Monopolistic Competition,

Oligopoly, and Strategic Pricing

MODULE 4
 Introduction

• Perfect competition, with an

infinite number of firms, and
monopoly, with a single firm,
are polar opposites.
 Introduction

• Monopolistic competition and oligopoly lie

between these two extremes.

– Monopolistic competition is a market

structure in which there are many firms
selling differentiated products.
– Oligopoly is a market structure in which
there are a few interdependent firms.
 Introduction

• Most U.S. industry structures fall almost

entirely between monopolistic competition
and oligopoly.
• Perfectly competitive and monopolistic
industries are nearly nonexistent.
 Determining Industry Structure
• Economists use one of two methods to
measure industry structure:

1. The Concentration Ratio

2. The Herfindahl Index
 Monopolistic Competition

• The four distinguishing characteristics of

monopolistic competition are:
– Many sellers.
– Differentiated products.
– Multiple dimensions of competition.
– Easy entry of new firms in the long run.
 Many Sellers

• When there are many sellers as in

monopolistic competition, they do not
take into account rivals’ reactions.
• The existence of many sellers also makes
collusion difficult.
• Monopolistically competitive firms act
independently.
 Differentiated Products

• The “many sellers” characteristic gives

monopolistic competition its competitive
aspect.
• Product differentiation gives monopolistic
competition its monopolistic aspect.
 Differentiated Products

• Differentiation exists so long as

advertising convinces buyers that it
exists.

• Firms will continue to advertise as

long as the marginal benefits of
advertising exceed its marginal costs.
Multiple Dimensions of Competition
• One dimension of competition is product
differentiation.
• Another is competing on perceived
quality.
• Competitive advertising is another.
• Others include service and distribution
outlets.
 Easy Entry of New Firms
in the Long Run
• There are no significant barriers to
entry.
• Barriers to entry prevent competitive
pressures.
• Ease of entry limits long-run profit.
 Output, Price, and Profit of a
Monopolistic Competitor
• A monopolistically competitive firm prices
in the same manner as a monopolist—
where MC = MR.
• But the monopolistic competitor is not
only a monopolist but a competitor as well.
 Output, Price, and Profit of a
Monopolistic Competitor
• At equilibrium, ATC equals price and
economic profits are zero.

• This occurs at the point of tangency

of the ATC and demand curve at the
output chosen by the firm.
Monopolistic Competition

Price
MC

ATC
PM

MR D
0 QM Quantity
Comparing Monopolistic Competition
with Perfect Competition

• Both the monopolistic competitor and the

perfect competitor make zero economic
profit in the long run.
Comparing Monopolistic Competition
with Perfect Competition

• The perfect competitors demand curve is

perfectly elastic.
• Easy entry, zero economic profits, and a
uniform product means that the perfect
competitor produces at the minimum of
the ATC curve.
Comparing Monopolistic Competition
with Perfect Competition

• A monopolistic competitor faces a

downward sloping demand curve, and
produces where MC = MR.

• The ATC curve is tangent to the

demand curve at that level, which is
not at the minimum point of the ATC
curve.
Comparing Monopolistic Competition
with Perfect Competition

• Increasing market share is a relevant

concern for a monopolistic competitor but
not for a perfect competitor.
Comparing Monopolistic Competition
with Perfect Competition

• In the real world of monopolistic

competition, increasing output and market
share lowers average total cost.
Comparing Perfect and Monopolistic
Competition

Perfect competition Monopolistic competition

Price Price
MC MC
ATC ATC

PM
PC D PC

MR D
0 QC Quantity 0 QM QC Quantity
Comparing Monopolistic Competition
with Monopoly
• The difference between a monopolist and
a monopolistic competitor is in the
position of the average total cost curve in
long-run equilibrium.
 Advertising and Monopolistic
Competition
• Firms in a perfectly competitive market
have no incentive to advertise: they can
sell all they produce at the market price.
• Monopolistic competitors have a strong
incentive to do so.
 Advertising and Monopolistic
Competition
• The primary goals of the advertiser is
to
1. move the demand curve to the right and
2. make it more inelastic.
 Advertising and Monopolistic
Competition
• Advertising shifts the demand curve
shifts out and shifts the ATC curve up.

• That way the firm can sell more,

charge more, or both.
 Advertising
& the Creation of Name Brands
• There is a sense of trust in buying brands we
know.
• Advertising creates Name Brand Recognition.
• Consumers are sometimes willing to pay more to
reduce their uncertainty about the quality of
the product.
• Companies that develop name brands can often
charge more than for “no name” homogeneous
products.
 Oligopoly
• Oligopoly is a market structure where
there are a small number of mutually
interdependent firms.
• Each firm must take into account the
expected reaction of other firms to its
profit maximizing output decision.
 Models of Oligopoly Behavior

• No single general model of oligopoly

behavior exists.
• Two models of oligopoly behavior are the
cartel model and the contestable market
model.
 Models of Oligopoly Behavior

• In the cartel model, the firms in the

industry (oligopolies) collude to set a
monopoly price.
• In the contestable market model, an
oligopolistic firm with no barriers to
entry sets a competitive price.
 The Cartel Model

• A cartel (sometimes called a trust) is a

combination of firms that acts as it were
a single firm.
• A cartel is a shared monopoly.
 The Cartel Model

• If oligopolies can limit the entry of other

firms and form a cartel, they can
increase the profits going to the
combination of firms in the cartel.
 The Cartel Model

• The model assumes that oligopolies act as

if they were monopolists that have
assigned output quotas to individual
member firms so that total output is
consistent with joint profit maximization.
 Implicit Price Collusion

• Formal collusion is illegal in the U.S. while

informal collusion is permitted.
• Implicit price collusion exists when
multiple firms make the same pricing
decisions even though they have not
consulted with one another.
 Implicit Price Collusion

• Sometimes the largest or most dominant

firm takes the lead in setting prices and
the others follow.
Cartels and Technological Change

• Cartels can be destroyed by an outsider

with technological superiority.
• Thus, cartels with high profits will
provide incentives for significant
technological change.
 Why Are Prices Sticky/rigid?

• Informal collusion is an important reason

why prices are sticky/rigid.
• Another is the kinked demand curve.
 Why Are Prices Sticky/RIGID?

• When there is a kink in the demand curve,

there has to be a gap in the marginal
revenue curve.

• The kinked demand curve is not a

theory of oligopoly but a theory of
sticky/RIGID prices.
The Kinked Demand Curve

Price
a
b MC0
P
c
MC1 D1

d MR1
D2
0 Quantity
Q MR2
 The Contestable Market Model

• According to the contestable market

model, barriers to entry and barriers to
exit determine a firm’s price and output
decisions.
– Even if the industry contains only one firm, it
could still be a competitive market if entry is
open.
 Price Wars

• Price wars are the result of strategic

pricing decisions gone wild.
• Sometimes a firm engages in this activity
because it hates its competitor.
 Game Theory
and Strategic Decision Making
• Most oligopolistic strategic decision
making is carried out with explicit or
implicit use of game theory.
• Game theory is the application of
economic principles to interdependent
situations.
The Prisoner’s Dilemma and a Duopoly
Example
• The prisoner's dilemma can be used to
illustrate the behavior of a duopoly.
• The prisoner’s dilemma is one well-known
game that demonstrates the difficulty of
cooperative behavior in certain
circumstances.
The Prisoner’s Dilemma and a Duopoly
Example
• The prisoners dilemma has its simplest
application when the oligopoly consists of
only two firms—a duopoly.
The Prisoner’s Dilemma and a Duopoly
Example
• By analyzing the strategies of both firms
under all situations, all possibilities are
placed in a payoff matrix.

• A payoff matrix is a box that

contains the outcomes of a strategic
game under various circumstances.
The Payoff Matrix of Strategic
Pricing Duopoly

A Does not cheat A Cheats

A $75,000 A +$200,000
B Does not
cheat B $75,000 B – $75,000

A – $75,000 A0
B Cheats
B +$200,000 B0
 Oligopoly Models, Structure, and
Performance
• A monopoly is the least competitive,
perfectly competitive industries are the
most competitive.
 Oligopoly Models, Structure, and
Performance
• The contestable market model gives less
weight to market structure.

– Markets in this model are judged by

performance, not structure.
– Close relatives of it have previously been
called the barriers-to-entry model, the
stay-out pricing model, and the limited-
pricing model.
 Oligopoly Models, Structure, and
Performance
• There is a similarity in the two
approaches.
– Often barriers to entry are the reason
there are only a few firms in an industry.
– When there are many firms, that
suggests that there are few barriers to
entry.
– In such situations, which make up the
majority of cases, the two approaches
come to the same conclusion.