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McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.


Chapter 9:
Monopolistic
Competition
and
Oligopoly
Characteristics of
Monopolistic Competition
Large number of sellers:
Small market shares
No collusion
Independent action
Differentiated products:
Firms have some control over prices.
Products may differ in
attributes
services
location
brand name and packaging
Easy entry and exit


Examples:

furniture
jewelry
leather goods
grocery stores
gas stations
restaurants
clothing stores
medical care


LO: 9-1
9-2
Monopolistically competitive firms engage in
non-price competition (such as advertising) in
order to differentiate their products.
Because products are differentiated, the demand
curve of a monopolistically competitive firm is
not perfectly elastic (although it is more elastic
than a pure monopolists demand).
The price elasticity of a firms demand is higher
The larger the number of rival firms
The weaker the product differentiation
Pricing and Output in
Monopolistic Competition
LO: 9-2
9-3
Profits and Losses in
Monopolistic Competition
Short run
The monopolistically
competitive firm uses the
MC = MR Rule to maximize
profit or minimize loss in the
short run.
It produces a quantity Q at
which MR = MC and
charges a price P based on
its demand curve.
When P > ATC, the firm
earns an economic profit.
When P < ATC, the firm
incurs a loss.
Long run
Because entry and exit are
easy,
Economic profits attract
new firms, which lowers
profits of existing firms,
until P=ATC.
Economic losses make
firms exit until P=ATC.
As a result, a monopolistic
competitor will earn only a
normal profit in the long run.

LO: 9-2
9-4
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D in SR

ATC
Economic
Profit
Q

ATC

P

0

Short-Run Profits in
Monopolistic Competition
LO: 9-2
9-5
Long-Run Profits in
Monopolistic Competition
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D in SR

ATC
Economic
Profit
Q

ATC

P

0

D in LR

P=
ATC

LO: 9-2
9-6
Quantity
P
r
i
c
e

a
n
d

C
o
s
t
s

MR = MC
MC
MR
D
3
ATC
Q
MC

P
MC
0

P
PC
Q
PC
Price is Higher
Excess Capacity at
Minimum ATC
Monopolistic competition is not efficient
Monopolistic Competition vs.
Pure Competition
LO: 9-2
9-7
Characteristics of
Oligopoly
A few large producers:
Firms are price markers
Firms engage in strategic behavior
Firms profits depend on the
actions of other firms
Homogeneous or differentiated
products:
If products are differentiated, firms
engage in advertising
Blocked entry


Examples:

tires
beer
cigarettes
copper
greeting cards
automobiles
breakfast cereals
airlines

LO: 9-3
9-8
Oligopoly and Game
Theory
Behavior of firms in the oligopoly can be
analyzed using game theory.
Consider an example where two firms (a
duopoly) decide whether to set their price high
or low.
A payoff matrix can be constructed to show the
payoffs (profit) to each firm that result from each
combination of strategies.

Game theory is the study of how people or firms
behave in strategic situations.
LO: 9-3
9-9
RareAirs Price Strategy
U
p
t
o
w
n

s

P
r
i
c
e

S
t
r
a
t
e
g
y

A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
2 competitors
2 price strategies
Each strategy has a
payoff
Greatest combined
profit
Independent actions
stimulate a response
Oligopoly and Game
Theory: Example
LO: 9-4
9-10
RareAirs Price Strategy
U
p
t
o
w
n

s

P
r
i
c
e

S
t
r
a
t
e
g
y

A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
Independently
lowered prices in
expectation of
greater profit leads
to the worst
combined outcome
Eventually low
outcomes make
firms return to
higher prices
There is a gain from
collusion
Oligopoly and Game
Theory: Example
LO: 9-4
9-11
Kinked-Demand Model of
Oligopoly
In the kinked-demand model, oligopolists face
a demand curve based on the assumption that
rivals will ignore a price increase and follow a
price decrease.
An oligopolists rivals will ignore a price increase
above the going price but will follow a price decrease
below the going price.
The demand curve is kinked at this price and the
marginal-revenue curve has a vertical gap.
Price and output are optimized at the kink.
This model helps explain why prices are generally
stable in noncollusive oligopolistic industries.
LO: 9-5
9-12
P
r
i
c
e

P
r
i
c
e

a
n
d

C
o
s
t
s

Quantity Quantity
0 0
P
0
MR
2
D
2
D
1
MR
1
e
f
g
Rivals Ignore
Price Increase
Rivals Match
Price Decrease
Q
0
Competitors and rivals strategize versus each other
Consumers effectively have 2 partial demand curves
and each part has its own marginal revenue part
MR
2
D
2
D
1
MR
1
Q
0
MC
1
MC
2
P
0
e
f
g
Kinked-Demand Model of
Oligopoly
LO: 9-5
9-13
Collusion
Collusion, through price control, may allow oligopolists to
reduce uncertainty, increase profits, and possibly block
potential entry.
If oligopolistic firms produce an identical product and have
identical cost, demand, and marginal-revenue curves, then
each firm can maximize profit using the MR = MC Rule.
Firms will choose the price and quantity according to the MR
= MC Rule, because it is the most profitable price-output
combination.
One form of collusion is the cartel.

A Cartel is a formal agreement among producers to set the price
and the individual firms output levels of a product. One example is
OPEC.
LO: 9-6
9-14
P
r
i
c
e

a
n
d

C
o
s
t
s

Quantity
D
MR=MC
ATC
MC
MR
P
0
A
0
Q
0
Economic
Profit
Effectively Sharing
The Monopoly Profit
Profit Maximization by a
Cartel
Cartel-type oligopoly is inefficient
LO: 9-6
9-15
Obstacles to Collusion
Anti-trust law prevents cartels from forming
Demand and costs may be different across firms
There may be too many firms to coordinate
There are strong incentives to cheat
If rivals charge prices lower than P
o
, then the demand curve of
the firm charging P
o
will shift to the left as its customers turn to
its rivals, and its profits will fall.
The firm can retaliate and cut its price, too. However, all firms
profits would eventually fall.
Recessions increase excess capacity and
strengthen incentives to cheat
High profits attract potential entry.
LO: 9-6
9-16
Oligopoly and Advertising
Positive Effects of Advertising
Enhances competition
Reduces consumers
search time, direct costs,
and indirect costs
Facilitates the introduction
of new products
Negative Effects of Advertising
Alters consumers
preferences in favor of the
advertisers product
Brand-loyalty promotes
monopoly power

Oligopolists have sufficient financial resources to
engage in product differentiation through product
development and advertising.
LO: 9-7
9-17