1. Monopolistic Competition
• A monopolistically competitive
industry has the following
characteristics:
• A large number of firms
• No barriers to entry
• Product differentiation
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

2. Monopolistic Competition
• Monopolistic competition is a common
form of industry (market) structure in the
United States, characterized by a large
number of firms, none of which can influence
market price by virtue of size alone.
• Some degree of market power is achieved
by firms producing differentiated products.
• New firms can enter and established firms
can exit such an industry with ease.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

3. Nine Industries with Characteristics of
Monopolistic Competition
Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1992
FOUR EIGHT TWENTY NUMBER
INDUSTRY LARGEST LARGEST LARGEST OF
SIC NO. DESIGNATION FIRMS FIRMS FIRMS FIRMS
3792 Travel trailers and campers 41 57 72 270
3942 Dolls 34 47 67 204
2521 Wood office furniture 26 34 51 611
2731 Book publishing 23 38 62 2504
2391 Curtains and draperies 22 32 48 1004
2092 Fresh or frozen seafood 19 28 47 600
3564 Blowers and fans 14 22 41 518
2335 Women’s dresses 11 17 30 3943
3089 Miscellaneous plastic products 5 8 13 7605
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series
MC92-S-2, 1997.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

4. Product Differentiation, Advertising,
and Social Welfare
Total Advertising Expenditures in 1998
DOLLARS
(BILLIONS)
Newspapers 44.2
Television 48.0
Direct mail 39.5
Other 31.7
Yellow pages 12.0
Radio 14.5
Magazines 10.4
Total 200.3
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United
States, 1999, Table 947.
States,
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

5. The Case for Product Differentiation
and Advertising
• The advocates of free and open
competition believe that differentiated
products and advertising give the
market system its vitality and are the
basis of its power.
• Product differentiation helps to ensure
high quality and efficient production.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

6. The Case for Product Differentiation
and Advertising
• Advertising provides consumers with
the valuable information on product
availability, quality, and price that
they need to make efficient choices
in the market place.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

7. The Case Against Product
Differentiation and Advertising
• Critics of product differentiation and
advertising argue that they amount to
nothing more than waste and
inefficiency.
• Enormous sums are spent to create
minute, meaningless, and possibly
nonexistent differences among
products.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

8. The Case Against Product
Differentiation and Advertising
• Advertising raises the cost of products
and frequently contains very little
information. Often, it is merely an
annoyance.
• People exist to satisfy the needs of the
economy, not vice versa.
• Advertising can lead to unproductive
warfare and may serve as a barrier to
entry, thus reducing real competition.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

9. Product Differentiation Reduces the
Elasticity of Demand Facing a Firm
• Based on the availability of
substitutes, the demand
curve faced by a
monopolistic competitor is
likely to be less elastic
than the demand curve
faced by a perfectly
competitive firm, and likely
to be more elastic than the
demand curve faced by a
monopoly.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

10. Monopolistic Competition in the Short Run
• In the short-run, a monopolistically competitive
firm will produce up to the point where MR = MC.
• This firm is
earning positive
profits in the
short-run.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

11. Monopolistic Competition in the Short-Run
• Profits are not guaranteed. Here, a firm with a
similar cost structure is shown facing a weaker
demand and suffering short-run losses.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

12. Monopolistic Competition in the Long-Run
• The firm’s demand
curve must end up
tangent to its average
total cost curve for
profits to equal zero.
This is the condition for
long-run equilibrium in
a monopolistically
competitive industry.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

13. Economic Efficiency
and Resource Allocation
• In the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,
however:
• Price is above marginal
cost. More output could
be produced at a
resource cost below the
value that consumers
place on the product.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

14. Economic Efficiency
and Resource Allocation
• In the long-run, economic profits are eliminated; thus, we
might conclude that monopolistic competition is efficient,
however:
• Average total cost is not
minimized. The typical
firm will not realize all the
economies of scale
available. Smaller and
smaller market share
results in excess capacity.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

15. Oligopoly
• An oligopoly is a form of industry
(market) structure characterized by a
few dominant firms. Products may
be homogeneous or differentiated.
• The behavior of any one firm in an
oligopoly depends to a great extent
on the behavior of others.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

16. Ten Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms in High-
Concentration Industries, 1992
FOUR EIGHT NUMBER
INDUSTRY LARGEST LARGEST OF
SIC NO. DESIGNATION FIRMS FIRMS FIRMS
2823 Cellulosic man-made fiber 98 100 5
3331 Primary copper 98 99 11
3633 Household laundry equipment 94 99 10
2111 Cigarettes 93 100 8
2082 Malt beverages (beer) 90 98 160
3641 Electric lamp bulbs 86 94 76
2043 Cereal breakfast foods 85 98 42
3711 Motor vehicles 84 91 398
3482 Small arms ammunition 84 95 55
3632 Household refrigerators and freezers 82 98 52
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject
Series MC92-S-2, 1997.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

17. Oligopoly Models
• All kinds of oligopoly have one
thing in common:
• The behavior of any given
oligopolistic firm depends on the
behavior of the other firms in the
industry comprising the oligopoly.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

18. The Collusion Model
• A group of firms that gets together
and makes price and output
decisions jointly is called a cartel.
• Collusion occurs when price- and
quantity-fixing agreements are
explicit.
• Tacit collusion occurs when firms
end up fixing price without a specific
agreement, or when agreements are
implicit.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

19. The Cournot Model
• The Cournot model is a model of a
two-firm industry (duopoly) in which a
series of output-adjustment
decisions leads to a final level of
output between the output that would
prevail if the market were organized
competitively and the output that
would be set by a monopoly.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

20. The Kinked Demand Curve Model
• The kinked demand model is a
model of oligopoly in which the
demand curve facing each individual
firm has a “kink” in it. The kink
follows from the assumption that
competitive firms will follow if a
single firm cuts price but will not
follow if a single firm raises price.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

21. The Kinked Demand Curve Model
• Above P*, an increase in
price, which is not followed
by competitors, results in a
large decrease in the firm’s
quantity demanded
(demand is elastic).
• Below P*, price decreases
are followed by
competitors so the firm
does not gain as much
quantity demanded
(demand is inelastic).
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

22. The Price-Leadership Model
• Price-leadership is a form of
oligopoly in which one dominant firm
sets prices and all the smaller firms
in the industry follow its pricing
policy.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

23. The Price-Leadership Model
• Assumptions of the price-leadership model:
1. The industry is made up of one large firm and a
number of smaller, competitive firms;
2. The dominant firm maximizes profit subject to
the constraint of market demand and subject to
the behavior of the smaller firms;
3. The dominant firm allows the smaller firms to
sell all they want at the price the leader has set.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

24. The Price-Leadership Model
• Outcome of the price-leadership model:
1. The quantity demanded in the industry is split
between the dominant firm and the group of
smaller firms.
2. This division of output is determined by the
amount of market power that the dominant firm
has.
3. The dominant firm has an incentive to push
smaller firms out of the industry in order to
establish a monopoly.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

25. Predatory Pricing
• The practice of a large, powerful firm
driving smaller firms out of the
market by temporarily selling at an
artificially low price is called
predatory pricing.
• Such behavior became illegal in the
United States with the passage of
antimonopoly legislation around the
turn of the century.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

26. Game Theory
• Game theory analyzes oligopolistic
behavior as a complex series of
strategic moves and reactive
countermoves among rival firms.
• In game theory, firms are assumed
to anticipate rival reactions.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

27. Payoff Matrix for Advertising Game
B’s STRATEGY
A’s STRATEGY Do not advertise Advertise
A’s profit = $50,000 A’s loss = $25,000
Do not advertise
B’s profit = $50,000 B’s profit = $75,000
A’s profit = $75,000 A’s profit = $10,000
Advertise
B’s loss = $25,000 B’s profit = $10,000
• The strategy that firm A will actually choose depends on
the information available concerning B’s likely strategy.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

28. Payoff Matrix for Advertising Game
B’s STRATEGY
A’s STRATEGY Do not advertise Advertise
A’s profit = $50,000 A’s loss = $25,000
Do not advertise
B’s profit = $50,000 B’s profit = $75,000
A’s profit = $75,000 A’s profit = $10,000
Advertise
B’s loss = $25,000 B’s profit = $10,000
• Regardless of what B does, it pays A to advertise. This is
the dominant strategy, or the strategy that is best no
matter what the opposition does.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

29. The Prisoners’ Dilemma
ROCKY
GINGER Do not confess Confess
Ginger: 1 year Ginger: 7 years
Do not confess
Rocky: 1 year Rocky: free
Ginger: free Ginger: 5 years
Confess
Rocky: 7 years Rocky: 5 years
• Both Ginger and Rocky have dominant strategies: to
confess. Both will confess, even though they would be
better off if they both kept their mouths shut.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

30. Payoff Matrix for
Left/Right-Top/Bottom Strategies
Original Game • Because D’s behavior is
D’s STRATEGY predictable (he will play
C’s the right-hand strategy), C
STRATEGY Left Right will play bottom.
Top C wins $100 C wins $100 • When all players are
D wins no $ D wins $100
playing their best strategy
given what their
C loses $100 C wins $200
Bottom D wins no $ D wins $100 competitors are doing, the
result is called Nash
equilibrium.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

31. Payoff Matrix for
Left/Right-Top/Bottom Strategies
New Game • C is likely to play top and
D’s STRATEGY guarantee herself a $100
C’s profit instead of losing
STRATEGY Left Right $10,000 to win $200, even if
there is just a small chance of
C wins $100 C wins $100
Top D wins no $ D wins $100 D’s choosing left.
C loses
• When uncertainty and risk are
C wins $200
Bottom
$10,000
D wins no $
D wins $100 introduced, the game
changes. A maximin
strategy is a strategy chosen
to maximize the minimum
gain that can be earned.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

32. Contestable Markets
• A market is perfectly contestable if
entry to it and exit from it are
costless.
• In contestable markets, even large
oligopolistic firms end up behaving
like perfectly competitive firms.
Prices are pushed to long-run
average cost by competition, and
positive profits do not persist.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

33. Oligopoly is Consistent with
a Variety of Behaviors
• The only necessary condition of oligopoly is
that firms are large enough to have some
control over price.
• Oligopolies are concentrated industries. At
one extreme is the cartel, in essence,
acting as a monopolist. At the other
extreme, firms compete for small
contestable markets in response to
observed profits. In between are a number
of alternative models, all of which stress
the interdependence of oligopolistic firms.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

34. Oligopoly and Economic Performance
• Oligopolies, or concentrated industries, are
likely to be inefficient for the following reasons:
• They are likely to price above marginal cost. This
means that there would be underproduction from
society’s point of view.
• Strategic behavior can force firms into deadlocks
that waste resources.
• Product differentiation and advertising may pose a
real danger of waste and inefficiency.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

35. The Role of Government
• The Celler-Kefauver Act of 1950
extended the government’s authority
to ban vertical and conglomerate
mergers.
• The Herfindahl-Hirschman Index
(HHI) is a mathematical calculation
that uses market share figures to
determine whether or not a proposed
merger will be challenged by the
government.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

36. Regulation of Mergers
Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical
Industries, Each With No More Than Four Firms
PERCENTAGE SHARE OF: HERFINDAHL-
HIRSCHMAN
FIRM 1 FIRM 2 FIRM 3 FIRM 4 INDEX
Industry A 50 50 − − 502 + 502 = 5,000
Industry B 80 10 10 − 802 + 102 + 102 = 6,600
Industry C 25 25 25 25 252 + 252 + 252 + 252 = 2,500
Industry D 40 20 20 20 402 + 202 + 202 + 202 = 2,800
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

37. Department of Justice Merger
Guidelines (revised 1984)
ANTITRUST DIVISION ACTION
HHI Concentrated
Challenge if Index is
raised by more than 50
points by the merger
1,800
Moderate
Concentration
Challenge if Index is
raised by more than 100
points by the merger
1,000
Unconcentrated
No challenge
0
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair