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Monopolistic Competition & Oligopoly

©2005 South-Western College Publishing

• Key Concepts• Summary

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What will I learn in this chapter?

This chapter will help you understand the impact of monopolistic competition and oligopoly market structures on the price and output decisions of real-world firms.

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What isimperfect competition?

A market structure between the extremes of perfect competition and monopoly

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What is monopolistic competition?

• many small sellers• differentiated product• easy entry and exit

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What isproduct differentiation?The process of creating real or apparent differences between goods and services

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What does many small sellers mean?

Each firm is so small relative to the total market that each firm’s pricing decisions have a negligible effect on the market price

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What isnonprice competition?

A firm competes using advertising, packaging, product development, better service, rather than lower prices

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How easy is entry and exit in monopolistic

competition?Not as easy as in perfect competition because of product differentiation

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Why is a monopolistic competitive firm a

price maker?Product differentiation gives the firm some control over its price

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What does the demand curve for monopolistic competition look like?It is less elastic (steeper) than for a perfectly competitive firm and more elastic (flatter) than for a monopolist

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What are examples of monopolistic competition?

• grocery stores• hair salons• gas stations• video rental stores• restaurants

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How effective is advertising?

Somewhat effective in the short-run but less effective in the long-run

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What effect does advertising have on

average costs?It raises the long-run average cost curve

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$2.00$1.50$1.00$.50

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$2.50$3.00$3.50$4.00

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The effect of Advertising

LRAC2

Co

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nit With advertising

Without advertisingLRAC1

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Q

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How does a firm decide what price to

charge and how many units to produce?

MR = MC

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ATC

MCMR=MC

DMR

ProfitAVC

Q

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Why is a normal profit made in the long-run?The combination of the leftward shift in the firm’s demand curve and the upward shift in the LRAC curve

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LRAC

MC

DMR

Normal Profit

AVC

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How efficient is monopolistic competition?

Less resources are used and a higher price is charged than would be the case under perfect competition

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ATCMC

DMR

Monopolistic Competition

AVC

Minimum LRAC

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LRACMC

MR

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LRAC

Perfect CompetitionP

Q

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What isone way monopolistic competition compares to perfect competition?Price is higher and quantity is lower in monopolistic competition

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Why isprice higher and quantity

lower in monopolistic competition?

Because of the downward sloping demand curve and the MR curve that is beneath the demand curve and more steeply sloped

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How efficient is monopolistic competition?

Less resources are used and a higher price is charged than would be the case under perfect competition

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What is an oligopoly? In an oligopolistic market there are:

• few sellers• a differential product• difficulties of market entry

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How few are a few sellers?

When the firms are so large relative to the total market that they can affect the market price

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What is a significant barrier to entry?

Economies of scale

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What isnonprice competition?Competition in ways other than pricing policies

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What is the distinguishing

feature of oligopoly?mutual

interdependence

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What is mutual interdependence?

A condition in which an action by one firm may cause a reaction on the part of other firms

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What does mutual interdependence do to

the demand curve?A kinked demand curve is a possible result of this characteristic

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What does a kinked demand curve show?It shows that rivals will match a firm’s price decrease, but ignore a price increase

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$200$150$100$50

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$250$300$350$400

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Oligopolist’s Kinked Demand Curve

Rivals ignore price changes

Rivals match price changes

P

Q

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How do oligopolists determine price?

They play the game “follow the leader” that economists call price leadership

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What isprice leadership?

A pricing strategy in which a dominant firm sets the price for an industry and the other firms follow

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What is a cartel?A group of firms formally agreeing to control the price and output of a product

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What are examples of cartels?

• Organization of Petroleum Exporting Countries (OPEC)

• International Telephone Cartel (CCITT)

• International Airline Cartel (IATA)

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What is the major weakness of a cartel?Member firms cheating

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LRACMC

Why a Cartel Member Has an Incentive to Cheat

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MR2

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MR1

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What is Game Theory?

A model of the strategic moves and countermoves of rivals.

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What are two pricing methods in

Game Theory?Tit for tatPrice leadership

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What is tit for tat?Under this approach, a player will do whatever the other player did the last time.

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What is price leadership?

One company follows whatever price the leader sets

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What is formal collusion?

This is when companies communicate and decide what price to charge customers

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What is informal collusion?

This is when companies find alternative ways to agree on a price without any tacit communication

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Is formal collusion legal?

No, it is against the law for firms to come together and agree amongst them what price to charge

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What conclusion can be drawn

from collusion?As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits

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What conclusion can be drawn

from oligopolies?The price charged for the product will be higher than under perfect competition

More money is spent on forms of nonprice competition

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Key Concepts

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• What is imperfect competition?• What is monopolistic competition?• What is product differentiation?• What is nonprice competition?• Why is a monopolistic competitive firm a price ma

ker?• How does a firm decide what price to charge and

how many units to produce?• Why is a normal profit made in the long-run?

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• How efficient is monopolistic competition?• What is oligopoly?• What is nonprice competition?• What is the distinguishing feature of

oligopoly?• What does a kinked demand curve show?• How do oligopolists determine price?• What is a cartel?• What is Game Theory?

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Summary

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Imperfect competition is the market structure between the extremes of perfect competition and monopoly Monopolistic competition and oligopoly belong to the imperfect competition category.

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Monopolistic competition is a market structure characterized by (1) many small sellers, (2) a differentiated product, and (3) easy market entry and exit. Given these characteristics, firms in monopolistic competition have a negligible effect on the market price.

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Product differentiation is a key characteristic of monopolistic competition. It is the process of creating real or apparent differences between products.

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Nonprice competition includes advertising, packaging, product development, better quality, and better service. Under imperfect competition, firms may compete using nonprice competition, rather than price competition.

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Short-run equilibrium for a monopolistic competitor can yield economic losses, zero economic profits, or economic profits. In the long run, monopolistic competitors make zero economic profits.

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$20$15$10

$5

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$25$30$35$40

5 6 7 8 9

ATC

MCMR=MC

DMR

ProfitAVC

Q

P

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Comparing monopolistic competition with perfect competition, we find that the monopolistic competitive firm does not achieve allocative efficiency,charges a higher price, restricts output, and does not produce where average costs are at a minimum.

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$20$15$10

$5

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$25$30$35$40

5 6 7 8 9

ATCMC

DMR

Monopolistic Competition

AVC

Minimum LRAC

P

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$20$15$10

$5

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$25$30$35$40

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LRACMC

MRP

rice

& C

ost

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it Minimum LRAC

Perfect CompetitionP

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Oligopoly is a market structure characterized by (1) few sellers, (2) a homogeneous or differentiated product, and (3) difficult market entry. Oligopolies are mutually interdependent because an action by one firm may cause a reaction on the part of other firms.

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The nonprice competition model is a theory that might explain oligopolistic behavior. Under this theory, firms use advertising and product differentiation, rather than price reductions, to compete.

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The kinked demand curve is a model that explains why prices may be rigid in an oligopoly. The kink is established because an oligopolist assumes that rivals will match a price decrease, but ignore a price increase.

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$200$150$100$50

5 10 15 20

$250$300$350$400

25 30 35 40 45

Oligopolist’s Kinked Demand Curve

Rivals ignore price changes

Rivals match price changes

P

Q

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Price leadership is another theory of pricing behavior under oligopoly. When a dominant firm in an industry raises or lowers price, other firms follow suit.

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A cartel is a formal agreement among firms to set prices and output quotas. The goal is to maximize profits, but firms have an incentive to cheat, which is a constant threat to a cartel.

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$30

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LRACMC

Why a Cartel Member Has an Incentive to Cheat

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MR2

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MR1

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Comparing oligopoly with perfect competition, we find that the oligopolist allocates resources inefficiently, charges a higher price, and restricts output so that price may exceed average cost.

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Oligopoly is much more difficult to evaluate than other market structures. None of the models just presented gives a definite answer to the question of efficiency under oligopoly. Depending on the assumptions made, an oligopolist can behave much like a perfectly competitive firm or more like a monopoly.

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