C H A P T E R 12 Monopolistic Competition and Oligopoly CHAPTER OUTLINE 12.1 Monopolistic Competition I n the last two chapters, we saw how firms with monopoly power can choose prices and output levels to maximize profit We also saw that monopoly power does not require a firm to be a pure monopolist In many industries, even though several firms compete with each other, each firm has at least some monopoly power: It has control over price and can profitably charge a price that exceeds marginal cost In this chapter, we examine market structures other than pure monopoly that can give rise to monopoly power We begin with what might seem like an oxymoron: monopolistic competition A monopolistically competitive market is similar to a perfectly competitive market in two key respects: There are many firms, and entry by new firms is not restricted But it differs from perfect competition in that the product is differentiated: Each firm sells a brand or version of the product that differs in quality, appearance, or reputation, and each firm is the sole producer of its own brand The amount of monopoly power wielded by a firm depends on its success in differentiating its product from those of other firms Examples of monopolistically competitive industries abound: Toothpaste, laundry detergent, and packaged coffee are a few The second form of market structure we will examine is oligopoly: a market in which only a few firms compete with one another, and entry by new firms is impeded The product that the firms produce might be differentiated, as with automobiles, or it might not be, as with steel Monopoly power and profitability in oligopolistic industries depend in part on how the firms interact For example, if the interaction is more cooperative than competitive, firms could charge prices well above marginal cost and earn large profits In some oligopolistic industries, firms cooperate, but in others, they compete aggressively, even though this means lower profits To see why, we need to consider how oligopolistic firms decide on output and prices These decisions are complicated because each firm must operate strategically—when making a decision, it must weigh the probable reactions of its competitors To understand oligopolistic markets, we must therefore introduce some basic concepts of gaming and strategy We develop these concepts more fully in Chapter 13 The third form of market structure that we examine is a cartel In a cartelized market, some or all firms explicitly collude: They coordinate prices and output levels to maximize joint profits Cartels can arise in markets that would otherwise be competitive, as with the OPEC oil cartel, or oligopolistic, as with the international bauxite cartel 452 12.2 Oligopoly 456 12.3 Price Competition 464 12.4 Competition versus Collusion: The Prisoners’ Dilemma 469 12.5 Implications of the Prisoners’ Dilemma for Oligopolistic Pricing 472 12.6 Cartels 477 LIST OF EXAMPLES 12.1 Monopolistic Competition in the Markets for Colas and Coffee 455 12.2 A Pricing Problem for Procter & Gamble 467 12.3 Procter & Gamble in a Prisoners’ Dilemma 471 12.4 Price Leadership and Price Rigidity in Commercial Banking 475 12.5 The Prices of College Textbooks 476 12.6 The Cartelization of Intercollegiate Athletics 480 12.7 The Milk Cartel 481 451