Chapter 10

Monopolistic Competition

and Oligopoly

Monopolistic Competition

• Characteristics– many small buyers & sellers– nonhomogeneous or differentiated product– no barriers to entry/exit– perfect information– mobile resources– no public goods / externalities

The only difference between perfect competition and monopolistic competition is the nature of the product

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Monopolistic Competition

• Product differentiation– Physical differences, location, product

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– Results in the firm facing a downward sloping demand for its own product

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Short-Run Profit Max. or Loss Min.

• Maximize profit– Produce q where MR=MC

– Price is found on firm’s D curve

(like a monopoly)

– Profit can be positive, zero or negative• Depends on AC

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Max. Profit or Min. Loss in Short-Run

• If P>AC– Economic profit

• If AC>P>AVC– Economic loss

– Produce in short run

• If P<AVC: AVC curve above D curve– Economic loss

– Shut down in short run

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Long-Run Profit Maximization

• If SR economic profit exists– New firms enter the market

– Draw customers away from other firms

– Reduce demand facing other firms• Shift firm’s demand to left

– Profit disappears in long run• Zero economic profit• P = LRAC • Demand is tangent to LRAC

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Long-Run Profit Maximization

• If SR economic loss exists– Some firms exit the market

– Their customers switch to other firms

– Increase demand facing the remaining firms• shift firm’s demand to right

– Loss is erased in the long run• Zero economic profit for remaining firms• P = LRAC• Demand is tangent to LRAC 7

Profit Maximization

• In monopolistic competition equilibrium– P > MC

– Inefficient (deadweight loss exists)

– AC at q* > min AC

– Excess Capacity is the difference between the profit max. rate of output and the cost min. rate of output• “too many firms each producing too little”• diversity of products??

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Monopolistic vs. Perfect Competition

• Both– Zero economic profit in long run

– MR = MC for quantity• where D is tangent to AC

• Perfect competition– Firm’s demand is horizontal line

– Produces at minimum average cost

– Productive and allocative efficiency

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Advertising

• Occurs in monopolistic competition– Shifts demand for firm

• Increases demand• More inelastic demand

• Increasing potential for profit

– Increases costs to firm

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Oligopoly

• Few, large sellers• Homogeneous or differentiated product• May be barriers to entry

• Oligopolistic interdependence– each firm must take its rival’s behavior

into account in their own decision making

• Many models exist in oligopoly 11

Models of Oligopoly

• Cartel / Collusion• Kinked Demand• Price leadership• Game theory

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Collusion and Cartels

• Collusion– Agreement among firms to

• Divide the market• Fix the price

• Cartel– Group of firms that agree to collude to

maximize industry profit• Act as monopoly• Increase economic profit

• Illegal in U.S. 13

Cartel Example

• 5 firms in industry– Divide up output equally

– MCi = 5

• QM = 100,000

• Qi = 20,000

• PM = 10

• Πi = 20,000 (10 – 5) = $100,000

• ΠM = $500,000

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Cartel & Cheating

• Firm 1 cheats

– Q1 = 40,000

– QM = 120,000

– PM = 9

– Π1 = 40,000 (9 – 5) = $160,000

– Πi = 20,000 (9 – 5) = $80,000

– ΠM = $480,000

• Incentive exists to cheat!15

Collusion and Cartels

• Difficulties to maintain a cartel:– Differences in average cost

– Increase # of firms

– Differentiated product

– Low barriers to entry

– Cheating by cartel members

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Kinked Demand

• Each firm assumes that– Rivals will follow all price decreases

– Rivals will not follow any price increases• Demand is more elastic for price increases

than for price decreases

– Results in price rigidity in the face of increasing costs

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Price Leadership

• 1 large firm• Many small firms (competitive fringe)• Price leader

– Sets the price for the industry

– Initiate price changes

– Followed by the other firms

• Tacit Price coordination18

Price Leadership

• Obstacles– U.S. antitrust laws

– # & size of firms

– Nature of product

– Growth and innovation in industry

– Ease of entry/exit

• Contestable Market– costs of entry and exit are low

• Enough firms so P = MC19

Game Theory

• Analyzes firm behavior as a series of strategic moves and countermoves

• Payoff matrix– Shows all possible outcomes for the

“players”

• Dominant-strategy equilibrium– Each player’s action does not depend on

what he thinks the other player will do

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Game Theory

• 2 firms• 2 strategies

– maintain current price

– raise price

• Goal– minimize the worst case outcome

• Can result in suboptimal solution– but is a dominant strategy

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Game Theory

• One-shot versus repeated games– One-shot game

• Game is played just once

– Repeated games• Establish reputation for cooperation• Tit-for-tat strategy

– Highest payoff results

• Coordination game

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Oligopoly vs. Perfect Competition

• Oligopoly– If firms collude or operate with excess

capacity• Higher price (P > MC)• Lower output

– If price wars • Lower price

– Higher profits in the long run

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