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Honors Economics-Mr. Doebbler-Chapter 11 Study Guide

Chapter Opener

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AFTER READING THIS CHAPTER, YOU SHOULD BE ABLE TO:
1 / List the characteristics of monopolistic competition.
2 / Explain why monopolistic competitors earn only a normal profit in the long run.
3 / Describe the characteristics of oligopoly.
4 / Discuss how game theory relates to oligopoly.
5 / Relate why the demand curve of an oligopolist may be kinked.
6 / Compare the incentives and obstacles to collusion among oligopolists.
7 / Contrast the potential positive and negative effects of advertising.
8 / (Appendix) Utilize additional game-theory terminology and applications.

In the United States, most industries have a market structure that falls somewhere between the two poles of pure competition and pure monopoly. To begin with, most real-world industries have fewer than the large number of producers required for pure competition but more than the single producer that defines pure monopoly. In addition, most firms in most industries have both distinguishable rather than standardized products as well as some discretion over the prices they charge. As a result, competition often occurs on the basis of price, quality, location, service, and advertising. Finally, entry to most real-world industries ranges from easy to very difficult but is rarely completely blocked.

This chapter examines two models that more closely approximate these widespread industry structures. You will discover thatmonopolistic competitionmixes a small amount of monopoly power with a large amount of competition.Oligopoly,in contrast, blends a large amount of monopoly power with both considerable rivalry among existing firms and the threat of increased future competition due to foreign firms and new technologies. (You should quickly reviewTable 8.1, page 164, at this point.)

Summary

  1. The distinguishing features of monopolistic competition are (a) there are enough firms in the industry to ensure that each firm has only limited control over price, mutual interdependence is absent, and collusion is nearly impossible; (b) products are characterized by real or perceived differences so that economic rivalry entails both price and nonprice competition; and (c) entry to the industry is relatively easy. Many aspects of retailing, and some manufacturing industries in which economies of scale are few, approximate monopolistic competition.
  2. The four-firm concentration ratio measures the percentage of total industry output accounted for by the largest four firms. The Herfindahl index sums the squares of the percent market shares of all firms in the industry.
  3. Monopolistically competitive firms may earn economic profits or incur losses in the short run. The easy entry and exit of firms results in only normal profits in the long run.
  4. The long-run equilibrium position of the monopolistically competitive producer is less efficient than that of the pure competitor. Under monopolistic competition, price exceeds marginal cost, indicating an underallocation of resources to the product, and price exceeds minimum average total cost, indicating that consumers do not get the product at the lowest price that cost conditions might allow.
  5. Nonprice competition provides a way that monopolistically competitive firms can offset the long-run tendency for economic profit to fall to zero. Through product differentiation, product development, and advertising, a firm may strive to increase the demand for its product more than enough to cover the added cost of such nonprice competition. Consumers benefit from the wide diversity of product choice that monopolistic competition provides.
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  1. In practice, the monopolistic competitor seeks the specific combination of price, product, and advertising that will maximize profit.
  2. Oligopolistic industries are characterized by the presence of few firms, each having a significant fraction of the market. Firms thus situated engage in strategic behavior and are mutually interdependent: The behavior of any one firm directly affects, and is affected by, the actions of rivals. Products may be either virtually uniform or significantly differentiated. Various barriers to entry, including economies of scale, underlie and maintain oligopoly.
  3. High concentration ratios are an indication of oligopoly (monopoly) power. By giving more weight to larger firms, the Herfindahl index is designed to measure market dominance in an industry.
  4. Game theory (a) shows the interdependence of oligopolists' pricing policies, (b) reveals the tendency of oligopolists to collude, and (c) explains the temptation of oligopolists to cheat on collusive arrangements.
  5. Noncollusiveoligopolists may face a kinked-demand curve. This curve and the accompanying marginal-revenue curve help explain the price rigidity that often characterizes oligopolies; they do not, however, explain how the actual prices of products were first established.
  6. The uncertainties inherent in oligopoly promote collusion. Collusive oligopolists such as cartels maximize joint profits—that is, they behave like pure monopolists. Demand and cost differences, a “large” number of firms, cheating through secret price concessions, recessions, and the antitrust laws are all obstacles to collusive oligopoly.
  7. Price leadership is an informal means of collusion whereby one firm, usually the largest or most efficient, initiates price changes and the other firms in the industry follow the leader.
  8. Market shares in oligopolistic industries are usually determined on the basis of product development and advertising. Oligopolists emphasize nonprice competition because (a)advertising and product variations are less easy for rivals to match and (b) oligopolists frequently have ample resources to finance nonprice competition.
  9. Advertising may affect prices, competition, and efficiency either positively or negatively. Positive: It can provide consumers with low-cost information about competing products, help introduce new competing products into concentrated industries, and generally reduce monopoly power and its attendant inefficiencies. Negative: It can promote monopoly power via persuasion and the creation of entry barriers. Moreover, it can be self-canceling when engaged in by rivals; then it boosts costs and creates inefficiency while accomplishing little else.
  10. Neither productive nor allocative efficiency is realized in oligopolistic markets, but oligopoly may be superior to pure competition in promoting research and development and technological progress.
  11. Table 8.1, page 164, provides a concise review of the characteristics of monopolistic competition and oligopoly as they compare to those of pure competition and pure monopoly.

Monopolistic Competition

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ORIGIN OF THE IDEA
O 11.1
Monopolistic competition

Let's begin by examiningmonopolistic competitionA market structure in which many firms sell a differentiated product, into which entry is relatively easy, in which the firm has some control over its product price, and in which there is considerable nonprice competition.,which is characterized by (1) a relatively large number of sellers, (2) differentiated products (often promoted by heavy advertising), and (3) easy entry to, and exit from, the industry. The first and third characteristics provide the “competitive” aspect of monopolistic competition; the second characteristic provides the “monopolistic” aspect. In general, however, monopolistically competitive industries are much more competitive than they are monopolistic.

Relatively Large Number of Sellers

Monopolistic competition is characterized by a fairly large number of firms, say, 25, 35, 60, or 70, not by the hundreds or thousands of firms in pure competition. Consequently, monopolistic competition involves:

  • Small market sharesEach firm has a comparatively small percentage of the total market and consequently has limited control over market price.
  • No collusionThe presence of a relatively large number of firms ensures that collusion by a group of firms to restrict output and set prices is unlikely.
  • Independent actionWith numerous firms in an industry, there is no feeling of interdependence among them; each firm can determine its own pricing policy without considering the possible reactions of rival firms. A single firm may realize a modest increase in sales by cutting its price, but the effect of that action on competitors' sales will be nearly imperceptible and will probably trigger no response.
Differentiated Products

In contrast to pure competition, in which there is a standardized product, monopolistic competition is distinguished byproduct differentiationA strategy in which one firm's product is distinguished from competing products by means of its design, related services, quality, location, or other attributes (except price)..Monopolistically competitive firms turn out variations of a particular product. They produce products with slightly different physical characteristics, offer varying degrees of customer service, provide varying amounts of locational convenience, or proclaim special qualities, real or imagined, for their products.

Let's examine these aspects of product differentiation in more detail.

Product AttributesProduct differentiation may entail physical or qualitative differences in the products themselves. Real differences in functional features, materials, design, and workmanship are vital aspects of product differentiation. Personal computers, for example, differ in terms of storage capacity, speed, graphic displays, and included software. There are dozens of competing principles of economics textbooks that differ in content, organization, presentation and readability, pedagogical aids, and graphics and design. Most cities have a variety of retail stores selling men's and women's clothes that differ greatly in styling, materials, and quality of work. Similarly, one pizza place may feature thin-crust Neapolitan style pizza, while another may tout its thick-crust Chicago-style pizza.

ServiceService and the conditions surrounding the sale of a product are forms of product differentiation too. One shoe store may stress the fashion knowledge and helpfulness of its clerks. A competitor may leave trying on shoes and carrying them to the register to its customers but feature lower prices. Customers may prefer one-day over three-day dry cleaning of equal quality. The prestige appeal of a store, the courteousness and helpfulness of clerks, the firm's reputation for servicing or exchanging its products, and the credit it makes available are all service aspects of product differentiation.

LocationProducts may also be differentiated through the location and accessibility of the stores that sell them. Small convenience stores manage to compete with large supermarkets, even though these minimarts have a more limited range of products and charge higher prices. They compete mainly on the basis of location—being close to customers and situated on busy streets. A motel's proximity to an interstate highway gives it a locational advantage that may enable it to charge a higher room rate than nearby motels in less convenient locations.

Brand Names and PackagingProduct differentiation may also be created through the use of brand names and trademarks, packaging, and celebrity connections. Most aspirin tablets are very much alike, but many headache sufferers believe that one brand—for example, Bayer, Anacin, or Bufferin—is superior and worth a higher price than a generic substitute. A celebrity's name associated with watches, perfume, or athletic shoes may enhance the appeal of those products for some buyers. Many customers prefer one style of ballpoint pen to another. Packaging that touts “natural spring” bottled water may attract additional customers.

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Some Control over PriceDespite the relatively large number of firms, monopolistic competitors do have some control over their product prices because of product differentiation. If consumers prefer the products of specific sellers, then within limits they will pay more to satisfy their preferences. Sellers and buyers are not linked randomly, as in a purely competitive market. But the monopolistic competitor's control over price is quite limited since there are numerous potential substitutes for its product.

Easy Entry and Exit

Entry into monopolistically competitive industries is relatively easy compared to oligopoly or pure monopoly. Because monopolistic competitors are typically small firms, both absolutely and relatively, economies of scale are few and capital requirements are low. On the other hand, compared with pure competition, financial barriers may result from the need to develop and advertise a product that differs from rivals' products. Some firms have trade secrets relating to their products or hold trademarks on their brand names, making it difficult and costly for other firms to imitate them.

Exit from monopolistically competitive industries is relatively easy. Nothing prevents an unprofitable monopolistic competitor from holding a going-out-of-business sale and shutting down.

Advertising

The expense and effort involved in product differentiation would be wasted if consumers were not made aware of product differences. Thus, monopolistic competitors advertise their products, often heavily. The goal of product differentiation and advertising—so-callednonpricecompetitionCompetition based on distinguishing one's product by means of product differentiation and then advertising the distinguished product to consumers.—is to make price less of a factor in consumer purchases and make product differences a greater factor. If successful, the firm's demand curve will shift to the right and will become less elastic.

Monopolistically Competitive Industries

Table 11.1lists several manufacturing industries that approximate monopolistic competition. Economists measure the degree of industry concentration—the extent to which the largest firms account for the bulk of the industry's output—to identify monopolistically competitive (versus oligopolistic) industries. Two such measures are the four-firm concentration ratio and the Herfindahl index. They are listed in columns 2 and 3 of the table.

TABLE 11.1 / Percentage of Output Produced by Firms in Selected Low-Concentration U.S. Manufacturing Industries

*As measured by value of shipments. Data are for 2002. See.
Source:Bureau of Census,Census of Manufacturers, 2002.

Afour-firm concentration ratioThe percentage of total industry sales accounted for by the top four firms in the industry.,expressed as a percentage, is the ratio of the output (sales) of the four largest firms in an industry relative to total industry sales.

Four-firm concentration ratios are very low in purely competitive industries in which there are hundreds or even thousands of firms, each with a tiny market share. In contrast, four-firm ratios are high in oligopoly and pure monopoly. Industries in which the largest four firms account for 40 percent or more of the market are generally considered to be oligopolies. If the largest four firms account for less than 40 percent, they are likely to be monopolistically competitive. Observe that the four-firm concentration ratios inTable 11.1range from 4 percent to 25 percent.

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Published concentration ratios such as those inTable 11.1are helpful in categorizing industries but must be used cautiously because the market shares (percentage of total sales) that they list are national in scope, whereas competition in many industries is often local in scope. As a result, some industries with low national concentration ratios are in fact substantially concentrated if one focuses on local markets.

As an example, the national four-firm concentration ratio for ready-mix concrete shown inTable 11.1is only 11 percent. This suggests that ready-mix concrete is a monopolistically competitive industry. But the sheer bulk of ready-mix concrete and the fact that it “sets up” as it dries limits the relevant market to a specific town, city, or metropolitan area. In most of these local markets, only a few firms compete, not the numerous firms needed for monopolistic competition.

Column 3 ofTable 11.1lists a second measure of concentration: theHerfindahlindexA measure of the concentration and competitiveness of an industry; calculated as the sum of the squared percentage market shares of the individual firms in the industry..This index is the sum of the squared percentage market shares of all firms in the industry. In equation form:

where %S1is the percentage market share of firm 1, %S2is the percentage market share of firm 2, and so on for each of thentotal firms in the industry. By squaring the percentage market shares of all firms in the industry, the Herfindahl index purposely gives much greater weight to larger, and thus more powerful, firms than to smaller ones. For a purely competitive industry, the index would approach zero since each firm's market share—%Sin the equation—is extremely small. In the case of a single-firm industry, the index would be at its maximum of 10,000 (= 1002), indicating an industry with complete monopoly power.

We will discover later in this chapter that the Herfindahl index is important for assessing oligopolistic industries. But for now, the relevant generalization is that the lower the Herfindahl index, the greater is the likelihood that an industry is monopolistically competitive rather than oligopolistic. Column 3 ofTable 11.1lists the Herfindahl index (computed for the top 50 firms, not all the industry firms) for several industries. Note that the index values are decidedly closer to the bottom limit of the Herfindahl index—0—than to its top limit—10,000.

The numbers inTable 11.1are for manufacturing industries. In addition, many retail establishments in metropolitan areas are monopolistically competitive, including grocery stores, gasoline stations, hair salons, dry cleaners, clothing stores, and restaurants. Also, many providers of professional services such as medical care, legal assistance, real estate sales, and basic bookkeeping are monopolistic competitors.

Price and Output in Monopolistic Competition

How does a monopolistic competitor decide on its price and output? To explain, we initially assume that each firm in the industry is producing a specific differentiated product and engaging in a particular amount of advertising. Later we will see how changes in the product and in the amount of advertising modify our conclusions.

The Firm's Demand Curve

Our explanation is based onFigure 11.1 (Key Graph),which shows that the demand curve faced by a monopolistically competitive seller is highly, but not perfectly, elastic. It is precisely this feature that distinguishes monopolistic competition from both pure monopoly and pure competition. The monopolistic competitor's demand is more elastic than the demand faced by a pure monopolist because the monopolistically competitive seller has many competitors producing closely substitutable goods. The pure monopolist has no rivals at all. Yet, for two reasons, the monopolistic competitor's demand is not perfectly elastic like that of the pure competitor. First, the monopolistic competitor has fewer rivals; second, its products are differentiated, so they are not perfect substitutes.