Monopolistic Competition and Oligopoly

Monopolistic Competition

FIGURE 13.2 Characteristics of Different Market Organizations

2 of 18

Monopolistic Competition
Monopolistic competition is a market structure in which many firms sell a differentiated product and entry into and exit from the market are relatively easy.
Examples: furniture, jewelry, leather goods,

grocery stores, gas stations, restaurants, clothing stores and medical care.

Characteristics of Monopolistic Competition

Relatively large number of sellers firms

have small market shares, collusion is unlikely and each firm can act independently Differentiated products the product is slightly different and is often promoted by heavy advertising Easy entry to, and exit from, the industry economies of scale are few, capital requirements are low but financial barriers exist

Differentiated Products
Product differentiation is a form of

nonprice competition in which a firm tries to distinguish its product or service from all competing ones on the basis of attributes such as design and quality. Production differentiation entails product attributes, service, location, brand name and packaging, and some control over price.

Advertising
The goal of product differentiation and

advertising is to make price less of a factor in consumer purchases and make product differences a greater factor. The intent is to increase the demand for a product and to make demand less elastic.

Pricing and Output in Monopolistic Competition

The demand curve of a monopolistically

competitive firm is highly, but not perfectly, elastic.

The price elasticity of demand for a

monopolistic competitor depends on the number of rivals and the degree of product differentiation. The larger the number of rival firms and the weaker the product differentiation, the greater the price elasticity of each firms demand.

The Short Run: Profit or Loss

The monopolistically competitive firm maximizes profit or minimizes loss in the short run. It produces a quantity Q at which MR = MC and charges a price P based on its demand curve.
When P > ATC, the firm earns an economic

profit. When P < ATC, the firm incurs a loss.

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.

Incumbent firms demand curves shift to the left. Demand for the incumbent firms products fall, and their

profits decline.

Figure 1 Monopolistic Competition in the Short Run

(a) Firm Makes Profit Price MC

ATC

Price Average total cost Profit

Demand

MR
0 Profitmaximizing quantity Quantity

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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.

Figure 1 Monopolistic Competitors in the Short Run

(b) Firm Makes Losses Price MC ATC

Losses

Average total cost

Price

MR 0 Lossminimizing quantity

Demand
Quantity

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The Long-Run Equilibrium

Firms will enter and exit until the firms are making

exactly zero economic profits.

Figure 2 A Monopolistic Competitor in the Long Run

Price MC ATC

P = ATC

Demand MR 0 Profit-maximizing quantity Quantity

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Monopolistic or Imperfect Competition

Implications for the diagram:
Cost/Revenue

MC AC

Because there is relative freedom of entry and exit into the market, new firms will enter encouraged by the existence of abnormal profits. New entrants will increase supply causing price to fall. As price falls, the AR and MR curves shift inwards as revenue from each sale is now less.

MR1
Q1

MR

AR1

D (AR)
Output / Sales

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.

Monopolistic versus Perfect Competition

There are two noteworthy differences between

monopolistic and perfect competitionexcess 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.

Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm Price MC Price

(b) Perfectly Competitive Firm

ATC

MC

ATC

P P = MC P = MR (demand curve)

MR

Demand

Quantity produced

Efficient scale

Quantity

Quantity produced = Efficient scale

Quantity

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Why Monopolistic Competition Is Less Efficient than Perfect Competition Excess capacity The monopolistic competitor operates on the downward-sloping part of its ATC curve, produces less than the cost-minimizing output. Under perfect competition, firms produce the quantity that minimizes ATC.
Markup over marginal cost Under monopolistic competition, P> MC. Under perfect competition, P= MC.

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.

Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm Price MC

Markup

(b) Perfectly Competitive Firm Price MC

ATC

ATC

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

Quantity produced

Quantity

Quantity produced

Quantity

Copyright2003 Southwestern/Thomson Learning

Figure 3 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm Price MC

Markup

(b) Perfectly Competitive Firm Price MC

ATC

ATC

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

Quantity produced

Efficient scale

Quantity

Quantity produced = Efficient scale

Quantity

Excess capacity

Copyright2003 Southwestern/Thomson Learning

The Long Run: Only a Normal Profit

In the long-run, firms will enter a

profitable monopolistically competitive industry and leave an unprofitable one. A monopolistic competitor will earn only a normal profit and price just equals average total cost at the MR = MC output.

The Long Run: Only a Normal Profit

Because entry to the industry is

relatively easy, economic profits attract new rivals.

As new firms enter, the demand curve faced

by the typical firm shifts to the left, reducing its economic profit. When entry of new firms has reduced demand to the extent that the demand curve is tangent to the ATC curve at the profitmaximizing output, the firm is just making a normal profit, leaving no incentive for new firms to enter.

The Long Run: Only a Normal Profit

When the industry suffers short-run losses, some firms will exit in the long run.
As firms exit, the demand curve of surviving

firms begins to shift to the right, reducing losses until the firms are just making normal profit.

Pricing and Output in Monopolistic Competition

Monopolistic Competition and Efficiency

In monopolistic competition, neither

productive nor allocative efficiency occurs in long-run equilibrium.

Since the firms profit-maximizing price (and

average total cost) slightly exceed the lowest average total cost, productive efficiency is not achieved. Since the profit-maximizing price exceeds marginal cost, monopolistic competition causes an underallocation of resources.

Excess Capacity
The gap between the minimum ATC

output and the profit-maximizing output is a monopolistically competitive firms excess capacity.
Plants and equipment are unused because

the firm is producing less than the minimumATC output. Monopolistically competitive industries are overcrowded with firms each operating below its optimal capacity.

Product Variety and Improvement

Despite the overcrowded feature,

monopolistic competition does promote product variety and product improvement.

A firm earning a normal profit will develop

and improve its product in order to regain its economic profit. Successful product improvements by one firm obligates rivals to imitate or improve on that firms temporary market advantage or else lose business.

Oligopoly
Oligopoly is a market structure dominated by a few large producers of homogeneous or differentiated products. Because of their fewness, oligopolists have considerable control over their price.
Examples: tires, beer, cigarettes, copper,

greeting cards, steel, aluminum, automobiles and breakfast cereals

Characteristics of Oligopoly
A few large producers firms are generally

large and together they dominate the industry. Either homogeneous or differentiated products the products are standardized, or differentiated with heaving advertising. Price maker the firm can set its price and output levels to maximize its profit.

Characteristics of Oligopoly
Strategic behavior Self-interested behavior

that takes into account the reactions of others. Mutual interdependence each firms profit depends not entirely on its own price and sales strategies but also on those of the other firms. Blocked entry barriers to entry exist which make it hard for new firms to enter.

Collusive Tendencies
Oligopolists can often benefit from

cooperation, or collusion. Collusion is a situation in which firms act together and in agreement to fix prices, divide markets, or otherwise restrict competition.
In the example, firms A and B can agree to

establish and maintain a high-price strategy so each can earn $12 million.

Kinked-Demand Model
In the kinked-demand model, oligopolists

face a demand curve based on the assumption that rivals will ignore a price increase and follow a price decrease.
An oligopolists rivals will ignore a price

increase above the going price but follow a price decrease below the going price. The demand curve is kinked at this price and the marginal-revenue curve has a vertical gap.

Kinked-Demand Model

Price Leadership
Price leadership involves an implicit

understanding that other firms will follow the lead when a certain firm in the industry initiates a price change. A price leader is likely to observe the following tactics:
Infrequent price changes Communications Avoidance of price wars

Collusion
Collusion, through price control, may

allow oligopolists to reduce uncertainty, increase profits, and possibly block potential entry. One form of collusion is the cartel: a formal agreement among producers to set the price and the individual firms output levels of a product.

Joint-Profit Maximization
If oligopolistic firms produce an identical

product, and have identical cost, demand, and marginal-revenue curves, than each firm can maximize profit using the MR=MC rule.

A profitable oligopolist when rivals charge the same price, Po

MC Price

Po

Economic Profit ATC D

Q0

MR

Quantity of output

Joint-Profit Maximization
If rivals charge prices lower than Po,

then the demand curve of the firm charging Po will shift to the left as its customers turn to its rivals, and its profits will fall.
The firm can retaliate and cut its price, too,

however, all firms profits would eventually fall.

Firms will choose to charge Po and

produce Qo because it is the most profitable price-output combination.

Obstacles to Collusion
Barriers to collusion beyond the antitrust

laws include:
Demand and cost differences Number firms

Cheating
Recession Potential entry

Oligopoly and Advertising

Each firms share of the total market is

generally determined through product development and advertising for two reasons:
Product development and advertising

campaigns are less easily duplicated than price cuts. Oligopolists have sufficient financial resources to engage in product differentiation and advertising.

Oligopoly and Advertising

Positive effects of advertising are: Enhances competition Reduces consumers search time, direct costs, and indirect costs Facilitates the introduction of new products Negative effects of advertising include: Alters consumers preferences in favor of the advertisers product Brand-loyalty promotes monopoly power

Oligopoly and Efficiency

Many economists believe the oligopoly

market structure is neither productively efficient nor allocatively efficient.

This is because many oligopolistic firms

price higher than average total cost and produce less than the optimal output level.

Oligopoly and Efficiency

A few believe that oligopoly is actually

less desirable than pure monopoly, because government can guard against abuses of monopoly power but not against informal collusion among oligopolists that give the outward appearance of competition involving independent firms.
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