Chapter 11

Question 1

What does the theory of monopolistic competition explain?

Answer 1

Why there are many small firms, but where each has some degree of market power.

Question 2

What is the theory of oligopoly?

Answer 2

It helps us to understnad industries in which there are a small number of large firms, each with considerable market power, and that compete actively with each other.

(e.g., groceries, life insurance, railway industry)

Question 3

What is a concentration ratio?

What is the main problem with them?

Answer 3

The fraction of total market sales controlled by a specific number of the industry’s largest firms.

The main problem associated with using concentration ratios is to define the market with reasonable accuracy.

Question 4

What is imperfect competition?

Answer 4

• The word competitive emphasizes that we are not dealing with monopoly.
• The word imperfect emphasizes that we are not dealing with perfect competition, in which firms are price takers.

Question 5

What are characteristics of an imperfectly competitive firms? [3]

Answer 5

• They differentiate their products.
• They set their prices.
• They engage in non-price competition

Question 6

What is a differentiated product?

Answer 6

A group of products similar enough to be called the same product but dissimilar enough that all of them do not have to be sold at the same price.

Question 7

What is a price setter?

Answer 7

A firm that faces a downward-sloping demand curve for its product. It chooses which price to set.

Question 8

Describe how imperfectly competitive firms typically engage in behaviour that is absent in either monopoly or perfect competition. [3]

Answer 8

• spend large sums of money on advertising
• engage in a variety of forms of non-price competition, such as offering competing standards of quality and product gaurantees
• may engage in activities that appear to be designed to hinder the entry of new firms, which prevents the erosion of existing profits

Question 9

What is the key difference between industries with a large number of small firms (monopolistic competition) and industries with a small number of large firms (oligopoly)?

Answer 9

Strategic behaviour displayed by firms.

Question 10

Describe monopolistic competition. [5]

Answer 10

• originally developed to deal with the phenomenon of production differentiation
• many firms
• freedom of entry and exit
• product is somewhat differentiated from others
• firms have some control over its price

Question 11

What are the assumptions of monopolistic competition? [4]

Answer 11

1. Each firm produces its own version of the industry’s differentiated product. Thus, it faces a demand curve that, although negatively sloped, is highly elastic because competing firms produce many close substitutes.
2. All firms have access to the same technology and so have the same cost curves.
3. The industry contains so many firms that each one ignores competitors when making price and output decisions.
4. Firms are free to enter and exit the industry.

Question 12

Describe profit maximization for a firm in monopolistic competition.

Answer 12

• In the long run, each firm is producing an output less than that corresponding to the lowest point on its LRAC curve.
• If the firm increases its output, cost per unit decreases but revenue decreases by more than cost decreases.
• Selling more would reduce revenue by more than it reduces cost.

Question 13

What is the excess-capacity theory?

Answer 13

• When a firm produces an output less than that corresponding to the lowest point on its LRAC curve, the firm has excess capacity.
• The excess-capcity theory is the property of long-run equilibrium in monopolistic competition that firms produce on the falling portion of their long-run average cost curves.
• This results in excess capacity, measured by the gap between present output and the output that coincides with minimum average cost.

Question 14

What is oligopoly?

Answer 14

An industry that contains two or more firms, at least one of which produces a significant portion of the industry’s total output.

Question 15

Why is profit maximization complicated for an oligopoly?

Answer 15

Determining the level of output that maximizes profits is complicated for an oligopolistic firm because it must consider its rivals’ likely responses to its actions.

Oligopolists exhibit strategic behaviour - behaviour designed to take account of the reactions of one’s rivals to one’s own behaviour.

Question 16

What is game theory? Describe how it is applied to oligopoly.

Answer 16

• Game theory is the theory that studies decision making in situations in which one player anticipates the reactions of the other players to its own actions.
• When game theory is applied to oligopoly:
  
  • the players are firms
  • their game is played in the market
  • their strategies are their price or output decisions
  • the payoffs are their profits

Question 17

Describe entry barriers in oligopoly.

Answer 17

1. Brand proliferation
   
   • A large number of differentiated products leaves small market share available to newcomers.
2. Advertising
   
   • Heavy advertising establishes brands in consumer’s minds
3. Predatory pricing
   
   • Existing firms can keep prices below costs until entrants go bankrupt, discouraging future rivals

Question 18

Oligopoly is more efficient than perfect competition

True or false?

Answer 18

False.

Oligopolies are less efficient than perfect competition.

Question 19

Why is oligopoly an important market structure in modern economies?

Answer 19

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 competing, rather than colluding, and using their competitive energies to improve products and to reduce costs, rather than merely to erect entry barriers.