Chapter 9: Monopolistic
Competition and Oligopoly
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Monopolistic Competition
Monopolistic competition is a market
structure in which many firms sell a
differentiated product and entry into and
exit from the market are relatively easy.

Examples: furniture, jewelry, leather goods,
grocery stores, gas stations, restaurants,
clothing stores and medical care.
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Characteristics of
Monopolistic Competition
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Relatively large number of sellers – firms
have small market shares, collusion is
unlikely and each firm can act independently
Differentiated products – the product is
slightly different and is often promoted by
heavy advertising
Easy entry to, and exit from, the industry –
economies of scale are few, capital
requirements are low but financial barriers
exist
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Differentiated Products
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Product differentiation is a form of
nonprice competition in which a firm tries
to distinguish its product or service from all
competing ones on the basis of attributes
such as design and quality.
Production differentiation entails product
attributes, service, location, brand name
and packaging, and some control over
price.
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Advertising
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The goal of product differentiation and
advertising is to make price less of a factor
in consumer purchases and make product
differences a greater factor.
The intent is to increase the demand for a
product and to make demand less elastic.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Pricing and Output in
Monopolistic Competition

The demand curve of a monopolistically
competitive firm is highly, but not perfectly,
elastic.
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The price elasticity of demand for a
monopolistic competitor depends on the
number of rivals and the degree of product
differentiation.
The larger the number of rival firms and the
weaker the product differentiation, the greater
the price elasticity of each firm’s demand.
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The Short Run: Profit or Loss
The monopolistically competitive firm
maximizes profit or minimizes loss in the
short run. It produces a quantity Q at
which MR = MC and charges a price P
based on its demand curve.
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When P > ATC, the firm earns an economic
profit.
When P < ATC, the firm incurs a loss.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Long Run:
Only a Normal Profit
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In the long-run, firms will enter a profitable
monopolistically competitive industry and
leave an unprofitable one.
A monopolistic competitor will earn only a
normal profit and price just equals average
total cost at the MR = MC output.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Long Run:
Only a Normal Profit

Because entry to the industry is relatively
easy, economic profits attract new rivals.
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As new firms enter, the demand curve faced
by the typical firm shifts to the left, reducing its
economic profit.
When entry of new firms has reduced demand
to the extent that the demand curve is tangent
to the ATC curve at the profit-maximizing
output, the firm is just making a normal profit,
leaving no incentive for new firms to enter.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Long Run:
Only a Normal Profit
When the industry suffers short-run
losses, some firms will exit in the long run.

As firms exit, the demand curve of surviving
firms begins to shift to the right, reducing
losses until the firms are just making normal
profit.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Pricing and Output in
Monopolistic Competition
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Monopolistic Competition
and Efficiency

In monopolistic competition, neither
productive nor allocative efficiency occurs
in long-run equilibrium.
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Since the firm’s profit-maximizing price (and
average total cost) slightly exceed the lowest
average total cost, productive efficiency is not
achieved.
Since the profit-maximizing price exceeds
marginal cost, monopolistic competition
causes an underallocation of resources.
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Excess Capacity

The gap between the minimum ATC
output and the profit-maximizing output is
a monopolistically competitive firm’s
excess capacity.
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Plants and equipment are unused because
the firm is producing less than the minimumATC output.
Monopolistically competitive industries are
overcrowded with firms each operating below
its optimal capacity.
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Product Variety
and Improvement

Despite the overcrowded feature,
monopolistic competition does promote
product variety and product improvement.
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A firm earning a normal profit will develop and
improve its product in order to regain its
economic profit.
Successful product improvements by one firm
obligates rivals to imitate or improve on that
firm’s temporary market advantage or else
lose business.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Oligopoly
Oligopoly is a market structure dominated
by a few large producers of homogeneous
or differentiated products.
Because of their “fewness”, oligopolists
have considerable control over their price.

Examples: tires, beer, cigarettes, copper,
greeting cards, steel, aluminum, automobiles
and breakfast cereals
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Characteristics of Oligopoly
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A few large producers – firms are generally
large and together they dominate the
industry.
Either homogeneous or differentiated
products – the products are standardized, or
differentiated with heaving advertising.
Price maker – the firm can set its price and
output levels to maximize its profit.
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Characteristics of Oligopoly
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Strategic behavior – Self-interested behavior
that takes into account the reactions of
others.
Mutual interdependence – each firm’s profit
depends not entirely on its own price and
sales strategies but also on those of the
other firms.
Blocked entry – barriers to entry exist which
make it hard for new firms to enter.
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Oligopoly Behavior: A
Game-Theory Overview

Game theory is the study of how people or
firms behave in strategic situations.
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It can be used to analyze the pricing behavior of
oligopolists.
Suppose in a two-firm oligopoly (a duopoly),
each firm must chose a pricing strategy, high or
low.
A payoff matrix can be constructed to show
payoffs (profit) to each firm that result from each
combination of strategies.
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Game Theory Example
Two firms, A and B,
must decide on a
pricing strategy: price
high or price low.

Although firms A and B
are mutually
interdependent, both
can benefit from
collusion. However,
there may be incentive
to cheat.
Firm A
Price High Price Low
Firm B

Price
High
$12
$15
$6
$12
$6
Price
Low
$15
$8
$8
A
B
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Mutual Interdependence

Each firm’s profit depends on its own
pricing strategy and that of its rival.
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In the example, if both firms adopt a highprice strategy, each firm will earn $12 million;
if both adopt a low-price strategy, each will
earn $8 million. If one firm adopts a low-price
strategy while the other adopts a high-price
strategy, the low-price firm will earn $15
million while the other firm earns $6 million.
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Collusive Tendencies
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Oligopolists can often benefit from
cooperation, or collusion.
Collusion is a situation in which firms act
together and in agreement to fix prices,
divide markets, or otherwise restrict
competition.

In the example, firms A and B can agree to
establish and maintain a high-price strategy so
each can earn $12 million.
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Incentive to Cheat

Oligopolists might have an incentive to
cheat on a collusive agreement if they can
benefit from such action.

In the example, suppose firms A and B agree
to establish and maintain a high-price strategy.
Either firm can cheat and lower its price in
order to increase profit to $15 million (a $3
million increase).
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Incentive to Cheat

Because of possible incentives to cheat,
independent action by oligopolists may lead
to mutually “competitive” low-price
strategies, which benefit consumers but not
the oligopolists.

In the example, firms A and B will choose a
low-price strategy and earn $8 million each.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Kinked-Demand Model
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In the kinked-demand model, oligopolists
face a demand curve based on the
assumption that rivals will ignore a price
increase and follow a price decrease.
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An oligopolist’s rivals will ignore a price
increase above the going price but follow a
price decrease below the going price.
The demand curve is kinked at this price and
the marginal-revenue curve has a vertical gap.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Kinked-Demand Model
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Price Leadership
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Price leadership involves an implicit
understanding that other firms will follow
the lead when a certain firm in the industry
initiates a price change.
A price leader is likely to observe the
following tactics:
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Infrequent price changes
Communications
Avoidance of price wars
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Collusion
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Collusion, through price control, may allow
oligopolists to reduce uncertainty, increase
profits, and possibly block potential entry.
One form of collusion is the cartel: a
formal agreement among producers to set
the price and the individual firm’s output
levels of a product.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Joint-Profit Maximization

If oligopolistic firms produce an identical
product, and have identical cost, demand,
and marginal-revenue curves, than each
firm can maximize profit using the MR=MC
rule.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
A profitable oligopolist when rivals
charge the same price, Po
MC
Price
Po
Economic
Profit
ATC
D
Q0
MR
Quantity of output
Joint-Profit Maximization
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If rivals charge prices lower than Po, then
the demand curve of the firm charging Po
will shift to the left as its customers turn to
its rivals, and its profits will fall.
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The firm can retaliate and cut its price, too,
however, all firms’ profits would eventually fall.
Firms will choose to charge Po and
produce Qo because it is the most
profitable price-output combination.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Obstacles to Collusion

Barriers to collusion beyond the antitrust
laws include:
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Demand and cost differences
Number firms
Cheating
Recession
Potential entry
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Oligopoly and Advertising

Each firm’s share of the total market is
generally determined through product
development and advertising for two
reasons:
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Product development and advertising
campaigns are less easily duplicated than
price cuts.
Oligopolists have sufficient financial resources
to engage in product differentiation and
advertising.
Oligopoly and Advertising
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Positive effects of advertising are:
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Enhances competition
Reduces consumers’ search time, direct
costs, and indirect costs
Facilitates the introduction of new products
Negative effects of advertising include:
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Alters consumers’ preferences in favor of the
advertiser’s product
Brand-loyalty promotes monopoly power
Oligopoly and Efficiency

Many economists believe the oligopoly
market structure is neither productively
efficient nor allocatively efficient.

This is because many oligopolistic firms price
higher than average total cost and produce
less than the optimal output level.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Oligopoly and Efficiency

A few believe that oligopoly is actually less
desirable than pure monopoly, because
government can guard against abuses of
monopoly power but not against informal
collusion among oligopolists that give the
outward appearance of competition
involving independent firms.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.