MARKET STRUCTURES:

IMPERFECT OR
MONOPOLISTIC
COMPETITION

Dr. Mudenda
 Introduction

 Monopolistic competition a market structure in which

many firms sell products that are similar but not identical
 For example : the market for microeconomics text books
books, like Begg et al, Tucker et at, Hardwick et al seems
monopolistic.
 Because each of these books is unique, publishers have some
latitude in choosing what price to charge.
 Firms in these markets are neither price takers like those in
perfect competition, nor are they protected from competition
by barriers to entry like a monopoly.

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 Assumptions or Characteristics
 Monopolistic competition is a market with the
following characteristics:
1. A large number of firms that are in the industry
 The presence of a large number of firms has three
implications:
 Small market share for each firm – for example, we have many
producers of bathing soaps. Each producer takes a small
market share of the Zambian soap market
 Collusion is impossible – here the individual firms –because
they are many may to be able to agree together to manipulate
price of the bathing soaps
 Firms in monopolistically competitive markets recognize the
existence of competitors
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 Assumptions or Characteristics
2. Each firm produces a differentiated product.
 Firms there are many close substitutes coming from other
monopolistically competitive firms
 Product differentiation – is a set of marketing strategies
designed to capture and retain a particular market segment by
producing a range of related products.
 Sources of differentiation

 These products may be differentiated in terms in terms of

packaging, design, quality and advertising. Among others
physical differences, prestige considerations, service quality
and location branding etc
 With differentiation, buyers believe that the products of the
various sellers are not the same, whether the products are
actually physically different or not
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 Assumptions or Characteristics
3. Free Entry and Exit
 There are no barriers to entry in monopolistic competition.
 This means entry in monopolistic competition is relatively
unrestricted:
 New firms may easily start the production of close substitutes
for existing products. The entry of new firms reduces the
market share of existing firms and exit of firms does the
opposite
 Economic profits tend to be eliminated in the long run, as new
firms as is the case in perfect competition. Thus firms cannot
earn an economic profit in the long run.

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 Assumptions or Characteristics

4. Selling Costs – unlike perfect competition and monopoly,

firms under monopolistic competition make heavy
expenditure on advertising and other sales promotion
schemes for their products
 These affect the firm’s equilibrium

▪ Examples of Monopolistic Competition

 Audio and video equipment, computers (dell, Lenovo, hp, etc)
frozen foods, petrol stations.
▪ Overall An industry with monopolistic competition has many
sellers of products that are close substitutes for one another.
Each firm has only a limited ability to affect its output price.

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 Market Equilibrium: Price and Output in
Monopolistic Competition
 Monopolistically competitive
sellers are price searchers; they price
do not regard price as given by
market conditions.
 Because each firm sells a
slightly different product, each
D
firm’s demand curve is MR
downward sloping, but quite Quantity per day)
flat (elastic) because of many
close substitutes. with brand loyalty and
increase the demand for its
 The reason is that by exercising
its monopoly power, product by decreasing the
monopolistic firms increase price because of a relatively
price and still retain some high cross-elasticity of the
buyers competitive product

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 Short Run Equilibrium

 For every individual firm’s demand curve, we can

determine short-run equilibrium output and price using a
method similar to that used to determine monopoly output
and price.
 The intersection of MR and MC (MC=MR) curves
indicates the short-run equilibrium output under
monopolistic competition
 By observing the price on the demand curve at which that
output can be sold, we then find the short-run equilibrium
price.

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 Short -Run Equilibrium

 Price is determined from the

DD curve for the firm’s
product and is the highest

price
price the firm can charge for
the profit-maximising
quantity.
 The perfectly competitive
firm can make losses or
supernormal profits in  A firm could maximise profit
the short-run or minimise loss by producing
 As shown the graph the output at which marginal
revenue equals marginal cost
 Short -Run Equilibrium
MC
 A firm might face a level ATC
of demand for its product c A
that is too low for it to P*
B MC
make an economic profit Total
D

price
Losses
 If at q* where MR= MC.
 TR < TC (P is less than MR
ATC), the firm is generating
0
losses q*
(Loss Minimizing Output)
 In the graph TR = P*Bq*0 Quantity
and TC = cAq*o the firm is  In the short-run the firm
making a loss of CABP* can decide t shut down in
this case
Long Run Equilibrium : Zero Economic Profit

 The short-run equilibrium situation, whether involving

profits or losses, will probably not last long because there is
entry and exit in the long run.
 If market entry and exit are sufficiently free,
 new firms will enter when there are economic profits, and
 some firms will exit when there are economic losses.
 In the long run, economic profit induces entry. If firms incur
economic losses, exit will occur.
 Entry continues as long as firms in the industry earn an
economic profit—as long as (P > ATC).
 Price and quantity fall with firm entry until P = ATC and firms
earn zero economic profit.
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Long Run Equilibrium : Zero Economic Profit

 Overall: If existing firms are earning economic profits, new

firms enter to take advantage of the economic profits;
 the demand curves for each of the existing firms will fall and
become more elastic due to increasing substitutes
 This decline in demand continues until ATC becomes tangent
with the demand curve, and economic profits are reduced to
zero.
 When monopolistically competitive firms are making
economic losses,
 some firms will exit the industry;
 the demand curves for the remaining firms shift to the right
and makes them more inelastic due to reduced substitutes.

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Long Run Equilibrium : Zero Economic Profit

 Long-run equilibrium will

occur when demand is equal
to average total cost for each
firm at a level of output at
which each firms’ demand
curve is just tangent to its
ATC curve.
 The point of tangency will
always occur at the same
level of output as where MR  zero economic profits and
= MC.  no incentives for firms to
 At this equilibrium point, either enter or exit the
there are: industry.

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 Monopolistic Competition Versus Perfect
Competition

 Both monopolistic competition and perfect competition

 have many buyers and sellers
 and relatively free entry and exit
 However, product differentiation allows a monopolistic
competitor the ability to have some influence over price
 A monopolistic competitive firm
 has a downward-sloping demand curve,
 but it tends to be more elastic than the demand curve for a
monopolist
 because of the large number of good substitutes for its
product.

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 Monopolistic Competition Versus Perfect
Competition

 Because of the downward slope of the demand curve, its

point of tangency with ATC will not and cannot be at the
lowest level of average cost.
 Therefore, even when long-run adjustments are complete,
firms will not be operating at a level that permits the lowest
average cost of production the efficient scale of the firm
 The existing plant, even though optimal for the equilibrium
volume of output, will not be used to capacity.
 That is, excess capacity will exist at that level of output.

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 Monopolistic Competition Versus Perfect
Competition

 Unlike a perfectly competitive firm, a monopolistically

competitive firm could increase output and lower its
average total costs.
 However, increasing output to attain lower average costs
would be unprofitable. The price reduction necessary to sell
the greater output would cause MR to fall below MC of the
increased output.
 In monopolistic competition, firms are not operating
where P = MC.
 At the intersection of MC and MR, P > MC.
 This means that society is willing to pay more for the product
(the price) than it costs society to produce it.
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 Monopolistic Competition Versus Perfect
Competition

 The firm is not allocativally efficient, (where P = MC).

 Too many firms are producing at output levels that are less
than full capacity
 Perfectly competitive firms reach both
 productive efficiency (P = ATC at the minimum point on the
ATC curve)
 and allocative efficiency (P = MC).

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Market Structures
OPEC

OLIGOPOLY

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 Definition

 Oligopoly a market structure in which only a few sellers

offer similar or identical products. The market has:
1. A Few Large Producers
 structure characterized by a few dominant firms. This small
number of firms serve market demand
2. The produce or sell Homogeneous or Differentiated
Products
 Homogeneous Oligopoly
 Differentiated Oligopoly
 That is products may be homogeneous or differentiated.
 Examples: Plane making industry
3. Barriers to Entry
 Either natural or legal barriers to entry can create oligopoly
 Economies of scale and demand can form a natural barriers to
entry and create oligopoly
 A legal oligopoly arises when a legal barrier or natural to entry
protects the small number of firms in a market
4. Control Over Price, But Mutual Interdependence
 The behavior of any given oligopolistic firm depends on the
behavior of the other firms in the industry
 That is, firms are interdependent and they face a temptation to
cooperate to increase their joint profit or
 if they do not cooperate, then they price taking into account
that their rivals are watching to undercut them
 Intro

 Simplest case
 duopoly (i.e. only two sellers)
 Each aware of the existence of the other firm

 Compete instead of collude ➔ each firm has market

power less than monopolist
 Examples? Mobile phone providers in Zambia
 Oligopolistic firms are interdependent and they face a
temptation to cooperate to increase their joint profit.

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 The Kinked Demand Curve Model
K  The kinked demand curve model of
P0
oligopoly is based on the assumption that
each firm believes that if it raises its price,
others will not follow, but if it cuts its price,
other firms will cut theirs.
Consider how a firm may perceive its
demand curve under oligopoly.
D
It can observe the current price and
Q0 Quantity output, but must try to anticipate rival
reactions to any price change.
 Imagine firm is at P0, if it raises the price above Po, the other
firms can reduce price and undercut it
 But if it reduces price, it may expect rivals to respond as this will
be seen as an aggressive move
 The Kinked Demand Curve Model
K  … so demand in response to a price
P0 reduction is likely to be relatively inelastic.
 The demand curve will be steep below P0.
…so the firm perceives that it faces a
kinked demand curve.
Above Po, an increase in price, which
D is not followed by competitors, results
Q0
in a large decrease in the firm’s
Quantity
quantity demanded (DD is elastic).
… Thus, rivals are less likely to
react,
 so demand may be relatively elastic above P0
 Below P*, price decreases are followed by competitors so the firm
does not gain as much quantity demanded (demand is inelastic).
 The kinked demand curve

so the firm perceives that it faces a

kinked demand curve.

£ Given this perception, the firm sees

that revenue will fall whether price is
increased or decreased,
P0
MC2
so the best strategy is to keep
MC1 price at P0.

Price will tend to be stable, even in

the face of an increase in marginal
D cost.
Q0 Quantity
MR
24
 Cartels/ Collusive Oligopoly

 The essence of an oligopolistic industry is the need for each

firm to consider how its own actions affect the decisions of
its relatively few competitors.
 Oligopoly may be characterised by collusion or by non-co-
operation.
 A group of firms that gets together and makes price and output
decisions to maximize joint profits is called a cartel.
 Collusion: an explicit or implicit agreement between existing
firms to avoid or limit competition with one another.
 CARTEL -is a situation in which formal agreements between
firms are legally permitted. e.g. OPEC
 The objective of collusion is to act like a monopolist by
restricting output and raising price, thereby earning profits
 Cartels/ Collusive Oligopoly

 Cartel agreements can be in

terms of overt –(where the Effectively Sharing
terms of agreements ae The Monopoly Profit
know like OPEC) to covert
(known only to participants Pm
A

 May be only know to Economic

participants because cartels

Profit B E
Pc MC
are prohibited by legislation MR=MC
relating to competition
D=AR
 By colluding, the cartel sets MR
O
total production at Qm sold at Qm Qc
Pm  Cartels are likely to break down
 The price exceeds the MC. in the long run because
The cartel makes monopoly individual firms have an
profits incentive to cheat
 Cartels/ Collusive Oligopoly

 A firm can produce more

than their quota & undercut Effectively Sharing
the agreed price The Monopoly Profit
 As noted, cartels set the price
A
at Qm and charge Opm Pm

 The price Opm exceeds the Economic

Profit B E
MC and the individual Pc
MR=MC
MC

oligopolist who believes that

other producers will adhere D=AR

to the cartel agreement has O

Qm
MR
Qc
an incentive to increase profit
by producing more output at
a lower price
 Cartels/ Collusive Oligopoly

 Cartels are not likely to survive in the long long-run if

a. There are many firms in the industry
b. The product is not standardised
c. Demand and cost conditions are changing rapidly
d. There are no barriers to entry
e. Firms have surplus capacity

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Conclusion

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