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Monopolistic Competition and Oliogopoly. In this chapter,  What market structures lie between perfect competition and monopoly, and what are their characteristics?

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Presentation on theme: "Monopolistic Competition and Oliogopoly. In this chapter,  What market structures lie between perfect competition and monopoly, and what are their characteristics?"— Presentation transcript:

1 Monopolistic Competition and Oliogopoly

2 In this chapter,  What market structures lie between perfect competition and monopoly, and what are their characteristics?  How do monopolistically competitive firms choose price and quantity? Do they earn economic profit?  What are the social costs and benefits of advertising?  What outcomes are possible under oligopoly?  Why is it difficult for oligopoly firms to cooperate? 2

3 Characteristics & Examples of Monopolistic Competition Characteristics:  Many sellers  Product differentiation  Free entry and exit Examples:  apartments  car insurance  auto repair shops  clothing  restaurants  night clubs

4 profi t ATC P A Monopolistically Competitive Firm Earning Profits in the Short Run The firm faces a downward-sloping D curve. At each Q, MR < P. To maximize profit, firm produces Q where MR = MC. The firm uses the D curve to set P. Quantity Price ATC D MR MC Q

5 Comparing Monopoly & Monop. Competition yes firm has market power? downward- sloping downward-sloping (market demand) D curve facing firm manynoneclose substitutes zeropositivelong-run econ. profits yesnofree entry/exit manyonenumber of sellers Monopolistic Competition Monopoly

6 Comparing Perfect & Monop. Competition yes none, price-takerfirm has market power? downward- sloping horizontal D curve facing firm differentiatedidentical the products firms sell zero long-run economic profits yes free entry/exit many number of sellers Monopolistic competition Perfect competition

7 Why Monopolistic Competition Is Less Efficient than Perfect Competition 1. Excess capacity  The monopolistic competitor operates on the downward-sloping part of its ATC curve, meaning it produces less than the cost-minimizing output.  Under perfect competition, firms produce the quantity that minimizes costs. 2. Markup over marginal cost  Under monopolistic competition, P > MC.  Under perfect competition, P = MC.

8 Non-Price Competition  Profit margins are slim in Monopolistic Competition, because there are many substitutes…  Competition based on something other than price is necessary to differentiate products. 1. Physical Characteristics 2. Location 3. Service 4. Advertising

9 Advertising In monopolistically competitive industries, product differentiation and markup pricing lead naturally to the use of advertising. In general, more advertising creates greater differentiation, which allows for greater markup Economists disagree about the social value of advertising.

10 The Critique of Advertising Critics of advertising believe:  Society is wasting the resources it devotes to advertising.  Advertising impedes competition – it creates the perception that products are more differentiated than they really are, allowing higher markups.  Brand names cause consumers to perceive differences that do not really exist.  Eliminating government protection of trademarks would reduce influence of brand names, result in lower prices.

11 Proponents of Advertising believe:  Ads may convince buyers to try a product once, but the product must be of high quality for people to become repeat buyers.  Defenders of brand names believe:  Brand names provide information about quality to consumers.  Companies with brand names have incentive to maintain quality, to protect the reputation of their brand names.

12 Monopolistic Competition and Welfare Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. Because P > MC, the market quantity is below the socially efficient quantity. Yet, not easy for policymakers to fix this problem: Firms earn zero profits, so cannot require them to reduce prices.

13 Oligopoly Oligopoly: a market structure in which only a few sellers offer similar or identical products. Strategic behavior in oligopoly: A firm’s decisions about P or Q can affect other firms and cause them to react. The firm will consider these reactions when making decisions. Game theory: the study of how people behave in strategic situations.

14 Collusion vs. Self-Interest Both firms would be better off if both stick to the cartel agreement. But each firm has incentive to renege on the agreement. Lesson: It is difficult for oligopoly firms to form cartels and honor their agreements.

15 The Output & Price Effects Increasing output has two effects on a firm’s profits:  Output effect: If P > MC, selling more output raises profits.  Price effect: Raising production increases market quantity, which reduces market price and reduces profit on all units sold. If output effect > price effect, the firm increases production. If price effect > output effect, the firm reduces production.

16 CONCLUSION Differentiated products are everywhere; examples of monopolistic competition abound. The theory of monopolistic competition describes many markets in the economy, yet offers little guidance to policymakers looking to improve the market’s allocation of resources. Oligopolists can maximize profits if they form a cartel and act like a monopolist.

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