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Monopolistic Competition and Oligopolies
Lesson 11


Monopolistic Competitive Markets

Market structures

Social welfare is lowest Social welfare is highest

(1 - firm)
(Several firms)
Pure Competition
  • Monopolistic Competitive Market - similar to a purely competitive market, but firms have a touch of monompoly power
    • Called a price searcher
    • Many firms in market, but not as many as pure competition
      • Producers are independent
      • Collusion is not possible
    • Low entry barriers
      • If one firm earns economic profit, then new firms enter the market
    • Produce differentiated products
      • Give s little monopoly power
      • Face a downward sloping demand curve
      • Different from competitors' products
      • Nonprice competition - compete in other areas other than price
        • Product quality - physical or qualitative differences
          • Sony TV vs. Goldstar TV
        • Services - condition surrounding the sale of a product
          • Friendly sales clerk
        • Location and accessibility
          • Gas station versus store, when buying Pepsi.
        • Promotion, packaging, and brand names - imaginary or real differences in quality
    • Use advertising to create differentiated product



1. Pros.
  • Advertising -
    • Provides information; informs consumers about new products
    • Provides revenue to TV, radio stations & internet
    • Is successful when based on a product's uniqueness
    • Allows firms to expand output and realize greater economies of scale. Consumers buy more
    • Promotes competition.

2. Cons.

  • Advertising -
    • Persuades and not informs
    • Promotes artificial distinctions
    • Higher costs to consumers
      • Contributes little to human well-being
    • Has large social cost, if people are enticed to smoke cigarettes or drink alcohol
    • Tends to be self-canceling
      • If Pepsi spends $1 million on advertising, then Coca-Cola will match or exceed that.
    • May promote growth for monopolies
      • High advertising costs create a barrier
      • $1 million in advertising to enter into new market

Price and Output for Monopolistic Competition

Price searchers face a downward-sloping highly-elastic demand curve
  • Monopolistic competitive firm faces a downward sloping demand function
    • Created from product differentiation
    • Not as steep as a monopoly
      • Demand function is more elastic
    • If firm raises price to much, then consumers can switch to competitor
  • Monopolistic competitive firms do not have an incentive to increase market price
    • Shown below in graph
    • Demand function is elastic
    • Original price and quantity is (P1, and q1)
      • q is production for a firm
    • Lower price to P2 and increasing production to q2 causes revenue to change
    • Red area is revenue loss and green area is revenue gained
    • The price decrease lowers total revenue for the firm
  • These firms maximize profuts when MR = MC
    • A price searcher expands output when MR > MC
    • A price searcher contracts output when MC > MR
    • However, P > MC, because demand function is downward sloping
      • Note allocative efficient
Monopolistic Competitive Firm
Price Price, Per-Unit Costs
demand and marginal revenue for a price searcher Profits for a price searcher
Quantity Quantity
  1. If firms are making economic profits, then rival firms will enter the market.
      • SR supply increases.
      • Market price decreases
    • Each firm's demand and MR curves will shift inward until economic profits are eliminated.
    • Example: 10 shoe companies
      • 10 more companies enter the shoe market
      • Customers have more choices and spread out their consumption over 20 firm's products
      • Each firm experiences a decrease in demand for their product
  2. Economic losses cause price searchers to exit from the market.
      • SR supply decreases
      • Market price increases
    • Each firm's demand and MR curve will shift outward until economic losses are eliminated
    • Example: 20 computer companies
      • 10 companies leave the market, because of losses
      • Customers have less choices and focus their consumption on the 10 remaining firm's products.
      • Each firm experiences an increase in demand for their product
Blue arrow Profits and losses determine the size of the industry

Comparing Price Takers to Price Searchers

  • Similarities:
    1. Incentives to innovative and adopt technology that reduces costs
    2. Earn zero economic profit in the long run
      • Economic profits attract new firms to the market
        • Supply increases and curve shifts right
        • Price decreases until firms earn zero economic profit
      • Economic losses cause some firms to leave the market
        • Supply decreases and curve shifts left
        • Price increases until firms earn zero economic profit
  • Differences:
    1. Allocative efficiency - goods desired by consumers are produced at the lowest cost P = MC
      • Pure competitive market is allocative efficient
        • P = MR = MC
      • Monopolistic competitive market is not allocative efficient
        • P > MR = MC
    2. Productive efficiency - goods are produced at minimum long-run costs
        • P = min ATC
      • Price taker is productive efficient
      • Price searcher is not productive efficient
        • Producing less output at a higher price
        • Too much duplication
          • Many restaurants, gas stations, & stores
          • Consolidate them so they produce larger output
Price Taker Price Searcher with low entry barriers
Price Price
Purely competitive firm is earning zero economic profits Price searcher is earning zero economic profits
Quantity Quantity
Blue arrow Historically, economist criticized monopolistic competitive markets. Recently economists are more positive about them, because consumers have a variety of quality and styles to choose from.

Characteristics of Oligopoly

Oligopoly - small number of rival firms in the market

  • Characteristics
    1. Mutual interdependence - a firm has to consider the competitors, when deciding prices, production level, or product quality
      • The rival firms react to the firm's decision
    2. Mergers - a firm can buy other firms and combine them into one company.
      • Firm controls a larger market share and could gain more monopoly power
    3. Oligpopolies have entry barriers
      • Example: Automobile industry - economies of scale.
      • To achieve low-per unit costs, a car manufacturer has to produce over a million cars.
      • If demand is only 6 million cars, then the market cannot support more than 6 firms.
    4. Products may be identical (homogeneous) or differentiated
      • Identical products - milk, cement, gasoline, etc.
      • Differentiated products - sodas, shoes, computers, etc.
      • Use product style, quality, and advertising
    5. Example - Beer industry
      • In 1947, beer industry had over 400 independent breweries
      • In 1967, there were 124 suppliers
      • In 1980, there were 33
      • Currently, four brewing companies dominate the U.S. market
        • Anheuser-Busch - 49% of market
        • SABMiller - 20% of market
        • Coors
        • Pabst

Market Concentration

Economists use two methods to determine how concentrated a market is

  1. Concentration Ratio - calculate the percentage concentration of the four largest firms in the market
    • If concentration ratio is 0%, no firm has a market share; purely competitive
    • If concentration ratio is 100%, the four largest firms completely dominated the market
  2. Herfindahl index - for each firm, take the percent market share and square, add all firms together
    • Benefit - includes all firms in the market and can tell if market had a monopoly
      • Monopoly - market share is 100%
        • Herfindahl index = 1002 = 10,0000
      • Pure competitive market - market share is 0%
        • Herfindahl index = 02 = 0


Market Concentration Ratio Herfindahl Index
Beer 91 NA
Breakfast Cereals 78 2,521
Cement 11 63
Cigarettes 95 NA
Computers 85 2,662
Motor Vehicles 81 2,321
Women's dresses 13 84

Source: McDonnell and Brue (2008), p.452


  1. Localized markets - a market is for a small area and isolated from other markets
    • The concentration ratio or Herfindahl index is calculated for whole market
    • A firm can dominate a local market
    • Example - cement production seems to be in a competitive market
    • Cement is bulky and has high transportation costs, thus, these firms may be monopolies at the local level
  2. Interindustry Competition - a product in the market may compete with products from other markets
    • Example: Breakfast cereals seems to be a concentrated industry
    • If these companies raise the price too much, consumers may switch to other breakfast foods
  3. International Competition - a concentrated industry may be competing with other large companies from other countries
    • Example: Motor vehicles is a concentrated industry; they compete with car manufacturers from Japan, South Korea, and Germany


Price and Output under Oligopoly

  1. Several theories explain price and output.
    • Strategic behavior (i.e. game theory) - when one firm makes a decision, it has to consider how its rival will respond
    • Many possible scenarios
  2. Two extreme scenarios:
    • Price war - a firm lowers its price to gain a larger market. The other firms will also lower their prices, until economic profit = 0. The firms are independent and no collusion.
      • Outcome is similar to a competitive market.
      • P = long run ATC
      • P = MC
    • Collusion - sellers cooperate together
      • Different levels
      • If firms collude, they lower production levels, causing the market price to increase
      • Opposite of competition.
      • Similar to a monopoly - productive and allocative inefficient
      • Could earn economic profits
    • The outcome may lie between these two extreme outcomes.
  • Note - book explains "kinked" demand.
    • Demand has two demand functions
      • Elastic demand - if competitors do not change their prices, when a firm changes its price
        • A firm can capture more consumers
      • Inelastic demand - if competitors change their price to match a change in a firm's price
        • A firm cannot capture more consumers because other firms lower their price
    • Put the two demand functions together and we have a "kinked" demand function
      • A firm lowers its price to capture more consumers until it hits the point where the kink is.
      • That point is where competitors will also lower their price
Blue arrow The microprocessor market is dominated by Intel and AMD. These two companies are fierce competitors.


  1. Cartel - sellers organize together and make joint decisions
    • Highest form of collusion
    • Example: Organization of Petroleum Exporting Countries (OPEC).
      • 11 Oil producing countries.
        • Algeria
        • Indonesia
        • Iran
        • Iraq
        • Kuwait
        • Libya
        • Nigeria
        • Qatar
        • Saudi Arabia
        • United Arab Emirates
        • Venezuela
      • Successful in increasing oil prices in 1973, early 1980s, and 2000.
        • U.S. entered into a recession a year later.
  2. Obstacles which prevent collusion.
    1. As the number of firms increases, collusion becomes less effective.
      • More difficult to communicate, negotiate, and reach agreements.
        • Many time OPEC could not agree on production quotas.
    2. Firms have different market shares, different costs, etc
      • Firms may have trouble agreeing
    3. Strong incentive to cheat and secretly sell its product
      • Big problem with OPEC
      • Nonprice competition (get around a fixed price)
        • Better quality & service.
        • Larger containers (more for each $)
    4. Low entry barriers.
      • New rivals enter the market because of economic profits.
        • Economic profits decrease.
      • When oil prices are high, new oil wells are opened in Alaska, Oklahoma, Texas, etc.
    5. Unstable demand conditions.
      • Oligopolists are uncertain how consumers will react.
      • In long run, consumer reduced demand for gas.
        • Bought fuel efficient cars.
        • Traveled less.
        • Moved closer to work, etc.
      • Economy enters recession
        • Consumers lower their spending, the cartel could breakup if they cannot sell their quotas
    6. Antitrust laws
      • It is illegal to collude in the U.S.
      • As the threat of getting caught increases, firms are less likely to collude.
  3. Tacit understandings (i.e. Gentlemen's agreements) - competitors verbally agree and commit to the agreement by shaking hands
    • CEOs of rival companies playing golf together and talk about business
  4. Price Leadership - one firm in the industry is the price leader and the others are followers
    • No collusion!
    • Examples of price leaders
      • General Motors - automobile market
      • Kellogg - breakfast cereal market
      • American Airlines - air travel market
    • Characteristics
      • Price changes are infrequently
        • For car industry, new prices are announced in the fall
      • A firm publicly announces a price change
      • A leader may not want to choose a price that maximizes profits
        • May choose a lower price to discourage new rivals into market


Contestable Market and Potential Competition

Contestable market- a highly competitive market because of potential competition

  • Few sellers
  • Low entry and exit costs
  • Example: Airline industry
    • Airline route between Salt Lake City and Albuquerque are served by two airlines.
    • A high barriers industry because airplanes cost millions of dollars plus facilities for tickets, baggage, etc.
    • The two airlines could collude and drive up the price
    • If two airlines are making a economic profit, other airlines can switch routes with very little cost, driving profits to zero.
  • Firms earn zero economic profit in long run.
Blue arrow Government can make market more competitive by reducing entry barriers and encouraging potential competition.

The Prisoner's Dilemma & Game Theory

A simple game theory example. Two firms have an advertising war.
  • Assumptions.
    1. Two firms: Coca-Cola & Pepsi
    2. No collusion
    3. If both firms have the same advertising budget, then each firm has 1/2 the market
      • Both firms earn the same profit.
      • If one firm has a larger advertising budget
        • Has more than 1/2 the market.
        • Earns more profit.

Starting in cell A.

  • Starting in Cell A, firms have the same advertising budget and a profit of $1,000 each.
  • Pepsi decides to advertise more and we move to cell C.
  • Pepsi has more of the market, a profit of $1,200, while Coca-Cola's profit is $600.
  • Coca-Cola increases its advertising budget and we move to cell D.
  • Firms will be better off at cell A, but end up at cell D.
    • Strong incentive to collude.
  • Same thing happens if we start in Cell A and Coca-cola increases its advertising.
    Small Ad, Budget         Large Ad. Budget
"Pepsi Small Ad. Budget

Large Ad. Budget
Prisoner's dilemma



  • monopolistic competitive market
  • product differentiation
  • nonprice competition
  • oligopoly
  • homogeneous oligopoly
  • differentiated oligopoly
  • mutual interdependence
  • mergers
  • concentration ratio
  • localized markets
  • interindustry competition
  • international competition
  • Herfindahl index
  • strategic behavior
  • game theory
  • collusion
  • kinked-demand curve
  • price war
  • cartel
  • tacit understandings
  • price leadership

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