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1 Chapter 10 Monopolistic Competition and Oligopoly CHAPTER SUMMARY The characteristics of the monopolistically competitive and the oligopoly are introduced and compared with the other market structures. The key characteristic of monopolistic competition is product differentiation. Doing something different in real or imaginary terms with the product sold is critical to a monopolistically competitive firm s success. The key characteristic for the oligopoly market environment is mutual pricing interdependence. This was stressed in this chapter. The same analytical procedure is employed for these two remaining market structures as for perfect competition and monopoly. But note, as with all non-competitive markets it is possible for long-run profits to be earned depending on the strength of the barriers to entry. The stronger the barriers to entry preventing other firms from entering the market, the more likely a firm is to earn long-run profits. This chapter also devotes coverage to nonprice competition, the kinked demand curve, price leadership, and cartel behavior within an oligopoly. This chapter concludes with a critique of the monopolistically competitive and oligopolistic markets from society's perspective and a review of the four market structures. NEW CONCEPTS INTRODUCED game theory product differentiation price leadership monopolistic competition nonprice competition mutual interdependence oligopoly cartel kinked demand curve INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to: 1. Describe the characteristics of the monopolistically competitive and oligopoly market environments. 2. Understand that the key characteristic of the monopolistically competitive market is differentiation and in the oligopoly it is pricing interdependence. 3. Graphically express the demand curve facing firms operating in a monopolistically competitive and oligopoly market environment. 4. Graphically find the profit maximizing quantity to produce and explain why this output is the profit maximizing quantity. 5. Graphically determine the area representing any economic profits or losses. 6. Explain why short-run economic profits may persist in the long run. 7. Describe some examples of nonprice competition. 8. Define what a cartel is and describe its behavior. 9. Explain the reasoning for a kinked demand curve. 10. Understand what price leadership is and its role in an oligopoly.

2 92 Economics for Today 11. Compare and contrast the pros and cons of each of the 4 market environments from society's perspective. CHAPTER OUTLINE I. Preview II. The Monopolistic Competition Market Structure a. Many Small Sellers b. Differentiated Product c. Easy Entry and Exit III. The Monopolistically Competitive Firm as a Price Maker a. Advertising Pros and Cons Exhibit 1 "The Effects of Advertising on Average Cost" You're The Economist: Analyze the Issue "Social-Networking Sites: The New Advertising Game" Applicable Concept: product differentiation IV. Price and Output Decisions for a Monopolistically Competitive Firm a. Monopolistic Competition in the Short Run Exhibit 2 "A Monopolistically Competitive Firm in the Short Run" b. Monopolistic Competition in the Long Run Exhibit 3 "A Monopolistically Competitive Firm in the Long Run" V. Comparing Monopolistic Competition and Perfect Competition a. The Monopolistic Competitor as a Resource Misallocator b. Monopolistic Competition Means Less Output for More Exhibit 4 "A Comparison of Perfect Competition and Monopolistic Competition in the Long Run" VI. Oligopoly---Competition among the Few a. Few sellers b. Homogeneous or Differentiated Product c. Difficult Entry VII. Price and Output Decisions for an Oligopolist a. Nonprice competition b. The Kinked Demand Curve Exhibit 5 "The Kinked Demand Curve" c. Price Leadership d. The Cartel Exhibit 6 "Why a Cartel Member has an Incentive to Cheat" Global Economics Major Cartels in Global Markets Applicable Concept: cartel e. Game Theory

3 Chapter 10: Monopolistic Competition and Oligopoly 93 Exhibit 7 "A Two-Firm Payoff Matrix" You're The Economist: Analyze the Issue "How Oligopolists Compete at the Final Four" Applicable Concept: oligopoly VIII. An Evaluation of Oligopoly Checkpoint: "Which Model Fits the Cereal Aisle?" IX. Review of the Four Market Models Exhibit 8 "Comparison of Market Structures" X. List of Key Concepts XI. Summary XII. Summary of Conclusion Statements a. The many-sellers condition is met when each firm is so small relative to the total market that each firm's pricing decisions have a negligible effect on the market price. b. When a product is differentiated, buyers are no indifferent as to which seller's product they buy. c. The demand curve for a monopolistically competitive firm is less elastic (steeper) than for a perfectly competitive firm and more elastic (flatter) than for a monopolist. d. The few-sellers condition is met when these few firms are so large relative to the total market that they can affect the market price. e. Buyers in an oligopoly may or may not be indifferent as to which seller's product they buy. f. The pay-off matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low-price strategy that does not maximize mutual profits. g. As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits. XIII. Study Questions and Problems XIV. Checkpoint Answer XV. Sample Quiz HINTS FOR EFFECTIVE TEACHING 1. You may want to use the same 5-step process suggested in the last two chapters to analyze these market environments. 2. Again, try not to get too bogged down in the graphs. Approach this material in an intuitive way. 3. Ask students to identify some examples of markets which are monopolistically competitive and oligopolistic. 4. Point out that most real-world markets are monopolistically competitive. 5. Stress the importance of product differentiation for monopolistically competitive firms success. Ask students to identify strategies to differentiate products in either real (most is in the form of product design and quality) or imaginary terms. This is an opportunity for students to appreciate the marketing tactics most firms employ. 6. Stress the similarities among the three noncompetitive markets---it's just a matter of degree as to the extent of "monopoly power." Remind students that monopoly power really refers to an ability to control price. 7. Stress the pros and cons of each of the market models from society s perspective 8. Focus on nonprice competition (most is in the form of product design and quality), the kinked demand curve, price leadership, and cartel behavior. 9. Game theory is a difficult notion for most students. You may want to use the analogy of a chess game to stress the dynamics involved. The essential pint however is that the pay-off matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low-price strategy that does not maximize mutual profits. This may help to explain the tendency for oligopolies to want to collude.

4 94 Economics for Today CRITICAL THINKING/GROUP DISCUSSION QUESTIONS 1. How can cartels sow the seeds of their own destruction? There is an inherent tendency for members to cheat on the agreement. 2. What kind of agreements may cartels work out to reduce competition among themselves? In addition to setting prices and production quotas, they may carve out markets and agree not to compete on each other's turf. 3. How are the professional sports leagues like a cartel? They are the only legal cartel in the U.S. The agreements made within the leagues are cartel arrangements. Consider the draft. 4. What happens to employment opportunities and wages paid in all non-competitive product markets? Why? Because they all restrict production then the demand for workers (as well as other resources) is lower. This creates lower wages and fewer employment opportunities than would otherwise be observed. 5. Which market structure do most real world markets approximate? The monopolistically competitive. For example, most businesses have a relatively large number of competitors, have some control over price, and attempt to differentiate their product out of necessity to survive. 6. What effect would a successful advertising campaign differentiating a product from one's competitors have on a monopolistically competitive firm's demand and its elasticity of demand? What does this do to the firm's profits? You may have heard the slogan: "advertising doesn't cost, it pays?" Is that sometimes true? It would increase the firm's demand and make it more inelastic (because now there would be fewer acceptable substitutes). This would increase its profits. Sometimes, if advertising is successful, it does pay more than it costs. 7. In a non-collusive oligopoly if one firm increased its price what would the other firms likely do? What about a price decrease? How is this related to a kinked demand curve? Firms will not follow a price increase. They'll follow a price decrease. This explains the nature of a kinked demand curve because if firms do not follow a price increase then the firm which increased its price initially will experience a significant loss in total revenue (sales) to its competitors. That is, an elastic (relatively flat) demand is observed---elastic demand means a price increase will decrease total revenue. Conversely, a price decrease followed by competitors will mean all firms are now selling at lower prices resulting in a decline in each firm's total revenue. Because a decrease in price results in a decrease in total revenue we observe an inelastic (steep) demand. Hence the demand curve is kinked around the prevailing price. This helps explain why prices are usually "sticky" in oligopolies. 8. What are some strategies that firms use to collude? Strategies for collusion include carving out markets, setting prices, and self-imposed production quotas. CLASSROOM GAMES Approximately 170 non-computerized economic games (experiments) for use in the classroom are available for free at The following games are recommended to help teach some of the concepts in this chapter: Game #9 Objective: To illustrate the interdependence of oligopolistic decision-making. Game #10 Objective: To illustrate some of the difficulties involved in price coordination (collusion) under circumstances of imperfect competition. Game #11 Objective: To demonstrate interdependence. Game #41 Objective: To illustrate the tendency of collusive agreements to breakdown due to competitive behavior. Game #42 Objective: To illustrate the power of game theory in explaining the behavior of oligopolists.

5 Chapter 10: Monopolistic Competition and Oligopoly 95 Game #43 Objective: To illustrate the strategic implications of predation theory. Game #70 Objective: To illustrate the coordination problems associated with common pool resources and cartels. Game #90 Objective: To illustrate interdependent decision making; cartel formation; cartel break-down Game #113 Objective: To illustrate strategic interaction among firms. ANSWERS TO: "You're the Economist: Analyze the Issue" SOCIAL-NETWORKING SITES: THE ADVERTISING GAME Advertising is tasteless, offensive, and a nuisance that wastes resources. Give three arguments against this idea. One argument in favor of advertising is that it represents competition among firms and results in lower prices. Another argument is that advertising allows new entrants to compete with established firms. It can also be argued that advertising provides valuable information to customers on the availability, benefits, and prices of products. HOW OLIGOPOLISTS COMPETE AT THE FINAL FOUR In this feature, two forms of oligopoly were observed. Identify each of these forms and explain why it is being used by the oligopolists. First, soft drink companies can perceive that its rival will match price competition and so nonprice competition is used to gain market share by being more clever in advertising. Second, the hotels avoided a price war and raised their prices by openly establishing a cartel through a centralized booking service. This system allowed each hotel to easily see prices set by other hotels, and identify any cheaters. ANSWERS TO EVEN-NUMBERED "Study Questions and Problems" 2. The demand curve for a monopolistically competitive firm is downward sloping. In the long run, the MR = MC output corresponds to a price greater than the minimum point on the LRAC curve. 4. It is correct that long-run profits are zero for a firm under monopolistic competition. However, the firm does not reach the minimum point on its long-run cost curve, and it is therefore not efficient. 6. See Figure 10A-1. Advertising causes a firm's average cost curve to shift upward from ATC 1 to ATC 2. If advertising is successful, it increases the quantity demanded from Q 1 to Q 2 units. As a result, the average total cost falls from AC 1 (point A) to AC 2 (point B). Thus, advertising lowers unit costs as economies of scale are realized. Consumers therefore get the product at a lower price from advertising than without it. Figure 10A-1

6 96 Economics for Today 8. The condition of mutual interdependence is most important to an oligopoly. In perfect competition, each firm is so small that no single firm's price changes affect the market prices. Under monopoly there is no other firm in the industry. In the case of a monopolistic competition, each firm has a somewhat differentiated product. This means that a firm in this market structure can raise its price slightly above its competitors without trying to anticipate their reactions. 10. In general, the nonadvertising oligopolist produces intermediate goods such as steel, rather than final consumer goods such as beer and automobiles. 12. The cartel model is highly desirable from the oligopolist's viewpoint. If successful, it allows each firm to maximize profits as a monopolist by setting the price and using quotas to restrict output. From the viewpoint of the consumer, a cartel has no economic desirability because its purpose is to raise prices. CHAPTER 10 SUMMARY QUIZ 1. A monopolistically competitive market is characterized by: a. many small sellers selling a differentiated product. b. a single seller of a product that has few suitable substitutes. c. very strong barriers to entry. d. mutual interdependence in pricing decisions. 2. A monopolistically competitive firm will: a. maximize profits by producing where MR = MC. b. not likely earn an economic profit in the long run. c. shut down if price is less than average variable cost. d. all of the above. 3. Which of the following is true about advertising by a firm? a. It is not always successful in increasing demand for a firm s product. b. It can increase demand and make demand more inelastic. c. It may reduce per unit costs of production when economies of scale are experienced. d. All of the above. 4. An oligopoly: a. and monopolistically competitive market produce less and charge higher prices than if their markets were perfectly competitive. b. is characterized by mutual interdependence of pricing decisions. c. may be characterized by a kinked demand curve. d. all of the above. 5. A cartel: a. is a group of firms formally agreeing to control the price and the output of a product. b. has as its primary goal to reap monopoly profits by replacing competition with cooperation. c. is illegal in the United States, but not in other nations. d. all of the above. 1. a ANSWERS TO CHAPTER 10 SUMMARY QUIZ 2. d 3. d 4. d 5. d

CH short answer study questions Answer Section

CH short answer study questions Answer Section CH 15-16 short answer study questions Answer Section ESSAY 1. ANS: There are a large number firms; each produces a slightly different product; firms compete on price, quality and marketing; and firms are