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Lecture Outlines

Monopolistic Competition and Oligopoly

Reading: Chapter 10 of Tucker

Overview:

The Monopolistic Competition Market Structure
The Monopolistically Competitive Firm as a Price Maker
Price and Output Decisions for a Monopolistically Competitive Firm
Comparing Monopolistic Competition and Perfect Competition
The Oligopoly Market Structure
Price and Output Decisions for an Oligopolist
Evaluation of Oligopoly
Review of Four Market Structures

Imperfect Competition: A market structure between the extremes of perfect competition and monopoly. There are two types: monopolistic competition and oligopoly.

The Monopolistic Competition Market Structure

Monopolistic Competition: A market structure characterized by:

1. Many small sellers: Each firm is so small relative to the total market that each firm's pricing decisions have a negligible effect in the market price.

2. A differentiated product: Real or apparent differences between products. Close, but not perfect, substitutes exist.

Non-price Competition: The situation in which a firm competes using advertising, packaging, product development, better quality, and better service, rather than lower prices.
Advertising is a primary method used to distinguish product.

3. Easy market entry and exit: There are low barriers to entry, although market entry is not as easy as in a perfectly competitive market.

The Monopolistically Competitive Firm as a Price Maker

Monopolistically competitive firms are price makers instead of price takers primarily because of product differentiation.
The demand curve is downward sloping.
The demand curve for a monopolistically competitive firm is less elastic (steeper) than for a perfectly competitive firm and more elastic (flatter) than for a monopolist.

Price and Output Decisions for a Monopolistically Competitive Firm

Monopolistic Competition in the Short Run

In the short run, monopolistic competition resembles monopoly.
Short run profit is maximized by following the MR = MC rule.
If the price equals the ATC curve, the firm earns a short-run normal profit.

2. Monopolistic Competition in the Long Run

In the long run, the monopolistically competitive firm will not earn an economic profit -- only a normal profit (zero economic profit).
Short run profits and easy market entry attract new firms to the industry.
Market share is taken away by new firms and advertising costs increase, resulting in long-run average cost increases.

Comparing Monopolistic Competition and Perfect Competition

1. The Monopolistic Competitor as a Resource Misallocator

As with monopoly, the price charged by monopolistically competitive firms exceeds the marginal cost and so the value to the consumer is greater than the cost of producing it.
Less resources are used and output is restricted in order to maximize profit.

2. Monopolistic Competition Means Less Output at a Higher Cost

Monopolistically competitive firms do not produce at the lowest point on the Long Run Average Cost (LRAC) curve.
Too many firms are producing too little output at inflated prices and wasting society's resources.

The Oligopoly Market Structure

Oligopoly: A market structure characterized by:

1. Few sellers: A few firms are so large relative to the total market that they can affect the market price.

Mutual Interdependence: A condition in which an action by one firm may cause a reaction on the part of other firms.

2. Either a homogenous or a differentiated product: Buyers may or may not be indifferent as to which seller's product they buy.

3. Difficult market entry: Formidable barriers to entry. For example, exclusive financial requirements. Control over an essential resource, patent rights, and economies of scale.

Price and Output Decisions for an Oligopolist

No single model can describe oligopoly. There are four commonly used models: Nonprice Competition, The Kinked Demand Curve, Price Leadership, and Cartel.

Nonprice Competition

Oligopolies often compete through nonprice methods such as advertising and product differentiation.
The reason is that changes in price would be easy for competitors to match, while it is more difficult to compete with clever or important product improvement.

2. The Kinked Demand Curve: A demand curve facing an oligopolist that assumes rivals will match a price decrease, but ignore a price increase.

Oligopolists are price makers.
Above the "kink" in the demand curve, demand is relatively elastic (flat). An increase in price would not be copied by competitors, and consumers would shift to the cheaper product, causing a large decrease in QD from a given increase in price.
The segment of the demand curve below the "kink" is relatively inelastic (steep). A decrease in price would be copied by competitors and each firm keeps its original market share, implying a small decrease in QD from a given decrease in price.
The price established at the "kink" changes very infrequently.

3. Price Leadership: A pricing strategy in which a dominant firms sets the price for an industry and the other firms follow -- both for price increases and decreases.

An informal process that assumes firms do not collude.

4. Cartel: A group of firms formally agreeing to control the price and output of a product.

Replaces competition with cooperation in order to reap monopoly profits.
Cartels are illegal in the US, but not in other countries (Ex. OPEC).
If one firm "cheats" it increases output above the agreed level and increases profits.

An Evaluation of Oligopoly

Prices charged for products will be higher than under perfect competition.
Spending money on nonprice competition can shift the demand curve to the right, causing price and output to be higher than under perfect competition.
In the long run, oligopolists can earn economic profit, while the perfectly competitive firm cannot.

Review of the Four Market Structures

Market Structure	Number of Sellers	Type of Product	Entry Condition	Examples
Perfect Competition	Large	Homogenous	Very Easy	Agriculture
Monopoly	One	Unique	Impossible	Public utilities
Monopolistic Competition	Many	Differentiated	Easy	Retail trade
Oligopoly	Few	Homogenous or differentiated	Difficult	Autos, steel, oil