Chapter 10: Monopolistic Competition and Oligopoly:
The Concept of Imperfect Competition:



Refers to market structures between perfect competition and monopoly
More than one seller, but too few to create a perfectly competitive market
Other conditions of perfect competition, such as the requirement of a standardized
product or easy entry/exit are not satisfied
Monopolistic Competition:
Characterized by Three Fundamental Characteristics:
1. Many buyers and sellers
2. Easy entry and exit
3. Differentiated products
Definition: Monopolistic Competition: A market structure in which there are many
firms selling products that are differentiated, yet are still close substitutes, and in which
there is free entry and exit.
 Each firm produces a differentiated product in a monopolistic competitive market;
thus each firm faces a downward sloping demand curve. Therefore it will not lose all
of its customers if it raises its price. We know that whenever a firm faces a downward
sloping demand curve, its marginal revenue curve lies below the demand curve. The
relationship between the demand and marginal revenue curves is illustrated below.
Monopolistic Competition in the Short Run:
The constraints of a monopolistic competitor are very similar to a monopoly:
1. Its current technology of production
2. The prices for inputs
3. The downward sloping demand curve
Profit case:
 The restaurant marketplace in Beverly Hills is a good example of a monopolistically
competitive market. Every restaurant offers a different menu and special dishes, but
still has to compete with other comparable restaurants. Further, each restaurant sells
a somewhat unique product; therefore the restaurants are not perfectly competitive
and can raise their price and not lose all customers.

A monopolistically competitive firm (as does any other firm) maximizes its profit
by producing the level of output where MR = MC.

MR = MC at point output level Qo. In monopolistic competition the price is
determined by the amount that customers are willing to pay to buy Qo units of
output.
 Under monopolistic competition, firms can earn positive or negative economic
profit in the short run
Monopolistic
Monopolistic Competition
Competition in
in the
the Short
Short Run
Run
Dollars
Dollars
$70
$70
AA
MC
MC
ATC
ATC
dd11
30
30
MR
MR11
250
250
Homes
HomesServiced
Serviced
per
perMonth
Month
 The monopolistically competitive firm illustrated above faces a downward
sloping demand curve d1 and marginal revenue MR1. MR = MC at 250 units per
month and a price of $70 per unit. Therefore the firm illustrated above earns a
short-run profit of $10,000 ($40*250), represented by the blue shaded rectangle.
Monopolistic Competition in the Long Run

Economic profits will not last due to easy entry/exit. Where a monopoly market
has barriers to entry, a monopolistically competitive market does not. Therefore
we should expect any economic profit to be reduced to zero due to entry of new
firms:
 Monopolistic competition allows firms to profit or incur losses in the short run.
However, in the long run, easy entry and exit will ensure that, in the long run,
there is no economic profit.
Monopolistic Competition in
the Long Run
Dollars
MC
ATC
$40
E
d
MR2
100
200
d2
Homes Serviced
per Month
The individual firm’s demand curve “d” shifts to the left to “d2” when new firms enter the
market, and each firm eventually earns zero economic profit. Point “E” represents the
long run equilibrium at which price ($40) equals ATC.
Excess Capacity under Monopolistic Competition:
 In the long run, a monopolistic competitor will operate with excess capacity—that is,
it will produce too little output to achieve minimum cost per unit.

The monopolistic competitor will always produce with P> minimum ATC in the
long run, unlike perfectly competitive firms, which, in the long run, produce at an
output level where P = minimum ATC. Perfectly competitive markets are more
efficient, have lower prices but they produce a standardized product. If we wish to
enjoy the benefit of differentiated products, we, as a society must bear the price.
Definition: Nonprice Competition: Any action a firm takes to increase the demand for
its product, other than cutting its price; advertising, free gifts, etc.
Oligopoly:
An oligopoly market is characterized by:
1.
2.
3.
4.
Few firms
A standardized or a differentiated product
Strategically interdependent firms
Difficult entry
 Today’s music industry is an example of an oligopoly. “The Big Five,” (WMG, EMI,
Sony Music, UMG, and BMG) control over 80% of all the musical titles released in
the world.
 The market for soft drinks is also considered an oligopoly market.
 Definition: Oligopoly: A market structure in which a small number of firms are
strategically interdependent. These strategically interdependent firms produce the
dominant share of output in the market.
Economies of Scale: Natural Oligopolies

Some industries remain oligopolies due to economies of scale. When these
industries reach the output level where the long run average total cost (LRATC)
in at minimum, they have reached the minimum efficient scale.
Definition: The minimum efficient scale (MES): The level of output at which
economies of scale are exhausted and minimum LRATC is achieved.

Depicted above is the LRATC curve for a hypothetical firm. Economies of scale
cause LRATC to decrease as output increases, constant returns to scale results
in no change in LRATC as output increases, and diseconomies of scale cause
LRATC to increase as output increases. It is important to note where MES is
located. If the minimum efficiency scale for the firm depicted above is 10,000
units and 500,000 units are demanded in the market, then the market is not a
monopoly. However, if the MES for a firm is 125,000 and market demand is
500,000, then we can assume very few firms coexist in that market and the market
might be an oligopoly.
The following figures illustrate three different possibilities for the MES of a typical firm
in an industry. Note that in each case, the minimum LRATC is $50, where the firm is not
suffering a loss in the long run. From the demand curve we see that when the price is $50
quantity demanded equals 100,000 units. At a price of $50 and production of 100,000
units, we reach the minimum LRATC—the maximum total output and lowest price
possible for this market.
In panel (a), MES occurs at 1,000 units. If there are no barriers, entry will occur until
there are 100 firms in the market. Panel (b) depicts a natural oligopoly; MES occurs at
25,000 units so there should be no more than four firms. Panel (c) portrays a natural
monopoly; the lowest average cost is achieved when a single firm supplies the entire
market.
Why Oligopolies Exist:
 Reputation as a barrier: In several markets, such as the markets for soft drinks
and breakfast cereals, it is difficult for a new entrant to enter the market when a
natural oligopoly already exists due to the loyalty consumers’ exhibit to well
advertised and established brands.
 Strategic barriers: Oligopolists often use strategies to keep out potential
competitors.
 Government-created barriers: Oligopolies commonly lobby politicians to
defend their market dominance (US Steel example).
Oligopoly Behavior:


Strategic interdependence is the essence of oligopoly
The MC = MR rule, as we used it for other types of markets, is largely invalid in
the analysis of oligopoly.
The Game Theory Approach:
Definition: Game theory: An approach to modeling the strategic interaction of
oligopolists in terms of moves and countermoves.
 Firms do not know which response its rivals will make
 The firm needs to be able to measure the effect of each possible response (this
becomes difficult when many firms are at “play”); therefore the fewer firms at
play the better estimate
 How well do “players” control the game?
1. Every game depends on the number of players—they greater the number of firms
the more difficult it becomes to anticipate the next move.
2. The firms with the larger amount of cash will better be able to fund advertising,
research, or development.
3. Brainpower: the degree to which the firm understands the market they are
playing.
The Prisoner’s Dilemma:
Definition: Payoff Matrix: A table showing the payoffs to each of two players for each
pair of strategies they choose.
Bob confesses
Bob does not confess
Jane
confesses
Jane gets 3 years
Bob gets 3 years
Jane gets 4 months
Bob gets 4 years
Jane does
not
confess
Jane gets 4 years
Bob gets 4 months
Jane gets 6 months
Bob gets 6 months
 The prisoner’s dilemma is a game situation like that in an oligopoly market. In
this example Bob and Jane committed a felony punishable by up to 4 years in
prison. The prisoner’s dilemma focuses on the non-cooperative strategy Bob and
Jane pursue when arrested and placed in separate rooms. The police tell Bob and
Jane separately that if they confess and their partner in crime does not, they will
get 4 months in jail and their partner will get 4 years. At the same time both Bob
and Jane recognize that if they both confess they will each get 3 years. However,
if Bob and Jane trusted each other (colluded) they would both only serve 6 month
sentences.
Definition: Dominant strategy: A strategy that is best for a firm no matter what strategy
its competitor chooses.
Simple Oligopoly Games:
Definition: Duopoly: An oligopoly market with only two sellers
Oligopoly Games in the Real World: Cooperative Behavior in Oligopoly
Definition: Repeated play: A situation in which strategically interdependent sellers
compete over many time periods.
Definition: Explicit collusion: Cooperation involving direct communication between
competing firms about setting prices.
Definition: Cartel: A group of firms that selects a common price that maximizes total
industry profits.
Definition: Tacit collusion: Any form of oligopolistic cooperation that does not involve
an explicit agreement.
Definition: Tit for tat: A game theoretic strategy of doing to another player this period
what he has done for you in the previous period.
Definition: Price leadership: A form of tacit collusion in which one firm sets a price
that other firms copy.
The Limits to Collusion:
1. Oligopolists in collusion are still confined to the downward sloping market
demand curve: any rise in prices will decrease quantity demanded.
2. Collusion is illegal; if suspected, firms can be subject to scrutiny by the US
Justice Department.
3. Incentives to cheat: cheating is a widespread problem among colluding
oligopolists.
When is cheating likely?
1. Difficulty in observing other firm’s prices: in markets where it is difficult for
firms to monitor the prices charged by their competitors.
 Retail auto sales
 Retail jewelry sales
2. Unstable market demand: Often in markets in which prices are constantly
changing it is more difficult to evaluate firms’ actions.
3. A large number of sellers: Cheating will often go undetected in larger markets.
Graphs above used with permission from John Kane