Narsee Monjee Institute of Management Studies

NMIMS University

Market Structure Analysis: III

Dipankar De
Mumbai, September 2007

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Monopolistic Competition
• A market in which firms compete by selling differentiated products that are highly
substitutable for one another, and there is free entry and exit so that profits are
driven to zero (only normal profits exist).

• The industry structure shares elements of both competition and monopoly.

• The industry structure is monopolistic in that each firm faces a downward sloping
demand curve for its product. It therefore has some market power in the sense that
it can set its own price, rather than passively accept the market price as does a
competitive firm.

• On the other hand, the firms must compete for customers in terms of both price and
the kinds of products they sell. Further, there are no restrictions against new firms
entering into a monopolistically competitive market. In these aspects the industry is
like a competitive industry.

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Monopolistic Competition

• Monopolistic competition is probably the most prevalent form of

market structure.

• Each firm sells a brand or version of the product that differs in

quality, appearance, or reputation, and each firm is the sole producer
of its own brand.

• The amount of monopoly power the firm has depends on its success
in differentiating its product from other competitor.

• Examples of monopolistic competition industries include toothpaste,

laundry detergent, packaged coffee, etc.

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Monopolistic Competition

• A monopolistically competitive market has two key characteristics:

First, firms compete by selling differentiated products, which are
highly substitutable for one another but not perfect substitutes.

• Second, there is free entry and exit – i.e. it is relatively easy for new
firms to enter the market with their own brands of the product and
for existing firms to exit if their products become unprofitable.

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 Monopolistic Competition

• Monopolistic competition can result in too much or too little product

differentiation. Each firm may attempt to make consumers think that its
product is different from the products of its competitors so as to create some
degree of monopoly power.

• • If the firms succeed in convincing them that their product has no close
substitutes, the firms will be able to charge higher price for it than
otherwise.

• A firm is the sole producer of its own brand that gives it monopoly power. But
its monopoly power is limited because consumers can easily substitute other
brands if its price rises. Although consumers who prefer that particular brand
will pay more for it, most of them will not pay much more.

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Oligopoly

• An oligopoly is characterised by a market with a few firms that recognise their

strategic interdependence, i.e. it contains a number of sellers, sufficient so
that the actions of any one seller have a perceptible influence upon his rivals.

• The essential characteristic in an oligopolistic structure is the recognition of the

mutual interdependence of the sellers’ decisions. There are several possible
ways for oligopolies to behave depending on the exact nature of their
interaction.

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Oligopoly

• In some oligopolistic market, some or all of the firms earn substantial profits
over the long-run because barriers to entry make it difficult or impossible for
new firms to enter the market.

• Examples of oligopolistic industries include automobiles, steel, aluminium,

petrochemicals, electrical equipment, and computers.

• In an oligopoly market, the product may or may not be differentiated.

Oligopolists may supply a relatively homogenous product, such as oil, or they
may compete through differentiated products, such as the automobile

industry.
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Oligopoly

• Managing an oligopolistic firm is complicated because pricing, output,

advertising, and investment decisions involve important strategic considerations.
Because only a few firms are competing, each firm must carefully consider how
its action will affect its rivals, and importantly how its rivals are likely to react.

• Competitive strategy is formulated based on some belief about the reaction of

rivals, both in terms of price and non-price competition. These are the two very
crucial competitive elements in an oligopoly structure.

• Many strategic questions are involved: How will competitors react to a price
reduction, or a new advertising campaign, or extra investment, or development
of a new product? What is the implication of the new product by a firm? Could it
limit the response by patenting the process?

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Oligopoly

• Another important feature of oligopoly market is the assumption of ‘common

knowledge’’

• When making decisions, each firm must weigh its competitors’ reactions,
knowing that these competitors will also weigh its reaction to their decisions.

• Furthermore, decisions, reactions, reactions to reactions, and so forth are

dynamic, evolving over time. When the managers of a firm evaluate the
potential consequences of their decisions, they must assume that their
competitors are as rational and intelligent as they are. Then, they must put
themselves in their competitors’ place and consider how they would react.

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Oligopoly

• There are several standard models to explain some of the topicalities

of the oligopolistic market structure.

1. Cournot Model of no-interdependence

2. Stackleberg Reaction model or Leader-Follower model, etc.

3. Sweezy Model of Kinky Demand Curve

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Oligopoly

• The most popular solution for the oligopolistic market is kink-demand

curve solution.

• It assumes that rival sellers follow a price cut policy but not a price
increase one. That is, whenever a seller increases price of its product
no one else will follow it but whenever a seller reduces the price, all
others will do so to maintain their market shares.

• Price rigidity under oligopoly is an important feature, and can

effectively be explained by the model.

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