Oligopolies and
monopolistic
competition
In between the two competition
benchmarks
Oligopolies and monopolistic competition
Today we finish examining the
competition continuum we introduced
last week
 After today, you will know all four of the
main models used to explain the
different market structures

The two extreme benchmarks (previous
weeks)
 The two “middle ground” models

Oligopolies and monopolistic competition
The “competition continuum”
Market power of firms
Perfect
competition
Many firms with a
homogeneous
product
Monopolistic
competition
Many firms with
differentiated
products
Oligopoly
A few
producers
with high
market power
Monopoly
A single
producer
Oligopolies and monopolistic competition


Importantly, the two cases we see today are
in the middle of the competition continuum
They are more realistic that the extreme
benchmarks of perfect competition and pure
monopoly



More “powerful” models in that they correspond
better to the real world
Unfortunately, this means that they are also
more complex
These models have required the development of
new tools
Oligopolies and monopolistic competition
Oligopolies
Monopolistic competition
Oligopolies

1.
2.
3.
4.
5.

The oligopoly corresponds to the following market
structure :
A few large producers
Homogeneous products
No entry of competing producers on the market
Perfect information
Perfect mobility of inputs
Apart from the few producers instead of one, this
is not much different from the monopoly
Oligopolies

Oligopolies are usually caused by the presence
of barriers to entry which deter potential
competitors.



Institutional or regulatory barriers (Example:
defence industry or utilities)
The nature of the technology, which determines
the existence of returns to scale and the minimal
efficient scale of the firm (Example : Aeronautical
industry)
Absolute cost differentials: Vertical integration,
access to an efficient supply or distribution
network (example: agribusiness)
Oligopolies

This is a common situation in many industries :





Car industry, aeronautical industry
Agribusiness (Nestlé, Danone, Kraft foods, CocaCola Co)
Electronics, computing
Utilities, buildings, etc.
Compared to the monopoly case, each firm has
an extra element to consider: The behaviour of
its competitors (introduced last week)


Because a firm’s output influences market prices,
competitors will react
This will lead to strategic behaviour
Oligopolies


A simple solution for the market price and quantity
is possible if the firms decide to cooperate. This
cooperative equilibrium is called a cartel.
OPEC is a good example: an organisation of
independent producers, producing the same goods,
who decide to coordinate their strategies, so as to
limit their output and increase prices.


The good news: When firms do this (ie maximise collective
profit), they practise monopoly pricing and get monopoly
profits. This means the simple monopoly model is enough
The “bad” news: This practise is illegal in most countries!
Also, there is an incentive to cheat. So usually, firms will
not cooperate, and a more complex model is needed...
Oligopolies
Price
p
The cooperative
equilibrium
mCA
ACA
G
Inverse demand
facing firm A
mRA
q
Quantity
Oligopolies


When firms in an oligopoly do not cooperate, there
is a non-cooperative equilibrium
Compared to the monopoly and the cooperative
cartel case, it becomes difficult to characterise the
market equilibrium (equilibrium price and quantity)


If a firm changes its output (price), this changes the market
price, and the profits of competitors. They will react to this
change in profits by changing their output (price).
The optimal strategy of a firm depends on the
strategies of its competitors. There are as many
types of equilibria as there are combinations of
strategies.
Oligopolies


As a simplification, economic theory typically
examines the duopoly: The case with two
producers on a market with barriers to entry
There are many possible models of duopoly:
Quantity
competition
Price
competition
Simultaneous
setting
Cournot
duopoly
Bertrand
duopoly
Leader/Follower
setting
Stackelberg
duopoly
Price
leadership
Oligopolies

The Cournot duopoly (1838) :


Is the first and simplest model of a
duopoly: each firm considers the output
of its competitor as given
The 2 firms simultaneously choose their
output, and consider that the current
output of their competitor will not change
(not very realistic...)
Oligopolies

The profits of the two firms is given by:

1  p  q1  q2   q1  c1  q1 


 2  p  q1  q2   q2  c2  q2 
The cost of production depends
only on the firm’s output
The market price however, depends
on the aggregate output q1 + q2

For simplicity, we re-write them as:
 1  F1  q1 , q2 

 2  F2  q1 , q2 
Oligopolies

As for all firms, the maximum profit condition
is given by the first order condition  i qi  0
  1 F1  q1 , q2 

0

q1
 q1

  2  F2  q1 , q2   0
 q
q2
 2

These first order conditions can be rearranged
to give a system of equations known as reaction
functions
q1  f1  q2 

q2  f 2  q1 
A reaction function tells you the
quantity q1 that maximises the
profits of firm 1 given the quantity
q2 produced by firm 2
Oligopolies
Reaction functions and Cournot equilibrium
q2
Reaction function of firm 1
q1  f1  q2 
Reaction function of firm 2
q2  f 2  q1 
C1
C0
C3
q*2
C2
C
q*1
q1
Oligopolies

The existence and the stability of an equilibrium in
an oligopoly depends on the expectations that
firms form about the strategies of their competitors


Most often, the tools of classical economics cannot
find these different equilibria...



Several different equilibria are possible depending on
the various combinations of strategies formulated.
...unless strong simplifying assumptions are made.
See the Cournot example: “treat output as given”
Game theory was developed as a response to this
problem.
This will be seen next week
Oligopolies and monopolistic competition
Oligopolies
Monopolistic competition
Monopolistic competition

1.
2.
3.
4.
5.

Monopolistic competition corresponds to the
following market structure :
Large number of agents (Atomicity)
Differentiated products
Free entry and exit from the market
Perfect information
Perfect mobility of inputs
The output of each producer is slightly different
from the others ⇒ existence of varieties (brands)
Monopolistic competition

Because each firm produces a slightly different
good, consumers can have preferences over these
different varieties.



There will be an element of “brand loyalty” in
consumer behaviour, where one variety of a good
will be preferred over another one.
Examples: Corner shops, restaurants, hair
dressers, travel agents, etc.
Unfortunately, the algebra necessary to generate
such “preference for variety” models is a bit
complicated ⇒ We will only look at the diagrams
Monopolistic competition

Each firm has a small amount of market power





Because of “brand loyalty”, it can increase its price a
bit without loosing all its customers (as is the case
in perfect competition)
The price elasticity of demand is not infinite
The demand curve facing the firm is downwardsloping (not flat as in perfect competition)
There will be a (small) mark-up: Price is above mC
However, because firms can enter the market
freely, economic profits are equal to zero in the
long run
Monopolistic competition

How does this work ?

At the firm level, the short run equilibrium
diagram looks like the monopoly diagram
 It also solves like a monopoly ⇒ short run profits

The adjustment to the long run behaves like
perfect competition:
 Extra firms enter the market, attracted by the
profits
 The demand facing each firm decreases until
profits are competed away
Monopolistic competition
Firm-market equilibrium
Firm level
Market level
Price
Price
Positive profits
in the short run
mC
S
AC
p
mR
q
d
D
quantity
Q
Quantity
Monopolistic competition
Firm-market equilibrium
Firm level
Market level
Price
Price
zero profits in
the long run
mC
Positive profits attract firms
to the market (free entry +
perfect information)
S S
AC
p
p2
mR
q2 q
d
D
quantity
Q Q2
Quantity
Monopolistic competition
Price
Long run welfare implications
mC
AC
In the long run, Total
revenue is equal to Total
cost ⇒ Profits are equal
to zero
Similar to perfect
competition. An
improvement on
monopolies/oligopolies
p = AC
p
mR
q
Demand
Quantity
Monopolistic competition
Price
Long run welfare implications
mC
AC
Even in the long run,
there is a mark-up
p > mC
Consumer surplus
This implies some
deadweight loss
p
mR
Producer surplus
q
Demand
Quantity
Monopolistic competition
Price
Long run welfare implications
mC
AC
Firms are not producing
at the minimum AC.
There is excess capacity
(i.e. some production
resources are wasted)
p
mR
q
q*
Demand
Quantity
Monopolistic competition


This model has a competitive limit
The weaker the preferences of consumer for
variety (the “brand loyalty”), the less market
power the firms have and the closer the
model predictions are to perfect
competition



The demand curve becomes flatter
The mark-up and deadweight loss are reduced
The equilibrium tends to P = mC = AC
Monopolistic competition
The competitive limit
Case 1
Case 2
Price
Price
mC
mC
AC
p
mR
q
d
AC
d
p
quantity
mR
q
Quantity