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Chapter 10
Monopolistic Competition and Oligopoly
Key Concepts Summary Practice Quiz
2000 South-Western College Publishing

What is Imperfect Competition?

A market structure between the extremes of perfect competition and monopoly
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What is Monopolistic Competition?

many small sellers differentiated product easy entry and exit Perfect information
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What is Product Differentiation?

The process of creating real or apparent differences between goods and services
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What does Many Small Sellers mean?

Each firm is so small relative to the total market that each firms pricing decisions have a negligible effect on the market price
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What is Nonprice Competition?

A firm competes using advertising, packaging, product development, better service, rather than lower prices
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How easy is entry and exit in Monopolistic Competition?

Not as easy as in Perfect Competition because of product differentiation
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Why is a Monopolistic Competitive firm a price maker?

Product differentiation gives the firm some control over its price
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What does the demand curve for Monopolistic Competition look like?
It has a negative slope, But it is less elastic (steeper) than for a perfectly competitive firm and more elastic (flatter) than for a monopolist
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What are examples of Monopolistic Competition? grocery stores hair salons gas stations video rental stores restaurants
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How effective is Advertising?

Somewhat effective in the short-run but less effective in the long-run

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What effect does Advertising have on Average Costs?

It raises the long-run average cost curve

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$4.00 $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $.50

P
Cost per unit

The effect of Advertising

With advertising

LRAC2 LRAC1

Without advertising

2 4 6 8 10 12 14 16 18

Q
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How does a firm decide what price to charge and how many units to produce?

MR = MC
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$50 $40 $30 $25 $20 $15 $10 $5

P
MC

MR=MC

ATC

Profit
AVC MR

1 2 3 4 5 6 7 8 9

Q
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Price and Output under Monopolistic Competition

MR = MC rule applies for setting output.

Long-run equilibrium: the firms demand curve must be tangent to its average cost curve.

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How efficient is Monopolistic Competition?

Less resources are used and a higher price is charged than would be the case under Perfect Competition
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How efficient is Monopolistic Competition?

Under monopolistic competition, in the long run the firm will produce an output lower than that which minimizes its unit costs. Hence, unit costs will be higher than necessary Achievement of minimum average costs would require fewer but larger firms. This inefficiency may, however, be a reasonable price to pay for providing a large range of consumer choice.
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$40 $35 $30 $25 $20 $15 $10 $5

Monopolistic Competition
Minimum LRAC

MC

ATC
AVC MR

1 2 3 4 5 6 7 8 9

Q
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$40 $35 $30 $25 $20 $15 $10 $5

Price & Cost per unit

Perfect Competition
Minimum MC LRAC LRAC

MR

1 2 3 4 5 6 7 8 9

Q
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What is Oligopoly?
few sellers either homogeneous or a differential product difficult market entry
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Why Oligopolistic Behavior is So Hard to Analyze

Oligopolistic firms interact with each other in complex ways, and almost anything can and sometimes does happen under oligopoly.

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How few are a few Sellers?

When the firms are so large relative to the total market that they can affect the market price
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What is a significant Barrier to Entry? Economies of scale

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What is Nonprice Competition?

Competition in ways other than pricing policies

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What is the distinguishing feature of Oligopoly? Mutual interdependence

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What is Mutual Interdependence?

A condition in which an action by one firm may cause a reaction on the part of other firms
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How do Oligopolists determine price?

They play the game follow the leader that economists call price leadership
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What is Price Leadership?

A pricing strategy in which a dominant firm sets the price for an industry and the other firms follow
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What is a Cartel?
A group of firms formally agreeing to control the price and output of a product

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Organization of Petroleum Exporting Countries (OPEC) International Telephone Cartel (CCITT) International Airline Cartel (IATA)
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What are examples of Cartels?

What is the major weakness of a Cartel?

Member firms cheating

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Monopolistic Competition, Oligopoly, and Public Welfare

Behavior is so varied that it is hard to come to a simple conclusion about welfare implications. In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum.

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Perfect competition and pure monopoly are uncommon in reality. Many monopolistically competitive firms exist. Oligopoly firms account for the largest share of the economys output.

A Glance Backward: Comparison of the Four Market Forms

Profits are zero in long-run equilibrium under perfect competition and monopolistic competition because of free entry and exit.
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A Glance Backward: Comparison of the Four Market Forms

In equilibrium, MC = MR for the profit-maximizing firm under any market form. In the equilibrium of the oligopoly firm, MC may be unequal to MR. The behavior of the perfectly competitive firm and industry theoretically leads to an efficient allocation of resources. Monopoly and monopolistic competition are both likely to yield an inefficient allocation of resources. Under oligopoly, almost anything can happen, so it is impossible to generalize about its vices or virtues
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ATTRIBUTES OF THE FOUR MARKET FORMS

MARKET FORM
Perfect competition Pure monopoly Monopolistic competition

NUMBER OF FIRMS IN THE MARKET

Very many One Many

FREQUENCY IN REALITY
Rare (if any) Rare Widespread Produces large share of GDP

ENTRY BARRIERS
None Likely to be high Minor

PUBLIC INTEREST RESULTS

Good Misallocates resources Inefficient

LONG-RUN EQUILIBRIUM CONDITIONS PROFIT

Zero May be High Zero MC = MR = AC = AR = P MR = MC MR = MC AR = AC

Oligopoly

Few

Varies

Varies

Varies

Vary

Copyright 2000 by Harcourt, Inc. All rights reserved.

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Key Concepts

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Key Concepts
What is Imperfect Competition? What is Monopolistic Competition? What is Product Differentiation? What is Nonprice Competition? Why is a Monopolistic Competitive firm a price maker? How does a firm decide what price to charge and how many units to produce?
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Key Concepts cont.

How efficient is Monopolistic Competition? What is Oligopoly? What is Nonprice Competition? What is the distinguishing feature of Oligopoly? How do Oligopolists determine price? What is a Cartel?

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Summary

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Imperfect competition is the market structure between the extremes of perfect competition and monopoly Monopolistic competition and oligopoly belong to the imperfect competition category.

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Monopolistic competition is a market structure characterized by (1) many small sellers, (2) a differentiated product, and (3) easy market entry and exit. Given these characteristics, firms in monopolistic competition have a negligible effect on the market price.

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Product differentiation is a key characteristic of monopolistic competition. It is the process of creating real or apparent differences between products.

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Nonprice competition includes advertising, packaging, product development, better quality, and better service. Under imperfect competition, firms may compete using nonprice competition, rather than price competition.

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Short-run equilibrium for a monopolistic competitor can yield economic losses, zero economic profits, or economic profits. In the long run, monopolistic competitors make zero economic profits.

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$50 $40 $30 $25 $20 $15 $10 $5

P
MC

MR=MC

ATC

Profit
AVC

MR

1 2 3 4 5 6 7 8 9

Q
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Comparing monopolistic competition with perfect competition, we find that the monopolistic competitive firm does not achieve allocative efficiency,charges a higher price, restricts output, and does not produce where average costs are at a minimum.
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$40 $35 $30 $25 $20 $15 $10 $5

Monopolistic Competition
Minimum LRAC

MC ATC AVC

MR

1 2 3 4 5 6 7 8 9

Q
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$40 $35 $30 $25 $20 $15 $10 $5

Price & Cost per unit

Perfect Competition
Minimum MC LRAC LRAC

MR

1 2 3 4 5 6 7 8 9

Q
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Oligopoly is a market structure characterized by (1) few sellers, (2) a homogeneous or differentiated product, and (3) difficult market entry. Oligopolies are mutually interdependent because an action by one firm may cause a reaction on the part of other firms.
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The nonprice competition model is a theory that might explain oligopolistic behavior. Under this theory, firms use advertising and product differentiation, rather than price reductions, to compete.

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Price leadership is another theory of pricing behavior under oligopoly. When a dominant firm in an industry raises or lowers price, other firms follow suit.

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A cartel is a formal agreement among firms to set prices and output quotas. The goal is to maximize profits, but firms have an incentive to cheat, which is a constant threat to a cartel.

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Comparing oligopoly with perfect competition, we find that the oligopolist allocates resources inefficiently, charges a higher price, and restricts output so that price may exceed average cost.

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Chapter 10 Quiz

2000 South-Western College Publishing

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1. An industry with many small sellers, a differentiated product, and easy entry would best be described as which of the following? a. Oligopoly. b. Monopolistic competition. c. Perfect competition. d. Monopoly. B. An oligopoly has only a few sellers. A monopoly only has one, and perfect competition has homogeneous products.
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2. Which of the following industries is the best example of monopolistic competition? a. Wheat. b. Restaurant. c. Automobile. d. Water service. B. Wheat would be in a perfectly competitive market. Automobiles would be an oligopoly. And the water service is an example of a regulated monopoly.
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3. Which of the following is not a characteristic of monopolistic competition? a. A large number of small firms. b. A differentiated product. c. Easy market entry. d. A homogeneous product. D. A characteristic of monopolistic competition is differentiated products.

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4. A monopolistically competitive firm will

a. maximize profits by producing where MR = MC. b. probably not earn an economic profit in the long run. c. shut down if price is less than average variable cost. d. do all of the above.

D. Both a monopolistically competitive firm and a perfectly competitive firm share these characteristics.

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5. The theory of monopolistic competition predicts that in long-run equilibrium a monopolistically competitive firm will a. produce the output level at which price equals long-run marginal cost. b. operate at minimum long-run average cost. c. overutilize its insufficient capacity. d. produce the output level at which price equals long-run average cost.

D
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$40 $35 $30 $25 $20 $15 $10 $5

Monopolistic Competition
Minimum LRAC

MC

ATC
AVC MR

1 2 3 4 5 6 7 8 9

Q
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6. A monopolistically competitive firm is inefficient because the firm a. earns positive economic profit in the long run. b. is producing at an output where marginal cost equals price. c. in not maximizing its profit. d. produces an output where average total cost is not minimum.

D.
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$40 $35 $30 $25 $20 $15 $10 $5

Monopolistic Competition
Minimum LRAC

MC

ATC
AVC MR

1 2 3 4 5 6 7 8 9

Q
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7. A monopolistically competitive firm in the long run earns the same economic profit as a a. perfectly competitive firm. b. monopolist. c. cartel. d. none of the above. A. In the long-run, a normal profit is made because of the ease of entry and exit. Once economic profits are made, more firms will enter the industry, driving price down. When losses are made, firms leave the industry, driving price up, restoring profits.
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8. One possible effect of advertising on a firms long-run average cost curve is to a. raise the curve. b. lower the curve. c. shift the curve rightward. d. shift the curve leftward. A. The ATC curve is raised because of the added expense of the advertising.

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9. Monopolistic competition is an inefficient market structure because a. firms earn zero profit in the long-run. b. marginal cost is less than price in the longrun. c. a wider variety of products is available compared to perfect competition. d. all of the above. B. In the long-run, marginal cost is less than price because of the downward sloping demand curve and a marginal revenue curve that is more steeply sloped beneath the demand curve.
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10. The Big Three U.S. automobile industry is described as a (an) a. monopoly. b. perfect competition. c. monopolistic competition. d. oligopoly. D. An oligopoly is a market form with only a few sellers.

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11. The cigarette industry in the United States is described as a (an) a. monopoly. b. perfect competition. c. monopolistic competition. d. oligopoly. D. The cigarette industry has only a few sellers.

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12. A characteristic of an oligopoly is a. mutual interdependence in pricing decisions. b. easy market entry. c. both (a) and (b). d. neither (a) nor (b). A. The distinguishing feature of an oligopoly is mutual interdependence. No one firm will make a decision without first considering the reaction of its competitors to its policy change.
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15. Which of the following is evidence that OPEC is a cartel? a. Agreement on price and output quotas by oil ministries. b. Ability to raise prices regardless of demand. c. Mutual interdependence in pricing and output decisions. d. Ability to completely control entry. A. A cartel is characterized by collusion, the coming together and agreeing to certain policies, for example, the level of prices.
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END
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