Robert F. Mulligan WESTERN CAROLINA UNIVERSITY COLLEGE OF BUSINESS Department of Economics, Finance, & International Business

MBA 505 ECONOMICS AND PUBLIC POLICY

Chapter 10 MONOPOLISTIC COMPETITION AND OLIGOPOLY

FUNDAMENTAL QUESTIONS

1. What is monopolistic competition?

2. What behavior is most common in monopolistic competition?

3. What is oligopoly?

4. In what form does rivalry occur in an oligopoly?

5. Why does cooperation among rivals occur most often in oligopolies?

6. What occurs when the perfect information assumption is relaxed?

Key Words

strategic behavior	cartel	adverse selection
game theory	facilitating practices	moral hazard
dominant strategy	cost-plus/markup pricing
sequential game	most favored customer (MFC)

1. Monopolistic Competition

This is a market structure in which there are a large number of firms, the products produced by the firms are differentiated, and entry and exit occur easily.

1.a. Profits and entry: Firms use product differentiation more than price to compete.

Example: The Gap introducing Gap Kids to compete with other retailers.

Entry into the market causes the demand curve for all other competitors' products to decrease. New products are introduced as long as economic profits are positive.

1.a.1. In the short run: Demand is price elastic.

1.a.2. In the long run: Free entry and exit allow the firm only normal profit in the long run. Normal profit is zero economic (normal) profit. Expansion and entry into this industry cease when normal profits are made.

1.b. Monopolistic competition vs. perfect competition: In the long run Q_mc is less than Q_pc, P_mc is greater than P_pc, and ATC_mc is greater than ATC_pc.

Although allocative efficiency does not occur in monopolistic competition, this is due to consumer desires for product differentiation.

1.c. Nonprice competition: Product differentiation reduces price elasticity of demand because of brand loyalty.

Product differentiation could allow the firm to slightly raise price and profits due to the market demand curve rotating to the right (demand becomes less elastic) from D₁ to D₂. Profits may not rise because of cost increases, however. Differentiation can result from style, quality, and location. Advertising is used intensively to advise consumers of product differences.

2. Oligopoly and Interdependence

This is a market structure in which few firms exist, producing either a standardized or a differentiated product, and entry is difficult. A key factor is that firms act interdependently—that is, firms change product quantity and price after considering what other firms are likely to do in response.

Interdependence operates in the automobile industry as firms change models, styles, accessories, and prices each model year in response to each others' actions.

2.a. Oligopoly and strategic behavior: Strategic behavior occurs when what is best for A depends on what B does and vice versa.

2.a.1. The kinked demand curve: This occurs when firms follow or copy market price decreases but not price increases.

The kinked demand curve predicts price rigidity in oligopoly.

Newcar sticker prices are held constant for the model year.

2.a.2. Dominant strategy: Dominant strategy is a strategy that produces the best results for a firm no matter what strategy the opposing player follows.

2.a.3. Nondominant strategy: Firm B has a nondominant strategy if the best strategy for firm B depends on the strategy chosen by firm A.

2.a.4. Sequential games: In many market situations, when firm A moves first, firm B is able to choose a strategy based on the initial choice of firm A. This is called a sequential game.

2.b. Cooperation

2.b.1. Price leadership oligopoly: Firms follow the pricing behavior of one firm, thus eliminating the kink in the demand curve.

U.S. Steel (now CSX) was formerly the price leader in the steel industry. GM is the price leader in the car industry.

2.b.2. Collusion, cartels, and other cooperative mechanisms: Cartels occur when firms divide the market and each acts as a monopoly. Their purpose is to control and limit production and maintain or increase prices and profits. A secretive, cooperative agreement to form a cartel is known as collusion and is illegal in the United States.

OPEC was able to increase the price of oil by restricting supply. Each member agreed to limit production to a certain level, which would sustain a high equilibrium price of over $30 per barrel. The restricted production level was divided among the OPEC members as a quota for each country. Several OPEC members, including Iraq, cheated by selling more than their quota. Saudi Arabia accepted this cheating and voluntarily produced below their quota to keep the total amount of oil produced at the amount necessary to support the high price. Eventually Saudi Arabia got tired of supporting the cheaters. When Saudi Arabia started producing their full quota, the price collapsed. Oil prices fell to $12/barrel in 1988 and only rose to more than $35/barrel in 1990 during the gulf crisis.

2.b.3. Facilitating practices: When firms have no formal agreement but still cooperate and effectively collude—for example, cost-plus pricing or most favored customer policies—these policies discourage price competition.

3. Summary of Market Structures and the Information Assumption

3.a. Brand names: Brand names provide signals to the consumer of a product's quality and/or the quality of the firm producing and selling the product.

Examples of brand name producers: Vidal Sassoon, Guess, Bayer, McDonald's, Apple, and Nike.

Consumers are willing to pay a higher price for brand name products than a similar unknown brand; thus, firms expend resources on advertising and marketing so as to establish a brand name.

Consider TV advertising for automobiles and the amounts spent by the car producers for these ads.

3.b. Guarantees: The higher the quality of a product, the better the guarantee offered by the firm.

Consider the unconditional money-back guarantee offers by such mailorder houses as Land's End and L.L. Bean. What does this guarantee tell the consumer?

3.c. Adverse selection: Unobservable qualities of a product are misvalued because of a lack of information.

Lower quality used cars tend to be sold by nondealers because dealers refuse to accept low quality cars as tradeins, thus generating adverse selection in the nondealer used car market. Adverse selection can be lessened by using middlemen, requiring down payments, and offering warranties.

Mortgage lenders are compensated for additional risk by charging extra points for mortgage loans to borrowers they don't have enough information about.

3.d. Moral hazard: A moral hazard exists when people can change their behavior from what was anticipated when a trade or contract was made.

Drivers who are reckless after buying insurance, or doctors who are less careful after buying malpractice insurance, exhibit moral. Moral hazard can be lessened with insurance deductibles, collateral on loans, etc. Would you act differently if you had nofault insurance, full coverage without deductibility, or partial coverage with a deductible on your cars?

Opportunities for Discussion

1. List firms from which you regularly buy goods that seem to fit the monopolistically competitive model; do the same for the oligopoly model.

2. Why did OPEC fail to raise oil prices during the 1980s, and what is OPEC attempting to accomplish now? Cite the Iraq-Kuwait conflict.

3. Why are cartels detrimental to the consumer?

4. Compare and contrast the levels of efficiency that exist in each of the four market structures.

5. List the brand names you routinely buy. Then discuss why you prefer to use these particular brand name items. What market structures do the firms that produce these products operate within?