Chapter 13 Imperfect Competition and
Firm Strategy
6
were a pure monopoly, it would not have to fear a loss of business to other producers
because of a change in price.) Inefficiency in this market is slightly greater than in a
monopolistically competitive market—see the shaded triangular area of Figure 13.3.
The Oligopolist as Price Leader
Alternatively, oligopolists may look to others for leadership in determining prices. One
producer may assume price leadership because it has the lowest costs of production; the
others will have to follow its lead or be underpriced and run out of the market. The
producer that dominates industry sales may assume leadership. Figure 13.4 depicts a
situation in which all the firms are relatively small and of equal size, except for one large
producer. The small firms’ collective marginal cost curve (minus the large producer’s) is
shown in part (a), along with the market demand curve, D
m
. The dominant producer’s,
marginal cost curve, MC
d
, is shown in part (b) of Figure 13.4.
FIGURE 13.4 The Oligopolist as Price Leader
The dominant producer who acts as a price leader will attempt to undercut the market price established by
small producers (part (a)). At price P
1
the small producers will supply the demand of the entire market, Q
2
.
At a lower price—P
d
or P
c
—the market will demand more than the small producers can supply. In part (b),
the dominant firm determines its demand curve by plotting the quantity it can sell at each price in part (a).
Then it determines its profit-maximizing output level, Q
d
, by equating marginal cost with marginal revenue.
It charges the highest price the market will bear for that quantity, P
d
, forcing the market price down to P
d
in
part (a). The dominant producer sells Q
3
-Q
1
units, and the smaller producers supply the rest.
The dominant producer can see from part (a) that at a price of P
1
, the smaller
producers will supply the entire market for the product, say, steel. At P
1
the quantity
demanded, Q
2
, is exactly what the smaller producers are willing to offer. At P
1
or above,
therefore, the dominant producer will sell nothing. At prices below P
1
, however, the total
quantity demanded exceeds the total quantity supplied by the smaller producers. For
Chapter 13 Imperfect Competition and
Firm Strategy
7
example, at a price of P
d
the total quantity demanded in part (a) is Q
3
, whereas the total
quantity supplied is Q
1
.
Therefore the dominant producer will conclude that at price Pd, it
can sell the difference, Q
3
-Q
1
. For that matter, at every price below P
1
, it can sell the
difference between the quantity supplied by the smaller producers and the quantity
demanded by the market.
As the price falls below P
1
, the gap between supply and demand expands, so that
the dominant producer can sell larger and larger quantities. If these are plotted on
another graph, they will form the dominant producer’s demand curve, D
d
(part (b)). Once
it has devised its demand curve, the dominant producer can develop its accompanying
marginal revenue curve, MR
d
, also shown in Figure 13.4(b). Using its marginal cost
curve, MC
d
, and its marginal revenue curve, it establishes its profit-maximizing output
level and price, Q
d
and P
d
.
The dominant producer knows that it can charge price P
d
for quantity Q
d
, because
that price-quantity combination (and all others on curve D
d
) represents a shortage not
supplied by small producers at a particular price in part (a). Q
d
, as noted earlier, is the
difference between the quantity demanded and the quantity supplied at price P
d
. So the
dominant producer picks its price, P
d
. And the smaller producers must follow.
3
If they
try to charge a higher price, they will not sell all they want to sell.
Price Stability and the “Kinked” Demand Curve
Several decades ago, economists believed they had noticed something quite significant
about oligopolies. For relatively long periods of time, prices in these industries seemed
to remain more or less fixed. This observed “stickiness” of oligopolistic prices gave rise
to the theory of the “kinked” demand curve—a theory that tries to explain not how prices
are determined, but why they do not move very much.
Figure 13.5 shows the hypothetical kink in the oligopolist’s demand curve that
was thought to produce price stickiness. The notion was that the interdependent nature of
oligopolistic pricing decisions gave rise to the kink. Suppose the price of steel is P
1
. An
oligopolistic firm can reason that if it lowers its price, other firms will follow suit to
protect their shares of the market. Therefore, the demand curve below that point is
relatively inelastic. If the firm raises its prices, however, it will lose customers to the
other firms, who have no reason to follow a price increase. The demand curve above P
1
is therefore relatively elastic.
Because of the kink at P
1
the marginal revenue curve is discontinuous. At an
output of Q
1
, a gap develops between the upper and lower portions of the curve (see
Figure 13.5). The existence of this gap is easier to understand if one thinks of the kinked
demand curve as two separate curves intersecting at the kink. The curve’s bottom half
3
Consider market equilibrium with and without the dominant producer. In the absence of the dominant
producer, the market price will be P
1
, the equilibrium price for a market composed of only the smaller
producers. The dominant producer adds quantity Q
d
, which causes the price to fall, forcing the smaller
producers to cut back production to Q
1
in part (a).
Chapter 13 Imperfect Competition and
Firm Strategy
8
_______________________________________________
FIGURE 13.5 The Kinked Demand Curve
The theory of the kinked demand curve is based on the
questionable premise that an oligopolist’s prices are
relatively rigid, or unresponsive to cost increases.
According to the theory, the individual oligopolist
reasons that other oligopolists will match a price
reduction in order to protect their market shares, but will
not match a price increase. The individual oligopolist’s
demand curve is therefore kinked at the established price:
the bottom part is less elastic than the top, where even a
small increase in price will cause customers to go
elsewhere. Given the kinked demand curve, the firm’s
marginal revenue curve will be discontinuous. Even if the
oligopolist’s marginal cost curve shifts upward from MC
1
to MC
2
, the firm will not change its price-quantity
combination, P
1
Q
2
.
belongs to demand curve D
1
in Figure 13.6, and its top half to demand curve D
2
. Seen
that way, the two-part marginal revenue curve in Figure 13.5 is simply the composite of
the relevant portions of the marginal revenue curves MR
1
and MR
2
in Figure 13.5. At that
output level, marginal cost can shift all the way up to MC
2
and the oligopolist will still
maximize profits. As long as output remains at Q
2
, the price will remain P
1
. A price
increase would not benefit the firm unless its marginal cost curve rose higher than MC
2
–
say to MC
3
. In that case the firm’s profit-maximizing price would be only slightly
higher, P
2
.
___________________________________________
FIGURE 13.6 The Kinked Demand Curve as Two
Separate Curves
The oligopolist’s kinked demand curve can be
viewed as the composite of two different demand
curves. The portion above the kink comes from the
top of a demand curve (D
2
) that is relatively elastic.
The portion below the kink comes from the bottom
of a demand curve (D
1
) that is less elastic.
Economists at one time thought they had explained the rigidity of oligopolistic
prices. The only problem is that further observation has cast doubt on the evidence that
motivates the development of the theory. Research conducted over the last three decades
Chapter 13 Imperfect Competition and
Firm Strategy
9
suggests that prices in industries dominated by a few firms are no stickier than prices in
other industries. Because there is some disagreement on the interpretation of the data, the
theory remains with us. At best, it is a theory in search of reasonable confirmation.
The Oligopolist in the Long Run
In an oligopolistic market, significant barriers to entry face new competitors. Firms in
oligopolistic industries can therefore retain their short-run positions much longer than can
monopolistically competitive firms.
Oligopoly is normally associated with the automobile, cigarette, and steel
markets, which include some extremely large corporations. There the financial resources
required to establish production on a competitive scale may be a formidable barrier to
entry. One cannot conclude that all new competition is blocked in an oligopoly,
however. Many of the best examples of oligopolies are found in local markets—for
instance, drugstore, stereo shops, and lumber stores—in which one, two, or at most a few
competitors exist, even though the financial barriers to entry could easily be overcome.
Even in the national market, where the financial requirements for entry may be
substantial, some large firms have the financial capacity to overcome barriers to entry. If
firms in the electric light bulb market exploit their short-run profit opportunities by
restricting production and raising prices, outside firms like General Motors Corporation
can move into the light bulb market and make a profit. In recent years, General Motors
has in fact moved into the market for electronics and robotics.
Oligopoly power remains a cause for concern. The basis for competition,
however, is the relative ability of firms to enter a market where profits can be made—not
the absolute size of the firms in the industry. The small regional markets of a century
ago, isolated by lack of transportation and communication, were perhaps less competitive
than today’s markets, even if today’s firms are larger in an absolute sense. In the
nineteenth century the cost of moving into a faraway market effectively protected many
local businesses from the threat of new competition.
Cartels: Monopoly through Collusion
In either a monopolistically competitive market or an oligopolistic market (or even
sometimes in a competitive market), firms may attempt to improve their profits by
restricting output and raising their market price. In other words, they may agree to
behave as it they were a unified monopoly, an arrangement called a cartel. A cartel is an
organization of independent producers intent on thwarting competition among themselves
through the joint regulation of market shares, production levels, and prices. The principal
purpose of their anticompetitive efforts is to raise their prices and profits above
competitive levels. In fact, however, a cartel is not a single unified monopoly, and cartel
members would find it very costly to behave as if they were.
Incentives to Collude and to Cheat
Chapter 13 Imperfect Competition and
Firm Strategy
10
The size of monopoly profits provides a real incentive for competitors to collude—to
conspire secretly to fix prices, production levels, and market shares. Once they have
reduced market supply and raised the price, however, each has an incentive to chisel on
the agreement. The individual competitor will be tempted to cut prices in order to expand
sales and profits. After all, if competitors are willing to collude for the purpose of
improving their own welfare, they will probably also be willing to chisel on cartel rules to
enhance their welfare further. The incentive to chisel can eventually cause the demise of
the cartel. If a cartel works for long, it is usually because some form of external cost,
such as the threat of violence, is imposed on chiselers.
4
Although a small cartel is usually a more workable proposition than a large one,
even small groups may not be able to maintain an effective cartel. Consider an oligopoly
of only two producers, called a duopoly. A duopoly is an oligopolistic market shared by
only two firms. To keep the analysis simple, we will assume that each duopolist has the
same cost structure and demand curve. We will also assume a constant marginal cost,
which means that marginal cost and average costs are equal and can be represented by
one horizontal curve. Figure 13.7 shows the duopolists’ combined marginal cost curve,
MC, along with the market demand curve for the good, D. The two producers can
maximize monopoly profits if they restrict the total quantity they produce to Q
m
and sell
it for price P
m
. Dividing the total quantity sold between them, each will sell Q
1
at the
monopoly price (2 x Q
1
= Q
m
). Each will receive an economic profit equal to the shaded
area bounded by ATC
1
P
m
ab, which is equal to total revenues (P
m
x Q
1
) minus total cost
(ATC
1
x Q
1
).
____________________________________
FIGURE 13.7 A Duopoly (Two-Member Cartel)
In an industry composed of two firms of equal size,
firms may collude to restrict total output to Q
m
and
sell at a price of P
m
. Having established that price-
quantity combination, however, each has an
incentive to chisel on the collusive agreement by
lowering the price slightly For example, if one firm
charges P
1
, it can take the entire market, increasing
its sales from Q
1
to Q
2
. If the other firm follows suit
to protect its market share, each will get a lower
price, and the cartel may collapse.
____________________________________
Once in that position, each firm may reason that by reducing the price slightly
say to P
1
and perhaps disguising the price cut through customer rebates or more
attractive credit terms, it can capture the entire market and even raise production to Q
2
.
4
A cartel may provide members with some private benefit that can be denied nonmembers. For example,
local medical associations can deny nonmembers the right to practice in local hospitals. In that case, the
cost of chiseling is exclusion from membership in the group.
Chapter 13 Imperfect Competition and
Firm Strategy
11
Each firm may imagine that its own profits can grow from the area bounded by
ATC
1
P
m
ab to the much larger area bounded by ATC
1
P
m
cd. This tempting scenario
presumes, of course, that the other firm does not follow suit and lower its price. Each
firm must also worry that the other will chisel, cut the price, and steal its market.
Thus each duopolist has two incentives to chisel on the cartel. The first is
offensive, to garner a larger share of the market and more profits. The second is
defensive, to avoid a loss of its market share and profits. Generally, firms that seek
higher profits by forming a cartel will also have difficulty holding the cartel together, for
much the same reason. As each firm responds to the incentive to chisel, the two undercut
each other and the price falls back toward (but not necessarily to) the competitive
equilibrium price, at the intersection of the marginal cost and demand curves. Just how
far price will decline depends on the firms’ ability to impose penalties on each other for
chiseling.
The strength and viability of a cartel depend on the number of firms in an industry
and the freedom with which other firms can enter. The larger the number of actual or
potential competitors, the greater the cost of operating the cartel, of detecting chiselers,
and of enforcing the rules. If firms differ in their production capabilities, the task of
establishing each firm’s share of the market is more difficult. If a cartel member believes
it is receiving a smaller market share than it could achieve on its own, it has a greater
incentive to chisel. Because of the built-in incentives first to collude and then to chisel,
the history of cartels tends to be cyclical. Periods in which output and prices are
successfully controlled are followed by periods of chiseling, which lead eventually to the
destruction of the cartel.
Government Regulation of Cartels
Government can either encourage or discourage a cartel. Through regulatory agencies
that fix prices, determine market shares, and impose penalties for violation of rules,
government can keep competitors or cartel members from doing what comes naturally—
chiseling. In doing so, government may be providing an important service to industry.
Perhaps that is why, in most states, insurance companies oppose deregulation of their rate
structures. In seeking or welcoming regulation, an industry may calculate that it is easier
to control one regulatory agency than a whole group of firms plus potential competitors.
Thus in 1975, the airline industry opposed President Ford’s proposal that
Congress curtail the power of the Civil Aeronautics Board to set rates and determine
airline routes. As the Wall Street Journal reported,
The administration bill quickly drew a sharp blast form the Air Transport
Association, which was speaking for the airline industry. The proposed
legislation “would tear apart a national transportation system recognized as the
finest in the world,” the trade group said, urging Congress to reject it because it
would cause “a major reduction or elimination of scheduled air service to many
communities and would lead inevitably to increased costs to consumers.”
5
5
“Less Regulation of Airline Sector Is Urged by Ford,” Wall Street Journal, October 9, 1975, p. 3.
Chapter 13 Imperfect Competition and
Firm Strategy
12
The real reason the airlines opposed deregulation became clear in the early 1980s, when
several airlines filed for bankruptcy. Partial deregulation, begun in 1979, had increased
competition, depressing fares and profits. Fares began to rise again in 1980, mainly
because of rapidly escalating fuel costs. Real fares have nonetheless fallen since
deregulation.
Government can suppress competition in many other ways that have nothing to do
with price. Prohibiting the sale of hard liquor on Sunday, for example, can benefit liquor
dealers, who might otherwise be forced to stay open on Sundays. In Florida, a state
representative who managed to get a law through the legislature permitting Sunday liquor
sales was denounced by liquor dealers. As one dealer commented, the legislator had
“pulled the boner of the year.”
6
Cartels with Lagged Demands
Our analysis of cartels has been based on the presumption of a “standard good,” one not
subject to the forces of lagged demand introduced in an earlier chapter. Under market
conditions of lagged demand, the pricing strategies of a cartel are potentially different.
When the market is split among two or more producers, then each firm can understand
that if it lowers its price, then more goods will be sold currently, but even more goods
will be sold in the future, when the benefits of the lagged demand/rational addition kick
in. However, each can reason that the additional future sales generated by its current
price reduction could be picked up by one of the other producers. The benefits are, in
other words, external. So each producer can reason that it should not incur the current
costs of a lower price for the benefit of others. Each producer individually has an
impaired incentive to lower the price.
On the other hand, each producer can also see that they all have a collective
incentive to lower the price currently. Why? To stimulate future demand and to raise
their future price and profits. A cartel under such circumstances would be organized to
do what they all have an interest in doing, lower the price (not raise the price as is true in
conventional markets). The problem is that the incentive to not go along with or chisel
on the cartel remains strong for each firm, as is true in the conventional case, which
suggest that consumers may not get the lower current price because of cartel cheating.
However, not all is lost. If firms are inclined to chisel on such a cartel, there is a
potential solution that might be seen as perfectly legal by the antitrust authorities. One
firm can buy the other firms simply because their profits and stock prices will be
suppressed by the inability of the firm to develop a workable cartel. Once one firm
controls the market, then that one firm can lower the current price for the purpose of
stimulating future demand. This one firm might end up as the sole producer but might
escape prosecution as a monopolist in violation of the antitrust laws (in spite of the fact
that it does what a cartel of firms can’t do) simply because the net effect of the buyouts is
a lower price and expanded market.
6
St. Petersburg Times, June 7, 1975, p. 1-B.
Chapter 13 Imperfect Competition and
Firm Strategy
13
Antitrust Legislation
As we have seen, monopoly power often leads to market inefficiencies, or a misallocation
of resources. Reductions in monopoly power should therefore improve consumer
welfare. The U.S. government’s antitrust policy is designed, ostensibly, to improve
market efficiency by reducing barriers to entry, breaking up monopolies, and reducing the
monetary benefits of conspiring to reconstruct production or raise prices. It is based on
three major laws, which have been amended and modified by court decisions: the
Sherman, Clayton, and Federal Trade Commission Acts.
PERSPECTIVE: A Real-World Case of Price Fixing
During the 1950s, General Electric Company, Westinghouse Electric Corporation, Allis-Chalmers, Southern
States Equipment, and other firms and their executives were accused of conspiring to set prices and divide the
market for electrical equipment.
1
Their conspiracy, which covered everything from two-dollar insulators to
turbine generators, illustrates the incentives for competitors first to collude and then to chisel on their collusive
agreement. As a result of a court case brought against them, which ended in 1961, fines of nearly $2 million
were levied again
st the conspirators and the companies they represented. Six corporate executives were sent
to prison, and twenty-four others were fined or given suspended sentences. It was the largest case brought to
trial in the history of antitrust law, a classic example of the benefits and pitfalls of industrial conspiracy.
The seeds of the conspiracy were planted during the Second World War, when the prices of various types
of electrical equipment were regulated by the Office of Price Administration (OPA). Under the auspices of
the National Electrical Manufacturers Association, firms met on a regular basis to determine how they could
supply the heavy wartime demand for electrical equipment. After their meetings, executives would regroup to
talk about how they could get the OPA to raise prices.
When the war was over and prices were no longer controlled, these manufacturers faced competition from a
growing number of smaller companies. Increasingly, buyers were asking for sealed bids as a means of getting
the lowest possible prices. The major manufacturers continued their meetings, this time to talk about price
fixing and methods of dividing the market. They decided to agree on their bids ahead of time and to rotate the
privilege of making the lowest bid. After learning what the lowest bid would be, the others would make
higher bids. The business was divided on the basis of past sales volume. In the circuit-breaker market, for
example, General Electric received 45 percent of the business, Westinghouse 35 percent, Allis-Chalmers 10
percent, and Federal Pacific 10 percent.
For a more detailed account of this case, see Richard Austin Smith, “The Incredible electrical Conspiracy,”
parts I and II, Fortune, April and May 1961, pp. 132 ff. (April) and pp. 161 ff. (May).
Chapter 13 Imperfect Competition and
Firm Strategy
14
The Sherman Act
The Sherman Act was passed in 1890, after a series of major corporate mergers. It
contains two critical provisions. The first, Section 1, declares illegal “every contract,
combination in the form of trust or otherwise, or conspiracy, in restraint of trade or
commerce among several states or with foreign nations.” The second, Section 2, declares
that “every person who shall monopolize, or conspire with any other person or persons to
monopolize any part of trade or commerce among the several states, or with foreign
nations, shall be guilty of a misdemeanor. . . .” In short, the first section outlaws any
form of cooperative behavior that restrains competition; the second outlaws
monopolization or any attempt to acquire monopoly power.
The language seems clear enough, yet the courts were initially reluctant to rule
against violations of the law, citing prosecutors’ loose interpretation of the words
“restraint of trade” and “conspire. . . .to monopolize.” In 1911, however, the Supreme
Court ruled that Standard Oil Company, which then controlled 90 percent of the nation’s
refinery capacity, should be broken up. By dividing the firm along geographical lines
(which explains the names Standard Oil of Ohio and Standard Oil of California), the
court effectively nullified the economic benefits of the breakup. In place of one large
monopoly, the justices created smaller monopolies. Later, the court broke up the United
States Steel Corporation and American Can Company on the grounds that they and
followed “unfair and unethical” business practices.
The Clayton Act
Because the Sherman Act did not specify what constituted unfair and unethical business
practice, and because the courts generally took a very narrow view of what constituted
restraint of trade and commerce, Congress passed a new law in 1914. The Clayton Act
listed four illegal practices in restraint of competition. It outlawed price discrimination,
or the use of price differences not justified by cost differentials to lessen competition or
create a monopoly. This provision was intended to prevent firms from cutting prices
below cost in a particular geographical region in order to drive competitors out of the
market. Railroads and department stores were allegedly involved in such “predatory
competition.”
The Clayton Act also forbade tying contracts and exclusive dealerships. A tying
contract is an agreement between seller and buyer that requires the buyer of one good or
service to purchase some other product or service. If IBM tried to force buyers of home
computers to purchase only IBM software, for example, its purchase and sale agreement
with customers might be considered a typing contract. An exclusive dealership is an
agreement between a manufacturer and its dealers that forbids the dealers from handling
other manufacturers’ products. The Clayton Act is applicable only to exclusive
dealerships that reduce competition “substantially,” however. As long as other
manufacturers’ products are sold in the same area, manufacturers may organize exclusive
dealerships covering designated territories, as is common in the automobile industry.
Since 1985, the antitrust enforcement agencies and the courts have been more lenient
toward such nonprice vertical restraints as tying contracts and exclusive dealerships.
Chapter 13 Imperfect Competition and
Firm Strategy
15
Section 7 of the Clayton Act forbids mergers, or the acquisition by a firm of its
competitors’ stock, if the effect of the merger is to reduce competition substantially. The
act applies only to horizontal mergers, however.
A horizontal merger is the joining of two or more firms in the same market—for
example, two car companies into a single firm. Vertical mergers were excluded from
the act. A vertical merger is the joining of two or more firms that perform different
stages of the production process into a single firm. For example, the Clayton Act would
permit the merging of an oil-drilling firm with a refining firm. So would conglomerate
mergers. A conglomerate is a firm that results from the merging of several firms from
different industries or markets. The combining of firms in tow entirely different
markets—washing machines and light bulbs, for instance, would be considered a
conglomerate merger. These loopholes in the Clayton Act—vertical and conglomerate
mergers—were closed in part by the Celler-Kefauver Antimerger Amendment, passed in
1950. Although the act has since been applied to vertical mergers, it has never been
applied to conglomerates.
Finally, the Clayton Act declared interlocking directorates illegal. An
interlocking directorate is the practice of having the same people serve as directors of
two or more competing firms. If the same people direct competing firms and advise
policies that effectively reduce industry output, they constitute a defacto monopoly.
Section 8 of the Clayton Act prohibits such arrangements if they “substantially reduce”
competition.
The Federal Trade Commission Act
The original purpose of the Federal Trade Commission Act, passed in 1914, was to
thwart “unfair methods of competition” among firms. The act empowered the Federal
Trade Commission to investigate cases of industrial espionage, bribery for the purpose of
obtaining trade secrets or gaining business, and boycotts.
7
Later the Wheeler-Lea
Amendment expanded the commission’s mandate to cover “unfair or deceptive acts or
practices” that harmed customers, including the sale of shoddy merchandise and
misleading or deceptive advertising.
The Purposes and Consequences of Antitrust Laws
The ostensible purpose of all these laws is to fight monopoly power by outlawing
business practices that prevent or retard competition. By forcing firms to restrict
production or fix prices surreptitiously, antitrust legislation makes collusion among
competitors more costly. Violations of the law carry fines and penalties on conspiring
firms and their employees.
7
Not all boycotts are prohibited, of course—only efforts designed to prevent goods from reaching their
intended designation. That is, a union cannot prevent goods from crossing its picket lines, and firms cannot
organize restrictions on the purchase of other firms’ products.
.
has in fact moved into the market for electronics and robotics.
Oligopoly power remains a cause for concern. The basis for competition,
however, is the.
quantity supplied is Q
1
.
Therefore the dominant producer will conclude that at price Pd, it
can sell the difference, Q
3
-Q
1
. For that matter, at every