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Monopolistic
Competition and
Oligopolies
Rachel Lim
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Monopolistic Competition

n Large number of firms, relatively small size that act

independently of one another
n Prevents collusion

n Relatively free entry and exit into industry

n No significant barriers

n Product Differentiation
n Includes physical differences, quality differences,
location, services, & product image
n Provides a wide variety of products and services!
However, the variety is costly and inefficient
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Similarities to Perfect
Competition and Monopoly
n This market structure combines both elements of competition and
monopoly.

n Resembles perfect competition because of the many firms in the

industry and the freedom of entry and exit

n Resembles a monopoly because it uses product differentiation, which

means that each firm in an industry is a “mini monopoly” because
of the specific version of the good it produces.
n Nike is a monopoly in Nike shoes, Puma is a monopoly in Puma shoes.

n That means that each of the producers faces a downward sloping

demand curve for its product
n but at the same time, these products are substitutes for each other, the
demand curve is relatively elastic.

n The curve is therefore more elastic than the monopoly curve and less
elastic than the perfect competition curve
n however, the goods are not perfect substitutes.

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Important Implications

n That means that to the extent that consumers are loyal

to a certain firm or product, the greater monopoly
power of the firm
n the more that consumers are convinced that a specific
product is worth purchasing, superior to other
substitutes
n The more potential to make economic profits with more
monopoly power

n If Puma raises its price for shoes but customers are

loyal or believe that the shoe is superior to
substitutes , they will continue to buy them, despite
of the price hike
n inelastic demand curve!

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Other strategies!

n Firms also engage in price and non-price competition.

n Price competition occurs when a firms lowers its price

n in order to increase sales at the expense of other firms.

n Non-price competition occurs when firms use methods

such as product differentiation, advertising, and
branding to attract customers away from rivals.
n To influence consumer tastes in favor for a product
n Eventually increase monopoly power so that firms can
charge a higher price without risking loss of buyers to
other firms.

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Profit Maximization

n Economic profit or loss in the short run, not necessarily

profit in the long run
n Dependent upon consumer loyalty to the product or firm

n In the short run, the monopolistically competitive

equilibrium position is identical to that of a monopoly
n the only difference being that the demand curve is more
elastic for the former.

n Use MR=MC to find the profit-maximizing or loss-

minimizing level of output and then for that level
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Allocative and Productive
Efficiency
n Productive Efficiency
n NO, because Price  Minimum ATC, producing at quantity
where MR = MC

n Allocatively Efficient
n NO, because Price  MC, MR curve is below the Demand
curve

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Oligopolies

n Small number of firms, each firm has a relatively large

share of the market and firms are mutually
interdependent.
n Profit earned by each firm depends on the firms own
actions and on the actions of the other firms.
n Incentive to collude! (Illegal Cartels)

n Difficult to enter and exit into industry

n Significant barriers such as economies to scale, and legal
barriers

n Products can be identical or different

n Ex: Car, airline, cigarette industry
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Incentive to Collude

n When a small number of firms share a market, they can

increase their profit by forming a cartel
n A group of firms acting together to limit output, raise price,
and increase economic profit) and acting like a monopoly

n Cartels are illegal, but by limiting production to the

monopoly quantity, the firms can maximize joint profits.
n However, while it pays for firms to collude, in order to earn
positive profits, it also pays to cheat on the collusive
agreement.
n If one firm cuts its price to slightly below the others, it
could gain a lot of business.
n If everyone cheats on the agreement, however, the
agreement falls apart
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Game Theory

n The tool used to analyze strategic behavior—behavior

that recognizes mutual interdependence
n takes account of the expected behavior of others.

n Prisoners’ dilemma
n A game between two prisoners that shows why it is hard
to cooperate, even when it would be beneficial to both
players to do so.

n Pay off matrix – a table that shows the pay offs for
every possible action by each player given every
possible action by the other player
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Collusive agreements cont’d

n Nash Equilibrium - An equilibrium in which each player

takes the best possible action given the action of the
other player.
n The Nash equilibrium for Art and Bob is to confess.
n This is not the best possible outcome

n Collusive agreements are less likely to occur when

market conditions are unstable
n because differences in expectations make it difficult to
reach an agreement.

n In addition, government intervention, such as vigorous

antitrust action can increase the cost of collusion.
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Non-Collusive Oligopolies

n Oligopolists may compete with each other and drive

prices down to where profits are zero.

n Some oligopolistic markets operate in a situation of

price leadership
n when a single firm sets industry price and the remaining
firms charge the same price as the leader.

n Kinked demand curve!

n The shape of the demand curve facing an oligopolist
depends on how its rivals responded to a change in the
price of its own output.
n Rival oligopolists match price reductions but not price
increases

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Demand curve facing

oligopolist if rivals
match price changes
PRICE (per computer)

B M
$1100 A
1000 D
900 C
Demand curve facing Demand curve
oligopolist if rivals facing oligopolist if
match price cuts but rivals don't match
not price hikes price changes

0 8000
QUANTITY DEMANDED (computers per month)
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Kinked Demand Curve cont’d

n The kinked demand curve is actually made up of an

elastic Demand curve and an inelastic Demand curve.

n If a firm raises prices, other firms won’t follow and the

firm loses a lot of business
n so demand is very responsive or elastic to price
increases.

n But if a firm lowers prices, other firms follow and the

firm doesn’t gain much business
n so demand is fairly unresponsive or inelastic to price
decreases.
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Price (dollars per computer)

S The kink in the demand curve

A
F
The MR gap d1
G
mr2 mr1
d2
0 8000 H
Quantity Demanded (computers per month)
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Sticky prices

n Prices tend to be stable because there is a gap in an

oligopolist’s marginal revenue (MR) curve.

n Oligopolists want to produce at MR=MC to maximize

profits, and modest increases in MC does not result in
increased prices.

n
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Price or Cost (dollars per unit)

Marginal revenue

MC2
MC1
MC3

0
Quantity (units per period)
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Effectively creating
a kinked demand curve

MC1
MR2
Price

MC2

D
Quantity MR1
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Efficiency

n Price exceeds marginal cost, it is not productively

efficient.

n The quantity produced is less than the efficient

quantity, it is not allocatively efficient.

n Oligopoly suffers from the same source and type of

inefficiency as monopoly.

n Because oligopoly is inefficient, antitrust laws and

regulations are used to try to reduce market power
and move the outcome closer to that of competition
and efficiency.