Principles of Economics - 3e Chapter 10 Monopolistic Competition and Oligopoly

Monopolistic Competition and Oligopoly FIGURE Competing Brands ?

The laundry detergent market is one that is characterized neither as perfect competition nor monopoly . Credit of by Pixel Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Monopolistic Competition Oligopoly Introduction to Monopolistic Competition and Oligopoly BRING IT HOME The Temptation to Defy the Law Laundry detergent and bags of of industries that seem pretty mundane , maybe even boring . Hardly ! Both have been the center of clandestine meetings and secret deals worthy of a spy novel . In France , between 1997 and 2004 , the top four laundry detergent producers ( Proctor Gamble , and ) controlled about 90 percent of the French soap market . from the soap firms were meeting secretly , in , small cafes around Paris . Their goals Stamp out competition and set prices . Around the same time , the top Midwest ice makers ( Home City Ice , Lang Ice , Ice , Dairy , and Products of Ohio ) had similar goals in mind when they secretly agreed to divide up the bagged ice market . If both groups could meet their goals , it would enable each to act as though they were a single essence , a

238 10 Monopolistic Competition and Oligopoly enjoy . The problem ?

In many parts of the world , including the European Union and the United States , it is illegal for to divide markets and set prices collaboratively . These two cases provide examples of markets that are characterized neither as perfect competition nor monopoly . Instead , these are competing in market structures that lie between the extremes of monopoly and perfect competition . How do they behave ?

Why do they exist ?

We will revisit this case later , to out what happened . Perfect competition and monopoly are at opposite ends of the competition spectrum . A perfectly competitive market has many selling identical products , who all act as price takers in the face of the competition . If you recall , price takers are that have no market power . They simply have to take the market price as given . Monopoly arises when a single sells a product for which there are no close substitutes . We consider , for instance , as a monopoly because it dominates the operating systems market . What about the vast majority of real world and organizations that fall between these extremes , that we could describe as imperfectly competitive ?

What determines their behavior ?

They have more over the price they charge than perfectly competitive , but not as much as a monopoly . What will they do ?

One type of imperfectly competitive market is monopolistic competition . Monopolistically competitive markets feature a large number of competing , but the products that they sell are not identical . Consider , as an example , the Mall ofAmerica in Minnesota , the largest shopping mall in the United States . In 2010 , the Mall of America had 24 stores that sold women clothing ( like Ann Taylor and Urban ) another 50 stores that sold clothing for both men and women ( like Banana Republic , Crew , and ) plus 14 more stores that sold women specialty clothing ( like Motherhood Maternity and Victoria Secret ) Most of the markets that consumers encounter at the retail level are monopolistically competitive . The other type of imperfectly competitive market is oligopoly . Oligopolistic markets are those which a small number of dominate . Commercial aircraft provides a good example Boeing and each produce slightly less than 50 of the large commercial aircraft in the world . Another example is the soft drink industry , which and Pepsi dominate . We characterize by high barriers to entry with choosing output , pricing , and other decisions strategically based on the decisions of the other in the market . In this chapter , we explore how monopolistically competitive will choose their maximizing level of output . We will then discuss oligopolistic , which face two temptations to collaborate as if they were a single monopoly , or to individually compete to gain by expanding output levels and cutting prices . Oligopolistic markets and can also take on elements of monopoly and of perfect competition . Monopolistic Competition LEARNING OBJECTIVES By the end of this section , you will be able to Explain the of differentiated products Describe how a monopolistic competitor chooses price and quantity Discuss entry , exit , and as they pertain to monopolistic competition Analyze how advertising can impact monopolistic competition Monopolistic competition involves many 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 a variety 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 . There are over restaurants in the United States . When products are distinctive , each has a on its particular style or Access for free at

Monopolistic Competition 239 or brand name . However , producing such products must also compete with other styles and and brand names . The term monopolistic competition captures this mixture of and tough competition , and the following Clear It Up feature introduces its derivation . CLEAR IT UP Who invented the theory of imperfect competition ?

Two economists independently but simultaneously developed the theory of imperfect competition in 1933 . The first was Edward of Harvard University who published The Economics of Monopolistic Competition . The second was Joan Robinson of Cambridge University who published The Economics Competition . Robinson subsequently became interested in and she became a prominent , and later a economist . See the Welcome to Economics ! and The Perspective chapters for more on Keynes . Differentiated Products A can try to make its products different from those of its competitors in several ways physical aspects of the product , location from which it sells the product , intangible aspects of the product , and perceptions of the product . We call products that are distinctive in one of these ways differentiated products . Physical aspects of a product include all the phrases you hear in advertisements unbreakable bottle , nonstick surface , extra spicy , newly redesigned for your comfort . A firm location 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 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 ketchup or mayonnaise if they were blindfolded but , because 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 , locations , and characteristics creates product differentiation and monopolistic competition . Perceived Demand for a Monopolistic Competitor A monopolistically competitive perceives a demand for its goods that is an intermediate case between monopoly and competition . Figure offers a reminder that the demand curve that a perfectly competitive faces is perfectly elastic or , 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 in the market , and hence is downward sloping .

240 10 Monopolistic Competition and Oligopoly Price ( Price ( Price ( Quantity Quantity Quantity ( a ) Perfect competitor ( Monopoly ( Monopolistic competitor FIGURE Perceived Demand for Firms in Different Competitive Settings The demand curve that a perfectly competitive faces is perfectly elastic , meaning it can sell all the output it wishes at the prevailing market price . The demand curve that a monopoly faces is the market demand . It can sell more output only by price it charges . The demand curve that a monopolistically competitive firm faces falls in between . The demand curve as a monopolistic competitor faces is not , but rather , 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 is more elastic than that ofa monopoly where there are no close substitutes . If a monopolist raises its price , some consumers will choose not to purchase its 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 . Ifa monopolistic competitor raises its price , it will not lose as many customers as would a perfectly competitive , but it will lose more customers than would a monopoly that raised its prices . At a glance , the demand curves that a monopoly and a monopolistic competitor face look is , they both slope down . However , 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 . Rather , a monopolistically competitive demand curve is but one of many that make up the before market demand curve . Are you following ?

If so , how would you categorize the market for ?

Take a swing , then see the following Clear It Up feature . CLEAR IT UP Are golf balls really differentiated products ?

Monopolistic competition refers to an industry that has more than a few firms , each offering a product which , from the consumer perspective , is different from its competitors . The . Golf Association runs a laboratory that tests golf balls a year . There are strict rules for what makes a golf ball legal . A ball weight can not exceed ounces and its diameter can not be less than inches ( which is a weight of grams and a diameter of millimeters , in case you were wondering ) The Association also tests the balls by hitting them 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 120 miles per hour . As the testing center explains The system then uses an array of sensors that accurately measure the flight of a golf ball during a short , indoor trajectory from a ball launcher . 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 317 yards . Over 1800 golf balls made by more than 100 companies meet the standards . The balls do differ in various ways , such as the pattern of dimples on the ball , the types of plastic on the cover and in the cores , and other factors . Access for free at

Monopolistic Competition 241 Since all balls need to conform to the tests , they are much more alike than different . In other words , golf ball manufacturers are monopolistically competitive . However , retail sales of golf balls are about 500 million per year , which means that many large companies have a powerful incentive to persuade players that golf balls are highly differentiated and that it makes a huge difference which one you choose . Sure , Tiger Woods can tell the difference . For the average amateur golfer who plays a few times a who loses many golf balls to the woods and lake and needs to buy new golf balls are pretty much indistinguishable . How a Monopolistic Competitor Chooses Price and Quantity The monopolistically competitive decides on its quantity and price in much the same way as a monopolist . A monopolistic competitor , like a monopolist , faces a demand curve , and so it will choose some combination of price and quantity along its perceived demand curve . As an example of a monopolistic competitor , consider the Authentic Chinese Pizza store , which serves pizza with cheese , sweet and sour sauce , and your choice and meats . Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants , it has a differentiated product . The firms perceived demand curve is downward sloping , as Figure 103 shows and the two columns of Table . 35 30 Marginal cost 25 Total profit is i lo Total cost Price ( Average cost Demand Marginal revenue i i i i i i i i i 20 30 40 50 60 70 80 90 Quantity FIGURE How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price To maximize profits , the Authentic Chinese Pizza shop would choose a quantity where marginal revenue equals marginal cost , or where . Here it would choose a quantity of 40 and a price of 16 . Quantity Price Total Revenue Marginal Revenue Marginal Cost Average Cost 10 23 230 23 340 34 34 20 20 400 17 400 20 30 18 540 14 480 16 40 16 640 10 580 10 50 14 700 700 12 14 TABLE Revenue and Cost Schedule

242 10 Monopolistic Competition and Oligopoly Quantity Price Total Revenue Marginal Revenue Marginal Cost 60 12 720 840 14 14 70 10 700 18 80 640 26 16 TABLE Revenue and Cost Schedule We can multiply the combinations and quantity at each point on the demand curve to calculate the total revenue that the would receive , which is in the third column of Table . We calculate marginal revenue , in the fourth column , as the change in total revenue divided by the change in quantity . The columns of Table 101 show total cost , marginal cost , and average cost . As always , we calculate marginal cost by dividing the change in total cost by the change in quantity , while we calculate average cost by dividing total cost by quantity . The following Work It Out feature shows how these calculate how much of their products to supply at what price . How a Monopolistic Competitor Determines How Much to Produce and at What Price The process by which a monopolistic competitor chooses its quantity and price resembles closely how a monopoly makes these decisions process . First , the selects the quantity to produce . Then the decides what price to charge for that quantity . Step . The monopolistic competitor determines its level of output . In this case , the Authentic Chinese Pizza company will determine the quantity to produce by considering its marginal revenues and marginal costs . Two scenarios are possible If the is producing at a quantity of output where marginal revenue exceeds marginal cost , then the should keep expanding production , because each marginal unit is adding to by bringing in more revenue than its cost . In this way , the will produce up to the quantity where . If the is producing at a quantity where marginal costs exceed marginal revenue , then each marginal unit is costing more than the revenue it brings in , and the will increase its by reducing the quantity of output until . In this example , and intersect at a quantity of 40 , which is the level of output for the . Step . The monopolistic competitor decides what price to charge . When the has determined its maximizing quantity of output , it can then look to its perceived demand curve to out what it can charge for that quantity of output . On the graph , we show this process as a vertical line reaching up through the maximizing quantity until it hits the perceived demand curve . For Authentic Chinese Pizza , it should charge a price of 16 per pizza for a quantity of 40 . Once the has chosen price and quantity , it in a position to calculate total revenue , total cost , and . At a quantity of 40 , the price of 16 lies above the average cost curve , so the is making economic . From Table we can see that , at an output of 40 , the total revenue is 640 and its total cost is 580 , so are 60 . In Figure , the total revenues are the rectangle with the quantity of 40 on the horizontal axis and the price of 16 on the vertical axis . The total costs are the light shaded rectangle with the same quantity of 40 on the horizontal axis but the average cost of on the vertical axis . are total revenues minus total costs , which is the shaded area above the average cost curve . Access for free at

Monopolistic Competition 243 Although the process by which a monopolistic competitor makes decisions about quantity and price is similar to the way in which a monopolist makes such decisions , two differences are worth remembering . First , although both a monopolist and a monopolistic competitor face demand curves , the monopolist perceived demand curve is the market demand curve , while the perceived demand curve for a monopolistic competitor is based on the extent of its product differentiation and how many competitors it faces . Second , a monopolist is surrounded by barriers to entry and need not fear entry , but a monopolistic competitor who earns must expect the entry of with similar , but differentiated , products . Monopolistic Competitors and Entry If one monopolistic competitor earns positive economic , other will be tempted to enter the market . A gas station with a great location must worry that other gas stations might open across the street or down the perhaps the new gas stations will sell coffee or have a carwash or some other attraction to lure customers . A successful restaurant with a unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or offer their own unique recipes . A laundry detergent with a great reputation for quality must take note that other competitors may seek to build their own reputations . The entry of other into the same general market ( like gas , restaurants , or detergent ) shifts the demand curve that a monopolistically competitive faces . As more enter the market , the quantity demanded at a given price for any particular will decline , and the perceived demand curve will shift to the left . As a perceived demand curve shifts to the left , its marginal revenue curve will shift to the left , too . The shift in marginal revenue will change the quantity that the chooses to produce , since marginal revenue will then equal marginal cost at a lower quantity . Figure ( a ) shows a situation in which a monopolistic competitor was earning a with its original perceived demand curve ( The intersection of the marginal revenue curve ( and marginal cost curve ( occurs at point , corresponding to quantity , which is associated on the demand curve at point with price . The combination and quantity lies above the average cost curve , which shows that the is earning positive economic . AC ( PE , Pi Pi Oi Quantity Quantity ( a ) Profit induces entry shift to zero ( Loss induces exit shift to zero profit FIGURE Monopolistic Competition , Entry , and Exit ( a ) At and , the monopolistically competitive in this is making a positive economic . This is clear because if you follow the dotted line above 00 , you can see that price is above average cost . Positive economic attract competing to the industry , driving the original demand down to . At the new equilibrium quantity ( the original firm is earning zero economic , and entry into the industry ceases . In ( the opposite occurs . At and 00 , the firm is losing money . If you follow the dotted line above 00 , you can see that average cost is above price . Losses induce to leave the industry . When they do , demand for the original firm rises to , where once again the is earning zero economic .

244 10 Monopolistic Competition and Oligopoly Unlike a monopoly , with its high barriers to entry , a monopolistically competitive with positive economic will attract competition . When another competitor enters the market , the original perceived demand curve shifts to the left , from Do to , and the associated marginal revenue curve shifts from to . The new output is , because the intersection of the and now occurs at point . Moving vertically up from that quantity on the new demand curve , the optimal price is at . As long as the is earning positive economic , new competitors will continue to enter the market , reducing the original demand and marginal revenue curves . The equilibrium is in the at point , where the perceived demand curve touches the average cost curve . When price is equal to average cost , economic are zero . Thus , although a monopolistically competitive may earn positive economic in the short term , the process of new entry will drive down economic to zero in the long run . Remember that zero economic is not equivalent to zero accounting . A zero economic means the accounting is equal to what its resources could earn in their next best use . Figure ( shows the reverse situation , where a monopolistically competitive is originally losing money . The adjustment to equilibrium is analogous to the previous example . The economic losses lead to exiting , which will result in increased demand for this particular , and consequently lower losses . Firms exit up to the point where there are no more losses in this market , for example when the demand curve touches the average cost curve , as in point Monopolistic competitors can make an economic or loss in the short run , but in the long run , entry and exit will drive these toward a zero economic outcome . However , the zero economic outcome in monopolistic competition looks different from the zero economic outcome in perfect competition in several ways relating both to and to variety in the market . Monopolistic Competition and Efficiency The result of entry and exit in a perfectly competitive market is that all end up selling at the price level determined by the lowest point on the average cost curve . This outcome is why perfect competition displays productive goods are produced at the lowest possible average cost . However , in monopolistic competition , the end result of entry and exit is that end up with a price that lies on the portion of the average cost curve , not at the very bottom of the AC curve . Thus , monopolistic competition will not be productively . In a perfectly competitive market , each produces at a quantity where price is set equal to marginal cost , both in the short and long run . This outcome is why perfect competition displays the social of additional production , as measured by the marginal , which is the same as the price , equal the marginal costs to society of that production . In a monopolistically competitive market , the rule for maximizing is to set price is higher than marginal revenue , not equal to it because the demand curve is downward sloping . When , which is the outcome in a monopolistically competitive market , the to society of providing additional quantity , as measured by the price that people are willing to pay , exceed the marginal costs to society of producing those units . A monopolistically competitive does not produce more , which means that society loses the net of those extra units . This is the same argument we made about monopoly , but in this case the will be smaller . Thus , a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry . See the following Clear It Up feature for more detail on the impact of demand shifts . CLEAR IT UP Why does a shift in perceived demand cause a shift in marginal revenue ?

We use the combinations of price and quantity at each point on a firm perceived demand curve to calculate total revenue for each combination of price and quantity . We then use this information on total revenue to calculate Access for free at Competition 245 marginal revenue , which is the change in total revenue divided by the change in quantity . A change in perceived demand will change total revenue at every quantity of output and in turn , the change in total revenue will shift marginal revenue at each quantity of output . Thus , when entry occurs in a monopolistically competitive industry , the perceived demand curve for each will shift to the left , because a smaller quantity will be demanded at any given price . Another way of interpreting this shift in demand is to notice that , for each quantity sold , the will charge a lower price . Consequently , the marginal revenue will be lower for each quantity the marginal revenue curve will shift to the left as well . Conversely , exit causes the perceived demand curve for a monopolistically competitive to shift to the right and the corresponding marginal revenue curve to shift right , too . A monopolistically competitive industry does not display productive or in either the short run , when are making economic and losses , nor in the long run , when are earning zero . The Benefits of Variety and Product Differentiation Even though monopolistic competition does not provide productive or , it does have of its own . Product differentiation is based on variety and innovation . Most people would prefer to live in an economy with many kinds of clothes , foods , and car styles not in a world competition where everyone will always wear blue jeans and white shirts , eat only spaghetti with plain red sauce , and drive an identical model of car . Most people would prefer to live in an economy where are struggling to out ways of attracting customers by methods like friendlier service , free delivery , guarantees of quality , variations on existing products , and a better shopping experience . Economists have struggled , with only partial success , to address the question a economy produces the optimal amount of variety . Critics of economies argue that society does not really need dozens athletic shoes or breakfast cereals or automobiles . They argue that much of the cost of creating such a high degree differentiation , and then of advertising and marketing this differentiation , is socially is , most people would be just as happy with a smaller range of differentiated products produced and sold at a lower price . Defenders of a economy respond that if people do not want to buy differentiated products or highly advertised brand names , no one is forcing them to do so . Moreover , they argue that consumers substantially when seek by providing differentiated products . This controversy may never be fully resolved , in part because deciding on the optimal amount is very , and in part because the two sides often place different values on what variety means for consumers . Read the following Clear It Up feature for a discussion on the role that advertising plays in monopolistic competition . CLEAR IT UP How does advertising impact monopolistic competition ?

The economy spent about billion on advertising in 2014 , according to . Roughly one third of this was television advertising , and another third was divided roughly equally between internet , newspapers , and radio . The remaining third was divided between direct mail , magazines , telephone directory yellow pages , and billboards . Mobile devices are increasing the opportunities for advertisers . Advertising is all about explaining to people , or making people believe , that the products of one firm are differentiated from another products . In the framework of monopolistic competition , there are two ways to conceive of how advertising works either advertising causes a firm perceived demand curve to become more inelastic ( that is , it causes the perceived demand curve to become steeper ) or advertising causes demand for the firm product to increase ( that is , it causes the perceived demand curve to shift to the right ) In either case , a successful advertising campaign may allow a to sell either a greater quantity or to charge a higher price , or both ,

246 10 Monopolistic Competition and oligopoly and thus increase its . However , economists and business owners have also long suspected that much of the advertising may only offset other advertising . Economist wrote the following back in 1920 in his book , The Economics of Welfare It may happen that expenditures on advertisement made by competing that is , what we now call monopolistic competitors will simply neutralise one another , and leave the industrial position exactly as it would have been if neither had expended anything . For , clearly , if each of two rivals makes equal efforts to attract the favour of the public away from the other , the total result is the same as it would have been if neither had made any effort at all . Oligopoly LEARNING OBJECTIVES By the end of this section , you will be able to Explain why and how exist Contrast collusion and competition Interpret and analyze the prisoner dilemma diagram Evaluate the of imperfect competition Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive , monopolies , nor monopolistically competitive . Rather , they are . Oligopoly arises when a small number of large have all or most of the sales in an industry . Examples of oligopoly abound and include the auto industry , cable television , and commercial air travel . Oligopolistic are like cats in a bag . They can either scratch each other to pieces or cuddle up and get comfortable with one another . If compete hard , they may end up acting very much like perfect competitors , driving down costs and leading to zero for all . If collude with each other , they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of . We typically characterize by mutual interdependence where various decisions such as output , price , and advertising depend on other ( decisions . Analyzing the choices of oligopolistic about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time . Why Do Exist ?

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly . For example , when a government grants a patent for an invention to one , it may create a monopoly . When the government grants patents to , for example , three different pharmaceutical companies that each has its own drug for reducing high blood pressure , those three may become an oligopoly . Similarly , a natural monopoly will arise when the quantity demanded in a market is only large enough for a single to operate at the minimum of the average cost curve . In such a setting , the market has room for only one , because no smaller can operate at a low enough average cost to compete , and no larger could sell what it produced given the quantity demanded in the market . Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost means that the market would have room for only two or three oligopoly ( and they need not produce differentiated products ) Again , smaller would have higher average costs and be unable to compete , while additional large would produce such a high quantity that they would not be able to sell it at a price . This combination of scale and market demand creates the barrier to entry , which led to the oligopoly ( also called a duopoly ) for large passenger aircraft . The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly . Access for free at

oligopoly 247 For example , may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name . The problem in competing with , say , Coca Cola or Pepsi is not that producing drinks is technologically difficult , but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task . Collusion or Competition ?

When oligopoly in a certain market decide what quantity to produce and what price to charge , they face a temptation to act as if they were a monopoly . By acting together , oligopolistic can hold down industry output , charge a higher price , and divide the among themselves . When act together in this way to reduce output and keep prices high , it is called collusion . A group of that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel . See the following Clear It Up feature for a more analysis of the difference between the two . CLEAR IT UP Collusion versus cartels How to differentiate In the United States , as well as many other countries , it is illegal for to collude since collusion is competitive behavior , which is a violation of antitrust law . Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States . The problem of enforcement is hard evidence of collusion . Cartels are formal agreements to collude . Because cartel agreements provide evidence of collusion , they are rare in the United States . Instead , most collusion is tacit , where implicitly reach an understanding that competition is bad for profits . Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher . Adam Smith wrote in Wealth in 1776 People of the same trade seldom meet together , even for merriment and diversion , but the conversation ends in a conspiracy against the public , or in some contrivance to raise prices . Even when recognize that they would as a group by acting like a monopoly , each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher still counting on the other to hold down their production and keep prices high . If at least some give in to this temptation and start producing more , then the market price will fall . A small handful of oligopoly may end up competing so that they all themselves earning zero economic if they were perfect competitors . The Prisoner Dilemma Because of the complexity of oligopoly , which is the result of mutual interdependence among , there is no single , theory of how behave , in the same way that we have theories for all the other market structures . Instead , economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do . Game theory has found widespread applications in the social sciences , as well as in business , law , and military strategy . The prisoner dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing . It applies well to oligopoly . Note that the term prisoner is not typically an accurate term for someone who has recently been arrested , but we will use the term here , since this scenario is widely used and referenced in economic , business , and social . The story behind the prisoners dilemma goes like this Two are arrested . When they are taken to the police station , they refuse to say

248 10 Monopolistic Competition and oligopoly anything and are put in separate interrogation rooms . Eventually , a police enters the room where Prisoner A is being held and says You know what ?

Your partner in the other room is confessing . Your partner is going to get a light prison sentence ofjust one year , and because you re remaining silent , the judge is going to stick you with eight years in prison . Why do you get smart ?

If you confess , too , well cut time down to years , and your partner will get years , also . Over in the next room , another police is giving exactly the same speech to Prisoner . What the police do not say is that prisoners remain silent , the evidence against them is not especially strong , and the prisoners will end up with only two years in jail each . The game theory situation facing the two prisoners is in Table . To understand the dilemma , consider the choices from Prisoner A point of view . IfA believes that will confess , then A should confess , too , so as to not get stuck with the eight years in prison . However , ifA believes that will not confess , then A will be tempted to act and confess , so as to serve only one year . The key point is that A has an incentive to confess regardless of what choice makes ! faces the same set of choices , and thus will have an incentive to confess regardless of what choice A makes . To confess is called the dominant strategy . It is the strategy an individual ( or ) will pursue regardless of the other individual ( or ) decision . The result is that if prisoners pursue their own , both are likely to confess , and end up being sentenced to a total of 10 years ofjail time between them . Prisoner Remain Silent ( cooperate with Confess ( do not cooperate with other prisoner ) other prisoner ) Remain Silent ( cooperate with , A gets years , gets years A gets years , gets year other prisoner ) Prisoner A Confess ( do not cooperate with other prisoner ) A gets year , gets years A gets years gets years TABLE The Prisoner Dilemma Problem The game is called a dilemma because if the two prisoners had cooperated by both remaining silent , they would only have been incarcerated for two years each , for a total of four years between them . If the two prisoners can work out some way of cooperating so that neither one will confess , they will both be better off than if they each follow their own individual , which in this case leads straight into longer terms . The Oligopoly Version of the Prisoner Dilemma The members of an oligopoly can face a prisoner dilemma , also . If each of the cooperates in holding down output , then high monopoly are possible . Each , however , must worry that while it is holding down output , other are taking advantage of the high price by raising output and earning higher . Table shows the prisoners dilemma for a as a duopoly . If Firms A and both agree to hold down output , they are acting together as a monopoly and will each earn in . However , both dominant strategy is to increase output , in which case each will earn 400 in . Firm Hold Down Output ( cooperate Increase Output ( do not cooperate with other ) with other ) TABLE A Dilemma for Access for free at

Oligopoly 249 Hold Down Output ( cooperate with A gets , gets A gets 200 , gets other ) Firm Increase Output ( do not cooperate with other ) A gets , gets 200 A gets 400 , gets 400 TABLE A Prisoner Dilemma for Can the two trust each other ?

Consider the situation of Firm A IfA thinks that will cheat on their agreement and increase output , then A will increase output , too , because for A the of 400 when both increase output ( the bottom choice in ) is better than a of only 200 ifA keeps output low and raises output ( the upper choice in the table ) IfA thinks that will cooperate by holding down output , then A may seize the opportunity to earn higher by raising output . After all , if is going to hold down output , then A can earn in by expanding output ( the bottom choice in the table ) compared with only by holding down output as well ( the upper choice in the table ) Thus , A will reason that it makes sense to expand output if holds down output and that it also makes sense to expand output raises output . Again , faces a parallel set of decisions that will lead also to expand output . The result of this prisoner dilemma is often that even though A and could make the highest combined by cooperating in producing a lower level of output and acting like a monopolist , the two may well end up in a situation where they each increase output and earn only 400 each in . The following Clear It Up feature discusses one cartel scandal in particular . CLEAR IT UP What is the Lysine cartel ?

Lysine , a 600 industry , is an amino acid that farmers use as a feed additive to ensure the proper grow of swine and poultry . The primary producer of lysine is Archer Daniels Midland ( but several other large European and Japanese are also in this market . For a time in the first half of the , the world major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge . The Federal Bureau of Investigation ( FBI ) however , had learned of the cartel and placed wire on a number of their phone calls and meetings . From FBI surveillance tapes , following is a comment that Terry Wilson , president of the corn processing division at , made to the other lysine producers at a 1994 meeting in Mona , Hawaii wan na go back and I wan na say something very simple . If we going to trust each other , okay , and if assured that I gon na get tons by the year end , we gon na sell it at the prices we agreed to . The only thing we need to talk about there because we are gon na get manipulated by these expletive can be smarter than us if we let them be smarter . They the customers are not your friend . They are not my friend . And we got ta have em , but they are not my friends . You are my friend . I wan na be closer to you than I am to any customer . Cause you can make us money . And all I wan na tell you again is let put the prices on the board . Let all agree that what we gon na do and then walk out of were and do it . The once of lysine doubled while the cartel was in effect . Confronted by the FBI tapes , Archer Daniels Midland pled guilty in 1996 and paid a of 100 million . A number of top executives , both at and other , later paid

250 10 Monopolistic Competition and oligopoly of up to and were sentenced to months in prison . In another one of the FBI recordings , the president of Archer Daniels Midland told an executive from another competing firm that had a slogan that , in his words , had penetrated the whole company . The company president stated the slogan this way Our competitors are our friends . Our customers are the That slogan could stand as the motto of cartels everywhere . How to Enforce Cooperation How can parties who themselves in a prisoner dilemma situation avoid the undesired outcome and cooperate with each other ?

The way out of a prisoner dilemma is to a way to penalize those who do not cooperate . Perhaps the easiest approach for colluding , as you might imagine , would be to sign a contract with each other that they will hold output low and keep prices high . If a group of companies signed such a contract , however , it would be illegal . Certain international organizations , like the nations that are members of the Organization of Petroleum Exporting Countries ( have signed international agreements to act like a monopoly , hold down output , and keep prices high so that all of the countries can make high from oil exports . Such agreements , however , because they fall in a gray area of international law , are not legally enforceable . If , for example , decides to start cutting prices and selling more oil , Saudi Arabia can not sue in court and force it to stop . LINK up Visit the Organization of the Petroleum Exporting Countries website zo ' and learn more about its history and how it itself . Because can not sign a legally enforceable contract to act like a monopoly , the may instead keep close tabs on what other are producing and charging . Alternatively , may choose to act in a way that generates pressure on each to stick to its agreed quantity of output . One example of the pressure these can exert on one another is the kinked demand curve , in which competing oligopoly commit to match price cuts , but not price increases . Figure 105 shows this situation . Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of seats on the New York to Los Angeles route , at a price of 500 . This choice the kink in the firms perceived demand curve . The reason that the firm faces a kink in its demand curve is because of how the other react to changes in the price . Ifthe oligopoly decides to produce more and cut its price , the other members of the cartel will immediately match any price therefore , a lower price brings very little increase in quantity sold . If one cuts its price to 300 , it will be able to sell only seats . However , if the airline seeks to raise prices , the other will not raise their prices , and so the that raised prices will lose a considerable share of sales . For example , if the raises its price to 550 , its sales drop to seats sold . Thus , if always match price cuts by other in the cartel , but do not match price increases , then none of the will have a strong incentive to change prices , since the potential gains are minimal . This strategy can work like a silent form of cooperation , in which the cartel successfully manages to hold down output , increase price , and share a monopoly level even without any legally enforceable agreement . Access for free at

Oligopoly 251 600 ( 5000 . 550 ) 10000 500 ) 11000 , 300 ) 500 400 Price ( 300 200 100 Quantity FIGURE A Kinked Demand Curve Consider a member in an oligopoly cartel that is supposed to produce a quantity of and sell at a price of 500 . The other members of the cartel can encourage this to honor its commitments by acting so that the faces a kinked demand curve . If the attempts to expand output and reduce price slightly , other firms also cut prices if the expands output to , the price per unit falls dramatically , to 300 . On the other side , if the Oligopoly attempts to raise its price , other firms will not do so , so if the raises its price to 550 , its sales decline sharply to . Thus , the members of a cartel can discipline each other to stick to the levels of quantity and price through a strategy of matching all price cuts but not matching any price increases . Many , prodded by economic changes , legal and political pressures , and the egos of their top executives , go through episodes of cooperation and competition . If could sustain cooperation with each other on output and pricing , they could earn as if they were a single monopoly . However , each in an oligopoly has an incentive to produce more and grab a bigger share of the overall market when start behaving in this way , the market outcome in terms of prices and quantity can be similar to that ofa highly competitive market . of Imperfect Competition Monopolistic competition is probably the single most common market structure in the economy . It provides powerful incentives for innovation , as seek to earn in the short run , while entry assures that do not earn economic in the long run . However , monopolistically competitive firms do not produce at the lowest point on their average cost curves . In addition , the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing . Oligopoly is probably the second most common market structure . When result from patented innovations or from taking advantage of economies of scale to produce at low average cost , they may provide considerable to consumers . are often buffered by barriers to entry , which enable the to earn sustained over long periods of time . also do not typically produce at the minimum of their average cost curves . When they lack vibrant competition , they may lack incentives to provide innovative products and service . The task policy with regard to competition is to sort through these multiple realities , attempting to encourage behavior that is to the broader society and to discourage behavior that only adds to the ofa few large companies , with no corresponding to consumers . Monopoly and Antitrust Policy discusses the delicate judgments that go into this task .

252 10 Monopolistic Competition and Oligopoly BRING IT HOME The Temptation to Defy the Law Oligopolistic firms have been called cats in a bag , as this chapter mentioned . The French detergent makers chose to cozy up with each her . The result ?

An uneasy and tenuous relationship . When the Wall Street Journal reported on the matter , it wrote According to a statement a manager made to the French commission , the detergent makers wanted to limit the intensity of the competition between them and clean up the Nevertheless , by the ear sometimes lasting more executive recalled chao cartels , the soap cartel individual . How did this soap opera and Proctor Gamble a 19905 , a price war had broken out among During the soap executives meetings , than four hours , the companies established complex pricing structures . One soap ic meetings as each side tried to work out how the other had bent the Like many due to the very strong temptation for each member to maximize its own end ?

After an investigation , French antitrust authorities , of million ( 484 million ) A similar fate befell the . Bagged ice is a commodity , a perfect substitute , generally sold in or bags . No one cares what label is on the bag . By agreeing to carve up the moved from perfect bagged ice to a region . ice market , control broad geographic swaths of territory , and set prices , the petition to a monopoly model . After the agreements , each firm was the sole supplier of were were in both the long run and the short run . According to the courts These companies illegally cons aired to manipulate the Fines totaled about steep considering a bag of ice sells for under in most parts of the United States . Even though it is illegal in many parts of the world for to set prices and carve up a market , the temptation to earn higher makes it extremely tempting to defy the law . Access for free at

10 Key Terms 253 Key Terms cartel a group of that collude to produce the monopoly output and sell at the monopoly price collusion when act together to reduce output and keep prices high differentiated product a product that consumers perceive as distinctive in some way duopoly an oligopoly with only two game theory a branch of mathematics that economists use to analyze situations in which players must make decisions and then receive payoffs based on what decisions the other players make imperfectly competitive and organizations that fall between the extremes of monopoly and perfect competition kinked demand curve a perceived demand curve that arises when competing oligopoly commit to match price cuts , but not price increases monopolistic competition many competing to sell similar but differentiated products oligopoly when a few large have all or most of the sales in an industry prisoner dilemma a game in which the gains from cooperation are larger than the rewards from pursuing product differentiation any action that do to make consumers think their products are different from their competitors Key Concepts and Summary Monopolistic Competition Monopolistic competition refers to a market where many sell differentiated products . Differentiated products can arise from characteristics of the good or service , location from which the sells the product , intangible aspects of the product , and perceptions of the product . The perceived demand curve for a monopolistically competitive is , which shows that it is a price maker and chooses a combination of price and quantity . However , the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist , because the monopolistic competitor has direct competition , unlike the pure monopolist . A monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost . The monopolistic competitor will produce that level of output and charge the price that the demand curve indicates . If the in a monopolistically competitive industry are earning economic , the industry will attract entry until are driven down to zero in the long run . If the in a monopolistically competitive industry are suffering economic losses , then the industry will experience exit of until economic losses are driven up to zero in the long run . A monopolistically competitive is not productively because it does not produce at the minimum of its average cost curve . A monopolistically competitive is not because it does not produce where , but instead produces where . Thus , a monopolistically competitive will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive . Monopolistically competitive industries do offer to consumers in the form of greater variety and incentives for improved products and services . There is some controversy over whether a economy generates too much variety . oligopoly An oligopoly is a situation where a few sell most or all of the goods in a market . earn their highest if they can band together as a cartel and act like a monopolist by reducing output and raising price . Since each member of the oligopoly can individually from expanding output , such collusion often breaks since explicit collusion is illegal .

254 10 Questions The prisoners dilemma is an example of the application of game theory to analysis of oligopoly . It shows how , in certain situations , all sides can from cooperative behavior rather than behavior . However , the challenge for the parties is to ways to encourage cooperative behavior . Questions . Suppose that , due to a successful advertising campaign , a monopolistic competitor experiences an increase in demand for its product . How will that affect the price it charges and the quantity it supplies ?

Continuing with the scenario in question , in the long run , the positive economic that the monopolistic competitor earns will attract a response either from existing in the industry or outside . As those capture the original , what will happen to the original maximizing price and output levels ?

Consider the curve in the below , which shows the market demand , marginal cost , and marginal revenue curve for in an oligopolistic industry . In this example , we assume have zero COS Demand Marginal Revenue FIGURE Marginal Cost a . Suppose the collude to form a cartel . What price will the cartel charge ?

What quantity will the cartel supply ?

How much will the cartel earn ?

Suppose now that the cartel breaks up and the oligopolistic compete as vigorously as possible by cutting the price and increasing sales . What will be the industry quantity and price ?

What will be the collective of all in the industry ?

Compare the equilibrium price , quantity , and for the cartel and cutthroat competition outcomes . Sometimes in the same industry are very different in size . Suppose we have a duopoly where one ( Firm A ) is large and the other ( Firm ) is small , as the prisoners dilemma box in Table shows . Firm with Firm A Firm cheats by selling more output Firm A with Firm A gets , gets 100 A gets 300 , gets 200 Firm A cheats by selling more output A gets , gets 50 TABLE A gets 500 , gets 20 Assuming that both know the payoffs , what is the likely outcome in this case ?

Access for free at 10 Review Questions 255 Review Questions . 10 . 11 . 12 . 13 . What is the relationship between product differentiation and monopolistic competition ?

How is the perceived demand curve for a monopolistically competitive different from the perceived demand curve for a monopoly or a perfectly competitive ?

How does a monopolistic competitor choose its quantity of output and price ?

How can a monopolistic competitor tell whether the price it is charging will cause the to earn or experience losses ?

If the in a monopolistically competitive market are earning economic or losses in the short run , would you expect them to continue doing so in the long run ?

Why ?

Is a monopolistically competitive productively ?

Is it ?

Why or why not ?

Will the in an oligopoly act more like a monopoly or more like competitors ?

explain . Does each individual in a prisoner dilemma more from cooperation or from pursuing interest ?

Explain . What stops from acting together as a monopolist and earning the highest possible level of ?

Critical Thinking Questions 14 . 15 . 16 . 17 . 18 . Aside from advertising , how can monopolistically competitive increase demand for their products ?

Make a case for why monopolistically competitive industries never reach equilibrium . Would you rather have or variety ?

That is , one opportunity cost of the variety of products we have is that each product costs more per unit than if there were only one kind of product ofa given type , like shoes . Perhaps a better question is , What is the right amount ?

Can there be too many varieties of shoes , for example ?

Would you expect the kinked demand curve to be more extreme ( like a right angle ) or less extreme ( like a normal demand curve ) if each in the cartel produces a product like and petroleum ?

What if each produces a somewhat different product ?

Explain your reasoning . When raised the price dramatically in the , experts said it was unlikely that the cartel could stay together over the long the incentives for individual members to cheat would become too strong . More than forty years later , still exists . Why do you think has been able to beat the odds and continue to collude ?

Hint You may wish to consider reasons .

256 10 Problems Problems 19 . Andrea Day Spa began to offer a relaxing aromatherapy treatment . The asks you how much to charge to maximize . The two columns in Table provide the price and quantity for the demand curve for treatments . The third column shows its total costs . For each level of output , calculate total revenue , marginal revenue , average cost , and marginal cost . What is the level of output for the treatments and how much will the earn in ?

Price Quantity 130 10 275 20 435 30 610 40 800 50 60 TABLE 20 . Mary and Raj are the only two growers who provide organically grown corn to a local grocery store . They know that if they cooperated and produced less corn , they could raise the price of the corn . If they work independently , they will each earn 100 . If they decide to work together and both lower their output , they can each earn 150 . If one person lowers output and the other does not , the person who lowers output will earn and the other person will capture the entire market and will earn 200 . Table represents the choices available to Mary and Raj . What is the best choice for Raj if he is sure that Mary will cooperate ?

If Mary thinks Raj will cheat , what should Mary do and why ?

What is the prisoners dilemma result ?

What is the preferred choice if they could ensure cooperation ?

A Work independently Cooperate and Lower Output . Each results entry lists Raj earnings , and Mary earnings second . Mary ( 100 , 100 ) 200 , 200 ) 150 , 150 ) TABLE Access for free at 10 Problems 257 21 . Jane and Bill are apprehended for a bank robbery . They are taken into separate rooms and questioned by the police about their involvement in the crime . The police tell them each that if they confess and turn the other person in , they will receive a lighter sentence . If they both confess , they will be each be sentenced to 30 years . If neither confesses , they will each receive a sentence . If only one confesses , the confessor will receive 15 years and the one who stayed silent will receive 35 years . Table below represents the choices available to Jane and Bill . If Jane trusts Bill to stay silent , what should she do ?

If Jane thinks that Bill will confess , what should she do ?

Does Jane have a dominant strategy ?

Does Bill have a dominant strategy ?

A Confess Stay Silent . Each results entry lists Jane sentence ( in years ) and Bill sentence second . Jane A A ( Bill ( 20 , 20 ) TABLE