Monopolistic Competition &

Oligopoly
In the last session we covered the theory on the two extremes and moreover, rarely do firms
find themselves in market structures of Perfect competition and Monopoly.
Today we will know more on the other two market structures, Monopolistic Competition and
Oligopoly that do exist in the real world. However to understand the constraints of market
structure that a firm operates in, a manager needs to know the theory based on which markets
work and what opportunities and hurdles they pose in decision-making.

Monopolistic Competition

Monopolistic competition is a form of imperfect competition and can be found in many real
world markets ranging from fast food shops and coffee stores to pizza delivery businesses or
hairdressers in a local area. Small-scale manufacturers like sports goods, readymade garments,
electrical fittings etc. fit into the market structure known as monopolistic competition.
It is similar to perfect competition while being more realistic, because the products are
differentiated.
Characteristics of firms in monopolistic competition
 There are many producers and many consumers - the industry concentration ratio is low
 Consumers perceive that there are non-price differences among products i.e. there is
product differentiation – competition is strong, plenty of consumer switching takes
place
 Producers have some control over price - they are “price makers" not “price takers" but
the price elasticity of demand is higher than it would be under a situation of monopoly
 The barriers to entry and exit into and out of the market are low.
Differentiated products prevent demand curve from becoming horizontal. Cross price
elasticities are large but not infinite. So the products available are less than perfect
substitutes and this allows the firms enjoy a small market power. Most products in the retail
market, differentiation based on location, availability, credit terms, sales people.
Downward sloping curve, relatively elastic but not horizontal, a firm could raise its price without
losing its entire market share. The firm can act independently as it is so small in the market. In
the long run, it resembles perfect competition with free entry and exit.

Profit Maximization for a Monopolistically Competitive Firm in the Short Run

It chooses the output level where marginal revenue is equal to marginal cost.
It sets the price using the demand curve to ensure that consumers will buy the amount
produced.
In the short run the profits made by businesses competing in this type of market structure can
be at any level. In the graph below, the business is making supernormal profits indicated by the
shaded area. Strong brand loyalty can make consumer demand less sensitive to price making
price elasticity less than infinity.
It profit maximizes at MR = SMC. Price is decided by demand curve so P > MR.

Short run equilibrium: MR = MC. In the short run it could suffer loss if price < ATC but above
AVC, identical to that of monopoly in the short run.
Should the firm produce or shutdown: P > = AVCmin. How much to produce: SMC = MR
Profit Maximization for a Monopolistically Competitive Firm in the Long-Run
Unlike monopoly, there are no barriers to entry. This means that the short run supernormal
profit attracts new producers into the market, and so normal profits only are made in the long
run equilibrium.
We can determine whether or not the monopolistically competitive firm is earning a profit or
loss by comparing price and average total cost.
If P > ATC, the firm is earning a profit.
If P < ATC, the firm is earning a loss.
If P = ATC, the firm is earning zero economic profit.
When firms in monopolistic competition are making profit, new firms have an incentive to
enter the market.
This increases the number of products from which consumers can choose.
Thus, the demand curve faced by each firm shifts to the left.
As the demand falls, these firms experience declining profit.
When firms in monopolistic competition are incurring losses, firms in the market will have an
incentive to exit.
Consumers will have fewer products from which to choose.
Thus, the demand curve for each firm shifts to the right.
The losses of the remaining firms will fall.
The process of exit and entry continues until firms are earning zero profit.
This means that the demand curve and the average total cost curve are tangent to each other.
At this point, price is equal to average total cost and the firm is earning zero economic profit.
There are two characteristics that describe the long-run equilibrium in a monopolistically
competitive market.
Price exceeds marginal cost (due to the fact that each firm faces a downward-sloping demand
curve).
Price equals average total cost (due to the freedom of entry and exit).
Therefore two conditions for long-run profit maximization for a firm under Monopolistic
Competition are:
 1. MR = LMC
2. Price = LAC – Zero Economic Profit / Normal Profit

Inefficiencies in Monopolistic Competition

Excess Capacity
The quantity of output produced by a monopolistically competitive firm is smaller than the
quantity that minimizes average total cost (the efficient scale).
This implies that firms in monopolistic competition have excess capacity, because the firm could
increase its output and lower its average total cost of production.
Because firms in perfect competition produce where price is equal to the minimum average
total cost, firms in perfect competition produce at their efficient scale.

Markup over Marginal Cost

In monopolistic competition, price is greater than marginal cost because the firm has some
market power.
Prices are above marginal cost – meaning that the equilibrium is not allocatively efficient.
In the graph, the mark
up and the excess
capacity has been
highlighted.
The demand curve
downward sloping
implies that the price is
higher than the
marginal cost. In profit-
maximizing, the
marginal cost is equal to
marginal revenue which
is the efficient price. But the firms have the power to charge higher price. Thus, the gap
between marginal cost and price is call as mark-up. The inequality between price and
marginal cost is the reason that monopolistic competition is inefficient.
Other than that, the firms have the power to produce less than the efficient quantity. Q3 is
the quantity that the firm willing to produce while Q4 is the efficient quantity which touches
the minimum ATC. Therefore, excess capacity incurred. In another word, excess capacity is
the differences between the efficient quantity and the quantity the firms willing to produce.
Heavy spending on marketing and advertising is considered as wasted and is an inefficient
use of scarce resources. The debate over the environmental impact of packaging is linked
strongly to this aspect of monopolistic competition.
 Oligopoly
A market structure which has only a few sellers offering similar or identical products.
Characteristics of Oligopoly:
Markets with only a Few Sellers
Product may be homogenous or slightly differentiated
Interdependence of decision-making
Barriers to entry

A key feature of oligopoly is the tension between cooperation and self-interest.

Products may or may not be differentiated but what matters is that only a few firms account for
most of the total output. Some or all firms earn high profits due to barriers to entry.
Reasons are the same as monopoly power: scale, patents, access to technology. Decisions
regarding output and price are difficult to make as demand curve depends on reaction of rivals.

Working of firms in an Oligopoly

Hari and Sadhu own the only water wells in town. They have to decide how much water to
bring to town to sell. (Assume that the marginal cost of each gallon of water is zero.)
The demand for the water is as follows:

Quantity Price Total Revenue (and Total Profit)

0 Rs.120 Rs. 0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
 90 30 2,700
100 20 2,000
110 10 1,100
120 0 0

Competition, Monopolies, and Cartels

If the market for water were perfectly competitive, price would equal marginal cost (Rs.0). This
means that 120 gallons of water would be sold.
If a monopoly controlled the supply of water, profit would be maximized at a price of Rs.60 and
an output of 60 gallons.
Note that in this case, price (Rs.60) exceeds marginal cost (Rs.0).
This level of output is lower than the socially efficient level of output (120 gallons).
The duopolists may agree to act together to set the price and quantity of water.
Collusion: an agreement among firms in a market about quantities to produce or prices to
charge.
Cartel: a group of firms acting in unison.
If Hari and Sadhu did collude, they would agree on the monopoly outcome of 60 gallons and a
price of Rs.60.
The cartel must also decide how to split the production of water. Each member will want a
larger share because that means more profit.

The Equilibrium for an Oligopoly

It is often difficult for oligopolies to form cartels.
Antitrust laws prohibit agreements among firms.
Squabbling among cartel members over their shares is also likely to occur.
In the absence of a binding agreement, the monopoly outcome is unlikely.
Assume that Hari expects Sadhu to produce 30 gallons of water (half of the monopoly
outcome).
Sadhu could also produce 30 gallons and earn a profit of Rs.1,800.
However, he could produce 40 gallons and earn a profit of Rs.2,000.
Sadhu will want to produce 40 gallons.
Hari might reason the same way. If he expects Sadhu to produce 30 gallons, he could increase
his profits by raising his output to 40 gallons.
If duopolists pursue their own self-interest when deciding how much to produce, they produce
a quantity greater than the monopoly quantity, charge a price lower than the monopoly price,
and earn total profit less than the monopoly profit.

Profit maximizing output is studied under two scenarios, whether the firms under Oligopoly
operate collusively or non-collusively.
Non-collusive Oligopoly is examined through Nash Equilibrium and Game theory and
Sweezy’s Kinked Demand curve.
Collusive Oligopoly is examined through the study of Price Leadership and Cartels.

Non-collusive Oligopoly
Nash equilibrium: Set of strategies or actions in which each firm does the best it can given its
competitors’ actions.
Each firm makes a decision to maximize its profits, given the action of its competitors. The
profit is higher than perfect competition but lower than if the firms colluded. But cooperation
can lead to higher profits, so cooperate without explicitly colluding. So set a price and hope
your competitor will follow suit. Both the firms will make higher profits. But the competitor will
not follow suit but he will set a price below your price, if he knows you are going to set price at
collusive level.
Suppose we find out that if the two firms through Nash equilibrium will charge Rs. 4 and earn a
profit of Rs. 12. But if they collude, charge a price of Rs. 6 and they will earn a profit of Rs. 16. If
they do not collude but firm 1 charge Rs. 6 hoping that firm will do the same. If firm 2 charges
Rs.4, then it will earn a profit of: Firm 1 demand = Q1 = 12 – 2P1 + P2
Firm 2 demand = Q2 = 12 – 2P2 + P1
Profit of firm 2 = P2Q2 – 20 = 4 * (12 – 2 * 4 + 6) – 20 = Rs. 20
Profit of firm 1 = P1Q1 – 20 = 6 * (12 – 2 * 6 + 4) – 20 = Rs. 4
Rs. 20 is the fixed cost and zero variable cost. Clearly firm 2 does the best by charging only Rs 4,
the situation had been reversed then firm 1 would have made a profit of Rs. 20 and firm 2 a
profit of Rs. 4 only. A pay-off matrix summarizes the result of these possibilities.
Firm 1 Firm 2
Charge Rs 4 Charge Rs 6
Charge Rs 4 Rs. 12, Rs. 12 Rs. 20, Rs. 4
Charge Rs 6 Rs. 4 , Rs. 20 Rs. 16, Rs. 16
A pay-off matrix shows the non- cooperative possibilities for two firms. Each firm does the best
it can taking the competitor into consideration. This answers the question why firms do not
collude and earn higher profits. The point is that each firm wants to make more money by
charging Rs. 4, no matter what the competitor does.

Prisoners’ dilemma: Game theory example in which two prisoners must decide separately
whether to confess to a crime, if a prisoner confesses, he gets a lighter sentence and his
accomplice will get a heavier one, but if neither confesses, sentence will be lighter than if both
confess. If both confess, they both get 5 years, both do not confess, they get 2 years, one
confesses the other does not then one who confesses 1 year while the other gets a term of 10
years. They cannot talk to each other; even if they could can they trust each other. No matter
what one does, the other will come out confessing. So they both confess and go to jail for 5
years. In oligopoly, if firms compete aggressively to capture a larger market share they make
less profit than when they compete more passively, settle for the market share they have. Both
firms do better by charging a high price but they cannot trust the other firm to set a higher
price.
Implications of prisoners’ dilemma for oligopolistic firm: Though the prisoners cannot talk to
each other the oligopolistic firms can and they can observe their competitors and know their
competitors and trust their response and due this oligopoly cooperation can prevail. But most
of the times implicit collusion is short lived, where one of the firms changes its price or
aggressively advertises.
Sweezy’s Kinked Demand Curve
The kinked demand curve model assumes that a business might face a dual demand curve for
its product based on the likely reactions of other firms to a change in its price or another
variable
 The assumption is that firms in an oligopoly are looking to protect and maintain their
market share and that rival firms are unlikely to match another's price increase but may
match a price fall.
 If a business raises price and others leave their prices constant, then we can expect
quite a large substitution effect making demand relatively price elastic. The business
would then lose market share and expect to see a fall in its total revenue.
 If a business reduces its price but other firms follow suit, the relative price change is
smaller and demand would be inelastic. Cutting prices when demand is inelastic leads to
a fall in revenue with little or no effect on market share.

The kinked demand curve model makes a prediction that a business might reach a stable profit-
maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.
Changes in costs using the kinked demand curve analysis
  One prediction of the kinked demand curve model
is that changes in variable costs might not lead to a rise or
fall in the profit maximising price and output.
 This is shown in the next diagram where it is
assumed that a rise in costs such as energy and raw
material prices leads to an upward shift in the marginal
cost curve from MC1 to MC2.

Collusive Oligopoly
Price Leadership
The big problem in implicitly collusive oligopoly is that it is difficult for the firms to agree on a
price so one firm can declare its raised price through the media and expect others to follow to
attain high profits. Pattern can be maintained where one of the firms signals and the others
follow. This is called price leadership, all charge what the leader is charging. e.g. In the Indian
scenario, Maruti Udyog is the price leader in the automobile industry.

Dominant Firm Model: where there is one large firm has a major share of total sales and a
group of small firms supplies the remainder, then the large firm acts as a dominant firm in
setting the price that maximizes its profits. The others then act as perfect competitors to take
market price as given.

Barometric price leadership: where price changes occur in response to clear a widely
understood changes in the market. In case of stagnating sales in the market one player may
offer a price cut and others understand that it is not to capture the market but to revive the
market, others will also follow. The critical requirement to be a barometric leader is to be able
to read the market changes correctly.
Cartels
Producers in a cartel explicitly cooperate to set the output and price. The cartel includes subset
of producers. If market demand is inelastic then the cartel is able to drive up the prices. Cartels
are formed internationally comprising governments and international companies.
Why do some cartels fail? Members must agree to price and output levels and more
importantly adhere to the agreement. Unlike prisoners’ dilemma, the members can discuss
amongst each other. The members need monopoly power to be able to raise the prices.
Equilibrium in cartel pricing: A cartel usually forms only a portion of total production and must
take into account the supply of non-cartel members when it sets the price and output. Thus
cartel pricing can be analyzed by the dominant firm model.
Joint-profit maximization:
Cartels imply direct (although secret) agreements among the competing oligopolists with the
aim of reducing the uncertainty arising from their mutual interdependence. The aim of the
cartel is the maximisation of the industry (joint) profit. The firms appoint a central agency, to
which they delegate the authority to decide not only the total quantity and the price at which it
must be sold so as to attain maximum group profits, but also the allocation of production
among the members of the cartel, and the distribution of the maximum joint profit among the
participating members.
The authority of the central cartel agency is complete. Clearly the central agency will have
access to the cost figures of the individual firms. From the horizontal summation of the MC
curves of individual firms the market MC curve is derived. Given the market demand DD the
monopoly solution, which maximises joint profits, is determined by the intersection of MC and
MR.
Although theoretically the monopoly solution is easy to derive, in practice cartels rarely achieve
maximum joint profits.

There are several reasons why industry profits cannot be maximised, even with direct cartel
collusion:
 Mistakes in the estimation of market demand. Usually the elasticity of market demand
is underestimated.
 Mistakes in the estimation of MC. The estimation of the market MC, from the
summation of individual costs, may involve mistakes, due to incomplete knowledge of
the individual MC curves at all levels of output.
 Slow process of cartel negotiations. Cartel agreements take a long time to negotiate due
to the differences in size, costs, and markets of the individual firms.
 The existence of high-cost firms. If a firm is operating with a cost curve which is higher
than the equilibrium MC, clearly this firm should close down if joint profits are to be
maximised.
 Fear of government interference. If the monopoly price yields too high profits the cartel
members may decide not to charge it, for fear of government interference.
 The wish to have a good public image. Similarly the members of the cartel may decide
not to charge the profit-maximising price if profits are lucrative, if they wish to have the
‘good’ reputation of charging a ‘fair price’ and realising ‘fair profits’.

Market-sharing cartels:
This form of collusion is more common in practice because it is more popular. The firms agree
to share the market, but keep a considerable degree of freedom concerning the style of their
output, their selling activities and other decisions.
Non-price competition agreements:
In this form of ‘loose’ cartel the member firms agree on a common price, at which each of them
can sell any quantity demanded. The price is set by bargaining, with the low-cost firms pressing
for a lower price and the high-cost firms for a high price. The agreed price must be such as to
allow some profits to all members.
The firms agree not to sell at a price below the cartel price, but they are free to vary the style of
their product and/or their selling activities. In other words, the firms compete on a non-price
basis. By keeping their freedom regarding the quality and appearance of their product, as well
as advertising and other selling policies, each firm hopes that it can attain a higher share of the
market.
If all firms have the same costs, then the price will be agreed at the monopoly level. However,
with cost differences the cartel will be inherently unstable, because the low-cost firms will have
a strong incentive to break away from the cartel openly and charge a lower price, or to cheat
the other members by secret price concessions to the buyers.
Sharing of the market by agreement on quotas:
The second method for sharing the market is the agreement on quotas, that is, agreement on
the quantity that each member may sell at the agreed price (or prices). If all firms have identical
costs, the monopoly solution will emerge, with the market being shared equally among
member firms. For example, if there are only two firms with identical costs, each firm will sell at
the monopoly price one-half of the total quantity demanded in the market at that price.
Another popular method of sharing the market is the definition of the region in which each firm
is allowed to sell. In this case of geographical sharing of the market the price as well as the style
of the product may differ. There are many examples of regional market-sharing cartels, some
operating at international levels.
Comparison:

Perfect Monopolistic Oligopoly Monopoly

Competition Competition
Goal of Firms Maximize Maximize Maximize Maximize
profits profits profits profits
Rule for maximizing MR = MC MR = MC Depends MR = MC
on kind of
firm.
Can the firm earn Yes Yes Yes Yes
economic profits in
the short-run?
Price taker? Yes No No No
Price P = MC P > MC P > MC P > MC
Produces welfare- Yes No No No
maximizing level of
output
Entry in the long run? Yes Yes Barriers to entry
Can it earn economic No No Yes Yes
profit in the long run?
Number of firms Many Many Few One

Examples Oilseeds, Novels, Cars, Designer

wheat, steel. toothpaste, airlines, labels,
colas, telecom Microsoft
packaged
coffee
Oligopoly