Chapter 11
Monopolistic
Competition and
Oligopoly
Chapter Objectives
 Characteristics
of monopolistic
competition
 Normal profit in the long run
 Characteristics of oligopoly
 Game theory
 The oligopolist’s kinked demand
curve
 Collusion among oligopolists
 The effects of advertising
Monopolistic Competition
 Large number of sellers
 Small market shares
 No collusion
 Independent action
 Differentiated Products
 Product attributes
 Service
 Location
 Brand names and packaging
 Some control over price
Monopolistic Competition
 Easy
entry and exit
 Need for advertising
 Nonprice Competition
 Which industries?
 Degree of concentration
 Four-firm concentration ratio
 Herfindahl index
Monopolistic Competition
Short-Run Profits
Price and Costs
MC
ATC
P1
A1
Economic
Profit
D1
MR = MC
MR
0
Q1
Quantity
Monopolistic Competition
Short-Run Losses
Price and Costs
MC
ATC
A2
P2
Loss
D2
MR = MC
MR
0
Q2
Quantity
Monopolistic Competition
Long-Run Equilibrium
MC
ATC
Price and Costs
P3= A3
D3
MR = MC
MR
0
Q3
Quantity
Monopolistic Competition
 Firm’s demand curve
 Highly elastic
 Short run profit or loss
 Produce where MR=MC
 Long run normal profit
 Entry and exit
 Inefficient
 Product variety
P=MC=Min ATC for pure competition
MC
Price and Costs
ATC
P3= A3
P4
Price is Lower
D3
MR = MC
Excess Capacity at
Minimum ATC
0
MR
Q3
Quantity
Q4
P3>lowest ATC A3; therefore, P ≠ MC & minimum ATC. Productive
efficiency is not achieved.
P3>MC, meaning underallocation of resources. Allocative
efficiency is not achieved
Oligopoly
 A few large producers
 Homogeneous or
differentiated products
 Control over price
 Mutual interdependence
 Strategic behavior
 Entry barriers
 Mergers
 Four-firm concentration ratio
 Needs to be more than 40%
 Half of U.S. manufacturing
 Localized
markets
 Interindustry competition
 World trade
 Import Competition
 Herfindahl
index
Oligopoly Behavior: Game Theory
Mutual
interdependence
-Pricing policy-Oligopolistic firms can increase their
profit, and influence their rivals’ profits by changing
their pricing strategies. Each firm’s profit depends on
its own pricing strategy and that of its rivals, which is
why this relationship between oligopolies is called
mutual interdependence.
Collusion
-Oligopolists often can benefit from collusion or cooperation with
rivals.
Incentive to cheat
-After a collusive pricing agreement every oligopolist might be
tempted to cheat, because either firm can increase its profit by
lowering its price.
Oligopoly Behavior: Game Theory
Model
RareAir’s Price Strategy
High
Uptown’s Price Strategy
• 2 competitors
• 2 price strategies
• Each strategy
has a payoff
matrix
• Greatest
combined
profit
• Independent
actions
stimulate a
response
A
$12
Low
B
$15
High
$12
C
$6
$6
D
$8
Low
$15
$8
Game Theory Model
RareAir’s Price Strategy
High
Uptown’s Price Strategy
• Independently
lowered prices in
expectation of
greater profit
leads to the
worst combined
outcome
• Eventually low
outcome make
firms return to
higher prices
A
$12
Low
B
$15
High
$12
C
$6
$6
D
$8
Low
$15
$8
Three Oligopoly Models
 Kinked-demand
 Collusive
pricing
 Price leadership
curve
Kinked-Demand Curve
Noncollusive oligopoly
 Strategies

 Match price changes- when one firm lowers their prices to
have a better profit, the other companies match their price so
the demand and marginal revenue curve will be steeper.
 Ignore price changes-when a firm changes their prices and
their rivals ignore this change, the demand curve for this first
firm will be more elastic.

Combined strategy
 Oligopolistic industries suggest that a firm’s rivals will match
price declines below P0, and they will ignore price changes
over P0.
Kinked Demand Curve

Price Inflexibility
 The kinked demand curve gives each
oligopolist reason to believe that any change
in price will be for the worse. If it raises its
price, many of its customers will desert it. If it
lowers its price, its sales at best will increase
very modestly, since rivals will match the
lower prices.
Kinked-Demand Curve
Competitor and rivals strategize versus each other
Consumers effectively have 2 partial demand curves and
each part has its own marginal revenue part
e
P0
f
D2
Rivals Match
g
Price Decrease
0
Q0
MR1
Quantity
MR2
Price and Costs
Price
Rivals Ignore
Price Increase
MC1
D2
P0
e
MR2
f
MC2
g
D1
D1
0
Q0
MR1
Quantity
Cartels and Other Collusion
 Price and output
 Joint profit maximization
Price and Costs
MC
Effectively Sharing
The Monopoly Profit
P0
ATC
A0
MR=MC
Economic
Profit
D
MR
Q0
Quantity
Cartels and Other Collusion
 Overt collusion
 Covert collusion
 Tacit understandings
 Obstacles to collusion
 Demand and cost differences
 Number of firms
 Cheating
 Recession
 Potential entry
 Legal obstacles: antitrust law
The OPEC Cartel
Daily oil production (barrels) , November 2008
Saudi Arabia
Iran
Kuwait
Venezuela
Iraq
Nigeria
UAE
Angola
Libya
Algeria
Qatar
Indonesia
Ecuador
8,904,000
3,843,000
2,538,000
2,368,000
2,297,000
2,183,000
2,117,000
1,804,000
1,737,000
1,417,000
848,000
843,000
530,000
Source: A. T. Kearney, Foreign Policy
Price Leadership Model
 Leadership
tactics
 Infrequent price changes
 Communications
 Limit pricing
 Breakdowns in price leadership:
 Price wars
Advertising
 Prevalent
in monopolistic
competition and oligopoly
 Capture market share
 Better than a price cut
 Information for consumers
 Manipulation
Oligopoly and Advertising
The Largest U.S. Advertisers, 2006
Advertising Spending
Millions of $
Company
Proctor and Gamble
AT&T
General Motors
Time Warner
Verizon
Ford Motor
GlaxoSmithKline
Walt Disney
Johnson & Johnson
Unilever
Source: Advertising Age
$4898
3345
3296
3089
2822
2577
2444
2320
2291
2098
Oligopoly and Advertising
World’s Top 10 Brand Names, 2007
Coca-Cola
Microsoft
IBM
General Electric
Nokia
Toyota
Intel
McDonald’s
Disney
Mercedes-Benz
Source: Interbrand
Oligopoly and Efficiency
 Not
productively efficient
 Not allocatively efficient
 Tendency to share the monopoly
profit
 Qualifications
 Increased foreign competition
 Limit pricing
 Technological advance