Chapter 6 Theory of Firm and Market Structure - PART 2

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 8– 1

CHAPTER 6
MARKET STRUCTURE 2:
MONOPOLISTIC
COMPETITION AND
OLIGOPOLY

MONOPOLISTIC
COMPETITION
 Definition
– Market structure in which there are large numbers of
small sellers selling differentiated products but these
are close substitute products and have easy entry into
and exit from the market.
 Characteristics
– Large number of sellers – there is a large number of
sellers under the monopolistic competition and no
individual firm can influence the market price.
However, each firm follows an independent price-
output policy.
MONOPOLISTIC
COMPETITION (cont.)
– Differentiated products – product differentiation could be
through packaging, design, labelling, advertising and
brand name. Eg: Shampoo
– Free of entry and exit into the market – not as easy as
perfect competition because of the existence of product
differentiation.
– Role of non-price competition is significant – various
methods used to attract the customers to buy a particular
brand.
– Selling cost – different types of expenditure on
advertisement would incur additional cost.

MONOPOLISTIC
COMPETITION (cont.)
The demand curve for monopolistic competitive firm is
downward sloping due to product differentiation.
Price
Demand curve for monopolistic

competitive firm is more elastic
than demand curve for
monopolist firm because in
monopolistic competition there
AR=P are many firms and many
substitutes.
MR
Quantity

PROFIT MAXIMIZATION IN
SHORT RUN
Monopolistic competitive firm earns economic profit
At this output, the firm earns
Economic profit or economic profit or supernormal The profit maximization
supernormal profit profit equal to the shaded area. level occurs where MR
is the profit earned curve and MC curve
Price (RM) MC
by a monopolist intersects at Point A.
competitive firm
when TR > TC. AC
To find the price, we use the
same vertical line with
output up to the demand
curve. The profit maximizing
P*
price and output is
PROFIT
AC P* and Q*.
A
AR = D
MR
Quantity
Q*
SHORT RUN (cont.)
Monopolistic competitive firm at break-even
Normal profit or break-even is The profit maximization
earned when TR = TC. level occurs where MR
curve and MC curve
Price (RM) At this output, monopolistic intersects at Point A.
MC
competitive firm is at the break-
even or earns normal profit. AC
The profit maximizing price

and output is P* and Q*.
AC/ P*
DD = AR
MR
Quantity
Q*
SHORT RUN (cont.)
Monopolistic competitive firm suffers economic losses
Economic losses or subnormal At this output, monopolist suffers economic losses
profit is the losses incurred by a or subnormal profit equal to the shaded area.
monopolistic competitive firm when
Price (RM) AC
MC
TR < TC.
The profit maximization

level occurs where MR
AC curve and MC curve
LOSSES intersect at Point A.
P*
The profit maximizing price
A and output is P* and Q*.
AR = DD
MR
Quantity
Q*
LONG RUN
Monopolistic competitive firm earns normal profit in long
run
A monopolistic competitive
firm earns normal profit in
Price (RM) the long run due to free LRMC
entry and exit.
LRAC
P*
LRAR = D
LRMR
Q*
Quantity
OLIGOPOLY
 Definition
– Exists when there are only a few firms in the market which
dominate the sale of a product because entry of any new forms is
difficult or impossible. An oligopoly produces either homogeneous
or differentiated products, whereby the price and output decision of
one firms will affect other firms. Eg: Automobile, steel, petroleum.
 Characteristics
– Few numbers of firms – the number of firms is small but size of
the firms is large. (Petronas, Caltex)
– Homogeneous or differentiated product (petroleum, tire)
– Mutual interdependence – firms in an oligopoly market always
consider the reaction of their rivals when choosing price, sales
target, advertising budgets and other business policies. (McD vs
KFC)
OLIGOPOLY (cont.)
– Barriers to entry – restrict new entrants into the market

through various types of barriers to entry such as control of
certain resources, ownership of patent and copyright,
exclusive financial requirements and other legal barriers.
 Price Rigidity and Kinked Demand Curve
– Since there is mutual interdependence between oligopoly
firms, the prices in the market are more stable. This is called
price rigidity in oligopoly market.
– The price rigidity explains the behaviour of an oligopoly firm
that has no incentive to increase or decrease the price.

OLIGOPOLY (cont.)
The theory of the kinked demand curve is based on two

assumptions.
1. First assumption: If an oligopolist reduces its price, its

rivals will follow and cut their prices to prevent losing the
customers.
2. Second assumption: If an oligopolist increases its
price, its rivals do not increase the price and keep their
prices the same, thereby they gain customers from the
firm that increases the price.
OLIGOPOLY (cont.)
Because of this According to the assumption, when the firm
assumption, an increases the price (P*), no other firms will follow.
oligopolist faces kinked
If the firm decreases the price, other firms will follow.
Price (RM) demand curve.
Below P*, the firm follow the DD curve.
P*
DD
Q* Quantity

OLIGOPOLY (cont.)
This shows the price At this range of MR, any The kinked demand
rigidity in the oligopoly change in the MC does not curve below Point E
market. reflect changes in the profit creates a gap in the
Price (RM)
maximizing price and MR, which is indicated
output. by the dotted line ab.
MC1
MC2
E
P*
b DD
Q*
MR Quantity

SUMMARY OF MARKET
STRUCTURE
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Number of sellers
Large One Many Few
Identical or Unique or no Homogenous or

Type of product Differentiated
homogenous close substitution differentiated
Entry condition Very easy Impossible Easy Difficult

Control over
None Some Some Considerable
price
Local phone Automobiles,
Examples Wheat, corn Food, clothing
service, electricity cigarettes
Profit
MR = MC MR = MC MR = MC MR = MC
maximization

SUMMARY OF MARKET
STRUCTURE (cont.)
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Subnormal, Subnormal, Subnormal, Subnormal,
Short run
supernormal or supernormal or supernormal or supernormal or
equilibrium
normal profit normal profit normal profit normal profit
Normal profit due Supernormal Normal profit due Supernormal
Long run
to free entry and profit because of to free entry and profit because of
equilibrium
exit barriers to entry exit barriers to entry
Production
efficiency (at Yes No No No
minimum AC)
S/run: AR<AVC S/run AR<AVC S/run: AR<AVC S/run: AR<AVC
Shut down
L/run: AR< AC L/run: AR< AC L/run: AR< AC L/run: AR< AC

EXERCISE 1

EXERCISE 1

EXERCISE 3


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PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 8– 1

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Demand curve for monopolistic

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

The profit maximizing price

The profit maximization

– Barriers to entry – restrict new entrants into the market

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

The theory of the kinked demand curve is based on two

1. First assumption: If an oligopolist reduces its price, its

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Identical or Unique or no Homogenous or

Entry condition Very easy Impossible Easy Difficult

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

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