Chapter 8
Monopoly and
Imperfect Competition
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 8 / MONOPOLY AND IMPERFECT COMPETITION
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
Monopoly

A monopoly firm is the only seller of a good or service with
no close substitutes
 Market in which the monopoly firm operates is called a monopoly
market



Key concept is notion of substitutability
Definition of monopoly firm or market may seem precise
 But in real world, definition is not always so clear-cut
Because we all have different tastes and characteristics, we
can have different opinions about what is, and what is not, a
“close” substitute
 As a result, we can have different ideas about how broadly or how
narrowly we should define a market when trying to decide if it is a
monopoly
Lieberman & Hall; Introduction to Economics, 2005
2
Why Monopolies Exist

Existence of a monopoly means that
something is causing other firms to stay out
of the market
 Rather than enter and compete with firm already
there

What barrier prevents additional firms from
entering the market?
 Several possible answers
• Economies of scale
• Legal barriers
• Network externalities
Lieberman & Hall; Introduction to Economics, 2005
3
Economies of Scale

If economies of scale persist to the point where a
single firm is producing for entire market, the
market is a natural monopoly
 Market in which, due to economies of scale, one firm can
operate at lower average cost than can two or more firms


Unless government intervenes, only one seller
would survive—market would naturally become a
monopoly
Small local monopolies are often natural
monopolies
 Because they continue to enjoy economies of scale up to
point at which they are serving entire market
Lieberman & Hall; Introduction to Economics, 2005
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Figure 1: A Natural Monopoly
Dollars
A
15
B
12
LRATC
C
5
DMarket
300
Lieberman & Hall; Introduction to Economics, 2005
350
Pieces of Clothing
per Week
5
Legal Barriers
 Sometimes
public interest is best
served by having a single seller in a
market
 Many monopolies arise because of legal
barriers including
 Protection of intellectual property
 Government franchise
Lieberman & Hall; Introduction to Economics, 2005
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Protection of Intellectual Property


The words you are reading right now are an example of intellectual
property, which includes literary, artistic and musical works, and scientific
inventions
In dealing with intellectual property government strikes a compromise
 Allows creators of intellectual property to enjoy a monopoly and earn


economic profit, but only for a limited period of time
Once time is up, other sellers are allowed to enter the market, and it is
hoped that competition among them will bring down prices
Most important kinds of legal protection for intellectual property are
 Patents
• Temporary grant of monopoly rights over a new product or scientific discovery
 Copyrights

• Grant of exclusive rights to sell a literary, musical, or artistic work
Copyrights and patents are often sold to another person or firm, but this
does not change monopoly status of the market, since there is still just
one seller
Lieberman & Hall; Introduction to Economics, 2005
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Government Franchise



Large firms we usually think of as monopolies have
their monopoly status guaranteed through
government franchise
 Grant of exclusive rights over a product
Barrier to entry is
 Any other firm that enters the market will be prosecuted
Governments usually grant franchises when they
think market is a natural monopoly
Lieberman & Hall; Introduction to Economics, 2005
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Network Externalities


Exist when an increase in network’s membership
increases its value to current and potential
members
When network externalities are present, joining a
large network is more beneficial than joining a
small network
 Even if product in larger network is somewhat inferior to
product in smaller one

In addition to advantages of joining a larger
network
 Advantage in not leaving it once you’ve joined
• Avoiding switching costs
Lieberman & Hall; Introduction to Economics, 2005
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Network Externalities

All of this clearly applies to the market for computer
operating systems
 When you buy a computer already loaded with Microsoft Windows,
you benefit
• By having a large number of people with whom you can easily share
•
documents
Huge number of computers everywhere you can easily operate
 You gain access to many more software programs, like Microsoft
Word, Excel, or Outlook, since many more programs are designed
for Windows than for the few alternatives
 You can save time by just calling knowledgeable friends or
coworkers
• Rather than attempting to contact technical support
Lieberman & Hall; Introduction to Economics, 2005
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Monopoly Goals And Constraints


Goal of a monopoly—like that of any firm—is to
earn highest profit possible
However, a monopolist faces constraints
 Constraint on monopoly’s cost
• For any level of output it might produce, total cost is determined
by


Technology of production
Price it must pay for its inputs
 Demand constraint
• Monopolist’s demand curve tells us maximum price monopolist
can charge to sell any given quantity of output
• And for any level of output it might produce, maximum price it can
charge is determined by market demand curve for its product
Lieberman & Hall; Introduction to Economics, 2005
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Monopoly Price or Output Decision



Noncompetitive firms—such as monopolies—do not make
two separate decisions about price and quantity, but rather
one decision
 Once firm determines its output level, it has also determined its price
When any firm—including a monopoly—faces a downward
sloping demand curve, marginal revenue is less than price
of output
 Therefore, marginal revenue curve will lie below demand curve
Monopoly will produce at an output level where marginal
revenue is positive
Lieberman & Hall; Introduction to Economics, 2005
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Figure 2: Demand and Marginal
Revenue
Monthly $60
Price per
Subscriber 50
48
A
B
C
38
30
F
20
18
G
Demand
5,000
6,000
Lieberman & Hall; Introduction to Economics, 2005
15,000 20,000
30,000
MR 21,000
Number of Subscribers
13
The Profit-Maximizing Output Level
To maximize profit, the firm should produce
level of output where MC = MR and
 MC curve crosses MR curve from below
 For a monopoly, price and output are not
independent decisions
 But different ways of expressing the same

decision
Lieberman & Hall; Introduction to Economics, 2005
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Figure 3: Monopoly Price and Output
Determination
Monthly $60
Price per
Subscriber
40
MC
E
D
10,000
30,000
MR
Lieberman & Hall; Introduction to Economics, 2005
Number of Subscribers
15
Profit And Loss

A monopoly earns a profit whenever P > ATC
 Its total profit at best output level equals area of a
rectangle
• Height equal to distance between P and ATC
• Width equal to level of output

A monopoly suffers a loss whenever P < ATC
 Its total loss at best output level equals area of a
rectangle
• Height equal to distance between ATC and P
• Width equal to level of output
Lieberman & Hall; Introduction to Economics, 2005
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Figure 4: Monopoly Profit and Loss
(a)
Dollars
MC
(b)
ATC
MC AVC
Dollars
ATC
$50
E
$40
40
32
E
Total Loss
Total
Profit
D
D
10,000
Number of
MR Subscribers
Lieberman & Hall; Introduction to Economics, 2005
10,000
Number of
MR Subscribers
17
The Shut-Down Decision

What if a monopoly suffers a loss in shortrun?
 Any firm should shut down if P < AVC at output
level where MR = MC

If monopoly suddenly finds that P < AVC,
government will usually not allow it to shut
down,
 Instead use tax revenue to make up for firm’s
losses
Lieberman & Hall; Introduction to Economics, 2005
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Monopoly in the Long-Run




In the short run, a monopoly may earn an economic
profit or suffer an economic loss
 But what about the long run?
Important insights of previous chapter—perfectly
competitive firms cannot earn a profit in long-run
equilibrium
However, monopolies may earn economic profit in
long-run
A privately owned monopoly suffering an economic
loss in long-run will exit the industry
 Should not find privately owned monopolies suffering
economic losses in long-run
Lieberman & Hall; Introduction to Economics, 2005
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Comparing Monopoly to Perfect
Competition


In perfect competition, economic profit is relentlessly
reduced to zero by entry of other firms
 In monopoly, economic profit can continue indefinitely
But monopoly differs from perfect competition in another
way
 Can expect a monopoly market to have a higher price and lower
output than an otherwise similar perfectly competitive market


By raising price and restricting output, new monopoly earns
economic profit
Consumers lose in two ways
 Pay more for output they buy
 Due to higher prices they buy less output
Lieberman & Hall; Introduction to Economics, 2005
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Figure 5(a/b): Comparing Monopoly
and Perfect Competition
(a) Competitive Market
Price
per
Unit
(b) Competitive Firm
Dollars
per
Unit
S
2. and each firm produces
1,000 units, where P = MC.
MC
ATC
E
$10
3. When monopoly $10
takes over, the old
market supply
curve . . .
d
D
100,000
1. In this competitive
market of 100 firms,
equilibrium price is $10
Lieberman & Hall; Introduction to Economics, 2005
Quantity of
Output
1,000
Quantity of
Output
21
Figure 5(c): Comparing Monopoly and
Perfect Competition
(c) Monopoly
Price
per
Unit
$15
S = MC
4. becomes the monopoly's MC curve.
F
E
5. The monopoly produces where MR = MC,
10
6. with a higher price and lower market
output than under perfect competition.
MR
D
100,000
Quantity of
Output
60,000
Lieberman & Hall; Introduction to Economics, 2005
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Comparing Monopoly to Perfect
Competition

Changeover from perfect competition to monopoly benefits
owners of monopoly and harms consumers of the product
 Important proviso concerning this result
• In comparing monopoly and perfect competition, price is higher and
output is lower under monopoly if all else is equal

General conclusion
 Monopolization of a competitive industry leads to two opposing
effects
• For any given technology of production, monopolization leads to higher
•
prices and lower output
Changes in technology of production made possible under monopoly
may lead to lower prices and higher output
 Ultimate effect on price and quantity depends on relative strengths of
two effects
Lieberman & Hall; Introduction to Economics, 2005
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The Decline of Monopoly?
Past century was not kind to monopolies
 Today, monopolies face a different threat
 Relentless advance of technology
 The world of monopolies is changing rapidly
 But monopolies in many forms will be with us for

some time
Lieberman & Hall; Introduction to Economics, 2005
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Monopolistic Competition

Imperfect competition refers to market structures between perfect
competition and monopoly
 In imperfectly competitive markets, there is more than one seller, but still too


few to create a perfectly competitive market
In addition, imperfectly competitive markets often violate other conditions of
perfect competition, such as the requirement of a standardized product or
free entry and exit
Monopolistic competition is a market sturcture with three fundamental
characteristics
 1. Many buyers and sellers
 2. Sellers offer a differentiated product
 3. Sellers can easily enter into or exit from the market

Because it produces a differentiated product, a monopolistic competitor
faces a downward-sloping demand curve
 When it raises its price a modest amount, quantity demanded will decline
(but not all the way to zero)
Lieberman & Hall; Introduction to Economics, 2005
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Monopolistic Competition in the ShortRun
Individual monopolistic competitor behaves
very much like a monopoly
 Key difference is this
 While a monopoly is the only seller in its market,

a monopolistic competitor is one of many sellers
 When a monopolistic competitor raises its price,
its customers have one additional option
• Can buy similar good from some other firm
Lieberman & Hall; Introduction to Economics, 2005
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Figure 6: A Monopolistically
Competitive Firm in the Short Run
Dollars
$70
1. Kafka services 250 homes
per month, where MC and
MR intersect . . .
A
ATC
2. and charges
$70 per home.
d1
30
MR1 3. ATC at 250 units is less
than price, so profit per
unit is positive.
4. Kafka's monthly
profit–$10,000–is
the area of the
shaded rectangle.
250
Lieberman & Hall; Introduction to Economics, 2005
MC
Homes Serviced per Month
27
Monopolistic Competition in the LongRun

Under monopolistic competition—in which there are no
barriers to entry and exit—the firm will not enjoy its profit for
long
 Entry will continue to occur, and demand curve will continue to shift
leftward

Under monopolistic competition, firms can earn positive or
negative economic profit in short-run
 But in long-run, free entry and exit will ensure that each firm earns
zero economic profit just as under perfect competition

In real world, monopolistic competitors often earn economic
profit or loss in the short-run
 But—given enough time—profits attract new entrants, and losses
result in an industry shakeout
• Until firms are earning zero economic profit
Lieberman & Hall; Introduction to Economics, 2005
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Figure 7: A Monopolistically
Competitive Firm in the Long Run
In the long run, profit attracts
entry, which shifts the firm's
demand curve leftward.
Dollars
MC
ATC
$40
E
The typical firm
produces where
its new MR
crosses MC.
MR2
100
Lieberman & Hall; Introduction to Economics, 2005
Entry continues until P = ATC
at the best output level, and
economic profit is zero. d1
d2
250
MR1
Homes Serviced
per Month
29
Nonprice Competition


If monopolistic competitor wants to increase its output it can
cut its price
 Move along its demand curve
Any action a firm takes to increase demand for its output—
other than cutting its price—is called nonprice competition
 Examples include better service, product guarantees, free home
delivery, more attractive packaging


Nonprice competition is another reason why monopolistic
competitors earn zero economic profit in long-run
All this nonprice competition is costly
 Must pay for advertising, for product guarantees, for better staff
training
 Costs must be included in each firm’s ATC curve, shifting it upward

None of this changes conclusion that monopolistic
competitors will earn zero economic profit in long-run
Lieberman & Hall; Introduction to Economics, 2005
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Oligopoly

When just a few large firms dominate a market
 So that actions of each one have an important impact on



the others
Would be foolish for any one firm to ignore its
competitors’ reactions
In such a market, each firm recognizes its strategic
interdependence with others
An oligopoly is a market dominated by a small
number of strategically interdependent firms
Lieberman & Hall; Introduction to Economics, 2005
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Economies of Scale: Natural
Oligopolies

When minimum efficient scale (MES) for a typical
firm is a relatively large percentage of market
 A large firm—supplying a large share of the market—will
have lower cost per unit than a small firm
• Since small firms can’t compete, only a few large firms survive

Market becomes an oligopoly
• Tends to happen on its own unless there is government
intervention

Such a market is often called a natural oligopoly—analogous to
natural monopoly
Lieberman & Hall; Introduction to Economics, 2005
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Reputation as a Barrier

A new entrant may suffer just from being new
 Established oligopolists are likely to have favorable
reputations


In some cases, where potential profits are great,
investors may decide it is worth the risk and accept
initial losses in order to enter industry
In other industries, the initial losses may be too
great and probability of success too low for
investors to risk their money starting a new firm
Lieberman & Hall; Introduction to Economics, 2005
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Strategic Barriers

Oligopoly firms often pursue strategies designed to
keep out potential competitors
 Maintain excess production capacity as a signal to a



potential entrant that they could easily saturate market
and leave new entrant with little or no revenue
Make special deals with distributors to receive best shelf
space in retail stores
Make long-term arrangements with customers to ensure
that their products are not displaced quickly by those of a
new entrant
Spend large amounts on advertising to make it difficult for
a new entrant to differentiate its product
Lieberman & Hall; Introduction to Economics, 2005
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Legal Barriers
Patents and copyrights—which can be
responsible for monopoly—can also create
oligopolies
 Like monopolies, oligopolies are not shy
about lobbying government to preserve their
market domination
 Government barriers can operate against
domestic entrants, too

Lieberman & Hall; Introduction to Economics, 2005
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Oligopoly Behavior


Oligopoly presents the greatest challenge to
economists
Essence of oligopoly is strategic interdependence
 Wherein each firm anticipates actions of its rivals when
making decisions

In order to understand and predict behavior in
oligopoly markets
 Economists have had to modify the tools used to analyze
other market structures and to develop entirely new tools
as well

One approach—game theory—has yielded rich
insights into oligopoly behavior
Lieberman & Hall; Introduction to Economics, 2005
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The Game Theory Approach

Game theory
 An approach to modeling strategic interaction of
oligopolists in terms of moves and countermoves


In all games—except those of pure chance, such
as roulette—a player’s strategy must take account
of the strategies followed by other players
Game theory analyzes oligopoly decisions as if
they were games by
 Looking at the rules players must follow
 Payoffs they are trying to achieve
 Strategies they can use to achieve them
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Simple Oligopoly Games



Duopoly
 Oligopoly market with only two sellers
Assume that Gus and Filip must make their
decisions independently
 Without knowing in advance what the other will do
No matter what Filip does, Gus’s best move is to
charge a low price—his dominant strategy
 A similar analysis from Filip’s point of view, would tell us
that his dominant strategy is the same: a low price

Equilibrium price in market is the low price
Lieberman & Hall; Introduction to Economics, 2005
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Fig. 4: A Duopoly Game
Gus’s Actions
Confess
Don’t Confess
Gus’s profit
= $25,000
Confess
Filip’s Actions
Don’t Confess
Lieberman & Hall; Introduction to Economics, 2005
Filip’s
Profit =
$25,000
Gus’s profit
= $75,000
Filip’s
Profit =
$–10,000
Gus’s profit
= –$10,000
Filip’s
Profit =
$75,000
Gus’s profit
= $50,000
Filip’s
Profit =
$50,000
39
Oligopoly Games in the Real World
Will typically be more than two strategies
from which to choose
 Will usually be more than two players
 In some games, one or more players may
not have a dominant strategy
 When one player has a dominant strategy, we

can still predict the game’s outcome
• Whether the other has a dominant strategy or not
Lieberman & Hall; Introduction to Economics, 2005
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Cooperative Behavior in Oligopoly
In real world, oligopolists will usually get
more than one chance to choose their prices
 The equilibrium in a game with repeated
plays may be very different from equilibrium
in a game played only once
 Often, firms will evolve some form of cooperation

in the long run
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Explicit Collusion


Simplest form of cooperation is explicit collusion
 Managers meet face-to-face to decide how to set prices
Most extreme form of explicit collusion is creation of a cartel
 Group of firms that tries to maximize total profits of the group as a
whole


If explicit collusion to raise prices is such a good thing for
oligopolists, why don’t they all do it?
 Usually illegal
 Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways
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Tacit Collusion


Any time firms cooperate without an explicit
agreement, they are engaging in tacit collusion
Tit for tat
 A game-theoretic strategy of doing to another player this
period what he has done to you in previous period

However, gentle reminder of tit-for-tat is not always
effective in maintaining tacit collusion
 Oligopolist will sometimes go further
• Attempting to punish a firm that threatens to destroy tacit
cooperation
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Tacit Collusion

Another form of tacit collusion is price leadership
 One firm—the price leader—sets its price and other
sellers copy that price

With price leadership, there is no formal agreement
 Rather the decisions come about because firms realize—
without formal discussion—that system benefits all of
them
 Decisions include
• Choice of leader
• Criteria it uses to set its price
• Willingness of other firms to follow
Lieberman & Hall; Introduction to Economics, 2005
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The Limits to Collusion

Oligopoly power—even with collusion—has
its limits
 Even colluding firms are constrained by market
demand curve
 Collusion—even when it is tacit—may be illegal
 Collusion is limited by powerful incentives to
cheat on any agreement
Lieberman & Hall; Introduction to Economics, 2005
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The Future of Oligopoly

Some people think U.S. and other Western
economies are moving toward oligopoly as
dominant market structure
 In 1932, two economists—Adolf Berle and Gardiner
Means—noted trend toward big business
• Predicted the 200 largest U.S. firms would control nation’s entire
economy by 1970


Unless something were done to stop it
Prediction has not come true
 Today, there are hundreds and thousands of ongoing
businesses in United States
Lieberman & Hall; Introduction to Economics, 2005
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Antitrust Legislation and Enforcement

Antitrust enforcement has focused on three types of actions
 Preventing collusive agreements among firms
• Such as price-fixing agreements
 Breaking up or limiting activities of large firms—oligopolists and
monopolists—whose market dominance harms consumers
 Preventing mergers that would lead to harmful market domination


Managers of other firms considering anticompetitive moves
have to think long and hard about consequences of acts that
might violate antitrust laws
While thrust of these policies is to preserve competition
 Type of competition preserved—and zeal with which policies are
applied—can shift
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The Globalization of Markets




By enlarging markets from national ones to global ones,
international trade can increase the number of firms in a
market
 Decreasing market dominance by a few, and increasing competition
Although oligopolists often try to prevent it, they face
increasingly stiff competition from foreign producers
Entry of U.S. producers has helped to increase competition
in foreign markets for movies, television shows, clothing,
household cleaning products, and prepared foods
While consumers in each nation may have access to more
firms, these may be larger and more powerful firms
 Creating greater likelihood of strategic interaction and danger of
collusion
Lieberman & Hall; Introduction to Economics, 2005
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Technological Change



Technological change works to increase competition by
creating new substitute goods
Can reduce barriers to entry in much the same way that
globalization does
 By increasing size of market
Technology—the internet—has enabled residents in many
smaller towns to choose among a dozen or more online
sellers of the same merchandize
 Trend can also be seen as encouraging oligopoly
 Result could be strategic interaction, or collusion, among large
national players

Finally, some technologies actually increase MES of typical
firm
 Thereby encouraging formation of oligopolies
Lieberman & Hall; Introduction to Economics, 2005
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Figure 9(a): Advertising in Monopolistic
Competition
1.Before advertising, long-run
economic profit is zero.
Dollars
$120
4. Advertising
can lead to a
higher price
in the long
run, as in this
panel . . .
3. But in the long run, imitation
and entry bring economic
profit back to zero.
B
C
100
60
2. In the short run, the first firms to
advertise earn economic profit.
ATCads
ATCno ads
A
dads
dno ads
1,000
2,000
Lieberman & Hall; Introduction to Economics, 2005
dall advertise
6,000
Bottles of Perfume
per Month
50
Figure 9(a): Advertising in Monopolistic
Competition
Dollars
$120
60
50
5. or to a lower price
B
in the long run, as
in this panel.
dall advertise
A
C
ATCads
ATCno ads
dads
dno ads
1,000
2,000
Lieberman & Hall; Introduction to Economics, 2005
6,000
Bottles of Perfume
per Month
51
Using the Theory: Advertising in
Monopolistic Competition and Oligopoly

Perfect competitors never advertise and
monopolies advertise relatively little
 But advertising is almost always found under
monopolistic competition and very often in oligopoly

Why?
 All monopolistic competitors, and many oligopolists,
produce differentiated products

Since other firms will take advantage of opportunity
to advertise, any firm that doesn’t advertise will be
lost in shuffle
Lieberman & Hall; Introduction to Economics, 2005
52
Using the Theory: Advertising and Market
Equilibrium Under Monopolistic Competition

A monopolistic competitor advertises for two reasons
 To shift its demand curve rightward (greater quantity demanded at
each price)
 To make demand for its output less elastic
• So it can raise price and suffer a smaller decrease in quantity demanded

Can summarize impact of advertising as illustrated in panel
(a)
 Since each firm must pay costs of advertising, and more competitors
have entered the market, Narcissus and its competitors are each
earning normal economic profit—just as they were originally

Advertising has raised the price from $60 to $100 in longrun
 But this is not the only possible result
Lieberman & Hall; Introduction to Economics, 2005
53
Using the Theory: Advertising and Market
Equilibrium Under Monopolistic Competition

Because you and I and everyone else is buying
more perfume
 Each producer can operate closer to capacity output,


with lower costs per unit
In long-run, entry will force each firm to pass cost savings
on to us
Analysis suggests the following conclusion
 Under monopolistic competition, advertising may
increase size of market, so that more units are sold
• But in long-run, each firm earns zero economic profit, just as it
would if no firm were advertising
• Price to consumer, however, may either rise or fall
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Advertising and Collusion in Oligopoly

Oligopolists have a strong incentive to engage in tacit
collusion
 But in some cases can use a simple game theory model to show that
collusion is almost certainly taking place


Take airline industry as an example
In theory, any airline should be able to claim superior safety
 Yet no airline has ever run an advertisement with information about
its security policies or attacked those of a competitor
• Airlines are playing against each other repeatedly and reach the kind of
cooperative equilibrium we discussed earlier
Lieberman & Hall; Introduction to Economics, 2005
55
Figure 10: An Advertising Game
American's Actions
Run Safety Ads Don't Run Ads
Run Safety Ads
United's Actions
Don't Run Ads
Lieberman & Hall; Introduction to Economics, 2005
American
earns low
profit
United
earns low
profit
American
earns high
profit
United
earns very
low profit
American
earns very
low profit
United
earns high
profit
American
earns
medium
United
profit
earns
medium
profit
56
The Four Market Structures: A
Postscript
Different market structures
 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly
 Market structure models help us organize
and understand apparent chaos of real-world
markets

Lieberman & Hall; Introduction to Economics, 2005
57