Chapter 11

Monopolistic
Competition
and Oligopoly
Topics to be Discussed
• Monopolistic Competition
• Oligopoly
• Price Competition
• Competition Versus Collusion: The
Prisoners’ Dilemma

Chapter 1 2
Topics to be Discussed
• Implications of the Prisoners’
Dilemma for Oligopolistic Pricing

• Cartels

Chapter 1 3
Monopolistic Competition
• Characteristics
1) Many firms

2) Free entry and exit

3) Differentiated product

Chapter 1 4
Monopolistic Competition
• The amount of monopoly power
depends on the degree of
differentiation.
• Examples of this very common
market structure include:
– Toothpaste
– Soap
– Cold remedies

Chapter 1 5
Monopolistic Competition
• Toothpaste
– Crest and monopoly power
• Procter & Gamble is the sole producer of
Crest
• Consumers can have a preference for
Crest---taste, reputation, decay preventing
efficacy
• The greater the preference (differentiation)
the higher the price.

Chapter 1 6
Monopolistic Competition
• Question
– Does Procter & Gamble have much
monopoly power in the market for Crest?

Chapter 1 7
Monopolistic Competition
• The Makings of Monopolistic
Competition
– Two important characteristics
•Differentiated but highly substitutable
products
•Free entry and exit

Chapter 1 8
 A Monopolistically Competitive
Firm in the Short and Long Run

$/Q Short Run $/Q Long Run

MC MC

AC AC

PSR

PLR

DSR
DLR

MRSR
MRLR

QSR Quantity QLR Quantity

A Monopolistically Competitive
Firm in the Short and Long Run

• Observations (short-run)
– Downward sloping demand--
differentiated product
– Demand is relatively elastic--good
substitutes
– MR < P
– Profits are maximized when MR = MC
– This firm is making economic profits

Chapter 1 10
A Monopolistically Competitive
Firm in the Short and Long Run

• Observations (long-run)
– Profits will attract new firms to the
industry (no barriers to entry)
– The old firm’s demand will decrease to
DLR
– Firm’s output and price will fall
– Industry output will rise
– No economic profit (P = AC)
– P > MC -- some monopoly power
Chapter 1 11
 Comparison of Monopolistically Competitive
Equilibrium and Perfectly Competitive Equilibrium

Perfect Competition Monopolistic Competition

$/Q $/Q
Deadweight
MC AC loss MC AC

P
PC
D = MR

DLR

MRLR

QC Quantity QMC Quantity

Monopolistic Competition
• Monopolistic Competition and
Economic Efficiency
– The monopoly power (differentiation)
yields a higher price than perfect
competition. If price was lowered to
the point where MC = D,
consumer surplus would increase by
the yellow triangle.

Chapter 1 13
Monopolistic Competition
• Monopolistic Competition and
Economic Efficiency
– With no economic profits in the long
run, the firm is still not producing at
minimum AC and excess capacity
exists.

Chapter 1 14
Monopolistic Competition
• Questions
1) If the market became
competitive, what would happen
to output and price?
2) Should monopolistic competition
be regulated?

Chapter 1 15
Monopolistic Competition
• Questions
3) What is the degree of monopoly
power?
4) What is the benefit of product
diversity?

Chapter 1 16
 Monopolistic Competition
in the Market for Colas and Coffee

• The markets for soft drinks and

coffee illustrate the characteristics of
monopolistic competition.

Chapter 1 17
Elasticities of Demand for
Brands of Colas and Coffee

Brand Elasticity of Demand

Colas: Royal Crown -2.4

-5.7 Coke -5.2 to
Ground Coffee: Hills Brothers -7.1
Maxwell House -8.9
Chase and Sanborn -5.6

Chapter 1 18
Elasticities of Demand for
Brands of Colas and Coffee

• Questions
1) Why is the demand for Royal
Crown more price inelastic than for
Coke?
2) Is there much monopoly power in
these two markets?
3) Define the relationship between
elasticityChapter
and 1
monopoly 19
Oligopoly
• Characteristics
– Small number of firms
– Product differentiation may or may not
exist
– Barriers to entry

Chapter 1 20
Oligopoly
• Examples
– Automobiles
– Steel
– Aluminum
– Petrochemicals
– Electrical equipment
– Computers

Chapter 1 21
Oligopoly
• The barriers to entry are:
– Natural
• Scale economies
• Patents
• Technology
• Name recognition

Chapter 1 22
Oligopoly
• The barriers to entry are:
– Strategic action
• Flooding the market
• Controlling an essential input

Chapter 1 23
Oligopoly
• Management Challenges
– Strategic actions
– Rival behavior

• Question
– What are the possible rival responses to
a 10% price cut by Ford?

Chapter 1 24
Oligopoly
• Equilibrium in an Oligopolistic Market
– In perfect competition, monopoly, and
monopolistic competition the producers
did not have to consider a rival’s
response when choosing output and
price.
– In oligopoly the producers must consider
the response of competitors when
choosing output and price.
Chapter 1 25
Oligopoly
• Equilibrium in an Oligopolistic Market
– Defining Equilibrium
• Firms doing the best they can and have no
incentive to change their output or price
• All firms assume competitors are taking rival
decisions into account.

Chapter 1 26
Oligopoly
• Nash Equilibrium
– Each firm is doing the best it can given
what its competitors are doing.

Chapter 1 27
Implications of the Prisoners’
Dilemma for Oligipolistic Pricing

• Observations of Oligopoly Behavior

1) In some oligopoly markets, pricing
behavior in time can create a
predictable pricing
environment and implied collusion
may occur.

Chapter 1 28
Implications of the Prisoners’
Dilemma for Oligipolistic Pricing

• Observations of Oligopoly Behavior

2) In other oligopoly markets, the
firms are very aggressive and
collusion is not possible.
• Firms are reluctant to change price because
of the likely response of their competitors.
• In this case prices tend to be relatively rigid.

Chapter 1 29
The $/Q
Kinked Demand Curve
If the producer raises price the
competitors will not and the
demand will be elastic.

If the producer lowers price the

competitors will follow and the
demand will be inelastic.

Quantity

Chapter 1 30
MR
The $/Q
Kinked Demand Curve
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.

MC’

P* MC

Q* Quantity

Chapter 1 31
MR
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing

Price Signaling & Price Leadership

• Price Signaling
– Implicit collusion in which a firm
announces a price increase in the hope
that other firms will follow suit

Chapter 1 32
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing

Price Signaling & Price Leadership

• Price Leadership
– Pattern of pricing in which one firm
regularly announces price changes that
other firms then match

Chapter 1 33
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing

• The Dominant Firm Model

– In some oligopolistic markets, one large
firm has a major share of total sales,
and a group of smaller firms supplies
the remainder of the market.
– The large firm might then act as the
dominant firm, setting a price that
maximized its own profits.

Chapter 1 34
Cartels
• Characteristics
1) Explicit agreements to set output
and price

2) May not include all firms

Chapter 1 35
Cartels
• Characteristics
3) Most often international
– Examples of – Examples of
successful cartels unsuccessful
• OPEC cartels
• International • Copper
Bauxite • Tin
Association • Coffee
• Mercurio Europeo • Tea
• Cocoa

Chapter 1 36
Cartels
• Characteristics
4) Conditions for success
• Competitive alternative sufficiently deters
cheating
• Potential of monopoly power--inelastic
demand

Chapter 1 37
Cartels
• Comparing OPEC to CIPEC
– Most cartels involve a portion of the
market which then behaves as the
dominant firm

Chapter 1 38
Cartels
• About OPEC
– Very low MC
– TD is inelastic
– Non-OPEC supply is inelastic
– DOPEC is relatively inelastic

Chapter 1 39
Cartels
• Observations
– To be successful:
• Total demand must not be very price elastic
• Either the cartel must control nearly all of
the world’s supply or the supply of noncartel
producers must not be price elastic

Chapter 1 40
The Cartelization
of Intercollegiate Athletics

• Observations
1) Large number of firms (colleges)

2) Large number of consumers (fans)

3) Very high profits

Chapter 1 41
The Cartelization
of Intercollegiate Athletics

• Question
– How can we explain high profits in a
competitive market? (Hint: Think cartel
and the NCAA)

Chapter 1 42
Summary
• In a monopolistically competitive
market, firms compete by selling
differentiated products, which are
highly substitutable.

• In an oligopolistic market, only a few

firms account for most or all of
production.

Chapter 1 43
Summary
• In the Cournot model of oligopoly,
firms make their output decisions at
the same time, each taking the
other’s output as fixed.

• In the Stackelberg model, one firm

sets its output first.

Chapter 1 44
Summary
• The Nash equilibrium concept can
also be applied to markets in which
firms produce substitute goods and
compete by setting price.

• Firms would earn higher profits by

collusively agreeing to raise prices,
but the antitrust laws usually prohibit
this.
Chapter 1 45
Summary
• The Prisoners’ Dilemma creates price
rigidity in oligopolistic markets.

• Price leadership is a form of implicit

collusion that sometimes gets around
the Prisoners Dilemma.

• In a cartel, producers explicitly

collude in setting prices and output
levels. Chapter 1 46
End of Chapter
12
Monopolistic
Competition
and Oligopoly