Chp 15 monopolistic competition, oligopoly and contestable markets

What are the main characteristics of monopolistic competition?

There are many relatively small, independent firms; products are differentiated through branding; there are close substitutes; firms have some price-setting power; competition is mainly non-price competition; barriers to entry and exit are low; and consumers and producers have imperfect information.

Why do firms in monopolistic competition have some monopoly power?

Product differentiation and branding create customer loyalty, meaning firms face a downward-sloping demand curve. They can increase prices without losing all their customers, although close substitutes limit their pricing power.

DIAGRAM How do firms maximise profit in monopolistic competition in the short run?

Firms produce where MC = MR and charge the price indicated by the AR (demand) curve. If AR exceeds AC at this output, firms earn supernormal profits. This attracts new entrants.

DIAGRAM How does monopolistic competition reach long-run equilibrium?

Supernormal profits attract new firms, increasing competition and reducing demand for existing firms. Their AR curve shifts left and becomes more price elastic. Entry continues until only normal profits remain, where AR = AC and MC = MR.

What are the advantages of monopolistic competition?

Consumers benefit from greater product variety and choice. Short-run supernormal profits can fund investment and innovation, potentially improving dynamic efficiency. The model is also more realistic than perfect competition because real markets involve branding and product differentiation.

What are the disadvantages of monopolistic competition?

Firms are allocatively inefficient because P > MC, and productively inefficient because they do not produce at minimum AC (excess capacity). X-inefficiency may occur due to limited pressure to minimise costs. Dynamic efficiency may also be limited in the long run because firms only earn normal profits.

What is excess capacity in monopolistic competition?

Firms produce below the output level that minimises average costs. They therefore operate on the downward-sloping section of their AC curve, meaning they are productively inefficient.

What are the main characteristics of an oligopoly?

A market dominated by a few large firms, with a high concentration ratio, high barriers to entry, interdependence between firms and often significant product differentiation. Firms may compete through prices or non-price methods and may collude.

What is a concentration ratio and how is it calculated?

The combined market share of the largest firms in an industry. For example, the four-firm concentration ratio is calculated by adding together the market shares of the four largest firms. A higher ratio generally indicates less competition.

What is interdependence in an oligopoly?

Firms' decisions are affected by the actions of their competitors. For example, if one firm lowers its prices, rivals may respond by lowering theirs to protect their market share. This creates uncertainty when making business decisions.

What is non-price competition and why is it important in oligopolies?

Competition through methods other than changing prices, such as advertising, branding, loyalty schemes, customer service and product quality. It helps firms attract customers and increase brand loyalty, making demand more price inelastic.

What is price leadership?

When one dominant firm changes its prices and other firms follow. Smaller firms may follow the price leader to avoid losing market share, helping maintain price stability.

What is a price war and what are its consequences?

A situation where firms repeatedly cut prices in response to competitors' price reductions. This can benefit consumers through lower prices but reduces profit margins and may cause firms to make losses.

What is a cartel and how does it operate?

A group of firms that agree to coordinate prices, restrict output or divide markets to maximise joint profits. By restricting supply, they can increase market prices and reduce competition. Cartels are generally illegal under competition law.

What is the difference between overt and tacit collusion?

Overt collusion involves an explicit agreement between firms, such as formally fixing prices. Tacit collusion involves firms coordinating their behaviour without a formal agreement, for example by following a price leader.

What conditions make collusion more likely?

Few dominant firms, similar production costs, high barriers to entry, stable market conditions, easy communication and difficulty detecting cheating. Consumer inertia and ineffective competition policy can also make collusion easier to maintain.

What is the difference between collusive and non-collusive oligopoly?

Collusive oligopolies involve firms cooperating to restrict competition and increase joint profits. Non-collusive oligopolies involve firms competing independently, attempting to gain market share through prices, advertising, quality and other methods.

DIAGRAM What is the kinked demand curve model and what does it explain?

It explains price stability in oligopolies. If a firm raises its price, competitors do not follow, causing it to lose significant market share, so demand is price elastic above the kink. If it lowers its price, competitors follow, giving it only a small increase in market share, so demand is relatively price inelastic below the kink.

Why does the kinked demand curve create price rigidity?

Firms have little incentive to change prices. Raising prices risks losing customers, while lowering prices is likely to trigger competitors to follow, producing little additional market share. This creates relatively stable prices.

DIAGRAM How does the kinked demand curve explain a discontinuous marginal revenue curve?

The change in price elasticity at the kink creates a gap in the MR curve. If MC shifts within this gap, the profit-maximising output and price remain unchanged, explaining price rigidity.

What is game theory and why is it relevant to oligopolies?

Game theory analyses how firms make decisions while considering the likely actions of competitors. It is relevant because oligopolists are interdependent and often face uncertainty about how rivals will respond.

What is the Prisoner's Dilemma in economics?

A game theory model showing why individuals or firms may choose not to cooperate even when cooperation would benefit both. Each has an incentive to pursue its own best outcome, potentially leaving both worse off than if they had cooperated.

What is a dominant strategy?

A strategy that gives a player the best outcome regardless of the strategy chosen by the other player.

What is a Nash equilibrium?

An outcome where each player has chosen the best strategy given the choices of the other players. No player can improve their position by changing strategy independently.

DIAGRAM How does a payoff matrix illustrate the Prisoner's Dilemma?

It shows the possible outcomes of different decisions made by two players. Each player's dominant strategy may lead to an outcome where both are worse off than if they had cooperated, demonstrating the difficulty of maintaining collusion.

What are the advantages of oligopolies?

Large firms can exploit economies of scale, reducing average costs. Supernormal profits can fund research and development, improving dynamic efficiency. Collaboration can also improve industry standards and avoid duplicated research.

What are the disadvantages of oligopolies?

High concentration and collusion can lead to higher prices, restricted output and lower consumer surplus. Reduced competitive pressure may cause productive and allocative inefficiency, X-inefficiency and barriers that prevent new firms entering.

What is a contestable market?

A market where firms face both actual and potential competition. New firms can enter and leave relatively easily, meaning existing firms must consider the threat of new competitors even if few firms currently operate.

What are the main characteristics of a perfectly contestable market?

Free entry and exit, no significant sunk costs, access to production techniques and technology, low consumer loyalty and potential competition from new entrants. The number of firms can change as businesses enter and leave.

What is hit-and-run competition?

When new firms enter a market to take advantage of supernormal profits, then leave once profits fall. This threat encourages existing firms to keep prices competitive and avoid excessive profits.

How does contestability influence the behaviour of existing firms?

The threat of new entrants encourages firms to keep prices low, minimise costs and operate efficiently. Otherwise, new competitors could enter, undercut them and take market share.

DIAGRAM How does a perfectly contestable market affect long-run efficiency?

The threat of entry encourages firms to produce at minimum AC and where P = MC. This creates productive and allocative efficiency, similar to perfect competition.

What are sunk costs and why do they reduce contestability?

Sunk costs are costs that cannot be recovered when a firm leaves a market, such as advertising expenditure. High sunk costs increase the financial risk of entry and exit, discouraging potential competitors.

What are the main barriers to entry that reduce contestability?

Economies of scale, legal restrictions such as patents and licences, brand loyalty, predatory pricing, limit pricing, anti-competitive practices and vertical integration. These make it harder for new firms to enter and compete.

What is the difference between predatory pricing and limit pricing?

Predatory pricing involves setting prices below average costs to drive existing competitors out of the market, accepting short-run losses. Limit pricing involves setting prices low enough to discourage potential new entrants from entering profitably.

What are barriers to exit and how do they affect contestability?

Costs that make it difficult or expensive for firms to leave a market, such as lease commitments, writing off assets, redundancy payments and losing brand value. They increase the risks of entering a market, reducing contestability.

What is brand proliferation and how can it reduce contestability?

When large firms introduce multiple brands within the same market, creating the appearance of greater competition. In reality, several brands may be owned by a small number of large businesses, making it harder for new firms to compete.

Why are markets rarely perfectly contestable in reality?

Most markets have some barriers to entry and exit, sunk costs, consumer loyalty and imperfect access to technology. Therefore, markets usually have varying degrees of contestability rather than being perfectly contestable.

What are the advantages and disadvantages of contestable markets?

Advantages include lower prices, greater competitive pressure, improved efficiency and potentially less need for government intervention. Disadvantages include limited dynamic efficiency because firms may only earn normal profits, reducing funds available for research and development.