Monopolistic Competition And
Oligopoly
• On any given day, you are probably
exposed to hundreds of advertisements
• In perfect competition and monopoly firms
do little, if any, advertising
• Where, then, is all the advertising coming
from?
Hall & Leiberman;
Economics: Principles
1
The Concept of Imperfect
Competition
• Refers to market structures between
perfect competition and monopoly
• Types of imperfectly competitive markets
– Monopolistic competition
– Oligopoly
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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
3
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
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Economics: Principles
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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
5
Sellers Offer a Differentiated
Product
• What makes a product differentiated?
• Product differentiation is a subjective
matter
• Thus, whenever a firm (that is not a
monopoly) faces a downward-sloping
demand curve, we know buyers perceive
its product as differentiated
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Economics: Principles
6
Easy Entry and Exit
• Same as in perfect competition
– 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
7
Monopolistic Competition in the
Short-Run
• Individual monopolistic competitor
behaves very much like a monopoly
• Key difference is this
– When a monopolistic competitor raises its
price, its customers have one additional
option – to buy from another seller
Hall & Leiberman;
Economics: Principles
8
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
9
The Long-Run
• 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
• But in long-run, free entry and exit will
ensure that each firm earns zero economic
profit just as under perfect competition
Hall & Leiberman;
Economics: Principles
10
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. d1
d2
250
MR1
Homes Serviced
per Month
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Excess Capacity Under
Monopolistic Competition
• In long-run, a monopolistic competitor will
operate with excess capacity
• Excess capacity suggests that monopolistic
competition is costly to consumers
• Does that mean consumers prefer perfect
competition to monopolistic competition?
Hall & Leiberman;
Economics: Principles
12
Nonprice Competition
• Any action a firm takes to increase
demand for its output—other than cutting
its price—is called nonprice competition
• Nonprice competition is another reason
why monopolistic competitors earn zero
economic profit in long-run
• All this nonprice competition is costly
Hall & Leiberman;
Economics: Principles
13
Oligopoly
• An oligopoly is a market dominated by a
small number of strategically
interdependent firms
• In such a market, each firm recognizes its
strategic interdependence with others
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Economics: Principles
14
Number of Firms
• Oligopoly requires that a few firms
dominate the market
• No absolute number at which oligopoly
ends and monopolistic competition begins
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Economics: Principles
15
Market Domination
• Strategic interdependence requires that a
few firms dominate the market
• As combined market share shrinks,
strategic interdependence becomes
weaker
• Oligopoly is a matter of degree
– Not an absolute classification
Hall & Leiberman;
Economics: Principles
16
Economies of Scale: Natural
Oligopolies
• When minimum efficient scale (MES) for a
typical firm is a relatively large percentage
of market
– A large firm will have lower cost per unit than
a small firm
• Does it remind you of monopoly? How is
this different?
Hall & Leiberman;
Economics: Principles
17
Barriers to entry
• Reputation - A new entrant may suffer just
from being new
• Strategic barriers - Oligopoly firms often
pursue strategies designed to keep out
potential competitors
• Legal barriers - Patents and copyrights,
Govt. legislation
Hall & Leiberman;
Economics: Principles
18
Oligopoly vs. Other Market
Structures
• Oligopoly presents the greatest challenge to
economists
• Essence of oligopoly is strategic
interdependence
• Need new tools of modeling
• One approach—game theory—has yielded rich
insights into oligopoly behavior
Hall & Leiberman;
Economics: Principles
19
The Game Theory Approach
• Game theory
• In all games, except those of pure chance,
a player’s strategy must take account of
the strategies followed by other players
• Game theory analyzes oligopoly decisions
as if they were games
Hall & Leiberman;
Economics: Principles
20
The Prisoner’s Dilemma
• 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
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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
• “Confess” is the dominant strategy for both
• Outcome of this game is an example of a Nash
equilibrium
• As long as each player acts in an entirely self-interested
manner Nash equilibrium is best outcome for both of
them
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Economics: Principles
23
Simple Oligopoly Games
• To apply the same method to a simple oligopoly
market
• Duopoly - Oligopoly market with only two sellers
• Assume that Gus and Filip must make their
decisions independently
• No matter what Filip does, Gus’s best move is to
charge a low price—his dominant strategy
• The same holds for Filip
• The outcome is a Nash equilibrium
Hall & Leiberman;
Economics: Principles
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Figure 4: A Duopoly Game
Gus’s Actions
Confess
Don’t Confess
Gus’s profit
= $25,000
Confess
Filip’s Actions
Don’t Confess
Hall & Leiberman;
Economics: Principles
Filip’s
Profit =
$25,000
Gus’s profit
= $75,000
Filip’s
Profit =
$–10,000
Gus’s profit
= –$10,000
Filip’s
Profit =
$75,000
Gus’s profit
= $50,000
Filip’s
Profit =
$50,000
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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
– 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
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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
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
• If explicit collusion to raise prices is such a good
thing for oligopolists, why don’t they all do it?
• 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
Hall & Leiberman;
Economics: Principles
30
Tacit Collusion
• Another form of tacit collusion is price
leadership
• With price leadership, there is no formal
agreement
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
– One way or another they arrive at high-price
cooperative solution
– Will the market stay there?
• Each player has an incentive to cheat
• Analyzing this sort of behavior requires some
rather sophisticated game theory models
Hall & Leiberman;
Economics: Principles
33
When is Cheating Likely?
• 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
Figure 5a: Advertising in
Monopolistic Competition
1.Before advertising, long-run
economic profit is zero.
Dollars
$120
3. But in the long run, imitation
and entry bring economic
profit back to zero.
B
C
100
ATCads
ATCno ads
A
60
4. Advertising
can lead to a
higher price
in the long
run, as in this
panel . . .
2. In the short run, the first firms to
advertise earn economic profit.
dads
dno ads
1,000
2,000
Hall & Leiberman;
Economics: Principles
dall advertise
6,000
Bottles of Perfume
per Month
35
Figure 5b: Advertising in
Monopolistic Competition
Dollars
$120
5. or to a lower price
B
in the long run, as
in this panel.
dall advertise
A
60
50
C
ATCads
ATCno ads
dads
dno ads
1,000
2,000
Hall & Leiberman;
Economics: Principles
6,000
Bottles of Perfume
per Month
36
Using the Theory: Advertising in
Monopolistic Competition and Oligopoly
• Perfect competitors never advertise and
monopolies advertise relatively little
– But advertising is almost always found under
monopolistic competition and very often in oligopoly
• Why?
– All monopolistic competitors, and many oligopolists,
produce differentiated products
• Since other firms will take advantage of
opportunity to advertise, any firm that doesn’t
advertise will be lost in shuffle
Hall & Leiberman;
Economics: Principles
37
Advertising and Collusion in
Oligopoly
• Oligopolists have a strong incentive to
engage in tacit collusion
• Take airline industry as an example
• In theory, any airline should be able to
claim superior safety
– Yet no airline has ever run an advertisement
with information about its security policies or
attacked those of a competitor
Hall & Leiberman;
Economics: Principles
38
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
39
The Four Market Structures: A
Postscript
• Different market structures
– Perfect competition
– Monopoly
– Monopolistic competition
– Oligopoly
• Market structure models help us organize
and understand apparent chaos of realworld markets
Hall & Leiberman;
Economics: Principles
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