CHAPTER 10

OLIGOPOLY AND MONOPOLISTIC COMPETITION

I. CHAPTER OVERVIEW

Chapter 10 explores various sources of monopoly power and the effect of imperfect competition on the
marketplace. Although the measured degree of industrial concentration has declined in the United States in
recent years, the ability of firms to differentiate their products produces monopoly power that has an important
impact on market participants. Perfect competition provides consumers with the lowest prices and the highest
levels of output, but concentration may lead to increases in research and innovation. Thus, evaluating the
impact of imperfect competition is not an easy task.
As you work through this chapter, you will find that analysis of imperfect competition requires a solid
understanding of both the perfectly competitive model and the monopoly model. Depending upon the nature of
the firms in the industry, behavior may more closely follow one model than the other. For example, the market
for personal computers is more like a perfectly competitive environment, while the market for automobiles is
more like a monopoly environment. In any case, most “real world” markets can be placed somewhere along a
continuum between the perfectly competitive and monopoly extremes.
Over the past century, policymakers in the United States have protected and served the interests of
competition in most instances. A major question that must be considered as you work through this chapter is as
follows: Do the benefits to competitive markets outweigh the costs of protecting and preserving them? Later
chapters in the text will help you to develop a complete answer to this question.

II. LEARNING OBJECTIVES

After you have read Chapter 10 in your text and completed the exercises in this Study Guide chapter, you should
be able to:
1. List the determinants of market power, and understand how cost structure, barriers to entry, and the
potential for collusion influence the translation of that market power into a particular market structure of
imperfect competition.
2. Understand the spectrum of imperfect competition, stretching from perfect competition at one extreme
to monopoly at the other, and identify examples of industries that appear at various spots along the length
of this spectrum.
3. Understand the potential risks and gains involved when a few firms collude to determine industry price
and/or output. Use the model of cartel behavior to illustrate the effects of tacit collusion on markets.
4. Describe the importance of game theory for modeling firm behavior in noncollusive imperfectly
competitive markets.
5. Conceptualize how profit-maximizing behavior in large firms might be compromised by the divorce of
ownership from control. Translate profit-maximizing behavior from the theoretical models to the “real
world” using rules of thumb like cost-plus markup, or using price discrimination.
6. Evaluate to your own satisfaction the Schumpeterian hypothesis that significant market power leads to
extensive and socially desirable programs of research and development that would otherwise not be
forthcoming.
7. Understand how imperfect competition leads to prices which exceed marginal cost, and use
deadweight loss to evaluate the associated welfare cost.
8. Compare and contrast alternative intervention strategies that governments might pursue in order either
to promote the emergence of competitive markets or to manage big business where it must exist due to the
importance of economies of scale in production.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.
A B
__ Market power 1. The analysis of situations involving two or more decision makers who have
conflicting objectives.
__ Concentration- 2. Pricing strategy in which firms take the expected average cost of a product and
ratio mark it up by a percentage.
__ Herfindahl- 3. The loss in real income to both buyers and sellers that arises due to the existence
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Hirschman of monopoly, tariffs, taxes, or other distortions.

Index
__ Strategic 4. The percent of total industry output that is accounted for by the four (or eight)
interaction largest firms.
__ Tacit collusion 5. Denotes a situation in which two or more firms jointly set their prices or outputs,
divide the market among them, or make other business decisions jointly.
__ Game theory 6. Laws that prohibit certain kinds of anticompetitive behavior or restrict the emergence
of highly concentrated industries.
__ Price 7. Occurs in large businesses in which the owners have given decision-making
discrimination authority over to managers.
__ Separation of 8. Refers to the ability of a firm to control price and dominate other competitors in a
ownership from market.
control
__ Markup 9. General term that describes how each firm’s business strategy depends upon its
pricing rivals’ business behaviors.
__ Schumpeterian l0. The inability of firms to capture the full monetary value of their inventions.
hypothesis
__ Inappropriability 11. Argues that the innovation produced by large firms more than offsets the losses
brought about by too high prices.
__ Deadweight loss 12. Allows specialized agencies to oversee the prices, outputs, entry, and exit of firms in
certain industries.
__ Regulation 13. Occurs when firms refrain from competition without explicit agreements.
__ Antiturst policy 14. The sum of the squares of the percentage market shares of all participants in a
market.
__ Collusive 15. Occurs when the same product is sold to different consumers for different prices.
oligopoly

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Behavior of Imperfect Competitors

l. Declining costs and artificial or collusive barriers to entry can give firms operating in a particular market
some degree of market power and thus some discretion over both quantity and price. One possible result is
monopoly—a single seller of a particular commodity. Another possibility is oligopoly—a few sellers of the
same product. Oligopolists need to be aware of the actions and reactions of other firms when they contemplate
changes in their behavior. Monopolistic competition is a third possible structure, involving many sellers of
close substitutes; long-run equilibrium here presents zero pure economic profit but inefficient cost allocations.
Market power can also be measured by the Herfindahl-Hirschman Index. The index is the sum of the
squared market shares of all participants in the market. It differs from the concentration ratio in that it better
reflects the existence of a single dominant firm in an industry with many smaller, or “fringe”, producers. As
this index approaches 10,000, the industry approaches monopoly. Both the CR and the HHI can be useful if one
is trying to understand the degree of monopoly power that exists in an industry.
2. Market power in an industry can be measured by concentration ratios, which define the percentage of total
industry output that is controlled by the largest firms. (Concentration ratios are usually based on the largest four
or eight firms, but can be calculated based upon any number of competitors.) As this percentage gets larger, the
industry moves away from competition and toward monopoly.
3. Oligopolists can try to collude in a way that mimics a monopoly supplier, but there are risks. Collusion is
illegal in the United States, and in many other countries. Collusion presents circumstances in which it is
profitable to cheat, but if all partners cheat, then every firm can end up worse off. Cartels, such as DeBeers in
the diamond industry and OPEC in the oil industry, are collusive oligopoly arrangements that exist in
international markets.
4. Colluding oligopolists maximize their joint profits by producing where the marginal cost of each firm is set
equal to the marginal revenue of market demand.
5. Monopolistic competitors maximize profits where marginal cost equals the marginal revenue for their
specific variant of product. Product differentiation occurs as each firm tries to design a product that has some
unique characteristics, guaranteeing it some degree of monopoly power. Free entry and exit drive long-run
equilibrium profits to zero, but because the monopolistic competitors’ demand curves are downward-sloping,
production will not occur at minimum average cost.
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6. Rivalry exists in oligopolistic industries due to mutual interdependence. Modeling this rivalry is very
difficult; industries tend to develop their own standards of behavior depending on the particular nature of the
production and distribution process and on the demand for the product itself. Game theory is a method of
analysis that is used in situations involving two or more decision makers who have conflicting objectives.
Game theory can help us to understand and even to predict, in some cases, the behavior of rivals in an industry.
7. Price discrimination is a technique used by firms with monopoly power to extract additional consumer
surplus. Price discrimination schemes occur when firms charge different consumers different prices for the
same product. Firms want to charge higher prices to consumers whose demand is more inelastic.

B. Innovation and Information

l. In large firms, ownership is often divorced from control. This means that the owners of the firm have given
decision-making authority over to a group of managers, who may or may not be operating in the best interest of
the owners. Managers might be more interested in increasing their own salaries or improving their own
working conditions than maximizing profits. Managers have less incentive to pay dividends; often it is in their
own best interest to plow retained earnings back into the firm rather than to distribute them to owners.
2. Because of the difficulty in assessing actual market demand and cost structures a priori, firms approximate
the profit-maximizing strategies that we have developed in theory by using rules of thumb. For example,
markup pricing rules are strategies that set price at a percentage over estimated average production costs. This
may land us exactly on the demand curve; the rules can be adjusted with experience to converge toward profit-
maximizing pricing behavior in a world where managers do not operate with perfect information or certainty.
3. The Schumpeterian hypothesis suggests that large firms support valuable research and development that
would not otherwise be forthcoming. However, in recent years small businesses have forged ahead, increasing
their share of R&D advances. The real issue involves incentives for firms to innovate and to take risks. If firms
believe that they will be unable to appropriate a significant portion of the benefits to R&D, they will be
unwilling to make sufficient investments. Because information is costly to produce but cheap to reproduce,
markets in information are subject to severe market failure. For example, markets for “bootlegged” computer
programs exist in most countries around the world, making it more difficult for firms to justify large
investments in new software.

C. The Balance Sheet on Imperfect Competition

l. Imperfect competitors generally produce too little and charge prices in excess of marginal cost. The
welfare cost of their approach can be measured in terms of diminished consumer surplus—the deadweight loss
that results from their exploiting whatever market power is available. The notion that big business exploits
consumers is pervasive and so governments and policy-makers in the United States are encouraged to support
competitive behavior.
2. Intervention strategies are used by governments as they attempt to preserve competitive markets. These
include antitrust laws, regulation, government ownership or nationalization, price controls, and taxation.
Regardless of their form, these actions all indicate a desire on the part of governments to encourage the
efficiencies brought about by competition.

V. HELPFUL HINTS

l. As you learned in Chapter 9, entry barriers are important to the emergence of imperfect competition.
However, notice that these barriers evolve over time. For example, IBM had a near monopoly in the market for
computers throughout the 1960s and 1970s. Their economic profits encouraged entry by competitors; “Big
Blue” was able to hold them at bay for years due to the fact that it was heavily invested in research and
development. This led to large numbers of patents on new products. However, with the emergence of the
personal computer around 1980, rivals burst into the market with a passion. Economic profits were soon eroded
by fierce competition among firms in the industry, and IBM now sees itself fighting for market share.
2. Oligopoly behavior is very difficult to model, posing great challenges for economists. In oligopolistic
industries, firms must explicitly recognize and react to their competitors. This mutual interdependence is one of
the factors that makes modeling difficult. If you think about big industries in the U.S. economy, you can
imagine why. Domestic airlines have a system of pricing that is mystifying to even the most knowledgeable
travelers, auto producers use a complex and ever-changing system of rebates and financing incentives, and
producers of breakfast cereals have an endless variety of products on the grocery store shelves. All of these
industries are dominated by domestic oligopolies, requiring that firms be aware of the responses of competitors
to changes in prices and output. Because of this mutual interdependence, economists have a wide class of
models from which they can pick and choose when describing oligopoly behavior. There is no single model
that can accurately generalize the actions and reactions of rivals.
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3. Figure 10-6 in your textbook compares the long-run perfectly competitive market equilibrium with the
long-run monopoly solution using the simplifying assumption that marginal costs are fixed and constant. The
result in no way depends upon this assumption. If marginal costs are upward-sloping, there is still a deadweight
loss to monopoly. The assumption simply makes the illustration more clear.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.

A. Behavior of Imperfect Competitors

l. Which of the following characteristics tends to prevail in highly concentrated markets?
a. Slightly higher than normal profits.
b. Above-average advertising expenditure.
c. Above-average research-and-development expenditure.
d. Below-average price flexibility.
e. All the above.
2. A concentration ratio describes the:
a. percentage of total industry sales accounted for by the largest four to eight firms.
b. percentage of total industry sales accounted for by the smallest four to eight firms.
c. degree of regulatory power that government policy-makers have over an industry.
d. degree of decision-making power that the owners of a firm have.
e. significance of antitrust policy in a particular industry.
Please use the following data to answer questions 3 and 4. Suppose the market for toy trains is composed of
seven competitors with the following market shares;
Little Toot Toys 55% Trains R Us 3%
I Think I can 25% Thomas Trains 3%
Engines Inc. 8% The Fastest Trains 2%
Silver Streak 4%
3. In this industry, the four-firm concentration ratio is:
a. .12
b. .92
c. 3730
d. 3752
e. none of the above
4. In this industry, the Herfindahl-Hirschman Index is:
a. .12
b. .92
c. 3730
d. 3752
e. none of the above
5. Which of the following represents a contrived but nonetheless legal barrier to entry that might support an
oligopolistic market structure?
a. Price setting below the lowest price that a potential new entrant could afford to charge.
b. A tariff that keeps all but a trickle of foreign products off the domestic market.
c. Product differentiation among a few producers.
d. Average cost curves that reach their minima at roughly 30 percent of market demand.
e. All the above.
6. Which alternative to question 5 would have been correct if the barrier to entry were a cost barrier?
a. Price setting below the lowest price that a potential new entrant could afford to charge.
b. A tariff that keeps all but a trickle of foreign products off the domestic market.
c. Product differentiation among a few producers.
d. Average cost curves that reach their minima at roughly 30 percent of market demand.
e. All the above.
7. Which alternative to question 5 represents an illegal barrier to entry that might support an oligopolistic
structure?
a. Price setting below the lowest price that a potential new entrant could afford to charge.
b. A tariff that keeps all but a trickle of foreign products off the domestic market.
c. Product differentiation among a few producers.
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d. Average cost curves that reach their minima at roughly 30 percent of market demand.
e. All the above.
e.
8. OPEC represents a market structure most accurately represented by:
a. the pure monopoly model.
b. a collusive oligopoly model with incomplete market coverage.
c. the monopolistic competition model.
d. the duopoly model.
e. perfect competition.
9. Which alternative to question 8 would have been correct if the market in question had been the market for
soybeans?
a. the pure monopoly model.
b. a collusive oligopoly model with incomplete market coverage.
c. the monopolistic competition model.
d. the duopoly model.
e. perfect competition.
10. If we consider an industry composed of many sellers of differentiated products, and if entry into this
industry is free, then we should expect the long-run equilibrium position of the typical firm in this industry to
have which of the following properties?
a. Average cost (AC) would be at its minimum possible level, and the price charged (P) would be equal
to that AC.
b. AC would be at its minimum level, and P would be above that AC.
c. AC would be above its minimum level, and P would be above that AC.
d. AC would be above its minimum level, and P would be equal to that AC.
e. AC would be above its minimum level, but P would equal that minimum.
11. Suppose Figure 10-1 (below) represents the demand and cost conditions for an industry operating as an
international cartel. The profit-maximizing price and output for this industry are:
a. $5 and 10 units.
b. $2 and 10 units.
c. $4 and 20 units.
d. $4 and 15 units.

Figure 10-1

12. A firm in the industry described in question 11 is a:

a. monopolistic competitor.
b. collusive oligopolist.
c. noncollusive oligopolist.
d. perfect competitor.
e. single monopolist.
13. Price discrimination is a technique used by firms who want to:
a. capture the deadweight loss to monopoly.
b. capture additional consumer surplus by charging different prices to different consumers.
c. relinquish producer surplus by charging different prices to different consumers.
d. increase producer surplus by buying their inputs from the lowest-price provider.
c. none of the above.
14. Which of the following are characteristics of concentrated market?
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a. higher than normal profits.

b. higher than normal advertising.
c. higher than normal research and development
d. all of the above.
15. Collusive oligopoly produces prices and quantities very similar to those produced by:
a. perfect monopoly.
b. monopolistic competition.
c. perfect competition.
d. none of the above

B. Innovation and Information

16. Ownership and control are sometimes divorced in a large corporation. Which of the following problems
might arise as a result?
a. Managers might try to increase their own salaries and benefits rather than to maximize the profits of
the firm.
b. Managers tend to be less likely to distribute profits as dividends rather than reinvest in the company.
c. Managers are often more risk-seeking than owners, leading to a greater degree of uncertainty than
owners would prefer.
d. Both A and B are true.
e. None of the above.
17. One reason why a firm operating under conditions of imperfect competition is likely to want to use an
administered or markup price is:
a. a lack of sufficient knowledge of marginal revenue at various levels of output.
b. a lack of sufficient knowledge of marginal cost at various levels of output.
c. the desire to have a break-even point occurring at a high level of output.
d. the fear that charging a higher price would attract new competition into the field.
e. the notion that this price corresponds to the most efficient plant output level.
18. The Schumpeterian hypothesis is:
a. big business is not necessarily bad business.
b. firms never really have any power to set prices, since demand curves must be considered.
c. research and development is more efficiently supported by a consortium of government, small
business, and big business.
d. innovation would be accelerated if managers of large firms were required to be owners of large firms.
e. all the above.
19. In the past few years, the banking industry in the United States has experienced increasing concentration, as
new banking regulations have allowed mergers across state lines. According to the Schumpeterian hypothesis,
this increased concentration is:
a. good, because it leads to a redistribution of income from the wealthy to the poor.
b. good, because increased concentration creates external benefits in the area of innovation.
c. bad, because the banks involved are more likely to go bankrupt.
d. bad, because banks should be governed by local banking laws.
e. possibly good or bad, depending upon the profitability of the banks that are merging.

C. The Balance Sheet on Imperfect Competition

20. In light of the pros and cons of imperfect competition, policy could be directed at:
a. keeping the barriers to competition low.
b. attacking anticompetitive business conduct.
c. tolerating bigness if it is founded in technology.
d. encouraging the research-and-development efforts of large and small firms.
e. all the above.
Use Figure 10-2 (top of next page) to answer questions 19 through 23.
21. A profit-maximizing monopolist facing demand curve DD would maximize profits by selling:
a. 4 units at a price of $2.
b. 4 units at a price of $6.
c. 8 units at a price of $2.
d. 10 units at a price of $2.
e. 5 units at a price of $5.
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Figure 10-2

22. Which answer to question 21 would have been the correct description of the competitive equilibrium?
a. 4 units at a price of $2.
b. 4 units at a price of $6.
c. 8 units at a price of $2.
d. 10 units at a price of $2.
e. 5 units at a price of $5.
23. Which answer to question 21 would have been correct if the monopolist were trying to maximize revenue?
a. 4 units at a price of $2.
b. 4 units at a price of $6.
c. 8 units at a price of $2.
d. 10 units at a price of $2.
e. 5 units at a price of $5.
24. The monopolist of question 21 creates distortions whose welfare cost, measured in terms of consumer
surplus, equals:
a. $2.
b. $4.
c. $6.
d. $8.
e. $10.
25. Unlike antitrust laws, regulation:
a. allows monopolies and near-monopolies to exist under the watchful eye of a government agency.
b. breaks monopolized industries into many small firms which then operate competitively.
c. places heavy taxes on firms to provide them with incentives to do the right thing.
d. encourages government ownership, or nationalization, of industries that have been monopolized.
e. provides firms with the capital that they need to pursue research and development of new products.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this chapter.

A. Behavior of Imperfect Competitors

1. Empirical research has uncovered patterns of correlation between the degree of concentration displayed by
various industries and nonproduction activities such as research and development, advertising, and price
administration.
Using the letters given, indicate in the blanks below whether the following descriptions most likely apply to
a:
a. High-concentration industry (H) like motor vehicles
b. Moderate-concentration industry (M) like chemicals
c. Low-concentration industry (L) like printing
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d. Perfectly competitive industry (P) like farming

___ a. Industry A shows a normal profit rate, high expenditure on research and development as well as
advertising (each around 1.7 percent of total sales), and a moderate level of price administration.
___ b. Industry B shows negligible expenditure on research and development (measured as a percentage
of total sales), negligible expenditure on advertising, and no price administration.
___ c. Industry C shows no economic profits in the long run, small expenditure on research and
development as well as advertising (each less than 1 percent of total sales), but the highest level of price
administration.
___ d. Industry D shows a normal profit rate, the highest expenditure on research and development,
expenditure on advertising that is comparable to that of industry C, and a high degree of price
administration.
2. Consider the hypothetical data in Table 10-1. This represents the market share of the top eight firms in this
industry in 1995 and again in 2000.

TABLE 10-1
1995 2000
Market Market
Firm Share Share
A 10% 30%
B 8 6
C 12 12
D 20 30
E 21 10
F 2 1
G 5 3
H 6 1

a. Calculate the four-firm concentration ratios for 1995 and 2000. What happened in this industry over
this time period?
b. Calculate the eight-firm concentration ratios for 1995 and 2000. Do these calculations give you a
different notion of developments in this industry over this time period?
c. Calculate the Herfindahl-Hirschman Indexes for 1995 and 2000. What does this index tell you about
changes in concentration in this industry over this time period?
3. As stated above, oligopoly behavior is characterized by mutual interdependence; that is, rivals in an
oligopolistic market must be constantly aware of one another’s behavior. In Figure 10-3, DD represents the
effective demand curve facing some oligopolist who abides by a collusive agreement with a few competitors. It
could, for example, be the result of a consistent 30 percent share of total sales for any price along a market
demand curve. Notice that every reduction of $1 in the price produces, for the firm when all other firms
conform, an increase in sales of 10 units. Marginal revenue is given by MR. Average cost and marginal cost
are assumed, for simplicity only, to be constant at $4 per unit regardless of output level.

Figure 10-3
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a. On the basis of the assumption of perfect collusion, the firm will maximize profits along DD by
agreeing to a price of $___, therefore selling ___ units and earning profits of $___.
b. Now suppose that the firm could, by lowering its price relative to that of its colluding partners (i.e., by
cheating on its collusive agreement), pick up an extra 20 units of sales for every $1 reduction in price. It
could, in other words, increase its market share at the expense of other firms by lowering its price alone.
The resulting demand and marginal revenue curves are represented in Figure 10-3 by D’D’ and MR’,
respectively. The firm could, in this case, move to a new profit-maximizing position by (reducing /
maintaining / increasing) its price to $___ and selling ___ units. The result would be $___ in profits.
c. It is, of course, highly unlikely that the other firms would not catch on. Suppose, in response to the
cheating of the first firm, that all the other firms changed their prices to the cheater’s new price. DD would
again be relevant, and the cheating firm’s profits would fall to $___ as sales declined to ___ units.
d. It is clear, therefore, that successful cheating is better for a single firm than is successful collusion, but
cheating entails the risk of reducing profitability if all firms catch on and follow the behavior of cheaters to
protect themselves. Were the process to continue, in fact, the firms would, collectively, end up producing
the (competitive / monopoly) output and selling it at the (competitive / monopoly) price. In terms of
Figure 10-3, price would converge to $___, output would converge to ___ units, and pure economic profit
would converge to $___.

B. Innovation and Information

4. a. For a monopoly firm facing demand curve DD in Figure 10-4, profits would be maximized by setting a
price equal to $___ and expecting to sell ___ units. Relative to average cost, that price amounts to a ___
percent markup over cost.

Figure 10-4

b. Now complete Table 10-2 to convince yourself that a sequence of trial markup percentages could lead
a careful manager to the profit-maximizing intersection of MR and MC without computing either schedule.
5. The Schumpeterian hypothesis about the large firms which dominate imperfectly competitive markets
postulates that “big business may have had more to do with creating our (high) standard of life than (with)
keeping it down.” This hypothesis is based, at least in part, upon the notion that (research-and-development
expenditure / purchasing power / real competition) seems to be concentrated most heavily in the largest
firms on the American scene. Since Edwin Mansfield has argued that the social return to invention is (3 / 0.5 /
5) times the private gain, it can certainly be argued that research and development is (overfunded / properly
funded / underfunded). However, the extent of underfunding depends critically upon the nature of innovation
and the ability of firms to appropriate the gains to expensive research and development projects. Particularly
when the (average / total / marginal) costs of reproducing an idea or product approach zero, high fixed costs of
innovation may pay slim rewards to the deserving firm or individual.
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TABLE 10-2
Percentage
Markup Output
over Cost Price (units) Profit
60 $___ ___ $___
80 ___ ___ ___
100 ___ ___ ___
120 ___ ___ ___
110 ___ ___ ___
105 ___ ___ ___

C. The Balance Sheet on Imperfect Competition

6. It has been shown throughout Chapters 9 and 10 that P > MR along a downward-sloping demand curve,
and MR = MC at the profit-maximizing output.
a. As a result, the price that a monopolist charges is (higher than / lower than / equal to) the
competitive price.
b. Since monopolistic firms face downward-sloping demand curves, the monopolist must therefore
produce (less output than / more output than / the same output as) the competitive industry would
produce.
c. On the basis of the efficiency properties of the perfectly competitive market, it is thus clear that the
marginal utility derived from consuming the monopolist’s product is (greater than / less than / equal to)
the marginal cost of producing the good in question.
d. Consult Figure 10-5. If the illustrated cost structure were representative of a competitive market, the
long-run equilibrium output and price must equal ___ units and $___, respectively. A profit-maximizing
monopolist would, meanwhile, sell ___ units at a price of $___. The result would be a reduction in
consumer surplus from $___ to $___. Of that reduction, $___ would go to the monopolist in the form of
excess economic profit, and $___ would represent deadweight loss.

Figure 10-5

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. Studies show that the measured degree of concentration in U.S. industry has been decreasing in recent
years. What do you think Schumpeter would say about this trend?
2. In a monopolistically competitive market, the long-run position occurs where firms are earning no
economic profits. However, firms are not at the minimum of their long-run average cost curves. How can this
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be? Why do some people charge that monopolistic competition leads to waste and inefficiency? What, if
anything, do consumers gain when they purchase products from monopolistically competitive industries?
3. The DeBeers diamond syndicate is an example of a highly successful international cartel. Using the theory
developed in the text, illustrate the profit-maximizing decision of competitors in this industry. Why might
competitors decide to cheat? What impact might the emergence of Russia as an international competitor, but
nonmember of the cartel, have on the stability of agreements?
4. What is the difference between collusive and noncollusive oligopoly in the United States? Why is
collusive oligopoly illegal?
5. List and explain the alternative government policies that might be used to encourage competition in U.S.
industry. If Schumpeter is correct, should these policies be adopted? Why or why not?
6. Explain how one finds the supply curve for a monopolist.

IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts

8 Market power
4 Concentration ratio
14 Herfindahl-Hirschman Index
1 Strategic interaction
13 Tacit collusion
9 Game theory
15 Price discrimination
7 Separation of ownership from control
2 Markup policy
11 Schumpeterian hypothesis
10 Inappropriability
3 Deadweight loss
12 Regulation
6 Antitrust policy
5 Collusive oligopoly

VI. Multiple Choice Questions

1. E 2. A 3. B 4. D 5. C 6. D
7. A 8. B 9. E 10. D 11. A 12. B
13. B 14. D 15. A 16. D 17. A 18. A
19. B 20. E 21. B 22. C 23. E 24. B
25. A

VII. Problem Solving

1. a. M
b. P
c. L
d. H
2. a. 4-firm ratios: 63% in 1995, 82% in 2000. These numbers indicate that the industry has become more
heavily concentrated during this time period.
b. 8-firm ratios: 84% in 1995, 93% in 2000. These numbers again indicate that the industry has become
more heavily concentrated during this time period. However, the change in the 8-firm ratio is not as
dramatic, indicating that the degree of concentration has not changed as much as is indicated by the 4-firm
ratio.
c. 1995 HHI = 1214, 2000 HHI = 2091. Using the HHI, market concentration has increased over this
time period.
3. a. $7, 30 units, $90
b. reducing, $6.25,45 units, $101.25
c. $78.75, 35 units
d. competitive, competitive, $4, 90 units, $0
4. a. $8, 6 units, 100%
b. Table answers:
Row 1 = $ 8, 14 units, $42 profits
Row 2 = $ 9,12 units, $48 profits
 186

Row 3 = $10, 10 units, $50 profits

Row 4 = $11,8 units, $48 profits
Row 5 = $10.50, 9 units, $49.50 profits
Row 6 = $10.25,9.5 units, $48.88 profits
5. research-and-development expenditure, 3, underfunded, marginal
6. a. higher than
b. less output than
c. greater than
d. 20 units, $5, 10 units, $10, $100, $25, $50, $25.

VIII. Discussion Questions

1. Schumpeter might be concerned about this trend. In his view, the existence of “big business” allows for
greater amounts of research and innovation in an economy. He might fear that excessive levels of competition
would lead to even less basic research than exists in the U.S. today.
2. All firms in a monopolistically competitive industry operate with excess capacity; this means that each firm
reaches the profit-maximizing level of output before average total costs are minimized, in the long run. This
leads to the charge that firms are wasteful and inefficient. There are many firms, each producing a slightly
different version of the product. This product differentiation leads to costs of production that are higher than
would be generated by a perfectly competitive industry. Consumers gain product variety and a wider range of
choice in these markets.
3. See diagram.

The cartel will produce Q* units of output and sell it at $P* per unit. Competitors might decide to cheat if
they think that they can lower price and increase sales without attracting the attention of other cartel members.
As Russia enters this market as a competitor, the DeBeers cartel will suffer, unless it can pull Russia into the
cartel. Successful cartels must maintain control over the supply of the product.
4. In a collusive oligopoly, members make agreements concerning market strategy and share information. In
a noncollusive oligopoly, members consider the behavior of rivals, but they do not actually discuss strategy.
Collusive oligopoly is illegal because it severely limits competition among rivals.
5. To encourage competition, the government might make all monopolies illegal. The government might
break up large firms into several small firms. The government might refuse to allow mergers when the merging
firms operate in the same markets. According to Schumpeter, these actions all limit the size and scope of firms,
and hence limit their incentives to be innovative.
6. One cannot derive the supply curve for a monopolist.