Monopolistic Competition

and Oligopoly
CHAPTER 13

Profits, like sausages, are esteemed

most by those that know least
about what goes into them.
Alvin Toffler
Futurist, Author
(1928 - )
CHAPTER CHECKLIST

When you have completed your study of this

chapter, you will be able to

1 Explain how price and quantity are determined in

monopolistic competition.
2 Explain why selling costs are high in monopolistic
competition.

3 Explain the dilemma faced by firms in oligopoly.

4 Use game theory to explain how price and quantity are

determined in oligopoly.
MARKET CHARACTERISTICS

Perfect Competition Monopoly

Monopolistic
Competition
Many, many, many, many Relatively many sellers, little One seller that likely can
sellers, none so large that they influence on price influence price
can influence price
Homogeneous product (buyers Heterogeneous products, with Heterogeneous product,
don’t care who they by from) substitutes no close substitutes

No barriers to entry or exit (easy Low to no barriers to entry or HIGH barriers to entry or
to get in and out of market) exit exit

Long run economic profit = zero Long run economic profit = Long run economic profit
(only earning normal profit) zero (only earning normal profit) is positive

Firms are price takers (no Firms have power over their Firms are price makers
market power, so market sets own pricing because (lots of market power,
same price for all firms) producing different, but market IS the firm)
similar, products
13.1 MONOPOLISTIC COMPETITION

Relatively Large Number of Firms

• Fewer than perfect competition.

• Three implications are:

– Small market share
– No market dominance
– Collusion impossible
13.1 MONOPOLISTIC COMPETITION

Product Differentation
Product differentiation - making a product that
is slightly different from the products of
competing firms.
•A differentiated product has close substitutes, but not
perfect substitutes.
•When the price of one firm’s product rises, the quantity
demanded of that firm’s product decreases.
13.1 MONOPOLISTIC COMPETITION

Competition on Quality, Price, and Marketing

Quality
Design, reliability, after-sales service, and buyer’s
ease of access to the product.
Price
Because of product differentiation, the demand
curve for the firms’ product is downward sloping.
Marketing
Advertising and packaging.
13.1 MONOPOLISTIC COMPETITION

 Entry and Exit

Low to no barriers to entry, so the firm is
unlikely to make economic profit in the long run.

These firms are monopolistic in

 Examples: that each one has a monopoly
•Restaurants on their brand, image, service,
•Gas stations ambience, menu, etc. They are
•Hair salons competitive in the sense that
•Dry Cleaners there are many, many of them,
and consumers can easily sub
one for another.
Industry Concentration

Concentration ratio – percentage of sales accounted for

by specified number of top firms in a market.
• Usually reported as 4-firm, 8-firm, or 20-firm.
• The higher the concentration ratio, the greater the
degree of market dominance by small number of
firms.
• The range of concentration ratio is from almost zero
for perfect competition to 100 percent for monopoly.
• Can distinguish between market structures by
concentration ratio
Industry Concentration

% of GDP
CR1 > 90% Effective monopoly 2-3%

CR4 > 60% Tight oligopoly 10%

CR4 between Loose oligopoly 12%

40% & 60%
CR4 < 40% Effectively competitive 75%
PC and monopolistic
competition
Industry Concentration

Herfindahl-Hirschman Index (HHI) – sum of the squared

market shares of all firms.

• HHI = s12 + s22 + . . . .sn2

• Ranges from 10,000 for pure monopolist to zero for

infinite number of small firms.
• The more unequal the market share, the higher the HHI
value. The greater the number of firms, the lower the
HHI.
Industry Concentration

• Increases in concentration typically yield increased

prices and profits, ceteris paribus.

• Squaring gives greater weight to larger shares.

• Example: If there are five firms in a market with

market shares of 40%, 30%, 16%, 10% and 4%:

HHI = 402 + 302 + 162 + 102 + 42 = 2,872

Industry Concentration

Level Ratio / Range Firm Structure

Extreme High 10,000 Only one firm

High 1,800 up High concentration
Medium 1,000-1,800 Moderately competitive
Low 1,000 down Very competitive
Extreme Low Nearly zero Infinite number firms
13.1 MONOPOLISTIC COMPETITION

The Firm’s Profit-Maximizing Decision

The firm in monopolistic competition makes
its output and price decision just like a
monopoly firm does (MC=MR).
13.1 MONOPOLISTIC COMPETITION

1. Profit is maximized
when MR = MC.
2. The profit-maximizing
output is 125 pairs of
Tommy jeans per day.

3. The profit-maximizing
price is $75 per pair.
ATC is $25 per pair, so
4. The firm makes an
economic profit of
$6,250 a day.
13.1 MONOPOLISTIC COMPETITION

Long Run: Zero Economic Profit

• Economic profit induces entry and economic loss
induces exit, as in perfect competition.
• Entry decreases the demand for the product of each
firm. (demand curve shifts left)
• Exit increases the demand for the product of each
firm. (demand curve shifts right)
• In the long run, economic profit is competed away
and firms earn normal profit.
 13.1 MONOPOLISTIC COMPETITION

1. In LR, the output

that maximizes profit
is 75 pairs of
Tommy jeans a day.

2. The price is $50 per

pair. Average total
cost is also $50 per
pair.

3. Economic profit is
zero.
 Equilibrium in Monopolistic Competition

The short run The long run

Price or Cost (dollars per unit)

Price or Cost (dollars per unit)

MC MC
F ATC
pa ATC
G
pg Initial
ca Demand demand
K
Later
MR demand
0 qa 0 qg Later MR
Quantity (units per period) Quantity(units per period)
13.1 MONOPOLISTIC COMPETITION

Monopolistic Competition and Efficiency

• Efficiency requires that the MB of the consumer equal
the MC of the producer.
• Price measures marginal benefit, so efficiency requires
P=MC.
• In monopolistic competition, P > MR and MR=MC, so P
> MC – a sign of inefficiency.
• Demand curve can’t lie tangent to minimum ATC, so
tangency is at higher ATC – inefficient.
13.1 MONOPOLISTIC COMPETITION

• But this inefficiency arises from product differentiation

—variety—that consumers value and for which they
are willing to pay.
• So the loss that arises because MB > MC must be
weighed against the gain that arises from greater
product variety.
• In a broader view of efficiency, monopolistic
competition brings gains for consumers.
• But firms in monopolistic competition always have
excess capacity in long-run equilibrium.
13.1 MONOPOLISTIC COMPETITION

Excess Capacity
Excess capacity - quantity produced is less
than the quantity at minimum ATC.

• Efficient scale = quantity at minimum ATC.

• Figure 13.3 on the next slide illustrates excess
capacity.
 13.1 MONOPOLISTIC COMPETITION

1. The efficient scale is 100

pairs of Tommy jeans a
day. (min ATC)
2. The firm produces less
than the efficient scale and
has excess capacity.
3. Price exceeds 4. marginal
cost.
5. Deadweight loss arise.
 MARKET CHARACTERISTICS
Perfect Competition Monopolistic Monopoly
Competition Oligopoly
Many, many, many, many Relatively many sellers, Few (usually 3-5) One seller that likely
sellers, none so large that little influence on price sellers, but little direct can influence price
they can influence price price control because
of rivals

Homogeneous product Heterogeneous products, Heterogeneous Heterogeneous

(buyers don’t care who with substitutes product, but rivals are product, no close
they by from) close substitutes substitutes

No barriers to entry or exit Low to no barriers to HIGH barriers to entry HIGH barriers to
(easy to get in and out of entry or exit
market)
Long run economic profit = Long run economic profit Long run economic Long run economic
zero (only earning normal = zero (only earning normal profit is positive profit is positive
profit) profit)

Firms are price takers (no Firms have power over Firms are price makers Firms are price makers
market power, so market their own pricing becausebecause their output (lots of market power,
sets same price for all producing different, but influences price market IS the firm)
firms) similar, products
13.3 OLIGOPOLY
Tight oligopoly – concentration ratio > 60
• Duopoly - market in which there are only two producers.

Loose oligopoly – concentration ratio between 40 and 60.

Firms in an oligopoly are closely interdependent. Price

and output changes will impact rivals, and likely draw
some reaction from the rival firms.

Examples: airlines, aircraft, soft drinks, cellular service,

computer chips, athletic shoes, cigarettes.
 OLIGOPOLY
The Battle for Market Shares
Increased sales on the part of one firm will
be noticed immediately by the other firms.
 Increases in the market share of one oligopolist will
reduce the shares of the remaining oligopolists.
 There isn’t any way that a firm can do so without
causing alarms to go off in the industry.
 An attempt by one oligopolist to increase its market
share by cutting prices will lead to a general reduction in
the market price, eventually harming everyone.
 This is why oligopolists avoid price competition and
instead pursue non-price competition.
OLIGOPOLY
NON-PRICE COMPETITION
 Product differentiation – Features that make one
product appear different from competing products in the
same market.
 Advertising - strengthens brand loyalty, and makes it
expensive for new producers to enter the market
 Training - Customers of training-intensive products
(computer hardware, software) become familiar with a
particular system. Creates barriers to later competition.
 Network Economies - The widespread use of a particular
product may heighten its value to consumers, thereby
making potential substitutes less viable.
 OLIGOPOLY
The Kinked Demand Curve
Close interdependence between firms
 The degree to which sales increase when the
price is reduced depends on the response of rival
oligopolists.
 We expect oligopolists to match any price

cuts by rival oligopolists.

 Rival oligopolists may not match price

increases in order to gain market share.
The Kinked Demand Curve
OLIGOPOLY

The shape of the demand curve facing an

oligopolist depends on how its rivals
respond to a change in the price of its own
output.

The demand curve will be “kinked” if rival

oligopolists match price cuts, but not price
increases.
 Price Rigidity (Kinked Demand)
• Oligopolistic firms are interdependent – when one firm
changes, others will have to consider whether action is
required on their part.
• Firms tend to match price cuts and NOT match price
increases.
• When firm cuts price, Q will increase – if other firms also
cut price, increase in Q will be minimal (inelastic)
• When firm raises price, Q will decrease. If other firms do
not raise their price, increase in Q will be more
substantial (elastic).
• Difference in relative elasticity will cause kink in demand
curve at current price.
P1

Dnomatch

MR
nom
atch
MR m

Dmatch
atch

Q1
P1

Dnomatch

MR
nom
atch
MR m

Dmatch
atch

Q1
 Profit max output is
where the MR curve
is discontinuous
(where MC runs
MC3 thru discontinuity).
Marginal costs can
MC2 increase or
P1 decrease without
changing profit max
MC1
output as long as
MC stays in gap.

MR

D
Q1
 Response by
other firms tends
to discourage this
MC3 firm from
changing price,
MC2 keeping prices
P1 stable (price
rigidity).
MC1

MR

D
Q1
Oligopoly
OLIGOPOLYvs. Competition
Oligopolists may try to coordinate their behavior
in a way that maximizes industry profits.

 An oligopoly will want to behave like a

monopoly, choosing a rate of industry output
that maximizes total industry profit.
 To maximize industry profit, the firms in an
oligopoly must agree on a monopoly price and
agree to maintain it by limiting production and
allocating market shares.
13.3 OLIGOPOLY
Collusion
When a small number of firms share a market,
they can increase their profit by forming a cartel
and acting like a monopoly.
Cartel - group of firms acting together to limit
output, raise price, and increase economic
profit.
•Firms would behave collectively like a multi-firm profit-
maximizing monopolist
•Cartels are illegal in U.S., but they can operate covertly in
some markets.
OLIGOPOLY
Price Fixing
• Explicit agreement among producers about price at
which goods will be sold.

• The most explicit form of coordination among

oligopolists.

• NOT LEGAL.
 Examples ofof
Examples Price Fixing
Price Fixing
Coca Cola – The Coca-Cola Bottling Co. of North Carolina agreed to
pay a fine and give consumers discount coupons to settle charges
of conspiring to fix soft-drink prices from 1982 to 1985.
School Milk – Between 1988 and 1991, the U.S. Justice Department
filed charges against 50 companies for fixing the price of milk sold
to public schools in 16 states.
Beer – In 2007, the European Commission fined Heineken and three
other beer producers €273.7 (about $380 million) for operating a
price fixing cartel in Holland. The beer cartel operated between
1996 and 1999 in the EU market.
Cases currently pending in court:
Chocolate – Hershey’s, Mars, Nestle and Cadbury (control 75% of
chocolate candy industry) accused of conspiring to fix prices since
2002.
– Accused of price fixing and squeezing out internet
competition by colluding with manufacturers on prices.
OLIGOPOLY
Price Leadership (Dominant Firm Strategy)
• Often one firm in oligopolistic market owns dominant
market share.
• Dominant firm can establish profit max price based on
their cost structure, then smaller, or less aggressive,
firms behave as price takers.

• Example: Airlines
13.4 GAME THEORY

Game theory is the tool used to analyze

strategic behavior—behavior that
recognizes mutual interdependence and
takes account of the expected behavior of
others.
13.4 GAME THEORY

What Is a Game?
All games involve three features:
• Rules
• Strategies
• Payoffs

Prisoners’ dilemma is a game between two

prisoners that shows why it is hard to
cooperate, even when it would be beneficial
to both players to do so.
13.4 GAME THEORY

The Prisoners’ Dilemma

Art and Bob are caught stealing a car: sentence
is 2 years in jail.
DA wants to convict them of a big bank robbery:
sentence is 10 years in jail.
DA has no evidence and to get the conviction,
he makes the prisoners play a game.
13.4 GAME THEORY

Rules
Players cannot communicate with one another.
• If both confess to the larger crime, each will receive a
sentence of 3 years for both crimes.
• If one confesses and the accomplice does not,
the one who confesses will receive a 1-year sentence,
while the accomplice receives a
10-year sentence.
• If neither confesses, both receive a 2-year sentence.
13.4 GAME THEORY

Strategies
The strategies of a game are all the possible
outcomes of each player.
The strategies in the prisoners’ dilemma are
• Confess to the bank robbery.
• Deny the bank robbery.
13.4 GAME THEORY

Payoffs
Four outcomes:
• Both confess.
• Both deny.
• Art confesses and Bob denies.
• Bob confesses and Art denies.
A payoff matrix is a table that shows the payoffs
for every possible action by each player given
every possible action by the other player.
13.4 GAME THEORY

Table 13.5
shows the
prisoners’
dilemma payoff
matrix for Art and
Bob.
13.4 GAME THEORY
Equilibrium
•Occurs when each player takes the best possible action given
the action of the other player.

•Nash equilibrium is an equilibrium in which each player takes

the best possible action given the action of the other player.

•The Nash equilibrium for Art and Bob is to confess.

•The equilibrium of the prisoners’ dilemma is not the best

outcome possible for the players, but is the best option if players
don’t know what the other is doing.
13.4 GAME THEORY

The Duopolists’ Dilemma as a Game

The dilemma of Boeing and Airbus is similar
to that of Art and Bob.
Each firm has two strategies. It can produce
airplanes at the rate of:
• 3 a week
• 4 a week
13.4 GAME THEORY

Because each firm has two strategies, there

are four possible combinations of actions:
• Both firms produce 3 a week (monopoly outcome).
• Both firms produce 4 a week.
• Airbus produces 3 a week and Boeing produces 4
a week.
• Boeing produces 3 a week and Airbus produces 4
a week.
13.4 GAME THEORY

The Payoff Matrix

Table 13.6 shows
the payoff matrix
as the economic
profits for each
firm in each
possible
outcome.
 13.4 GAME THEORY

Equilibrium of the
Duopolists’ Dilemma
Both firms produce 4 a
week.

Like the prisoners, the

duopolists fail to
cooperate and get a
worse outcome than
the one that
cooperation would
deliver.
13.4 GAME THEORY
Collusion Is Profitable but Difficult to Achieve
•The duopolists’ dilemma explains why it is difficult for firms to
collude and achieve the maximum monopoly profit.

•Even if collusion were legal, it would be individually rational for

each firm to cheat on a collusive agreement and increase output.

•In OPEC, member countries frequently break the cartel agreement

and overproduce (more players = more difficult to prevent
cheating).
13.4 GAME THEORY
Advertising Game
Coke and Pepsi have two
strategies: advertise or not
advertise.

Table 13.8 shows the

payoff matrix as the
economic profits for each
firm in each possible
outcome.
13.4 GAME THEORY

The Nash equilibrium for this

game is for both firms
advertise.

But they could earn a

larger joint profit if they
could collude and not
advertise.
13.4 GAME THEORY

Is Oligopoly Efficient?

• In oligopoly, price usually exceeds marginal cost.
• So the quantity produced is less than the efficient
quantity.
• Oligopoly suffers from the same source and type of
inefficiency as monopoly.