ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
Monopolistic Competition
 A market structure with many firms selling products
that are substitutes but different enough that each
firm’s demand curve slopes downward, firm entry is
relatively easy
 Characteristics
o Relatively large number of sellers
 Small market shares
 Each firm has a comparatively small
percentage of the total market and
limited control over market price
 No collusion
 Ensures that collusion by a group of
firms to restrict output and set prices is
unlikely
 Independent action
 No interdependence among them
 Each firm can determine its own pricing
policy without considering the possible
reactions of rival firms.
o Differentiated product
 Turn out variations of a particular product
 Produce products with slightly different
physical characteristics
 Customer service
 Location
 Proclaim special qualities
 Many substitutes
o Ease of entry and exit
 Low barriers to entry
Created by: M. Mari
Fall 2007
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ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
o Price makers
o Advertising
 Expense and effort involved in product
differentiation would be wasted if consumers
were not made aware of product differences.
 Heavy advertising
 Product image
Short-Run Profit Maximization or Loss Minimization
 Because each monopolistic competitor offers a product
that differs somewhat from what others supply
o Each has some control over the price charged
o Market power
 Means that each firm’s demand curve slopes
downward
 Price increases can lose customers
o The price elasticity of the monopolistic
competitor’s demand depends on
 The number of rival firms that produce
similar products
 The firm’s ability to differentiate its product
form those if its rivals
o A firm’s demand curve will be more elastic the
more substitutes there are and the less
differentiated its product is.
o Marginal revenue = marginal cost
Created by: M. Mari
Fall 2007
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ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
Short run profit scenario
Price
Marginal Cost
Average Total
Cost
Price
Profit
Cost
Demand
Marginal
Revenue
Q
Minimizing Short Run Loss
Price
Marginal Cost
Cost
Price
Average Total
Cost
LOSS
Demand
Marginal
Revenue
Q
Created by: M. Mari
Fall 2007
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ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
Long Run Economic Profit
 If short run has economic profit
o Firms enter the industry due to low barriers to
entry
o Output increases, then price decreases
o Until economic profit is ZERO
 If short run has economic loss
o Firms exit the industry
o Output decreases, then price increases
o Until economic loss is zero
 In long run
o No economic profit or loss
Oligopoly
Oligopoly is a market structure characterized by a few
firms whose behavior is interdependent
Characteristics
 A few large producers
 Homogeneous or differentiated products
 Control over Price
o Each firm is price maker
 It sets its price and output levels to maximize
profit
Created by: M. Mari
Fall 2007
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ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
 It must consider how its rivals will react to
any change in its output, price, product
characteristics, or advertising
 Mutual interdependence and strategic behavior
o Each firm’s profit depends not entirely on its own
price and sales strategies but also on those of the
other firms.
o Burger King and McDonalds
 Barriers to entry
o Economies of scale
o Large expenditure for capital
o Ownership and control over resource
o Can preclude the entry of new competitors
through preemptive and retaliatory pricing and
advertising strategies
 El Dorado and Ikea
 Mergers
o Oligopolists have a tendency to merge and
become monopolists
o Increases market share
o Greater economies of scale
o Caused by desire for monopoly power
o Measures of Industry Concentration
 Used to measure the degree to which
oligopolistic industries are concentrated in
the hands of their largest firms
 Concentration ratios
o Reveals the percentage of total
output produced and sold by an
industry’s largest firms.
o When largest four firms control
over 40% then it is oligopoly
o Automotive 81%
o Sugar cane 99%
o Shortcomings
 Localized markets
 Interindustry competition
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Fall 2007
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ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
 World trade
 Herfindahl Index
o The index is the sum of squared
percentage market shares of all
firms in the industry.
o Larger the index, the more market
power within the industry
Oligopoly Behavior
A Game-Theory Overview
 There is no general theory of oligopoly but rather a set
of theories, each based on the diversity of observed
behavior in an interdependent market.
 COLLUSION
o An agreement among firms to increase economic
profit by dividing the market or fixing the price
o CARTEL
 A group of firms that agree to coordinate
their production and pricing decisions to act
like a monopolist.
 For a cartel’s profit to be maximized, output
must be allocated so that the marginal cost
for the final unit produced by each firm is
identical.
o Problems with Collusion and Cartels
 Differences in Average Cost
 If all firms have identical average cost
curves, output and profit would be
easily allocated across firms but if costs
differ then problems arise
 If average cost differ across firms, the
output allocation that maximizes cartel
profit will yield unequal profit across
cartel members
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Fall 2007
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ECO 2023
Chapter 11: Monopolistic Competition & Oligopoly
 Firms earning less profit will drop out of
the cartel which undermines it.
 Number of firms in the Cartel
 Consensus becomes harder to achieve
as the number of firms grows.
 New Entry into the Industry
 New firms force prices down and reduce
economic profit
 Cheating
 Price Leadership
o A firm whose price is adopted by other firms in the
industry
o Tacit form of collusion
o Typically a dominant firm in the industry
 Sets price and others follow avoiding
competition
o Violates US Antitrust laws
 Game Theory
o An approach that analyzes oligopolistic behavior
as a series of strategic moves and countermoves
by rival firms
o Outcome is achieved when each player’s choice
does not depend on what the other player does.
 Dominant-strategy equilibrium
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Fall 2007
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