Topic Twelve

Monopolistic Competition and Oligopoly

12.0 Introduction

In this unit you will study the pricing policy of monopolistic competitive market and
oligopolistic market. Monopolistic competitive markets are quite similar to perfectly
competitive markets except that they sell differentiated products. In this market, supernormal
profits attract new entrants into the market, since there are no entry barriers. In oligopolist
market, you will find that the product may or may not be differentiated. What you find is that
only a few firms account for most or all of total production. In oligopolist markets, only a few
firms compete with one another and entry by new firms is restricted.

12.1 Topic Objectives

At the end of this unit, the student is expected to know:

Pricing policy of monopolistic competition and oligopoly

Profit maximization of monopolistic competition and oligopoly
Determination of market equilibrium and the excess capacity
Unique characteristics for oligopoly
The interdependence of firms under oligopoly
How cartels are formed under oligopoly

12.2 Nature of Monopolistic Competition

The term monopolistic competition suggests that there are some elements of monopoly and
competition under this market structure. Like a competitive model it includes a large number of
sellers and entry into and exit from the industry is unrestricted. However, the firms produce
differentiated and identical product. Because they produce a product that is different from but
similar to, that of other firms they will have a small degree of monopoly power.

Product differentiation may be real or it may be based on perceived differences by the

consumers. The characteristics of monopolistic competition are:

The product has close substitutes.

A large number of firms produce the product.

Entry into the industry is unrestricted.

The number of firms in the product group is sufficiently large so that each firm expects its action
to be ignored by its rivals.

The cost and demand conditions are the same for all firms in the product group.

12.3 Determination of Market Equilibrium

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The demand curve that confronts a single firm under this type of market structure is downward
sloping but highly elastic. Figure 12.1 shows how a monopolistically competitive firm makes
profits in the short-run indicated by the shaded area.

Prices MC

AC

P1

MR

0 Q1 Output

Figure 12.1: A Monopolistically Competitive firm in the Short-run

In the short-run a firm in a monopolistically competitive market may make a profit as shown in
the figure above. Attracted by the prospects of profits new firm enter the market. This shifts the
demand curve confronting the firm downward until a zero-profit long-run equilibrium is attained
as shown in figure 12.2 below

Prices MC

T AC

P2 S

MR

0 Q2 Output

Figure 12.2: Zero Profit long-run equilibrium

12.4 Excess Capacity

The industry has excess capacity because each firm does not produce at the minimum point on its
LAC curve. Consider the figure 12.2 above. Notice that in the longrun equilibrium the firm
operates to the left of the minimum point S on its long-run AC curve. Thus the firms’ per
unit product costs are higher than the minimum cost possible. So in a monopolistically
competitive industry there are many firms each with excess capacity.
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12.5Nature of Oligopoly

The major characteristic of oligopoly that distinguishes it from other forms is the mutual
interdependence of firms in the industry. There are only a few firms each realizes its actions will
affect its rivals and vice versa. Oligopolistic industries usually exhibit economies of scale. prices
under oligopolistic market tend to be fairly stable. There is non-price competition under this type
of market.

12.6 Price and output

An oligopolists will want to behave like a monopoly, choosing a rate of industry output that
maximizes total industry profit. Industry profits are maximized at the rate of output at which the
industry`s marginal cost equals marginal revenue. In an oligopoly the MC and ATC curves
represent the combined production capabilities of several firms rather than one firm. The
industry MC curve is derived by horizontally summing the MC curves of the individual firms.
(See figure 12.3 below).

Price

or MC

cost

AC

Industry Profits

● Market

Demand

Marginal Revenue

0 Quantity

Figure 12.3: Industry marginal cost and profit

12.7The kinked demand curve model

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The shape of the demand curve facing an oligopolist depends on the responses of its rivals to its
price and output decisions. If rivaloligopolists match price reductions but not price increases the
demand curve will be kinked. We can summarize the case of a kinked demand curve as shown
in figure 12.4 below

Price D

1100 ●B Demand curve facing oligopoly

If rivals match price changes

1000 ●A

900 ●C

Oligopoly if rivals

don’t match price

changes

0 8000 Q

Figure 12.4: Kinked demand curve of oligopoly market

Initially, the oligopolist is at point A. If it raises its price to K1100 and its rivals don’t raise their
prices, it will be driven to point B. If its rivals match a price reduction to K900, the oligopolist
will end up at point C. The demand curve facing oligopolist if rivals match price cuts but not
price hikes is DD.

12.8 Cartel
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Because oligopolistic industries are characterized by few firms, they are by nature conducive to
the formation of cartels.

12.9 Problems of Cartels

Once the cartel is in operation the problem of cheating arises. However, cheating is less likely to
occur under the following conditions:

If the number of firms in the cartel is small so the cartel is easier for police to detect cheating.

If cartel members can retaliate against the cheater quickly.

If there is some way to punished the cheater severely.

If the product is homogeneous so price differentials are the obvious result of cheating rather than
price adjustments reflecting quality differences.

If business conditions are good since firms are more likely to cheat when demand is falling,
which puts pressure on profit margins.

12.10 Topic Summary

Monopolistic competition combines the features of perfect competition and monopoly.

Like perfect competition, there are a large number of buyers and sellers with no barriers
to entry. However, the products are differentiated. Differentiated products are similar but
not identical but are close substitutes to each other.

Product differentiation gives firms operating under monopolistic competition some form
of market power, just like under monopoly. The firms are able to earn supernormal
profits.

The amount of market share and power a monopolistically competitive firm possesses
depends on how successfully it differentiates it product from similar products.

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 Low entry barriers permit new firms to enter a monopolistically competitive industry
whenever economic profits exist

Monopolistic competition results in resource misallocations.

An oligopoly is a market structure in which a few firms produce all or most of a

particular good.

Because oligopolies involve several firms rather than only one, each firm must consider
the effect of its price and output decisions on the behaviour of rivals.

When groups of oligopoly firms agree on the price and output policies, then a cartel has
been formed.

12.11 Topic Reference

Schiller B.R, Hill C and Wall S (2013) The Economy today, Mcgraw Hill. ISBN 978-
0-07-131757-3

12.12Topic Activities

What are the characteristics of monopolistic competition?

How is the oligopoly market structure different from other market structures?

What is meant by non-price competition?

Draw a kinked demand curve.

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