Monopolistic Competition and Oliogopoly

In this chapter,

What market structures lie between perfect competition and monopoly, and what are their characteristics?

How do monopolistically competitive firms choose price and quantity? Do they earn economic profit?

What are the social costs and benefits of advertising?

What outcomes are possible under oligopoly? Why is it difficult for oligopoly firms to cooperate?

2

Characteristics & Examples of Monopolistic Competition

Characteristics: Many sellers Product differentiation Free entry and exit

Examples: apartments car insurance auto repair shops clothing restaurants night clubs

profit

ATC

P

A Monopolistically Competitive Firm Earning Profits in the Short Run

The firm faces a downward-sloping D curve.

At each Q, MR < P.

To maximize profit, firm produces Q where MR = MC.

The firm uses the D curve to set P. Quantity

Price

ATC

D

MR

MC

Q

Comparing Monopoly & Monop. Competition

yesyesfirm has market power?

downward-sloping

downward-sloping

(market demand)D curve facing firm

manynoneclose substitutes

zeropositivelong-run econ. profits

yesnofree entry/exit

manyonenumber of sellers

MonopolisticCompetition

Monopoly

Comparing Perfect & Monop. Competition

yesnone, price-takerfirm has market power?

downward-sloping

horizontalD curve facing firm

differentiatedidenticalthe products firms sell

zerozerolong-run economic profits

yesyesfree entry/exit

manymanynumber of sellers

Monopolistic competition

Perfect competition

Why Monopolistic Competition Is Less Efficient than Perfect Competition

1. Excess capacity The monopolistic competitor operates on the

downward-sloping part of its ATC curve, meaning it produces less than the cost-minimizing output.

Under perfect competition, firms produce the quantity that minimizes costs.

2. Markup over marginal cost Under monopolistic competition, P > MC. Under perfect competition, P = MC.

Non-Price Competition Profit margins are slim in Monopolistic

Competition, because there are many substitutes…

Competition based on something other than price is necessary to differentiate products.

1. Physical Characteristics2. Location

3. Service4. Advertising

AdvertisingIn monopolistically competitive industries,

product differentiation and markup pricing lead naturally to the use of advertising.

In general, more advertising creates

greater differentiation, which allows for greater markup

Economists disagree about the social value of advertising.

The Critique of Advertising Critics of advertising believe:

Society is wasting the resources it devotes to advertising.

Advertising impedes competition – it creates the perception that products are more differentiated than they really are, allowing higher markups.

Brand names cause consumers to perceive differences that do not really exist.

Eliminating government protection of trademarks would reduce influence of brand names, result in lower prices.

Proponents of Advertising believe:

Ads may convince buyers to try a product once, but the product must be of high quality for people to become repeat buyers.

Defenders of brand names believe:

Brand names provide information about quality to consumers.

Companies with brand names have incentive to maintain quality, to protect the reputation of their brand names.

Monopolistic Competition and Welfare

Monopolistically competitive markets do not

have all the desirable welfare properties of perfectly competitive markets.

Because P > MC, the market quantity is

below the socially efficient quantity.

Yet, not easy for policymakers to fix this problem: Firms earn zero profits, so cannot require them to reduce prices.

OligopolyOligopoly: a market structure in which only a

few sellers offer similar or identical products.

Strategic behavior in oligopoly: A firm’s decisions about P or Q can affect other firms and cause them to react. The firm will consider these reactions when making decisions.

Game theory: the study of how people behave in strategic situations.

Collusion vs. Self-InterestBoth firms would be better off if both stick

to the cartel agreement.

But each firm has incentive to renege on the agreement.

Lesson: It is difficult for oligopoly firms to form cartels and honor their agreements.

The Output & Price Effects

Increasing output has two effects on a firm’s profits: Output effect:

If P > MC, selling more output raises profits. Price effect:

Raising production increases market quantity, which reduces market price and reduces profit on all units sold.

If output effect > price effect, the firm increases production.

If price effect > output effect, the firm reduces production.

CONCLUSIONDifferentiated products are everywhere;

examples of monopolistic competition abound.

The theory of monopolistic competition describes many markets in the economy, yet offers little guidance to policymakers looking to improve the market’s allocation of resources.

Oligopolists can maximize profits if they form a cartel and act like a monopolist.