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Chapter 12:
Monopolistic
Competition,
Oligopoly, and
Strategic Pricing
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Introduction
Market structure is the focus of real-world
competition.
Market structure refers to the physical
characteristics of the market within which
firms interact.
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2
Introduction
Market structure involves the number of firms
in the market and the barriers to entry.
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3
Introduction
Perfect competition, with an infinite number of
firms, and monopoly, with a single firm, are
polar opposites.
Monopolistic competition and oligopoly lie
between these two extremes.
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4
Introduction
Monopolistic competition is a market
structure in which there are many firms
selling differentiated products.
There are few barriers to entry.
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5
Introduction
Oligopoly is a market structure in which
there are a few interdependent firms.
There are often significant barriers to entry.
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6
Defining a Market
Defining a market has problems:
What is an industry and what is its
geographic market?
Local, national, or international?
What products are to be included in the
definition of an industry?
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7
Classifying Industries
One of the ways in which economists classify
markets is by cross-price elasticities.
Cross-price elasticity measures the
responsiveness of the change in demand for
a good to change in the price of a related
good.
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8
Classifying Industries
Industries are classified by government using
the North American Industry Classification
System (NAICS).
The North American Industry
Classification System (NAICS) is a
classification system of industries adopted by
Canada, Mexico, and the U.S. in 1997.
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9
Classifying Industries
Under the NAICS, all firms are placed into 20
broadly defined two-digit sectors.
Two-digit sectors are further subdivided into
three-digit subsectors, four-digit industry
groupings, five-digit industries and six-digit
national industry groupings.
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10
Classifying Industries
When economists talk about industry
structure the general practice is to refer to
three-digit industries.
Under the NAICS, a two-digit industry is a broadly
based industry.
A three-digit industry is a specific type of industry
within a broadly defined two-digit industry.
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11
Classifying Industries
Two-Digit Sectors
Three-Digit Subsectors
44-45 Retail trade
48-49 Transportation
and warehousing
51 Information
513 Broadcasting and
telecommunications
52 Finance and
Insurance
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12
Determining Industry Structure
Economists use one of two methods to
measure industry structure:
The concentration ratio.
The Herfindahl index.
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13
Concentration Ratio
The concentration ratio is the percentage of
industry sales by the top few firms.
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14
Concentration Ratio
The most commonly used concentration ratio
is the four-firm concentration ratio, the CR4.
The higher the ratio, the closer to an
oligopolistic or monopolistic type of market
structure.
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15
Herfindahl Index
The Herfindahl index is an index of market
concentration calculated by adding the
squared values of the individual market
shares of all the firms in the industry.
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16
Herfindahl Index
Two advantages of the Herfindahl index is
that it takes into account all firms in an
industry, and that it gives extra weight to a
single firm that has an especially large
market share.
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17
Herfindahl Index
The Herfindahl Index is important because it
is used as a rule of thumb in determining
whether an industry is sufficiently competitive
to allow a merger between two large firms in
the industry.
If the index is less than 1,000, the industry is
considered to be sufficiently competitive.
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18
Conglomerate Firms and Bigness
Neither the four-firm concentration ratio nor
the Herfindahl index gives a complete picture
of corporations’ bigness.
This is because many firms are
conglomerates.
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19
Conglomerate Firms and Bigness
Conglomerates are huge corporations
whose activities span various unrelated
industries.
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20
Importance of Industry Structure
The less concentrated industries are more
likely to resemble perfectly competitive
markets.
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21
Importance of Industry Structure
The number of firms in an industry plays an
important role in determining whether firms
explicitly take other firms’ actions into
account.
Oligopolies take into account the reactions of
other firms; monopolistic competitors do not.
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22
Importance of Industry Structure
In monopolistic competition, there are so
many firms that firms do not take into account
their rivals’ responses to their decisions.
Collusion is difficult due to a large number of
firms.
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23
Importance of Industry Structure
In oligopoly, with fewer firms, each firm is
more likely to engage in strategic decision
making.
Strategic decision making – taking explicit
account of a rival’s expected response to a
decision you are making.
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24
Monopolistic Competition
The four distinguishing characteristics of
monopolistic competition are:
Many sellers.
Differentiated products.
Multiple dimensions of competition.
Easy entry of new firms in the long run.
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25
Many Sellers
There are many sellers in monopolistic
competition, but each of them is able to
identify its own small market segment.
Monopolistically competitive firms act
independently of their rivals.
The existence of many sellers also makes
collusion difficult.
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26
Differentiated Products
The “many sellers” characteristic gives
monopolistic competition its competitive
aspect.
Product differentiation gives monopolistic
competition its monopolistic aspect.
Competitors produce many close substitutes.
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27
Differentiated Products
Differentiation may be based on real
differences in product characteristics, or can
be based on consumers’ perceptions about
product differences.
Generally, monopolistic competition is
characterized by significant expenditures on
advertising, which acts as an important barrier
to entry.
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28
Differentiated Products
Differentiation exists so long as advertising
convinces buyers that it exists.
Firms will continue to advertise as long as the
marginal benefits of advertising exceed its
marginal costs.
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29
Differentiated Products
Any industry where brand proliferation is
present is likely to be monopolistically
competitive.
Some examples are soap, jeans, cookies and
games.
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30
Multiple Dimensions of Competition
Competition takes many forms in a
monopolistically competitive industry:
Product differentiation.
Perceived quality.
Competitive advertising.
Service and distribution outlets.
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31
Easy Entry
The existence of economic profits induces
other firms to enter, bringing long-run profit
down to zero.
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32
Output, Price, and Profit
A monopolistically competitive firm produces
in the same manner as a monopolist—to
maximize profit, it chooses the quantity where
MC = MR.
Having determined output, the firm will
charge what consumers are willing to pay
(determined by the demand curve).
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33
Output, Price, and Profit
If price exceeds ATC, the firm will earn
positive economic profits.
These profits attract entry.
Some customers of the existing firms switch
to become customers of the new firm.
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Output, Price, and Profit
Entry causes the existing firms’ demand
curve to shift left (decrease) as they lose
customers.
Competition, therefore, implies zero
economic profit in the long run.
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35
Output, Price, and Profit
At the long-run equilibrium, ATC equals price
and economic profits are zero.
This occurs at the point of tangency of the
ATC and demand curve at the output chosen
by the firm.
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36
Monopolistic Competition: Short Run
Price
P1
C1
MC
MR
0
Q1
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D1
Quantity
37
Monopolistic Competition: Short Run
Price
MC
P1
P2
C2
C1
0
Q2 Q1
MR1
D2
D1
Quantity
MR2
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38
Monopolistic Competition: Long Run
Price
MC
P1
P2
P3 =C3
C2
C1
ATC3
ATC2
MR2
MR3
0
Q3
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D2
D3
Quantity
39
Comparing Monopolistic Competition
and Perfect Competition
Both the monopolistic competitor and the
perfect competitor make zero economic profit
in the long run.
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40
Comparing Monopolistic Competition
and Perfect Competition
The perfect competitor’s demand curve is
perfectly elastic.
Zero economic profit means that it produces
at the minimum of the ATC curve.
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41
Comparing Monopolistic Competition
and Perfect Competition
A monopolistic competitor faces a downward
sloping demand curve, and produces where
MC = MR, not where MC = P.
The ATC curve is tangent to the demand
curve at that level, which is not at the
minimum point of the ATC curve.
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42
Comparing Monopolistic Competition
and Perfect Competition
A monopolistic competitor produces less than
a perfect competitor.
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Comparing Monopolistic Competition
and Perfect Competition
Perfect Competition
Price
Price
MC
ATC
D
PC
0
Monopolistic Competition
QC
Quantity
MC
ATC
PM
PC
0
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QM
MR
D
QC Quantity
44
Excess Capacity
The Excess Capacity theorem indicates
that a monopolistically competitive firm will
have excess capacity in long-run equilibrium.
It occurs because of product differentiation.
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45
Monopolistic Competition and
Advertising
Firms in a perfectly competitive market have
no incentive to advertise
Monopolistic competitors have a strong
incentive to do so.
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46
Monopolistic Competition and
Advertising
The goals of advertising are to increase
demand for the firm’s product and to increase
customer loyalty to the product.
The firm’s demand increases, and becomes
more inelastic.
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47
Monopolistic Competition and
Advertising
Advertising shifts the demand curve to the
right, and it increases firm’s costs, shifting the
ATC up.
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48
Does Advertising Help or Hurt
Society?
There is a sense of trust in buying brands we
know.
If consumers are willing to pay for
“differentness,” it’s a benefit to them.
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49
Comparing Monopolistic Competition
and Monopoly
It is possible for the monopolist to make
economic profit in the long-run.
No long-run economic profit is possible in
monopolistic competition.
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50
Characteristics of Oligopoly
Oligopolies are made up of a small number of
very large firms.
Products may be homogeneous or
differentiated
Firms are mutually interdependent.
Each firm must take into account the
expected reaction of other firms.
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51
Models of Oligopoly Behaviour
No single general model of oligopoly
behaviour exists because each oligopolistic
industry is different.
Two models of oligopoly behaviour are the
cartel model and the contestable market
model.
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52
Models of Oligopoly Behaviour
In the cartel model, an oligopoly sets a
monopoly price.
In the contestable market model, an oligopoly
with no barriers to entry sets a competitive
price.
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53
Cartel Model
A cartel is a combination of firms that acts as
it were a single firm.
A cartel is a shared monopoly.
In the cartel model, an oligopoly sets a
monopoly price.
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54
Cartel Model
If oligopolies can limit entry, they have a
strong incentive to collude.
To collude is to get together with other firms
to set price or allocate market share.
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55
Cartel Model
In the cartel model of oligopoly,
Oligopolies act as if they were monopolists
That have assigned output quotas to individual
member firms
So that total output is consistent with joint profit
maximization.
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56
Implicit Price Collusion
Formal collusion is illegal in Canada, but
informal collusion is permitted.
Implicit price collusion exists when multiple
firms make the same pricing decisions even
though they have not consulted with one
another.
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57
Implicit Price Collusion
Sometimes the largest or most dominant firm
takes the lead in setting prices and the others
follow.
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58
Cartels and Technological Change
Cartels can be destroyed by an outsider with
technological superiority.
Thus, cartels with high profits will provide
incentives for significant technological
change.
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59
Why Are Prices Sticky?
Sticky prices are prices that don’t change
very much.
Informal collusion is an important reason why
prices are sticky.
Another is the kinked demand curve.
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60
Kinked Demand Curve Model of
Oligopoly
Firms have expectations about how the other
firms in the industry will behave.
A firm’s assumptions about the other firm’s
behaviour creates the kink in the demand
curve.
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61
Kinked Demand Curve Model
Assumption 1:
If a firm raises its price, no other firms will
raise their prices.
This make the firm’s own demand curve very
elastic.
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62
Kinked Demand Curve Model
Assumption 2:
If a firm lowers its price, all the other firms will
lower their prices too.
This make the firm’s own demand curve very
inelastic.
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Kinked Demand Curve Model
When there is a kink in the demand curve,
there has to be a gap in the marginal revenue
curve.
The kinked demand curve is not a theory of
oligopoly but a theory of sticky prices.
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64
Kinked Demand Curve Model
No-one follows a price increase.
Price
a
P
b
MC0
c
MC1
Q
D1
MR1
d
0
All firms lower price.
MR2
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D2
Quantity
65
Kinked Demand Curve Model
If a firm’s MC curve crosses MR in the
vertical portion between c and d, it will
produce the quantity Q and charge a price
equal to P.
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66
Kinked Demand Curve Model
A high-cost firm and a low-cost firm will both
produce the same quantity and charge the
same price.
If a firm’s costs decrease, consumers will not
see any change.
Price will not decrease.
The firm’s profits will increase.
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67
Contestable Market Model
According to the contestable market model,
barriers to entry and barriers to exit
determine a firm’s price and output decisions.
Even if the industry contains a very small number
of firms, it could still be a competitive market if
entry is open.
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68
Contestable Market Model
In the contestable market model, an oligopoly
with no barriers to entry sets a competitive
price.
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Comparing the Contestable Market
and Cartel Models
The stronger the ability of oligopolists to
collude and prevent market entry, the closer it
is to a monopolistic situation.
The weaker the ability to collude is, the more
competitive it is.
Oligopoly markets lie between these two
extremes.
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Strategic Pricing and Oligopoly
Both the cartel and contestable market
models use strategic pricing decisions –
firms set their prices based on the expected
reactions of other firms.
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71
New Entry Limits Cartelization
Creation of cartels is limited by threat of
outside competition.
In many industries the outside competition
comes from international firms.
For a cartel with few barriers to entry, the
long run demand curve is very elastic.
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72
Price Wars
Price wars are the result of strategic pricing
decisions breaking down.
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Price Wars
A firm may develop predatory pricing
strategy, which involves temporarily pushing
the price down below cost in order to drive a
competitor out of business.
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74
Game Theory and Strategic Decision
Making
Most oligopolistic strategic decision making is
carried out with explicit or implicit use of
game theory.
Game theory is the application of economic
principles to interdependent situations.
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75
Game Theory and Strategic Decision
Making
The prisoner’s dilemma is a well-known
game that demonstrates the difficulty of
cooperative behaviour in certain
circumstances.
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76
Game Theory and Strategic Decision
Making
In the prisoner’s dilemma, it’s mutual trust
that gets each one out of the dilemma,
however, confessing is the rational choice.
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Prisoner’s Dilemma and Duopoly
The prisoners dilemma has its simplest
application when the oligopoly consists of
only two firms—a duopoly.
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Prisoner’s Dilemma and Duopoly
By analyzing the strategies of both firms
under all situations, all possibilities are placed
in a payoff matrix.
A payoff matrix is a box that contains the
outcomes of a strategic game under various
circumstances.
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79
Cooperative Equilibrium
MC ATC
$800
700
700
600
600
500
500
Price
575
Price
$800
400
300
D
100
100
2
3
4
5
6
7
8
Competitive
solution
300
200
1
0
MR
1
2
Quantity (in thousands)
(a) Firm's cost curves
MC
400
200
0
Monopolist
solution
3
4
5
6
7
8
9 10 11
Quantity (in thousands)
(b) Industry: Competitive and monopolist solution
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80
One Firm Cheats
$900
$800
$800
800
700
700
700
600
550
500
600
550
500
600
550
500
400
300
A
400
Price
A
Price
Price
MC ATC
MC ATC
300
200
200
100
100
100
1
2 3 4
5 6 7
Quantity (in thousands)
(a) Noncheating firm’s loss
0
1
2 3 4
5
6 7
Quantity (in thousands)
(b) Cheating firm’s profit
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B
A
NonCheating
400 cheating
firm’s
firm’s
output
300 output
200
0
C
0
1
2 3
4 5 6
7 8
Quantity (in thousands)
(c) Cheating solution
81
Duopoly and a Payoff Matrix
The duopoly is a variation of the prisoner's
dilemma game.
The results can be presented in a payoff
matrix that captures the essence of the
prisoner's dilemma.
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82
Payoff Matrix
A Does not cheat
A Cheats
A +$200,000
A $75,000
B Does not
cheat
B $75,000
B – $75,000
A – $75,000
A $0
B Cheats
B +$200,000
B $0
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83
Payoff Matrix
If both firms cooperate, they can both get
higher profits.
$75,000 each.
However, both firms have an incentive to
cheat on their agreement.
$200,000 for the one that cheats.
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84
Payoff Matrix
A dominant strategy is one which always
yields the highest payoff, no matter what the
other player does.
The dominant strategy is to not cooperate.
i.e. to cheat.
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Payoff Matrix
If both firms choose to cheat on their
agreement, the outcome will be a Nash
equilibrium, a non-cooperative equilibrium in
which no player can achieve a better
outcome by switching strategies, given the
strategy of the other player.
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86
Oligopoly, Structure, and Performance
Oligopoly models are based either on
structure or performance.
The four types of markets considered so far are
based on market structure.
Structure means the number, size, and
interrelationship of firms in the industry.
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87
Oligopoly, Structure, and Performance
A monopoly is the least competitive, while
perfectly competitive industries are the most
competitive.
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Oligopoly, Structure, and Performance
The contestable market model gives less
weight to market structure.
Markets are judged by performance, not
structure.
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Oligopoly, Structure, and Performance
Performance includes:
ratio of price to marginal cost
output
allocative and productive efficiency
product variety
innovation rate
profits
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Oligopoly, Structure, and Performance
There is a similarity in the two approaches.
Often barriers to entry are the reason there
are only a few firms in an industry.
When there are many firms, that suggests
that there are few barriers to entry.
In the majority of cases, the two approaches
come to the same conclusion.
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Monopolistic Competition,
Oligopoly, and Strategic
Pricing
End of Chapter 12
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