Today
 Monopolistic competition
 Cartels

Monopolistic Competition and
Oligopoly
Chapter 23

Four Basic Models

Monopolistic Competition
 Firms are able to charge different prices than their competitors because they sell heterogeneous products.
 We call these differentiated products .
 Differentiated Product : a product for which there exist a lot of varieties, quality levels, or images. Brand name may matter to consumers.

Examples of Differentiated
Products
 Cars
 Cigarettes
 Clothing
 Breakfast cereal
 Bread
 Sunscreen

Demand for Differentiated
Products

If each firm’s offering is somewhat different from its competitors, then it has more discretion over the price it charges.

The firm has a “monopoly” on the particular variety it produces.
 The firm faces a downward-sloping demand curve for its variety.

Demand for Differentiated
Products, Cont’d.
 The demand for a particular variety will be more price elastic than the market demand for the good.
 The demand for an existing variety will decrease when new, desirable varieties become available.

P p*
Profit-Maximization in
Monopolistic Competition
Q*
MC
D
LRATC
MR
Q
Choose Q where MR
= MC. Charge the price on the demand curve.
Price must cover
AVC in the SR.
Price must cover
ATC in the LR.

LR equilibrium in Monopolistic
Competition
 Just as in perfect competition, we assume no barriers to entry or exit in monopolistic competition.
 Profits will attract entry, in the form of a firm offering a new variety.
 With more varieties available, demand for each variety is smaller.

P p’
Effect of New Variety
Q’
MC
D
LRATC
D’
MR’
MR
Q
Demand for a given variety decreases.
Quantity, price, profits fall.

Long-Run Equilibrium
 Firms continue to offer additional varieties as long as there is a profit opportunity.
 The monopolistically competitive market is in long-run equilibrium when firms earn zero profits, zero losses.

Long-Run Equilibrium
P
P”
Q”
MR’
MC
LRATC
D’
Q
The demand for and costs of each variety may be different, the price and quantity may be different, but there are zero profits earned on all varieties.

Notes on Efficiency
 In equilibrium, the firms are producing on the downward-sloping portion of their
LRAC curves. Wasteful excess capacity?
 P > MC. Producing too little?
 But, the broadest possible range of products is available, which benefits consumers.

Advertising and Product
Differentiation

Advertising can be used to “create” demand for a product.
– Calvin Klein products.
– Toilet bowl cleaners.
– 4-wheel drive vehicles (in cities)
– Moisturizers
 Is this sort of advertising wasteful?

Location as Product
Differentiation
 Is the 7-Eleven across the street offering the same “product” as the 7-one at Gaskins Rd & Patterson Ave?
 Is oceanfront the same as oceanview?

Quality as Product
Differentiation
 Do we all demand the same quality clothing?
Housing? Food?
 Note: Advertising can make you believe brand name is an indication of quality
(RealLemon, branded gas, Clorox).
 Note: Advertising can also create a range quality levels in the minds of consumers, even if they don’t exist (ex: mattresses).

Oligopoly

Four Basic Models

How can two firms in a market maximize profit?
Assume at first that they can cooperate with each other.

P
Two Cooperating Firms
For simplicity, assume MC is constant.
What would the monopolist do?
What should two firms do?
MR D
MC
Q

P
P
M
Cartel
25 50 MR D
The monopolist chooses the point on D that maximizes profits. Two firm cooperating do best by emulating the monopolist.
Suppose they split the monopolist’s output.
This is a cartel .
MC
Q

A Cartel
 A cartel is a cooperative arrangement among firms designed to maximize joint profits.
 It is illegal to form a cartel under U.S. antitrust law (because it hurts consumers).
 Not prohibited internationally.

The Problem for Potential Cartels
 Each firm knows that if it produces more than its “quota” it can earn more profits.
Firms tend to “cheat”, produce more, which spoils the price.

P
P
M
Incentive to Cheat
25 50 D
If firm 1 produces 25 units, then firm 2 sees the remainder of the demand curve as the demand for its output.
The MR from firm 2’s 26th unit (Q = 51) is greater than its MC.
MC
Q
MR

Difficulties of Cartels
 Incentive to cheat
 Monitoring
– If price falls, is it because of a drop in demand or cheating? How can members monitor each other’s output?

Difficulties of Cartels, Cont’d.
 Entry
– Other potential firms see profits and wish to enter the market without joining the cartel.
– They cause price to fall, and members see they no longer benefit from the cartel.

Organization of Petroleum
Exporting Countries (OPEC)
 The most successful cartel in history.
 Cheating: For many years limited. But more in the last 10 years.
 Entry: limited by geology. North Sea &
Alaskan wells were started due to high prices in the 1970s and 1980s.
 Monitoring: A futures market in oil makes it harder to tell who intends to cheat.

Coming Up:
 Oligopoly
 Group Work: Monopolistic Competition

Monopolistic Competition versus
Perfect Competition & Monopoly
 Fill in the blanks in the table with the appropriate descriptor for a monopolistically competitive firm. In some cases, the feature listed for either perfect competition or monopoly will be correct. In other cases, you will need to modify your answer.

Table 1a
Perfect Comp Monopolistic
Competition
Firms are price takers
Choose q where
P=MC
In SR, P

AVC in order to produce.
In LR, P

ATC in order to produce.
Firms face perfectly elastic demand for their product.
Monopoly
Firms are price makers
Choose q where
MR=MC
In SR, P

AVC in order to produce.
In LR, P

ATC in order to produce.
Firms face downward-sloping market demand.

Table 1b
Perfect Comp Monopolistic
Competition
No profits or losses in LR
No barriers to entry or exit
Firms produce at lowest possible
LRAC
In LR equilibrium, P
= MC
Monopoly
May have profits in
LR
Barriers to Entry
May or may not produce at lowest possible LRAC
In LR equilibrium, P
> MC

Table 1c
Perfect Comp Monopolistic
Competition
No need for advertising, goods are homogeneous
Monopoly
Advertising may increase demand for product
Brand name is unimportant to consumers
Only one brand to choose from

Differentiated Educational
Institutions
 Institutions of higher education may not be profit-maximizing entities, but they are highly differentiated.
 List the dimensions in which institutions differentiate themselves to try to attract students. List as many dimensions as you can think of (at least 5)