Oligopoly and Monopolistic Competition

Introduction to Market Structures

Market structures describe the organization and characteristics of markets, primarily focusing on the number of firms and the nature of products offered. This chapter explores two intermediate market structures—oligopoly and monopolistic competition—which exist between perfect competition and monopoly.

Characteristics of Market Structures

• Number of Firms: Ranges from many (perfect competition) to one (monopoly).

• Product Differentiation: Products may be homogeneous (identical) or differentiated (similar but not identical).

These two characteristics define the four main market structures: perfect competition, monopoly, oligopoly, and monopolistic competition.

Oligopoly

An oligopoly is a market structure with only a few firms, which may sell either homogeneous or differentiated products. The actions of one firm significantly affect the others, leading to strategic behavior and interdependence.

• Barriers to Entry: Significant, allowing for long-run economic profits.

• Examples (Homogeneous): Steel, oil, gasoline, computer hard drives.

• Examples (Differentiated): Cereal, automobiles, laundry detergent, cigarettes.

• Interdependence: Firms must consider rivals' actions when making decisions.

Duopoly and Bertrand Competition

A duopoly is an oligopoly with two firms. In Bertrand competition, firms compete by setting prices for homogeneous products. If both firms set the same price, they split the market; if one lowers its price, it captures the entire market.

• Residual Demand: The demand not met by other firms, dependent on all firms' prices.

• Long-Run Equilibrium: Price equals marginal cost (), similar to perfect competition.

Oligopoly with Differentiated Products

When products are differentiated, firms have some pricing power. If one firm raises its price, it loses some but not all customers, as consumer preferences vary.

• Example: Coke and Pepsi—if Coke raises its price, some loyal customers remain.

• Profit Maximization: Firms set marginal revenue equal to marginal cost ().

Collusion and Cartels

Firms may attempt to collude—agreeing to set prices or output—to increase profits. However, collusion is illegal in many countries and unstable due to incentives to cheat (prisoner's dilemma).

• Cartel: A formal organization of colluding producers (e.g., OPEC).

• Collusion Stability: Requires enforcement and long-term profit incentives.

• Price Match Guarantees: Can signal to competitors a willingness to match lower prices, discouraging price wars.

Monopolistic Competition

Monopolistic competition features many firms selling similar but slightly differentiated products. There are no barriers to entry or exit, and firms earn zero economic profits in the long run.

• Examples: Clothing firms, restaurants, over-the-counter medications, food manufacturers.

• Profit Maximization: Firms set to determine output and price.

• Short-Run Profits: Possible if (average total cost).

• Long-Run Equilibrium: Entry and exit drive profits to zero; .

Market Entry and Exit

• Economic profits attract new firms, shifting demand for existing firms leftward and reducing profits.

• Economic losses cause firms to exit, shifting demand for remaining firms rightward and restoring zero profit.

The "Broken" Invisible Hand

Market power in oligopoly and monopolistic competition leads to inefficiency compared to perfect competition. Firms do not operate at minimum average total cost, resulting in a loss of efficiency, but consumers benefit from greater product variety.

• Government Regulation: May be warranted if collusion is suspected, the industry is highly concentrated, or regulation benefits exceed costs.

Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) measures market concentration by summing the squares of each firm's market share. Higher HHI indicates greater concentration and less competition.

• Formula: , where is the market share percentage of firm .

• Example: Two firms with 75% and 25% market shares: .

• HHI approaches zero as the number of equally sized firms increases.

Evidence-Based Economics: How Many Firms Make a Market Competitive?

Research suggests that some markets can be competitive with as few as three or four firms, though this varies by industry. The degree of competition depends on product differentiation, entry barriers, and market concentration.

Evidence-Based Economics Problem: Tire Dealers Example

• Bertrand Competition (Homogeneous Products): With two dealers (A: MC = $60), equilibrium price is $55, and dealer A captures the market.

• With a third dealer (C: $MC = $50), equilibrium price is $50, and dealer C captures the market.

• Differentiated Products: Each dealer can charge above marginal cost and maintain market share. HHI is calculated using market shares from equilibrium quantities.

• As more firms enter, HHI decreases, indicating increased competition and lower average prices for consumers.

Summary Table: Four Market Structures

Key Formulas

• Profit Maximization:

• Herfindahl-Hirschman Index:

Additional info: This summary expands on the provided slides by including definitions, examples, and formulas for clarity and completeness. The images provided (cover and publisher logo) are not directly relevant to the economic concepts and are therefore not included.