Chapter 10 : Monopolistic Competition and Oligopoly So far we have seen 2 types of markt © perfectly competitive: many buyers and prodacers, product homogeneity and free entry/exit ‘© monopolistic: many buyers but only one producer, product homogeneity (one product) and no entry/exit (except for the monopolist) + But many markets are between these two extremes: share some of the features of perfect com- petition but not everything ~ In some markets, there is only a limited aumber of sellers, Example: wireless phone service (Verizon, AT&T, Sprint and T-Mobile); provide services which somewhat differ in terms of coverage, customer service, reliability. Entry and exit is difficult ~ Sport shoe companies, soda industry: large number of competitors but they sell product which are highly differentiated. Example: Nike versus Adidas customers; Coca Cola versus Pepsi customers ... Entry and exit is easy. ‘+ The first example is an example of oligopoly while the second is an example of monopolistic competition. 10.1 Monopolistic Competition How can we understand advertising? Companies advertising their product as being cheaper or better than their alternatives in order to differentiate themselves and create separate markets. ‘¢ Monopolistic competition = market structure which has 3 main characteristics: — there are many sellers and buyers — sellers offer differentiated products — entry and exit of the market are easy + Relaxes product homogeneity © Buyer is still a price-taker but sellers are price-makers, © Competitive aspect: Many firms so no strategic interactions among them: each firm takes pric- ing/advertising decisions of the others as given and doesn’t account for how its decisions will affect its competitors. Example: restaurants in a given city. + Monopolistic aspect : Since no 2 products are exactly the same, each monopolistic competitor can raise its price (up to a certain point) aad only lose some of its customers. Monopolistic competitor faces a downward sloping deman¢ curve : can sell mote by charging less. ‘© Aspects of differentiation : quality (Mercedes versus Hyundai), location. + Easy entry and exit: no significant barriers to entry (Ike licenses, patents.., successful practices of others can be copied, Imitation i free. 5Monopolistic competition in the SR ‘* Like a monopoly, the demand curve faced by the monopolistic competitor is downward sloping. Here again, MR'< P (marginal revenue curve to the left of the inverse demand curve) and the goal is to set MR = MC to maximize profits, ‘* Difference: when a monopolistic competitor raises its price, customers have option to buy similar ‘but not identical product elsewhere. => The demand curve faced by a monopolistic competitor is more elastic than for the monopolist. «In the SR, a firm can make an economic proft or an economic loss (s0 long as price>AVC) Monopolistic competition in the LR + Since exit is ensy, a SR loss encourages a firm; to leave in the LR. # In the LR, profit attracts entry which shifts the firm's demand curve to the left as well as the MR curve, © Entry will occur until P = ATC i.e. until the demand curve becomes tangent to the average total cost curve. ‘* In the LR, a monopolistic competitor operates with excess capacity. © Graphically, this means that a monopolistic competitor produces on the downward-sloping por- tion of its ATC curve: the output level produced is too small to minimize the cost per unit. ‘© This has to be the case because increasing quantity implies P < ATC. Welfare effects of monopolistic competition ? ‘There are 2 sources of inefficiencies compared to the perfectly competitive case: Price exceeds marginal cost: there is a deadweight loss created by the monopoly power of each firm. ‘© With excess capacity, monopolistic competition is also costly to consumers because now P > min ATC. BL‘* However consumers benefit from product variety so P > min ATC is the price to pay for this variety. ‘© Overall, one can argue that monopolistic competition can be a socially desirable market structure since: — In general, monopoly power of the firms is small because brands are highly substitutable ‘meaning that each firm faces a very elassic demand curve, As a result, the deadweight loss is small. Furthermore, an elastic demand curve implies tha tthe average cost will be close to minimum, — Product diversity is valued by customers. = = 10.2 Oligopoly * In some markets, most of the output is sold only by a few firms. ‘* Asa result, the actions taken by one firm will afect the others and generate a direct response. ‘+ “If'we take action A, our competitors will do B, then we would do C and they would respond to D..” + Strategie interactions among firms is an essential characteristic of an oligopoly. « An oligopoly is a market structure where: ~ There is large number of buyers but oaly a stall number of sellers. = Those sellers strategically interact. ~ Entry and exit are more difficult. ‘© Examples in the real world: Market for natunal foods (Whole Foods, Trader Joe's). How do oligopolies arise? ‘Why is there only a restricted number of sollers in some markets ? => existence of barriers to entry. ‘+ Boonomiestof scale: a large firm will have a lower cost per unit than a small firm, ~ natural oligopoly: existence of a minimum efficient scale (Airlines, textbook publishers...) 2