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BB 107 Tutorial 12

Part A: MCQ

1. In a duopoly, if one firm increases its price, then the other firm can:
A. Keep its price constant and thus increase its market share.
B. Keep its price constant and thus decrease its market share.
C. Increase its price and thus increase its market share.
D. Decrease its price and thus decrease its market share.

2. The term oligopoly indicates:

A. A one-firm industry.
B. Many producers of a differentiated product.
C. A few firms producing either a differentiated or a homogeneous product.
D. An industry whose four-firm concentration ratio is low.

3. Game theory:
A. Is the analysis of how people (or firms) behave in strategic situations.
B. Is best suited for analyzing purely competitive markets.
C. Reveals that mergers between rival firms are self-defeating.
D. Reveals that price-fixing among firms reduces profits.

4. The kinked-demand curve of an oligopolist is based on the assumption that:

A. Competitors will follow a price cut but ignore a price increase.
B. Competitors will match both price cuts and price increases.
C. Competitors will ignore a price cut but follow a price increase.
D. There is no product differentiation.

5. If oligopolistic firms facing similar cost and demand conditions successfully collude,
price and output results in this industry will be most accurately predicted by which of
the following models?
A. The kinked demand curve model of oligopoly.
B. The price-leadership model of oligopoly.
C. The pure monopoly model.
D. The monopolistic competition model.

6. Which of the following is the best example of oligopoly?

A. women's dress manufacturing

B. automobile manufacturing
C. restaurants
D. cotton farming
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7. Oligopoly is more difficult to analyze than other market models because:

A. the number of firms is so large that market behavior cannot be accurately

predicted.
B. the marginal cost and marginal revenue curves of an oligopolist play no
part in the determination of equilibrium price and quantity.
C. of mutual interdependence and the fact that oligopoly outcomes are less
certain than in other market models.
D. unlike the firms of other market models, it cannot be assumed that
oligopolists are profit maximizers.

8. The above diagram portrays:

A. pure competition.
B. collusive oligopoly.
C. noncollusive oligopoly.
D. pure monopoly.

9. Oligopolistic firms engage in collusion to:

A. minimize unit costs of production.

B. realize allocative efficiency, that is, the P = MC level of output.
C. earn greater profits.
D. increase production.

Part B: Short Answer

1. Answer the following questions, which relate to measures of

concentration: LO3

(a) What is the meaning of a four-firm concentration ratio of 60 percent? 90

percent? What are the shortcomings of concentration ratios as measures of
monopoly power?

A four-firm concentration ratio of 60 percent means the largest four firms in

the industry account for 60 percent of sales; a four-firm concentration ratio of
90 percent means the largest four firms account for 90 percent of sales (just
add the percentage of sales for the largest four firms).
Shortcomings:
 they pertain to the nation as a whole, although relevant markets may
be localized;
 they do not account for interindustry competition
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 the data are for U.S. products—imports are excluded

 they don’t reveal the dispersion of size among the top four firms.

(b) Suppose that the five firms in industry A have annual sales of 25, 25, 25,
15, and 10 percent of total industry sales. For the five firms in industry B, the
figures are 50, 30, 10, 5, and 5 percent. Calculate the Herfindahl index for
each industry and compare their likely competitiveness.

For industry A we have:

Herfindahl index = 302+302+202+102+102= 900+900+400+100+100= 2400
For industry B we have:
Herfindahl index = 602+252+52+52+52= 3600+625+25+25+25= 4300
We would expect industry A to be more competitive than Industry B because
the largest two firms in industry B control a greater percentage of the market.
If all firms controlled an equal share of the market (20% for the five firms
above ) the Herfindahl index would equal 2000. If one firm (out of the five)
controlled the entire market (100%) the Herfindahl index would equal 10,000.
The latter case is obviously a monopoly. The closer the Herfindahl index is to
the monopoly case the less competition there will be in the market.

2. What assumptions about a rival’s response to price changes underlie the

kinked-demand curve for oligopolists? How does the kinked-demand curve
explain price rigidity in oligopoly? What are the shortcomings of the kinked-
demand model? LO5

The assumption about rival’s response to price changes is will ignore price
increase and will follow the price cut.
The gap in the MR curve results from the abrupt change in the slope of the
demand curve at the going price. Firms will not change their price because
they fear that if they do their total revenue and profits will fall.
Shortcomings of the model is it doesn’t explain how the current price
determined and doesn’t allow for price leadership, other forms of collusion
and price changed as it will cause price war.

3. Why might price collusion occur in oligopolistic industries? Assess the

economic desirability of collusive pricing. What are the main obstacles to
collusion?
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Price wars are a form of competition that can benefit the consumer but can be
highly detrimental to producers. As a result, oligopolists are naturally drawn
to the idea of price-fixing among themselves, i.e., colluding with regard to
price. In a recession, it is nice to know whether one’s rivals will cut prices or
quantity, so that a mutually satisfactory solution can be reached. It is also
convenient to be able to agree on what price to set to bankrupt any would-be
interloper in the industry.
From the viewpoint of society, collusive pricing is not economically desirable.
From the oligopoly’s viewpoint it is highly desirable since, when entirely
successful, it allows the oligopoly to set price and quantity as would a profit-
maximizing monopolist.
The main obstacles to collusion are demand and cost differences (which result
in different points of equality of MR and MC); the number of firms (the more
firms, the lower the possibility of getting together and reaching sustainable
agreement); cheating (it pays to cheat by selling more below the agreed-on
price—provided the other colluders do not find out); recession (when demand
slumps, the urge to shave prices—to cheat—becomes much greater);
potential entry (the above-equilibrium price that is the reason for collusion
may entice new firms into this profitable industry—and it may be hard to get
new entrants into the combine, quite apart from the unfortunate increase in
supply they will cause); legal obstacles (for a century, antitrust laws have
made collusion illegal).

4. Why is there so much advertising in monopolistic competition and

oligopoly? How does such advertising help consumers and promote
efficiency? Why might it be excessive at times? LO7

Two ways for monopolistically competitive firms to maintain economic profits

are through product development and advertising. Also, advertising will
increase the demand for the firm’s product. The oligopolist would rather not
compete on a basis of price. Oligopolists can increase their market share
through advertising that is financed with economic profits from past
advertising campaigns. Advertising can operate as a barrier to entry.
Advertising provides information about new products and product
improvements to the consumer. Advertising may result in an increase in
competition by promoting new products and product improvements. It may
also result in increased output for a firm, pushing it down its ATC curve and
closer to productive efficiency (P = minimum ATC).
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Advertising may result in manipulation and persuasion rather than

information. An increase in brand loyalty through advertising will increase the
producer’s monopoly power. Excessive advertising may create barriers to
entry into the industry.
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