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
Another important dimension of product differentiation, not emphasized in the book, is location. Gasoline seems like an undifferentiated product, yet different gas stations charge different prices. How can some gas stations get away with charging 5 or even 10 cents more per gallon? The answer is product differentiation by location.
Imagine you’re driving home in rush-hour traffic from a grueling 10-hour day at the office. The orange warning light comes on, indicating your car needs gas. After uttering a few choice expletives, you notice two gas stations at an upcoming intersection. The one on the right charges 5 cents more than the one on the left, but is easily accessible. The one on the left would require you to make a left-hand turn in heavy traffic to get into the station, and another to get out. And how much would you save? If you buy 20 gallons, you’d save only $1.
Alternatively, imagine you run a gas station located in a highly residential area, in which there are few other businesses – including gas stations. If people want gas, they can buy it from you, or they can drive 10 minutes to a more commercial area with lots of gas stations. Your location allows you to charge a higher price.
Business people have long understood that location is a critical dimension of product differentiation. Hence the saying “location, location, location.” 3

4. A Monopolistically Competitive Firm Earning Profits in the Short Run
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. MC
ATC
Quantity
Price
profit D P MR
ATC
The graphical analysis of the monopolistically competitive firm’s output, price, and profits/losses is very similar to that of the monopoly firm.
One subtle difference is that the demand curve (and MR curve) facing the monopolistically competitive firm is likely to be flatter than the demand curve facing the monopolist, as the monopolistic competitor faces competition from other firms selling similar products. Q 4

5. Comparing Monopoly & Monop. Competition
Monopoly
MonopolisticCompetition
many
one
number of sellers
yes no
free entry/exit
zero
positive
long-run econ. profits
yes
firm has market power?
For monopolistic competition, free entry/exit drives profits to zero in the long run.
In contrast, barriers to entry prevent the monopolist’s profits from being driven to zero.
A monopoly is the sole seller of a product with no close substitutes. In contrast, the monopolistic competitor sells a product with many close substitutes. As a result, demand for the monopolist’s product is less elastic than demand for the monopolistic competitor’s product.
downward-sloping
downward-sloping (market demand)
D curve facing firm
many
none
close substitutes 5

6. Comparing Perfect & Monop. Competition
Perfect competition
Monopolistic competition
many
number of sellers
yes
free entry/exit
zero
long-run economic profits
differentiated
identical
the products firms sell
That long-run profits are zero follows from free entry/exit.
The market power of a monopolistic competitor follows from the fact that it sells a product that is at least somewhat different from products sold by other firms.
The D curve facing a monopolistically competitive firm is downward-sloping because the firm has a bit of market power and sells a unique variety.
yes
none, price-taker
firm has market power?
downward-sloping
horizontal
D curve facing firm 6

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.
Due to the markup of price over marginal cost, the market output under monopolistic competition will be smaller than the socially efficient output, as we discuss on the following slide. 7

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.
This section of the textbook has a nice FYI box contrasting the views on advertising of John Kenneth Galbraith and Frederic Hayek, two of the great economists of the 20th century. 9

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. 10

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. 11

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.
The problem facing policymakers here is similar to the problem arising from natural monopoly:
With natural monopoly, ATC is always falling, so MC is below ATC. If regulators force a natural monopoly to price at marginal cost, it will incur losses. 12

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. 14

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. 15

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. 16