Monopolistic Competition and Oligopoly

A monopolistically competitive market is characterized by:

many buyers and sellers,

differentiated products, and

easy entry and exit.

The monopolistically competitive market is similar to perfect competition in that there are many
buyers and sellers who can enter or leave the market easily in response to economic profits or
losses. A monopolistically competitive firm, though, is similar to a monopoly in that it produces
a product that is different from that produced by all other firms in the market. The restaurant
market in New York City provides a good example of a monopolistically competitive market.
Each restaurant has its own recipes, decor, ambiance, etc. but also must compete with many other
similar restaurants.
Because each firm produces a differentiated product, it won't lose all of its customers if it raises
its prices. Thus, a monopolistically competitive firm faces a downward sloping demand curve for
its product. As noted in Chapters 8 and 10, whenever a firm faces a downward sloping demand
curve, its marginal revenue curve lies below its demand curve. The diagram below illustrates the
relationship that exists between a monopolistically competitive firm's demand and marginal
revenue curves.

While the diagram above seems similar to the demand and marginal revenue curves facing a
monopolist, there is a critical difference. In a monopolistically competitive market, the number
of firms changes as firms enter or leave the industry. When new firms enter the market, the
customers are spread over a larger number of firms and the demand for each firm's product
declines. An increase in the number of firms also tends to result in an increase in the elasticity of
demand for each firm's products (since demand is more elastic when more substitutes are
available). The diagram below illustrates the shift in a typical firm's demand curve that occurs
when additional firms enter a monopolistically competitive market.

Short-run and long-run equilibrium in monopolistically competitive markets

Let's examine the determination of short-run equilibrium in a monopolistically competitive
output market.
The diagram below illustrates a possible short-run equilibrium for a typical firm in a
monopolistically competitive market. As with any profit-maximizing firm, a monopolistically
competitive firm maximizes its profits by producing at a level of output at which MR = MC. In
the diagram below, this occurs at an output level of Qo. The price is determined by the amount
that customers are willing to pay to buy Qo units of output. In the example below, the demand
curve indicates that a price of Po will be charged when Qo units of output are sold.

In a monopoly industry, economics profits could persist indefinitely due to the existence of
barriers to entry. In a monopolistically competitive industry, however, the existence of economic
profits results in the entry of additional firms into the industry. As additional firms enter, the
demand for each firm's product will fall and become more elastic. This reduction in demand,
though, results in a reduction in the level of economic profit received by a typical firm. Entry

into the market continues until a typical firm receives zero economic profits. This possibility is
illustrated in the diagram below.

The diagram above depicts a monopolistically competitive firm in a state of long-run

equilibrium. This firm maximizes its profit by producing an output level of Q'. The equilibrium
price is P'. Since the price equals average total cost at this level of output, a typical firm receives
a level of economic profit equal to zero. This long-run equilibrium situation is often referred to
as a "tangency equilibrium" since the demand curve is tangent to the ATC curve at the profitmaximizing level of output.

In the short run, a monopolistically competitive firm may receive economic losses in the short
run. This possibility is illustrated in the diagram below. While each firm will continue operations
in the short run, firms will leave the industry in the long run. As firms leave, the demand curves
facing the remaining firms will shift to the right and become less elastic. (To see this, note that
when firms leave the industry, the remaining firms will receive some of the customers that used
to purchase the commodity at the firms that have left the industry.) Exit from the industry will
continue until economic profits again equal zero (as illustrated in the diagram below).

Monopolistic competition vs. perfect competition

As noted in Chapter 10, perfectly competitive markets result in economic efficiency since P =
MC and firms produce at the minimum level of ATC. The diagram below compares price and
output levels for perfectly competitive and monopolistically competitive firms. As this diagram
suggests, a perfectly competitive firm produces output at a price (Ppc) that is less than the price
that would be charged by a monopolistically competitive firm (Pmc). A perfectly competitive firm
will also produce a larger quantity of output (Qpc) than would be produced by a monopolistically
competitive firm (Qmc).

Because monopolistically competitive firms produce at a level of cost that exceeds the minimum
level of ATC, they are less efficient than perfectly competitive firms. This efficiency loss,
however, is a cost that society must bear if it wishes to have differentiated products. One of the
costs of having variety in restaurants, clothing, most types of prepared foods, etc., is that average
production costs will be higher than they would be if a homogenous product were produced.
It should be noted, though, that the larger the number of firms in the market, the more elastic will
be the demand for each firm's product. As the number of firms grows very large, the demand
curve facing a monopolistically competitive firm will approach the perfectly elastic demand

curve that is faced by a perfectly competitive firm. In such a situation, the efficiency cost of
product differentiation will be relatively small.
In the short run, monopolistically competitive firms may receive economic profits by
successfully differentiating their product. Successful product differentiation, however, will soon
be copied by other firms. It is expected that such profits will disappear in the long run.
Advertising campaigns may raise the profits of a firm in this industry in the short run, but will
successful advertising campaigns will lead to similar efforts by other firms in the industry.
As your text notes, monopolistically competitive firms in the same industry often locate near
each other in communities as a result of their attempts to appeal to the median customer in a
geographic region. This is why we often see car dealerships and fast-food restaurants locating
near each other on a particular street.

Oligopoly
An oligopoly market is characterized by:
a small number of firms,
either a standardized or a differentiated product,

recognized mutual interdependence, and

difficult entry.

Because there are few firms in an oligopoly industry, each firm's output is a large share of the
market. Because of this, each firm's pricing and output decisions have a substantial effect on the
profitability of other firms. Furthermore, when making decisions concerning price or output,
each firm has to take into account the expected reaction of rival firms. If McDonald's lowers the
price of their Big Macs, for example, the effect on their profits would be very different if Burger
King responded by lowering the price on their Whopper sandwiches by a larger amount. Because
of this mutual interdependence, oligopoly firms engage in strategic behavior. Strategic behavior
occurs when the best outcome for one party is determined by the actions of other parties.
The kinked demand curve model describes a situation in which a firm assumes that other firms
will match its price reductions but will not follow price increases. As your text notes, the optimal
strategy in such a situation is frequently to leave the price at the current level and to rely on
nonprice competition rather than price competition.
There is little evidence, though, that the kinked-demand curve model accurately describes the
behavior of oligopoly firms. Instead, economists generally rely on game-theory models to
describe outcomes in oligopoly markets. Game theory attempts to explain strategic behavior by
examining the payoffs associated with alternative choices by each participant in the "game." A
possible situation that can be analyzed by game theory is whether each firm in a 2-firm oligopoly
should maintain a high or a low price. In such a situation, the highest level of combined profits
may be received if each firm charges a high price. Either firm, however, could increase its profits
by offering a low price if the other firm continues to charge a high price. If both firms charge a
low price, combined profits are lower than if they both charged a high price.
Participants in a game face a relatively simple choice when a dominant strategy exists. A
dominant strategy is one that provides the highest payoff to an individual for each and every
possible action of their rivals. In the oligopoly pricing decision described above, the dominant
strategy is to offer a lower price. To see this, suppose that you are making this decision and do
not know what the other firm will do. If the other firm charges a high price, you can receive the

highest profits by undercutting this firm's price. On the other hand, if the other firm charges a
low price, the best strategy for you is again to charge a low price (if you charge a high price
when the other firm offers a low price, you will receive larger losses). In this case, if this game is
played only once, each firm would be expected to charge a low price even though their combined
profits would be higher if they both charged a high price. If collusion is possible (and
enforceable), though, both firms may charge a high price.
The oligopoly pricing decision described above is an example of a general type of game known
as a prisoners' dilemma. Under the traditional prisoners' dilemma game, two prisoners are
arrested and held separately. When they are interrogated, each is offered a reduced sentence if he
or she provides evidence against the other party. The dominant strategy in this situation is to
confess since for each possible action chosen by the other party, the prisoner receives a lighter
sentence by confessing. The prisoners' dilemma model is used in a wide variety of academic
disciplines to explain individual behavior in strategic situations.
Not all strategic situations result in a dominant strategy. It becomes much more difficult to
predict the outcome of a game when no dominant strategy exists.
The analysis of strategic decision making, though, becomes much more complex when they are
played repeatedly by the same players. In the case of the prisoners' dilemma, even though each
individual may gain in a single case by confessing, both prisoners will have a wealthier life of
crime if neither of them confesses and provides evidence against the other. If they know that they
will engage in further crimes in the future, they will be less likely to confess. By not confessing,
they are able to attain a higher level of lifetime income. In the case of oligopolies, each firm has
an incentive to undercut the prices charged by other firms in any given time period. Each firm,
though, realizes that if it charges a lower price now, the other firm may respond by charging
lower prices in the future. The threat of future retaliation may encourage firms to maintain high
prices in each time period.
The situations described above involve noncooperative games in which participants could not
work together to mutually decide on outcomes. If oligopoly firms are free to collude and jointly
determine their prices and output levels, they would be able to attain a higher combined level of
profits. In the U.S. collusion of this sort is illegal. While it is illegal for firms to officially meet
and determine prices and output levels, it is perfectly legal for them to charge the same high
prices as long as they didn't meet to determine the prices. Firms may be able to achieve outcomes
equivalent to the collusive outcome by engaging in a price-leadership situation in which one firm
sets the price for the industry and the other firms follow that firms' price changes. Other
facilitating practices such as cost-plus/markup pricing may also result in an equivalent outcome.
(Cost-plus or markup pricing occurs when firms determine the retail price of a commodity as a
given multiple of the wholesale price - if there is a 50% markup, a good that costs the firm $10 to
acquire will be sold for $15.) If all firms use the same markup percentage, they will all tend to
charge the same price. Manufacturers of goods often facilitate this practice by posting
"recommended retail prices" on the products.
Cartels are legal in some countries. Under a cartel arrangement, firms engage in explicit
collusive behavior. One problem with cartels, though, is that any individual firm can increase its
profits by cheating on the agreement. For this reason, most cartels have not been lasted very
long.

Imperfect information

One complicating factor in markets is that buyers and sellers do not always possess perfect
information about the characteristics of the products that they are buying and selling. Brand
name identification is important in many oligopoly and monopolistically competitive markets
because a seller that wishes to remain in business has an incentive to produce a high quality
product. Customers are often willing to pay a higher price for a product produced by an
established firm rather than buying a product from a firm that they do not recognize. Product
guarantees are also used by firms as a signal of product quality.
One problem caused by imperfect information is the adverse selection problem. The adverse
selection problem occurs when those who willing to agree to a transaction are selling a lowerquality product than is typical in the population as a whole. A classic example of the adverse
selection problem occurs in the market for used cars. Once a car is driven off the lot, its value
declines rather dramatically. The reason for this is that individuals who are stuck with "lemons"
are more likely to sell their cars in the used-car market than those who purchased reliable
vehicles. Because buyers cannot always determine whether a car is a good used car or a "lemon"
the price of all used cars is lower because of the lower average quality of the used cars that are
offered for sale.
Another example of the adverse selection problem occurs in the market for insurance. If there are
no restrictions on who is eligible to purchase a health insurance or life insurance policy, those
who purchase them are disproportionately those individuals who are more seriously ill. Because
of this, the cost of insurance policies offered to the general public is much higher than the cost of
insurance that is provided to all employees in a firm or all students at a college.
Moral hazard is another problem that results from imperfect information. Moral hazard occurs
when the existence of a contract causes one party to alter his or her behavior from the behavior
that was anticipated by the other party at the time the contract was agreed to. Medical insurance
provides an example of the moral hazard problem since the existence of insurance encourages
individuals to consumer more medical services than would otherwise be consumed.