INDUSTRIAL ORGANIZATION, MONOPOLISTIC
COMPETITION, AND OLIGOPOLY
WHERE YOU’RE GOING
When you have mastered this chapter, you will understand
1. How the structure of markets in the U.S. economy has changed over time.
2. How the interdependence of firms under oligopoly affects price and output decisions.
3. Why oligopolistic firms sometimes collude to increase profits, and the problems they encounter as a
4. The conditions that affect market performance under oligopoly.
5. How equilibrium is achieved under monopolistic competition, and how well monopolistically competitive
In addition, you will add the following terms to your economic vocabulary:
Market concentration Contestable market
Concentration ratio Oligopolistic interdependence
Herfindahl index Cartel
Barrier to entry Price leadership
After you have read this chapter at least once, you should work step by step through this walking tour. Fill in
the blanks and answer the questions as you go along. After you have answered each question, check yourself
by uncovering the answer given in the margin. If you do not understand why the answer given is the correct
one, refer back to the proper section of the text.
Measures of Market Concentration
The degree to which a market is dominated by a few large firms is called
market concentration ____________. There are several measures of market concentration. Some are
based on the percentage of all sales in a market that is accounted for by the four or
concentration ratios eight largest firms. These measures are called ____________. Another measure of
market concentration is calculated by squaring the percentage market shares of all
Herfindahl firms in an industry and summing the squares. This is called the ____________
index. For example, an industry in which there were four firms, one with 60
percent of the market, one with 20 percent of the market, and two with 10 percent
4.200 of the market, would have a Herfindahl index of ____________. A market with
four firms, each of which has 25 percent of the market, would have a Herfindahl
2.500 index of ____________.
Empirical studies of market concentration that blend structural and behavioral
less evidence suggest that the U.S. economy is becoming [more/less] concentrated over
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Market concentration has a variety of possible causes. One is the cost
economies of scale advantage of making a large volume of output, that is, ____________. Another is
any circumstance that prevents new firms from competing on an equal footing with
barriers to entry existing firms. These are called ____________. An industry in which there are no
substantial sunk costs, so that barriers to exit as well as entry are low, is called a
contestable / hit-and- ____________ market. Such markets are open to ____________ entry.
The Theory of Oligopoly: Interdependence and Collusion
There is no general model of profit maximization under oligopoly comparable to
the models of perfect competition and monopoly. The reason lies in the need of
each firm in an oligopoly to pay close attention to the actions of rivals when
oligopolistic making price or production decisions, that is, in the problem of ____________.
interdependence Oligopolistic interdependence can sometimes lead to intense rivalry, and at
collusion other times toward cooperation, or ____________. For example, a group of
producers may decide to maximize profits by agreeing to fix prices and limit
cartel output. Such a group is called a ____________. The object of a cartel is to
raise / restricting [raise/lower] prices by [increasing/restricting] output. Like a monopoly, a cartel
would maximize profit for the industry as a whole by adjusting the level of output
marginal revenue to a point where marginal cost was equal to ____________ for the industry.
However, cartels suffer problems of stability. One problem is that of control
entry / output quotas over ____________. A second serious problem is that of enforcing ____________.
Here, the problem is that if one firm cheats on its quota while other firms continue
greater to abide by theirs, the cheater will earn a [greater/smaller] profit than if it too
played by the rules. And, if a firm thinks other cartel members will cheat, then it
also cheating will earn a greater profit by [also cheating/playing by the rules]. Experience
rare indicates that successful, long-lived cartels are [common/rare] in the world
Even when firms do not form a cartel, they may tacitly coordinate their price
and output decisions in a way that will jointly increase their profit compared with
open competition. Several conditions are thought to make such tacit coordination
more difficult or less difficult. For example, an increase in the number and size of
more firms in a market is thought to make coordination [more/less] difficult. A
less homogeneous product is thought to make coordination [more/less] difficult than a
heterogeneous product. A rapid rate of innovation is thought to make coordination
more [more/less] difficult. Finally, barriers to entry and exit are thought to make
less coordination [more/less] difficult.
The Theory of Monopolistic Competition
Monopolistic competition refers to a market structure in which there, are
many / heterogeneous [few/many] firms, a [homogeneous/heterogeneous] product, and [easy/difficult]
/ easy entry and exit. The demand curve faced by a monopolistically competitive firm has
negative a [positive/negative/zero] slope. The profit-maximizing level of output for the firm
revenue is determined by the point where marginal cost is equal to marginal ____________
demand and the profit-maximizing price is determined by the height of the ____________
curve at that point. In long-run equilibrium for a monopolistically competitive
equal to firm, price is [greater than/less than/equal to] average total cost, so that pure
zero economic profit is [positive/negative/zero]. The equilibrium price is [equal
greater than to/greater than/less than] marginal cost.
Chapter 9 • 82
Now that you have reviewed the concepts introduced in this chapter, it is time for some hands-on practice with
the analytical tools that have been introduced. Work through each problem in this section carefully, and then
check your results against those given at the end of the chapter.
The following questions are based on Figure 9.1. Use parts a and b of this figure in answering the
questions that follow.
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a. Figure 9.la shows demand, marginal revenue, and marginal cost curves for an industry composed of 100
identical small firms. Assume that the industry is organized as a cartel. What is the profit-maximizing
quantity of output for the industry? The profit-maximizing price? If the 100 members of the cartel agree to
share the profit-maximizing quantity of output equally, what is the output quota allowed to each firm?
b. Figure 9.lb shows cost curves for one of the 100 identical firms making up the cartel. If the firm holds
production to its 100 unit quota, how much profit will it earn? What will the relationship between
marginal cost and marginal revenue be for this firm at 100 units of output?
c. Suppose that this firm were to treat the cartel’s profit-maximizing price of $1.20 per unit as a given. If it
acted like a price taker with a fixed $1.20 per unit price, what would its profit-maximizing level of output
be? How much profit would it make?
d. Does this example tell you anything about the temptation of an individual member of a cartel to cheat on
the cartel’s agreed output quotas? Explain.
The following questions are based on Figure 9.2, which shows demand and cost curves for a typical firm in a
monopolistically competitive industry.
a. Using the demand curve as a basis, sketch in the firm’s marginal revenue curve. What is the firm’s short-
run profit-maximizing level of output? Its short-run profit-maximizing price?
b. Under conditions of monopolistic competition, can the situation shown prevail in the long run? Why or
why not? If not, what will you expect to happen in the long run?
Chapter 9 • 84
These sample test items will help you check how much you have learned. Answers are found at the end of the
chapter. Scoring yourself: One or two wrong—on target. Three or four wrong—passing, but you haven’t
mastered the chapter yet. Five or more wrong—not good enough; start over and restudy the chapter.
1. The airline industry in the United States would best be described as
a. pure monopoly. c. oligopoly.
b. a cartel. d. monopolistic competition.
2. An industry with an eight-firm concentration ratio of 95 percent and a formal agreement on prices and
output among the top eight firms would best be described as
a. pure monopoly. c. oligopoly.
b. monopolistic competition. d. a cartel.
3. An industry in which one firm has a 20 percent share of the market and eight other firms each have a 10
percent share has a Herfindahl index of
a. 100. c. 1,200.
b. 1,000. d. 1,400.
4. According to a study by William G. Shephard, which of the following categories of industry accounted
for a greater share of the U.S. economy in 1980 than in 1958?
a. Pure monopoly. c. Tight oligopoly.
b. Dominant firm oligopoly. d. Effectively competitive.
5. Which of the following could be considered a barrier to entry into the New York City taxi industry?
a. The necessity of raising capital to buy cabs.
b. The necessity of training drivers in knowledge of the city streets.
c. The fact that the city places a fixed ceiling on the number of “medallions” (permits) without which
one cannot operate a cab.
d. All of the above are barriers to entry.
6. A cartel maximizes total profits for its membership by setting output at the point where the industry’s
marginal cost curve intersects
a. the horizontal axis. c. the industry’s marginal revenue curve.
b. the industry’s demand curve. d. none of the above.
7. If an individual member of a cartel could be certain of escaping detection, it would be tempted to cheat
a. increasing price. c. doing both of the above.
b. increasing output. d. doing neither of the above.
8. Which of the following is likely to make tacit coordination easier in an oligopolistic market?
a. A small number of firms. c. A slow pace of innovation.
b. A homogeneous product. d. All of the above.
9. Which of the following is likely to make tacit coordination more difficult in an oligopolistic market?
a. A small number of firms. c. Rapid growth and innovation.
b. Presence of single dominant firm. d. All of the above.
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10. Economists who have made empirical studies of the relationship between concentration and market
performance have generally looked at the data relating to
a. marginal cost.
b. marginal revenue.
c. producer surplus.
d. rates of return and the opportunity cost of capital.
11. An early study by Joe Bain concluded that
a. profits were always higher in more concentrated industries than in less concentrated industries.
b. there was a moderate but persistent tendency for firms in concentrated industries to earn relatively
c. there was no difference in terms of profits between more concentrated industries and less concentrated
d. concentrated industries had satisfactory market performance.
12. Which of the following might cause firms in more concentrated industries to earn higher rates of return,
on the average, than firms in less concentrated industries?
a. Oligopolies operate much like formal cartels.
b. Concentrated industries happen, on the average, to grow faster than less concentrated industries.
c. Data on rates of return are distorted by failure to account properly for advertising expenditures.
d. Any of the above might cause such a relationship.
13. The market for hair styling services in a medium- to large-sized community would best be described as
which of the following?
a. Monopoly. c. Monopolistic competition.
b. Oligopoly. d. Perfect competition.
14. If firms in a monopolistically competitive industry are earning pure economic profits in short-run
equilibrium, we will expect the number of firms to
b. remain constant.
d. the situation is impossible; monopolistically competitive firms can never earn a pure economic profit.
15. In long-run equilibrium under monopolistic competition, which of the following is true?
a. Marginal cost is equal to marginal revenue for all firms.
b. Average total cost is equal to price for all firms.
c. Pure economic profits are zero.
d. All of the above.
ANSWERS TO CHAPTER 9
Problem 1 (a) The profit-maximizing quantity is 10,000 units and the profit-maximizing price is $1.20. If
each firm produces an equal share of the total, the quota will be 100 units of output per firm. (b) At 100 units
of output, this firm’s average total cost is 90 cents per unit. It would thus make $30 profit if it sold 100 units
for $1.20 per unit, according to the cartel’s plan. Under these circumstances, marginal revenue will exceed
marginal cost at 100 units of output by 30 cents. (c) If the firm acted as a price taker with a price of $1.20, it
would increase output to the point where marginal cost rose to $1.20. That would occur at 140 units of output.
Average total cost at 140 units is about 95 cents, so the firm would earn a $35 profit. (d) In this, and every
other cartel situation, each individual firm would be able to increase its profit by producing more than its
quota, provided all other firms stuck to their quotas, thus keeping the market price high. Of course, if all firms
cheated, the price would fall to the competitive level, and no one would earn monopoly profits.
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Problem 2 (a) The vertical intercept of the marginal revenue curve is $14 and the horizontal intercept is 875.
The profit-maximizing output is 500 units per day, which corresponds to the intersection of the marginal cost
and marginal revenue curves. The profit-maximizing price is $10, which corresponds to the height of the
demand curve at 500 units of output. (b) This situation cannot prevail in the long run. At 500 units of output, as
the figure is drawn, price exceeds average total cost by $2 per unit. The firm thus earns a pure economic profit
of $1,000 per day. If other firms in the industry are earning similar profits, new entrants will be attracted. As
new firms enter, the demand curve will shift to the left. Entry will stop when pure economic profits disappear.
1. c. It has relatively few firms, some of which are quite large, and has no system of formal collusion.
2. d. It is the formal agreement that makes it a cartel. The concentration wouldn’t have to be so high.
3. c. The index is found by summing the squares of the market shares; 20 squared = 400, plus 8 firms that
contribute 10 squared = 100, for a total of $1,200.
4. d. This continued a trend also found when data for 1958 are compared with data for 1939.
5. c. The first two items are available to newcomers on the same terms as to existing firms, but existing
firms control all the medallions that the city is willing to issue. They are thus a true barrier to entry.
6. c. The condition is the same as that for a monopolist.
7. b. Alternative a would reduce the firm’s profit if customers went elsewhere.
8. d. For these and other reasons, the degree of tacit coordination is likely to vary greatly from one industry
9. c. Items a and b are thought to make it easier.
10. d. Information on items a, b, and c is not generally available.
11. b. Studies since then have found sometimes a, sometimes b, and sometimes c. The issue is still
12. d. Differing interpretations of the data on rates of return are one source of controversy in this area.
13. c. The key characteristics are many firms and a heterogeneous product.
14. a. Entry of new firms will eliminate the pure economic profits in the long run.
15. d. If these conditions do not prevail, firms will enter or leave the industry until they do.
Chapter 9 • 87