Monopolistic
Competition & Oligopoly
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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©2005 South -Western College Publishing
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What is imperfect 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 is product 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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1

What is nonprice 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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2

What effect does advertising have on average costs?
It raises the long-run average cost curve
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P
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
$1.00
$.50
The effect of Advertising
With advertising
LRAC
2
Without advertising
LRAC
1
2 4 6 8 10 12 14 16 18
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Q
How does a firm decide what price to charge and how many units to produce?
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$40
P
$35
$30
$25
$20
$15
$10
$5
Profit
1 2 3 4
MC
MR=MC
ATC
AVC
MR
D
5 6 7 8 9 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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$40
P
$35
$30
$25
$20
$15
$10
$5
Normal Profit
MC
LRAC
AVC
1 2 3 4
MR
D
5 6 7 8 9
Q
18
3

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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$40
P
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum LRAC
MC
ATC
AVC
1 2 3 4
MR
D
5 6 7 8 9
Q
20
$40
P
$35
$30
$25
$20
$15
$10
$5
Perfect Competition
Minimum
LRAC
MC LRAC
MR
1 2 3 4 5 6 7 8 9
Q
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What is one way monopolistic competition compares to perfect competition?
Price is higher and quantity is lower in monopolistic competition
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Why is price 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 is nonprice 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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5

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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P
$400
$350
$300
$250
$200
$150
$100
$50
Oligopolist’s Kinked Demand Curve
Rivals ignore price changes
Rivals match price changes
5 10 15 20 25 30 35 40 45
Q
33
How do oligopolists determine price?
They play the game “follow the leader” that economists call price leadership
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What is price 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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6

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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$40
P
$35
$30
$25
$20
$15
$10
$5
Why a Cartel Member Has an Incentive to Cheat
MC LRAC
MR
2
MR
1
1 2 3 4 5 6 7 8 9
Q
39
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 tat
Price 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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7

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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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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$40
P
$35
$30
$25
$20
$15
$10
$5
Profit
1 2 3 4
MC
MR=MC
ATC
AVC
MR
D
5 6 7 8 9 Q
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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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$40
P
$35
$30
$25
$20
$15
$10
$5
Monopolistic Competition
Minimum LRAC
MC
ATC
AVC
1 2 3 4
MR
D
5 6 7 8 9
Q
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P
$40
$35
$30
$25
$20
$15
$10
$5
Perfect Competition
Minimum
LRAC
MC LRAC
MR
1 2 3 4 5 6 7 8 9
Q
58
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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10

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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P
$400
$350
Oligopolist’s Kinked Demand Curve
Rivals ignore price changes
$300
$250
$200
$150
$100
$50
Rivals match price changes
5 10 15 20 25 30 35 40 45
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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$40
P
$35
$30
$25
$20
$15
$10
$5
Why a Cartel Member Has an Incentive to Cheat
MC LRAC
MR
2
MR
1
1 2 3 4 5 6 7 8 9
Q
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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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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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