Pure monopoly, together with the polar case of pure
competition are the exceptions, not the rule, in our economy.
The market structures of most industries fall somewhere in
between these two extremes and can be classified either by
monopolistic competition or oligopoly.
This figure illustrates the continuum of market structures
based on one key element, the number of firms in the industry.
In the second half of this lesson, we'll examine the
structure, conduct, and performance of monopolistic
competition and then tackle oligopoly in the next lecture. The
defining characteristics of monopolistic competition are; one,
a relatively large number of sellers, two, easy entry to and
exit from the industry, and three, product differentiation.
The first and second characteristics provide that competitive
aspect of monopolistic competition, while the third
characteristic contributes the monopolistic aspect.
In fact, monopolistic competition is one of the most prevalent
market structures in the American economy. From mattresses to
men's suits, from book publishing to paperboard boxes, and
from upholstered furniture to fur goods, all these industries
are monopolistically competitive just as are the industries
producing the several hundred magazines on a newsstand rack
and the 50 or so competing brands of personal computers.
And then of course, there are the numerous brands of gasoline
that can be found at the four corners of many intersections
and the several grocery stores in a neighborhood, all carrying
the same products but competing on the basis of location and
brand name. Perhaps the best way to understand monopolistic
competition is to focus on the differences between
monopolistic competition and oligopoly on the one hand, and
monopolistic competition and perfect competition on the other
hand. There are three key differences between oligopoly and
monopolistic competition. First, a monopolistically
competitive industry is relatively un-concentrated. That is,
each firm in a monopolistically competitive industry has a
comparatively small percentage of the total market so that
each has limited control over market price. In contrast,
market concentration in an oligopoly is relatively high, and
so too is the oligopolists’ price making power. This is
because there are only a small number of firms in concentrated
oligopoly so that each has a relatively large share of the
market. In economics, there are a number of different measures
of market concentration. Let's take a quick look at one of
them, the concentration ratio. The four-firm concentration
ratio is simply defined as the percent of total industry
output accounted for by the four largest firms. So if the
widget industry has the following market characteristics, what
is its four-firm concentration ratio?
That's right, the four-firm concentration ratio is 70 percent.
This table lists the concentration ratios for a sample of
industries.
Those industries in black are generally considered
oligopolies, while those in red are generally characterized as
monopolistic competition. Note how high market concentration
is in oligopolies such as chewing gum, cigarettes, cereals,
and greeting cards. In these industries four firms have over
85 percent of the market. In contrast, market concentration is
quite low for monopolistically competitive industries such as
metal doors, fur goods, paperboard boxes, and wood furniture.
The reason why concentration ratios are so important in
studying market structure is that they help serve as an
indicator of the degree of strategic interaction that might
occur in an industry.
Strategic interaction is a term that describes how each firm’s
business strategy depends on their rivals’ strategy. Put
simply, as the number of firms in an industry shrinks an
industry concentration grows, each firm is more likely to base
his or her pricing and output decisions on how other firms in
the industry are likely to respond.
At the same time, with this mutual interdependence recognized,
each firm is more likely to want to collude with the others
when setting price and quantity, where collusion may be
defined as the concerted action by firms to restrict output
and fixed price. This observation leads to two additional
important distinctions between oligopoly and monopolistic
competition. Because of the small number of firms in an
oligopoly, collusion is possible. However, the relatively
large number of firms in a monopolistically competitive
industry ensures that collusion is all but impossible.
At the same time, with numerous firms in the industry there is
no feeling of mutual interdependence among them. That means
that each firm determines its policies without considering
possible reactions of its rivals. In fact, this is a very
reasonable way to act in a market in which there are numerous
rivals. For example, the 10 or 15 percent increase in sales
which a firm may realize by cutting prices will be spread so
thinly over its 20, 40, or 100 rivals, that for all practical
purposes the impact on their sales will be imperceptible. That
means that rivals reactions can be ignored because the impact
of one firm’s actions on each of its many rivals is so small
that these rivals will have no reason to react. As we shall
see in the next lecture, this is certainly not the case with
oligopoly.
