MONOPOLISTIC

COMPETITION
&
OLIGOPOLY

CHAPTERS

14 & 15

Monopolistic Competition
Monopolistic competition is a market with the following
characteristics:
A large number of firms.
Each firm produces a differentiated product.
Firms compete on product quality, price, and marketing.
Firms are free to enter and exit the industry.

Monopolistic Competition
Large Number of Firms
The presence of a large number of firms in the market
implies:
Each firm has only a small market share and therefore
has limited market power to influence the price of its
product.
Each firm is sensitive to the average market price, but no
firm pays attention to the actions of the other, and no one
firms actions directly affect the actions of other firms.
Collusion, or conspiring to fix prices, is impossible.

Monopolistic Competition
Product Differentiation
Firms in monopolistic competition practice product
differentiation, which means that each firm makes a
product that is slightly different from the products of
competing firms.

Entry and Exit

There are no barriers to entry in monopolistic competition,
so firms cannot earn an economic profit in the long run.

Monopolistic Competition
Competing on Quality, Price, and Marketing
Product differentiation enables firms to compete in three
areas: quality, price, and marketing.
Quality includes design, reliability, and service.
Because firms produce differentiated products, each firm
has a downward-sloping demand curve for its own
product.

But there is a tradeoff between price and quality.

Differentiated products must be marketed using
advertising and packaging.

Output and Price in Monopolistic

Competition
The Firms Short-Run Output and Price Decision

A firm that has decided the quality of its product and its
marketing program produces the profit maximizing
quantity at which its marginal revenue equals its marginal
cost (MR = MC).
Price is determined from the demand curve for the firms
product and is the highest price the firm can charge for the
profit-maximizing quantity.

Output and Price in Monopolistic

Competition
The figure shows a shortrun equilibrium for a firm
in monopolistic
competition.
It operates much like a
single-price monopolist.

Output and Price in Monopolistic

Competition
The firm produces the
quantity at which price
equals marginal cost and
sells that quantity for the
highest possible price.
It earns an economic
profit (as in this example)
when P > ATC.

Output and Price in Monopolistic

Competition
Profit Maximizing Might
be Loss Minimizing
A firm might incur an
economic loss in the short
run.
Here is an example.

In this case, P < ATC.

Output and Price in Monopolistic

Competition
Long Run: Zero Economic Profit

In the long run, economic profit induces entry.

And entry continues as long as firms in the industry earn
an economic profitas long as (P > ATC).
In the long run, a firm in monopolistic competition
maximizes its profit by producing the quantity at which its
marginal revenue equals its marginal cost, MR = MC.

Output and Price in Monopolistic

Competition
As firms enter the industry, each existing firm loses some
of its market share. The demand for its product decreases
and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which
MR = MC and lowers the maximum price that the firm can
charge to sell this quantity.

Price and quantity fall with firm entry until P = ATC and
firms earn zero economic profit.

Output and Price in Monopolistic

Competition
The figure here shows a
firm in monopolistic
competition in long-run
equilibrium.
If firms incur an economic
loss, firms exit to achieve
the long-run equilibrium.

Output and Price in Monopolistic

Competition
Monopolistic Competition and Perfect Competition
Two key differences between monopolistic competition
and perfect competition are:
Excess capacity

Markup
A firm has excess capacity if it produces less than the
quantity at which ATC is a minimum.
A firms markup is the amount by which its price exceeds
its marginal cost.

Output and Price in Monopolistic

Competition
Firms in monopolistic
competition operate with
excess capacity in longrun equilibrium.
The downward-sloping
demand curve for their
products drives this result.

Output and Price in Monopolistic

Competition
Firms in monopolistic
competition operate with
positive mark up.
Again, the downwardsloping demand curve for
their products drives this
result.

Output and Price in Monopolistic

Competition
In contrast, firms in perfect
competition have no
excess capacity and no
markup.
The perfectly elastic
demand curve for their
products drives this result.

Product Development and Marketing

Innovation and Product Development
Weve looked at a firms profit maximizing output decision
in the short run and the long run of a given product and
with given marketing effort.
To keep earning an economic profit, a firm in monopolistic
competition must be in a state of continuous product
development.

New product development allows a firm to gain a

competitive edge, if only temporarily, before competitors
imitate the innovation.

Product Development and Marketing

Selling Costs and Total Costs
Selling costs, like advertising expenditures, fancy retail
buildings, etc. are fixed costs.
Average fixed costs decrease as production increases, so
selling costs increase average total costs at any given
level of output but do not affect the marginal cost of
production.
Selling efforts such as advertising are successful if they
increase the demand for the firms product.

Product Development and Marketing

Advertising costs might
lower the average total
cost by increasing
equilibrium output and
spreading their fixed costs
over the larger quantity
produced.
Here, with no advertising,
the firm produces 25 units
of output at an average
total cost of $60.

Product Development and Marketing

With advertising, the firm
produces 100 units of
output at an average total
cost of $40.
The advertising
expenditure shifts the
average total cost curve
upward, but the firm
operates at a higher output
and lower ATC than it
would without advertising.

Product Development and Marketing

Using Advertising to Signal Quality
Why do Coke and Pepsi spend millions of dollars a month
advertising products that everyone knows?
One answer is that these firms use advertising to signal
the high quality of their products.
A signal is an action taken by an informed person or firm
to send a message to uninformed persons.

Product Development and Marketing

Using Advertising to Signal Quality
Coke is a high quality cola and Oke is a low quality cola.
If Coke spends millions on advertising, people think Coke
must be good.
If it is truly good, when they try it, they will like it and keep
buying it.
If Oke spends millions on advertising, people think Oke
must be good.
If it is truly bad, when they try it, they will hate it and stop
buying it.

Product Development and Marketing

Using Advertising to Signal Quality
So if Oke knows its product is bad, it will not bother to
waste millions on advertising it.
And if Coke knows its product is good, it will spend
millions on advertising it.
Consumers will read the signals and get the correct
message.
None of the ads need mention the product. They just need
to be flashy and expensive.

What is Oligopoly?
The distinguishing features of oligopoly are:
Natural or legal barriers that prevent entry of
new firms
A small number of firms compete

What is Oligopoly?
Small Number of Firms
Because an oligopoly market has a small number of firms,
the firms are interdependent and face a temptation to
cooperate.
Interdependence: With a small number of firms, each
firms profit depends on every firms actions.
Cartel: A cartel and is an illegal group of firms acting
together to limit output, raise price, and increase profit.

Firms in oligopoly face the temptation to form a cartel, but

aside from being illegal, cartels often break down.

Two Traditional Oligopoly Models

Two common models are used to analyze oligopoly
markets:
1.The Kinked Demand Model
2.The Dominant Firm Model

The Kinked Demand Model

The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm
believes that if it raises its price, its competitors will not
follow, but if it lowers its price all of its competitors will
follow.

The Kinked Demand Model

If the firm reduces price,

competitors match the price

cut then there will be a
movement along the more
inelastic demand segment
Di
If the firm increases price,

competitors do not follow

then there will be a
movement along the more
elastic demand segment Df

Competitors do not
match price increases

Competitors
do match
price cuts

The Kinked Demand Model

The figure shows the
kinked demand curve
model.
The demand curve that a
firm believes it faces has a
kink at the current price
and quantity.

The Kinked Demand Model

Above the kink, demand is
relatively elastic because
all other firms prices
remain unchanged.
Below the kink, demand is
relatively inelastic because
all other firms prices
change in line with the
price of the firm shown in
the figure.

The Kinked Demand Model

The kink in the demand

curve means that the MR
curve is discontinuous at
the current quantityshown
by that gap AB in the figure.

The Kinked Demand Model

This slide helps to envisage

why the kink in the demand
curve puts a break in the
marginal revenue curve.

The Kinked Demand Model

Fluctuations in MC that
remain within the
discontinuous portion of the
MR curve leave the profitmaximizing quantity and
price unchanged.
For example, if costs
increased so that the MC
curve shifted upward from
MC0 to MC1, the profit
maximizing price and
quantity would not change.

The Kinked Demand Model

The beliefs that generate
the kinked demand curve
are not always correct and
firms can figure out this
fact
If MC increases enough,
all firms raise their prices
and the kink vanishes.
A firm that bases its
actions on wrong beliefs
doesnt maximize profit.

The Dominant Firm Model

Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that
has a significant cost advantage over many other, smaller
competing firms.
The large firm operates as a monopoly, setting its price
and output to maximize its profit.
The small firms act as perfect competitors, taking the
market price set by the dominant firm as given.

The Dominant Firm Model

The figure below shows a dominant firm industry. On the
left are 10 small firms and on the right is one large firm.

The Dominant Firm Model

The demand curve, D, is the market demand curve and the
supply curve S10 is the supply curve of the 10 small firms.
S10

The Dominant Firm Model

At a price of $1.50, the 10 small firms produce the quantity
demanded. At this price, the large firm would sell nothing.

The Dominant Firm Model

But if the price was $1.00, the 10 small firms would supply
only half the market, leaving the rest to the large firm.

The Dominant Firm Model

The demand curve for the large firms output is the curve
XD on the right.

The Dominant Firm Model

The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.

The Dominant Firm Model

The large firm maximizes profit by setting MR = MC. Lets
suppose that the marginal cost curve is MC in the figure.

The Dominant Firm Model

The profit maximizing quantity for the large firm is 10 units.
The price charged is $1.00.

The Dominant Firm Model

The small firms take this price and supply the rest of the
quantity demanded.

The Dominant Firm Model

A dominant firm oligopoly can arise only if one firm has
lower costs than the others.

The Dominant Firm Model

In the long run, such an industry might become a monopoly
as the large firm buys up the small firms and cuts costs.