Monopolistic Competition
And Oligopoly
Lecture by: Jacinto Fabiosa
Fall 2005
Monopolistic Competition And
Oligopoly
• On any given day, you are probably exposed to
hundreds of advertisements
– Advertising is everywhere in the economy
• So far in this book not much has been said about
advertising
– There is a good reason for this
• In perfect competition and monopoly firms do little, if any,
advertising
• Where, then, is all the advertising coming from?
– We must consider firms that are neither perfect
competitors nor monopolists
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The Concept of Imperfect
Competition
• Refers to market structures between perfect
competition and monopoly
– In imperfectly competitive markets, there is more than
one seller, but too few to create a perfectly competitive
market
– Imperfectly competitive markets often violate other
conditions of perfect competition
• Such as the requirement of a standardized product or free entry
and exit
• Types of imperfectly competitive markets
– Monopolistic competition
– Oligopoly
3
Monopolistic Competition
• Hybrid of perfect competition and monopoly,
sharing some of features of each
– A monopolistically competitive market has three
fundamental characteristics
• Many buyers and sellers
• Sellers offer a differentiated product
• Sellers can easily enter or exit the market
4
Many Buyers and Sellers
• Under monopolistic competition, an individual
buyer is unable to influence price he pays
– But an individual seller, in spite of having many
competitors, decides what price to charge
• Our assumption of many sellers, however, has
another purpose
– To ensure that no strategic games will be played among
firms in market
• There are so many firms, each supplying such a small part of
the market
– That no one of them needs to worry that its actions will be
noticed—and reacted to—by others
5
Sellers Offer a Differentiated Product
• Each seller produces a somewhat different
product from the others
• Faces a downward-sloping demand curve
– In this sense is more like a monopolist than a
perfect competitor
– When it raises its price a modest amount,
quantity demanded will decline (but not all the
way to zero)
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Sellers Offer a Differentiated Product
• What makes a product differentiated?
– Quality of product
– Difference in location
• Product differentiation is a subjective matter
– A product is different whenever people think that it is
• Whether their perception is accurate or not
• Thus, whenever a firm (that is not a monopoly) faces a
downward-sloping demand curve, we know buyers
perceive its product as differentiated
– This perception may be real or illusory, but economic implications
are the same in either case
• Firm chooses its price
7
Easy Entry and Exit
• This feature is shared by monopolistic
competition and perfect competition
– Plays the same role in both
– Ensures firms earn zero economic profit in
long-run
• In monopolistic competition, however,
assumption about easy entry goes further
– No barrier stops any firm from copying the
successful business of other firms
8
Monopolistic Competition in the
Short-Run
• 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
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A Monopolistically Competitive Firm
in the Short Run
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Monopolistic Competition in the
Long-Run
• 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
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A Monopolistically Competitive Firm
in the Long Run
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Excess Capacity Under Monopolistic
Competition
• In long-run, a monopolistic competitor will operate
with excess capacity
– Will produce too little output to achieve minimum cost
per unit
• Excess capacity suggests that monopolistic
competition is costly to consumers
• May tempt you to leap to a conclusion
– Consumers are better off under perfect competition;
however
• In order to get beneficial results of perfect competition, all firms
must produce identical output
• Consumers usually benefit from product differentiation
13
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
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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
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Market Definition
• In oligopoly, a few large firms dominate
market
• In many cases, common sense provides a
sufficient guideline
– Should broaden market definition just enough
to include all reasonably close substitutes
• In some cases, common sense isn’t
definitive
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Number of Firms
• Oligopoly requires that a few firms dominate the
market
– Even if we can agree on a market’s definition, what
number qualifies as “a few”?
• At some point, number of firms is large enough—
and interdependence weak enough—that
oligopoly becomes a poor description
– Monopolistic competition would fit better
– No absolute number at which oligopoly ends and
monopolistic competition begins
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Market Domination
• Strategic interdependence requires that a
few firms—whatever their number—
dominate the market
– Their share of market is large
• As combined market share shrinks,
strategic interdependence becomes weaker
• Oligopoly is a matter of degree
– Not an absolute classification
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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
19
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
20
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
21
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
22
Oligopoly vs. Other Market
Structures
• 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
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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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The Prisoner’s Dilemma
• Easiest way to understand how game theory works is to
start with a simple, noneconomic example—the prisoner’s
dilemma
– Explains why a technique for obtaining confessions, commonly
used by police, is so often successful
• Each of four boxes in payoff matrix represents one of four
possible strategy combinations that might be selected in
this game
–
–
–
–
Upper left box: Both Rose and Colin confess
Lower left box: Colin confesses and Rose doesn’t
Upper right box: Rose confesses and Colin doesn’t
Lower right box: Neither Rose nor Colin confesses
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The Prisoner’s Dilemma
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The Prisoner’s Dilemma
• Regardless of Rose’s strategy Colin’s best choice is to
confess
– In this game, the strategy “confess” is an example of a dominant
strategy
• Strategy that is best for a player regardless of strategy of other player
• Outcome of this game is an example of a Nash
equilibrium—appropriately named after the mathematician
John Nash, who originated the concept
– Exists when each player is taking the best action—given actions
taken by other players
• As long as each player acts in an entirely self-interested
manner Nash equilibrium is best outcome for both of them
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Simple Oligopoly Games
• Same method used to understand behavior of Rose and Colin in
prisoner’s dilemma can be applied to a simple oligopoly market
• 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, using the red-shaded entries of
Figure 4, would tell us that his dominant strategy is the same: a low price
• Notice that outcome is a Nash equilibrium
– Equilibrium price in market is the low price
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A Duopoly Game
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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
– A game with two players will have a Nash equilibrium
as long as at least one player has a dominant strategy
• Whether the other has a dominant strategy or not
– When neither player has a dominant strategy, we need
a more sophisticated analysis to predict an outcome to
the game
30
Oligopoly Games in the Real World
• We’ve limited the players to one play of the
game
– In reality, for gas stations and almost all other
oligopolies, there is repeated play
• Where both players select a strategy
• Observe the outcome of the trial
• Play the game again and again, as long as they
remain rivals
• One possible result of repeated trials is
cooperative behavior
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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
34
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
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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
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The Incentive to Cheat
• Go back to Gus and Filip for a moment
– One way or another they arrive at high-price cooperative solution
– Will the market stay there?
• Maybe, and maybe not
– Problem—each player may conclude that he can do even better by
cheating
– Two players would be back to noncooperative outcome based on
their dominant strategies
– May be in each player’s interest to cheat occasionally
• Analyzing this sort of behavior requires some rather
sophisticated game theory models
– Economists are actively engaged in building them
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When is Cheating Likely?
• While no firm wants to completely destroy a
collusive agreement by cheating
– Since this would mean a return to the noncooperative
equilibrium wherein each firm earns lower profit
– Some firms may be willing to risk destroying agreement
if benefits are great enough
– Suggests that cheating is most likely to occur—and
collusion will be least successful—under the following
conditions
• Difficulty observing other firms’ prices
• Unstable market demand
• Large number of sellers
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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
39
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
40
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
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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
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Advertising in Monopolistic
Competition
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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
44
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
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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
46
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
47
An Advertising Game
48
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 realworld markets
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