C H A P T E R 1 0 : M O N O P O LY, C A RT E L S , A N D P R I C E D I S C R I M I N AT I O N 249

d. Now suppose the industry is made up of many e. Show how the typical farm s profits would rise if it
small, price-taking firms (with the same technology). were the only farm to cheat. What level of output
What are the equilibrium price and level of output in would the cheating farm produce?
this case? f. Explain what would happen if all farms tried to
5. Imagine a monopolist that has fixed costs but no variable cheat in this way.
costs (thus there are no marginal costs, so MC * 0). For 7. Consider each of the following examples in which a
example, consider a firm that owns a spring of water that firm sells the same product to different customers at
can produce indefinitely once it installs certain pipes, in different prices. Identify in each case whether price
an area where no other source of water is available. discrimination is likely to be taking place. If there is
a. Draw a downward-sloping demand curve for unlikely to be price discrimination occurring, what
water, its associated MR curve, and the monopo- explains the different prices?
list s MC curve. a. Weekend airline fares that are less than mid-week
b. On your diagram, show the monopolist s profit- fares.
maximizing price and level of output. b. Business-class airline fares that are 50 percent
c. At the monopolist s profit-maximizing level of output, higher than economy-class fares. (Recognize that
what is the marginal value of this good to society, and two business-class seats take the same space inside
how does it compare with the marginal cost? the plane as three economy-class seats.)
6. Consider the market for corn. Suppose this is a competi- c. Discounts on furniture negotiated from the sug-
tive industry, made up of many price-taking farmers. We gested retail price for which sales personnel are
begin in a situation where market price is p0, industry authorized to bargain and to get as much in each
output is Q0, and the typical farm is earning zero profit. transaction as the customer is prepared to pay.
d. Higher tuition for law students than for graduate
a. Draw two diagrams like the ones below. students in economics.

MC
S
Price, Costs

ATC
Price

p0 p0

D
MR
0 Output 0 q0 Output
Q0
Corn Industry Typical Corn Farmer

b. Now suppose that the farmers in this industry 8. Look back to the diagram of the monopolist on Golf
form a cartel and collectively agree to restrict the Island in Question 3.
industry output of corn to the level that a monop- a. Suppose the monopolist is able to practise perfect
olist would produce. Call this level of output QM price discrimination. What would be the total num-
and call the new price pM. Each firm now produces ber of rounds of golf sold per week? What would
output of qM + q0. Show this outcome in the two be the price on the last round sold?
diagrams. b. What is the area representing consumer surplus in
c. Show how the cartel raises the profits for the typi- the absence of any price discrimination?
cal farmer. c. What is the area representing consumer surplus
d. Now consider the incentives for an individual farm when the monopolist is practising perfect price
to cheat on its fellow cartel members. Would it be discrimination?
profitable to produce an extra unit and sell it at the d. Could this monopolist realistically engage in per-
cartel price? How is this incentive illustrated in fect price discrimination? Describe a more likely
your diagram?
 250 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

form of price discrimination that this monopolist e. Compute the price elasticity of demand (at the
could achieve on Golf Island. profit-maximizing points) in each market seg-
9. In the text we mentioned how Levi Strauss price dis- ment. (You may want to review Chapter 4 on
criminates between the European and American mar- elasticity at this point.) Does the market seg-
kets. This question is designed to help you analyze ment with less elastic demand have the higher
this situation. The following equations are hypotheti- price?
cal demand curves for Levi s 501s in Europe and in 10. Consider each of the following examples of price
America. We have expressed the price in dollars in discrimination. For each case, explain how the
both markets, and quantity is thousands of units per price discrimination works. Also explain which
year. consumers would be worse off and which con-
sumers would be better off if the firm were unable
European Demand: QDE * 150 + p
to price discriminate in this way.
American Demand: QDA * 250 + 4p
a. Seniors pay lower prices for theatre tickets than
a. On two separate scale diagrams, one for Europe do other adults.
and one for America, plot the two demand curves. b. Consumers pay less for paperback books than for
b. Recalling that a straight-line demand curve has an hardcover books, but must wait six to twelve
associated MR curve that has twice its slope, plot months before the paperbacks are made available.
the two MR curves. c. Customers at garage sales often pay a lower
c. Suppose Levi Strauss has a constant marginal cost of price if they ask for one that is, if they reveal
$15 per unit. Plot the MC curve in both diagrams. that they are prepared to haggle.
d. What is the profit-maximizing price in each mar- d. Airline customers get a discount fare if they are
ket? Explain why profit maximization requires that prepared to stay over a Saturday night at their
MC be equated to MR in each market segment. destination.

Discussion Questions
1. Suppose only one professor teaches economics at your consumers lower rates the more electricity they use.
university. Would you say that this professor is a Are these all examples of price discrimination? What
monopolist who can exact any price from students additional information would you like to have before
in the form of readings assigned, tests given, and mate- answering this question?
rial covered? Suppose now that two additional profes- 5. Acme Department Store has a sale on luggage. It is
sors have been hired. Has the original professor s offering $30 off any new set of luggage to customers
market power been decreased? What if the three pro- who trade in an old suitcase. Acme has no use for the
fessors form a cartel agreeing on common reading old luggage and throws it away at the end of each day.
lists, workloads, and the like? Is this price discrimination? Why or why not? Which
2. Which of these industries licorice candy, copper of the conditions necessary for price discrimination
wire, outboard motors, coal, or the local newspaper are or are not met?
would it be most profitable to monopolize? Why? 6. The world price of coffee has declined in real terms
Does your answer depend on several factors or on just over the past 40 years. In 1950, coffee was priced at
one or two? Which would you as a consumer least like just under U.S.$3 per pound (in 1994 dollars),
to have monopolized by someone else? If your answers whereas by 1995 the world price had fallen to just
to the two questions are different, explain why. over U.S.$1 per pound. On July 29, 1995, The Econo-
mist magazine reported that
3. Aristotle Murphy owns movie theatres in two towns
of roughly the same size, 100 kilometres apart. In On July 26 the Association of Coffee Producing
Monopolia, he owns the only chain of theatres; in Countries agreed in New York to limit exports to 60m
Competitia, there is no theatre chain, and he is only bags for 12 months. The current level is 70m bags....
one of a number of independent theatre operators. Coffee prices rallied a bit on the news, but few expect
Would you expect movie prices to be higher in the pact to last: some big coffee producers such as
Monopolia or in Competitia in the short run? In the Mexico have not signed up, and even those who have
long run? If differences occur in his prices, would will probably cheat.
Murphy be discriminating in price? a. Explain why few expect the pact to last in situa-
4. Airline fares to Europe are higher in summer than in tions like this when producers form a cartel.
winter. Some railways charge lower fares during the b. By 2001, the price of coffee was approximately
week than on weekends. Electric companies charge U.S.$0.65 per pound. Was the cartel successful?
Imperfect
Competition and
Strategic Behaviour
The two market structures that we have studied so far
perfect competition and monopoly are polar cases;
they define the two extremes of a firm s market power
within an industry. Under perfect competition, firms are
price takers, price is equal to marginal cost, and eco-
11
L LEARNING OBJECTIVES
1
In this chapter you will learn
that most industries in Canada have either
a large number of small firms or a small
number of large firms.

nomic profits in the long run are zero. Under monopoly, 2 why imperfectly competitive firms have
the firm is a price setter, it sets price above marginal differentiated products and often engage
cost, and it can earn positive profits in the long run if in non-price competition.
there are sufficient entry barriers. 3 the key elements of the theory of monopo-
Although they provide important insights, these listic competition.
two polar cases are insufficient for understanding the
4 that strategic behaviour is a key feature of
behaviour of all firms. Indeed, most of the products oligopoly.
that we easily recognize swimsuits, cell phones, jeans,
cameras, hamburgers, sunglasses, perfume, running
5 how to use game theory to explain the
difference between cooperative and non-
shoes, computers, breakfast cereals, and cars, to name cooperative outcomes among oligopolists.
just a few are produced by firms that have some mar-
ket power yet are not monopolists.
This chapter discusses market structures that lie
between these two polar cases of perfect competi-
tion and monopoly. Before discussing the theory,
however, we turn to a brief discussion of the preva-
lence of these intermediate market structures in the
Canadian economy.
 252 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

11.1 The Structure of the

Canadian Economy
We can divide Canadian industries into two broad groups: those with a large number
of relatively small firms and those with a small number of relatively large firms.

Industries with Many Small Firms

About two-thirds of Canada s total annual output is produced by industries made up
of firms that are small relative to the size of the market in which they sell.
The perfectly competitive model does quite well in explaining the behaviour of some
of these industries. These are the ones in which individual firms produce more-or-less
identical products and so are price takers. Forest and fish products are two broad exam-
ples. Agriculture also fits fairly well in most ways since individual farmers are clearly
price takers. Many basic raw materials, such as iron ore, tin, copper, oil, and paper, are
sold on world markets where most individual firms lack significant market power.
Other industries, however, are not well described by the perfectly competitive
model, even though they contain many small firms. In retail trade and in services, for
example, most firms have some influence over prices. Your local grocery stores, cloth-
ing shops, night clubs, and restaurants spend a good deal of money advertising on
television and in newspapers something they would not have to do if they were price
takers. Moreover, each store in these industries has a unique location that gives it some
local market power over nearby customers.
The theory of monopolistic competition, which we will examine in this chapter,
was originally developed to help explain economic behaviour and outcomes in indus-
tries in which there are many small firms, each with some market power.

Industries with a Few Large Firms

About one-third of Canada s total annual output is produced by industries that are
dominated by either a single firm or a few large ones.
The most striking cases of monopolies in today s economy are the electric util-
ities (which are typically owned by provincial governments) and the firms that
provide local telephone and cable or digital TV and Internet services (which are
subject to government regulation and which we examine in Chapter 12). Other
than these and a few other similar cases in which government ownership or regula-
tion play an important role, cases of monopoly are rare in Canada today. However,
there are some notable examples of monopoly (or near monopoly) from many
years ago. For example, the Eddy Match Company was virtually the sole producer
of wooden matches in Canada between 1927 and 1940, and Canada Cement
Limited produced nearly all of the output of cement until the 1950s.
This type of market dominance by a single large firm is now a thing of the past.
Canada Life is one of only a
Today, most modern industries that are dominated by large firms contain several
few large firms serving the firms. Their names are part of the average Canadian s vocabulary: Canadian
Canadian life-insurance National and Canadian Pacific railways; Bank of Montreal, Royal Bank, and
market. This is an oligopolistic Scotiabank; Imperial Oil, Petro-Canada, and Irving; Bell, Telus, and Rogers;
industry. Loblaws, Safeway, and Sobeys; Ford, Toyota, and GM; Sony, Mitsubishi, and
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 253

Toshiba; Great-West Life, Sun Life, and Manulife; and General Foods, Nabisco, and Kel-
logg. Many service industries that used to be dominated by small independent producers
have in recent decades seen the development of large firms operating on a worldwide
basis. SNC-Lavalin and Acres are two examples of very large engineering firms that have For data on many aspects of
business contracts all over the world. In management consulting, McKinsey & Co., Canadian industries, see
Industry Canada s website:
Boston Consulting Group, and Monitor are also very large firms with market power.
www.strategis.ic.gc.ca.
The theory of oligopoly, which we will examine later in this chapter, helps us
understand industries in which there are small numbers of large firms, each with mar-
ket power, that compete actively with each other.
concentration ratio The
fraction of total market sales
Industrial Concentration (or some other measure of
market activity) controlled
An industry with a small number of relatively large firms is said to be highly concen- by a specified number of the
trated. A formal measure of such industrial concentration is given by the concentra- industry s largest firms.
tion ratio.

Concentration Ratios When we FIGURE 11-1 Concentration Ratios in Selected

measure whether an industry has Canadian Industries
power concentrated in the hands of
only a few firms or dispersed over Petroleum and coal
many, it is not sufficient to count the Beverage and tobacco products
firms. For example, an industry with Transportation equipment
one enormous firm and 29 very small Primary metals
ones is more concentrated in any mean- Chemicals
ingful sense than an industry with only
Paper
five equal-sized firms. One approach to
Non-metallic minerals
this problem is to calculate what is
called a concentration ratio, which Printing
shows the fraction of total market sales Textile products
(or shipments) controlled by the largest Leather products
sellers, often taken as the largest four Food
or eight firms. Textile mills
Figure 11-1 shows the four-firm Wood products
concentration ratios in several Cana-
Computers and electronics
dian manufacturing industries. As is
Electrical equipment and appliances
clear, the degree of concentration is
quite varied across these industries. In Plastics and rubber
the petroluem industry, for example, Miscellaneous
the largest four firms account for Furniture
about 65 percent of total sales. At the Clothing
other extreme, the largest four firms in Machinery
the fabricated metals industry account Fabricated metals
for less than 10 percent of sales. These
largest firms may be large in some 0% 10% 20% 30% 40% 50% 60% 70%
absolute sense, but the low concentra- Share of Shipments for Top Four Firms
tion ratios suggest that they have quite
limited market power. Concentration ratios vary greatly among manufacturing industries.
These data show the share of total annual shipments (in dollar terms)
accounted for by the four largest firms in the industry.
Defining the Market The main
(Source: Authors calculations based on data provided by Statistics Canada.)
problem associated with using concen-
tration ratios is to define the market
254 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

with reasonable accuracy. On the one hand, the market may be much smaller than the
whole country. For example, concentration ratios in national cement sales are low, but
they understate the market power of cement companies because high transportation
costs divide the cement industry into a series of regional markets, with each having rel-
atively few firms. On the other hand, the market may be larger than one country, as is
the case for most internationally traded commodities. This is particularly important for
Canada.
The globalization of competition brought about by the falling costs of transporta-
tion and communication has been one of the most significant developments in the
world economy in recent decades. As the world has become smaller through the
advances in transportation and communication technologies, the nature of domestic
markets has changed dramatically. For example, the presence of only a single firm in
one industry in Canada in no way implies monopoly power when it is in competition
with several foreign firms that can easily sell in the Canadian market. This is the situa-
tion faced by many Canadian companies producing raw materials, such as Petro-
Canada, Canfor, Rio Tinto Alcan, and Barrick. These companies may be large relative
to the Canadian market, but the relevant market in each case (oil, forest products,
aluminum, and gold) is the global one in which these firms have no significant market
power.
In the cases of markets for internationally traded products, concentration ratios
(appropriately adjusted to define the relevant market correctly) can still be used to
provide valuable information about the degree to which production in a given market
is concentrated in the hands of a few firms.

ADDI T IO NAL TOP I C S

The ongoing forces of globalization have been changing the world economy for
centuries. For more information on how relatively recent advances in
transportation and communications technologies have led to changes in the
location of production and the nature of competition, look for The Nature of
Globalization in the Additional Topics section of this book s MyEconLab.

w w w. m y e c o n l a b . c o m

11.2 What Is Imperfect Competition?

We have identified two types of industries that are not well described by the theories of
perfect competition or monopoly. In one type, there is a large number of small firms,
but the theory of perfect competition is not appropriate because each of the many firms
has some market power. In the other type, there is a small number of large firms, each
with considerable market power. That these industries have more than a single firm
makes the theory of monopoly inappropriate. We need theories to understand these
market structures between the polar cases of perfect competition and monopoly.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 255

The market structures that we are now going to study are called imperfectly com-
petitive. The word competitive emphasizes that we are not dealing with monopoly,
and the word imperfect emphasizes that we are not dealing with perfect competition
(in which firms are price takers). Let s begin by noting a number of characteristics that
are typical of imperfectly competitive firms. To help organize our thoughts, we
classify these under two main headings. First, firms choose the variety of the product
that they produce and sell. Second, firms choose the price at which they will sell that
product.

Firms Choose Their Products

If a new farmer enters the wheat industry, the full range of products that the farmer
can produce is already in existence. In contrast, if a new firm enters the cell phone
industry, that firm must decide on the characteristics of the new phones it is to pro-
duce. It will not produce cell phones that are identical to those already in produc-
tion. Rather, it will develop variations on existing products or even a product with a
whole new capability. Each of these will have its own distinctive characteristics
including colour, size, shape, screen quality, video capability, and so on. As a result,
firms in the cell phone industry sell an array of differentiated products, no two of
which are identical.
The term differentiated product refers to a group of commodities that are simi- differentiated product A
lar enough to be called the same product but dissimilar enough that they can be sold group of commodities that
at different prices. For example, although one brand of shampoo is similar to most are similar enough to be
others, shampoos differ from each other in chemical composition, colour, smell, called the same product
brand name, packaging, reputation, and a host of other characteristics that matter but dissimilar enough that
to customers. All shampoos taken together can be regarded as one differentiated all of them do not have to
product. be sold at the same price.

price setter A firm that

Most firms in imperfectly competitive markets sell differentiated products. In such faces a downward-sloping
industries, the firm itself must choose which characteristics to give the products demand curve for its
that it will sell. product. It chooses which
price to set.

Firms Choose Their Prices

Whenever different firms products are not identical, each
firm must decide on a price to set. For example, no market
sets a single price for cars or TVs or jeans by equating
overall demand with overall supply. What is true for cars
and TVs is true for virtually all consumer goods. Any one
manufacturer will typically have several product lines that
differ from each other and from the competing product
lines of other firms. Each product has a price that must be
set by its producer.
Firms that choose their prices are said to be price
setters. Each firm has expectations about the quantity it
can sell at each price that it might set. Unexpected demand These breakfast cereals are different enough that each can
fluctuations then cause unexpected variations in the quan- have its own price, but they are similar enough to be called
tities that are sold at these prices. the same product they are a differentiated product.
256 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

In market structures other than perfect competition, firms set their prices and then
let demand determine sales. Changes in market conditions are signalled to the firm
by changes in the firm s sales.

One striking contrast between perfectly competitive markets and markets for dif-
ferentiated products concerns the behaviour of prices. In perfect competition, prices
change continually in response to changes in demand and supply. In markets where dif-
ferentiated products are sold, prices change less frequently.
Modern firms that sell differentiated products typically have hundreds of distinct
products on their price lists. Changing such a long list of prices is often costly enough
that it is done only infrequently. The costs of changing the prices include the costs of
printing new list prices and notifying all customers, the difficulty of keeping track of
frequently changing prices for purposes of accounting and billing, and the loss of cus-
tomer and retailer goodwill because of the uncertainty caused by frequent changes
in prices. As a result, imperfectly competitive firms often respond to fluctuations in
demand by changing output and holding prices constant. Only after changes in
demand are expected to persist will firms incur the expense of adjusting their entire list
of prices. Since the advent of the Internet, some firms find it much easier to change
prices almost continuously, just as would happen in perfect competition. For example,
airlines have websites on which they post their prices, which change very frequently,
even hourly.

Non-price Competition
Firms in imperfect competition behave in other ways that are not observed under either
perfect competition or monopoly.
First, many firms spend large sums of money on advertising. They do so in an
attempt both to shift the demand curves for the industry s products and to attract
customers from competing firms. A firm in a perfectly competitive market would
not engage in advertising because the firm faces a perfectly elastic (horizontal)
demand curve at the market price and so advertising would involve costs but would
not increase the firm s revenues. A monopolist has no competitors in the industry
and so will not advertise to attract customers away from other brands. However, in
some cases a monopolist will still advertise in an attempt to convince consumers to
shift their spending away from other types of products and toward the monopolist s
product.
Second, many firms engage in a variety of other forms of non-price competition,
such as offering competing standards of quality and product guarantees. In the auto-
mobile industry, for example, Toyota and GM compete actively in terms of the dura-
tion of their bumper-to-bumper warranties. Many firms also compete through the
services they offer along with their products. The automobile industry is again a good
example, with manufacturers and dealers competing in their after-sales services pro-
vided to the customer, ranging from oil changes and car washes to emergency on-road
assistance.
Third, firms in many industries engage in activities that appear to be designed to
hinder the entry of new firms, thereby preventing the erosion of existing pure profits by
entry. For example, the public commitment to match any price offered by a competitor
may convince potential entrants not to enter the industry.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 257

Two Market Structures

Our discussion in this section has been a general one concerning firms in imperfectly
competitive market structures. We now go into a little more detail and make a distinc-
tion between industries with a large number of small firms and industries with a small
number of large firms.
Some of the behaviour in the first group of industries can be understood with the
theory of monopolistic competition. To understand behaviour in the second group
we use the theory of oligopoly, in which game theory plays a central role. As you will
see in the remainder of this chapter, a key difference between these two market struc-
tures is the amount of strategic behaviour displayed by firms.

11.3 Monopolistic Competition

The theory of monopolistic competition was originally developed to deal with the monopolistic competition
phenomenon of product differentiation. This theory was first developed by U.S. econ- Market structure of an
omist Edward Chamberlin in his pioneering 1933 book The Theory of Monopolistic industry in which there are
Competition. many firms and freedom of
This market structure is similar to perfect competition in that the industry contains entry and exit but in which
many firms and exhibits freedom of entry and exit. It differs, however, in one impor- each firm has a product
tant respect: Whereas firms in perfect competition sell an identical product and are somewhat differentiated
price takers, firms in monopolistic competition sell a differentiated product and thus from the others, giving it
have some power over setting price. some control over its price.
Product differentiation leads to the establishment of brand names and advertising,
and it gives each firm a degree of market power over its own product. Each firm can
raise its price, even if its competitors do not, without losing all its sales. This is the
monopolistic part of the theory. However, each firm s market power is severely
restricted in both the short run and the long run. The short-run restriction comes from
the presence of similar products sold by many competing firms; this causes the
demand curve faced by each firm to be very elastic.
The long-run restriction comes from free entry into
the industry, which permits new firms to compete
away the profits being earned by existing firms.
These restrictions comprise the competition part of
the theory.

The Assumptions of Monopolistic

Competition
The theory of monopolistic competition is based on
four key simplifying assumptions.

1. Each firm produces one specific brand of the

industry s differentiated product. Each firm thus
faces a demand curve that, although negatively Familiar retail stores, like these ones, compete in industries in
sloped, is highly elastic because competing firms which there are many firms. Such industries are said to be
produce many close substitutes. monopolistically competitive.
 258 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

2. All firms have access to the same technological knowledge and so have the same
cost curves.
3. The industry contains so many firms that each one ignores the possible reac-
tions of its many competitors when it makes its own price and output decisions.
In this respect, firms in monopolistic competition are similar to firms in perfect
competition.
4. There is freedom of entry and exit in the industry. If profits are being earned by
existing firms, new firms have an incentive to enter. When they do, the demand for
the industry s product must be shared among more brands.

Predictions of the Theory

Product differentiation, which is the only thing that makes monopolistic competition
different from perfect competition, has important consequences for behaviour in both
the short and the long run.

The Short-Run Decision of the Firm In the short run, a firm that is oper-
ating in a monopolistically competitive market structure is similar to a monopoly. It
faces a negatively sloped demand curve and maximizes its profits by equating mar-
ginal cost with marginal revenue. The firm shown in part (i) of Figure 11-2 makes
positive profits.

FIGURE 11-2 Profit Maximization for a Firm in Monopolistic Competition

MC
SRATC
MC
Dollars per Unit

Dollars per Unit

LRAC
ES
pS pL EL EC
pC
D

D
MR MR

0 QS 0 QL QC
Output Output
(i) A typical firm in the short run (ii) A typical firm when the industry is in long-run equilibrium

The short-run position for a monopolistically competitive firm is similar to that of a monopolist. In the long run, firms
in a monopolistically competitive industry have zero profits and excess capacity. Note the very elastic demand curve
this reflects the fact that each firm produces a good for which there are many close (but not perfect) substitutes. Short-
run profit maximization occurs in part (i) at ES, the output for which MR * MC. Price is pS and quantity is QS. Profits
may exist; in this example they are shown by the shaded area. Starting from the short-run position shown in part (i),
entry of new firms shifts each firm s demand curve to the left until profits are eliminated. In part (ii), point EL, where
demand is tangent to LRAC, is the position of each firm when the industry is in long-run equilibrium. Price is pL and
quantity is QL. In such a long-run equilibrium, each monopolistically competitive firm has excess capacity of QLQC.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 259

The Long-Run Equilibrium of the Industry Profits, as shown in part (i) of

Figure 11-2, provide an incentive for new firms to enter the industry. As they do so, the
total demand for the industry s product must be shared among this larger number of
firms; thus, each firm gets a smaller share of the total market. Such entry shifts to the Practise with Study Guide
left the demand curve faced by each existing firm. Entry continues until profits are Chapter 11, Exercises 1 and 2.
eliminated. When this has occurred, each firm is in the position shown in part (ii) of
Figure 11-2. Its demand curve has shifted to the left until the curve is tangent to the
long-run average cost (LRAC) curve. Each firm is maximizing its profit, but its profit
is equal to zero.1
To see why this tangency solution provides the only possible long-run equilib-
rium for an industry that fulfills all of the theory s assumptions, consider the two pos-
sible alternatives. First, suppose the demand curve for each firm lies below and never
touches its LRAC curve. There would then be no output at which costs could be cov-
ered, and firms would leave the industry. With fewer firms to share the industry s
demand, the demand curve for each remaining firm shifts to the right. Exit will con-
tinue until the demand curve for each remaining firm touches and is tangent to its
LRAC curve. Second, suppose the demand curve for each firm cuts its LRAC curve.
There would then be a range of output over which positive profits could be earned.
Such profits would lead firms to enter the industry, and this entry would shift the
demand curve for each existing firm to the left until it is just tangent to the LRAC
curve, where each firm earns zero profit.

The Excess-Capacity Theorem Part (ii) of Figure 11-2 makes it clear that
monopolistic competition results in a long-run equilibrium of zero profits, even though
each individual firm faces a negatively sloped demand curve. It does this by forcing
each firm into a position in which it has excess capacity; that is, each firm is producing
an output less than that corresponding to the lowest point on its long-run average cost
(LRAC) curve. If the firm were to increase its output, it would reduce its cost per unit,
but it does not do so because selling more would reduce revenue by more than it would
reduce cost. This result is often called the excess-capacity theorem. excess-capacity theorem
The property of long-run
In long-run equilibrium in monopolistic competition, goods are produced at a equilibrium in monopolistic
point where average total costs are not at their minimum. competition that firms
produce on the falling
portion of their long-run
In contrast, the long-run equilibrium under perfect competition has price equal to
average cost curves. This
the minimum of long-run average costs. In part (ii) of Figure 11-2, this is shown as
results in excess capacity,
point EC, with price pC and output QC. (Recall that with perfect competition, each
measured by the gap
firm faces a horizontal demand curve at the market price, so at price pC each firm
between present output
would be on its MC curve at point EC.)
and the output that
The excess-capacity theorem once aroused passionate debate among economists
coincides with minimum
because it seemed to show that all industries selling differentiated products would
average cost.
produce them at a higher cost than was necessary. Because product differentiation is a
characteristic of virtually all modern consumer goods and many service industries,
this theorem seemed to suggest that modern market economies were systematically
inefficient.

1
A standard assumption in this theory is that the industry is symmetric in the sense that when a new firm
enters the industry, it takes demand away equally from all existing firms, thus ensuring that all industry prof-
its are eliminated in the long run. The asymmetric case, in which the industry s differentiated products have
varying degrees of substitutability for each other, making long-run profits possible for some of the firms, is
discussed in advanced courses in industrial organization.
 260 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

Subsequent analysis by economists has shown that the charge of inefficiency has
not been proven. The excess capacity of monopolistic competition does not necessarily
indicate a waste of resources because some benefits accrue to consumers who can
choose among the variety of products.
Saying that consumers value variety is not saying that each consumer necessarily
values variety. You might like only one of the many brands of toothpaste and be better
off if only that one brand were produced and the price were lower. But other con-
sumers would prefer one of the other brands. Thus, it is the differences in tastes across
many consumers that give rise to the social value of variety, and the price of that
greater variety is the higher price per unit.

From society s point of view, there is a tradeoff between producing more brands to
satisfy diverse tastes and producing fewer brands at a lower cost per unit.

Monopolistic competition produces a wider range of products but at a somewhat

higher cost per unit than perfect competition (which produces only one type of each
generic product). As consumers clearly value variety, the benefits of variety must be
matched against the extra cost that variety imposes. Product differentiation is wasteful
only if the costs of providing variety exceed the benefits conferred by providing that
variety.

Empirical Relevance of Monopolistic Competition

A controversy raged for several decades as to the empirical relevance of the theory of
monopolistic competition. Of course, product differentiation is pervasive in many
industries. Nonetheless, many economists maintained that the monopolistically com-
petitive market structure was almost never found in practice.
To see why, we need to distinguish between products and firms. Single-product firms
are extremely rare in manufacturing industries. Typically, a vast array of differentiated
products is produced by each of the few firms in the industry. Most of the huge variety of
breakfast cereals, for example, is produced by only three firms (Kellogg, Nabisco, and
General Foods). Similar circumstances exist in soap, chemicals, cigarettes, and numerous
other industries in which many competing products are produced by a few very large
firms. These industries are clearly not perfectly com-
petitive and neither are they monopolies. Are they
monopolistically competitive? The answer is no
because they contain few enough firms for each to take
account of the others reactions when determining its
own behaviour. Furthermore, these firms often earn
large profits without attracting new entry (thereby vio-
lating the third assumption of monopolistic competi-
tion). In fact, they operate under the market structure
called oligopoly, which we consider in the next section.
Although monopolistic competition is not
applicable to differentiated products produced in
industries with high concentration, many economists
think that the theory is useful for analyzing industries
in which concentration ratios are low and products
The Canadian wine-making industry contains many firms
are differentiated, as in the cases of restaurants,
producing similar but differentiated products. It is a monopolisti- clothing and furniture stores, gas stations, dry clean-
cally competitive industry. ers, hair salons, and landscaping services.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 261

11.4 Oligopoly and Game Theory

Industries that are made up of a small number of large firms have a market structure
called oligopoly, from the Greek words oligos polein, meaning few to sell. An
oligopoly is an industry that contains two or more firms, at least one of which pro- oligopoly An industry that
duces a significant portion of the industry s total output. Whenever there is a high con- contains two or more firms,
centration ratio for the firms that are serving one particular market, that market is at least one of which
oligopolistic. The market structures of oligopoly, monopoly, and monopolistic compe- produces a significant
tition are similar in that firms in all these markets face negatively sloped demand portion of the industry s
curves. total output.
In contrast to a monopoly (which has no competitors) and to a monopolistically
competitive firm (which has many competitors), an oligopolistic firm faces only a few
competitors. The number of competitors is small enough for each firm to realize that
its competitors may respond to anything that it does and that it should take such pos-
sible responses into account. In other words, oligopolists are aware of the interdepen-
dence among the decisions made by the various firms in the industry.
Economists say that oligopolists exhibit strategic behaviour, which means that strategic behaviour
they take explicit account of the impact of their decisions on competing firms and of Behaviour designed to take
the reactions they expect competing firms to make. In contrast, firms in perfect compe- account of the reactions of
tition or monopolistic competition are assumed to engage in non-strategic behaviour, one s rivals to one s own
which means they make decisions based on their own costs and their own demand behaviour.
curves without considering any possible reactions from their large number of competi-
tors. Monopolists also do not engage in strategic behaviour simply because they have
no competitors to worry about.

The Basic Dilemma of Oligopoly

The basic dilemma faced by oligopolistic firms is very similar to the dilemma faced by
the members of a cartel, which we studied in Chapter 10. There we saw that the cartel
as a whole had an incentive to form an agreement to restrict total output, but each
individual member of the cartel had the incentive to cheat on the agreement and
increase its own level of output.
For the small number of firms in an oligopoly, the incentives are the same. We say
that firms can either cooperate (or collude) in an attempt to maximize joint profits, or
they can compete in an effort to maximize their individual profits. Not surprisingly, the
decision by one firm to cooperate or to compete will depend on how it thinks its rivals
will respond to its decision.

Oligopolistic firms often make strategic choices; they consider how their rivals are
likely to respond to their own actions.

When thinking about how firm behaviour leads to market outcomes, we distin-
guish between cooperative and non-cooperative behaviour. If the firms cooperate to
produce among themselves the monopoly output, they can maximize their joint profits.
If they do this, they will reach what is called a cooperative (or collusive) outcome, cooperative (collusive)
which is the position that a single monopoly firm would reach if it owned all the firms outcome A situation in
in the industry. which existing firms
If the firms are at the cooperative outcome, it will usually be worthwhile for any cooperate to maximize
one of them to cut its price or to raise its output, so long as the others do not do so. their joint profits.
 262 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

non-cooperative outcome However, if every firm does the same thing, they will be worse off as a group and may
An industry outcome all be worse off individually. An industry outcome that is reached when firms proceed
reached when firms by calculating only their own gains without cooperating with other firms is called a
maximize their own profit non-cooperative outcome.
without cooperating with The behaviour of firms in an oligopoly is complex, and studying it requires much
other firms. attention to detail. As in other market structures, it is necessary to think about how
game theory The theory
individual firm behaviour affects the overall market outcome. Unlike other market
that studies decision
structures, however, in oligopoly each firm typically thinks about how the other firms
making in situations in
in the industry will react to its own decisions. Then, of course, the other firms may
which one player
respond to what the first firm does, and so on. To help us keep our thoughts organized,
anticipates the reactions of
we will use game theory.
other players to its own
actions.

Some Simple Game Theory

Game theory is used to study decision making in situations in which there are a num-
ber of players, each knowing that others may react to their actions and each taking
account of others expected reactions when making
moves. For example, suppose a firm is deciding whether
FIGURE 11-3 The Oligopolist s Dilemma: to raise, lower, or maintain its price. Before arriving at
To Cooperate or to Compete? an answer, it asks, What will the other firms do in each
of these cases, and how will their actions affect the prof-
Firm A s output itability of whatever decision I make?

One-half Two-thirds When game theory is applied to oligopoly, the play-

monopoly monopoly ers are firms, their game is played in the market,
output output their strategies are their price or output decisions,
and the payoffs are their profits.
One-half
monopoly 20 20 15 22
Firm B s output

An illustration of the basic dilemma of oligopo-

output lists, to cooperate or to compete, is shown in Figure
11-3 for the case of a two-firm oligopoly, called a
Two-thirds duopoly. In this simplified game, we assume that both
monopoly 22 15 17 17 firms are producing the same product, and so there is a
output single market price. The only choice for each firm is
how much output to produce. If the two firms coop-
erate to jointly act as a monopolist, each firm pro-
Cooperation to determine the overall level of output duces one-half of the monopoly output and each earns
can maximize joint profits, but it leaves each firm large profits. If the two firms compete, they each
with an incentive to cheat. The figure shows a payoff
matrix for a two-firm game. Firm As production is
produce more than half (say two-thirds) of the monop-
indicated across the top, and its payoffs (profits in oly output, and in this case both firms earn low prof-
millions of dollars) are shown in the green circles its. As we will see, even this very simple example is
within each cell. Firm B s production is indicated sufficient to illustrate several key ideas in the modern
down the left side, and its payoffs are shown in the theory of oligopoly.
red circles within each cell.
If A and B cooperate, each produces one-half the A Payoff Matrix Figure 11-3 shows a payoff
monopoly output and receives a payoff of 20. If A
and B do not cooperate, they each end up producing
matrix for this simple game. It shows the profits that
two-thirds of the monopoly output and receiving a each firm earns in each possible combination of the
payoff of 17. In this example, this non-cooperative two firms actions. The upper-left cell in this example
equilibrium is a Nash equilibrium. shows that if each firm produces one-half of the
monopoly output, each firm will earn profits of 20.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 263

The lower-right cell shows that if each firm produces two-thirds of the monopoly out-
put, each firm will earn a profit of 17. Since joint profits must be maximized at the
monopoly output, the total profit in the upper-left cell (40) is greater than the total
profit in the lower-right cell (34). Practise with Study Guide
The upper-right and lower-left cells show the profits in the case where one firm Chapter 11, Exercises 3 and 5.
produces one-half of the monopoly output and the other firm produces two-thirds of
the monopoly output. Note that in these cells, the firm that produces more earns the
greater profit. The firm that produces one-half of the monopoly output is helping to
restrict output and keep prices high. The firm that produces two-thirds of the monop-
oly output then benefits from the first firm s output restrictions.

Strategic Behaviour The payoff matrix shows the profit each player earns with
each combination of the two players moves. But what will actually happen? To answer
this question, we must first know what type of game is being played. Specifically, can
the players cooperate or is the game a non-cooperative one?
COOPERATIVE OUTCOME. If the two firms in this duopoly can cooperate, the payoff
matrix shows that their highest joint profits will be earned if each firm produces one-
half of the monopoly output. This is the cooperative outcome. The payoff matrix also
shows, however, that if each firm thinks the other will cooperate (by producing half of
the monopoly output), then it has an incentive to cheat and produce two-thirds of the
monopoly output. Thus, the cooperative outcome can only be achieved if the firms
have some effective way to enforce their output-restricting agreement. As we will see in
Chapter 12, explicit output-restricting agreements are usually illegal.
NON-COOPERATIVE OUTCOME. Now suppose that firms believe that cooperation is
not possible because they have no legal way of enforcing an agreement. What will be
the non-cooperative outcome in this duopoly game? To answer this question, we must
examine each player s incentives, given the possible actions of the other player.
Firm A reasons as follows: If B produces one-half of the monopoly output (upper
row of the matrix), then my profit will be higher if I produce two-thirds of the monop-
oly output. Moreover, if B produces two-thirds of the monopoly output (bottom row
of the matrix), my profit will be higher if I also produce two-thirds of the monopoly
output. Therefore, no matter what B does, I will earn more profit if I produce two-
thirds of the monopoly output. A quick look at the payoff matrix in Figure 11-3
reveals that this game is symmetric, and so Firm B s reasoning will be identical to As: It
will conclude that its profit will be higher if it produces two-thirds of the monopoly
output no matter what A does.
The final result is clear. Each firm will end up producing two-thirds of the monop-
oly output and each firm will receive a profit of 17. This is the non-cooperative out-
come. Note that each firm will be worse off than it would have been had they been able
to achieve the cooperative outcome. This type of game, in which the non-cooperative
outcome makes both players worse off than if they had been able to cooperate, is called
a prisoners dilemma. The reason for this curious name is discussed in Extensions in
Theory 11-1.
Nash equilibrium An
NASH EQUILIBRIUM. The non-cooperative outcome shown in Figure 11-3 on equilibrium that results
page 262 is called a Nash equilibrium, after the U.S. mathematician John Nash, who when each firm in an
developed the concept in the 1950s and received the Nobel Prize in Economics in industry is currently doing
1994 for this work. (The 2002 movie A Beautiful Mind is about John Nash s life and the best that it can, given
contains a few fascinating bits of game theory!) In a Nash equilibrium, each player s the current behaviour
best strategy is to maintain its present behaviour given the present behaviour of the of the other firms in
other players. the industry.
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EXTENSIONS IN THEORY 11-1

The Prisoners Dilemma

The game shown in Figure 11-3 on page 262 is often John reasons as follows: William will plead either
known as a prisoners dilemma game. This is the story guilty or innocent. If he pleads innocent, I will get a
that lies behind the name: light sentence if I also plead innocent but no sentence at
Two men, John and William, are arrested for all if I plead guilty, so guilty is my better plea. If he
jointly committing a crime and are interro- pleads guilty, I will get a severe sentence if I plead inno-
gated separately. They know that if they both cent and a medium sentence if I plead guilty. So once
plead innocence, they will get only a light sen- again guilty is my preferred plea.
tence, and if they both admit guilt they will William reasons in the same way and, as a result,
both receive a medium sentence. Each is told, they both plead guilty and get a medium sentence. Note,
however, that if either protests innocence however, that if they had been able to communicate and
while the other admits guilt, the one who coordinate their pleas, they could both have agreed to
claims innocence will get a severe sentence plead innocent and get off with a light sentence.
while the other will be released with no sen- The prisoners dilemma arises in many economic
tence at all. situations. We have already seen an example of a two-
firm oligopoly. Economists use the basic structure of
Here is the payoff matrix for that game: this simple game to think about how firms compete in
their decisions to build new factories, launch advertising
campaigns, and adjust the prices of their differentiated
John s Plea products.
Simple game theory and the prisoners dilemma
also figure prominently in the study of political science.
Innocent Guilty Robert Axelrod s 1984 book The Evolution of Cooper-
ation discusses how the key insights from the prisoners
dilemma have been used in the analysis of elections
light no
J sentence J sentence
(where candidates choices are their electoral platforms)
Innocent and the nuclear arms race (in which national govern-
William s Plea

light severe ments choices are their decisions to build and stockpile
W sentence W sentence weapons).*
severe medium
J sentence J sentence * For those interested in a very readable treatment of game the-
Guilty
no medium ory applied to many aspects of life, see Thinking Strategically
W sentence W sentence (Norton, 1993), written by Avinash Dixit and Barry Nalebuff,
two leading economists.

It is easy to see that there is only one Nash equilibrium in Figure 11-3.2 In the bot-
tom-right cell, the best decision for each firm, given that the other firm is producing
two-thirds of the monopoly output, is to produce two-thirds of the monopoly output
itself. Between them, they produce a joint output of 11 3 times the monopoly output.
Neither firm has an incentive to depart from this position (except through enforceable
cooperation with the other). In any other cell, each firm has an incentive to change its
output given the output of the other firm.
The basis of a Nash equilibrium is rational decision making in the absence of coop-
eration. Its particular importance in oligopoly theory is that it is the only type of self-
policing equilibrium. It is self-policing in the sense that there is no need for group

2
In general, an economic game may have zero, one, or more Nash equilibria. For an example of an
economic setting in which there are two Nash equilibria, see Study Exercise #10 on page 277.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 265

behaviour to enforce it. Each firm has a self-interest to maintain it because no move
will improve its profits, given what other firms are currently doing.

If a Nash equilibrium is established by any means whatsoever, no firm has an

incentive to depart from it by altering its own behaviour.

ADDI T I ONA L T OPI C S

Our discussion of game theory has used examples of simultaneous games in
which both players make their decisions at the same time. But often one firm
is in a position to make its decision before its competitors. To see an example
of a sequential game, look for A Sequential Game in Fibre Optics in the
Additional Topics section of this book s MyEconLab.

w w w. m y e c o n l a b . c o m

11.5 Oligopoly in Practice

We have examined the incentives for firms in an oligopoly to cooperate and the incen-
tives for firms to cheat on any cooperative agreement. We can now look at the behav-
iour that we actually observe among oligopolists. How do they cooperate? How do
they compete?

Types of Cooperative Behaviour

When firms agree to cooperate in order to restrict output and raise prices, their behav-
iour is called collusion. Collusive behaviour may occur with or without an explicit collusion An agreement
agreement to collude. Where explicit agreement occurs, economists speak of overt or among sellers to act jointly
covert collusion, depending on whether the agreement is open or secret. Where no in their common interest.
explicit agreement actually occurs, economists speak of tacit collusion. In this case, all Collusion may be overt or
firms behave cooperatively without an explicit agreement to do so. They merely under- covert, explicit or tacit.
stand that it is in their mutual interest to restrict output and to raise prices.

Explicit Collusion The easiest way for firms to ensure that they will all main-
tain their joint profit-maximizing output is to make an explicit agreement to do so.
Such collusive agreements have occurred in the past, although they have been illegal
among privately owned firms in Canada for a long time. When they are discovered
today, they are rigorously prosecuted. We will see, however, that such agreements are
not illegal everywhere in the world, particularly when they are supported by national
governments.
We saw in Chapter 10 that when several firms get together to act in this way, they
create a cartel. Cartels show in stark form the basic conflict between cooperation and Practise with Study Guide
competition that we just discussed. Cooperation among cartel members allows them to Chapter 11, Exercise 4.
 266 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

restrict output and raise prices, thereby increasing the cartel members profits. But it
also presents each cartel member with the incentive to cheat. The larger the number of
firms, the greater the temptation for any one of them to cheat. After all, cheating by
one small firm may not be noticed because it will have a small effect on price. Con-
versely, a cartel made up of a small number of firms is more likely to persist because
cheating by any one member is more difficult to conceal from the other members.
As we mentioned in Chapter 10, DeBeers is an example of a firm that has been able
to assemble a cartel in the world s diamond industry. Through its own Diamond Trad-
ing Company (DTC), DeBeers markets approximately half of the world s annual dia-
mond production. With such influence over the market, it is able to manage the flow of
output, in response to changes in world demand, to keep prices high. In recent years,
however, the discovery of large diamond mines by firms that wanted to remain inde-
pendent of DeBeers has led to a reduction in DeBeers s ability to set the market price.
In fact, the independent producers in particular, Canadian producers have been suc-
cessful at establishing their own brand of diamonds. This has led DeBeers to reduce
its efforts through the DTC to manage market prices and instead focus more of its
efforts on creating its own brand of diamonds and other luxury products. Only time
will tell how this brand competition in the diamond industry will develop.
The most famous example of a cartel and the one that has had the most dramatic
effect on the world economy is the Organization of Petroleum Exporting Countries
For more information on
OPEC, check out its (OPEC). OPEC s explicit cooperation over the past four decades, as well as its failure
website: www.opec.org. to always sustain such cooperation, is discussed in Lessons From History 11-1.

Tacit Collusion Although collusive behaviour that affects prices is illegal, a small
group of firms that recognize the influence that each has on the others may act without
any explicit agreement to achieve the cooperative outcome. In such tacit agreements,
the two forces that push toward cooperation and competition are still evident. First,
firms have a common interest in cooperating to maximize their joint profits at the
cooperative solution. Second, each firm is interested in its own profits, and any one of
them can usually increase its profits by behaving competitively.
In many industries there is suggestive evidence of tacit collusion, although it is very
difficult to prove rigorously. For example, when one large steel company announces
that it is raising its price for a specific quality of steel, other steel producers will often
announce similar price increases within a day or two. This seemingly coordinated price
increase may be the result of a secret explicit agreement or of tacit collusion. However,
the firms that followed the first firm s price increase could easily argue (and usually do
in such cases) that with their competitor raising prices, and driving some customers
toward them, the natural response is to raise their own prices.

Types of Competitive Behaviour

Although the most obvious way for a firm to violate the cooperative solution is to pro-
duce more than its share of the joint profit-maximizing output, there are other ways in
which rivalrous behaviour can occur.

Competition for Market Share Even if joint profits are maximized, there is
still a question of how the profit-maximizing level of sales is to be divided among the
colluding firms. Competition for market share may upset the tacit agreement to hold to
joint profit-maximizing behaviour. Firms often compete for market share through var-
ious forms of non-price competition, such as advertising and variations in the quality
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of their product. Such costly competition may increase one firm s

profits only by decreasing profits for other firms, but since the
activities are costly, total industry profits would be reduced.
In an industry with many differentiated products and in
which sales are often by contract between buyers and sellers,
covert rather than overt cheating may seem attractive. Secret dis-
counts and rebates can allow a firm to increase its sales at the
expense of its competitors while appearing to hold to the tacitly
agreed price.

Innovation A firm may find that by innovating it can behave

Oligopolistic firms producing differentiated
competitively, keeping ahead of its rivals, and thereby maintain a products often compete very little through prices.
larger market share. In this way, it will earn larger profits than it Sometimes the most aggressive competition takes
would if it cooperated with the other firms in the industry, even place through their continual processes of innova-
though all the firms joint profits are lower. The great Austrian tion, as well as the introduction of new products.
economist Joseph Schumpeter called the process by which one
firm attacks another s monopolistic position by developing new products creative
destruction. Such competition through innovation contributes to the long-run growth
of living standards and may provide social benefits over time that outweigh any losses
caused by the restriction of output at any one point in time.
Oligopolistic firms typically compete by innovating. A firm can rectify a mistake in
its price-setting decisions easily, but falling behind its competitors in developing new
products and new production processes can spell disaster. A reading of the business
pages of any newspaper shows firms in continuous competition to outdo each other in
innovations.

There are strong incentives for oligopolistic firms to compete rather than to main-
tain the cooperative outcome, even when they understand the inherent risks to
their joint profits.

A good example is the continuous process of innovation by the relatively small

number of firms producing cell phones, such as Nokia, SonyEricsson, Samsung, Apple,
and Motorola. As one firm introduces a new feature, such as text messaging, video
screens, cameras, Internet access, downloadable games, or full audio/video capability,
the competing firms quickly follow suit. In this market, the introduction of new prod-
uct features is an important part of competitive behaviour.

The Importance of Entry Barriers

Suppose firms in an oligopolistic industry succeed in raising prices above long-run
average costs and earn substantial profits that are not completely eliminated by compe-
tition among them. In the absence of significant entry barriers, new firms will enter the
industry and erode the profits of existing firms, as they do in monopolistic competi-
tion. Natural barriers to entry were discussed in Chapter 10. They are an important
part of the explanation of the persistence of profits in many oligopolistic industries.
Where such natural entry barriers do not exist, however, oligopolistic firms can
earn profits in the long run only if they can create entry barriers. To the extent this is
done, existing firms can move toward joint profit maximization without fear that new
firms will enter the industry. We now discuss some types of firm-created entry barriers.
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LES SONS F RO M HIST ORY 11-1

Explicit Cooperation in OPEC

The experience of the Organization of Petroleum This experience in both the long run and the very
Exporting Countries (OPEC) in the 1970s and 1980s long run shows the price system at work, signalling
illustrates the power of cooperative behaviour to create the need for adaptation and providing the incentives
short-run profits, as well as the problems of trying to for that adaptation. It also provides an illustration of
exercise long-run market power in an industry without Joseph Schumpeter s concept of creative destruction,
substantial entry barriers. which we first discussed in Chapter 10. To share in
OPEC did not attract worldwide attention until the profits generated by high oil prices, new technolo-
1973, when its members voluntarily restricted their out- gies and new substitute products were developed, and
put by negotiating quotas among themselves. In that these reduced much of the market power of the origi-
year, OPEC countries accounted for about 70 percent of nal cartel.
the world s supply of crude oil. Although it was not a
complete monopoly, the cartel came close to being one.
By reducing output, the OPEC countries were able to Cheating in the Early 1980s
reduce the world supply of oil and thereby increase its
world price by almost 300 percent. Their actions At first, there was little incentive for OPEC countries to
resulted in massive profits both for themselves and for violate their production quotas. Member countries
non-OPEC producers, who obtained the high prices found themselves with such undreamed-of increases in
without having to limit their output. After several years incomes that they found it difficult to use all of their
of success, however, OPEC began to experience the typ- money productively. As the output of non-OPEC oil
ical problems of cartels. grew, however, OPEC s output had to be reduced to
maintain the high prices. Furthermore, as the long-run
adjustments in demand occurred, even larger output
High Prices Lead to Entry restrictions by OPEC were required to prop up the price
of oil. Incomes in OPEC countries declined as a result.
Entry became a problem for the OPEC countries. The Many OPEC countries had become used to their
high price of oil encouraged the development of new enormous incomes, and their attempts to maintain them
supplies, and within a few years, new productive capac- in the face of falling output quotas brought to the sur-
ity was coming into use at a rapid rate in non-OPEC face the instabilities inherent in all cartels. In 1981, oil
countries. The development of North Sea oil by the prices reached U.S.$35 per barrel. In real terms, this was
United Kingdom and the development of the Athabasca about six times as high as the 1972 price, but production
Tar Sands in Alberta and the Hibernia oil field in New- quotas were less than one-half of OPEC s capacity. Eager
foundland and Labrador are three examples of this new to increase their oil revenues, many individual OPEC
productive capacity. members gave in to the pressure to cheat and produced
in excess of their production quotas. In 1984, Saudi
Arabia indicated that it would not tolerate further cheat-
Long-Run Adjustment of Demand ing by its OPEC partners and demanded that others
share equally in reducing their quotas yet further. How-
The short-run demand for oil proved to be highly inelas- ever, agreement proved impossible. In December 1985,
tic. Over the long run, however, adaptations to reduce OPEC decided to eliminate production quotas altogether
the demand for oil were made within the confines of and let each member make its own decisions about out-
existing technology. Homes and offices were insulated put. The end of the production quotas effectively meant
more efficiently, and smaller, more fuel-efficient cars the end of the cartel.
became popular. This is an example of the distinction
between the short-run and long-run demand for a com-
modity first introduced in Chapter 4. After the Collapse
Innovation further reduced the demand for oil in
the very long run. Over time, technologies that were OPEC s collapse as an output-restricting cartel led to a
more efficient in their use of oil were developed, as were major reduction in world oil prices. Early in 1986, the
alternative energy sources. downward slide took the price to U.S.$20 per barrel,
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 269

and it fell to U.S.$11 per barrel later in the year. Allow- supply inelasticity, in turn, reflected the fact that most
ing for inflation, this was still double the price that had oil producers both inside and outside OPEC were
prevailed just before OPEC introduced its output producing at or close to their capacity and thus were
restrictions in 1973. Following the 1986 collapse, and unable to easily respond to higher prices by increasing
for the next decade or so, the world price of oil fluctu- their output. In this setting of low global excess capac-
ated between U.S.$15 per barrel and U.S.$25 per barrel. ity, OPEC s ability to increase prices through output
With the continuing expansion of output from non- restrictions was partially restored, even though their
OPEC producers, OPEC s share of world output share of world output was much less than in the 1970s.
steadily fell, reaching approximately 35 percent by the Beginning in the late fall of 2008, however, the
mid-1990s, where it remains today. world entered a significant economic recession, and the
Beginning in the late 1990s, the world price of oil decline in economic activity led to a sharp decline in
began to rise again, as the accompanying figure shows. the demand for oil. The world price fell quickly to
Measured in 2001 U.S. dollars, the price increased from about U.S.$50. This price decline, not surprisingly, led
below U.S.$20 per barrel in 1998 to just under U.S.$80 to a large reduction in incomes for oil-producing
in 2008 (although it was almost U.S.$150 per barrel nations and induced the OPEC countries to once again
briefly during that year). The main cause of this signifi- consider output restrictions in an effort to prop up the
cant price increase was a booming world economy that world price. But as could be predicted, the OPEC mem-
increased the world s demand for oil. The sharp price bers found it difficult to enforce any agreed-upon
increase reflected an increase in demand at a time when restrictions. As we have seen in this chapter, maintain-
the world supply curve was relatively inelastic. This ing an effective cartel is quite a challenge.

80
Onset of 2008
70 Second OPEC financial crisis and
oil shock, global recession
Dollars per Barrel (2001 U.S. dollars)

1979 80
60
U.S. invasion of Iraq, 2003
First OPEC
50
oil shock,
1974 Iraq s invasion of
Collapse of
40 Kuwait, 1990
OPEC, 1986

30

20

10

0
1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

(Source: Based on authors calculations. Annual average of the nominal U.S.-dollar price of OPEC s reference
basket: www.opec.org. U.S. CPI [all items]: www.bls.gov.)
 270 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

Brand Proliferation as an Entry Barrier By altering the characteristics of a

differentiated product, it is possible to produce a vast array of variations on the general
theme of that product, each with its unique identifying brand. Think, for example, of
the many different brands of soap or shampoo, breakfast cereals or cookies, and even
automobiles or motorcycles. In these cases, each firm in the industry produces several
brands of the differentiated product.
Although such brand proliferation is no doubt partly
a response to consumers tastes, it can also have the effect
of discouraging the entry of new firms. To see why, sup-
pose the product is the type for which there is a substan-
tial amount of brand switching by consumers. In this
case, the larger the number of brands sold by existing
firms, the smaller the expected sales of a new entrant.
Suppose, for example, that an industry contains
three large firms, each selling one brand of beer, and say
that 30 percent of all beer drinkers change brands in a
random fashion each year. If a new firm enters the indus-
try, it can expect to pick up one-third of the customers
who change brands (a customer who switches brands
now has three other brands among which to choose).
Many beer-producing firms produce several brands. Such The new firm would get 10 percent (one-third of 30 per-
brand proliferation by individual firms is an effective way cent) of the total market the first year merely as a result
to deter other firms from entering the market. of picking up its share of the random switchers, and it
would keep increasing its share for some time thereafter.
If, however, the existing three firms have five brands
each, there would be 15 brands already available, and a new firm selling one new
brand could expect to pick up only one-fifteenth of the brand switchers, giving it only
2 percent of the total market the first year, with smaller gains also in subsequent years.
This is an extreme case, but it illustrates a general result.

The larger the number of differentiated products that are sold by existing oligop-
olists, the smaller the market share available to a new firm that is entering with a
single new product. Brand proliferation therefore can be an effective entry
barrier.

Advertising as an Entry Barrier Advertising is one means by which existing

firms can impose heavy costs on new entrants. Advertising, of course, serves purposes
other than that of creating barriers to entry. Among them, it performs the useful func-
tion of informing buyers about their alternatives. Indeed, a new firm may find that
advertising is essential, even when existing firms do not advertise at all, simply to call
attention to its entry into an industry in which it is currently unknown.
Nonetheless, advertising can also operate as a potent entry barrier by increasing
the costs of new entrants. Where heavy advertising has established strong brand images
for existing products, a new firm may have to spend heavily on advertising to create its
own brand images in consumers minds. If the firm s sales are small, advertising costs
per unit will be large, and price will have to be correspondingly high to cover those
costs. Consider Nike, Reebok, and their competitors. They advertise not so much the
quality of their athletic shoes as images that they want consumers to associate with
the shoes. The same is true for cosmetics, beer, cars, hamburgers, and many more
consumer goods. The ads are lavishly produced and photographed. They constitute a
formidable entry barrier for a new producer.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 271

A new entrant with small sales but large required advertising

costs finds itself at a substantial cost disadvantage relative to its
established rivals.

The combined use of brand proliferation and advertising as an

entry barrier helps to explain one apparent paradox of everyday
life that one firm often sells multiple brands of the same product,
which compete actively against one another as well as against the
products of other firms. The soap and beer industries provide clas-
sic examples of this behaviour. Because all available scale
economies can be realized by quite small plants, both industries
have few natural barriers to entry. Both contain a few large firms,
each of which produces an array of heavily advertised products.
The numerous existing products make it harder for a new entrant
to obtain a large market niche with a single new product. The
heavy advertising, although directed against existing products, cre-
ates an entry barrier by increasing the average costs of a new prod-
uct that seeks to gain the attention of consumers and to establish its
own brand image.
Advertising can be very informative for
Predatory Pricing as an Entry Barrier A firm will not consumers. But by raising the costs of new
enter a market if it expects continued losses after entry. An existing entrants, advertising can also act as a potent
firm can create such an expectation by cutting prices below costs entry barrier.
whenever entry occurs and keeping them there until the entrant goes
bankrupt. The existing firm sacrifices profits while doing this, but it
sends a discouraging message to potential future rivals, as well as to present ones. Even
if this strategy is costly in terms of lost profits in the short run, it may pay for itself in
the long run by creating reputation effects that deter the entry of new firms at other
times or in other markets that the firm controls. See Industry Canada s
Predatory pricing is controversial. Some economists argue that pricing policies that website at www.strategis.
gc.ca for a discussion of
appear to be predatory can be explained by other motives and that existing firms only
predatory pricing in
hurt themselves when they engage in such practices instead of accommodating new Canada.
entrants. Others argue that predatory pricing has been observed and that it is in the
long-run interests of existing firms to punish the occasional new entrant even when it is
costly to do so in the short run.
Canadian courts have taken the position that predatory pricing does indeed
occur and a number of firms have been convicted of using it as a method of restrict-
ing entry.

ADDI T I ONA L T OPI C S

We have been discussing how the entry of firms to an industry can reduce
oligopoly profits toward the competitive level. But sometimes it is only the
threat of entry that is necessary to achieve this outcome. For a detailed
discussion of this point, look for Oligopoly and Contestable Markets in the
Additional Topics section of this book s MyEconLab.

w w w. m y e c o n l a b . c o m
272 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

Oligopoly and the Economy

Oligopoly is found in many industries and in all advanced economies. It typically
occurs in industries in which both perfect and monopolistic competition are made
impossible by the existence of major economies of scale. In such industries, there is
simply not enough room for a large number of firms all operating at or near their min-
imum efficient scales.
Three questions are important for the evaluation of oligopoly. First, do oligopolistic
firms respond to changes in market conditions very differently than perfectly competi-
tive firms? Second, in their short-run and long-run outcomes, where do oligopolistic
firms typically settle between the extreme outcomes of earning zero profits and earning
monopoly profits? Third, how much do oligopolists contribute to economic growth by
encouraging innovative activity in the very long run? We consider each of these ques-
tions in turn.

Market Adjustment Under Oligopoly We have seen that under perfect com-
petition, prices are set by the impersonal forces of demand and supply, whereas firms in
oligopolistic markets choose their prices. The market signalling system works slightly
differently when prices are chosen rather than being determined by the market.
Changes in market conditions are signalled to the perfectly competitive firm by
changes in the price of its product. For example, an increase in demand will lead to an
increase in market price; as the market price rises, the competitive firm will choose to
increase its output.
For an oligopolist that sets its prices, however, the order of events is a little differ-
ent. An increase in demand will cause the sales of oligopolistic firms to rise. Firms will
then respond by increasing output. Only after the increase in demand is expected to persist
will oligopolistic firms choose to increase their prices.

Temporary changes in demand lead to more price volatility in perfectly competi-

tive markets than in oligopoly markets. Permanent changes in demand, however,
lead to similar adjustments in both market structures.

Profits Under Oligopoly Some firms in some oligopolistic industries succeed in

coming close to joint profit maximization in the short run. In other oligopolistic indus-
tries, firms compete so intensely among themselves that they come close to achieving
competitive prices and outputs.
In the long run, those profits that do survive competitive behaviour among existing
firms will tend to attract entry. Profits will persist only insofar as entry is restricted
either by natural barriers, such as large minimum efficient scales for potential entrants,
or by barriers created, and successfully defended, by the existing firms.

Innovation Which market structure oligopoly or perfect competition is most

conducive to innovation? As we discussed in Chapter 8, innovation and productivity
improvements are the driving force of the economic growth that has so greatly raised
living standards over the past two centuries. They are intimately related to Schum-
peter s concept of creative destruction, which we first encountered in our discussion of
entry barriers in Chapter 10.
Examples of creative destruction abound. In the nineteenth century, railways
began to compete with wagons and barges for the carriage of freight. In the twentieth
century, trucks operating on newly constructed highways began competing with trains.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 273

During the 1950s and 1960s, airplanes began to compete seriously with both trucks
and trains. In recent years, fax machines and e-mail have eliminated the monopoly of
the postal service in delivering hard-copy (printed) communications. Cell phones have
significantly weakened the monopoly power that telephone companies had for the pro-
vision of local phone service. And the Internet has allowed consumers to download
music easily, thereby reducing the market power of the music production companies
that sell CDs.
An important defence of oligopoly is based on Schumpeter s idea of creative
destruction. Some economists argue that oligopoly leads to more innovation than
would occur in either perfect competition or monopoly. They argue that the oligopo-
list faces strong competition from existing rivals and cannot afford the more relaxed
life of the monopolist. Moreover, oligopolistic firms expect to keep a good share of
the profits that they earn from their innovative activity and thus have considerable
incentive to innovate.
Everyday observation provides support for this view. Leading North American
firms that operate in highly concentrated industries, such as Alcoa, Canfor, Bombardier,
DuPont, Kodak, General Electric, Canadian National, Xerox, Research In Motion,
and Boeing, have been highly innovative over many years.
This observation is not meant to suggest that only oligopolistic industries are inno-
vative. Much innovation is also done by very small new firms (although most of these
are in monopolistically competitive rather than perfectly competitive markets). If
today s small firms are successful in their innovation, they may become tomorrow s
corporate giants. For example, Microsoft, Research In Motion, Apple, and Intel, which
are enormous firms today, barely existed 40 years ago; their rise from new start-up
firms to corporate giants reflects their powers of innovation.

Oligopoly is an important market structure in modern economies because there are

many industries in which the minimum efficient scale is simply too large to support
many competing firms. The challenge to public policy is to keep oligopolists com-
peting, rather than colluding, and using their competitive energies to improve
products and to reduce costs, rather than merely to erect entry barriers.

Summary
11.1 The Structure of the Canadian Economy L1
Most industries in the Canadian economy lie between over many, it is not sufficient to count the firms.
the two extremes of monopoly and perfect competition. Instead, economists consider the concentration ratio,
Within this spectrum of market structure we can divide which shows the fraction of total market sales con-
Canadian industries into two broad groups: those with trolled by a group of the largest sellers.
a large number of relatively small firms and those with a One important problem associated with using concentra-
small number of relatively large firms. Such intermedi- tion ratios is to define the market with reasonable accu-
ate market structures are called imperfectly competitive. racy. Since many goods produced in Canada compete
When measuring whether an industry has power con- with foreign-produced goods, the national concentration
centrated in the hands of only a few firms or dispersed ratios overstate the degree of industrial concentration.
 274 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

11.2 What Is Imperfect Competition? L2

Most firms operating in imperfectly competitive market Imperfectly competitive firms usually choose their
structures sell differentiated products whose character- prices and engage in non-price competition.
istics they choose themselves.

11.3 Monopolistic Competition L3

Monopolistic competition is a market structure that has In long-run equilibrium in the theory of monopolistic
the same characteristics as perfect competition except competition, each firm produces less than its minimum-
that the many firms each sell a differentiated product cost level of output. This is the excess-capacity theorem
rather than all selling a single homogeneous product. associated with monopolistic competition.
Firms face negatively sloped demand curves and may Even though each firm produces at a cost that is higher
earn profits in the short run. than the minimum attainable cost, the resulting product
As in a perfectly competitive industry, the long run in choice is valued by consumers and so may be worth the
the theory of monopolistic competition sees new firms extra cost.
enter the industry whenever profits can be made. Long-
run equilibrium in the industry requires that each firm
earn zero profits.

11.4 Oligopoly and Game Theory L4

Oligopolies are dominated by a few large firms that Economists use game theory to think about the strategic
usually sell differentiated products and have significant behaviour of oligopolists that is, how each firm will
market power. They can maximize their joint profits if behave when it recognizes that other firms may respond
they cooperate to produce the monopoly output. By act- to its actions.
ing individually, each firm has an incentive to depart A possible non-cooperative outcome is a Nash equilib-
from this cooperative outcome. rium in which each player is doing the best it can, given
Oligopolists have difficulty cooperating to maximize the actions of all other players.
joint profits unless they have a way of enforcing their
output-restricting agreement.

11.5 Oligopoly in Practice L5

Explicit collusion between oligopolists is illegal in duction, finance, and marketing, and also to large entry
domestic markets. But it can take place in situations costs. Firm-created barriers can be formed by prolifera-
where firms in global markets are supported by national tion of competing brands, heavy brand-image advertis-
governments, as is the case for OPEC. ing, and the threat of predatory pricing when new entry
Tacit collusion is possible but may break down as firms occurs.
struggle for market share, indulge in non-price competi- In the presence of major scale economies, oligopoly may
tion, and seek advantages through the introduction of be the best of the feasible alternative market structures.
new technology. Evaluation of oligopoly depends on how much interfirm
Oligopolistic industries will exhibit profits in the long competition (a) drives the firms away from the cooper-
run only if there are significant barriers to entry. ative, profit-maximizing solution and (b) leads to inno-
Natural barriers relate to the economies of scale in pro- vations in the very long run.
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 275

Key Concepts
Concentration ratios Strategic behaviour Explicit and tacit collusion
Product differentiation Game theory Natural and firm-created entry
Monopolistic competition Cooperative and non-cooperative barriers
The excess-capacity theorem outcomes Oligopoly and creative destruction
Oligopoly Nash equilibrium

Study Exercises
SAVE TI M E. I MPR O VE RES U LT S.
Visit MyEconLab to practise Study Exercises and prepare for tests and exams.
MyEconLab also offers a variety of other study tools to help you succeed.
www.myeconlab.com

1. Fill in the blanks to make the following statements a. Economists say that oligopolistic firms exhibit
correct. __________ behaviour. These firms are aware of
and take account of the decisions of ________.
a. Suppose the four largest steel producers in Canada
b. The firms in an oligopoly have a collective incen-
among them control 85 percent of total market
tive to __________ in order to maximize joint
sales. We would say that this industry is highly
__________; individually, each firm has an incen-
__________. We say that 85 percent is the
tive to __________ in order to maximize individual
__________ in this industry.
__________.
b. A firm that has the ability to set prices faces a
c. Oligopolistic firms exhibit profits in the long run
__________ demand curve.
only if there are significant __________.
c. The theory of monopolistic competition helps
d. Three examples of non-competitive behaviour prac-
explain industries with a __________ number of
tised by firms with market power are __________,
________ firms. The theory of oligopoly helps
__________, and __________.
explain industries with a __________ number of
e. An important defence of oligopoly is the idea that
__________ firms.
it leads to more __________ than would occur in
d. A firm operating in a monopolistically competitive
either perfect competition or monopoly. The oli-
market structure maximizes profits by equating
gopolistic firm has an incentive to __________
__________ and __________. A firm that is operat-
because it can expect to keep a good share of the
ing in an oligopolistic market structure maximizes
resulting profit.
profit by equating __________ and __________.
e. In long-run equilibrium, and in comparison to per- 3. Each of the statements below describes a characteristic
fect competition, monopolistic competition pro- of the following market structures: perfect competi-
duces a __________ range of products but at a tion, monopolistic competition, oligopoly, and
__________ cost per unit. monopoly. Identify which market structure displays
each of the characteristics. (There may be more than
2. Fill in the blanks to make the following statements
one.)
correct.
 276 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

a. Each firm faces a downward-sloping demand vided are total Canadian and total world sales for the
curve. industry. (All figures are hypothetical and are in mil-
b. Price is greater than marginal revenue. lions of dollars.)
c. Each firm produces at MES in long-run equilibrium.
a. Suppose Canada does not trade internationally any
d. Firms earn profit in long-run equilibrium.
of the goods produced in these industries. Compute
e. Firms produce a homogeneous product.
the four-firm Canadian concentration ratio for
f. Firms advertise their product.
each industry.
g. Each firm produces output where MC * MR.
b. Rank the industries in order from the most concen-
h. Each firm produces output where P * MC.
trated to the least concentrated.
i. There is free entry to the industry.
c. Now suppose goods in these industries are freely
j. Firms produce a differentiated product.
traded around the world. Are the concentration
4. The following table provides annual sales for the four ratios from (a) still relevant? Explain.
largest firms in four industries in Canada. Also pro-

Total Sales Total Sales

Firm 1 Firm 2 Firm 3 Firm 4 (Canada) (World)
Forestry products 185 167 98 47 550 1368
Chemicals 27 24 9 4 172 2452
Women s clothing 6 5 4 2 94 3688
Pharmaceuticals 44 37 22 19 297 2135

5. The table below provides price, revenue, and cost c. What is the profit-maximizing number of car
information for a monopolistically competitive firm washes (per month)?
selling drive-through car washes in a large city. d. What is the profit-maximizing price?
e. Calculate the total maximum profit (per month).
a. Complete the table.
f. How can this firm differentiate its product from
b. Plot the demand, marginal revenue, marginal cost,
other car washes?
and average cost curves for the firm. (Be sure to
plot MR and MC at the midpoint of the output
intervals.)

Quantity (number of Total Marginal Total Average Marginal Profit

car washes per month) Price Revenue Revenue Cost Total Cost Cost (per car wash)
1000 30 _____ 25 000 _____ _____
_____ _____
1100 29 _____ 26 000 _____ _____
_____ _____
1200 28 _____ 27 200 _____ _____
_____ _____
1300 27 _____ 28 500 _____ _____
_____ _____
1400 26 _____ 30 000 _____ _____
_____ _____
1500 25 _____ 32 200 _____ _____
_____ _____
1600 24 _____ 35 000 _____ _____
_____ _____
1700 23 _____ 38 500 _____ _____
_____ _____
1800 22 _____ 43 000 _____ _____
 C H A P T E R 1 1 : I M P E R F E C T C O M P E T I T I O N A N D S T R AT E G I C B E H AV I O U R 277

6. Draw two diagrams of a monopolistically competitive c. Explain the sense in which long-run equilibrium in
firm. In the first, show the firm earning profits in the monopolistic competition is less efficient than in
short run. In the second, show the firm in long-run perfect competition.
equilibrium earning zero profits. What changed for
9. In the text we argued that a key difference between
this firm between the short run and the long run?
monopolistic competition and oligopoly is that in the
7. The following figure shows the revenue and cost former firms do not behave strategically whereas in
curves for a typical monopolistically competitive firm the latter they do. For each of the goods or services
in the short run. listed below, state whether the industries are likely
to be best described by monopolistic competition or
MC oligopoly. Explain your reasoning.
ATC
a. Car repair
p0 a b. Haircuts
d c. Dry cleaning
Price, Costs

p1 b
d. Soft drinks
e. Breakfast cereals
D
f. Restaurant meals
p2 c g. Automobiles
10. The table below is the payoff matrix for a simple two
MR firm game. Firms A and B are bidding on a govern-
0 ment contract, and each firm s bid is not known by the
Output
other firm. Each firm can bid either $10 000 or
a. Note that the firm s demand curve is shown to be $5000. The cost of completing the project for each
quite flat. Explain which assumption of monopolis- firm is $4000. The low-bid firm will win the contract
tic competition suggests a relatively elastic demand at its stated price; the high-bid firm will get nothing. If
curve for each firm. the two bids are equal, the two firms will split the
b. Show the profit-maximizing level of output for the price and costs evenly. The payoffs for each firm under
firm on the diagram. each situation are shown in the matrix.
c. At the profit-maximizing level of output, are prof-
its positive or negative? What area in the diagram A bids $10 000 A bids $5000
represents the firm s profits?
d. Will firms enter or exit the industry? Explain. B bids Firms share A wins the contract
$10 000 the contract
8. The diagram below shows a typical monopolistically
Payoff to A * $3000 Payoff to A * $1000
competitive firm when the industry is in long-run equi-
librium. Payoff to B * $3000 Payoff to B * $0

B bids B wins the contract Firms share the

$5000 contract
MC Payoff to A * $0 Payoff to A * $500
Payoff to B * $1000 Payoff to B * $500
pA LRAC
A
Price, Costs

a. Recall from the text that a Nash equilibrium is an

B outcome in which each player is maximizing his or
pB
her own payoff given the actions of the other play-
ers. Is there a Nash equilibrium in this game?
b. Is there more than one Nash equilibrium? Explain.
D
c. If the two firms could cooperate, what outcome
MR would you predict in this game? Explain.
0
Output 11. The table below shows the payoff matrix for a game
between Toyota and Honda, each of which is contem-
a. Explain why free entry and exit implies that the plating building a factory in a new market. Each firm
long-run equilibrium is at point A. can either build a small factory (and produce a small
b. What is the significance of point B and price pB? number of cars) or build a large factory (and produce
 278 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

a large number of cars). Suppose no other car manu- a. Assuming that the demand curve for cars in this
facturers are selling in this market. new market is negatively sloped and unchanging,
explain the economic reasoning behind the prices
and profits shown in each cell in the payoff matrix.
Toyota s Decision b. What is the cooperative outcome in this game? Is it
Small Factory Large Factory likely to be achievable? Explain.
c. What is Honda s best action? Does it depend on
High Industry Medium Industry Toyota s action?
Price Price d. What is Toyota s best action? Does it depend on
Honda s action?
Small Honda profits: Honda profits: e. What is the non-cooperative outcome in this game?
Factory $20 million $12 million Is it a Nash equilibrium?
Toyota profits: Toyota profits:
Honda s $20 million $25 million
Decision High Industry Medium Industry
Price Price
Large Honda profits: Honda profits:
Factory $25 million $14 million
Toyota profits: Toyota profits:
$12 million $14 million

Discussion Questions
1. It is sometimes said that there are more drugstores and profits that would be earned if the industry were
gasoline stations than are needed. In what sense might monopolized. What are some reasons why this might
this be correct? Does the consumer gain anything from be so?
this plethora of retail outlets?
5. What is the key difference between monopolistic com-
2. Do you think any of the following industries might be petition and oligopoly? Assume that you are in an
monopolistically competitive? Why or why not? industry that is monopolistically competitive. What
actual steps might you take to transform your industry
a. Textbook publishing (approximately 10 introduc-
into a more oligopolistic form?
tory economics textbooks are in use on campuses
in Canada this year) 6. Consider the following industries in Canada that have
b. Post-secondary education traditionally been oligopolistic.
c. Cigarette manufacturing Brewing
d. Restaurant operation Airlines
e. Automobile retailing Railways
3. The periods following each of the major OPEC price Banking
shocks proved to the world that there were many a. What are the barriers to entry in each of these
available substitutes for gasoline, among them bicy- industries that might explain persistently high prof-
cles, car pools, moving closer to work, cable TV, and its?
Japanese cars. Discuss how each of these may be a b. Explain in each case how technology is changing in
substitute for gasoline. ways that circumvent these entry barriers.
4. Evidence suggests that the profits earned by all the
firms in many oligopolistic industries are less than the
Economic
Efficiency and
Public Policy
In the previous three chapters we examined various
market structures, from perfect competition at one
end of the spectrum to monopoly at the other end. In
the middle were two forms of imperfect competition:
monopolistic competition and oligopoly. We have
12
L LEARNING OBJECTIVES
1

2
In this chapter you will learn
the distinction between productive and
allocative efficiency.

why perfect competition is allocatively

considered how firms behave in these various market efficient, whereas monopoly is allocatively
structures, and we are now able to evaluate the effi- inefficient.
ciency of the market structures. Then we will see why 3 alternative methods for regulating a natural
economists are suspicious of monopolistic practices monopoly.
and seek to encourage competitive behaviour. Table
4 some details about Canadian competition
12-1 provides a review of the four market structures policy.
and the industry characteristics relevant to each.
We begin our discussion in this chapter by
examining the various concepts of efficiency used
by economists. This discussion will develop more
fully the concept of efficiency we first saw at the end
of Chapter 5. We then discuss how public policy
deals with the challenges of monopoly and oligopoly
in an effort to improve the efficiency of the economy.
 280 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

12.1 Productive and Allocative

Efficiency
Efficiency requires that factors of production are fully employed. However, full
employment of resources is not enough to prevent the waste of resources. Even when
resources are fully employed, they may be used inefficiently. Here are three examples of
inefficiency in the use of fully employed resources.

1. If firms do not use the least-cost method of pro-

ducing their chosen outputs, they are being ineffi-
TABLE 12-1 Review of Four Market Structures cient. For example, a firm that produces 30 000
pairs of shoes at a resource cost of $400 000 when
Market
it could have been done at a cost of only $350 000
Structure Industry Characteristics
is using resources inefficiently. The lower-cost
Perfect Many small firms method would allow $50 000 worth of resources
competition Firms sell identical products to be transferred to other productive uses.
All firms are price takers
Free entry and exit 2. If the marginal cost of production is not the same
Zero profits in long-run for every firm in an industry, the industry is being
equilibrium inefficient. For example, if the cost of producing the
Price * MC last tonne of steel is higher for some firms than for
Monopolistic Many small firms others, the industry s overall cost of producing a
competition Firms sell differentiated products given amount of steel is higher than necessary. The
Each firm has some power to same amount of steel could be produced at lower
set price total cost if the total output were distributed differ-
Free entry and exit ently among the various producers.
Zero profits in long-run
3. If too much of one product and too little of another
equilibrium
product are produced, the economy s resources are
Price + MC; less output than in
being used inefficiently. To take an extreme example,
perfect competition; excess
capacity
suppose so many shoes are produced that every con-
sumer has all the shoes he or she could possibly want
Oligopoly Few firms, usually large and thus places a zero value on obtaining an addi-
Strategic behaviour among firms tional pair of shoes. Suppose also that so few coats are
Firms often sell differentiated produced that consumers place a high value on
products and are price setters
obtaining an additional coat. In these circumstances,
Often significant entry barriers
consumers can be made better off if resources are real-
Usually economies of scale
located from shoe production, where the last shoe
Profits depend on the nature of
firm rivalry and on entry barriers
produced has a low value in the eyes of each con-
Price usually + MC; output sumer, to coat production, where one more coat pro-
usually less than in perfect duced would have a higher value to each consumer.
competition
These three examples illustrate inefficiency in the
Monopoly Single firm faces the entire use of resources. But the type of inefficiency is differ-
market demand ent in each case. The first example considers the cost
Firm is a price setter for a single firm producing some level of output. The
Profits persist if sufficient entry
second example is closely related, but the focus is on
barriers
the total cost for all the firms in an industry. The
Price + MC; less output than in
third example relates to the level of output of one
perfect competition
product compared with another. Let s explore these
three types of inefficiency in more detail.
 CHAPTER 12: ECONOMIC EFFICIENCY AND PUBLIC POLICY 281

Productive Efficiency
Productive efficiency has two aspects, one concerning production within each firm and
one concerning the allocation of production among the firms in an industry. The first
two examples above relate to these two different aspects of productive efficiency.
Productive efficiency for the firm requires that the firm produce any given level of productive efficiency for
output at the lowest possible cost. In the short run, with only one variable factor, the the firm When the firm
firm merely uses enough of the variable factor to produce the desired level of output. chooses among all
In the long run, however, more than one method of production is available. Produc- available production
tive efficiency requires that the firm use the least costly of the available methods of methods to produce a
producing any given output that is, firms are located on, rather than above, their given level of output at the
long-run average cost curves. lowest possible cost.

Productive efficiency for the firm requires the firm to be producing its output at the
lowest possible cost.

Any firm that is not being productively efficient is producing at a higher cost than is
necessary and thus will have lower profits than it could have. It follows that any profit-
maximizing firm will seek to be productively efficient no matter the market structure productive efficiency for
within which it operates perfect competition, monopoly, oligopoly, or monopolistic the industry When the
competition. industry is producing a
Productive efficiency for the industry requires that the industry s total output be given level of output at the
allocated among its individual firms in such a way that the total cost in the industry is lowest possible cost. This
minimized. If an industry is productively inefficient, it is possible to reduce the indus- requires that marginal cost
try s total cost of producing any given output by reallocating production among the be equated across all firms
industry s firms. in the industry.

Productive efficiency for the industry requires that the marginal cost of production
be the same for each firm.

To see why marginal costs must be equated across firms,

consider a simple example that is illustrated in Figure 12-1.
Aslan Shoe Company has a marginal cost of $80 for the last
shoe of some standard type it produces. Digory Shoes Inc. has
a marginal cost of only $40 for its last shoe of the same type.
If Aslan were to produce one fewer pair of shoes and Digory
were to produce one more pair, total shoe production would
be unchanged. Total industry costs, however, would be lower
by $40.
Clearly, this cost saving can go on as long as the two firms
have different marginal costs. However, as Aslan produces
fewer shoes, its marginal cost falls, and as Digory produces more
shoes, its marginal cost rises. Once marginal cost is equated
across the two firms, at a marginal cost of $60 in the figure,
there are no further cost savings to be obtained by reallocat-
ing production.
Over the next few pages we will see how such an efficient
allocation of output across firms is achieved, but for now the Profit-maximizing firms will adopt the lowest-cost
methods of production and thus will be productively
point is simply that if marginal costs are not equated across
efficient. An industry will be productively efficient
firms, then a reallocation of output is necessary in order for only when its firms all have the same marginal cost
the industry to become productively efficient. for producing any one product.
 282 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

FIGURE 12-1 Productive Efficiency for the Industry

MC MC
MCA MCD
100 100

Dollars
Dollars

80 80

60 60

40 40

20 20
*Q *Q

}
}
0 0
QA Q A Output QD QD Output
Aslan Shoe Co. Digory Shoes Inc.

Productive efficiency for the industry requires that marginal costs for the production of any one product be equated
across firms. At the initial levels of output, QA and QD, marginal costs are $80 for Aslan and $40 for Digory. If
Digory increases output by *Q to Q+D and Aslan reduces output by the same amount, *Q to Q+A, total output is
unchanged. Aslan s total costs have fallen by the green shaded area, whereas Digory s total costs have increased by the
smaller purple shaded area. Total industry costs are therefore reduced when output is reallocated between the firms.
When marginal costs are equalized, at $60 in this example, no further reallocation of output can reduce costs
productive efficiency will have been achieved.

Productive Efficiency and the Production Possibilities Boundary If

firms are productively efficient, they are minimizing their costs; there is no way for
them to increase output without using more resources. If an industry is productively
efficient, the industry as a whole is producing its output at the lowest possible cost;
the industry could not increase its output without using more resources.
Now think about the economy s production possibilities boundary (PPB), which we
first saw in Chapter 1 and which is shown again in Figure 12-2. The PPB shows the com-
binations of output of two products that are possible when the economy is using its
resources efficiently. An economy that is producing at a point inside the PPB is being pro-
ductively inefficient it could produce more of one good without producing less of the
other. This inefficiency may occur because individual firms are not minimizing their costs
or because, within an industry, marginal costs are not equalized across the various firms.
Either situation would lead the economy to be inside its production possibilities boundary.

If firms and industries are productively efficient, the economy will be on, rather
than inside, the production possibilities boundary.

In Figure 12-2, every point on the PPB is productively efficient. Is there one point on
the PPB that is better in some way than the others? The answer is yes, and this brings
us to the concept of allocative efficiency.

allocative efficiency A
situation in which the Allocative Efficiency
market price for each good
is equal to that good s Allocative efficiency concerns the quantities of the various products to be produced.
marginal cost. When the combination of goods produced is allocatively efficient, economists say that
 CHAPTER 12: ECONOMIC EFFICIENCY AND PUBLIC POLICY 283

the economy is Pareto efficient, in honour of nineteenth-

century Italian economist Vilfredo Pareto (1843 1923), FIGURE 12-2 Productive Efficiency and
who developed this concept of efficiency. the Production Possibilities
How do we find the allocatively efficient point on Boundary
the production possibilities boundary? The answer is as
follows:
B
Y2
The economy is allocatively efficient when, for each
good produced, its marginal cost of production is D
equal to its price.

Good Y
To understand this answer, recall our discussion in A C
Chapters 5 and 6 about the marginal value that con- Y1
sumers place on the next unit of some good. When con-
sumers face the market price for some good, they adjust
their consumption of the good until their marginal value
is just equal to the price. Thus, the market price reflects
consumers marginal value of the good. Since price 0 X1 X2
reflects the marginal value of the good to consumers, we Good X
can restate the condition for allocative efficiency to be
that, for each good produced, marginal cost must equal Any point on the production possibilities boundary
is productively efficient. The boundary shows all
marginal value.1 combinations of two goods X and Y that can be
If the level of output of some product is such that produced when the economy s resources are fully
marginal cost to producers exceeds marginal value to employed and productively efficient.
consumers, too much of that product is being produced, Any point inside the curve, such as A, is produc-
because the cost to society of the last unit produced tively inefficient. If the inefficiency exists in industry
exceeds the benefits of consuming it. Conversely, if the X, then either some producer of X is productively
inefficient or industry X as a whole is productively
level of output of some good is such that the marginal
inefficient. In either case, it is possible to increase
cost is less than the marginal value, too little of that total production of X without using more resources,
good is being produced, because the cost to society of and thus without reducing the output of Y. This
producing the next unit is less than the benefits that would take the economy from point A to point C.
would be gained from consuming it. Similarly, if the inefficiency exists in industry Y, pro-
duction of Y could be increased, moving the
Allocative Efficiency and the Production economy from point A to point B.
Possibilities Boundary Figure 12-3 shows a pro-
duction possibilities boundary in an economy that can
produce wheat and steel, and also shows the individual supply-and-demand diagrams
for the two markets. Notice that the vertical axis in each of the supply-and-demand
diagrams shows the relative price of the appropriate good. For example, in the market
for wheat, the relevant price is the price of wheat relative to the price of steel. This is
consistent with our initial treatment of supply and demand in Chapter 3, in which we
held constant all other prices and then examined how the price of any specific product
was determined.
Figure 12-3 illustrates how the allocation of resources in the economy changes as
we move along the production possibilities boundary. For example, as the economy
moves from point A to point B to point C along the PPB, resources are being trans-
ferred from the steel sector to the wheat sector. Thus, steel output is falling and wheat
output is rising.

1
Allocative efficiency is exactly the same concept as market efficiency that we discussed in Chapter 5. Now
that we have introduced the distinction between productive and allocative efficiency, we will continue to use
these two terms only.
 284 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

FIGURE 12-3 Allocative Efficiency and the Production Possibilities Boundary

Allocative efficiency requires that all goods be produced Not enough wheat,
to the point where the marginal cost to producers equals A too much steel
the marginal value to consumers. The production possi- SA
Allocative
bilities boundary shows the combinations of wheat and efficiency
steel that are possible if firms and industries are produc- B

Quantity of Steel
SB
tively efficient. The lower diagrams show the marginal
cost (supply) and marginal value (demand) curves in each
industry.
At point A, steel output is SA and wheat output is C Not enough
WA. As the lower figures show, however, at WA the SC steel, too
marginal value of wheat consumption exceeds its mar- much wheat
ginal cost of production. Thus, society would be better
off if more wheat were produced. Similarly, at SA the
marginal cost of steel production exceeds its marginal
value to consumers, and thus society would be better off
with less steel being produced. WA WB WC
Point A is therefore not allocatively efficient; there
is too little wheat and too much steel being produced. Quantity of Wheat
The argument is similar at point C, at which there is too
much wheat and too little steel being produced. Only at
point B is each good produced to the point where the
marginal cost to producers is equal to the marginal value
to consumers. Only point B is allocatively efficient.

SS = marginal cost SW = marginal cost

Relative Price of Wheat

MC = MV: MC = MV:
Relative Price of Steel

allocative allocative
efficiency efficiency

MV > MC: MC > MV: MV > MC: MC > MV:

not enough too much not enough too much
steel steel wheat wheat

DS = marginal DW = marginal
value value

SC SB SA WA WB WC
Quantity of Steel Quantity of Wheat

What is the allocatively efficient combination of steel and wheat output? Allocative
efficiency will be achieved when in each market the marginal cost of producing the good
equals the marginal value of consuming the good. In Figure 12-3, allocative efficiency is
achieved at point B, with SB steel being produced and WB wheat being produced.2

2
Note that allocative efficiency requires that price equal marginal cost in all industries simultaneously. Based
on what economists call the theory of the second best, there is no guarantee that achieving p * MC in one
industry will improve overall welfare when price does not equal marginal cost in all other industries.
 CHAPTER 12: ECONOMIC EFFICIENCY AND PUBLIC POLICY 285

Which Market Structures Are Efficient?

We now know that for productive efficiency, all firms must be minimizing their costs
and marginal cost should be the same for all firms in any one industry. For allocative
efficiency, marginal cost should be equal to price in each industry. Do the market
structures that we have studied in earlier chapters lead to productive and allocative
efficiency?

Perfect Competition We saw in Chapter 9 that in the long run under perfect
competition, each firm produces at the lowest point on its long-run average cost curve.
Therefore, no one firm could reduce its costs by altering its own production. Every firm
in perfect competition is therefore productively efficient.
We also know that in perfect competition, all firms in an industry face the same
price of their product and they equate marginal cost to that price. It follows immedi-
ately that marginal cost will be the same for all firms. (Suppose, for example, that
Aslan and Digory faced the same market price in Figure 12-1 on page 282. Aslan
would produce where MCA * p and Digory would produce where MCD * p. It follows
that MCA * MCD.) Thus, in perfectly competitive industries, the industry as a whole is
productively efficient.
We have already seen that perfectly competitive firms maximize their profits by
choosing an output level such that marginal cost equals market price. Thus, when
perfect competition is the market structure for the whole economy, price is equal to
marginal cost in each industry, resulting in allocative efficiency.

Perfectly competitive industries are productively efficient. If an economy could be

made up entirely of perfectly competitive industries, the economy would be alloca-
tively efficient.

Note, however, that perfect competition exists only in some industries in modern
economies. So, while specific industries may be perfectly competitive and therefore
allocatively efficient, entire modern economies are neither perfectly competitive nor
allocatively efficient. Extensions in Theory 12-1 explains why, even in an economy made
up entirely of perfectly competitive industries, the point on the production possibilities
boundary that is allocatively efficient depends on the economy s distribution of income.
Monopoly Monopolists have an incentive to be productively efficient because their
profits will be maximized when they adopt the lowest-cost production method. Hence,
profit-maximizing monopolists will operate on their LRAC curves and thus be produc-
tively efficient.
Although a monopolist will be productively efficient, it will choose a level of out-
put that is too low to achieve allocative efficiency. This result follows from what we
saw in Chapter 10 that the monopolist chooses an output at which the price charged
is greater than marginal cost. Such a choice violates the conditions for allocative
efficiency because the price, and hence the marginal value to consumers, exceeds the
marginal cost of production. From this result follows the classic efficiency-based pref-
erence for competition over monopoly:

Monopoly is not allocatively efficient because the monopolist s price always

exceeds its marginal cost.

This result has important policy implications for economists and for policymakers,
as we will see later in this chapter.
 286 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

EXTENSIONS IN THEORY 12-1

Allocative Efficiency and the Distribution of Income

We have said in the text that economy-wide perfect the hands of the rich and more income in the hands of
competition would lead to an efficient allocation of the poor. In other words, it alters the distribution of
resources, with production and consumption at a point income in favour of the poor. In our example, the
like B on the production possibilities boundary in Fig- demand curve for wheat shifts to the right because
ure 12-3. But even for an economy with widespread the poor are relatively intensive wheat consumers; at the
perfect competition and a given production possibilities same time, the demand curve for steel shifts to the left
boundary, there is not a unique allocation of resources because the rich are intensive steel consumers. The price
that is efficient or optimal. Specifically, changes in the of wheat therefore rises, as does its production and con-
distribution of income, which naturally change the rela- sumption, whereas the price and quantity of steel both
tive demands for various products, will also change the fall. The whole society then moves to a new allocatively
allocatively efficient point. efficient point on the production possibilities boundary,
By means of a simple example, consider a country away from point B and toward point C. It should now
in which there are only two income classes: the rich con- be clear that point B is an optimal allocation of
sume a lot of steel but little wheat, whereas the poor resources for the initial distribution of income, whereas
consume a lot of wheat but little steel. (In a more gen- point C could be the optimal allocation for a different
eral mathematical model, we could have three or more distribution.
products and three or more income groups, each with The moral of this story is very general. There is no
different expenditure patterns.) Further, suppose that unique efficient (or optimal ) allocation of resources
the demand curves shown in Figure 12-3 are based on for any one society. The efficient point on the produc-
the existing distribution of income between these two tion possibilities boundary depends on the distribution
income classes. Point B is then the allocatively efficient of income. So, unless we are willing to make value
point of consumption and production. judgements between various distributions of income, we
But now suppose that a new, more egalitarian gov- cannot say that one efficient point on the production
ernment is elected. The new government alters the struc- possibilities boundary is better than any other.
ture of taxes and transfers so as to leave less income in

Other Market Structures The allocative inefficiency of monopoly extends to

other imperfectly competitive market structures. Whenever a firm has any market
power, in the sense that it faces a negatively sloped demand curve, its marginal revenue
will be less than its price. When it equates marginal cost to marginal revenue, as all
profit-maximizing firms do, marginal cost will also be less than price. This inequality
implies allocative inefficiency. Thus, oligopoly and monopolistic competition are also
allocatively inefficient.
Oligopoly is an important market structure in today s economy because in
many industries the minimum efficient scale is simply too high to support a large
number of competing firms. Monopolistic competition is also important, especially
in the many manufactured-goods industries in which economies of scale are not
so extreme but product differentiation is an important market characteristic.
Although neither oligopoly nor monopolistic competition achieves the conditions
for allocative efficiency, they may nevertheless produce more satisfactory results
than monopoly.
We observed one reason why oligopoly may be preferable to monopoly in
Chapter 11: Competition among oligopolists encourages innovations that result in
 CHAPTER 12: ECONOMIC EFFICIENCY AND PUBLIC POLICY 287

both new products and cost-reducing methods of producing old

ones. An important defence of oligopoly as an acceptable mar-
ket structure is that it may be the best of the available alterna-
tives when minimum efficient scale is large. As we observed at
the end of Chapter 11, the challenge to public policy is to keep
oligopolists competing and using their competitive energies to
improve products and to reduce costs rather than to restrict
interfirm competition and to erect entry barriers. As we will see
later in this chapter, much public policy has just this purpose.
What economic policymakers call monopolistic practices
include not only output restrictions operated by firms with
complete monopoly power but also anticompetitive behaviour
among firms that are operating in oligopolistic industries.

Allocative Efficiency and Total Surplus

By using the concepts of marginal value to consumers and the
marginal cost of production, we have established the basic
points of productive and allocative efficiency. A different way
of thinking about allocative efficiency though completely
consistent with the first approach is to use the concepts of
consumer and producer surplus, both of which are part of the
economic surplus that we first introduced in Chapter 5.

Allocative efficiency is a property of the entire

Consumer and Producer Surplus Recall from Chapter economy. The economy is allocatively efficient only
6 that consumer surplus is the difference between the value that when the quantity of each product is such that its
consumers place on a product and the payment that they actu- marginal cost equals its price.
ally make to buy that product. In Figure 12-4, if the competitive
market price is p0 and consumers buy Q0 units of the product,
consumer surplus is the blue shaded area.
Producer surplus is an analogous concept to consumer surplus. Producer surplus producer surplus The
is the difference between the actual price that the producer receives for a product price of a good minus
and the lowest price that the producer would be willing to accept for the sale of that the marginal cost of
product. By producing one more unit, the producer s costs increase by the marginal producing it, summed over
cost, and this is the lowest amount that the producer will accept for the product. To the quantity produced.
accept any amount less than the marginal cost would reduce the firm s profits.

For each unit sold, producer surplus is the difference between price and marginal
cost.

For a producer that sells many units of the product, total producer surplus is the
difference between price and marginal cost summed over all the units sold. So, for an
individual producer, total producer surplus is the area above the marginal cost curve
and below the price line.
For the industry as a whole, we need to know the industry supply curve in order to
compute overall producer surplus. Since in perfect competition the industry supply
curve is simply the horizontal sum of all firms MC curves, producer surplus in a per-
fectly competitive market is the area above the supply curve and below the price line,
as shown in Figure 12-4.
 288 PA RT 4 : M A R K E T S T R U C T U R E A N D E F F I C I E N C Y

FIGURE 12-4 Consumer and Producer FIGURE 12-5 The Allocative Efficiency of
Surplus in a Competitive Perfect Competition
Market

S = Marginal cost
S = Marginal cost

Price
Competitive
Price

E Market price 1 E 3 market price

p0 p*
2 4

D = Marginal D = Marginal
value value

Q0
Q1 Q* Q2
Quantity Quantity
Consumer surplus is the area under the demand curve
Competitive equilibrium is allocatively efficient because
and above the market price line. Producer surplus is the
it maximizes the sum of consumer and producer surplus.
area above the supply curve and below the market price
The competitive equilibrium occurs at the price output com-
line. The total value that consumers place on Q0 of the
bination of p* and Q*. At this equilibrium, consumer sur-
commodity is given by the area under the demand curve
plus is the blue area above the price line, while producer
up to Q0. The amount they pay is the rectangle p0Q0.
surplus is the red area below the price line.
The difference, shown as the blue shaded area, is con-
For any output that is less than Q*, the sum of the two
sumer surplus.
surpluses is less than at Q*. For any output that is greater than
The revenue to producers from the sale of Q0 units
Q*, the sum of the surpluses is also less than at Q*. Thus, total
is p0Q0. The area under the supply curve is the mini-
surplus is maximized when output is Q*.
mum amount producers require to supply the output.
The difference, shown as the red shaded area, is pro-
ducer surplus.

The Allocative Efficiency of Perfect Competition Revisited In

Chapter 5 we said that market (allocative) efficiency exists in a market if the total eco-
nomic surplus is maximized. At that point, we did not make the distinction between
the component parts of total surplus consumer surplus and producer surplus. Now
that we have identified these different parts of total surplus, we can restate the condi-
tions for allocative efficiency in a slightly different way.

Allocative efficiency occurs where the sum of consumer and producer surplus is max-
imized.

The allocatively efficient output occurs under perfect competition where the
demand curve intersects the supply curve that is, the point of equilibrium in a compet-
itive market. This is shown as the output Q* in Figure 12-5. For any level of output
below Q*, such as Q1, the demand curve lies above the supply curve, showing that con-
sumers value the product more than it costs to produce it. Thus, society would be better
off if more than Q1 units were produced. Notice that if output is only Q1 there is no
consumer or producer surplus earned on the units between Q1 and Q*. Thus, the areas
1 and 2 in Figure 12-5 represent a loss to the economy. Total surplus consumer plus
producer surplus is lower at Q1 than at Q*.
For any level of output above Q*, such as Q2, the demand curve lies below the sup-
ply curve, showing that consumers value the product less than the cost of producing it.