CHAPTER 8

MARKET STRUCTURE 2:
MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
 MONOPOLISTIC
COMPETITION
 Definition
– Market structure in which there are large numbers of
small sellers selling differentiated products but these
are close substitute products and have easy entry into
and exit from the market.
 Characteristics
– Large number of and sellers – there is a large
number of sellers under the monopolistic competition
and no individual firm can influence the market price.
However, each firm follows an independent price-
output policy.
 MONOPOLISTIC
COMPETITION (cont.)
– Differentiated products – product differentiation could be
through packaging, design, labelling, advertising and
brand name.
– Free of entry and exit into the market – not as easy as
perfect competition because of the existence of product
differentiation.
– Role of non-price competition is significant – various
methods used to attract the customers to buy a particular
brand.
– Selling cost – different types of expenditure on
advertisement would incur additional cost.
 MONOPOLISTIC
COMPETITION (cont.)
The demand curve for monopolistic competitive firm is
downward sloping due to product differentiation.
Price

Demand curve for monopolistic

competitive firm is more elastic
than demand curve for
monopolist firm because in
monopolistic competition there
AR=P are many firms and many
substitutes.

MR

Quantity
 PROFIT MAXIMIZATION IN
SHORT RUN
Monopolistic competitive firm earns economic profit
At this output, the firm earns
Economic profit or economic profit or supernormal The profit maximization
supernormal profit profit equal to the shaded area. level occurs where MR
is the profit earned curve and MC curve
Price (RM) MC
by a monopolist intersects at Point A.
competitive firm
when TR > TC. ATC
To find the price, we use the
same vertical line with
output up to the demand
curve. The profit maximizing
P*
PROFIT price and output is
AC P* and Q*.
A
DD = AR

MR

Quantity
Q*
 PROFIT MAXIMIZATION IN
SHORT RUN (cont.)
Monopolistic competitive firm at break-even
Normal profit or break-even is The profit maximization
earned when TR = TC. level occurs where MR
curve and MC curve
Price (RM) At this output, monopolistic intersects at Point A.
MC
competitive firm is at the break-
even or earns normal profit. ATC

The profit maximizing price

and output is P* and Q*.

AC/ P*

DD = AR

MR

Quantity
Q*
 PROFIT MAXIMIZATION IN
SHORT RUN (cont.)
Monopolistic competitive firm suffers economic losses
Economic losses or subnormal At this output, monopolist suffers economic losses
profit is the losses incurred by a or subnormal profit equal to the shaded area.
monopolistic competitive firm when
Price (RM) ATC
MC
TR < TC.

The profit maximization

level occurs where MR
AC curve and MC curve
LOSSES intersect at Point A.
P*
The profit maximizing price
A and output is P* and Q*.

DD = AR

MR

Quantity
Q*
 PROFIT MAXIMIZATION IN
LONG RUN
Monopolistic competitive firm earns normal profit in long
run
A monopolistic competitive
firm earns normal profit in
Price (RM) the long run due to free LRMC
entry and exit.

LRATC

P*

DD = LRAR

LRMR

Q*
Quantity
 OLIGOPOLY

 Definition
– Market structure in which there are only a few firms selling
either standardized or differentiated products and it
restricts the entry into and exit from the market.
 Characteristics
– Few numbers of firms – the number of firms is small but
size of the firms is large.
– Homogeneous or differentiated product
– Mutual interdependence – firms in an oligopoly market
always consider the reaction of their rivals when choosing
price, sales target, advertising budgets and other business
policies.
 OLIGOPOLY (cont.)

– Barriers to entry – restrict new entrants into the market

through various types of barriers to entry such as control of
certain resources, ownership of patent and copyright,
exclusive financial requirements and other legal barriers.
 Price Rigidity and Kinked Demand Curve
– Since there is mutual interdependence between oligopoly
firms, the prices in the market are more stable. This is
called price rigidity in oligopoly market.
– The price rigidity explains the behaviour of an oligopoly
firm that has no incentive to increase or decrease the
price.
 OLIGOPOLY (cont.)

– The theory of the kinked demand curve is based on two

assumptions.

1. First assumption: If an oligopolist reduces its price, its rivals will

follow and cut their prices to prevent losing the customers.
2. Second assumption: If an oligopolist increases its price, its rivals
do not increase the price and keep their prices the same, thereby
they gain customers from the firm that increases the price.
 OLIGOPOLY (cont.)
Because of this According to the assumption, An oligopoly firm faces
assumption, an when the firm increases the two demand curve,
oligopolist faces kinked price (P*), no other firms will individual demand
Price (RM) demand curve. follow. Above P*, the firm will curve (dd) and industry
follow the dd curve. demand curve (DD).
If the firm decreases the price,
other firms will follow. Below
P*, the firm follow the DD
curve.

P*

dd

DD

Q* Quantity
 OLIGOPOLY (cont.)
This shows the price At this range of MR, any The kinked demand
rigidity in the oligopoly change in the MC does not curve below Point E
market. reflect changes in the profit creates a gap in the
Price (RM)
maximizing price and MR, which is indicated
output. by the dotted line ab.

MC1
MC2
E
P*

b DD

Q*
MR Quantity
 OLIGOPOLY (cont.)
 Price Leadership
– Price leadership means the pricing strategy in which the
firms in an oligopolistic industry follow the price set by the
leading firm.
– Price leadership is one form of collusion under oligopoly.
– There is no formal or tacit agreement.
– There are two types of price leadership:
• Dominant price leadership
– The dominant price leadership firm may be the largest firm
that dominates the overall industry.
– The dominant price leader firm can act as a monopoly
where it sets its price to maximize profits; other firms will
set their prices at the same level.
 OLIGOPOLY (cont.)
• Barometric price leadership
– One firm will be the first to announce price change. This
firm does not dominate the industry.
– Its price will be followed by others.
 Cartel
– A cartel is a group of firms whose objective is to limit the
scope of competitiveness in the market.
– Cartel arises because firms want to eliminate uncertainty
and improve profits by stabilizing market shares and prices,
reducing competitiveness and eliminating promotional cost.
– The most famous cartel is Organization of Petroleum
Exporting Countries (OPEC).
Market-Sharing Cartels
Market-Sharing by Non-Price Competition.
Market-Sharing by Output Quota
Instability of Cartel
 OLIGOPOLY (cont.)

– Cartel agreement is an arrangement among the oligopoly

firms to cooperate with one another to act together as a
monopoly.
– An ideal cartel will be powerful to establish monopoly
price and earns supernormal profits.
– Profits are divided among firms based on their individual
level of production.
– Each firm sells at different quantities and obtains different
profits depending on the level of AC at the point of
production.
 OLIGOPOLY (cont.)

 Non-price Competition
– Non-price competition is the means for growing market
share and profitability in the face of new rivals through
advertising, marketing, after sales service, free gift and
others.
– The difference with price cuts by oligopoly firm and non-
price competition.
– Opting for price cut – If a firm reduces a price of a
product, it can attract customers, and establish in the
industry.
• Reactions of competitors – the reaction from rivals are quick
by reducing their prices. There is a risk of price war if the
price reduction continues. However, customers are better off.
 OLIGOPOLY (cont.)

– Opting for non-price competition – This strategy will

attract more customers to the firm.
• Reactions of competitors – the reaction from rivals toward
non-price competition is slow and less direct. The firms will
gain more advantages if it practices non-price competition
because product variation, improvements in quality and
successful advertising techniques cannot be duplicated so
easily. Some consumers are more attracted to the
advertisement and quality of the product compared to price.
 SUMMARY OF MARKET
STRUCTURE
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Number of sellers
Large One Many Few

Identical or Unique or no Homogenous or

Type of product Differentiated
homogenous close substitution differentiated

Entry condition Very easy Impossible Easy Difficult

Control over
None Some Some Considerable
price
Local phone Automobiles,
Examples Wheat, corn Food, clothing
service, electricity cigarettes
Profit
MR = MC MR = MC MR = MC MR = MC
maximization
 SUMMARY OF MARKET
STRUCTURE (cont.)
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Subnormal, Subnormal, Subnormal, Subnormal,
Short run
supernormal or supernormal or supernormal or supernormal or
equilibrium
normal profit normal profit normal profit normal profit
Normal profit due Supernormal Normal profit due Supernormal
Long run
to free entry and profit because of to free entry and profit because of
equilibrium
exit barriers to entry exit barriers to entry
Production
efficiency (at Yes No No No
minimum AC)
S/run: AR<AVC S/run AR<AVC S/run: AR<AVC S/run: AR<AVC
Shut down
L/run: AR< AC L/run: AR< AC L/run: AR< AC L/run: AR< AC