Applied Microeconomics Winter 20/21

Chapter 12 – Monopolistic Competition and Oligopoly

- Monopolistic competition is similar to a perfectly competitive market:
o There are many firms, & entry by new firms are not restricted
o Difference: the product is differentiated  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
- Amount of monopoly power depends on its success in differentiating its product from those
of other firms (e.g. toothpaste, laundry detergent, packaged coffee)
- Oligopoly: a few firms compete with one another, & entry by new firms is impeded
o Product might be differentiated, or it might not be
- Monopoly power & profitability in oligopolistic industries depend in part on how the firms
interact
- Cartel: some or all firms explicitly collude  they coordinate prices & output levels to
maximize joint profits  different from monopoly:
o Cartels must consider how pricing decisions will affect noncartel production levels
o Members of a cartel are not part of one big company: they may be tempted to “cheat”
their partners by undercutting prices & grabbing bigger shares of the market
o  many cartels tend to be unstable & short-lived

12.1 Monopolistic Competition

The Making of Monopolistic Competition:

- Two key characteristics:

1. Firms compete by selling differentiated products that are highly substitutable for one
another but not perfect substitutes  cross-price elasticities of demand: large (not infinite)
2. There is free entry & exit
o Entry is relatively easy, so if profits are high in a neighbourhood because there are only
a few stores, new stores will enter

Equilibrium in the Short Run & the Long Run:

- Monopolistic competition firms face downward-sloping demand curves  some monopoly

power  doesn’t mean that they are likely to earn large profits
- Free entry: potential to earn profits attracts new firms with competing brands  drives
economic profits down to zero
- Short-run equilibrium:
o Profit-maximizing quantity is at the intersection of MR & MC curves
o Corresponding price exceeds AC  firm earns profit
- Long-run equilibrium:
o Profit will induce entry by other firms  our firm will lose market share & sales
o Demand curve will shift down (AC & MC may also shift, simplicity: it doesn’t)
o Demand curve will be just tangent to the firm’s AC curve
o Profit maximization implies zero profit because price is equal to AC
o The firm still has monopoly power: demand curve is downward sloping  unique brand
o Firms may have different costs, & some brands will be more distinctive than others 
firms may charge slightly different prices, & some will earn small profits

Monopolistic Competition & Economic Efficiency:

Applied Microeconomics Winter 20/21

- Two sources of inefficiency in a monopolistic competitive industry:

1. Equilibrium price exceeds MC  value to consumers of additional output
exceeds the cost of producing those units. If output were expanded to
the point where demand curve intersects MC curve, total surplus could
be increased by an amount equal to the yellow-shaded area. Not
surprising, because monopoly power creates a deadweight loss.
2. In the Figure, output is below that which minimizes AC. Entry of new
firms drives profits to zero. Demand curve is downward sloping, so the
zero-profit point is to the left of minimum AC  excess capacity is inefficient because AC
would be lower with fewer firms
- These inefficiencies make consumers worse off

Monopolistic competition isn’t a socially undesirable market structure that should be regulated:
1. Usually enough firms compete, with brands that are sufficiently substitutable, so that no
single firm has much monopoly power. Any resulting deadweight loss will therefore be small.
And because firms’ demand curv es will be fairly elastic, AC will be close to the minimum.
2. Any inefficiency must be balanced against an important benefit from monopolistic
competition: product diversity. Most consumers value the ability to choose among a wide
variety of competing products & brands that differ in various ways. The gains from product
diversity can be large & may easily outweigh the inefficiency costs resulting from downward-
sloping demand curves

12.2 Oligopoly
- In some oligopolistic markets, some or all firms earn substantial profits over the long run
because barriers to entry make it difficult or impossible for new firms to enter
- Barrier entry:
o Scale economies may make it unprofitable for more than a few firms to coexist
o Patents or access to a technology may exclude potential competitors
o The need to spend money for name recognition & market reputation may discourage
entry by new firms
o Incumbent firms may take strategic actions to deter entry
- Because only a few firms are competing, each firm must carefully consider how its actions
will affect its rivals, & how its rivals are likely to react

Equilibrium in an Oligopoly Market:

- Nash equilibrium: each firm is doing the best it can, given what its competitors are doing
o It is natural to assume that these competitors will do the best they can, given what that
firm is doing
- The chapter focuses on markets in which two firms are competing with each otherduopoly

The Cournot Model:

- Each firm must decide how much to produce, & the two firms make their
decision at the same time  market price depends on the total output of
both firms
- Each firm treats the output level of its competitor as fixed
- Reaction curves: firm 1’s profit-maximizing output is thus a decreasing
schedule of how much it thinks firm 2 will produce  schedule = firm 1’s
reaction curve
Applied Microeconomics Winter 20/21

- Cournot equilibrium: equilibrium output levels are at the intersection of the two reaction
curves  each firm correctly assumes how much its competitor will produce, & it maximizes
its profits accordingly
o Example of a Nash equilibrium  Cournot-Nash equilibrium
o Say nothing about the dynamics of the adjustment process

The Linear Demand Curve – an Example:

- Total quantity produced: 20

- Equilibrium market price: 10
- Each firm earn a profit of 100
Suppose the antitrust laws were
relaxed & the two firms could
collude:
- They would set outputs to maximize
total profit, & presumably they
would split that profit evenly
- R = PQ
- MR = derivative of R
- MR = 0  total profit is maximized,
when Q=15
- Collusion curve gives all pairs of
outputs that maximize total profit
- Both firms produce less & earn
higher profits than in the Cournot
equilibrium

First Mover Advantage – The Stackelberg Model:

- = one firm sets its output before other firms do

- We assume that both firms have MC = 0, and market demand: P = 30 – Q
- Neither firm has any opportunity to react
- Firm 2 makes its output decision after firm 1  takes its output as fixed
- Firm 2’s profit-maximizing output is given by its Cournot reaction curve (12.2)
- Firm 1: to maximize profit, it chooses output so that MR = MC = 0
- Firm 1’s revenue:
- Firm 1 knows, firm 2’s output level (reaction curve in 12.2) 
substitute 12.2 for Q 2 in R1
- Derivate R1 to get MR and set it = 0  Q 1=15, Q 2=7.5
- Firm 1 produces twice as much as firm 2 & makes twice as much profit
- Announcing first creates a fait accompli: no matter what your competitor does, your output
will be large. To maximize profit, your competitor must take your large output level as given
and set a low level of output for itself. If your competitor produced a large level of output, it
would drive price down and you would both lose money. So unless your competitor views
“getting even” as more important than making money, it would be irrational for it to
produce a large amount.
Applied Microeconomics Winter 20/21

12.3 Price Competition

Price Competition with Homogeneous Products – The Bertrand Model:

- = firms produce a homogenous good, each firm treats the price of its competitors as fixed, &
all firms decide simultaneously what price to charge
- Because good is homogeneous, consumers will purchase only from the lowest-price seller
- Nash equilibrium: both firm set price = MC  both earn zero profit
- In the Cournot model, each firm makes a profit

Price competition with Differentiated Products:

- Choosing prices: both firms set prices at the same time & each takes its competitor’s price as
fixed  Nash equilibrium:
o Taking firm 2’s price as fixed, firm 1’ profit maximizing price is the derivative of the
profit over firm 1’ price
o Nash equilibrium is at the point where two reaction curves cross  neither firm has an
incentive to change its price
- If they collude:
o Both would be better off because each would earn more profits
- If firm 1 sets the price first & after observing firm 1’s decision, firm 2 makes its pricing
decision  firm 1 would be at a distinct disadvantage by moving first, because it gives the
firm that moves second an opportunity to undercut slightly & thereby capture a larger
market share

12.4 Competition versus Collusion: The Prisoners’ Dilemma

- Nash equilibrium is a noncooperative equilibrium: resulting profit earned by each firm is
higher than it would be under perfect competition but lower than if the firms collude
- Collusion is illegal
- Payoff matrix: table showing profit (or payoff) to each firm given its decision & the decision
of its competitor
- The prisoners’ dilemma:
o Game theory example in which two prisoners must decide separately whether to
confess to a crime; if a prisoner confesses, he will receive a lighter sentence and his
accomplice will receive a heavier one, but if neither confesses, sentences will be lighter
than if both confess.
- Oligopolistic firms must decide whether to compete aggressively, attempting to capture a
larger share of the market at their competitor’s expense, or to “cooperate” & compete more
passively, coexisting with their competitors & settling for their current market share, &
perhaps even implicitly colluding.

12.5 Implications of the Prisoners’ Dilemma for Oligopolistic Pricing

Price Rigidity:

= Characteristic by which firms are reluctant to change prices even if costs or demands change
- It’s the basis of the kinked demand curve model:
o Each firm faces a demand curve kinked at the currently prevailing price
o Prices above: demand curve is very elastic  firm believes that if it raises its price, other
firms will not follow suit, & will therefore lose sales & much of its market share
Applied Microeconomics Winter 20/21

o Prices lower: other firms will follow suit because they won’t want to lose their shares of
the market  sales will expand only to the extent that a lower market price increases
total market demand
o Demand curve is kinked  MR curve is discontinuous  firm’s costs can change
without resulting in a change in price
o However, it doesn’t say anything about how firms arrived at the price in the first place,
& why they didn’t’ arrive at some different price

Price Signalling & Price Leadership:

- Price signalling: form of implicit collusion in which a firm announces a price increase in the
hope that other firms will follow suit
- Price leadership: Pattern of pricing in which one firm regularly announces price changes that
other firms then match
- Price leadership can also serve as a way to deal with the reluctance to change prices, a
reluctance that arises out of the fear of being undercut or “rocking the boat”

The Dominant Firm Model:

- Firm with a large share of total sales that sets price to maximize profits, taking into account
the supply response of smaller firms
- The dominant firm must determine its demand curve (difference between market demand &
supply of fringe firms)
- To maximize profit: quantity produced is at the intersection of MR & MC

12.6 Cartels
- Producers in a cartel explicitly agree to cooperate in setting prices and output levels
- If enough producers adhere to the cartel’s agreements, and if market demand is sufficiently
inelastic, the cartel may drive prices well above competitive levels
- Conditions for cartel success:
1. A stable cartel organization must be formed whose members agree on price &
production levels & then adhere to that agreement
2. Potential for monopoly power: Even if a cartel can solve its organizational problems,
there will be little room to raise price if it faces a highly elastic demand curve. Potential
monopoly power may be the most important condition for success; if the potential gains
from cooperation are large, cartel members will have more incentive to solve their
organizational problems

Analysis of Cartel Pricing: OPEC & CIPEC  p. 492 f