1. Chapter 7: Monopolistic Competition and Oligopoly
Objectives of chapter 7:
Monopolistic competition
Price and output in monopolistic competition
Monopolistic competition and efficiency
Product variety
Oligopoly and its behavior- a game theory overview
Three oligopoly models
Oligopoly and advertising
Oligopoly and efficiency
Chapter 7 by TITH Seyla

2. What Is Monopolistic Competition?
Monopolistic competition is a market structure in which
A large number of firms compete.
Each firm produces a differentiated product.
Firms compete on product quality, price, and marketing.
Firms are free to enter and exit the industry.
Chapter 7 by TITH Seyla

3. Monopolistic Competition
Examples of Monopolistic Competition
Producers of audio and video equipment, clothing, jewelry, computers, and sporting goods operate in monopolistic competition.
Chapter 7 by TITH Seyla

4. Price and Output in Monopolistic Competition
The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing program produces the profit-maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC).
Price is determined from the demand curve for the firm’s product and is the highest price that the firm can charge for the profit-maximizing quantity.
Figure 14.1 shows a firm’s economic profit in the short run.
Chapter 7 by TITH Seyla

5. Price and Output in Monopolistic Competition
The firm in monopolistic competition operates like a single-price monopoly.
The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price.
It earns an economic profit (as in this example) when P > ATC.
Chapter 7 by TITH Seyla

6. Price and Output in Monopolistic Competition
Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.
Chapter 7 by TITH Seyla

7. Price and Output in Monopolistic Competition
As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.
Chapter 7 by TITH Seyla

8. Price and Output in Monopolistic Competition
Figure 14.3 shows a firm in monopolistic competition in long-run equilibrium.
Chapter 7 by TITH Seyla

9. Price and Output in Monopolistic Competition
Monopolistic Competition and Perfect Competition
Two key differences between monopolistic competition and perfect competition are:
Excess capacity
Markup
A firm has excess capacity if it produces less than the quantity at which ATC is a minimum.
A firm’s markup is the amount by which its price exceeds its marginal cost.
Chapter 7 by TITH Seyla

10. Price and Output in Monopolistic Competition
Firms in monopolistic competition operate with excess capacity in long-run equilibrium.
Firms produce less than the efficient scale—the quantity at which ATC is a minimum.
The downward-sloping demand curve for their products drives this result.
Chapter 7 by TITH Seyla

11. Price and Output in Monopolistic Competition
Firms in monopolistic competition operate with positive markup.
Again, the downward-sloping demand curve for their products drives this result.
Chapter 7 by TITH Seyla

12. Price and Output in Monopolistic Competition
In contrast, firms in perfect competition have no excess capacity and no markup.
The perfectly elastic demand curve for their products drives this result.
Chapter 7 by TITH Seyla

13. What Is Oligopoly? Oligopoly is a market structure in which
Natural or legal barriers prevent the entry of new firms.
A small number of firms compete.
Chapter 7 by TITH Seyla

14. What Is Oligopoly? Barriers to Entry
Either natural or legal barriers to entry can create oligopoly.
Figure 15.1 shows two oligopoly situations.
In part (a), there is a natural duopoly—a market with two firms.
Chapter 7 by TITH Seyla

15. What Is Oligopoly?
In part (b), there is a natural oligopoly market with three firms.
A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms.
Chapter 7 by TITH Seyla

16. What Is Oligopoly? Small Number of Firms
Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate.
Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions.
Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit.
Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.
Chapter 7 by TITH Seyla

17. Two Traditional Oligopoly Models
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.
Chapter 7 by TITH Seyla

18. Two Traditional Oligopoly Models
Figure 15.2 shows the kinked demand curve model.
The firm believes that the demand for its product has a kink at the current price and quantity.
Chapter 7 by TITH Seyla

19. Two Traditional Oligopoly Models
Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged.
Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.
Chapter 7 by TITH Seyla

20. Two Traditional Oligopoly Models
The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by that gap AB in the figure.
Chapter 7 by TITH Seyla

21. Two Traditional Oligopoly Models
Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.
For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit-maximizing price and quantity would not change.
Chapter 7 by TITH Seyla

22. Two Traditional Oligopoly Models
The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact.
If MC increases enough, all firms raise their prices and the kink vanishes.
A firm that bases its actions on wrong beliefs doesn’t maximize profit.
Chapter 7 by TITH Seyla

23. Two Traditional Oligopoly Models
Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms.
The large firm operates as a monopoly, setting its price and output to maximize its profit.
The small firms act as perfect competitors, taking as given the market price set by the dominant firm.
Chapter 7 by TITH Seyla

24. Two Traditional Oligopoly Models
Figure 15.3 shows10 small firms in part (a). The demand curve, D, is the market demand and the supply curve S10 is the supply of the 10 small firms.
Chapter 7 by TITH Seyla

25. Two Traditional Oligopoly Models
At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing.
Chapter 7 by TITH Seyla

26. Two Traditional Oligopoly Models
But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm.
Chapter 7 by TITH Seyla

27. Two Traditional Oligopoly Models
The demand curve for the large firm’s output is the curve XD on the right.
Chapter 7 by TITH Seyla

28. Two Traditional Oligopoly Models
The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.
Chapter 7 by TITH Seyla

29. Two Traditional Oligopoly Models
The large firm maximizes profit by setting MR = MC. Let’s suppose that the marginal cost curve is MC in the figure.
Chapter 7 by TITH Seyla

30. Two Traditional Oligopoly Models
The profit-maximizing quantity for the large firm is 10 units. The price charged is $1.00.
Chapter 7 by TITH Seyla

31. Two Traditional Oligopoly Models
The small firms take this price and supply the rest of the quantity demanded.
Chapter 7 by TITH Seyla

32. Two Traditional Oligopoly Models
In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.
Chapter 7 by TITH Seyla