEC now produces roughly 40% of the world’s oil (Nguyen, 2012).

In addition to the new oil supplies, the high oil prices have also had an effect on quantity demanded. OPEC’s dominance resulted in adjustments in consumer demand. Perhaps the most evident of these adjustments is the increased fuel efficiency of automobiles.

Informal Market Coordination

Informally coordinated oligopolies engage in unorganized and unstated attempts to prac- tice joint actions. Such tacit collusion is much weaker than the collusion among members of a cartel. It is weaker because all the incentives to cheat are still present, but organized vigilance against cheating is not. Tacit collusion is found in U.S. industries because cartels are illegal under federal antitrust laws. Informal cooperation among oligopolistic firms can be viewed as an attempt to form cartels while avoiding antitrust laws. Such collusion usually takes the form of informal agreements to behave in certain ways. Often these agreements arise naturally, without any need for formal organization.

ama80571_11_c11_305-330.indd 322 1/28/13 9:50 AM

Section 11.5 Collusion and Oligopolies CHAPTER 11

Game Theory: Strategy and Rivalry in Oligopoly

Life for the entrepreneur is simple in pure monopoly and pure competition. But most firms in the real world must make strategic decisions, based on how rival firms are likely to react to their own action. The just-completed review of oligopoly and monopolistic competition demonstrated the interdependence in these market structures. A review of some elements of game theory will show how firms might make moves that could gain a competitive edge in the market place. Game theory applied to economic reasoning asks how management of a firm should act if it believes that the rival firm is rational and out to maximize its profits.

Game theory, a theory of rational decision making under conditions of uncertainty, was first developed by John von Neumann (1903–1957) and Oskar Morgenstern (1902–1977) in a book entitled The Theory of Games and Economic Behavior. Game theory says that players

Policy Focus: Oligopoly and Tit-for-Tat In the real world of cartel behavior, oligopoly firms may develop a strategy to help support a collusive market in one form or another. One such example is called the Tit-for-Tat strategy, which is a form of tacit collusion. In Tit-for-Tat, firms begin by behaving cooperatively in time t. If the other firm cheats in time t = 1, then you engage in cheating in the next period, t = 2. Cheating results in a decrease in prices that serves one primary purpose: to reduce any profits the other firm would stand to earn from cheating on your arrangement.

However, sometimes cheating after the other player has cheated is not enough to enforce coopera- tion. Instead, a firm can create a punishment stage of the game, where you go beyond simply cheat- ing and engage is extreme behavior. Although this punishment stage is harmful to the other firm, it is usually also quite harmful to the punisher. The goal is to send a signal to the other firm that there is a cost of not cooperating.

Sometimes a Tit-for-Tat strategy results in an all-out price war. In July 2012, Southwest Airlines sparked a price war in airline fares by cutting some fares to as low as $50 each way depending on the cities. Other airlines started offering their own “fall specials” immediately after the announce- ment was made by Southwest. Because airlines typically update fares three times per day, they are quickly able to respond to other airlines’ price changes, speeding up the downward spiral of a price war (Cokely, 2012).

OPEC is the most well-known example of an organization engaging in a fairly successful Tit-for-Tat strategy. When the organization suspects that one of the countries may be cheating, the reaction is to punish cheating by matching the overproduction. Although this strategy harms the cheating country, it also increases oil price volatility, which has repercussions of its own. However, if the Tit- for-Tat strategy helps enable the oil cartel to deter cheating and maintain high prices in the market, the countries can achieve the joint profit maximizing outcome for an oligopoly.

being analyzed. The post-World War II developments in oligopoly theory rest heavily on game theory. Game theory is a field of mathematics that can provide insights into oligopolistic behavior.

ama80571_11_c11_305-330.indd 323 1/28/13 9:50 AM

Section 11.5 Collusion and Oligopolies CHAPTER 11

try to reach an optimal position through strategic behavior that takes into account the anticipated moves of other players. Game theory attempts to explain how a decision maker will make decisions based on the assumption that the competitors are rational and profit-maximizing. This model describes very accurately how oligopolists behave.

Standard microeconomic decision-making theory is based on the assumption that the outcomes of various decisions are known with certainty. Game theory suggests ratio- nal solutions when the outcomes are uncertain. Games are usually described as being either zero-sum or non-zero-sum. Zero-sum games are those in which one player’s gain is another player’s loss. Non-zero-sum games open the door to collusion or cooperative action because all players may gain (or all may lose) from a certain course of action. This aspect of game theory has proved very useful in the study of oligopolies in which each firm must take into account the reactions of its competitors.

Cooperative and Noncooperative Games Games can be cooperative or noncooperative. A cooperative game is a game in which a contract is possible. You may, for example, enter into an agreement with a rival to share risk or bring complementary technologies together to solve a customer’s problem. In both of these cases, it is possible for the parties to draw up a contract that divides the profits or losses. In a noncooperative game such a contract is not possible. An example of a non- cooperative game would be an airline deciding to cut prices on some flights expecting that its rivals will match the cut. Most games of interest in examining business strategic behavior are noncooperative.

One of the most famous economic games is called the Prisoners’ Dilemma. Two prisoners are interrogated separately. Each one knows that if neither confesses, both will go free. However, if one confesses and implicates the other, the one who confesses will receive a light sentence and the other will get a long prison term. The interrogator separately offers each prisoner the opportunity to confess and “get a better deal.” The rational course of action for the self-interested prisoner is to confess and implicate the other. Since both face the same incentive and the same uncertainty about the other’s action, both will confess. The outcome of the two rational decisions will make both of the prisoners worse off. They would both be better off if they could engage in collusion because if neither confesses, both will go free. This same lesson holds for oligopolistic firms. Oligopolistic firms may decide to compete aggressively, attempting to take their competitors’ market, or try to cooperate and settle for the market share they have. Like the prisoners, each firm has an incentive to undercut the other and each knows the other has the same incentive.