Econ 101:
Microeconomics
Chapter 10:
Monopolistic Competition
And Oligopoly
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
Hall & Leiberman;
Economics: Principles
2
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
Hall & Leiberman;
Economics: Principles
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
Hall & Leiberman;
Economics: Principles
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
Hall & Leiberman;
Economics: Principles
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)
Hall & Leiberman;
Economics: Principles
6
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
Hall & Leiberman;
Economics: Principles
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
Hall & Leiberman;
Economics: Principles
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
Hall & Leiberman;
Economics: Principles
9
Figure 1: 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
Hall & Leiberman;
Economics: Principles
MC
Homes Serviced per Month
10
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
•

Under monopolistic competition, firms can earn positive
or negative economic profit in short-run
•

Entry will continue to occur, and demand curve will continue
to shift leftward
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
Hall & Leiberman;
Economics: Principles
11
Figure 2: 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
Hall & Leiberman;
Economics: Principles
Entry continues until P = ATC
at the best output level, and
economic profit is zero.
d2
250
MR1
d1
Homes Serviced
per Month
12
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
Hall & Leiberman;
Economics: Principles
13
Non-price Competition

If monopolistic competitor wants to increase its output it can
cut its price
•

Any action a firm takes to increase demand for its output—
other than cutting its price—is called non-price competition
•



Move along its demand curve
Examples include better service, product guarantees, free home
delivery, more attractive packaging
Non-price competition is another reason why monopolistic
competitors earn zero economic profit in long-run
All this non-price 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
Hall & Leiberman;
Economics: Principles
14
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
Hall & Leiberman;
Economics: Principles
15
Market Domination and
Economies of Scale

Strategic interdependence requires that a few firms—
whatever their number—dominate the market
•

Their share of market is large
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
Hall & Leiberman;
Economics: Principles
16
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
Hall & Leiberman;
Economics: Principles
17
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
Hall & Leiberman;
Economics: Principles
18
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
Hall & Leiberman;
Economics: Principles
19
The Game Theory Approach



Oligopoly presents the greatest challenge to economists
Economist have had to modify tools used to analyze other market
structures and to develop entirely new tools as well to analyze
oligopoly behavior
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
Hall & Leiberman;
Economics: Principles
20
The Prisoner’s Dilemma

Easiest way to understand how game theory works is to
start with a simple, non-economic 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
Hall & Leiberman;
Economics: Principles
21
Figure 3: The Prisoner’s Dilemma
Colin’s Actions
Confess
Don’t Confess
Colin gets
20 years
Confess
Rose
gets 20
years
Colin gets
30 years
Rose
gets 20
years
Rose’s Actions
Colin gets
3 years
Don’t Confess
Hall & Leiberman;
Economics: Principles
Rose
gets 20
years
Colin gets
5 years
Rose
gets 20
years
22
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
•

Outcome of this game is an example of a Nash
equilibrium—appropriately named after the
mathematician John Nash, who originated the concept
•

Strategy that is best for a player regardless of strategy of other
player
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
Hall & Leiberman;
Economics: Principles
23
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
•
Assume that Gus and Filip must make their decisions
independently
•


Oligopoly market with only two sellers
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
Notice that outcome is a Nash equilibrium
•
Equilibrium price in market is the low price
Hall & Leiberman;
Economics: Principles
24
Figure 4: A Duopoly Game
Gus’s Actions
Low Price High Price
Gus’s profit
= $25,000
Low Price
Filip’s
Profit =
$25,000
Gus’s profit
= –$10,000
Filip’s
Profit =
$75,000
Filip’s Actions
Gus’s profit
= $75,000
High Price
Hall & Leiberman;
Economics: Principles
Filip’s
Profit =
$–10,000
Gus’s profit
= $50,000
Filip’s
Profit =
$50,000
25
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
Hall & Leiberman;
Economics: Principles
26
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
Hall & Leiberman;
Economics: Principles
27
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
Hall & Leiberman;
Economics: Principles
28
Explicit Collusion


Simplest form of cooperation is explicit collusion
•
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?
•
•

Managers meet face-to-face to decide how to set prices
Usually illegal
Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways
Hall & Leiberman;
Economics: Principles
29
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
Hall & Leiberman;
Economics: Principles
30
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
Hall & Leiberman;
Economics: Principles
31
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
Hall & Leiberman;
Economics: Principles
32
The Incentive to Cheat

Go back to Gus and Filip for a moment
•
•

Maybe, and maybe not
•
•
•

One way or another they arrive at high-price cooperative
solution
Will the market stay there?
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
Hall & Leiberman;
Economics: Principles
33
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
Hall & Leiberman;
Economics: Principles
34
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
Hall & Leiberman;
Economics: Principles
35
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
Hall & Leiberman;
Economics: Principles
36
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
Hall & Leiberman;
Economics: Principles
37
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
•

Technology—the internet—has enabled residents in many
smaller towns to choose among a dozen or more online
sellers of the same merchandize
•
•

By increasing size of market
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
Hall & Leiberman;
Economics: Principles
38
Figure 5a: 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
Hall & Leiberman;
Economics: Principles
dall advertise
6,000
Bottles of Perfume
per Month
39
Figure 5b: 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
Hall & Leiberman;
Economics: Principles
6,000
Bottles of Perfume
per Month
40
Figure 6: An Advertising Game
American's Actions
Run Safety Ads Don't Run Ads
Run Safety Ads
United's Actions
Don't Run Ads
Hall & Leiberman;
Economics: Principles
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
41
Problem #8



In Promaine Flats, Nevada there are two restaurants: Sal Monella
and Road Kill Café.
Current profit =$7000 each. If clean up will attract more
customers, but profit becomes $5000 each.
However, if clean up and doesn’t clean up then $12000 and $3000.
a. What is the payoff matrix?
b. What is each player’s dominant strategy?
c. What will be the outcome of the game?
d. Suppose the two restaurants will face the decision repeatedly.
How might the outcome differ?
e. Suppose the clean restaurant earns $6000 when one clean up
and one stays dirty. What is the outcome?
Hall & Leiberman;
Economics: Principles
42