Chapter 9: Monopolistic Competition and Oligopoly

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Chapter 9: Monopolistic Competition and OligopolyCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Monopolistic Competition Monopolistic competition is a market structure in which many firms sell a differentiated product and entry into and exit from the market are relatively easy. Examples: furniture, jewelry, leather goods, grocery stores, gas stations, restaurants, clothing stores and medical care.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Characteristics of Monopolistic CompetitionRelatively large number of sellers – firms have small market shares, collusion is unlikely and each firm can act independently Differentiated products – the product is slightly different and is often promoted by heavy advertising Easy entry to, and exit from, the industry – economies of scale are few, capital requirements are low but financial barriers existCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Differentiated ProductsProduct differentiation is a form of nonprice competition in which a firm tries to distinguish its product or service from all competing ones on the basis of attributes such as design and quality. Production differentiation entails product attributes, service, location, brand name and packaging, and some control over price.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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AdvertisingThe goal of product differentiation and advertising is to make price less of a factor in consumer purchases and make product differences a greater factor. The intent is to increase the demand for a product and to make demand less elastic.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Pricing and Output in Monopolistic CompetitionThe demand curve of a monopolistically competitive firm is highly, but not perfectly, elastic. The price elasticity of demand for a monopolistic competitor depends on the number of rivals and the degree of product differentiation. The larger the number of rival firms and the weaker the product differentiation, the greater the price elasticity of each firm’s demand.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Short Run: Profit or LossCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. The monopolistically competitive firm maximizes profit or minimizes 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.

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The Long Run: Only a Normal ProfitCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.In the long-run, firms will enter a profitable monopolistically competitive industry and leave an unprofitable one. A monopolistic competitor will earn only a normal profit and price just equals average total cost at the MR = MC output.

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The Long Run: Only a Normal ProfitBecause entry to the industry is relatively easy, economic profits attract new rivals. As new firms enter, the demand curve faced by the typical firm shifts to the left, reducing its economic profit. When entry of new firms has reduced demand to the extent that the demand curve is tangent to the ATC curve at the profit-maximizing output, the firm is just making a normal profit, leaving no incentive for new firms to enter.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Long Run: Only a Normal Profit When the industry suffers short-run losses, some firms will exit in the long run. As firms exit, the demand curve of surviving firms begins to shift to the right, reducing losses until the firms are just making normal profit.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Pricing and Output in Monopolistic CompetitionCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Monopolistic Competition and EfficiencyCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.In monopolistic competition, neither productive nor allocative efficiency occurs in long-run equilibrium. Since the firm’s profit-maximizing price (and average total cost) slightly exceed the lowest average total cost, productive efficiency is not achieved. Since the profit-maximizing price exceeds marginal cost, monopolistic competition causes an underallocation of resources.

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Excess CapacityCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.The gap between the minimum ATC output and the profit-maximizing output is a monopolistically competitive firm’s excess capacity. Plants and equipment are unused because the firm is producing less than the minimum- ATC output. Monopolistically competitive industries are overcrowded with firms each operating below its optimal capacity.

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Product Variety and ImprovementCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.Despite the overcrowded feature, monopolistic competition does promote product variety and product improvement. A firm earning a normal profit will develop and improve its product in order to regain its economic profit. Successful product improvements by one firm obligates rivals to imitate or improve on that firm’s temporary market advantage or else lose business.

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Oligopoly Oligopoly is a market structure dominated by a few large producers of homogeneous or differentiated products. Because of their “fewness”, oligopolists have considerable control over their price. Examples: tires, beer, cigarettes, copper, greeting cards, steel, aluminum, automobiles and breakfast cerealsCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Characteristics of OligopolyA few large producers – firms are generally large and together they dominate the industry. Either homogeneous or differentiated products – the products are standardized, or differentiated with heaving advertising. Price maker – the firm can set its price and output levels to maximize its profit.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Characteristics of OligopolyStrategic behavior – Self-interested behavior that takes into account the reactions of others. Mutual interdependence – each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms. Blocked entry – barriers to entry exist which make it hard for new firms to enter.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Oligopoly Behavior: A Game-Theory OverviewGame theory is the study of how people or firms behave in strategic situations. It can be used to analyze the pricing behavior of oligopolists. Suppose in a two-firm oligopoly (a duopoly), each firm must chose a pricing strategy, high or low. A payoff matrix can be constructed to show payoffs (profit) to each firm that result from each combination of strategies.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Game Theory ExampleTwo firms, A and B, must decide on a pricing strategy: price high or price low. Although firms A and B are mutually interdependent, both can benefit from collusion. However, there may be incentive to cheat.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.Firm AFirm BPrice High Price LowPrice HighPrice Low$12$12$8$8$6$6$15$15BA

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Mutual InterdependenceEach firm’s profit depends on its own pricing strategy and that of its rival. In the example, if both firms adopt a high-price strategy, each firm will earn $12 million; if both adopt a low-price strategy, each will earn $8 million. If one firm adopts a low-price strategy while the other adopts a high-price strategy, the low-price firm will earn $15 million while the other firm earns $6 million.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Collusive TendenciesOligopolists can often benefit from cooperation, or collusion. Collusion is a situation in which firms act together and in agreement to fix prices, divide markets, or otherwise restrict competition. In the example, firms A and B can agree to establish and maintain a high-price strategy so each can earn $12 million.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Incentive to CheatOligopolists might have an incentive to cheat on a collusive agreement if they can benefit from such action. In the example, suppose firms A and B agree to establish and maintain a high-price strategy. Either firm can cheat and lower its price in order to increase profit to $15 million (a $3 million increase).Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Incentive to CheatBecause of possible incentives to cheat, independent action by oligopolists may lead to mutually “competitive” low-price strategies, which benefit consumers but not the oligopolists. In the example, firms A and B will choose a low-price strategy and earn $8 million each.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Kinked-Demand ModelIn 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 oligopolist’s rivals will ignore a price increase above the going price but 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.Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Kinked-Demand ModelCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Price LeadershipPrice leadership involves an implicit understanding that other firms will follow the lead when a certain firm in the industry initiates a price change. A price leader is likely to observe the following tactics: Infrequent price changes Communications Avoidance of price warsCopyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

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Last Updated: 8th March 2018

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