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Microeconomics I
Tutorial 9

Olga Petranevskaya
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Monopolistic competition is a market structure in
which there are many competing producers in an
industry, each producer sells a differentiated product,
and there is free entry into and exit from the industry in
the long run.

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Monopolistically competitive markets exhibit the
following characteristics:

 Each firm makes independent decisions about price and

output, based on its product, its market, and its costs of
production.

 Knowledge is widely spread between participants, but it is

unlikely to be perfect. For example, diners can review all
the menus available from restaurants in a town, before
they make their choice. Once inside the restaurant, they
can view the menu again, before ordering. However, they
cannot fully appreciate the restaurant or the meal until
after they have dined.
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Monopolistically competitive markets exhibit the
following characteristics:

 The entrepreneur has a more significant role than in firms

that are perfectly competitive because of the increased
risks associated with decision making.

 There is freedom to enter or leave the market, as there are

no major barriers to entry or exit.

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Monopolistically competitive markets exhibit the
following characteristics:

 Firms are price makers and are faced with a downward

sloping demand curve. Because each firm makes a unique
product, it can charge a higher or lower price than its rivals.

The firm can set its own price and does not have to ‘take' it
from the industry as a whole, though the industry price may be
a guideline, or becomes a constraint. This also means that the
demand curve will slope downwards.

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Monopolistically competitive markets exhibit the
following characteristics:

 Firms operating under monopolistic competition usually

have to engage in advertising. Firms are often in fierce
competition with other (local) firms offering a similar
product or service, and may need to advertise on a local
basis, to let customers know their differences. Common
methods of advertising for these firms are through local
press and radio, local cinema, posters, leaflets and special
promotions.

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Monopolistically competitive markets exhibit the
following characteristics:

 Monopolistically competitive firms are assumed to be profit

maximisers because firms tend to be small with
entrepreneurs actively involved in managing the business.

 There are usually a large numbers of independent firms

competing in the market.

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A central feature of monopolistic competition is
that products are differentiated. There are four
main types of differentiation:

 Physical product differentiation, where firms use

size, design, colour, shape, performance, and
features to make their products different. For
example, consumer electronics can easily be
physically differentiated.

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 Marketing differentiation, where firms try to
differentiate their product by distinctive
packaging and other promotional techniques. For
example, breakfast cereals can easily be
differentiated through packaging.

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 Human capital differentiation, where the firm
creates differences through the skill of its
employees, the level of training received,
distinctive uniforms, and so on

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 Differentiation through distribution, including
distribution via mail order or through internet
shopping, such as Amazon.com, which
differentiates itself from traditional bookstores by
selling online.    

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Equilibrium under
monopolistic
competition
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Short-run equilibrium 17
As more firms come into the market, each firm’s share of
overall market demand will fall—that is, the typical firm’s
demand curve will shift leftward. Entry and the resultant
leftward shift in firms’ demand curves will cease when firms
make zero economic profit.

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Long-run equilibrium 19
Do prices fall when 20

more firms enter?

Do prices fall when 21

more firms enter?

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Oligopoly 23
The most important source of oligopoly is the existence of
increasing returns to scale, which give bigger producers a cost
advantage over smaller ones.

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 Herfindahl – Hirschman Index, or HHI

The HHI for an industry is the square of each firm’s market

share summed over the firms in the industry

For example, if an industry contains only three firms and their

market shares are 60%, 25%, and 15%, then the HHI for the
industry is:
HHI = 602 + 252 + 152 = 4,450

By squaring each market share, the HHI calculation produces

numbers that are much larger when a larger share of an
industry output is dominated by fewer firms. So it’s a better
measure of just how concentrated the industry is.
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 Herfindahl – Hirschman Index, or HHI

In a monopoly, where a single firm accounts for 100 percent of

industry sales, the HHI =1002 =10,000. This is the maximum
possible value of the HHI.

As the number of firms grows and their market shares shrink

to 0, the HHI would approach 0.

Thus, the HHI takes on values between 0 and 10,000.

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Task 1 27
Beryllium oxide is a chemical compound used in
pharmaceutical applications. Beryllium oxide can only be
made in one particular way, and all firms produce their
version of beryllium oxide to the exact same standards of
purity and safety. The largest firms have market shares
given in the following table:

Firm Market share

Mercury 80%
Mars 1%
Jupiter 1%
Saturn 1%

What is the Herfindahl-Hirschman Index (HHI) for this

industry?
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Which market structure best describes the beryllium oxide
industry?
Task 2 29
In the following, let the market demand curve be
P = 70 - 2Q, and assume all sellers can produce at a constant
marginal cost of c = 10, with zero fixed costs.

a) If the market is perfectly competitive, what is the

equilibrium price and quantity?

b) If the market is controlled by a monopolist, what is the

equilibrium price and quantity? How much profit does the
monopolist earn?

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Task 3 31
The accompanying table shows the Herfindahl– Hirschman
Index (HHI) for the restaurant, cereal, movie, and laundry
detergent industries as well as the advertising expenditures of
the top 10 firms in each industry in 2006. Use the information
in the table to answer the following questions.
Industry HHI Advertising expenditures
(millions)
Restaurants 179 1784
Cereal 2098 732
Movie studios 918 3324
Laundry detergent 2068 132

a. Which market structure—oligopoly or monopolistic

competition—best characterizes each of the industries?
b. Based on your answer to part a, which type of market
structure has higher advertising expenditures? Use the 32

characteristics of each market structure to explain why this

relationship might exist.
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Explain why each of the following industries is an oligopoly,
not a perfectly competitive industry.

The world oil industry, where a few countries near the

Persian Gulf control much of the world’s oil reserves
Explain why each of the following industries is an oligopoly,
not a perfectly competitive industry.

b. The microprocessor industry, where two firms, Intel and

its bitter rival AMD, dominate the technology
Explain why each of the following industries is an oligopoly,
not a perfectly competitive industry.

c. The wide - body passenger jet industry, composed

of the American firm Boeing and the European firm Airbus,
where production is characterized by extremely large fixed
cost
Task 5

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Currently, Texas Tea Oil Co. is the only local supplier of home
heating oil in Frigid, Alaska. This winter residents were
shocked that the price of a gallon of heating oil had doubled
and believed that they were the victims of market power.
Explain which of the following pieces of evidence support or
contradict that conclusion.

a. There is a national shortage of heating oil, and Texas Tea

could procure only a limited amount.
Currently, Texas Tea Oil Co. is the only local supplier of
home heating oil in Frigid, Alaska. This winter residents
were shocked that the price of a gallon of heating oil had
doubled and believed that they were the victims of market
power. Explain which of the following pieces of evidence
support or contradict that conclusion.

b. Last year, Texas Tea and several other competing local oil
- supply firms merged into a single firm.
Currently, Texas Tea Oil Co. is the only local supplier of
home heating oil in Frigid, Alaska. This winter residents
were shocked that the price of a gallon of heating oil had
doubled and believed that they were the victims of market
power. Explain which of the following pieces of evidence
support or contradict that conclusion.

c. The cost to Texas Tea of purchasing heating oil from

refineries has gone up significantly.
Currently, Texas Tea Oil Co. is the only local supplier of home
heating oil in Frigid, Alaska. This winter residents were shocked
that the price of a gallon of heating oil had doubled and
believed that they were the victims of market power. Explain
which of the following pieces of evidence support or contradict
that conclusion.

d. Recently, some nonlocal firms have begun to offer heating oil

to Texas Tea’s regular customers at a price much lower than
Texas Tea’s.
Currently, Texas Tea Oil Co. is the only local supplier of home
heating oil in Frigid, Alaska. This winter residents were
shocked that the price of a gallon of heating oil had doubled
and believed that they were the victims of market power.
Explain which of the following pieces of evidence support or
contradict that conclusion.

e. Texas Tea has acquired an exclusive government license to

draw oil from the only heating oil pipeline in the state.
Task 6

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You are thinking of setting up a coffee shop. The market
structure for coffee shops is monopolistic competition.
There are three Starbucks shops and two other coffee
shops very much like Starbucks in your town already. In
order for you to have some degree of market power, you
may want to differentiate your coffee shop. Thinking
about the three different ways in which products can be
differentiated, explain how you would decide whether you
should copy Starbucks or whether you should sell coffee in
a completely different way.
Task 7 45