To practice price discrimination you need to be able to (1) distinguish between at least two sets of buyers and (2) prevent one set of buyers from reselling the product to another set.

Examples of Monopolistically Competitive Markets

Monopolistic competition is similar to monopoly in that individual firms have some power to control the price of their product. It's similar to perfect competition in that each product is sold by many firms, and free entry and exit prevail in the market.

In retailing, hairstyling, and manufacturing, entry by new sellers is relatively easy, the products of individual firms are differentiated, and there are a relatively large number of sellers. Retailers can differentiate their products by quality of service, location of showrooms, and convenience of operating hours. Hair styling can be differentiated by the personal services offered to clients. Many manufactured goods like clothing, shoes, and furniture are sold in markets that can be considered monopolistically competitive.

 

Oligopoly

Unlike a monopolistically competitive market, oligopoly is a market structure in which a few sellers dominate in sales of a product and where entry of new sellers is difficult or impossible. The product can be either differentiated or standardized.

An oligopoly is an industry with just a few sellers. How few? So few that at least one firm is large enough to influence price.

Is the product identical or differentiated? It doesn't matter. In the case of the steel, copper, and aluminum industries, the product happens to be identical; but in most other cases, the product is differentiated.

The crucial factor under oligopoly is the small number of firms in the industry. Because there are so few firms, every competitor must think continually about the actions of his rivals, since what each does could make or break him. Thus there is a kind of interdependence among oligopolists.

For example, in market sales in the United States for a standardized product, aluminum, are dominated ALCOA, Reynolds, and Kaiser. Automobiles, cigarettes, beer, and chewing gum are examples of differentiated goods whose market structures are oligopolistic.

Oligopolistic markets are characterized by high market concentration. Usually the four largest producers of a good account for over half the domestic shipments.

Concentration ratios

One way of measuring how concentrated an industry is, is to look at the percentage share of sales of the leading firms. This is called the industry's concentration ratio.

Economists use concentration ratios as a quantitative measure of oligopoly.

The total percentage share of industry sales of the four leading firms is the industry concentration ratio. Industries with high ratios are very oligopolistic.

Two key shortcomings of concentration ratios should be noted.

1. Don't include imports. For example, in the auto industry, foreign cars account for about one third of the American market. Although Honda is listed among the top four American automakers, we have not taken into account the 2 million Japanese imports, not to mention the hundreds of thousands of Volkswagens, Saabs, BMWs, Audis, Jaguars, Porsches, and Rolls Royces we also import.

Concentration ratios have become less meaningful as foreign imports have increased. For instance, we get 75 percent of our consumer electronics and 50 percent of our oil from abroad, so concentration ratios in these industries are meaningless. Perhaps in a world with unrestricted international trade, which would make our world a veritable global village, we could replace national concentration ratios with international concentration ratios.

2. The concentration ratios tell us nothing about the competitive structure of the rest of the industry. Are the remaining firms all relatively large, as in the cigarette industry, which has a total of just 13 firms, or are they small, as in the aircraft and engine parts industry, which totals about 190 firms? This distinction is important because when the remaining firms are large, they are not as easily dominated by the top four as are dozens of relatively small firms.

The American automobile industry, which had long been a classic example of an oligopoly, has been changing drastically in recent years. Not only have imports had a substantial impact, but now seven Japanese carmakers have set up operations in thiscountry. The imports have made the automobile industry's concentration ratio much less relevant, while the transplants have been reducing that ratio. But these developments have been an unmitigated boon to the car buyer, who is reaping the benefits of lower prices and much higher quality.

A second way is to calculate the Herfindahl-Hirschman index, which, it turns out, is a lot easier to do than to say.

The Herfindahl-Hirschman Index (HHI). The Herfindahl-Hirschman index (HHI) is the sum of the squares of the market shares of each firm in the industry.

We'll start with a monopoly. One firm has all the sales, or 100 percent of the market share. So, its HHI would be 100², or 100 x 100 = 10,000.

Find the HHI of an industry with just two firms, both of which have 50 percent market shares. Work it out right here:

50² + 50² = 2,500 + 2,500 = 5,000

Find the HHI of an industry that has four firms, each with a 25 percent market share:

25² + 25² + 25² + 25² = 625 + 625 + 625 + 625 = 2,500

The less concentrated an industry, the lower its HHI. And here's one last question. Imagine an industry with 100 firms, each with an equal market share. Without going through all the work, see if you can figure out the HHI.

It would come to 100: 1² + 1² + 1²  ... + 1² = 100.

The Competitive Spectrum

No single general model of oligopoly behavior exists. The reason is that an oligopolist can decide on pricing and output strategy in many possible ways, and there are no compelling grounds to characterize any of them as the oligopoly strategy. Although there are five or six formal models, we'll focus on two informal models of oligopoly behavior that give you insight into real-world problems rather than exercise your reasoning and modeling abilities as my earlier discussion did.

The reason lies in the interdependence of oligopolists. Since thereare so few competitors, what one firm does, so specifically influences what other firms do, so an oligopolist's plan must always be a contingency or strategic plan. If my competitors act one way, I’ll do X, but if they act another way, I'll do Y. Strategic interactions have a varietyof potential outcomes rather than a single outcome such as shown in the formal models we discussed. An oligopolist spends enormous amounts of time guessing what its competitors will do, and it develops a strategy of how it will act, depending on what its competitors do.

The disastrous effect of price wars on profits of firms in oligopolistic markets provides an incentive for sellers to collude to keep profits up. Such collusion is illegal in most nations, and governments may prosecute firms that collude to fix prices at high levels or at temporarily low levels to force competitors out of business.

In this section we shall consider the possible degrees of competition from cartels and open collusion down through cutthroat competition.

Cartel

An extreme case of oligopoly is a cartel, where the firms behave as a monopoly in a manner similar to that of the Organization of Petroleum Exporting Countries (OPEC) in the world oil market.

A cartel is a group of firms acting together to coordinate output decisions and control prices as if they were a single monopoly. Cartels are illegal. International cartels, however, do exist. Perhaps the best known is OPEC: Organization of Petroleum Exporting Countries (most of which are Middle Eastern nations). It seeks to regulate its members' output of crude oil with the goal of controlling price to maximize group profits.