ECON 11026

Week 5
Chapter 6

Monopolistic
competition &
Oligopoly
Learning Objectives
6.1 Monopolistic competition; assumptions of
monopolistic competition
6.2 Oligopoly; what happens if there are just a few
firms that dominate the market?
6.3 Game theory; what strategic games are
oligopolists likely to play and what determines the
results of these games?
6.4 Price discrimination; in what situations will firms
be able to charge different prices to different
consumers?

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Monopolistic competition
Assumptions of monopolistic competition:
• Large number of firms
• Independence of firms
• Freedom of entry & exit
• Product differentiation.

Examples in Australia:
• Petrol stations, hairdressers, restaurants
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Monopolistic competition
• Equilibrium of the firm- Short run:
 MC=MR

 AR and MR are more elastic

 producing differentiated product may earn short-run
profit.
• Long run
 short-run supernormal profit will attract new firms
 demand for the established firm’s product will fall
 only normal profits remain in the long run.

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 Monopolistic competition
Short-run equilibrium of the firm
$
MC

AC

Ps
Economic profit
ACs

AR D

MR
0 Q
5
Qs
Monopolistic competition Long-run equilibrium of the
firm
$

LRMC

LRAC

PL

AR D

MR
Q
0 QL
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 Monopolistic competition
Non-price competition
● Product development:
 in high or potentially high demand
 inelastic demand due to lack of close substitutes.
● Advertising:
 increase demand & sell
 make demand less elastic
 MR>MC…additional advertising will add to profit
 Optimal advertising: MR= MC
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 Monopolistic competition
The public interest
• Comparison with perfect competition:
 less will be sold and at a higher price
 firms will not be producing at the least-cost point
 consumer may benefit by having a greater variety of
products to choose from.
• Comparison with monopoly:
 freedom of entry and lack of long-run supernormal under
monopolistic competition profits keep price down and
encourage cost saving
 greatereconomies of scale and more funds for
investment and R&D under monopoly.
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 Perfect and monopolistic competition
Long-run equilibrium of the firm contrasted
$ Long-run equilibrium under
Long-run equilibrium under
monopolistic competition
perfect competition
LRAC

P1

P2
DL perfect competition

DL monopolistic
competition

0 Q
9
Q1 Q2
 Oligopoly
Key features of oligopoly:

• Few firms

• Barriers to entry

• Interdependence of the firms

• Differentiated & undifferentiated goods

• Downwards sloping demand curve-depends on reaction of

the rivals to a price change
Examples in Australia:
• Motor vehicle industry, banking industry, supermarket
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retailers, cement
Oligopoly
Australia’s banking oligopoly
Banks’ % share of total bank assets

Bank %
Commonwealth 18.6
National Australia 18.2
Westpac 15.2
ANZ 14.6
Sub-total – four largest banks 66.7
All other banks 33.3
Total – all banks 100.0

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 Oligopoly: Competition and collusion

● Compete with their rivals to gain a bigger

share of industry profits OR….
● Collusive oligopoly: due to interdependence
firms collude and act as a monopoly (open
and tacit) and jointly maximise industry
profits
● Non-collusive oligopoly: no formal, informal
or tacit agreement between firms
● Cartel: formal collusive agreement
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 Collusive Oligopoly
● Firms (formal/informal) agree on prices, output quota,
market share, advertising expenditure, limit product
development, promotion, or agree not to poach on each
other’s market and so on …to limit competition between
them.
● Collusion reduces uncertainty, and the fear of engaging in
competitive price cutting or retaliatory advertising.
● Firms may form cartel such as OPEC:
 the cartel’s MC curve is the horizontal sum of the MC
curves of its members
 producing an output where MC=MR
 non-price competition
 set output and sale quota, illegal in many countries
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 Oligopoly
Figure 6.3 Profit-maximising cartel

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 Oligopoly
Tacit collusion- not to engage in price cutting,
excessive advertising or other forms of competition.

• Dominant firm price leadership- followers choose

the same price set by the dominant firm/leader in
the industry

• Barometric firm price leadership- where the prices

reflect market conditions in the most
reliable/satisfactory way to follow

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 Oligopolistic price leader aims to maximise profits
for a given market share (I)
$

D market = AR
market

D leader = AR leader

0 Q
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 Oligopolistic price leader aims to maximise profits
for a given market share (II)
$ Price leader has major
market share and MC leader
sets market price

PL

D market = AR
market

D leader = AR leader

MR leader

0 Q Q
l
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 Oligopolistic price leader aims to maximise profits
for a given market share (III)
Price leader has major
$
market share and
sets market price MC leader Market follows price
leader

EL EM
PL

D market = AR
market

D leader = AR leader

MR leader

0 Q Q Q
L M
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 Oligopolistic price leader aims to maximise profits
for a given market share (IV)
$ Leader drops price

MC leader
Market may retaliate -
EL EM
PL (=M) price war!
EL1
PL1
D market = AR
market

D leader = AR leader
Leader increases market share
MR leader

0 Q Q Q Q
L L1 M
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 Oligopoly
• Other forms of tacit collusion (rules of
thumb):

• average cost pricing: price is set by adding

a certain % for profit- on top of AC…(mainly
during inflation it is useful) …rather than
using MC=MR rule

• price benchmark: when rising a price, forms

usually raise it from one benchmark to
another
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 Oligopoly
Factors favouring collusion:
• Very few firms known to each other
• Open with each other about costs, and production methods
• Similar production methods and average costs
• Interdependent…change price at the same time by same %
• Produce similar products and reach agreement on a price
• There is one dominant firm
• Significant entry barriers and so little disturbance
• The market is stable-
• No government measures to curb collusion.

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 Oligopoly
Non-collusive oligopoly: the breakdown of collusion
● Temptation to cheat by cutting prices or selling
more than allotted quota
● Retaliation by members and price war.
● Break collusive agreement- will price war result in
winners OR can we get away without retaliation
● Aim is to have a successful strategy (price,
advertising, R&D product development in outwitting
the opponent)

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 Oligopoly
Non-collusive oligopoly: firm faces a demand curve
that is kinked at the current price, demand being
more elastic above the current price- than below…
to create price stability.

Assumptions of the model:

•Ifan oligopolist cuts its price, its rivals will feel
forced to follow suit and cut theirs, to prevent losing
customers to the first firm.
•If an oligopolist raises its price, however, its rivals
will not follow suit since, by keeping their prices the
same, they will gain customers from the first firm.
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 Oligopoly
Figure 6.5 Kinked demand for a firm under oligopoly

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Oligopoly and the consumer
Disadvantages:
● Depending on the size of the individual oligopolist, there
may be less scope for economies of scale to mitigate the
effects of market power.
● Oligopolist are likely to engage in more extensive advertising
than a monopolist.
● Countervailing power- when the power of the seller is is
offset by powerful buyers who can prevent the price from
rising.
Advantages:
● Oligopolist can use part of their supernormal profit for
research and development.
● Non-price competition through product differentiation may
25 result in greater choice for the consumer.
Game theory
Game theory-where alternative strategies are chosen to adopt,
depending on their assumptions about their rivals
Single-move games & Simple dominant strategy games:
● Maximin- choosing a policy …worse outcome is least bad
● Maximax- has the best possible outcome
● Dominant strategy game- same policy is suggested by different
strategies
● Nash equilibrium- every one makes optimal assumptions
about rivals decisions…without collusion, there is no incentive
for any firm to move from this position
● Prisoners’ dilemma- 2 or more firms independently choose the
best strategy…may end up in worse position, then if they had
cooperated
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 Game theory
Table 6.1 Profits for firms X and Y at different prices

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 Game theory
Prisoners’ dilemma

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 Game theory

The importance of threats and promises

● As long as the threat or promise is credible (i.e. its
competitors believe it), the firm can gain and it will
influence its rivals’ behaviour.
More complex games with no dominant strategy
● In complex and changing situations, firms may alter their
tactics in the light of new circumstances.
Repeated games
● Firms will react to what their rivals do; their rivals, in turn,
will react to what they do.
● Tit-for-tat.
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 Price discrimination
…same product sold at different prices
● Consumers are grouped into two or more
independent markets and a separate price is
charged in each market, even though there is no
difference in costs of production.
● Examples: different-priced seats on buses for adults
and children; different prices for the same seats on
aircraft.
● peak-period pricing-when price varies with periodic
variations in demand.

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 Price discrimination
Conditions necessary for price discrimination to operate
● The firms must be able to set their price.
● The market must be separate.
● Demand elasticity must differ in each market.
Advantages to the firm
● Higher revenue
● Driving competitors out of business (predatory pricing
Predatory =P< AVC.
Price discrimination and the consumer
● No clear-cut decision
● Some benefit, some lose.
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Price discrimination
Figure 6.6 Price discrimination

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 Price discrimination

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