Chapter 25:

Monopolistic Competition

And

Oligopoly

Monopolistic Competition1) Relatively Large Number of Sellers Small Market Shares No Collusion

(collusion needs few producers) Independent Action

(each firm sets its price without considering the possibility of rival reactions)

2) Differentiated ProductsProduct Attributes, Service, Location (accessibility),Brand Names and Packaging, Some Control Over Price

3) Role of AdvertisingTo differentiate their products (Non-price competition)4) Easy Entry and Exit (relative to monopoly)Relatively small, don’t heavily rely on economies of scale.

Price and Output in Monopolistic Competition

The firm’s demand curve

The firm faces a highly, but not perfectly, elastic demand curve.

Reasons:

• The seller has many competitors.

• Close substitutes to its product.

Elasticity of demand for the producer depends on:

• The number of rivals (+)

• The degree of product differentiation (-)

Optimal Output: The Short Run

Rule: MC = MRThere are tow possibilities: Profit Losses

Optimal Output: The long run:

Only a Normal Profit (i.e. economic profit = zero)

Profits: Firms enter. In the short run economic profits attract new

entrants. Demand facing the firm shifts to the left Profits decline Demand curve is tangent to ATC No further incentive for entry

Losses: Firms leave In the short run economic losses force some

firms to leave Demand facing the firm shifts to the right losses disappear Demand curve is tangent to ATC No further incentive to exit

D

MR

P1

ATCP

rice

an

d C

ost

s

Q1

EconomicProfits

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A1

MC

New competition drives down theprice level – leading to economic

losses in the short run

D

MR

MC

P2

ATCP

rice

an

d C

ost

s

Q2

EconomicLosses

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

A2

With economic losses, firms willexit the market – Stability occurswhen economic profits are zero

D

MR

MC

P3 = A3

ATCP

rice

an

d C

ost

s

Q3

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

Quantity

Long-Run EquilibriumNormalProfitOnly

MONOPOLISTIC COMPETITIONAND EFFICIENCY

In Pure Competition only• Economic Efficiency: P = MC = Minimum ATC• Productive Efficiency: P = ATC

Goods are produced in the least costly way.

Price is just efficient to cover total costs including a normal profit

• Allocative Efficiency: P = MC

The right amount of output is being produced.

The right amount of the society’s scarce resources is being devoted to this specific use.

MONOPOLISTIC COMPETITIONAND EFFICIENCY

In Monopolistic Competition

• Not Productively Efficient:

price Minimum ATC

P > Minimum ATC

• Not Allocatively Efficient:

Price MC

•

• Monopolistic competition results in underallocation of the society’s resources.

• Monopolistic competition is not allocatively efficient. • Consumers pay a higher than the competitive price and

obtain a less than optimal output.• Monopolistic competition producers must charge a

higher than the competitive price in the long run in order to achieve a normal profit.

• The price-marginal cost gap experienced by each firm creates an industrywide efficiency loss.

Excess Capacity

• Optimal capacity is to produce at minimum ATC.

• The gap between minimum ATC and the profit maximizing price identifies excess capacity:

• Plant and equipment are underused because production is at less than minimum ATC.

D

MR

MC

P3 = A3

ATCP

rice

an

d C

ost

s

Q3

Quantity

Long-Run Equilibrium Price is Not= Minmum

ATC

Price MC

MONOPOLISTIC COMPETITIONAND EFFICIENCY

Q4

Excess capacity

Oligopoly

1. Oligopoly exists where a few large firms producing a homogeneous or differentiated product dominate a market.

2. There are few enough firms in the industry that firms are mutually interdependent—each must consider its rivals’ reactions in response to its decisions about prices, output, and advertising.

3. Some oligopolistic industries produce standardized products (steel, zinc, copper, cement), whereas others produce differentiated products (automobiles, detergents, greeting cards).

Barriers to entry

1. Economies of scale may exist due to technology and market share.

2. The capital investment requirement may be very large.

3. Other barriers to entry may exist, such as patents, control of raw materials, preemptive and retaliatory pricing, substantial advertising budgets, and traditional brand loyalty.

Cartels and collusion agreements constitute another oligopoly model

1. Collusion reduces uncertainty, increases profits, and

may prohibit the entry of new rivals.2. A cartel may reduce the chance of a price war

breaking out particularly during a general business recession.

3. A cartel is a group of producers that creates a formal written agreement specifying how much each member will produce and charge.

4. Cartels are illegal in the U.S., thus any collusion that exists is covert and secret.

There are many obstacles to collusion:a. Differing demand and cost conditions among firms in

the industry;b. A large number of firms in the industry;c. The incentive to cheat;d. Recession and declining demand (increasing ATC);e. The attraction of potential entry of new firms if prices

are too high; andf. Antitrust laws that prohibit collusion.

Oligopoly and Advertising

A. Product development and advertising campaigns are more difficult to combat and match than lower prices.

B. Oligopolists have substantial financial resources with which to support advertising and product development.

C. By providing information about competing goods, advertising diminishes monopoly power, resulting in greater economic efficiency.

D. By facilitating the introduction of new products, advertising speeds up technological progress.

E. If advertising is successful in boosting demand, increased output may reduce long run average total cost, enabling firms to enjoy economies of scale.

Oligopoly and Efficiency

1. The economic efficiency of an oligopolistic industry is hard to evaluate.

2. Allocative and productive efficiency are not realized because price will exceed marginal cost and, therefore, output will be less than minimum average-cost output level.

3. Informal collusion among oligopolists may lead to price and output decisions that are similar to that of a pure monopolist while appearing to involve some competition.

Economic inefficiency may be lessened because:

1.1. Foreign competition has made many oligopolistic industries much more competitive when viewed on a global scale.

2. Oligopolistic firms may keep prices lower in the short run to deter entry of new firms.

3. Over time, oligopolistic industries may foster more rapid product development and greater improvement of production techniques than would be possible if they were purely competitive.