Monopolistic Competition

and Oligopoly
Chapter 14
 Monopolistic Competition

Imperfect competition refers to

those market structures that fall
between perfect competition and
pure monopoly.
Monopolistic Competition

 Types of Imperfectly Competitive Markets

 Monopolistic Competition
 Many firms selling products that are similar but not
identical.
 Markets that have some features of competition and
some features of monopoly.
 Oligopoly
 Only a few sellers, each offering a similar or identical
product to the others.
•The monopolistically competitive market is
similar to perfect competition in that there
are many buyers and sellers who can
enter or leave the market easily in response
to economic profits or losses.

•A monopolistically competitive firm,

though, is similar to a monopoly in that it
produces a product that is different from that
produced by all other firms in the market.
Monopolistic Competition

 Attributes of Monopolistic Competition

 Large number of sellers

 Product differentiation
 Free entry and exit (Relatively easy)
Monopolistic Competition

 Many Sellers

 There are many firms competing for the

same group of customers.
 Product examples include books, CDs,

movies, computer games, restaurants,

furniture, etc.
Monopolistic Competition
 Product Differentiation
 Each firm produces a product that is at

least slightly different from those of other

firms.
 Rather than being a price taker, each firm

faces a downward-sloping demand curve.

 Free Entry or Exit:

 Firms can enter or exit the market without
restriction.
 COMPETITION WITH
DIFFERENTIATED PRODUCTS
 The Monopolistically Competitive Firm in the
Short Run
 Short-run economic profits encourage new
firms to enter the market. This:
 Increases the number of products offered.
 Reduces demand faced by firms already in the market.
 Existing firms’ demand curves shift to the left.
 Demand for the existing firms’ products fall, and their
profits decline.
Demand curve facing a monopolistically competitive firm
Monopolistic Competitors in the Short Run

(b) Firm Makes Losses

Price

MC
ATC
Losses

Average
total cost
Price

MR Demand

0 Loss- Quantity
minimizing
quantity
 COMPETITION WITH
DIFFERENTIATED PRODUCTS

 The Monopolistically Competitive Firm in the

Short Run
 Short-run economic losses encourage firms to
exit the market. This:


 Decreases the number of products offered.

 Increases demand faced by the remaining firms.
 Shifts the remaining firms’ demand curves to the right.
 Increases the remaining firms’ profits.
Monopolistic Competition in the Short Run

(a) Firm Makes Profit

Price

MC

ATC

Price
Average
total cost
Profit Demand

MR

0 Profit- Quantity
maximizing
quantity
 A Monopolistic Competitor in the Long Run
Firms will enter and exit until the firms are making exactly zero economic profits…..
Price

MC
ATC

P = ATC

Demand
MR
0
Profit-maximizing Quantity
quantity
 Long-Run
 Equilibrium
Two Characteristics
 As in a monopoly, price exceeds marginal
cost.
 Profit maximization requires marginal revenue to
equal marginal cost.
 The downward-sloping demand curve makes
marginal revenue less than price.
 As in a competitive market, price equals
average total cost.
 Free entry and exit drive economic profit to zero.
This long-run equilibrium situation is often referred to
as a "tangency equilibrium" since the demand curve is
tangent to the ATC curve at the profit-maximizing
level of output.
Monopolistic versus Perfect Competition

 There are two noteworthy differences between

monopolistic and perfect competition;
 excess capacity and
 markup.
 Monopolistic versus Perfect Competition
 Excess Capacity
 There is no excess capacity in perfect competition
in the long run.
 Free entry results in competitive firms producing at
the point where average total cost is minimized,
which is the efficient scale of the firm.
 There is excess capacity in monopolistic
competition in the long run.
 In monopolistic competition, output is less than the
efficient scale of perfect competition.
Monopolistic versus Perfect Competition

 Markup Over Marginal Cost

 For a competitive firm, price equals marginal cost.
 For a monopolistically competitive firm, price
exceeds marginal cost.
 Because price exceeds marginal cost, an extra
unit sold at the posted price means more profit for
the monopolistically competitive firm.
 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC
Markup

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Excess capacity

Copyright©2003 Southwestern/Thomson Learning

Advertising and brand names

 Two views:
 Critics argue that firms use advertising and brand
names to take advantage of consumer irrationality
and to reduce competition.
 Defenders argue that firms use advertising and
brand names to inform consumers and to
compete more vigorously on price and product
quality.
 Oligopoly

• Examples of oligopolistic structures:

• Supermarkets
• Banking industry
• Chemicals
• Oil
• Medicinal drugs
• Broadcasting
 Oligopoly
An oligopoly market is characterized by:

• a small number of firms,

• either a standardized or a differentiated
product,
• recognized mutual interdependence, and
• difficult entry.

•Oligopoly firms engage in strategic behavior. Strategic

behavior occurs when the best outcome for one party is
determined by the actions of other parties.
The kinked demand curve model describes a situation in
which a firm assumes that other firms will match its price
reductions but will not follow price increases. The optimal
strategy in such a situation is frequently to leave the price
at the current level and to rely on nonprice competition
rather than price competition.

In the oligopoly pricing decision described above, the

dominant strategy is to offer a lower price.

There is little evidence, though, that the kinked-demand

curve model accurately describes the behavior of oligopoly
firms.
 Oligopoly The kinked demand curve - an explanation for price
stability?
If the firm seeks to lower its
Price Assume price the firm is charging a price of £5
Kinked D Curve to gain a competitive
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andemand
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100 Quantity
Price-leadership Model
If oligopoly firms are free to collude and jointly determine their prices and output
levels, they would be able to attain a higher combined level of profits. In many
countries collusion of this sort is illegal.
While it is illegal for firms to officially meet and determine prices and output
levels, it is perfectly legal for them to charge the same high prices as long as
they didn't meet to determine the prices.

Firms may be able to achieve outcomes equivalent to the collusive outcome by

engaging in a price-leadership situation in which one firm sets the price for the
industry and the other firms follow that firm’s price changes. Price leader uses
following tactics:

• Make infrequent changes with a fear that rivals may not follow.
• It communicates the need for prospective price to industry.
• Uses the limit price strategy to prevent new entry in industry.
Cartels and other collusions

Cartels are legal in some countries. Under a cartel arrangement,

firms engage in explicit collusive behavior. Collusion occurs
whenever firms in an industry reach an agreement to fix prices,
divide up the market, or otherwise restrict the competition among
themselves.

One problem with cartels, though, is that any individual firm can
increase its profits by cheating on the agreement. For this reason,
most cartels have not been lasted very long.
Brand name identification is important in many oligopoly and
monopolistically competitive markets because a seller that wishes
to remain in business has an incentive to produce a high quality
product.

Customers are often willing to pay a higher price for a product

produced by an established firm rather than buying a product from
a firm that they do not recognize.

Product guarantees are also used by firms as a signal of product

quality.