Introduction to Economics – 11175

Week 7

Market Structures – Monopolistic competition and

oligopoly
 Week 7 Lecture

1. Describe the characteristics of

monopolistically competitive markets.
2. Understand the equilibrium in
monopolistic competition in the short
run and long run
3. Describe the characteristics of
Oligopolistic markets.
4. Use game theoretic approach to
identify the equilibrium in oligopolistic
markets.
 Imperfect Competition
• Previously examined two distinct market structures:
perfect competition and monopoly.
• In perfect competition, competing firms have no
power to set prices. In a monopoly, the firm does have
the power to set prices, but no competition occurs.
• Markets in which competing firms have power to set
their prices are called imperfect competition.
• We will study two types of imperfect competition:
➢Monopolistic competition & oligopoly
Monopolistic Competition and Oligopoly
• These represent more realistic market structures.
➢Monopolistic competition is the realistic version of
perfect competition: many small firms but consumers
can distinguish between the firms and/or the
products sold by each firm.
➢Oligopoly is the realistic version of monopoly: A few
very large firms which struggle to gain dominance
over the market.
Monopolistic Competition: Assumptions
• A large number of firms compete
• Each firm produces a differentiated product
• Firms compete on product quality, price,
marketing and branding.
• There are no barriers to entry & exit.
Monopolistic Competition
• Examples: clothing shops, petrol stations, dry
cleaners, hair dressers, small restaurants etc.
• In these industries, a large number of firms
compete, selling differentiated products that are
heavily advertised, and firms come and go under
the pressure of competition..
Monopolistic Competition:
Implications
• Small market share: Each firm supplies a small part of the
total industry output. Thus, each firm has limited market
power to influence the price of its product.
• Can ignore other firms: Because all the firms are relatively
small, no one firm’s actions directly affects the actions of
other firms.
• Collusion is impossible: Firms would like to conspire to fix
a higher price, but there are too many firms to make this
possible.
Starbucks: limits to growth through
product differentiation
The key to the initial success of Starbucks was
that it was able to differentiate itself from
other coffee houses.
But it was not difficult for other coffee houses
to copy the approach taken by Starbucks.
Between 2008 and 2010 Starbucks was forced
to close hundreds of coffee houses in the US
and Australia.
It later became profitable again in part due to
expansion into other countries, particularly
Asia.

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Demand curve for a monopolistically
competitive firm
 Demand and revenue for a
monopolistically competitive firm
Output effect and price effect
Demand and Marginal revenue curves for a
monopolistically competitive firm
 Decisions to be Made
• Decide on the design and quality of product/service.
• Decide on a marketing plan
• Decide on the quantity of output to produce and the
price at which to sell them.
Monopolistic Competition vs. Monopoly

• The monopolistic competitive firm earning positive

economic profits will attract new firms into the
industry in the long run.
• New entering firms split up the market and eventually
each firm’s market share is so small that only normal
profits are being earned in the long run.
• Barriers to entry prevented this scenario in a
monopoly.
Long run equilibrium
 Long run profit
• Zero Economic Profit Inevitable in the Long Run?
➢A relatively easy entry into the market causes the
disappearance of economic profits in the long run.
➢However, if a firm finds new ways of differentiating its
product/service or finds new ways of lowering the cost
of producing its product/service, it can maintain
economic profits even in the long run.
Comparing Perfect Competition and
Monopolistic Competition
• There are two important differences between long-
run equilibrium in the two markets.
➢ Monopolistically competitive firms charge a price
greater than marginal cost.
➢ Monopolistically competitive firms do not produce at
minimum average cost.

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Comparing perfect competition and
monopolistic competition
• Excess capacity under monopolistic competition.
➢ As a monopolistically competitive firm produces at P >
minimum AC, the firm has excess capacity; if it
increased its output it could produce at a lower
average cost.

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The Efficient Scale Output: No Excess Capacity

• A firm’s efficient scale output is the output at which the

average total cost is a minimum.
• Monopolistically competitive firms usually operate at
higher average cost levels than do perfectly
competitive. ones.
Perfect competition vs monopolistic
competition
 Mark ups and loss of Efficiency
• Allocative efficiency, or no dwl, requires the marginal
benefit of the consumer to equal the marginal cost of the
producer.
• Price measures marginal benefit, so efficiency requires
price to equal marginal cost (i.e., P=MC). Perfectly
competitive firm and industry achieve this in short & long
run.
• In monopolistic competition, and of course in monopoly,
price exceeds marginal cost (i.e., P>MC). The amount by
which price exceeds marginal cost is a firm’s mark-up.
Evaluation of extent of Inefficiency
• Product differentiation gives rise to the firm having
some market power and facing a slightly downward
sloping demand curve.
• This leads to the the firm producing less than the
competitive amount or less than the allocatively
efficient amount.
• Consumers value some product variety so economists
do not worry about this inefficiency.
 Advertising & Marketing

• Advertising and packaging are the principal ways a firm

creates a consumer perception of product differentiation.
• Aside from costs of advertising on radio and TV and
magazines, selling costs include the cost of rental in new
shopping centers, cost of glossy catalogues, cost of
promotions etc.
 Advertising & Marketing
• Advertising expenditures and other selling costs
affect the profits of firms in two ways.
➢They increase fixed costs.
➢They change demand; hopefully [for the firm]
increasing demand by more than the increase in
costs.
 Oligopoly
• Oligopoly: A market structure in which a small number of
interdependent firms compete.
• Barrier to entry: Anything that keeps new firms from
entering an industry in which existing firms are earning
economic profits.
• Examples are economies of scale, ownership of a key input
and government-imposed barriers.
 Oligopoly
• Unlike the case of monopolistic competition, oligopolies
contain so few firms that each oligopolist formulates its
policies with an eye to the impact on its rivals.
• Since an oligopoly contains so few firms, any change in one
firm’s price or output heavily influences the sales and
profits of competitors, and it can lead to changes in the
actions of its competitors.
 Oligopoly
• Suppose you run one of three gas stations in a small town.
If you cut your price, you gain market share and your
profits might increase. The market share of your
competitors fall and perhaps they cut their prices. This
lowers your profits.
• Before you act, you have to predict how your
competitors will react and take this into account.
 Oligopoly
• Because of this interdependence, oligopolists face a
situation in which the optimal decision of one firm depends
on what other firms decide to do and where there is
opportunity for both conflict and or collusion.
• Collusion can be beneficial to the participants: increased
profits, decreased uncertainty and a better opportunity to
prevent entry.
• When a collusive arrangement to restrict output and lift
prices is made openly, it is called a cartel.
 Oligopoly

• It is difficult to know what an oligopolist’s demand

and marginal revenue curves look like.
• It is not known what quantity an oligopolist will
sell at a particular price, as the price charged
depends on the prices and actions of competitors.
 Oligopoly
• In recent years game theory is used to provide a framework
for studying the strategic behaviour of oligopoly firms.
• Game theory: The study of how people make decisions in
situations where attaining their goals depends on their
interactions with others; in economics, the study of the
decisions of firms in industries where the profits of each
firm depend on its interactions with other firms.
 Game theory
• A ‘game’ consists of three components:
➢ the set of players
➢ A set of actions (strategies) for each player
➢ A way of determining the payoffs to each player
from all possible outcomes of the game.
 Duopoly game

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4
 Using game theory to analyse
oligopoly
• Collusion: An agreement among firms to charge the same
price, or to otherwise not compete.
➢Is illegal in many countries.

• Dominant strategy: A strategy that is the best for a firm, no

matter what strategies other firms use.

• Nash equilibrium: A situation where each firm chooses the

best strategy, given the strategies chosen by other firms.

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 Using game theory to analyse
oligopoly
• Cooperative equilibrium: An equilibrium in a game in which
players cooperate to increase their mutual payoff.
• Non-cooperative equilibrium: An equilibrium in a game in
which players do not cooperate but pursue their own self-
interest.
• Prisoners’ dilemma: A game where pursuing dominant
strategies results in non-cooperation that leaves everyone
worse off.

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Quantity setting game

Jet Star
QUANTITY
SETTING GAME
QJ=64 QJ=48

QV=64 ($4.1, $4.1) ($5.1, $3.8)

Virgin
Blue QV=48 ($3.8, $5.1) ($4.6, $4.6)

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Quantity setting game

• Is there a dominant strategy for Virgin blue and Jet

star?
• What is the equilibrium of the game?
 Lecture Revision Questions
1. The reason that the coffeehouse market is monopolistically
competitive rather than perfectly competitive is because
A. barriers to entry are very low.
B. there are many firms in the market.
C. products are differentiated.
D. entry into the market is blocked.
 Lecture Revision Questions
2. Which of the following characteristics is not common to
monopolistic competition and perfect competition?
A. Firms act to maximise profit.
B. Entry barriers into the industry are low.
C. The market demand curve is downward sloping.
D. Firms take market prices as given.
Lecture Revision Questions
3. A monopolistically competitive firm will
A. charge the same price as its competitors do.
B. always produce at the minimum efficient scale of
production.
C. have some control over its price because its product is
differentiated.
D. produce an output level that is productively and
allocatively efficient.
 Lecture Revision Questions
4. Refer to the figure below. Which of the graphs depicts a
monopolitically competitive firm that is minimising its losses?
A. Panel A B. Panel B C. Panel C D. Panel A and C
Lecture Revision Questions
5. A characteristic found only in oligopolies is
A. a break-even level of profits.
B. the interdependence of firms.
C. the independence of firms.
D. products that are slightly different.
 Lecture Revision Questions
6. In an oligopoly market
A. the pricing decisions of all other firms have no effect
on an individual firm.
B. individual firms pay no attention to the behaviour of
other firms.
C. the advertising of one firm has no effect on all other
firms.
D. one firm's pricing decision affects all the other firms.
 Lecture Revision Questions
7.Producing a differentiated product occurs in which of the
following industries?
A. Oligopoly, monopolistic competition and perfect
competition
B. Monopolistic competition only
C. Oligopoly only
D. Monopolistic competition and oligopoly
Lecture Revision Questions
8. What is the prisoners' dilemma?
A. A game that involves no dominant strategies.
B. A game in which prisoners are stumped because they
cannot communicate with each other.
C. A game in which players act in rational, self-interested
ways that leave everyone worse off.
D. A game in which players collude to outfox the
authorities.
 Lecture Revision Questions
9. A Nash equilibrium is
A. reached when an oligopoly's market demand and supply
intersect.
B. reached when each player chooses the best strategy for
himself and for the group.
C. reached when each player chooses the best strategy for
himself, given the other strategies chosen by the other players in
the group.
D. an equilibrium comprising non-dominant strategies only.
 Lecture Revision Questions
10. Refer to the figure below. What is the nash equilibrium in this game?

A. There is no Nash equilibrium.

B. Godrickporter increases its advertising budget, but Star Connections does not.

C. Star Connections increases its advertising budget, but Godrickporter does not.

D. Both Godrickporter and Star Connections increase their advertising budgets.