Chapter 7.1
Monopolistic Competition
and Oligopoly
The Continuum of the Market Structure
Monopoly
n=1
No of firms, n
n small
Oligopoly
Perfect
Competition
n=infinity
n large
Monopolistic
Competition
MONOPOLISTIC COMPETITION
• Assumptions of monopolistic competition
• Each firm sells a different variety or brand (think
of coke or restaurants)
• There are many firms
– Act independently – ignore others’ reactions
• Freedom of Entry and Exit
• There is Symmetry
– New firms affect all old ones equally
MONOPOLISTIC COMPETITION
• Equilibrium:
– short run
Suppose we consider the case of demand for eating out.
The ‘Industry’
Demand Curve looks
like this
£
Ps
O
Qs
Q
Suppose we consider the case of demand for eating out.
£
What about an
individual
restaurant?
It is further in
Ps
and flatter
Why?
O
Qs
Q
Suppose we consider the case of demand for eating out.
Each restaurant
type has a share of
the industry
But knows that it
can only vary its
price a little
£ Ps
O
Qs
Q
Suppose we consider the case of demand for eating out.
£
Ps
O
What if a new
competitor appears?
Getting closer and
closer to Perfect
Competition
Qs
Demand line
shifts in more
and flattens
more
Q
So now suppose we have a firm like the blue line …
and this restaurant is doing well in the short-run
£ Ps
O
Qs
Q
Let’s make the picture bigger
£
Ps
AR = D
MR
O
Qs
Q
Let’s make the picture bigger
£
MC
AC
Ps
AR = D
MR
O
Qs
Q
Short-run equilibrium of the firm under monopolistic
competition
£
MC
AC
Ps
ACs
AR = D
MR
O
Qs
Q
Short-run equilibrium
£
MC
AC
Ps
ACs
AR = D
MR
O
Qs
Q
New Firms enter
What happens now?
£
MC What happens to D?
So P
and Q
down
AC
P1
ACs
D
MR
O
Qs
Q
New Firms enter
What happens now?
£
MC What happens to D?
So P
and Q
down
AC
ACs
D
And
Supernormal
Profits
down
MR
O
Qs
Q
New Firms enter
What happens now?
£
MC What happens to D?
So P
and Q
down
AC
ACs
D
And
Supernormal
Profits
down
MR
O
Qs
Q
What Happens Next?
• Still Super-Normal Profits
• So firms keep entering
• P keeps falling and Super-normal profits
keep falling until….
• In the LR
• AR = AC and there are no supernormal
profits
£
Long-run equilibrium of the firm under
monopolistic competition
LRMC
LRAC
PL
ARL = DL
MRL
O
QL
Q
NOTICE:
• AR (=D) curve still slopes down
• So not in perfectly competitive case
• Firms have market power (can choose price
and quantity), but….
• Competition is such that this power is
illusory (in the long run)
MONOPOLISTIC COMPETITION
• Limitations of the model
– imperfect information about profits and demand
– difficulty in identifying industry demand curve
– indivisibilities/local monopolies
– importance of non-price competition
 Variety
 Advertising
MONOPOLISTIC COMPETITION
•The public interest
–comparison with perfect competition;
PRODUCTION WILL NOT OCCUR WHERE
LRAC IS AT ITS MINIMUM (unlike perfect
competition which is efficient)
Long run equilibrium under perfect and
monopolistic competition (with decreasing or constant
returns to scale)
£
LRAC
P1
DL under perfect
competition
O
Q1
Q
Long run equilibrium under perfect and
monopolistic competition (with decreasing or constant
returns to scale)
£
LRAC
P2
P1
DL under perfect
competition
DL under monopolistic
competition
O
Q2
Q1
Q
The Continuum of the Market Structure
Monopoly
n=1
No of firms, n
n small
Oligopoly
Perfect
Competition
n=infinity
n large
Monopolistic
Competition
OLIGOPOLY
• Key features of oligopoly
– barriers to entry
– interdependence of firms
– ~What’s he up to?
– incentives to compete versus incentives to
collude
Day 1: Suppose initially Monopoly firm in the
Industry
£
To make life simple
suppose P=200-Q is
the demand curve
D
O
Q
Suppose initially Monopoly firm in the Industry
£
200
To make life simple
suppose P=200-Q is
the demand curve,
And MC are zero
What is the MR
curve?
D
O
200
Q
Suppose initially Monopoly firm in the Industry
£
200
P=200-Q
TR= P*Q
TR=[200-Q]*Q
TR=200Q-Q2
MR=200-2Q
D
O
200 Q
Suppose initially Monopoly firm in the Industry
£
P=200-Q
200
TR= P*Q
TR=[200-Q]*Q
TR=200Q-Q2
MR=200-2Q
If MR = 0,
200=2Q
MR
O
100
D
MC
200 Q
Suppose initially Monopoly firm in the Industry
What quantity will this
firm supply to the
market
£
200
MR=MC at 100
Q=100
P=100
P=200-Q
P=200-100
=100
MR
O
100
D
200 Q
MC
Suppose initially Monopoly firm in the Industry
So monopolist
supplies half the
market in this case
£
200
(Linear demand, MC=0)
P=100
MR
O
100
D
200 Q
MC
Day 2: Harmony is broken! Suppose now a new firm
£ notices there are unfulfilled customers
200
What will new firm do?
P=100
MR
O
100
D
200 Q
MC
Suppose now a new firm notices there are unfulfilled
customers
£
200
What will new firm do?
It thinks it has
demand
P=100
P=100-Q
MR=100-2Q
MR
O
100
D
MC2
200 Q
MC
Suppose now a new firm notices there are unfulfilled
customers
It is just
looking at
What will new firm do?
this bit of
200
the
It thinks it has
market
demand
Setting
P=100
P=100-Q
MC = MR
=0
MR=100-2Q
100=2Q
Q=50
MR
0
D
MC2
100 Q
MC
• So now firm 1 is supplying 100 units
• And firm 2 is supplying 50 Units
• Will firm 1 accept that?
• How will it react?
£
Day 3: The reckoning
200
Firm 1 sees that 50
people are already
being supplied. So its
market is
P=100
P=200-Q –50
P=150-Q
MR
O
100
D
MC2
200 Q
MC
£
Day 3: The reckoning
200
Firm 1 sees that 50
people are already
being supplied. So its
market is
150
P=100
P=200-Q –50
P=150-Q
MR
O
100
D
150
200 Q
MC
£
Day 3: The reckoning
200
And MR is now
150
MR=150-2Q
So when MR=MC=0
P=100
Q=75
D
MR
O
75
100
200 Q
MC
• Firm 1 was supplying 100 units
• Is Now Supply 75 units
• Firm 2 is still producing 50 units
• How will firm 2 react to the cut in firm 1’s
production?
£
This is essentially the story now
200
Firm 1 Supplies 75
Firm 2 Supplies 50
But now Firm 2 sees
that there are 125
unsatisfied consumers
P=100
MR1
MR2
O
D2
100
D1
Market D
MC
MC2
200 Q
£
Day 4: The Mob Strikes BACK
200
Firm 2 sees that 75
people are already
being supplied. So its
market now is
125
P=100
P=200-Q –75
P=125-Q
MR
O
100
D
125
200 Q
MC
£
Day 4: The Mob Strikes BACK
200
And MR is now
MR=125-2Q
125
So when MR=MC=0
P=100
Q=62.5
D
MR2
O
62.5
100 125
200 Q
MC
• Firm 1 was supplying 100 units
• Firm 1 Is Now producing 75 units
• Firm 2 was producing 50 units
• Firm 2 is now Producing 62.5 units
• Firm 1’s Q is going down as Firm 2 goes Up
• Firm 2’s Q is going Up as Firm 1 goes down
• When will equilibrium occur?
Armageddon
£
200
133.3
If each firm sees that
66.66 people are already
being supplied, then it
sees its market as
P=200-Q –66.66
P=100
P=133.33-Q
D
O
100 133.33
200 Q
MC
Armageddon
£
If each firm sees that 66.66
people are already being
supplied, then P=133.33-Q
200
133.3
And MR is now
MR=133.33-2Q
P=100
So when MR=MC=0
Q=66.66
D1=D2
MR1= MR2
O
66.66
100
133.33
D
200 Q
MC
• Firm 1 fall from supplying 100 units to 66.66
units
• Firm 2 rises from supplying 0 units to 66.66
units
• Given that firm 1 is supplying 66.66 units
firm 2’s best response is 66.66 units
• Given that firm 2 is supplying 66.66 units
firm 1’s best response is 66.66 units
• EQUILIBRIUM (Cournot equilibrium)
• What do we learn from this story?
• With a small number of firms, one firm’s
actions directly affects the other.
• Where the number of firms are small, the
firms will think strategically!!
• What is the other guy (male or female) up to
?
• How will they react to my actions
• Indeed:
• Firms wouldn’t go through this tortuous
process, they would figure out the situation
pretty quickly and if firm 1 couldn’t stop 2
entering they would go to final equilibrium.
• Called Cournot Competition (competing
over market share - Quantities)
• Can also model price competition- Bertrand
Comparison of Cournot
with Perfect Compt. and Monopoly
• Under Monopoly Firm 1 with a linear
demand curve Zero MC supplied half the
market, that is Q1 =1/2 of 200=100
• Here with 2 firms each supply 1/3 of 200,
that is, 66.66 and total output = 133.33
• Under perfect competition MC = 0 would
produce at Q = 200
• So oligopoly moves the economy closer to
perfect competition as compared with
monopoly
Cournot:
•
•
•
•
•
•
•
1 firm supplies ½ of market
2 firms supply 1/3 market each, 2/3 overall.
What about 3 firms?
3 firms supply 1/4 market each, 3/4 overall.
..and 4 firms?
4 firms supply 1/5 market each, 4/5 overall.
n firms, supply 1/(n+1) of market each,
n/(n+1) overall
• So more firms getting closer and closer to
perfect competition
Profits Under Cournot
£
P= 200-2(66.66)=
200
= 200-133.33= 66.66
Industry Profits=2(TR-TC)
133.3
=2{66.66(66.66)}=8887.7
P=100
But under Monopoly p=100;
Q=100 and
Profits = 100*100
MR1= MR2
O
66.66
D1=D2
100 133.33
=10,000
D
200 Q
MC
So two firms would be better
off if they could get together
and agree to limit market:
£
200
Collusion
Profits Under Cournot: 8,888
133.3
Profits under monopoly:
10,000
P=100
D1=D2
MR1= MR2
O
66.66
100
133.33
D
200 Q
MC
OLIGOPOLY
• Key features of oligopoly
– barriers to entry
– interdependence of firms~What’s s/he up to?
– incentives to compete versus incentives to
collude
• Factors favouring collusion
• Collusive oligopoly: cartels
– equilibrium of the industry
OLIGOPOLY
• Key features of oligopoly
– barriers to entry
– interdependence of firms
– incentives to compete versus incentives to
collude
• Factors favouring collusion
• Collusive oligopoly: cartels
– Join forces and act collectively as a monopoly
– allocating and enforcing quotas