Transcript Economics for Today 2nd edition Irvin B. Tucker

Chapter 10
Monopolistic Competition
and Oligopoly
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is
imperfect competition?
A market structure
between the extremes
of perfect competition
and monopoly
2
What is monopolistic
competition?
• many small sellers
• differentiated product
• easy entry and exit
3
What is
product differentiation?
The process of creating
real or apparent
differences between
goods and services
4
What does many small
sellers mean?
Each firm is so small
relative to the total
market that each firm’s
pricing decisions have a
negligible effect on the
market price
5
What is
nonprice competition?
A firm competes using
advertising, packaging,
product development,
better service, rather
than lower prices
6
How easy is entry and
exit in monopolistic
competition?
Not as easy as in perfect
competition because of
product differentiation
7
Why is a monopolistic
competitive firm a
price maker?
Product differentiation
gives the firm some
control over its price
8
What does the demand
curve for monopolistic
competition look like?
It is less elastic (steeper)
than for a perfectly
competitive firm and
more elastic (flatter)
than for a monopolist
9
What are examples of
monopolistic competition?
• grocery stores
• hair salons
• gas stations
• video rental stores
• restaurants
10
How effective is
advertising?
Somewhat effective in the
short-run but less
effective in the long-run
11
What effect does
advertising have on
average costs?
It raises the long-run
average cost curve
12
P
The effect of Advertising
Cost per unit
$4.00
With advertising
$3.50
$3.00
LRAC2
$2.50
$2.00
$1.50
LRAC1
$1.00
Without advertising
$.50
2 4 6 8 10 12 14 16 18
Q
13
How does a firm
decide what price to
charge and how many
units to produce?
MR = MC
14
P
$50
$40
$30
$25
$20
$15
$10
$5
MR=MC
MC
ATC
Profit
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
15
Why is a normal profit
made in the long-run?
The combination of the
leftward shift in the
firm’s demand curve
and the upward shift in
the LRAC curve
16
P
$40
$35
$30
$25
$20
$15
$10
$5
Normal Profit
MC
LRAC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
17
How efficient is
monopolistic
competition?
Less resources are used
and a higher price is
charged than would be
the case under perfect
competition
18
P
$40
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum
LRAC
MC
ATC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
19
P
Price & Cost per
unit
$40
$35
$30
$25
$20
$15
$10
$5
Perfect Competition
Minimum
LRAC
MC LRAC
MR
1 2 3 4 5 6 7 8 9
Q
20
What is oligopoly?
• few sellers
• either homogeneous or
a differential product
• difficult market entry
21
How few are a
few sellers?
When the firms are so
large relative to the total
market that they can
affect the market price
22
What is a significant
barrier to entry?
Economies of scale
23
What is
nonprice competition?
Competition in ways
other than pricing
policies
24
What is the
distinguishing
feature of oligopoly?
mutual
interdependence
25
What is mutual
interdependence?
A condition in which an
action by one firm may
cause a reaction on
the part of other firms
26
What does mutual
interdependence do to
the demand curve?
A kinked demand curve
is a possible result of
this characteristic
27
What does a kinked
demand curve show?
It shows that rivals will
match a firm’s price
decrease, but ignore a
price increase
28
Oligopolist’s Kinked Demand Curve
P
$400
$350
$300
$250
$200
$150
$100
$50
5 10 15 20 25 30 35 40 45 Q
29
How do oligopolists
determine price?
They play the game “follow
the leader” that economists
call price leadership
30
What is
price leadership?
A pricing strategy in
which a dominant firm
sets the price for an
industry and the other
firms follow
31
What is a cartel?
A group of firms
formally agreeing to
control the price and
output of a product
32
What are examples
of cartels?
• Organization of Petroleum
Exporting Countries (OPEC)
• International Telephone
Cartel (CCITT)
• International Airline Cartel
(IATA)
33
What is the major
weakness of a cartel?
Member firms cheating
34
$40
$35
$30
$25
$20
$15
$10
$5
Price & Cost per unit
P
Why a Cartel Member Has
an Incentive to Cheat
MC LRAC
MR2
MR1
1 2 3 4 5 6 7 8 9
Q
35
Key Concepts
36
Key Concepts
•
•
•
•
•
What is imperfect competition?
What is monopolistic competition?
What is product differentiation?
What is nonprice competition?
Why is a monopolistic competitive firm a price
maker?
• How does a firm decide what price to charge
and how many units to produce?
• Why is a normal profit made in the long-run?
37
Key Concepts cont.
•
•
•
•
How efficient is monopolistic competition?
What is oligopoly?
What is nonprice competition?
What is the distinguishing feature of
oligopoly?
• What does a kinked demand curve show?
• How do oligopolists determine price?
• What is a cartel?
38
Summary
39
Imperfect competition is the market
structure between the extremes of
perfect competition and monopoly
Monopolistic competition and
oligopoly belong to the imperfect
competition category.
40
Monopolistic competition is a
market structure characterized by
(1) many small sellers, (2) a
differentiated product, and (3) easy
market entry and exit. Given these
characteristics, firms in monopolistic
competition have a negligible effect
on the market price.
41
Product differentiation is a key
characteristic of monopolistic
competition. It is the process of
creating real or apparent
differences between products.
42
Nonprice competition includes
advertising, packaging, product
development, better quality, and
better service. Under imperfect
competition, firms may compete
using nonprice competition,
rather than price competition.
43
Short-run equilibrium for a
monopolistic competitor can yield
economic losses, zero economic
profits, or economic profits. In the
long run, monopolistic competitors
make zero economic profits.
44
P
$50
$40
$30
$25
$20
$15
$10
$5
MR=MC
MC
ATC
Profit
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
45
Comparing monopolistic
competition with perfect
competition, we find that the
monopolistic competitive firm does
not achieve allocative
efficiency,charges a higher price,
restricts output, and does not
produce where average costs are
at a minimum.
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P
$40
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum
LRAC
MC
ATC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
47
P
Price & Cost per
unit
$40
$35
$30
$25
$20
$15
$10
$5
Perfect Competition
Minimum
LRAC
MC LRAC
MR
1 2 3 4 5 6 7 8 9
Q
48
Oligopoly is a market structure
characterized by (1) few sellers, (2)
a homogeneous or differentiated
product, and (3) difficult market
entry. Oligopolies are mutually
interdependent because an action
by one firm may cause a reaction
on the part of other firms.
49
The nonprice competition model is
a theory that might explain
oligopolistic behavior. Under this
theory, firms use advertising and
product differentiation, rather than
price reductions, to compete.
50
The kinked demand curve is a
model that explains why prices
may be rigid in an oligopoly. The
kink is established because an
oligopolist assumes that rivals will
match a price decrease, but ignore
a price increase.
51
Oligopolist’s Kinked Demand Curve
P
$400
$350
$300
$250
$200
$150
$100
$50
5 10 15 20 25 30 35 40 45 Q
52
Price leadership is another theory
of pricing behavior under oligopoly.
When a dominant firm in an
industry raises or lowers price,
other firms follow suit.
53
A cartel is a formal agreement
among firms to set prices and
output quotas. The goal is to
maximize profits, but firms have
an incentive to cheat, which is a
constant threat to a cartel.
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$40
$35
$30
$25
$20
$15
$10
$5
Price & Cost per unit
P
Why a Cartel Member Has
an Incentive to Cheat
MC LRAC
MR2
MR1
1 2 3 4 5 6 7 8 9
Q
55
Comparing oligopoly with
perfect competition, we find that
the oligopolist allocates
resources inefficiently, charges a
higher price, and restricts output
so that price may exceed
average cost.
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Chapter 10 Quiz
©2002 South-Western College Publishing
57
1. An industry with many small sellers, a
differentiated product, and easy entry
would best be described as which of the
following?
a. Oligopoly.
b. Monopolistic competition.
c. Perfect competition.
d. Monopoly.
B. An oligopoly has only a few sellers. A
monopoly only has one, and perfect
competition has homogeneous
products.
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2. Which of the following industries is the
best example of monopolistic
competition?
a. Wheat.
b. Restaurant.
c. Automobile.
d. Water service.
B. Wheat would be in a perfectly
competitive market. Automobiles would
be an oligopoly. And the water service
is an example of a regulated monopoly.
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3. Which of the following is not a
characteristic of monopolistic
competition?
a. A large number of small firms.
b. A differentiated product.
c. Easy market entry.
d. A homogeneous product.
D. A characteristic of monopolistic
competition is differentiated products.
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4. A monopolistically competitive firm in
the long run earns the same economic
profit as a
a. perfectly competitive firm.
b. monopolist.
c. cartel.
d. none of the above.
A. In the long-run, a normal profit is
made because of the ease of entry
and exit. Once economic profits
are made, more firms will enter
the industry, driving price down.
When losses are made, firms
leave the industry, driving price
up, restoring profits.
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5. The theory of monopolistic
competition predicts that in long-run
equilibrium a monopolistically
competitive firm will
a. produce the output level at which
price equals long-run marginal cost.
b. operate at minimum long-run
average cost.
c. overutilize its insufficient capacity.
d. produce the output level at which
price equals long-run average cost.
D
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P
$40
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum
LRAC
MC
ATC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
63
6. A monopolistically competitive firm is
inefficient because the firm
a. earns positive economic profit in the
long run.
b. is producing at an output where
marginal cost equals price.
c. in not maximizing its profit.
d. produces an output where average
total cost is not minimum.
D.
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P
$40
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum
LRAC
MC
ATC
AVC
MR
D
1 2 3 4 5 6 7 8 9
Q
65
7. A monopolistically competitive firm in
the long run earns the same economic
profit as a
a. perfectly competitive firm.
b. monopolist.
c. cartel.
d. none of the above.
A. In the long-run, a normal profit is
made because of the ease of entry
and exit. Once economic profits
are made, more firms will enter
the industry, driving price down.
When losses are made, firms
leave the industry, driving price
up, restoring profits.
66
8. One possible effect of advertising on a
firm’s long-run average cost curve is to
a. raise the curve.
b. lower the curve.
c. shift the curve rightward.
d. shift the curve leftward.
A. The ATC curve is raised because
of the added expense of the
advertising.
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9. Monopolistic competition is an inefficient
market structure because
a. firms earn zero profit in the long-run.
b. marginal cost is less than price in the
long-run.
c. there is a wider variety of products
available compared to perfect
competition.
d. all of the above.
B. In the long-run, marginal cost is
less than price because of the
downward sloping demand curve
and a marginal revenue curve that
is more steeply sloped beneath the
demand curve.
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10. The “Big Three” U.S. automobile
industry is described as a (an)
a. monopoly.
b. perfect competition.
c. monopolistic competition.
d. oligopoly.
D. An oligopoly is a market form
with only a few sellers.
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11. The cigarette industry in the United
States is described as a (an)
a. monopoly.
b. perfect competition.
c. monopolistic competition.
d. oligopoly.
D. The cigarette industry has only a few
sellers.
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12. A characteristic of an oligopoly is
a. mutual interdependence in
pricing decisions.
b. easy market entry.
c. both (a) and (b).
d. neither (a) nor (b).
A. The distinguishing feature of an
oligopoly is mutual interdependence.
No one firm will make a decision
without first considering the reaction
of its competitors to its policy change.
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13. The kinked demand curve theory
attempts to explain why an oligopolistic
firm
a. has relatively large advertising
expenditures.
b. fails to invest in research and
development (R and D).
c. infrequently changes its price.
d. engages in excessive brand
proliferation.
C. Everything else being equal, if firm A
raises its price, other firms will not raise
theirs, and A will experience a big decline
in sales. If A lowers its price, other firms
will follow suit and A will not gain many
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sales.
14. According to the kinked demand
theory, when one firm raises its price,
other firms will
a. also raise their price.
b. refuse to follow.
c. increase their advertising
expenditures.
d. exit the industry.
B. They will refuse to follow firm A
because they can gain more by
charging a lower price, their sales will
increase because fewer people will
buy from firm A.
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15. Which of the following is evidence that
OPEC is a cartel?
a. Agreement on price and output
quotas by oil ministries.
b. Ability to raise prices regardless of
demand.
c. Mutual interdependence in pricing
and output decisions.
d. Ability to completely control entry.
A. A cartel is characterized by collusion,
the coming together and agreeing to
certain policies, for example, the level of
prices.
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END
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