Unit 11 - Monopolistic Competition and Oligopoly

Characteristics of Monopolistic Competition

We begin our analysis by looking at a model of monopolistic competition. As the name monopolistic competition suggests, the industry shares characteristics of both a perfectly competitive industry and a monopoly. Like perfect competition, a monopolistic competitive industry has many firms, or if there are not many firms, there are at least many competing products that are almost identical in nature. Consider the breakfast cereal industry. There are several major producers of breakfast cereal (e.g. Kellogg's, General Mills, Post) and each produces a corn flakes, raisin bran, and many other variations that can fill the breakfast bowl of the sleepy eater. In addition, there are a good number of smaller specialty brands that produce items such as organic corn flakes.

Like a monopoly, a monopolistically competitive firm faces a downward sloping demand curve. Even though the product of a monopolistically competitive faces competition from many similar brands, there are differences in the brands, either actual or perceived. Consider corn flakes. Cruising down the supermarket aisle, we can choose from corn flakes with the name of Kellogg's, Post, General Mills and a few store brands. Why do we choose one brand over the other? Kellogg's charges more for their brand than the relatively generic store brand. There probably is no significant difference in taste, texture or resistance to sogginess between the two brands, yet many consumers are willing to pay the premium for the Kellogg's box. The reason is advertising. Heavy advertising by Kellogg's convinces some shoppers that Kellogg's makes the better quality flake and these consumers are willing to pay a higher price. Brand loyalty allows Kellogg's to charge a higher price and for its corn flakes not loose all of its demand. However, since there are many close substitutes, the demand curve that Kellogg's faces will most likely be relatively elastic. As Kellogg's increases the price of its flakes, demand will fall as consumers will switch to substitute brands.

The characteristics of a good produced by a monopolistically competitive firm include:

• The consumer has many alternatives to choose from - there are many firms producing a similar product or a few firms producing multiple variations of the same product. As a result, the consumer has many close substitutes to choose from.
  
• Each firm faces a downward-sloping demand curve since their product is slightly differentiated from their competitors. Product differences may either be real or perceived, the differences emphasized by advertising.  Since the firm faces a downward sloping demand curve, it can raise price and demand will not drop to zero or it can lower price to increase sales.
  
• There are minimal barriers to entry. The goods and services produced are easy to replicate by other firms that represent potential competition. If economic profits are present, new firms will enter into the industry.
  
• The majority of products that we find in retail stores are produced in a monopolistically competitive environment.

Short Run Pricing and Output for the Monopolistically Competitive Firm

The monopolistically competitive firm generates brand loyalty and thus faces a downward sloping demand curve. Due to the wide availability of substitutes, the demand curve tends to be relatively elastic.

Figure 11-1 shows the short run behavior of the monopolistically competitive firm. As with a perfectly competitive firm or a monopoly, the monopolistically competitive firm produces at a profit maximizing level of output where marginal cost equals marginal revenue (Point A). The firm finds the price it will charge customers at the profit maximizing level of output (Q*) from the demand curve at Point B, and sets price to P*. As we can see from the shaded region, the firm is earning economic profits since price exceeds average total cost at the profit maximizing level of output.

Long Run Pricing and Output for the Monopolistically Competitive Firm

Unlike a monopoly industry, new firms can enter the monopolistically competitive industry. And like a perfectly competitive industry, economic profits attract new firms seeking a share of those profits into the industry. For example, assume that after a well crafted marketing campaign featuring a happy hippie wearing tied-died overalls, a national pizza chain (e.g. Dominoes) introduces fire roasted tofu pizza. It is a instant hit throughout America as eager consumers eat them up. Dominoes is soon reaping a whirlwind of profits - both accounting and economic as pizza sales soar. Although initially bewildered, other national pizza chains, local pizza companies and restaurants respond by rolling out their own versions of fire roasted tofu pizzas. The long run impact is a reduction in market share for Dominoes as customers find many substitutes available. The long run outcome for the monopolistically competitive firm is zero economic profits.

With new entrants in the market for fire roasted tofu pizza, the market share of Dominoes falls and its demand curve shifts inward. More firms share the existing market and individual market share falls. As long as economic profits remain, new firms enter until all economic profits disappear. In the long run, the typical monopolistically competitive firm makes zero economic profits. This is shown in Figure 11-2. Demand shrinks from D₀ to D₁ eventually settling at a point where the demand curve is tangent to the average total cost curve, resulting in zero economic profits (Point B). Note that the marginal revenue and marginal cost curves are excluded from Figure 11-2 to make the presentation clearer.

As we can see from Figure 11-2, unlike a perfectly competitive firm that produces at the minimum point of its average total cost curve and where price equals marginal cost, the monopolistically competitive firm does not produce at an economically efficient point in the long run. This does not mean to say that monopolistic competition is undesirable in comparison to perfect competition. Consumers value choice, and monopolistic competition offers variety in good or service. In contrast, perfectly competitive firms produce a generic, homogenous product offers consumers no product differences.

Monopolistic competition also encourages continuous product innovation. Innovative firms that introduce new or better products gain an edge, increase market share and can realize extra profits while their competitors attempt to catch up. A key to success for many firms in monopolistically competitive industries, especially in the information technology area, is constant innovation to maintain and expand market share.

Oligopoly

An oligopoly is an industry that is dominated by a few firms that display highly coordinated behavior. Examples of oligopoly include the auto and oil industries, and many commodity producers such as coffee, copper and other minerals. Characteristics of an oligopoly include:

• Firms produce in an industry dominated by a few firms whose output and pricing decisions are closely linked. The good produced by these firms is relatively homogenous and they control the majority of output produced in the industry.
  
• There are significant barriers to entry such as high start up costs or limited resources. For example, it is very expensive to set up a new auto firm. As a result, the majority of output is controlled by companies that already exist in the industry.
  
• The behavior of the firm is closely related to that of its competitors. Firms are interdependent in that they are aware of competitor pricing, output and products. There are ways to monitor member compliance and discourage cheating.
  
• There is little price competition and the competition present usually takes place through advertising.
  
• The technology involved in production is relatively stable. In contrast, rapid changes in technology will encourage new entrants and price competition as firms with a cost advantage will try to drive rivals out of business by lowering prices.
  
• The demand curve for the good produced by the oligopoly is relatively inelastic.

Firms in an oligopoly often exhibit significant economies of scale in production. For example, a successful auto producer must make a tremendous capital and telecommunications investment to enable production and distribution. The formidable start up costs prevents new entrants except by large multinational conglomerates. Alternatively, entrepreneurs will seek out opportunities where fixed costs are manageable. Oligopolies may also be the result of consolidation and merger within an industry. For example, throughout most of the 20th century, the U.S. steel industry was an economic powerhouse. It was the result of mergers that created a few dominant steel-producing firms.

A cartel is an organization through which members jointly make decisions about prices and production. One of the better-known cartels is OPEC (the Organization of Petroleum Exporting Countries), whose members attempt to limit production in order to support oil prices. International cartels are found for many other commodities such as coffee and many minerals. In the United States, antitrust laws prevent firms from obvious collusion and from forming a cartel. However, there are legally sanctioned cartels in the United States. The NCAA is one example. Even though you may be a great quarterback and have some friends that are excellent football players, you are not allowed to form a team and play in the NCAA. Participation is restricted to member colleges. Other legal cartels in the U.S. include the American Medical Association (AMA). You may have a great remedy for colds, but you are not allowed to open a medical practice until you meet the requirements of the AMA for membership.

When a legal cartel is prohibited, firms in an oligopoly often act through price leadership. When price leadership is present, a firm within the oligopolistic industry will change prices, leading the other firms to immediately follow with their own price moves. Price leadership can readily be observed in the airline and retail gasoline industry. When a major airline announces a fare cut, the other airlines rapidly follow with their own price cuts to prevent a loss of market share. With less fanfare, prices are raised, with the major airlines moving close to lockstep. Local gasoline prices rarely diverge. It is not uncommon to see several gas stations on the same block with identical prices even though they appear to be in a very competitive environment. If one station cuts the price per gallon, the others must quickly follow or they will rapidly lose market share as consumers switch to the lower priced station.

In the gas station and airline examples, direct collusion in setting prices is legally prohibited. To avoid detrimental government antitrust action, price leadership is a way to avoid price competition without direct negotiations and collusion. In general, the firms leave prices alone; each offers the same price, even in the face of direct competition. Uniform pricing behavior seldom breaks down due to competitive price cuts. The firm that tries to gain market share by reducing prices realizes that the competitors will so respond and only the consumer will gain. With price leadership, prices move up or down in response to changes in costs or demand. If crude oil prices fall, gas stations will slowly bring down their retail prices. Airlines offer specials during times when demand is weak, but seldom during major holidays or weekday hours that attract the business traveler.

Game Theory

One method of analyzing competitive behavior is through game theory. Game theory helps us to study the interactive behavior of two parties. This is especially useful in looking at behavior in an oligopoly where individual firms are very aware of the behavior of their rivals.

For example, assume for a given product, we have a firm (Big Zero Corp.) that produces a good basically identical to their main competitor (Little Zero Corp.). In terms of competitive behavior and market interaction, these firms have the following two options:

• they can compete by trying to undercut the other's price, grabbing market share and hoping to drive the competitor out of business, or
  
• they can cooperate on pricing, each maintaining their market share.

We use a payoff matrix to describe the basic competitive choices faced by each firm. For example, assume the following payoff matrix:

		Big Zero Corp.
		Comply	Price War
Little Zero Corp.	Comply	Little Zero = $50m Big Zero = $50m	Little Zero = $0m Big Zero = $80m
	Price War	Little Zero = $80m Big Zero = $0m	Little Zero = $0m Big Zero = $0m

From the payoff matrix we can see that there are two firms and during any given period they face two choices: comply with their agreement to avoid price competition, instead competing through advertising, or initiate a vicious price war to increase market share. Reading from left to right, we can observe the choices of Little Zero - to comply and hold the market price of the product constant, or slash price and initiate a price war. Reading from top to bottom, we see that Big Zero has the same options.

Assume that you are appointed the CEO of Big Zero. Big Zero and Little Zero have been avoiding price competition but the implicit agreement is about to expire with the roll out of this year's model of the product. If you want to play it safe and you trust the CEO of Little Zero, you may want to continue to comply with your past agreement and avoid cutting prices. In this case, we end up in the upper left cell of the payoff matrix and each firm earns $50 million in the upcoming quarter.

Alternatively, perhaps you want to be a hero with the shareholders and earn a sizable bonus for yourself when you cash in your stock options. To accomplish this you would want to sneak in a price cut while hoping that Little Zero complies with the agreement and holds their prices steady. In this case you gain the business of many of Little Zero's fickle customers and your higher market share leads to quarterly profits of $80 million. Betrayed, Little Zero Corporation sees its profits fall to zero (the upper right cell in the table). With the tremendous growth in profits, the price of Big Zero's stock soars.

Or, you may be the dummy and Little Zero takes part of your market share with a well-launched price offensive. Finally, both companies may battle it out by cutting prices, eliminating profits altogether.

From the alternatives given here, we can see the choices facing both companies in the industry. Clearly, when each company acts exclusively in its own self-interest, a price war is the result. In contrast, if the two firms act cooperatively and in their mutual long-run interest, they have an incentive to avoid competition, allowing earnings to grow with the market. The worst possible outcome for both firms is a prolonged price war. The optimal long-run strategy for both firms is to cooperate and maintain a unified industry price.

There are names for the corporate strategies involved here.

• A grim strategy involves no action by either party. The compliance status quo is maintained.
  
• Predatory pricing involves aggressive price reductions with the goal of gaining market share from rivals in the same industry. In our example and in reality, firms that cut prices will tend to have long-run success if they have advantages in technological advancement and the ability to produce at a lower cost. They may be able to earn a profit even with price-cutting while their higher-cost competitors may eventually be driven out of business.
  
• When a competitor cuts prices, most firms have little choice but to echo the behavior of the competitor, this is know as tit-for-tat.

Contestable Markets

Pricing in an oligopoly is often a function of the nature of the product and potential competition. From the perspective of a firm in an oligopoly, optimal behavior involves direct or indirect (e.g. price leadership) collusion to maintain uniform pricing by all producers. With a high degree of cooperation, firms will set price significantly higher than a competitive price, perhaps as high as a monopoly price. When direct collusion is present, firms can estimate their collective costs and the market demand and marginal revenue curves. When industry costs and demand are accurately estimated, the firms can set their industry profit maximizing output level where marginal revenue equals marginal cost and price off the industry demand curve. In essence, the firms are acting as a monopoly.

One of the key factors in maintaining a unified industry price is the ease of entry of new competitors. If entry of new firms is very difficult, monopoly behavior is likely to be sustained as the existing firms in the oligopolistic industry realize that it is in their best interest to restrict output and maintain a high market price. If entry of new competitors is relatively easy, disciplined behavior in an oligopoly is likely to erode rapidly and a competitive market will develop.

An example of the rise and fall of an oligopoly is OPEC. OPEC was formed during the 1950s and attracted little attention until the 1970s. By the early 1970s, the U.S. economy was highly dependent on oil imports; the majority arrived from OPEC member countries. With gasoline costing less than 30 cents a gallon, muscle cars and large luxury cars ruled the roads. Many would get less than ten miles per gallon of gas. Things changed rapidly when in 1973 and again in 1979, OPEC imposed well-coordinated oil embargoes and constricted the world's oil supply. As supply contracted, oil prices shot up from around $2.00 a barrel in the 1960s to almost $50 a barrel by 1979. The price per barrel was forecast to rise above $60 a barrel in the early 1980s.

By the 1990s, the price of a barrel of oil had fallen back below $20. OPEC's demise resulted from a combination of relatively easy entry into the industry, changes in consumer behavior and a loss of discipline among OPEC members. As the price per barrel of oil rose during the 1970s, it became increasingly cost effective for oil companies to tap new sources. Relatively expensive oil offshore oil drilling became profitable and major reserves in the North Sea of Europe were tapped. The U.S. government paid for the Alaskan oil pipeline that moved oil from arctic regions to Prudoe Bay. Non-OPEC oil producing nations increased production. Exxon, a major oil company built two towns from scratch in the high plains of Colorado near Grand Junction - Battlement Mesa and Parachute. With oil prices forecast to increase above $60 per barrel, Exxon decided that it would become profitable to mine the shale rock found in Western Colorado and "squeeze" the oil from it. Exxon predicted that over time as the industry developed, the quiet, sparsely populated area between Grand Junction and Glenwood Springs along the Interstate 70 corridor would be transformed into a huge metropolitan area of several million residents, and become an economic rival of the Denver metro area. Fortunately, Exxon's plan to turn this scenic area into an environmental wasteland never materialized. When the price of oil quickly collapsed in the early 1980s, Exxon abandoned the towns that it had built and the workers that it had convinced to move to Colorado and put their savings into the purchase of new homes that Exxon had built in the two new boomtowns. No rock was ever mined and the population of Glenwood Springs remains below 10,000 people. After Exxon bankrupted Battlement Mesa and Parachute the people that stayed on helped to develop the towns into attractive areas for retirees to settle in.

Oil prices never reached $60 a barrel as new sources increased the supply of oil on the market. Consumers also responded by reducing their consumption of gasoline by junking their gas guzzlers in favor of more fuel efficient cars, cutting back on electricity demand by increased energy conservation and found many other ways to reduce demand for energy. In addition, the Iran-Iraq war (that would last for a decade) led to widespread cheating by OPEC members. When disciplined, each OPEC member was given a production quota to limit total output. As their war escalated and desperate for money, both Iran and Iraq starting producing amounts beyond their quota and selling the extra in the oil spot market at a price below the official OPEC price. Observing this behavior, other OPEC members such as Libya, Nigeria, and Venezuela, decided to earn extra money buy also exceeding their quotas and selling the surplus in the spot market. Soon, the spot price of oil started a rapid decline, and oil firms found ample supply in the spot market. With changing circumstances, the OPEC oligopoly had no choice but to fold its cards and abandon production quotas and official prices. Today, the crude oil market displays behavior close to a perfectly competitive market. Price is determined by the demand and supply for crude oil and producers can sell as much as they want at the spot price.

Copyright © 1999, Jay Kaplan
All rights reserved
Last updated July 1999