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1. Chapter 6 IMPERFECT COMPETITION

2. Imperfect competition occurs when more than one seller competes for sales with other sellers, each of which has some price-making ability. Imperfect competition includes the market structures of monopolistic competition and oligopoly. 3. Economists have developed concentration ratios to tell how close an industry comes to the extremes of competition and monopoly. A low concentration ratio suggests a high degree of competition and a high concentration ratio implies a low degree of competition. 4. Monopolistic competition is characterized by a large number of sellers, each seller having a relatively small share of the total market, relative freedom of entry into the market and exit from the market, and product differentiation among sellers. Although monopolistically competitive firms tend to earn zero economic profits in the long run, they suffer from the problem of excess capacity. 5. The goal of persuasive advertising is to shift a firm’s demand curve to the right and make it less sensitive to price changes. Advertising is informative when it provides trustworthy information about the quality and price of a good or service or the location of suppliers. By informing potential customers about alternative sources of supply and pricing policies, advertising forces sellers to maintain low prices. 6. Price discrimination is the practice of charging some customers a lower price than others for an identical good or service even though there is no difference in the cost to the firm of supplying these consumers. A firm practicing price discrimination will charge a lower price to buyers with more elastic demand and a higher price to buyers with less elastic demand. 7. In oligopoly, a small number of firms compete with each other and each firm has significant price-making ability. Oligopolistic markets are characterized by high barriers to entry, economies of scale, and mergers. Uncertainty about the interaction of competing firms in oligopoly makes it virtually impossible to formulate a single theory of oligopoly behavior. However, game theory can be used to illustrate the mutual interdependence of firms in oligopolistic markets. 8. Oligopolies are characterized by horizontal mergers, vertical mergers, and conglomerate mergers. Of these three types of mergers, government regulators monitor proposed horizontal mergers most closely. The reason is that horizontal mergers can result in the uniting of formerly competing firms, thus increasing the monopoly power of the newly formed firm. 9. Government regulators are not necessarily the only force keeping an oligopolist in check. The threat of potential competition can also serve as an incentive for an oligopolist to produce a high quality product and sell it at a “competitive” price to consumers. Chapter Objectives After reading this chapter, you should be able to: 1. Distinguish between monopolistic competition and oligopoly. 2. Identify the goals and effects of advertising. 3. Explain how a seller successfully practices price discrimination. 4. Discuss the major theories of oligopolistic behavior. 5. Distinguish between a horizontal merger, a vertical merger, and a conglomerate merger. 1 2 Chapter 6: Imperfect Competition

6. Explain how the threat of potential competition encourages firms to produce a high quality product and sell it at a reasonable price to consumers.

Key Concept Quiz 1. concentration ratios _____ a the market structure closest to perfect competition 2. monopolistic competition _____ b the difference between the output corresponding to minimum average total cost and the output 3. product differentiation produced by a monopolistically competitive firm 4. excess capacity in the long run 5. price discrimination _____ c. a form of imperfect competition 6. oligopoly _____ d. a form of collusion 7. game theory _____ e. a market characterized by free entry and exit 8. cartel _____ f. provides an explanation for oligopolistic behavior 9. horizontal merger _____ g. the practice of charging some customers a lower 10. contestable market price than others for an identical product _____ h. tell us how close an industry comes to the extremes of perfect competition and monopoly ____ i. is a fundamental characteristic of monopolistic competition _____ j. when two firms selling similar products merge

Multiple Choice Questions 10. When markets are imperfectly competitive a. there is usually only one seller in a market b. firms have some price-making ability c. firms behave exactly like monopolists d. firms always behave like oligopolists 11. Concentration ratios typically refer to 12. top four firms in an industry 13. top two firms in an industry 14. top five firms in an industry 15. top 100 firms in an industry Chapter 6: Imperfect Competition 3

1. Monopolistically competitive markets are characterized by a. low concentration ratios b. high concentration ratios c. zero concentration ratios d. marginal concentration ratios 2. Product differentiation is a fundamental characteristic of a. monopolistic competition b. monopoly c. oligopoly d. perfect competition 3. If an online grocery company, Homegrocer.com of Seattle, is operating in a monopolistically competitive market and decides to raise prices it will a. lose a relatively large share of its market 16. lose a small share of its sales 17. not lose any sales a. lose all of its sales 18. The changes in the price of gas at a local Chevron station closely follow the changes in gas prices at the BP station down the road. This implies that these gas stations are operating in a. an oligopolistic market b. a perfectly competitive market c. a monopolistically competitive market d. a monopolistic market 4. Choice in a monopolistically competitive market involves a tradeoff in the form of a. excess capacity b. better quality products c. better quality service d. chronic shortages

5. If Oral Best sells toothbrushes in a monopolistically competitive industry, then in the long run, Oral Best will earn a. zero economic profit b. positive economic profits c. negative economic profits d. super-normal profits 6. Persuasive advertising by Starbucks will make the demand for Starbucks’ mochas a. more elastic b. less elastic c. perfectly elastic d. perfectly inelastic 4 Chapter 6: Imperfect Competition

7. If Starbucks’ advertising campaign is countered by an equally effective campaign by Seattle’s Best Coffee, such that the market share of each firm remains unchanged, one can conclude that a. the average total cost of Starbucks has increased b. the average total cost of Seattle’s Best Coffee has shifted upwards c. the consumer now faces a higher price d. all of the above 8. If MCI, AT&T and SPRINT engage in price discrimination, they are likely to charge a. a higher price to consumers with inelastic demand curves b. a higher price to consumers with elastic demand c. a lower price to consumers with inelastic demand curves d. the lowest possible prices 9. All of the following reasons may allow for an oligopolistic market to emerge except a. barriers to entry b. economies of scale c. mergers d. price-taking behavior 19. If the Grand Central movie theater practices successful price discrimination, it will charge a. the same price to all customers regardless of their elasticities of demand b. different prices to various customers regardless of their elasticities of demand c. higher prices to customers with more elastic demand schedules d. higher prices to customers with more inelastic demand schedules 20. A high concentration ratio in an industry suggests that a. the industry is perfectly competitive b. the industry is monopolistically competitive c. the dominant firms in the industry have negligible price-making ability d. the dominant firms in the industry have substantial price-making ability

1. Suppose that Hal’s Texaco is a retailer of gasoline in a monopolistically competitive market. In the long run, the firm will a. realize substantial economic profits b. provide the amount of output that minimizes average total cost c. provide less than the amount of output that minimizes average total cost d. have a demand curve that is perfectly inelastic 2. If Boeing is the only firm in a “contestable” market for commercial jetliners, a. Boeing cannot behave as though it is a monopoly even though it is the only firm in the market b. as a single firm in the market, Boeing can behave as a monopoly c. the potential entry of new firms enhances the monopoly power of Boeing d. the potential entry of new firms has no effect on the monopoly power of Boeing Chapter 6: Imperfect Competition 5

21. Boeing and Airbus compete for sales of commercial jetliners in a (an) _____market. a. perfectly competitive b. monopolistic c. oligopolistic d. monopolistically competitive 22. If the Top 4 concentration ratio equals 85 percent, the market is likely to be a. monopolistic b. oligopolistic c. monopolistically competitive d. perfectly competitive 23. 1 In the long run, firms in a monopolistically competitive industry tend to suffer from a. economic losses b. excess capacity c. dealing with strong labor unions d. governmental price ceilings applied to their products 24. For Coca-Cola Company, successful advertising would have the effect of a. shifting the demand for Coke rightward and making it less elastic b. shifting the demand for Coke rightward and making it more elastic c. shifting the demand for Coke leftward and making it less elastic d. shifting the demand for Coke leftward and making it more elastic 21. 2Because an oligopolistic market consists of a relatively small number of firms, they a. are mutually interdependent b. have the incentive to earn only normal profits c. operate similar to perfectly competitive firms d. tend to operate at the low points on their average total cost curves

22. A merger between two competing steel companies is a a. conglomerate merger b. vertical merger c. horizontal merger d. inflationary merger

True-False Questions 1. T F Both monopolistically competitive markets and perfectly competitive markets are characterized by price-taking behavior. 2. T F Vertical mergers are monitored most closely by government regulators. 3. T F An oligopolist has significant price-making ability. 4. T F A monopolistically competitive firm has limited price-making ability. 6 Chapter 6: Imperfect Competition

5. T F A price discriminating firm always charges higher prices to the customers who have highly inelastic demand curves. 6. T F Persuasive advertising makes a firm’s demand curve more elastic.

7. T F Monopolistically competitive firms behave like monopolies in the long run. 8. T F Monopolistically competitive firms can earn positive economic profits in the long run. 9. T F In a monopolistically competitive market, there are relatively few sellers. 10. T F Monopolistically competitive markets are characterized by product differentiation. 11. T F Game theory illustrates the mutual independence of firms. 12. T F Contestable markets are ones that are susceptible to potential competition. 13. T F If Microsoft argues that it is operating in a contestable market, it may be arguing that there area significant barriers to entry in this market. 14. T F Cartels are likely to reduce output below the competitive level. 15. T F Cartels are more susceptible to cheating if firms face identical costs. 16. T F A monopolistically competitive firm produces more output than a competitive firm, and this excess is known as excess capacity. 17. T F A high concentration ratio implies that the industry is operating in a perfectly competitive market.

318. T F Oligopoly involves a considerable dose of competition and a small dose of monopoly.

19. T F Experience shows that cartels are quite easy to form and operate.

20. T F Grocery stores in large cities likely provide an example of oligopoly. 21. T F Farming and commercial fishing provide good examples of oligopoly. 22. T F The acquisition of Cleveland Iron Ore Co. by U.S. Steel Co. represents a conglomerate merger.

423. T F When Delta Airlines charges different coach fares to different travels on a flight from Seattle to Chicago, it engages in price discrimination. 24. T F When Hollywood Video and Blockbuster Video entered the market for rental videos, they became perfectly competitive firms. 25. T F If the four largest firms control 75 percent of a market, they are regarded as monopolistically competitive sellers. Chapter 6: Imperfect Competition 7

Application Questions 1. Suppose you are the chief executive officer for the major U.S. brewing company, Soma. At the annual Brewers Association Meetings held in Seattle, you and your fellow CEOs from other brewing companies decide (secretly, of course) to collude on price and to allocate shares of the market between firms. Suppose that the price is set at $30 per barrel of beer and your share of the market is set at two million barrels per year. The demand, marginal revenue, average total cost, and marginal cost curves for Soma are shown in the graph below. Will Soma make a profit under the cartel agreement? If so, how much profit? Identify the area of profit on the graph.

2. In the scenario presented in question 1, does Soma have an incentive to cheat on the agreement? Why or why not? Use a graph to justify your answer.

Key Concept Answers 1. i 6. c 2. a 7. g 3. j 8. e 4. b 9. l 5. h 10. f

Multiple Choice Answers 1. b 6. c 11. a 16. a 21. a 2. a 7. a 12. d 17. c 22. c 3. a 8. a 13. d 18. b 4. a 9. b 14. d 19. b 5. a 10. d 15. c 20. a

True-False Answers 1. F 6. F 11. T 16. F 21. F 2. F 7. F 12. T 17. F 22. F 3. T 8. F 13. F 18. F 23. T 4. T 9. F 14. T 19. F 24. F 5. T 10. T 15. F 20. F 25. F 8 Chapter 6: Imperfect Competition

Application Question Answers 1. Soma will make a profit under the cartel agreement. The area of profit under the cartel agreement is shown in the graph by the heavy-lined rectangle. The profit is ($30 - $10) x 2 million barrels = $40 million.

2. Soma has an incentive to cheat because the profit maximizing level of output is 4 million barrels—MR = MC at 4 million barrels. Soma’s profits could be ($30 - $12) x 4 million barrels = $72 million. The profit is shown below as the area inside the heavy-lined rectangle.