Chap011 Rev

Chapter 11 - Monopolistic Competition and Oligopoly
Chapter 11 Monopolistic Competition and Oligopoly
QUESTIONS
1. How does monopolistic competition differ from pure competition in its basic characteristics?
From pure monopoly? Explain fully what product differentiation may involve. Explain how the
entry of firms into its industry affects the demand curve facing a monopolistic competitor and
how that, in turn, affects its economic profit. LO1
Answer: In monopolistic competition there are many firms but not the very large
numbers of pure competition. The products are differentiated, not standardized. There is
some control over price in a narrow range, whereas the purely competitive firm has none.
There is relatively easy entry; in pure competition, entry is completely without barriers.
In monopolistic competition, there is much nonprice competition, such as advertising,
trademarks, and brand names. In pure competition, there is no nonprice competition.
In pure monopoly there is only one firm. Its product is unique and there are no close
substitutes. The firm has much control over price, being a price maker. Entry to its
industry is blocked. Its advertising is mostly for public relations.
Product differentiation may well only be in the eye of the beholder, but that is all the
monopolistic competitor needs to gain an advantage in the market—provided, of course,
the consumer looks upon the assumed difference favorably. The real differences can be
in quality, in services, in location, or even in promotion and packaging, which brings us
back to where we started: possibly nonexistent differences. To the extent that product
differentiation exists in fact or in the mind of the consumer, monopolistic competitors
have some limited control over price, for they have built up some loyalty to their brand.
When economic profits are present, additional rivals will be attracted to the industry
because entry is relative easy. As new firms enter, the demand curve faced by the typical
firm will shift to the left (fall). Because of this, each firm has a smaller share of total
demand and now faces a larger number of close-substitute products. This decline firm’s
demand reduces its economic profit.
2. Compare the elasticity of a monopolistic competitor’s demand with that of a pure competitor
and a pure monopolist. Assuming identical long-run costs, compare graphically the prices and
outputs that would result in the long run under pure competition and under monopolistic
competition. Contrast the two market structures in terms of productive and allocative efficiency.
Explain: “Monopolistically competitive industries are populated by too many firms, each of
which produces too little.” LO2
Answer: The monopolistic competitor’s demand curve is less elastic than a pure
competitor and more elastic than a pure monopolist. Your graphs should look like Figure
9.6 (pure competition) and Figure 11.1 (monopolistic competition). Price is higher and
output lower for the monopolistic competitor. Pure competition: P = MC (allocative
efficiency); P = minimum ATC (productive efficiency). Monopolistic competition: P >
MC (allocative inefficiency) and P > minimum ATC (productive inefficiency).
Monopolistic competitors have excess capacity; meaning that fewer firms operating at
capacity (where P = minimum ATC) could supply the industry output.
11-1
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3. “Monopolistic competition is monopolistic up to the point at which consumers become willing

to buy close-substitute products and competitive beyond that point.” Explain. LO2
Answer: As long as consumers prefer one product over another regardless of relative
prices, the seller of the product is a monopolist. But in monopolistic competition this
happy state is limited because there are many other firms producing similar products.
When one firm’s prices get “too high” (as viewed by consumers), people will switch
brands. At this point, our firm has entered the competitive zone unwillingly, which is
why monopolistically competitive firms are forever trying to find ways to differentiate
their products more thoroughly and thus to gain more monopoly price-setting power.
4. “Competition in quality and service may be just as effective as price competition in giving
buyers more for their money.” Do you agree? Why? Explain why monopolistically competitive
firms frequently prefer nonprice competition to price competition. LO2
Answer: This can certainly be true. It depends on how much consumers value quality
and service, and are willing to pay for it through higher product prices. In a
monopolistically competitive market the consumer can buy a substitute brand for a lower
price, if the consumer prefers a lower price to better quality and service.
The monopolistically competitive firm frequently prefers nonprice competition to price
competition, because the latter can lead to the firm producing where P = ATC and thus
making no economic profit or, worse, producing in the short run where P < ATC and thus
losing money, with the possibility of eventually going out of business.
Nonprice competition, on the other hand, if successful, results in more monopoly power:
The firm’s product has become more differentiated from now less-similar competitors in
the industry. This increase in monopoly power allows the firm to raise its price with less
fear of losing customers. Of course, the firm must still follow the MR = MC rule, but its
success in nonprice competition has shifted both the demand and MR curves upward to
the right. This results in simultaneously a larger output, a higher price, and more
economic profits.
5. Critically evaluate and explain: LO2

(a) In monopolistically competitive industries, economic profits are competed away in the long
run; hence, there is no valid reason to criticize the performance and efficiency of such industries.
(b) In the long run, monopolistic competition leads to a monopolistic price but not to
monopolistic profits.
Answer:
(a) The first part of the statement may well be true, but it does not lead logically to the
second part. The criticism of monopolistic competition is not related to the profit
level but to the fact that the firms do not produce at the point of minimum ATC and
do not equate price and MC. This is the inevitable consequence of imperfect
competition and its downward sloping demand curves. With P > minimum ATC,
productive efficiency is not attained. The firm is producing too little at too high a
cost; it is wasting some of its productive capacity. With P > MC, the firm is not
allocating resources in accordance with society’s desires; the value society sets on the
product (P) is greater than the cost of producing the last item (MC).
11-2
whole or part.
(b) The statement is often true, since competition of close substitutes tends to compete
price of the average firm down to equality with ATC. Thus, there is no economic
profit. However, the firm is producing where its (moderately) monopolistically
downward-sloping demand curve is tangent to the ATC curve, short of the point of
minimum ATC and thus at a higher than purely competitive price. In other words, it
is at a “monopolistic” price.
6. Why do oligopolies exist? List five or six oligopolists whose products you own or regularly
purchase. What distinguishes oligopoly from monopolistic competition? LO3
Answer: Oligopolies exist for several reasons, the most common probably being
economies of scale. If these are substantial, as they are in the automobile industry, for
example, only very large firms can produce at minimum average cost. This makes it
virtually impossible for new firms to enter the industry. A small firm could not produce
at minimum cost and would soon be competed out of the business; yet to start at the
required very large scale would take far more money than an unestablished firm is likely
to be able to raise before proving it will be profitable.
Other barriers to entry include ownership of patents by the oligopolists and, possibly,
massive advertising that gives would-be newcomers no chance to establish a presence in
the public’s mind. Finally, there is the urge to merge. Mergers have the clear advantage
of reducing competition—of giving the emerging oligopolists more monopoly power.
Also, they may result in more economies of scale and thereby increase that barrier to new
entry.
Oligopolies with which we deal include manufacturers of automobiles, ovens,
refrigerators, personal computers, gasoline, and courier services.
Oligopoly is distinguished from monopolistic competition by being composed of few
firms (not many); by being mutually interdependent with regard to price (instead of
control within narrow limits); by having differentiated or homogeneous products (not all
differentiated); and by having significant obstacles to entry (not easy entry). Both engage
in much nonprice competition.
7. Answer the following questions, which relate to measures of concentration: LO3

(a) What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent? What are
the shortcomings of concentration ratios as measures of monopoly power?
(b) Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent
of total industry sales. For the five firms in industry B, the figures are 60, 25, 5, 5, and 5 percent.
Calculate the Herfindahl index for each industry and compare their likely competitiveness.
Answer: A four-firm concentration ratio of 60 percent means the largest four firms in the
industry account for 60 percent of sales; a four-firm concentration ratio of 90 percent
means the largest four firms account for 90 percent of sales (just add the percentage of
sales for the largest four firms). Shortcomings: (1) they pertain to the nation as a whole,
although relevant markets may be localized; (2) they do not account for interindustry
competition; (3) the data are for U.S. products—imports are excluded; and (4) they don’t
reveal the dispersion of size among the top four firms.
11-3
whole or part.
To calculate the Herfindahl index square the percentages for all firms in the industry (do
NOT use decimal form) and add them together.
11-4
whole or part.
For industry A we have:

Herfindahl index = 302+302+202+102+102= 900+900+400+100+100= 2400
For industry B we have:
Herfindahl index = 602+252+52+52+52= 3600+625+25+25+25= 4300
We would expect industry A to be more competitive than Industry B because the largest
two firms in industry B control a greater percentage of the market. If all firms controlled
an equal share of the market (20% for the five firms above ) the Herfindahl index would
equal 2000. If one firm (out of the five) controlled the entire market (100%) the
Herfindahl index would equal 10,000. The latter case is obviously a monopoly. The
closer the Herfindahl index is to the monopoly case the less competition there will be in
the market.
8. Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All
profit figures are in thousands. LO4
(a) Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic
industries.
(b) Assuming no collusion between X and Y, what is the likely pricing outcome?
(c) In view of your answer to 8b, explain why price collusion is mutually profitable. Why might
there be a temptation to cheat on the collusive agreement?
Answer:
(a) X and Y are interdependent because their profits depend not just on their own price,
but also on the other firm’s price. Note that Y's profits are in the lower corner and X's
profits are in the upper corner.
11-5
whole or part.
(b) Likely outcome: Both firms will set price at $35. If either charged $40, it would be
concerned the other would undercut the price and its profit by charging $35. For
example, if firm X chooses a price of $40 and firm Y chooses a price of $40 then
firm X's profits are $57,000 and firm Y's profits are $60,000. However, if firm Y
chooses to charge $35 it can increase its profit to $69,000. In effect, firm Y has an
incentive to deviate from the price of $40. The same logic applies to firm X. If firm X
deviates from the price of $40 it can increase profits to $59,000. The catch is that
both firms recognize this incentive structure and realize that if they continue to
charge $40 and the other firm deviates from this price their profits will fall (If firm X
continues to charge $40 and firm Y charges $35, rather than $40, to capture higher
profits then firm X's profits will fall to $50,000. If firm X also charged $35 its profits
would be $55,000, which is better than $50,000). Thus, both firms charge a price
$35; X’s profit is $55,000, Y’s, $58,000.
(c) Through price collusion—agreeing to charge $40—each firm would achieve higher
profits (X = $57,000; Y = $60,000). But once both firms agree on $40, each sees it
can increase its profit even more by secretly charging $35 while its rival charges $40,
which was discussed above.
9. What assumptions about a rival’s response to price changes underlie the kinked-demand curve
for oligopolists? Why is there a gap in the oligopolist’s marginal-revenue curve? How does the
kinked-demand curve explain price rigidity in oligopoly? What are the shortcomings of the
kinked-demand model? LO5
Answer: Assumptions: (1) Rivals will match price cuts: (2) Rivals will ignore price
increases. The gap in the MR curve results from the abrupt change in the slope of the
demand curve at the going price. Firms will not change their price because they fear that
if they do their total revenue and profits will fall. Shortcomings of the model: (1) It does
not explain how the going price evolved in the first place; (2) it does not allow for price
leadership and other forms of collusion.
10. Why might price collusion occur in oligopolistic industries? Assess the economic desirability
of collusive pricing. What are the main obstacles to collusion? Speculate as to why price
leadership is legal in the United States, whereas price-fixing is not. LO6
Answer: Price wars are a form of competition that can benefit the consumer but can be
highly detrimental to producers. As a result, oligopolists are naturally drawn to the idea
of price-fixing among themselves, i.e., colluding with regard to price. In a recession, it is
nice to know whether one’s rivals will cut prices or quantity, so that a mutually
satisfactory solution can be reached. It is also convenient to be able to agree on what
price to set to bankrupt any would-be interloper in the industry.
From the viewpoint of society, collusive pricing is not economically desirable. From the
oligopoly’s viewpoint it is highly desirable since, when entirely successful, it allows the
oligopoly to set price and quantity as would a profit-maximizing monopolist.
11-6
whole or part.
The main obstacles to collusion are demand and cost differences (which result in
different points of equality of MR and MC); the number of firms (the more firms, the
lower the possibility of getting together and reaching sustainable agreement); cheating (it
pays to cheat by selling more below the agreed-on price—provided the other colluders do
not find out); recession (when demand slumps, the urge to shave prices—to cheat—
becomes much greater); potential entry (the above-equilibrium price that is the reason for
collusion may entice new firms into this profitable industry—and it may be hard to get
new entrants into the combine, quite apart from the unfortunate increase in supply they
will cause); legal obstacles (for a century, antitrust laws have made collusion illegal).
Price leadership is legal because although the firms may follow the dominant firm’s
price, they are not compelled to. Also, the tacit agreement on price does not include an
agreement to control quantity and to divide up the market.
11. Why is there so much advertising in monopolistic competition and oligopoly? How does such
advertising help consumers and promote efficiency? Why might it be excessive at times? LO7
Answer: Two ways for monopolistically competitive firms to maintain economic profits
are through product development and advertising. Also, advertising will increase the
demand for the firm’s product. The oligopolist would rather not compete on a basis of
price. Oligopolists can increase their market share through advertising that is financed
with economic profits from past advertising campaigns. Advertising can operate as a
barrier to entry.
Advertising provides information about new products and product improvements to the
consumer. Advertising may result in an increase in competition by promoting new
products and product improvements. It may also result in increased output for a firm,
pushing it down its ATC curve and closer to productive efficiency (P = minimum ATC).
Advertising may result in manipulation and persuasion rather than information. An
increase in brand loyalty through advertising will increase the producer’s monopoly
power. Excessive advertising may create barriers to entry into the industry.
11-7
whole or part.
12. ADVANCED ANALYSIS Construct a game-theory matrix involving two firms and their
decisions on high versus low advertising budgets and the effects of each on profits. Show a
circumstance in which both firms select high advertising budgets even though both would be
more profitable with low advertising budgets. Why won’t they unilaterally cut their advertising
budgets? LO7
Answer: Consider the following example, where Firm B's profits are in the lower corner
and Firm A's profits are in the upper corner :
Firm A’s Advertising

Low High
Budget Budget
Low
Firm B’s Budget $100 $120
Advertising
$100 $60
High
Budget $60 $80
$120 $80
Profits from each advertising strategy appear in the cells

In the payoff matrix above, each firm can choose between a low and high advertising
budget. If, for example, Firm A chooses a high budget and Firm B a low budget, Firm
A’s profit will be $120, and Firm B’s only $60.
11-8
whole or part.
The payoff matrix suggests that both firms should have high advertising budgets, but if
both choose to do so, they will both be worse off relative to if they both had low budgets.
Neither firm will reduce its budget because if it does and its rival doesn’t, the firm
reducing will lose profits to the other firm. Unless they collude, the firms will both end
up with large advertising budgets and reduced profits. (This argument is similar to the
one found in problem 8b and 8c.)
Also note that any values with the ordering above can serve as an answer to this question:
Firm A’s Advertising

Low High
Budget Budget
Low
Firm B’s Budget $Q $X
Advertising
$Q $Y
High
Budget $Y $Z
$X $Z
The restrictions are $X > $Q > $Z > $Y.
13. LAST WORD What firm dominates the U.S. beer industry? What demand and supply factors
have contributed to “fewness” in this industry?
Answer: Anheuser-Busch is the dominant firm in the industry.

On the demand side, there is evidence that by the 1970s tastes had changed in favor of
lighter, drier beers produced by the larger brewers. Second, there has been a shift from
consumption in taverns to home consumption, which means higher sales of packaged
containers that can be shipped long distances.
On the supply side, technological advances have increased bottling lines, so that the
number of cans filled per hour rose from 900 in 1965 to over 2000 in 1990s; large plants
have been able to take advantage of economies of scale; television advertising also favors
the large producers; and extensive product differentiation exists despite the smaller
number of firms, which has enabled these firms to expand still further.
11-9
whole or part.
PROBLEMS
1. Suppose that a small town has seven burger shops whose respective shares of the local
hamburger market are (as percentages of all hamburgers sold): 23%, 22%, 18%, 12%, 11%, 8%,
and 6%. What is the four‐firm concentration ratio of the hamburger industry in this town? What is
the Herfindahl index for the hamburger industry in this town? If the top three sellers combined to
form a single firm, what would happen to the four‐firm concentration ratio and to the Herfindahl
index? LO3
Answers: The four-firm concentration ratio is 75%; the Herfindahl Index is 1702 (= 529 +
484 + 324 +144 + 121 + 64 + 36); The new four-firm concentration ratio would be 94%; the
new Herfindahl Index would be 4334 = (3969 + 144 +121 + 64 + 36).
Feedback: Consider the following example: Suppose that a small town has seven burger
shops whose respective shares of the local hamburger market are (as percentages of all
hamburgers sold): 23%, 22%, 18%, 12%, 11%, 8%, and 6%.
The four-firm concentration ratio is found by adding together the top four firm's
percentage of sales. For the values above, the four-firm concentration ratio equals 75% (=
23% + 22% + 18% + 12%).
The Herfindahl index is found by squaring the percentages for all of the firms in the
industry (not the decimal form) and then adding these values together. For the values
above, the Herfindahl index equals 1702 (= 232 + 222 +182 +122 + 112 + 82 + 62 = 529 +
484 + 324 + 144 + 121 + 64 + 36).
If the top three sellers combine to form a single firm, this combined firm will control
63% of the market (= 23% + 22% + 18%). Thus, we now have five firms in the industry
whose respective shares of the local hamburger market are now 63%, 12%, 11%, 8%, and
6%.
The new four-firm concentration ratio is 94% (= 63% + 12% + 11% + 8%).
The new Herfindahl index is 4334 ( = 632 + 122 + 112 + 82 + 62 = 3969 + 144 + 121 + 64
+ 36).
2. Suppose that the most popular car dealer in your area sells 10 percent of all vehicles. If all
other car dealers sell either the same number of vehicles or fewer, what is the largest value that
the Herfindahl index could possibly take for car dealers in your area? In that same situation, what
would the four‐firm concentration ratio be? LO3
Answers: To maximize the Herfindahl Index means to have an industry with as much
concentration as possible. That calls for firms that are as big as possible. With the largest
firm controlling only 10%, the way to have the rest of the industry be as concentrated as
possible would be for there to be 9 other firms that each also controlled 10% of the market
(for a total of 10 firms each controlling 10%). In that situation, the Herfindahl index would
be 1000 (= 10*(102)) and the four-firm concentration ratio would be 40% (= 4*10%).
11-10
whole or part.
Feedback: Consider the following example: Suppose that the most popular car dealer in
your area sells 10 percent of all vehicles. If all other car dealers sell either the same
number of vehicles or fewer in the market then the largest number of dealers possible is
10. This follows from the fact that the largest share any dealer can have is 10%, and the
sum of all dealer shares must equal 100% of the market, we therefore have a maximum
number of firms at 10 (= 100%/10%).
Given that the maximum number of firms in the market equals 10, at a maximum
concentration share of 10% for all firms, the largest Herfindahl index possible is 1000
(=10 (number of firms) x 102 (percentage squared for each firm)).
This logic also implies that the four-firm concentration ratio (largest possible) is 40% (=
4 (largest four firms, could be any of the ten) x 10% (share of the market)).
3. Suppose that an oligopolistically competitive restaurant is currently serving 230 meals per day
(the output where MR = MC). At that output level, ATC per meal is $10 and consumers are
willing to pay $12 per meal. What is the size of this firm’s profit or loss? Will there be entry or
exit? Will this restaurant’s demand curve shift left or right? In long‐run equilibrium, suppose that
this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th meal is
$8. What is the size of the firm’s profit? Suppose that the allocatively efficient output level in
long-run equilibrium is 200 meals. Is the deadweight loss for this firm greater than or less than
$60? LO3
Answers: The firm will earn a profit of $460 [= ($12-$10)*230]; there will be entry, shifting
the firm’s individual demand curve to the left; In long-run equilibrium, this firm will be
earning zero profit so the information about what the firm is charging and what the MC is
for the 180th meal are irrelevant pieces of information for this particular question; The
deadweight loss will be less than $60—students can see this by noting that $60 must be an
upper bound because even if the $3 per unit difference between marginal benefit as given by
the demand curve ($11) and marginal cost as given by the MC curve ($8) continued for all
units between the 180th and the 200th, the deadweight loss would only amount to $60 (= $3
per unit times 20 units). But with MC rising for all of these units and the demand curve
falling, the deadweight loss would have to be smaller.
Feedback: Consider the following example: An oligopolistically competitive restaurant

is currently serving 230 meals per day (the output where MR = MC). At that output level,
ATC per meal is $10 and consumers are willing to pay $12 per meal.
Since the restaurant's ATC per meal is $10 and the restaurant receives $12 per meal, the
restaurant's profit per meal is $2 (= $12 - $10). Given that the restaurant sells 230 meals
at this price its profit is $460 (= $2x230).
Given that this restaurant is making an economic profit there will be entry into this
industry since other firms will try to capture some of this economic profit. The entry of
other firms will reduce demand for the restaurant causing its demand schedule to shift to
the left.
Now assume that in long‐run equilibrium this restaurant charges $11 per meal for 180
meals and that the marginal cost of the 180th meal is $8. Also assume that the
allocatively efficient output level in long-run equilibrium is 200 meals in the long-run.
11-11
whole or part.
The economic profit in the long-run is always zero in this type of market (monopolistic
competition).
The deadweight loss will be less than $60—students can see this by noting that $60 must
be an upper bound because even if the $3 per unit difference between marginal benefit as
given by the demand curve ($11) and marginal cost as given by the MC curve ($8)
continued for all units between the 180th and the 200th, the deadweight loss would only
amount to $60 (= $3 per unit times 20 units). But with MC rising for all of these units and
the demand curve falling, the deadweight loss would have to be smaller.
11-12
whole or part.

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Chapter 11 - Monopolistic Competition and Oligopoly

Chapter 11 Monopolistic Competition and Oligopoly

3. “Monopolistic competition is monopolistic up to the point at which consumers become willing

5. Critically evaluate and explain: LO2

7. Answer the following questions, which relate to measures of concentration: LO3

For industry A we have:

Firm A’s Advertising

Profits from each advertising strategy appear in the cells

Firm A’s Advertising

The restrictions are $X > $Q > $Z > $Y.

Answer: Anheuser-Busch is the dominant firm in the industry.

Feedback: Consider the following example: An oligopolistically competitive restaurant

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