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Chapter 10 Monopolistic Competition

and Oligopoly

©2000 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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In this chapter, you will learn to solve these economic puzzles:

How does the NCAA Final Four basketball

tournament use imperfect competition

Why do OPEC and other cartels tend to break down?

Why will Ivan’s Oyster Bar make zero economic

profit in the long-run?

Are Cheerios, Rice Krispies, and other brands sold by firms in the

breakfast cereal industry produced under monopolistic

competition or oligopoly?

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What isImperfect Competition?A market structure between

the extremes of perfect competition and monopoly

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What is Monopolistic Competition?

• many small sellers• differentiated product• easy entry and exit

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What isProduct Differentiation?

The process of creating real or apparent differences between goods and services

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What does Many Small Sellers mean?

Each firm is so small relative to the total market that each firm’s pricing decisions have a negligible effect on the market price

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What isNonprice Competition?A firm competes using

advertising, packaging, product development, better service, rather than lower prices

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How easy is entry and exit in Monopolistic

Competition?Not as easy as in Perfect

Competition because of product differentiation

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Why is a Monopolistic Competitive firm a

price maker?Product differentiation

gives the firm some control over its price

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What does the demand curve for Monopolistic Competition look like?It is less elastic (steeper)

than for a perfectly competitive firm and more elastic (flatter) than for a monopolist

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What are examples of Monopolistic Competition?

• grocery stores• hair salons• gas stations• video rental stores• restaurants

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How effective is Advertising?

Somewhat effective in the short-run but less effective in the long-run

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What effect does Advertising have on

Average Costs?It raises the long-run

average cost curve

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$2.00$1.50$1.00

$.50

2 4 6 8

$2.50$3.00$3.50$4.00

10 12 14 16 18

The effect of Advertising

LRAC2

Cos

t p

er u

nit With advertising

Without advertisingLRAC1

P

Q

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How does a firm decide what price to

charge and how many units to produce?

MR = MC

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$20$15$10

$5

1 2 3 4

$25$30$40$50

5 6 7 8 9

ATC

MCMR=MC

DMR

ProfitAVC

P

Q

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Why is a Normal Profit made in the Long-run?

The combination of the leftward shift in the firm’s demand curve and the upward shift in the LRAC curve

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$20$15$10

$5

1 2 3 4

$25$30$35$40

5 6 7 8 9

LRAC

MC

DMR

Normal Profit

AVC

P

Q

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How efficient is Monopolistic Competition?

Less resources are used and a higher price is charged than would be the case under Perfect Competition

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$20$15$10

$5

1 2 3 4

$25$30$35$40

5 6 7 8 9

ATC

MC

DMR

Monopolistic Competition

AVC

Minimum LRAC

P

Q

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$20$15$10

$5

1 2 3 4

$30$25

$35$40

5 6 7 8 9

LRACMC

MRP

rice

& C

ost

per

un

itMinimum

LRAC

Perfect CompetitionP

Q

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What is Oligopoly?• few sellers• either homogeneous or

a differential product• difficult market entry

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How few are a few Sellers?

When the firms are so large relative to the total market that they can affect the market price

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What is a significant Barrier to Entry?Economies of scale

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What isNonprice Competition?Competition in ways other

than pricing policies

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What is the distinguishing feature

of Oligopoly?Mutual interdependence

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What is Mutual Interdependence?

A condition in which an action by one firm may cause a reaction on the part of other firms

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What does Mutual Interdependence do to the Demand Curve?A kinked demand curve

is a possible result of this characteristic

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What does a Kinked Demand Curve show?It shows that rivals will

match a firm’s price decrease, but ignore a price increase

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$200$150$100

$50

5 10 15 20

$250$300$350$400

25 30 35 40 45

Oligopolist’s Kinked Demand Curve

Rivals ignore price changes

Rivals match price changes

P

Q

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How do Oligopolists determine price?

They play the game “follow the leader” that economists call price leadership

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What isPrice Leadership?

A pricing strategy in which a dominant firm sets the price for an industry and the other firms follow

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What is a Cartel?A group of firms

formally agreeing to control the price and output of a product

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What are examples of Cartels?

• Organization of Petroleum Exporting Countries (OPEC)

• International Telephone Cartel (CCITT)

• International Airline Cartel (IATA)

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What is the major weakness of a Cartel?Member firms cheating

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$30

6

$20$15$10

$5

1 2 3 4

$25

$35$40

5 7 8 9

LRACMC

Why a Cartel Member Has an Incentive to Cheat

P

Q

MR2

Pri

ce &

Cos

t p

er u

nit

MR1

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Key Concepts

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Key Concepts• What is Imperfect Competition?

• What is Monopolistic Competition?

• What is Product Differentiation?

• What is Nonprice Competition?

• Why is a Monopolistic Competitive firm a price maker?

• How does a firm decide what price to charge and how many units to produce?

• Why is a Normal Profit made in the Long-run?

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• How efficient is Monopolistic Competition?

• What is Oligopoly?

• What is Nonprice Competition?

• What is the distinguishing feature of Oligopoly?

• What does a Kinked Demand Curve show?

• How do Oligopolists determine price?

• What is a Cartel?

Key Concepts cont.

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Summary

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Imperfect competition is the market structure between the extremes of perfect competition and monopoly Monopolistic competition and oligopoly belong to the imperfect competition category.

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Monopolistic competition is a market structure characterized by (1) many small sellers, (2) a differentiated product, and (3) easy market entry and exit. Given these characteristics, firms in monopolistic competition have a negligible effect on the market price.

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Product differentiation is a key characteristic of monopolistic competition. It is the process of creating real or apparent differences between products.

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Nonprice competition includes advertising, packaging, product development, better quality, and better service. Under imperfect competition, firms may compete using nonprice competition, rather than price competition.

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Short-run equilibrium for a monopolistic competitor can yield economic losses, zero economic profits, or economic profits. In the long run, monopolistic competitors make zero economic profits.

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$20$15$10

$5

1 2 3 4

$25$30$40$50

5 6 7 8 9

ATC

MCMR=MC

DMR

ProfitAVC

P

Q

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Comparing monopolistic competition with perfect competition, we find that the monopolistic competitive firm does not achieve allocative efficiency,charges a higher price, restricts output, and does not produce where average costs are at a minimum.

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$20$15$10

$5

1 2 3 4

$25$30$35$40

5 6 7 8 9

ATC

MC

DMR

Monopolistic Competition

AVC

Minimum LRAC

P

Q

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$20$15$10

$5

1 2 3 4

$25$30$35$40

5 6 7 8 9

LRACMC

MRP

rice

& C

ost

per

un

itMinimum

LRAC

Perfect CompetitionP

Q

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Oligopoly is a market structure characterized by (1) few sellers, (2) a homogeneous or differentiated product, and (3) difficult market entry. Oligopolies are mutually interdependent because an action by one firm may cause a reaction on the part of other firms.

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The nonprice competition model is a theory that might explain oligopolistic behavior. Under this theory, firms use advertising and product differentiation, rather than price reductions, to compete.

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The kinked demand curve is a model that explains why prices may be rigid in an oligopoly. The kink is established because an oligopolist assumes that rivals will match a price decrease, but ignore a price increase.

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$200$150$100

$50

5 10 15 20

$250$300$350$400

25 30 35 40 45

Oligopolist’s Kinked Demand Curve

Rivals ignore price changes

Rivals match price changes

P

Q

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Price leadership is another theory of pricing behavior under oligopoly. When a dominant firm in an industry raises or lowers price, other firms follow suit.

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A cartel is a formal agreement among firms to set prices and output quotas. The goal is to maximize profits, but firms have an incentive to cheat, which is a constant threat to a cartel.

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$30

6

$20$15$10

$5

1 2 3 4

$25

$35$40

5 7 8 9

LRACMC

Why a Cartel Member Has an Incentive to Cheat

P

Q

MR2

Pri

ce &

Cos

t p

er u

nit

MR1

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Comparing oligopoly with perfect competition, we find that the oligopolist allocates resources inefficiently, charges a higher price, and restricts output so that price may exceed average cost.

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Chapter 10 Quiz

©2000 South-Western College Publishing

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1. An industry with many small sellers, a differentiated product, and easy entry would best be described as which of the following?a. Oligopoly.b. Monopolistic competition.c. Perfect competition.d. Monopoly.

B. An oligopoly has only a few sellers. A monopoly only has one, and perfect competition has homogeneous products.

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2. Which of the following industries is the best example of monopolistic competition? a. Wheat.b. Restaurant.c. Automobile.d. Water service.

B. Wheat would be in a perfectly competitive market. Automobiles would be an oligopoly. And the water service is an example of a regulated monopoly.

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3. Which of the following is not a characteristic of monopolistic competition? a. A large number of small firms.b. A differentiated product.c. Easy market entry.d. A homogeneous product.

D. A characteristic of monopolistic competition is differentiated products.

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4. A monopolistically competitive firm willa. maximize profits by producing where MR = MC.b. probably not earn an economic profit in the long

run. c. shut down if price is less than average variable cost. d. do all of the above.

D. Both a monopolistically competitive firm and a perfectly competitive firm share these characteristics.

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5. The theory of monopolistic competition predicts that in long-run equilibrium a monopolistically competitive firm will a. produce the output level at which price

equals long-run marginal cost.b. operate at minimum long-run average

cost.c. overutilize its insufficient capacity.d. produce the output level at which price

equals long-run average cost.

D

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$20$15$10

$5

1 2 3 4

$25$30$35$40

5 6 7 8 9

ATC

MC

DMR

Monopolistic Competition

AVC

Minimum LRAC

P

Q

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6. A monopolistically competitive firm is inefficient because the firm a. earns positive economic profit in the long

run.b. is producing at an output where marginal

cost equals price.c. in not maximizing its profit.d. produces an output where average total

cost is not minimum.

D.

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$20$15$10

$5

1 2 3 4

$25$30$35$40

5 6 7 8 9

ATC

MC

DMR

Monopolistic Competition

AVC

Minimum LRAC

P

Q

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7. A monopolistically competitive firm in the long run earns the same economic profit as a a. perfectly competitive firm.b. monopolist.c. cartel.d. none of the above.

A. In the long-run, a normal profit is made because of the ease of entry and exit. Once economic profits are made, more firms will enter the industry, driving price down. When losses are made, firms leave the industry, driving price up, restoring profits.

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8. One possible effect of advertising on a firm’s long-run average cost curve is to a. raise the curve.b. lower the curve.c. shift the curve rightward.d. shift the curve leftward.

A. The ATC curve is raised because of the added expense of the advertising.

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9. Monopolistic competition is an inefficient market structure because a. firms earn zero profit in the long-run.b. marginal cost is less than price in the long-

run.c. a wider variety of products is available

compared to perfect competition.d. all of the above.

B. In the long-run, marginal cost is less than price because of the downward sloping demand curve and a marginal revenue curve that is more steeply sloped beneath the demand curve.

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10. The “Big Three” U.S. automobile industry is described as a (an) a. monopoly.b. perfect competition.c. monopolistic competition.d. oligopoly.

D. An oligopoly is a market form with only a few sellers.

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11. The cigarette industry in the United States is described as a (an) a. monopoly.b. perfect competition.c. monopolistic competition.d. oligopoly.

D. The cigarette industry has only a few sellers.

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12. A characteristic of an oligopoly is a. mutual interdependence in pricing

decisions.b. easy market entry.c. both (a) and (b).d. neither (a) nor (b).

A. The distinguishing feature of an oligopoly is mutual interdependence. No one firm will make a decision without first considering the reaction of its competitors to its policy change.

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13. The kinked demand curve theory attempts to explain why an oligopolistic firm a. has relatively large advertising

expenditures.b. fails to invest in research and

development (R and D).c. infrequently changes its price.d. engages in excessive brand proliferation.

C. Everything else being equal, if firm A raises its price, other firms will not raise theirs, and A will experience a big decline in sales. If A lowers its price, other firms will follow suit and A will not gain many sales.

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14. According to the kinked demand theory, when one firm raises its price, other firms will a. also raise their price.b. refuse to follow.c. increase their advertising expenditures.d. exit the industry.

B. They will refuse to follow firm A because they can gain more by charging a lower price, their sales will increase because fewer people will buy from firm A.

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15. Which of the following is evidence that OPEC is a cartel? a. Agreement on price and output quotas by

oil ministries.b. Ability to raise prices regardless of

demand.c. Mutual interdependence in pricing and

output decisions.d. Ability to completely control entry.

A. A cartel is characterized by collusion, the coming together and agreeing to certain policies, for example, the level of prices.

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END