Oligopoly and Monopolistic Competition

A. Behavior of Imperfect Competitors

1. Recall the four major market structures: (a) Perfect competition is found when no firm is large enough to affect the market price. (b) Monopolistic competition occurs when a large number of firms produce slightly differentiated products. (c) Oligopoly is an intermediate form of imperfect competition in which an industry is dominated by a few firms. (d) Monopoly comes when a single firm produces the entire output of an industry.

2. Measures of concentration are designed to indicate the degree of market power in an imperfectly competitive industry. Industries which are more concentrated tend to have higher levels of R&D expenditures, but their profitability is not higher on average.

3. High barriers to entry and complete collusion can lead to collusive oligopoly. This market structure produces a price and quantity relation similar to that under monopoly.

4. Another common structure is the monopolistic competition that characterizes many retail industries. Here we see many small firms, with slight differences in the quality of products (such as different locations of gasoline stations). The existence of product differentiation leads each firm to face a downward-sloping dd demand curve. In the long run, free entry extinguishes profits as these industries show an equilibrium in which firms’ AC curves are tangent to their dd demand curves. In this tangency equilibrium, prices are above marginal costs but the industry exhibits greater diversity of quality and service than would occur under perfect competition.

5. A final situation recognizes the strategic interplay when an industry has but a handful of firms. Where a small number of firms compete in a market, they must recognize their strategic interactions. Competition among the few introduces a completely new feature into economic life: It forces firms to take into account competitors’ reactions to price and output deviations and brings strategic considerations into these markets.

6. Price discrimination occurs when the same product is sold to different consumers for different prices. This practice often occurs when sellers can segment their market into different groups.

B. Innovation and Information

7. A careful study of the actual behavior of oligopolists shows certain kinds of behavior at variance with standard economic assumptions about profit maximization. One limit on profit maximization is bounded rationality. This principle recognizes that it may take time and effort to make perfectly informed decisions, so managers may make less-than-perfect decisions, often employing rules of thumb, to economize on search and decision time. An important example of rule-of-thumb behavior is markup pricing – where prices are set by adding a percentage increase on top of costs of production. Also, remember that market power can allow firms to lead the easy life.

8. Schumpeter emphasized the importance of the innovator, who introduces “new combinations” in the form of new products or methods of organization and is rewarded by temporary entrepreneurial profits. The Schumpeterian hypothesis holds that traditional monopoly theory ignores the dynamics of technological change. According to this view, monopolies and oligopolies are the chief source of innovation and growth in living standardsÑto turn large firms into perfect competitors would risk raising prices in the long run as the fragmentation of industry slows technological progress.

9. Today, the economics of information emphasizes the difficulties involved in efficient production and distribution of new and improved knowledge. Information is different from normal goods because it is expensive to produce but cheap to reproduce. The inability of firms to capture the full monetary value of their inventions is called inappropriability. To increase appropriability, governments create intellectual property rights governing patents, copyrights, trade secrets, and electronic media. The growth of electronic information systems like the Internet raises, in heightened form, the dilemma of the efficient pricing of information services.

C. A Balance Sheet on Imperfect Competition

10. Monopoly power often leads to economic inefficiency when price rises above marginal cost, costs are bloated by lack of competitive pressure, and product quality deteriorates.

11. To curb the abuses of imperfect competition, governments in an earlier age sometimes used taxation, price controls, and nationalization. These are little used today in most market economies. The three major tools in American industrial policy today are regulation, antitrust laws, and the encouragement of competition. Of these, the most important is to ensure vigorous rivalry by lowering the barriers to competition whenever possible.