Monopolistic Competition

· Large number of sellers

· relative ease of exit / entry
· products are differentiated
· actual differentiation
· perceived differentiation
· Only difference from pure comp is that the
demand faced by the firm is not perfectly elastic;
MR will lie below the Demand function [AR]

Principles of Microeconomics Slide -- 1

Monopolistically competitive firms have differentiated products but
must compete with other sellers of goods that are close subsitutes.
The result is that each firm faces a negatively sloped demand function
that is “relatively elastic.”
$
If there are “below normal  “
some firms will exit and the
demand for remaining firms
will shift out. D’
D
Above normal will encourage
D*
entry and each firm’s demand
function will shift in and may
become more relatively more Q /ut
“elastic.”

As firms enter there are more close substitutes so each firms’

demand shifts in and is relatively more elastic.

Principles of Microeconomics Slide -- 2

 Oligopoly
· Characteristics:
· A “few sellers” who recognize their
interdependence
· Products may be homogeneous or
differentiated
· Significant barriers to entry exist
· Explanations of oligopoly behavior require
knowledge of competititors’ behavior

Principles of Microeconomics Slide -- 3

 Cartels
• Explicit agreements among firms to fix output and prices
and act as a monopolist.
• Examples are OPEC, Shipping Cartel
• Incentive to cooperate – earn monopoly profits
• Incentive to cheat – increase individual profits if cheating
is not detected or punished.
• Sources of instability in cartels:
– Number of Sellers
– Cost differences
– Potential competition
– Cheating
 Kinked Demand Curve Model
• Show a situation where the best situation for players is to
maintain current prices and that prices remain stable in
spite of firms with different cost structures.
• Asymmetry in price movements:
– If firm raises price, no one follows, therefore quantity demanded is
elastic
– If firm lowers price, all follow suit so the quantity demanded is
quite inelastic
• Marginal revenue curve is discontinuous and allows for
various marginal cost curves.
 Kinked Demand Curve

– If the firm raises its

price above P, it faces an
elastic demand curve,
payoff low
– If the firm lowers its
price below P, it faces an
inelastic demand curve,
payoff low
 Kinked Demand Curve
– Different firms can have
different MCs. As long as
they fall with in the
discontinuous MR, P will
remain stable.
– Output Effect < Price
Effect for price
movements with the
discontinuous MR curve.
– If MC increases enough,
all firms raise their prices
and the kink vanishes.
 Oligopoly and Efficiency
• The question whether oligopoly affects economic
welfare depends on whether or not they exercise
market power over prices and production
• In competition, the level of output produced is
where P=MC or MB=MC. Hence, net benefits to
society are maximized. Market prices as low as
possible and respond to changes in market forces.
This allows prices to help direct resource
allocation.
• In monopoly, the level of output produced is
where P>MC or MB>MC. Hence, net benefits to
society are NOT maximized. Market prices are
higher and respond to changes in market forces.
This allows prices to help direct resource
allocation.
• In oligopoly, the level of output is somewhere
between the competitive and the monopolistic
outcome. As the oligopolist produces closer to the
competitive solution, the net benefits to society
move closer to being maximized. The opposite is
true if the outcome moves closer to the monopoly
outcomes, such as occurs with a perfect carte.
• Non-price competition, such as advertising and
product differentiation, can negatively affect
resource allocation, but it can also contribute to
efficiency. People have different preferences for
products and advertising can help inform
consumers about the price and nature of a product.
• If prices are sticky, they can also cause inefficiency
by failing to act as signals for resource allocation.
• The extent of these inefficiencies are the subject of
debate among economists and non-economists.