1. Chapter 10 Monopolistic Competition and Oligopoly
Key Concepts
Summary
Practice Quiz
Internet Exercises
©2002 South-Western College Publishing

2. What is imperfect competition?
A market structure between the extremes of perfect competition and monopoly

3. What is monopolistic competition?
many small sellers
differentiated product
easy entry and exit

4. What is product differentiation?
The process of creating real or apparent differences between goods and services

5. 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

6. What is nonprice competition?
A firm competes using advertising, packaging, product development, better service, rather than lower prices

7. How easy is entry and exit in monopolistic competition?
Not as easy as in perfect competition because of product differentiation

8. Why is a monopolistic competitive firm a price maker?
Product differentiation gives the firm some control over its price

9. 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

10. What are examples of monopolistic competition?
grocery stores
hair salons
gas stations
video rental stores
restaurants

11. How effective is advertising?
Somewhat effective in the short-run but less effective in the long-run

12. What effect does advertising have on average costs?
It raises the long-run average cost curve

13. The effect of AdvertisingP
The effect of Advertising
$4.00
With advertising
$3.50
$3.00
LRAC2
Cost per unit
$2.50
$2.00
$1.50
LRAC1
$1.00
Without advertising
$.50 Q 2 4 6 8 10 12 14 16 18

14. How does a firm decide what price to charge and how many units to produce?
MR = MC

15. D P Q Profit MC ATC AVC MR MR=MC 1 2 3 4 5 6 7 8 9 $50 $40 $30 $25 $20
$15
AVC
$10 D $5 MR Q 1 2 3 4 5 6 7 8 9

16. 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

17. D P Q Normal Profit MC LRAC AVC MR 1 2 3 4 5 6 7 8 9 $40 $35 $30 $25
$20
$15
AVC
$10 D $5 MR Q 1 2 3 4 5 6 7 8 9

18. How efficient is monopolistic competition?
Less resources are used and a higher price is charged than would be the case under perfect competition

19. Monopolistic Competition
$40
Minimum LRAC
$35 MC
$30
$25
ATC
$20
$15
AVC
$10 D $5 MR Q 1 2 3 4 5 6 7 8 9

20. P Q MC LRAC Perfect Competition MR 1 2 3 4 5 6 7 8 9 $40 Minimum LRAC
$35
$30 MR
$25
Price & Cost per unit
$20
$15
$10 $5 Q 1 2 3 4 5 6 7 8 9

21. What is oligopoly? few sellers
either homogeneous or a differential product
difficult market entry

22. How few are a few sellers?
When the firms are so large relative to the total market that they can affect the market price

23. What is a significant barrier to entry?
Economies of scale

24. What is nonprice competition?
Competition in ways other than pricing policies

25. What is the distinguishing feature of oligopoly?
mutual interdependence

26. What is mutual interdependence?
A condition in which an action by one firm may cause a reaction on the part of other firms

27. What does mutual interdependence do to the demand curve?
A kinked demand curve is a possible result of this characteristic

28. What does a kinked demand curve show?
It shows that rivals will match a firm’s price decrease, but ignore a price increase

29. P
Oligopolist’s Kinked Demand Curve
$400
$350
Rivals ignore price changes
$300
$250
$200
$150
$100
Rivals match price changes
$50 Q 5 10 15 20 25 30 35 40 45

30. How do oligopolists determine price?
They play the game “follow the leader” that economists call price leadership

31. What is price leadership?
A pricing strategy in which a dominant firm sets the price for an industry and the other firms follow

32. What is a cartel?
A group of firms formally agreeing to control the price and output of a product

33. What are examples of cartels?
Organization of Petroleum Exporting Countries (OPEC)
International Telephone Cartel (CCITT)
International Airline Cartel (IATA)

34. What is the major weakness of a cartel?
Member firms cheating

35. P Q MC LRAC MR2 MR1 1 2 3 4 5 6 7 8 9 $40 $35 $30 $25 $20 $15 $10 $5
Why a Cartel Member Has an Incentive to Cheat
$40 MC
LRAC
$35
$30
MR2
Price & Cost per unit
$25
$20
MR1
$15
$10 $5 Q 1 2 3 4 5 6 7 8 9

36. Key Concepts

37. 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?

38. Key Concepts cont. 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?

39. Summary

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

41. 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.

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

43. 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.

44. 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.

45. D P Q Profit MC ATC AVC MR MR=MC 1 2 3 4 5 6 7 8 9 $50 $40 $30 $25 $20
$15
AVC
$10 D $5 MR Q 1 2 3 4 5 6 7 8 9

46. 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.

47. Monopolistic Competition
$40
Minimum LRAC
$35 MC
$30
$25
ATC
$20
$15
AVC
$10 D $5 MR Q 1 2 3 4 5 6 7 8 9

48. P Q MC LRAC Perfect Competition MR 1 2 3 4 5 6 7 8 9 $40 Minimum LRAC
$35
$30 MR
$25
Price & Cost per unit
$20
$15
$10 $5 Q 1 2 3 4 5 6 7 8 9

49. 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.

50. 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.

51. 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.

52. P
Oligopolist’s Kinked Demand Curve
$400
$350
Rivals ignore price changes
$300
$250
$200
$150
$100
Rivals match price changes
$50 Q 5 10 15 20 25 30 35 40 45

53. Price leadership is another theory of pricing behavior under oligopoly
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.

54. 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.

55. P Q MC LRAC MR2 MR1 1 2 3 4 5 6 7 8 9 $40 $35 $30 $25 $20 $15 $10 $5
Why a Cartel Member Has an Incentive to Cheat
$40 MC
LRAC
$35
$30
MR2
Price & Cost per unit
$25
$20
MR1
$15
$10 $5 Q 1 2 3 4 5 6 7 8 9

56. 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.

57. END