Price and Output Under Monopolistic Competition and Oligopoly

1. Monopolistic Competition
a. This refers to the case in which there are many sellers of a heterogeneous or
differentiated product
b. Entry Into or exit from the industry is rather easy in the long run
c. Differentiated products
i. There are products that are similar but not identical.
ii. They satisfy the same basic consumption needs
d. Each seller is too small to affect the other sellers
e. Most common in the retail and service sectors
f. Firms affect volume of their sales by
i. Changing the product price
ii. Changing the characteristics of the product
iii. Varying their selling expenses (such as advertising)
2. Analysis
a. Demand curve is
i. negatively sloped
1. Because monopolistically competitive firm produces a differentiated
product
ii. Highly price elastic
1. Since there are many close substitutes for the product
b. Short-Run
i. MR = MC
ii. P > AVC

iii. Firms can

1. Make profit, if P>SATC
2. Break even, if P=SATC
3. Incur loss, if P<SATC
c. Long-Run
i. Due to new entrants
 1. Demand curve shifts to left, till tangent to LAC curve
2. Firms produce at negative slope of LAC curve, rather than the lowest
point
3. Firms break even
ii. As Monopolistically competitive firms produce to the left of the lowest point
on its LAC curve in long-run equilibrium
1. Average cost of production and price of the product under
monopolistic competition are higher than under perfect competition
2. This difference is however not large, because the demand curve face
by the monopolistic competition is very elastic
iii. Excess capacity
1. The difference between the level of output indicated by the lowest
point on LAC curve and the monopolistic competitor’s output when
in long-run equilibrium
d. Product Variation and Selling Expense
i. A firm can increase its expenditure on product variation and selling efforts
to increase the demand for the its product and make it more price inelastic
ii. Product Variation
1. It refers to changes in some of the characteristics of the product
that a monopolistic competitor undertakes in order to make its
product more appealing to consumers
iii. Selling Expenses
1. There are all those expenses that the firm incurs to advertise the
product, increase its sales force, provide better service for its
product.
iv. Firms should spend more on product variation and selling expenses as long
as the MR from these efforts exceeds the MC and until MR=MC

v. While these efforts can lead to larger short-run profits, however, our typical
or representative firm will break even in the long run
 1. Because other firms can also increase product variation and selling
expenses, and more firms can also enter the market in long-run
vi. Advertisement
1. Create false need
2. Enhance competition
e. Challenges to
i. Difficult to define the market and determine the firms and products to
include
ii. In markets, where there are many small sellers, product differentiation has
been found to be slight. As a result, the demand curve is close to being
horizontal. Here, perfectly competitive model easily provides better
approximation
iii. In markets, where there are strong brand preferences, it usually turns out
that there are only a few producers, so that the market is oligopolistic rather
than monopolistically competitive
iv. In market, where there are many small sellers of a product or service, a
change in price by one seller may have little or no effect on most
competitors located far away from it, but the price change will have a
significant impact on competitors in the immediate vicinity. The oligopoly
model is more appropriate than the model of monopolistic competition.

3. Oligopoly
a. It is a form of market organization in which there are few sellers of a homogeneous
or differentiated product.
b. Pure Oligopoly
i. If the product is homogeneous
c. Differentiated Oligopoly
i. If the product is differentiated
d. Not easy to enter
e. Distinguishing characteristic is the independency or rivalry among the firm in the
industry
i. Result of fewness
f. Source
i. Economies of scale may operate over a sufficiently large range of outputs so
as to leave only a few firms supplying the entire market
ii. Huge capital investments and specialized inputs are usually required to
enter an oligopolistic industry; and this act as a natural barrier to entry
iii. A few firms may own a patent for the exclusive rights to produce a
commodity or to use a particular production process
iv. Established firms might have a loyal following of customer based on product
quality and service that new firms may find very difficult to match
v. A few firms may own or control the entire supply of a raw material required
in the production of the product
vi. The government may award a franchise to only a few to operate in the
market
g. Concentration ratio
i. The degree by which an industry is dominated by a few large firms is
measured by concentration ratio
 ii. 4-firm concentration close to 100, signifies oligopolistic industry

4. Cournot Model
a. The basic behavioural assumption made in the model is that each firm, while trying
to maximise profits, assumes that the other duopolist holds its output constant at
the existing level. The result is a cycle of moves and countermoves by the duopolists
until each sells one-third of the total industry output

b. In a more advanced treatment, with three oligopolists, each would supply one-
fourth of the perfectly competitive market of twelve units and three-fourth in total

5. Kinked-Demand Curve Model

a. It postulates that if an oligopolist raised its price, it would lose most of its customers
because the other firms in the industry would not match the price increase. On the
other hand, an oligopolist could not increase its share of the market by lowering its
price, since its competitors would immediately match the price reduction.
b. As a result, oligopolists face a demand curve that is highly elastic for price increases
and less elastic for price reduction. That is, demand curve faced by oligopolists has a
kink at the established price
6. Price Leadership
a. It is a way by which firms in an oligopolistic market can make necessary price
adjustments without fear of starting a price war and without overt collusion
b. The dominant firm sets the price for the commodity that maximized the profits,
allows all the other firms in the industry to sell all they want at that price, and then
comes in to fill the market.
c. The small firms in the industry behave as perfect competitors or price takers, and
the dominant firm acts as the residual supplier of the commodity