In this chapter, we first explore how monopolistically competitive firms will choose their profit-maximizing level of output. We will then discuss oligopolistic firms, which face two conflicting temptations: to collaborate as if they were a single monopoly, or to individually compete to gain profits by expanding output levels and cutting prices.
Oligopolistic markets and firms can also take on elements of monopoly and of perfect competition. Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way.
Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell different kinds of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. When products are distinctive, each firm has a mini-monopoly on its particular style or flavor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names.
The theory of imperfect competition was developed by two economists independently but simultaneously in Robinson subsequently became interested in macroeconomics where she became a prominent Keynesian, and later a post-Keynesian economist.
A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which the product is sold, intangible aspects of the product, and perceptions of the product.
Products that are distinctive in one of these ways are called differentiated products. Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort.
The location of a firm can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory. Intangible aspects can differentiate a product, too.
Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of beer or cigarettes if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.
The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.
A monopolistically competitive firm perceives a demand for its goods that is an intermediate case between monopoly and competition. Figure 2 offers a reminder that the demand curve as faced by a perfectly competitive firm is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.
Figure 2. Perceived Demand for Firms in Different Competitive Settings The demand curve faced by a perfectly competitive firm is perfectly elastic, meaning it can sell all the output it wishes at the prevailing market price.
The demand curve faced by a monopoly is the market demand. It can sell more output only by decreasing the price it charges. The demand curve faced by a monopolistically competitive firm falls in between. The demand curve as faced by a monopolistic competitor is not flat, but rather downward-sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers.
Since there are substitutes, the demand curve facing a monopolistically competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its price, some consumers will choose not to purchase its product—but they will then need to buy a completely different product. However, when a monopolistic competitor raises its price, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm.
If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.
At a glance, the demand curves faced by a monopoly and by a monopolistic competitor look similar—that is, they both slope down. But the underlying economic meaning of these perceived demand curves is different, because a monopolist faces the market demand curve and a monopolistic competitor does not. Are you following? If so, how would you categorize the market for golf balls? The U. Golf Association runs a laboratory that tests 20, golf balls a year.
There are strict rules for what makes a golf ball legal. The weight of a golf ball cannot exceed 1. The balls are also tested by being hit at different speeds. For example, the distance test involves having a mechanical golfer hit the ball with a titanium driver and a swing speed of miles per hour. From this flight data, a computer calculates the lift and drag forces that are generated by the speed, spin, and dimple pattern of the ball….
The distance limit is yards. Over golf balls made by more than companies meet the USGA standards. The balls do differ in various ways, like the pattern of dimples on the ball, the types of plastic used on the cover and in the cores, and so on.
Since all balls need to conform to the USGA tests, they are much more alike than different. In other words, golf ball manufacturers are monopolistically competitive.
Sure, Tiger Woods can tell the difference. The monopolistically competitive firm decides on its profit-maximizing quantity and price in much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a downward-sloping demand curve, and so it will choose some combination of price and quantity along its perceived demand curve. As an example of a profit-maximizing monopolistic competitor, consider the Authentic Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice of vegetables and meats.
Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants, it has a differentiated product. Figure 3. The combinations of price and quantity at each point on the demand curve can be multiplied to calculate the total revenue that the firm would receive, which is shown in the third column of Table 1.
The fourth column, marginal revenue, is calculated as the change in total revenue divided by the change in quantity. The final columns of Table 1 show total cost, marginal cost, and average cost.
As always, marginal cost is calculated by dividing the change in total cost by the change in quantity, while average cost is calculated by dividing total cost by quantity. The process by which a monopolistic competitor chooses its profit-maximizing quantity and price resembles closely how a monopoly makes these decisions process.
First, the firm selects the profit-maximizing quantity to produce. Then the firm decides what price to charge for that quantity. Step 1. The monopolistic competitor determines its profit-maximizing level of output.
In this case, the Authentic Chinese Pizza company will determine the profit-maximizing quantity to produce by considering its marginal revenues and marginal costs. Two scenarios are possible:. In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing level of output for the firm. Step 2. The monopolistic competitor decides what price to charge. When the firm has determined its profit-maximizing quantity of output, it can then look to its perceived demand curve to find out what it can charge for that quantity of output.
Profits are total revenues minus total costs, which is the shaded area above the average cost curve. Because there is no dominant force in the industry, companies may be tempted to collude with one another rather than compete, which keeps non-established players from entering the market.
This cooperation makes them operate as though they were a single company. In , the U. Department of Justice alleged that Apple AAPL and five book publishers had engaged in collusion and price fixing for e-books. District Court sided with the government, a decision which was upheld on appeal.
In a free market, price fixing—even without judicial intervention—is unsustainable. If one company undermines its competition, others are forced to quickly follow. Companies that lower prices to the point where they are not profitable are unable to remain in business for long.
Because of this, members of oligopolies tend to compete in terms of image and quality rather than price. Oligopolies and monopolies can operate unencumbered in the United States unless they violate anti-trust laws. Without competition, companies have the power to fix prices and create product scarcity, which can lead to inferior products and services and higher costs for buyers.
Anti-trust laws are in place to ensure a level playing field. District Court judge disagreed with the government's argument and approved the merger, a decision that was upheld on appeal.
The government has several tools to fight monopolistic behavior. This includes the Sherman Antitrust Act , which prohibits unreasonable restraint of trade, and the Clayton Antitrust Act , which prohibits mergers that lessen competition and requires large companies that plan to merge to seek approval in advance.
A company with a new or innovative product or service enjoys a monopoly until competitors emerge. Sometimes these new products are protected by law. For example, pharmaceutical companies in the U.
Without this protected status, firms would not be able to realize a return on their investment , and potentially beneficial research would be stifled. Gas and electric utilities are also granted monopolies. However, these utilities are heavily regulated by state public utility commissions. Rates are often controlled, along with any rate increases the company may pass onto consumers. Oligopolies exist throughout the business world. A handful of companies control the market for mass media and entertainment.
Federal Trade Commission. Government Accountability Office. Accessed May 18, Department of Justice. Microsoft, for instance, has been considered a monopoly because of its domination of the operating systems market. What about the vast majority of real world firms and organizations that fall between these extremes, firms that could be described as imperfectly competitive? What determines their behavior? They have more influence over the price they charge than perfectly competitive firms, but not as much as a monopoly would.
What will they do? One type of imperfectly competitive market is called monopolistic competition. Monopolistically competitive markets feature a large number of competing firms, but the products that they sell are not identical.
Consider, as an example, the Mall of America in Minnesota, the largest shopping mall in the United States. Most of the markets that consumers encounter at the retail level are monopolistically competitive. Second, the benefit provided by monopolistic competition is product diversity. The gain from product diversity can be large, as consumers are willing to pay for different characteristics and qualities.
Therefore, the gain from product diversity is likely to outweigh the costs of inefficiency. Evidence for this claim can be seen in market-based economies, where there is a huge amount of product diversity. The next chapter will introduce and discuss oligopoly: strategic interactions between firms!
An oligopoly is defined as a market structure with few firms and barriers to entry. There is often a high level of competition between firms, as each firm makes decisions on prices, quantities, and advertising to maximize profits. Thus, there is a continuous interplay between decisions and reactions to those decisions by all firms in the industry.
Each oligopolist must take into account these strategic interactions when making decisions. Since all firms in an oligopoly have outcomes that depend on the other firms, these strategic interactions are the foundation of the study and understanding of oligopoly. If Ford lowers prices relative to other car manufacturers, it will increase its market share at the expense of the other automobile companies.
When making decisions that consider the possible reactions of other firms, firm managers usually assume that the managers of competing firms are rational and intelligent. These strategic interactions form the study of game theory, the topic of Chapter 6 below.
John Nash , an American mathematician, was a pioneer in game theory. Economists and mathematicians use the concept of a Nash Equilibrium NE to describe a common outcome in game theory that is frequently used in the study of oligopoly.
In the study of oligopoly, the Nash Equilibrium assumes that each firm makes rational profit-maximizing decisions while holding the behavior of rival firms constant.
This assumption is made to simplify oligopoly models, given the potential for enormous complexity of strategic interactions between firms. The concept of Nash Equilibrium is also the foundation of the models of oligopoly presented in the next three sections: the Cournot, Bertrand, and Stackelberg models of oligopoly. Augustin Cournot , a French mathematician, developed the first model of oligopoly explored here.
This is the basis for strategic interaction in the Cournot model: if one firm increases output, it lowers the price facing both firms. The inverse demand function and cost function are given in Equation 5. This will result in a Nash Equilibrium, since each firm is holding the behavior of the rival constant.
Firm One maximizes profits as follows. This is as far as the mathematical solution can be simplified, and represents the Cournot solution for Firm One. Oligopolists are interconnected in both behavior and outcomes. The two firms are assumed to be identical in this duopoly. The two reaction functions can be used to solve for the Cournot-Nash Equilibrium.
There are two equations and two unknowns Q 1 and Q 2 , so a numerical solution is found through substitution of one equation into the other. This is the Cournot-Nash solution for oligopoly, found by each firm assuming that the other firm holds its output level constant. The Cournot model can be easily extended to more than two firms, but the math does get increasingly complex as more firms are added. Economists utilize the Cournot model because is based on intuitive and realistic assumptions, and the Cournot solution is intermediary between the outcomes of the two extreme market structures of perfect competition and monopoly.
This can be seen by solving the numerical example for competition, Cournot, and monopoly models, and comparing the solutions for each market structure. The competitive solution is given in Equation 5. The competitive, Cournot, and monopoly solutions can be compared on the same graph for the numerical example Figure 5.
The Cournot price and quantity are between perfect competition and monopoly, which is an expected result, since the number of firms in an oligopoly lies between the two market structure extremes.
Assume two firms in an oligopoly a duopoly , where the two firms choose the price of their good simultaneously at the beginning of each period. Consumers purchase from the firm with the lowest price, since the products are homogeneous perfect substitutes.
If the two firms charge the same price, one-half of the consumers buy from each firm. The Bertrand model follows these three statements:. A numerical example demonstrates the outcome of the Bertrand model, which is a Nash Equilibrium.
Firm Two has the lower price, so all customers purchase the good from Firm Two. After period one, Firm One has a strong incentive to lower the price P 1 below P 2. Firm One has the lower price, so all customers purchase the good from Firm One. After period two, Firm Two has a strong incentive to lower price below P 1. The price cannot go lower than this, or the firms would go out of business due to negative economic profits. The Bertrand results are given in Equation 5.
The Bertrand model of oligopoly suggests that oligopolies are characterized by the competitive solution, due to competing over price. There are many oligopolies that behave this way, such as gasoline stations at a given location. Other oligopolies may behave more like Cournot oligopolists, with an outcome somewhere in between perfect competition and monopoly. Heinrich Freiherr von Stackelberg was a German economist who contributed to game theory and the study of market structures with a model of firm leadership, or the Stackelberg model of oligopoly.
A numerical example is used to explore the Stackelberg model. Assume two firms, where Firm One is the leader and produces Q 1 units of a homogeneous good. Firm Two is the follower, and produces Q 2 units of the good. This model is solved recursively, or backwards. Mathematically, the problem must be solved this way to find a solution. All of this is shown in the following example.
This is the reaction function of the follower, Firm Two. We have now covered three models of oligopoly: Cournot, Bertrand, and Stackelberg.
These three models are alternative representations of oligopolistic behavior.
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