Monopolistic Competition and Oligopoly

Chapter 10: Monopolistic Competition and Oligopoly

Monopolistic Competition

• Definition: A market structure characterized by many medium-sized firms that need to be innovative and differentiate their products through both price and non-price methods.

  • Example: Fast-food industry.

• Unique Features:

  • Product Differentiation: Firms offer products that are similar but not identical.

  • Advertising: Firms invest in advertising to attract new consumers and build brand loyalty.

Similarities with Perfect Competition

• Number of Firms: Many firms compete with each other.

• Barriers to Entry: Very low.

• Economic Profit (Short Run): Possible to earn economic profit.

• Economic Profit (Long Run): Attracted competition diminishes economic profits.

Similarities with Monopoly

• Pricing Power: Firms can set prices for their products but within a narrower range compared to monopolies.

• Demand Curve: Downward-sloping with a flatter demand curve than in monopoly (indicating a more elastic curve).

• Marginal Revenue: Marginal revenue (MR) is less than demand.

Key Characteristics of Monopolistic Competition

• Product Differentiation: Firms like McDonald’s, Burger King, Wendy’s, etc., differentiate their burgers.

• Advertising Costs: To create and maintain brand loyalty, firms allocate resources to advertising at the expense of production.

Comparison between Perfect Competition and Monopolistic Competition

Efficiency in Long Run

• Perfect Competition: Zero economic profit; Price = Minimum Average Total Cost (ATC); Efficiency.

• Monopolistic Competition: Zero economic profit; Price = ATC (not minimum); Inefficiency due to excess capacity (e.g., multiple gas stations in a busy intersection).

Pricing and Revenue Graphs

1. Monopolistically Competitive Firm (Short Run and Long Run):

   • Short run: Profits exist if price exceeds average cost (AC).

   • Long run: Economic profits dissolve as new firms enter the market leading to zero profits.

Profit Maximization in Monopolistic Competition

• Profit Maximizing Output: Firms identify the quantity where marginal revenue (MR) equals marginal cost (MC) to establish the price consumers are willing to pay (profit-maximizing price).

• Elastic Demand Curve: The demand curve faced by these firms is more elastic than for monopolists, due to available substitutes.

Product Differentiation

• Definition: Key characteristic defining monopolistic competition, where firms distinguish their products through features, branding, or quality.

• Market Power: Allows firms to set prices slightly above competitors due to perceived differences by consumers.

Summary: Monopolistic Competition

1. Large number of buyers and sellers.

2. Relatively easy entry (low barriers to entry and exit).

3. Differentiated products (not identical).

4. Heavy reliance on advertising and non-price competition.

5. Inefficient, resulting in excess capacity.

6. Long-run equilibrium results in zero economic profit.

7. Allocative inefficiency indicated by Price > MC.

8. Marginal revenue greater than price (P > MR).

9. Common in the U.S., though not the dominant market structure.

Oligopoly

• Definition: A market structure characterized by few sellers who act interdependently and/or collusively as price-makers.

  • Examples: Breakfast cereal, automobile, airline, and cellular phone industries.

Characteristics of Oligopoly

• Barriers to Entry: High, making it difficult for new firms to enter the market.

• Interdependence: Pricing and output decisions are mutually influenced by actions of rival firms.

• Collusion: Firms may engage in illegal agreements to fix prices or control production to maintain higher profits.

  • Cartel Example: OPEC, which sets production limits to control pricing.

Forms of Collusion

1. Price-Fixing: Agreement among firms to set prices above market levels.

2. Market Division: Agreement amongst firms to divide the market into segments to guarantee sales.

3. Price Wars: Competitive efforts leading to reduced prices that can temporarily drop below production costs.

Oligopoly Demand Curve

• Kinked Demand Curve: Represents the demand for oligopoly firms that respond to price changes of other firms—limited price increases lead to significant demand drops, while price cuts may provoke similar actions from competitors but cause less dramatic changes in demand.

Game Theory Concepts

• Payoff Matrix: A grid showing possible outcomes for firms based on their decision-making.

• Nash Equilibrium: The scenario in which players make optimal decisions considering the actions of others, achieving equal payoffs.

• Prisoner’s Dilemma: A game illustrating potential gains from cooperation over self-interest.

Summary: Oligopoly

1. Few firms control major market shares.

2. Significant barriers to entry exist.

3. Products may be differentiated or similar.

4. Interdependent behavior among firms.

5. Occurrence of collusive strategies.

6. Prices set above marginal cost (P > MC).

7. Pricing is driven by market-maker status (Price > MR).

8. Firm actions are influenced by anticipated rival behaviors.

Key Terms

• Cartel: A colluding group of firms controlling production output and pricing.

• Collusion: Firms cooperating to reduce output and maintain high prices.

• Differentiated Product: A product perceived as unique in some manner by consumers.

• Duopoly: An oligopoly consisting of only two firms.

• Game Theory: A mathematical approach to understanding strategic interactions.

• Kinked Demand Curve: A demand curve illustrating a firm’s price stability due to competitor reactions to price changes.

• Oligopoly: A market structure defined by a few large firms dominating sales.

• Prisoner’s Dilemma: A situation illustrating the benefits of cooperative behavior versus self-interest.

Comparison of Market Structures

Practice Questions

1. Which of the following is characteristic of monopolistic competition?
   a. Economically efficient in the long run
   b. Pricing at minimum ATC in long run
   c. Excess capacity
   d. Very few competitors
   e. Most dominant market structure in United States

2. Which of the following is characteristic of monopolistic competition?
   a. Price > MC
   b. Efficiency
   c. Mostly price competition
   d. Price = MR
   e. Homogeneous or similar products.

3. Which of the following is NOT a characteristic of monopolistic competition?
   a. Price = MC
   b. Price-maker
   c. Low barrier to entry
   d. Many medium-sized firms
   e. Price > MR

Review Questions

1. Analyze the relationship between product differentiation and monopolistic competition.

2. Compare the perceived demand curves of monopolistically competitive, monopoly, and perfectly competitive firms.

3. Explain how a monopolistic competitor establishes profit-maximizing output and price.

4. Determine how a monopolistic competitor assesses pricing for profits or losses.

5. Assess whether firms in a monopolistically competitive market will maintain economic profits or losses in the long run and explain why.

6. Evaluate the productivity and allocative efficiency of a monopolistically competitive firm and provide justification.

7. Discuss whether firms in an oligopoly behave more like monopolists or competitors and provide an explanation.

8. Identify factors preventing oligopolists from acting cohesively as a monopoly to achieve maximum profit levels.