Chapter 10
Professor Yuna Chen
Monopolistic
Competition
and
Oligopoly
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Monopolistic Competition
1. Monopolistic competition
– How many sellers and buyers?
Many sellers and many buyers
– How difficult to start up business?
Low barriers to entry and exit
– Are products from different sellers identical?
No. They are slightly different products – differentiated product
• A firm that raises prices: lose some customers to rivals
– Do sellers have market power?
Yes, they have some control over price ‘Price makers’
• Downward sloping demand curve
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Monopolistic Competition
1a. Product differentiation is generated from
– Physical differences
• Appearance; quality
– Location
• Spatial differentiation
– Services
• Friendly, professional
– Product image
• Promotion; advertising
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Question 1
•
Suppose people believe you are the best babysitter in town. Your neighbor
also babysits but people think her service is mediocre. Compare the demand
for your service and your neighbor's, which one is more elastic?
•
Review: if quantity demanded drops more when price increases, the demand
is more elastic.
•
Answer: the demand for your neighbor’s service is more elastic. If you and
your neighbor both raise $1/hour, you would lose less customers than your
neighbor because you are the best in town.
•
Conclusion: the more differentiate the product is, the less elastic the
demand
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Question 2
• Suppose the number of dog sitters in the spring is 10, and in the
summer is 60. Which demand curve for dog sitting is more elastic, the
one in the spring or the one in the summer?
• Answer: The demand in the summer is more elastic because more
people offer dog sitting service.
• Conclusion: the more substitutes there are, the more elastic the
demand.
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1b. Short-Run Profit or Loss
– Demand curve, D
• Slopes downward, more elastic than the monopoly
demand due to many substitutes
• Demand curve comparison
Perfect competition/monopolistic competition/
monopoly
– Marginal revenue, MR
• Below the demand curve
• Slopes downward
– Average total cost, ATC
– Average variable cost, AVC
– Marginal cost, MC
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Short-Run Profit or Loss
• Golden Rule to maximize profit:
MR=MC
A firm in monopolistic competition market
maximize profit just like a monopolist.
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Example 1. How to maximize profit
Refer to the graph on the right.
Step 1. MR = MC at point e.
Step 2. Go vertically down to find q,
the output level that maximizes profit.
Step 3. From q, go vertically up to the
demand curve and find b.
Step 4. From b, go horizontally to the y
axis to find p, the profit maximizing price.
Step 5. Total revenue TR = (p)(q)
Step 6. Total cost TC = (c)(q)
(ATC is c)
Step 7. Profit = TR – TC = (p)(q) – (c)(q) This is the blue shaded area.
This firm is making profit.
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Answers for Example 2
Refer to the graph on the right.
• What is the profit maximizing output?
• 100 (because MR = MC)
• Which price maximizes profit?
• $10
• What is ATC?
• $10 (to produce 100)
• What is total revenue?
• TR = (P)(Q) = ($10)(100) = $1000
• What is total cost?
• TC = (ATC)(Q) = ($10)(100) = $1000
• What is the profit?
• Profit = TR-TC = $1000 - $1000 = 0
• This firm is breaking even
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Answers for Example 3
Refer to the graph on the right,
• What is the profit maximizing
output?
400
• Which price maximizes profit?
$50
• What is ATC?
$60
• What is total revenue?
TR = (400)($50) = $20,000
• What is total cost?
TC = ($60)(400) = $24,000
• What is the profit?
Profit = $20,000 - $24,000 = -$4,000
• This firm incurs loss.
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Example 4. Shutdown or stay?
•
•
•
•
•
•
•
•
•
Refer to the graph
Q=
P=
TR =
TC =
Profit =
VC =
FC =
Shutdown or stay?
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1c. Profit in the Long-Run
• If the firm in the industry make economic
profit
New firms enter the market
Draw customers away from existing firms
Demand for each firm decreases
Economic profit drops until zero
For example, if there are only 5 restaurants in a town and
they are all making economic profit. Very soon, new
restaurants will keep opening until no one earns
economic profit.
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Profit in the Long-Run
• If firms in the industry suffer from economic
losses
Some of the firms shut down or exit the market
Their customers switch to remaining firms
 demand for the remaining firms increase
 Loss declines until zero
For example, if there are too many gas stations in town
and suffer from losses, some of them close out. The
remaining gas stations break even in the long run.
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Exhibit 2
Dollars
per unit
Long-Run Equilibrium in Monopolistic Competition
MC
ATC
b
p
a
D
MR
0
q
Quantity per period
If existing firms earn economic
profit in the short run, new firms
will enter the industry in the long
run. This entry reduces the
demand facing each firm. In the
long run, each firm’s demand
curve shifts leftward until marginal
revenue equals marginal cost
(point a) and the demand curve is
tangent to the average total cost
curve (point b). Economic profit is
zero at output q. With zero
economic profit, no more firms will
enter, so the industry is in longrun equilibrium. The same longrun outcome occurs if firms suffer
a short-run loss. Firms leave until
remaining firms earn just a normal
profit.
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Summery
In the short run
• If p>ATC
• Economic profit
• If p = ATC
• Breaking even
• If ATC>p>AVC
– Economic loss; stay in production
• If p<AVC:
– Economic loss; Shut down in short run
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Summary
In the long run,
• Economic profit = 0 because of the low barriers to
entry.
• Exit the industry if P < ATC in the long run.
• Acts like a monopolist in profit maximization
because the demand curve is downward sloping;
• Like a perfectly competitive firm, makes zero
economic profit in the long run due to easy entry
and exit.
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Exhibit 3
Perfect Competition Versus Monopolistic Competition in
Long-Run Equilibrium
(b) Monopolistic competition
Dollars per unit
MC
ATC
p
d=MR=AR
Dollars per unit
(a) Perfect competition
MC
ATC
p’
D
MR
0
q Quantity per period
0
q’ Quantity per period
Cost curves are assumed to be the same in each panel. The perfectly competitive firm of panel (a) faces
a demand curve that is horizontal at market price p. Long-run equilibrium occurs at output q, where the
demand curve is tangent to the average total cost curve at its lowest point. The monopolistically
competitive firm of panel (b) is in long-run equilibrium at output q’, where demand is tangent to the
average total cost curve. Because the demand curve slopes downward in panel (b), the tangency does
not occur at the minimum point of average total cost. Thus, the monopolistically competitive firm
produces less output and charges a higher price than does a perfectly competitive firm with the same
cost curves. Neither firm earns economic profit in the long run. The firm in monopolistic competition has
excess capacity, meaning that it could reduce average cost by increasing its rate of output.
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Comparison Table
Perfect competition
Monopolistic competition
Demand
Marginal revenue
Profit maximizing rule
Product
Control over price
Profit max. output
Profit max price
Short run operation
Long run profit
Long run
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Comparison Table
Demand
Perfect competition
Horizontal
Monopolistic competition
Downward sloping
Marginal revenue
The same as demand
Below the demand curve
Profit maximizing rule MR=MC
MR=MC
Product
Identical
Differentiated
Control over price
Price taker
Price maker
Profit max. output
More than monopolistic
competition firm
Less than perfect competition
firm
Profit max price
Market equilibrium price
Higher than perfect competition
equilibrium price
Short run operation
Economic profit, breaking
even, or loss are possible
Economic profit, breaking even,
or loss are possible
Long run profit
Economic profit = zero
Economic profit = zero
Long run
Produce at minimum AC
Not produce at minimum AC
Excess capacity
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2. Introduction to Oligopoly
• Oligopoly
– A few firms, many buyers
– Each behaves interdependently (not independent)
• The more similar the products
– The greater the interdependence
2a. Varieties of oligopoly
• Undifferentiated oligopoly
– Oligopoly that sells a commodity
• Differentiated oligopoly
– Oligopoly that sells products that are slightly different
across suppliers
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Introduction to Oligopoly
2b. Barriers to entry
– Economies of scale
– Legal restrictions
– Brand names
– Control over an essential resource
– High cost of entry
(High start-up costs; high spending on advertising; high cost on
testing and developing new product)
– Crowding out the competition
(by making many similar products from the same brand)
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Models of Oligopoly
• Collusion and cartels
• Price leadership
• Game theory
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Collusion and Cartels
• Collusion
– Agreement among firms to increase economic
profit by
– Dividing the market
– Fixing the price
• Cartel
– Group of firms that agree to coordinate their
production and pricing decisions
• To reap monopoly profit
– Illegal in U.S.
– OPEC (12 members)
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Collusion and Cartels
• Colluding firms, compared to the noncolluding ones, produce less output,
charge higher price, and earn more
profit.
• Collusion hurts consumers due to
charging higher price. Thus collusion
and cartels are illegal in the United
States
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Collusion and Cartels
• Since the cartel acts as if they are just
one firm, they maximize profit exactly
like a monopolist does.
• Cheating – firms in the cartel have high
temptation to cheat on the agreement
because the firm can earn more profit by
breaking the agreement of the fixed price
or fixed quantity.
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3b. Price Leadership
• Price leadership
– Informal, tacit collusion
• Price leader
– Sets the price for the industry
– Initiate price changes
– Followed by the other firms
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Price Leadership
• Obstacles
– U.S. antitrust laws
– Product differentiation
– No guarantee others will follow
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3c. Game Theory
• Game theory
– Approach that analyzes oligopolistic
behavior
– Series of strategic moves and
countermoves by rival firms
– Focus: each player’s incentives to
cooperate or compete
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Game Theory
• Prisoner’s dilemma
– Game that shows why players have
difficulty cooperating
– Even though they would benefit from
cooperation
• Strategy
– Operational plan pursued by a player
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Game Theory
• Payoff matrix
– Table listing the payoffs
• that each player can expect from each move
• based on the actions of the other player
• Dominant-strategy equilibrium
– Outcome achieved when each player’s
choice does not depend on what the
other player does
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Example 5
Prisoner’s Dilemma
Rocky
Ginger
Not confess
Confess
Not confess
Confess
Ginger: 2 year
Rocky: 2 year
Ginger: 5 years
Rocky: 1 year
Ginger: 1 year Ginger: 3 years
Rocky: 5 years Rocky: 3 years
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Game Theory
• Nash equilibrium
– A player chooses the best strategy given the
strategies chosen by others
(In the Prisoner’s Dilemma example, Nash equilibrium is 3 years
for Rocky and 3 years for Ginger)
– No participant can improve his or her outcome
by changing strategies
• Even after learning of the strategies selected by
other participants
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Example 6 Two firms game
One-shot game
• Game is played just once
• Firms maximize self-benefit regardless of the
others.
Firm A
Firm B
Low price
High price
Low price
A: $20,000
B: $10,000
A: - $5,000
B: $80,000
High price
A: $100,000
B: - $2,000
A: $70,000
B: $60,000
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Game Theory
– Repeated games
• Cooperation between firms can increase
profit for both firms
• Tit-for-tat strategy
• Collusion is illegal
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Comparison
• oligopoly charges higher price and lower
output compared to perfect competition
• - oligopoly makes higher profits in the
long run
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Examples
• This video clip gives a few examples of
game theory.
• https://www.youtube.com/watch?v=t9Lo
2fgxWHw
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