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Monopolistic and oligopolistic competition: theory and examples
Introduction
One of the most important characteristics of an industry is its competitiveness. It often determines how profitable the businesses within this industry are or potentially can be, whether they have incentives to provide quality products and happy the customers are purchasing the products. In microeconomics, three types of market competition are usually being considered: monopoly, oligopoly and perfect competition. Monopoly implies that there is sole supplier of a good or service in the market who is a price setter and most often exploits its monopolistic power to derive excessive profits. The opposite to it is perfect competitions, where large – theoretically, infinite – number of firms sell homogeneous (not differing from each other) products to infinite number of buyers – in this case they are the price takers, do not earn profits in the long run as they only cover their economic costs. Perfect competition is barely existent in the real world due to the strict theoretical criteria, but some markets (e.g. stock exchange) are close approximations. Oligopoly is in between, but closer to monopoly: in oligopoly the market is dominated by small number of sellers, which may result in different outcomes depending on the level of rivalry between the firms. On the one hand, it can result in higher prices for consumers and abnormal profits for producers if the sellers manage to maintain non-rival relationship between them or, worse, engage in cartel behavior by agreeing not to lower prices or to limit amounts of advertisement, which is strictly prohibited in most economies; on the other hand, fierce competition, especially when it is expressed in a price war, may be favorable for customers.
These three categories, however, is hardly enough to reflect all the variety of competition levels in the real world. Fortunately, there are precise (are close to precise) ways to measure competitiveness, with Herfindahl-Hirschmann index (HHI) being the most widely used. HHI is a sum of squares of each firm’s fraction of total output produced in the industry with number varying from 0 to 1. In monopoly, with one firm controlling the entire output, HHI is equal to 1, while in perfect competition, with assumed infinite number of firms and infinitely market share held by each, HHI is approaching 0. The index is an important indicator of competitiveness in oligopolies, especially when analyzing horizontal mergers. According to Matsumoto, Merlone and Szidarovsky (2012), higher HHI indicator is associated with higher price-cost margins and can be a sign of conspiracy within the industry.
With theoretical criteria of perfect competition being too strict to be met in the real world, another way to describe competitive markets had been needed which led to development of a new concept – monopolistic competition, which, together with oligopoly is the topic of this work. The following chapters will provide theoretical background as well as examples of both kinds of competition.
Monopolistic competition
Theoretical background
The theory of monopolistic competition was developed by Edward Hastings Chamberlin and presented to the world in the book Theory of Monopolistic Competition (1993). The work may have not received worldwide recognition and arguably had little influence on economics in general (Telser, 2001), as it does not lead to testable predictions (which often happens to economic theories that try to be realistic), but it can be treated as a decent attempt to explain real microeconomic world theoretically.
Monopolistic competition is a type of imperfect competition, where many firms sell products, which are similar, but not the perfect substitutes, as they are differentiated in terms of quality, branding or location. Unlike in perfect competition, firms have some control over the prices, even though they are price-takers in general. With coercive government, monopolistic competition may turn into government-granted monopoly – one where competitors are excluded from the market by law and regulations. Monopolistic competition implies free barriers to entry and exit, meaning that the firms cannot earn abnormal profits in the long run: the firms make profits if price (P) is higher than average total cost (ATC), they make losses if P<ATC and earn zero profit if P=ATC. When firms within a monopolistically competitive industry make excessive profits, the new firms should have an incentive to enter, and if they do, supply curve for the industry shifts to the right. At the same time, with demand fixed and increased number of the products available on the market due to new entries, each firm’s demand curve shifts to the left – in both cases prices go down. Theoretically, the process must continue until P is equal ATC – at this point new firms stop entering the market as there is no more space for making profits. The opposite happens when the firms make losses – in that case the participants have incentive to exit until the price come back to P=ATC level. It needs to be mentioned that profit maximization is one of the assumptions.
One of the integral parts of monopolistic competition is the Theory of Excess Capacity, which states that, in monopolistic competition, actual output produced by the firms is smaller than Ideal output – something that is implied by perfect competition. Unlike in perfect competition where demand curve is flat, demand curve faced by each competitor in monopolistic competition is downward sloping. For that reason each firm will produce less than ATC minimizing output as producing more will lead to higher marginal costs than marginal revenue, meaning that each firm in the industry is less than of optimal size. As quoted in Adegoke Yotunde (2012), Chamberlin argues that excess capacity occurs when there is not enough price competition within the industry. The assumptions for access capacity are the following (2012: 107):
- There are many firms in the industry.
- The firms produce similar, though not perfectly substitutable, products
- A firm gains new customers if it decreases the price and loses customers if raises them
- Preferences are uniformly distributed within the variety of the product
- Nobody has institutional monopoly in the industry
- There is no barriers to entry
- Long-run costs of the firms are identical and U-shaped
- No price competition within industry
In fact, the first seven bullets are the characteristics of monopolistic competition itself, while lack of price competition is the reason why excess capacity occurs. Among the possible reasons why price competition may be non-existence are such as implicit agreements to maintain the price level, uniform prices on distributors and some marketing considerations, for instance, price cuts may be associated with inferior quality or they may be an attempt to justify prices by product differentiation (2012: 107).
Discussion
While empirical rigor of monopolistic competition approach and its predictive power might be questionable, in my opinion, there are at least two reasons to admire Chamberlin’s theory. At first, it is a legitimate effort to step back from purely theoretical and unrelated to the real world idea of perfect competition by modeling a theory that approximates the reality much better (arguably, that is why it lacks rigor). At second, monopolistic competition is to some extent a bridge between economics and marketing, as it incorporates branding and advertising as variables that implicitly determine microeconomic equilibrium – one may guess why Chamberlin’s work has been so widely criticized by hardcore economists.
Chamberlin’s argument about differentiation as justification of price is an intriguing one. Price setting is the privilege of monopolists and is expression of monopolist power. Logic suggests that if a company succeeds at differentiation it has greater capacity to “justify” higher prices. Now, while in some markets may be achieved by superior/inferior quality, there can be few arguments against the assumption that in a big variety of markets differentiation is achieved by branding and manipulation of quality perception – clothes industry is an example. What Chamberlin, among other things, tacitly claims is that equilibrium in monopolistic competition partly directly depends on success of branding efforts undertaken by the firms. It also implies that consumers are ready to pay more for exactly the same product if it has been successfully promoted, which is perfectly true but may interfere with economic understanding of people as homo economicus. Was Chamberlin’s theory coldly accepted because it undermined one of the basic assumptions of economics is an open question.
While irrationality of human beings is perhaps beyond doubts nowadays (which was beautifully manifested in awarding Kahnemann with Nobel Prize in economics), there are still legitimate attempts to explain response to advertisement as a rational one. In his book Armchair Economist: Economics and Everyday Life (1993), Steven Landsburg, talking about product enhancements by celebrities, argues that consumers perceive at as a form of insurance: investing in promotion of a good by celebrity, producer demonstrates faith in the own product, while consumers subsequently share the cost among themselves in form of price premium. The same applies to the banks which invest hardly in the design of location – according to Landsburg, not so much because they want to make clients feel comfortable, but rather because they are willing to demonstrate their commitment to a particular place, meaning that they do not plan to leave the place in foreseeable future. In both cases branding efforts are mere demonstration of quality, which implies that the product is differentiated by its characteristics, with branding just informing about differentiation. One may argue that it is not always the case in the real world, where advertisement and positioning are often the only sources of differentiation, but this is not the main focus point of this essay.
Celebrate diversity?
So is monopolistic competition good? Capozzi (n.d.) states several advantages of monopolistic competition such as higher prices, product development and potential for price discrimination. These, however, serve only producers (if we accept their well-being as total being we should probably turn every industry into monopoly) – on consumer side high prices are definitely a disadvantage, while differentiation is perhaps a good thing (subject to one’s values and beliefs). The source of differentiation also matters: if the competing companies bring their best efforts to enhance the quality of their products with branding efforts merely reflecting their achievements in terms of quality, then everybody should be better off; on the other hand, when companies sell homogeneous products while heavily investing in marketing campaign, only advertisement agencies are better off – Frederic Beigbeder would argue that the latter situation dominates in the world.
I would like to offer two examples of monopolistically competitive industries representing two scenarios described above. The first is entertainment industry – music, professional sports (within one sport) or even books. The markets follow definition of monopolistic competition, as similar products are being offered by many producers with producers (no matter how one defines them – as singers/sportsmen/writers or recording companies/sport clubs/publishers) competing in quality. Even if it is perceived quality rather than objective, still it is determined by consumers’ tastes and preferences rather than aggressive marketing measures. Interestingly, these industries are, as Taleb (2005) puts it, Extremistan ones – very small fraction of musicians/sportsmen/writers account for huge fraction of total sales.
On the other end are the industries where products themselves are little (if at all) differentiated, but the companies create differentiation artificially – those are hygiene products (tooth pastes, soaps, shaving foams), certain types of food and beverages (like yogurt, beer), clothes etc. Here the differences in quality of products are minor and the companies enhance differentiation mostly by advertisement campaigns. I believe, in this case consumers are worse off than in case of entertainment.
Non-competitive markets: monopolies and oligopolies
Monopoly
Monopoly refers to a market situation when the sole producer controls the whole output with no close substitutions for a product. Monopolists use their power to produce fewer goods and to sell them at higher prices (similar to what firms in capitalistic competition do, but to a greater extent). Monopolies are characterized by insurmountable barriers to entry, either natural, such as access to resources, economy of scale, capital requirements etc., or legal, such as laws and regulations – the latter take place in case of coercive monopolies. While in some cases monopolies are established and supported by governments, most often competition law restrict monopolistic power. Holding a big market share is not illegal in itself, but some practices that are deemed to be abusive may result in sanctions against the company.
Monopolists earn excessive profits by setting prices above marginal costs – there can do due to two main reasons: i) demand is inelastic; ii) there is no threat of entry. While it is good to be a monopolist, it is much worse to purchase from one – as there is no competition, producer has very little incentive to produce quality products. In general, monopolies are believed to be economically inefficient and governments seek to avoid them.
One of the most intriguing case on monopoly is De Beers case in diamonds industry. Until 19th century, diamonds were rarity with only monarch wearing them. However, after diamond rush begun in Africa in the second half of century, the supply might have gone up so much that diamonds could cease be perceived as luxury – and that was when De Beers came into play. By 1888, the company established control over production and distribution of diamonds coming out of South Africa. By the start of 20th century the company controlled 90% of worldwide diamonds output, but it was only just a beginning: after death of Cecil Rhodes, the establisher of De Beers, Ernest Oppenheimer obtained (or rather bought) a place on the board of directors and became the chairman in 1927. Having signed exclusive contracts with both suppliers and buyers, De Beers made it impossible to operate in the industry without their participation: not only did they control the number of diamonds sold each year, they were also in charge for all the marketing operations. In the U.S., a huge market for luxury goods, men were being convinced that there is a positive correlation between the size of diamond presented to fiancée and strength of their love; the slogan “diamonds are forever” could be called without exaggeration one of the most effective ever. The monopolistic domination of De Beers lasted until the early 2000’s, when they were eventually forced to give up some of their power under the pressure of both the U.S. and the European Union (Goldschein, 2011).
The question is whether monopoly in diamonds market is a bad thing. It is pretty hard to imagine diamonds being a worthless trinket, and it would have been so if the market were competitive. Had not De Beers established tight control over diamonds output, the competition would have driven prices lower and lower, and no doubt that the industry would have lost its romantic appeal. On the other hand, all of this suggests that the value of diamonds is not the real value, but rather artificial one. It is a legitimate opinion, but I would not encourage one going to a woman who has just received a diamond ring and explaining that she is not supposed to be happy because ‘the value is artificial’. After all, it is utility that matters for economists.
Oligopoly
Oligopoly is a market that is dominated by a small number of producers. Oligopolies often occur as a result of mergers and acquisitions with increasing power of particular firms. Apart from Herfindahl-Hirschmann index mentioned in the introduction, concentration ratios – markets shares of chosen number of market leaders (e.g. four) – are used for quantitative representation of oligopolies. The higher the fraction, the less competitive the industry is.
The most interesting thing about oligopoly is that decisions of one firm influence decisions of the others; more specifically, expected responses of other firms might influence decision of a firm in the first place, tightly connecting oligopoly with game theory. Like monopolists, firms in oligopolies enjoy abnormal profits due to high barriers to entry. Another important feature of oligopolies is that they tend not to compete in prices, but rather in advertisement and product differentiation, which makes them similar to firms in monopolistic competition. There is also a strong incentive for firms in oligopolies to engage in cartel behavior with cartel being equivalent of monopolists, but such practices are strictly prohibited by antitrust law in majority of economies.
Even though there are similarities in how firms compete in oligopolies and monopolistic competition (mostly, non-price competition), there is a major difference: firms in oligopolies are less likely to be involved in product diversification than firms in monopolistic competition. Ottaviano and Thisse (2011) conclude that large number of firms and substantial product diversity are associated with weak economies of scope and wide product differentiation – something peculiar to monopolistic competition. The diversification can be explained from marketing point of view: differentiated products often appeal for particular market segments, so launching another product for another segment may increase sales and provide some economy of scope, though it is never fully exploited in monopolistic competition due to excess capacity.
Conclusion
In this work the types of competition that are present in the real world were analyzed with the main focus on monopolistic competition. In my opinion, monopolistic competition is a positive phenomenon when the firms compete improving quality rather than in amounts of advertisement with latter being unproductive activity both adding costs to producers and returning to customers in the form of higher prices.
Talking about monopolies, De Beers case demonstrates that, while monopolies are a negative thing, in some cases, such as luxury goods, where control of supply and maintenance of high prices are necessary to support reputation, it may not be that obvious, and in my opinion, society is better off with contribution of De Beers.
Finally, it is shown that oligopoly possesses some features of monopoly, such as high barriers to entry, and some of monopolistic competition – for instance, non-price competition and product differentiation. However, monopolistic competition differs in a way that individual firms tend to diversify products more often.
References:
Agedoke Yotunde, O., (2012). The Theory of Monopolistic Competition: Implication for Excess Capacity in the Global System for Mobile Communication Industry in Nigeria. International Research Journal of Finance and Economics, 94. 103-113.
Capozzi, Catherine (n,d) The advantages of Monopolistic Competition. Retrieved from http://smallbusiness.chron.com/advantages-monopolistic-competition-20585.html
Goldschein, E. (2011). The Incredible Story Of How De Beers Created And Lost The Most Powerful Monopoly Ever. Business Insider, Dec 19, 2011. Retrieved from: http://www.businessinsider.com/history-of-de-beers-2011-12?op=1
Landsburg, S.E. (1993). The Armchair Economist: Economics and Everyday Life. New York: Pocket Books.
Matsumoto, A., Merlone U., and Sziradovszky, F. (2012). Some notes on applying the Herfindahl–Hirschman Index. Applied Economics Letters, 19, 181-184.
Ottaviano, G.I.P., and Thisse J.-F. (2001). Monopolistic Competition, Multiproduct Firms. And Product Diversity. Manchester School, 79-5. 938-951.
Taleb, N.N. (2007). The Black Swan: The Impact of the Highly Improbable. New York: Random House.
Telser, L.G. (2001). Monopolistic Competition: Any Impact Yet. Journal of Political Economy, 312-315
