Oligopoly and Monopolistic Competition in Economics
These are my notes and thoughts on oligopoly and monopolistic competition in economics.
Realistic models of market structure lie somewhere between perfect competition and monopoly. Oligopoly and monopolistic competition are the market structures that do just that. We will learn that even markets with only two firms can yield competitive outcomes.
Two market structures that lie between perfect competition and monopoly are oligopoly and monopolistic competition. In both of these markets, the seller must recognize the actions of competitors. In oligopolies, economic profits in the long run can be positive. In monopolistically competitive markets, entry and exit drive economic profits to zero in the long run. Several important variables, such as the number of firms in the industry, the degree of product differentiation, entry barriers, and the presence or absence of collusion, determine the competitiveness of a market.
Coffee and tasty foods are typical examples of differentiated products, which are goods that are similar but are not perfect substitutes. They contrast with homogenous products, which are those goods that are identical and are therefore perfect substitutes. Soybeans grown by different farmers are perfect substitutes, books produced by different authors are not.
Industries differ not only in whether their products are differentiated or homogeneous but also in the number of sellers present in the industry. Some industries will have a few sellers, like airlines or cable tv. Other industries will have many sellers, like the book or music industries.
Between the two extremes of perfect competition and monopoly, there are oligopoly and monopolistic competition. In oligopoly, only a few firms are competing, which could be in the context of either homogeneous or differentiated products. In monopolistic competition, many firms sell differentiated products, and each enjoys some degree of market power.
Our first new market structure is oligopoly, which applies when there are only a few suppliers of a product. They can feature either homogeneous or different products. Because in an oligopoly only a few firms are operating, each firm’s profits and profit-maximizing choices depend on other firms’ actions.
Our second new market structure is monopolistic competition. The name reflects the basic tension between market power and competitive forces that exists in this market type. All firms in a monopolistically competitive industry face a downward-sloping demand curve, so they have market power and choose their own price. What’s competitive about such markets is that there are no restrictions on entry, any number of firms can enter the industry at any time. This means that firms in a monopolistically competitive industry, despite having pricing power, make zero economic profits in the long run. Similar to a perfectly competitive industry, monopolistic competition features many competing firms, but unlike perfect competition, the sellers produce and sell different products.
You will see that oligopolies can be usefully divided into two categories, those that sell homogeneous goods and those that sell different goods. The first model, oligopoly with identical products, is similar to the monopoly model, but one key difference is that the oligopolist must recognize the behavior of its competitors, whereas the monopolist does not. The second model, oligopoly with different products, is linked to the monopolistic competition market structure with one major exception, entry is impeded in the oligopoly, whereas there is free entry in the monopolistically competitive market.
The oligopolist’s problem shares important similarities with the two market types discussed in previous chapters, perfect competition and monopoly. It has the following features. Due to cost advantages associated with the economies of scale of oligopoly or other barriers to entry, entry and exit will not necessarily push the market to zero economic profits in the long run. Because of relatively few competitors, the sellers that do occupy the market interact strategically.
One of the simplest cases of oligopoly is an industry with only two competing firms, a duopoly. Two firms can compete against each other and set prices. This model is called the Bertrand competition.
What is directly relevant for a firm’s profit-maximizing decisions is not the market demand curve but its residual demand curve, which is the demand that is not met by other firms. This residual demand curve depends on the prices charged by all firms in the market.
In a duopoly with homogeneous products, the best response of a firm that has a higher price is to undercut its rival. The Nash equilibrium is often marginal cost. So, in this equilibrium, each of the two companies ends up supplying half of the market, and because both are selling at marginal cost, they both earn zero economic profits.
One important lesson I see from these topics is for a business not to make a homogeneous product, so that it cant easily be price cut down to marginal cost.
In summary, we have seen that with two homogeneous products, two firms competing head to head are sufficient to bring the price down to marginal cost. This is no longer true with different products. In fact, in an oligopoly with different products, firms typically make positive economic profits, and some oligopolies persist in the long run with positive profits because of barriers to entry.
It’s not in the interest of one company to collude if the other is colluding. The standard oligopoly models discussed so far cannot explain such puzzling behavior. To get at the motivations behind the behavior, we must consider a model of collusion. Collusion occurs when rival firms conspire among themselves to set prices or to control production quantities rather than let the free market determine them.
One model of how an oligopoly might behave is for all the firms to coordinate and collectively act as a monopolist and then split the monopoly profits among themselves. Jointly acting together to earn monopoly profits is the best an industry can do in terms of profit. Collusion is therefore much more profitable than competition.
We now return to the final major market structure, monopolistic competition. You will recall this market features many firms offering different products.
The residual demand curve facing a monopolistically competitive firm is downward-sloping, much like the demand curve for the monopolist. As a result, the marginal revenue curve is below the demand curve, again just like the marginal revenue curve facing a monopolist.
The solution to the monopolistic competitor’s problem is identical to the profit-maximizing choice of a monopolist, find where marginal cost equals marginal revenue, drop straight down to find quantity, go straight up to the demand curve, and go left to the y-axis to find the profit-maximizing price.
This summary of the optimal decision rule highlights the fact that the decision concerning the relationship between marginal revenue and marginal cost, which determines the level of production, is identical across the three market structures of perfect competition, monopoly, and monopolistic competition: expand production until marginal cost equals marginal revenue. The major difference arises with the firm in a perfectly competitive industry: it faces a perfectly elastic demand curve for its product, which leads to price being equal to marginal revenue. For the monopolistic competitor, however, we have the price being greater than marginal revenue because they face a downward-sloping demand curve.
Similar to sellers in all market structures, economic profits are not ensured for the seller in a monopolistically competitive industry.
What’s competitive about monopolistically competitive industries is that there are no restrictions on entry-firms can freely enter and exit the industry at any time.
If total revenues cover variable costs, then continue to produce in the short run. If total revenues do not cover variable costs, then shutdown is optimal, as you will lose less money by shutting down and paying fixed costs than you would by operating.
In a perfectly competitive industry, market changes operate through shifts in the market supply curve. In monopolistic competition, market changes occur because the residual demand curve becomes flatter and shifts leftward with entry.
Because entry pushes economic profits to zero in the long run, monopolistically competitive firms have an incentive to continually try to distinguish themselves from rivals, so that markets are perpetually in motion.
Firms have to continually make new products from their same inputs, to distance themselves from competitors and new entries into the market. Don’t do too much though because these actions cost a lot of money and contribute to long run zero economic profits for firms.
Compared to a competitive market, monopolists will be able to charge a price greater than marginal cost, thereby reducing sales and thus total surplus. This is also the case for oligopolies with different products. In both market structures, firms have market power and are able to charge prices greater than marginal cost, reducing total surplus.
With free entry and exit, economic profits in the long run equilibrium will equal zero. Then firms will exit the market. However, in real life, you will see that firms do not exit the market. That is because they constantly try to innovate and show how their products are different from competitors. This keeps consumers coming and revenue coming.
The fact that monopolistic competitors each have a downward-sloping demand curve causes them to act differently than a perfectly competitive seller. First, they produce at a level that is below the efficient scale of production. Second, they mark up prices above its marginal cost.
Allin all, economists favor regulation for monopolies and for highly regulated oligopolies, but are generally comfortable with permitting the more limited market power of monopolistically competitive firms, even though it still reduces total surplus to the economy.
As we just learned, monopolistic competition and oligopoly share many features with monopolies, including the ability to set prices. The primary difference across these three market structures is the number of competitors, or the number of sellers. A monopoly has only one seller. But monopolistic competition and oligopoly are market structures with more than one seller, and because of this, they have to concern themselves with the actions of the other firms.
Oligopoly and monopolistic competition are two market structures that lie between the market extremes of perfect competition and monopoly. Firms in these market structures must consider the behavior of competitors, whereas neither a monopolist nor firms in a perfectly competitive industry need to do so.
No single model of oligopoly is applicable for every situation. The equilibrium will depend on the unique features of the market-whether the goods are homogeneous or different, how many firms are in the industry, and whether collusion is sustainable. Nevertheless, there are some important general lessons from the study of oligopoly. Economic profits of firms will be higher when goods are different, when there are fewer firms in the industry, and when collusion is sustainable.
In the short run, behavior of the monopolistic competitor and the monopolist are identical: set price greater than marginal revenue and marginal cost. In the long run, entry and exit cause the equilibrium in a monopolistically competitive industry-zero economic profits-to be identical to equilibrium in perfect competition.
Economics provides a useful set of tools to begin a discussion of whether a market is competitive, but there is no one factor-such as the number of firms-that wholly dictates the nature of competition in a specific industry.
How are the products sold by a monopolistically competitive firm different from the products sold in a competitive market? Unlike products sold in a competitive market, the products sold in a monopolistically competitive market are:
- Different
Consider a noncollusive duopoly model with both firms supplying bottled drinking water. The marginal cost for each firm is 1.25. The market demand is shown by the figure on the right.
Let us assume that the two forms supplying drinking water are Firm A and Firm B. The price charged by A is Pa and the price charged by B is denoted Pb. Find the demand functions for each of the firms.
If Pa is less than or equal 4, then demand for A bottled drinking water is:
The demand curve in the figure indicates that 2 thousand units of bottled drinking water are demanded at a price of 4 per bottle. However, if the price is more than 4, quantity demanded falls to zero.
- 2 thousand if Pa < Pb
- 1 thousand if Pa = Pb
- 0 thousand if Pa > Pb
If Pb is less than or equal to 4, then demand for B’s bottled drinking water is:
- 2 thousand if Pb < Pa
- 1 thousand if Pb = Pa
- 0 thousand if Pb > Pa
The Nash equilibrium is when A charges a price of
- 1.25
Acme is currently the only grocery store in town. Bi-Rite is thinking of entering this market. They will play the following game. First, Bi-Rite will decide whether or not to enter. If it does not enter, then the game ends, Acme earns a payoff of 50, and Bi-Rite earns a payoff of 0. If Bi-Rite does enter, then Acme has to decide whether to fight by slashing prices or to accommodate. If Acme decides to fight, then Acme and Bi-Rite each earns -10, if Acme accommodates, then each earns 20.
Using backward induction, the Nash equilibrium for Bi-Rite is:
- To enter and for Acme to accommodate
Suppose Acme threatens to fight if Bi-Rite enters. This threat:
- Is not credible
Tobacco companies have often argued that they advertise to attract more existing smokers and not to persuade more people to smoke. Suppose there were just two cigarette manufacturers, Jones and Smith. Each can either advertise or not advertise. If neither advertises, they each capture 50 percent of the market and each earns 50 million. If they both advertise, they again split the market evenly, but each spends 10 million on ad and so each earns just 40 million. If one company advertises but the other does not, then the company that advertises attracts many of its rivals' customers. As a result, the company that advertises earns 60 million and the company that does not earns just 30 million.
What is each firm’s dominant strategy?
- Both firms’ dominant strategy is to advertise
Suppose the government proposes a ban on cigarette ads.
The two companies should:
- Favor the ban
Major league baseball teams have imposed what is commonly called the luxury tax on themselves. A team is subject to the tax if its payroll exceeds a specified level. The annual threshold for the luxury tax is 189 million. A team that exceeds the threshold must pay 17.5 percent to 50 percent of the amount by which its payroll is above the threshold, where the tax rate depends on the number of years the team is over. This question looks at why teams might subject themselves to this tax.
Suppose there are two major league baseball teams, 1 and 2. They will both choose to offer either high salaries to players or low salaries. They will make their decisions simultaneously. If both choose low each will earn 500, if both choose high each will earn 450. If one chooses high and the other low, the team that chooses high will attract the best players and will earn 650, but the team that chooses low will earn just 350.
Show that high is a dominant strategy but that both teams would be better off if both chose low.
If one team picks low, then the other team reduces its payoff by:
A dominant strategy is one best response to every possible strategy of the other players. If one team picks low, then the other team reduces its payoff from 650 to 500 from picking low instead of high, and if one team picks high, the other team reduces its payoff from 450 to 350 from picking low instead of high.
1.150 and 100
If both teams picked low, then their combined payoff would be higher by:
- 100
Under a 1922 Supreme Court decision, major league baseball is not subject to many antitrust laws. Suppose these two teams agree to a luxury tax. Under this luxury tax, a team that chooses high must pay a tax of 275. What is the Nash equilibrium?
- The Nash equilibrium is for both teams to pick low
Some people might argue that the luxury tax in baseball is not an important determinant of major league salaries. As evidence, they show that team payrolls rarely exceed the threshold level and so teams rarely pay the tax. Your answer tot his question suggests the logic of the luxury tax is:
- Important because it promotes low salaries
Suppose the world demand schedule for oil is:
55 20
80 15
130 10
There are two oil producing countries, A and B. Each will produce either 5 of 10 barrels of oil. To keep things simple, assume they can produce this oil at zero cost.
There are four possible outcomes. B produces 5 or 10 barrels of oil and A produces 5 or 10 barrels of oil.
Find each country’s profit for each of these four possibilities.
If A produces 5 and B produces 5 then A’s profit is:
- 650 for A and 650 for B
If A produces 10 and B produces 5 the profit is:
- 800 for A and 400 for B
If A produces 5 and B produces 10 then profit is:
- 400 for A and 800 for B
If A produces 10 and B produces 10 then profit is:
- 550 for A and 550 for B
Suppose these countries choose the quantity of oil to produce simultaneously and without consulting with one another. What is each country’s dominant strategy?
- Each country’s dominant strategy is to produce 10
The oil ministers realize they can do better if they collude and agree that each will produce 5. By colluding, each country will increase its profit by:
- 100
Do they have incentives to cheat?
- A will have incentive to cheat and produce 10
- B will have incentive to cheat and produce 10
Two firms are planning to sell 10 or 20 units of their goods. Suppose firm 1 decides how much to produce first. The game tree is illustrated right. What is the Nash equilibrium?
- The Nash equilibrium is for firm 1 to produce 20 units and for firm 2 to produce 10 units.
Consider a noncollusive duopoly model with both firms supplying ketchup. The marginal cost for each firm is 1.00. The market demand is shown by the figure on the right.
Let us assume that the two firms supplying ketchup are A and B. The price charged by A is denoted by Pa and the price charged by B is denoted Pb.
If the firms collude, then:
- A will charge a price of 6.00
- B will charge a price of 6.00
Both monopolies and monopolistically competitive firms set marginal revenue equal to marginal cost to maximize profit. Given the same cost curves, would you expect prices to be higher in a monopoly or a monopolistically competitive market?
- Monopoly because its demand is more inelastic
The diagram on the right shows the short-run demand curve, marginal revenue curve, average total cost curve, and marginal cost curve for a firm in a monopolistically competitive market. The firm should produce:
- 32 units of output. mr=mc
The firm should charge a price of:
- 19
The firm will earn:
- Positive economic profits
In the long runs, firms should:
- Enter this industry
Consider the following graphs:
Which of the graphs above corresponds to a firm that faces perfect competition?
- Graph C
Which of the graphs above, that does not actually show perfect competition, is closest to perfect competition in terms of the price and quantity?
- Graph B
Which of the following statements is true of monopolistic competition and perfect competition?
- Perfect competition is a special case of monopolistic competition, which occurs when demand is perfectly elastic
A monopolistically competitive industry in the short run is illustrated by the figure on the right with the demand, marginal revenue, marginal cost, and long-run average cost curves for a representative firm. Suppose firms in this industry are initially producing such that they maximize profits. Does this monopolistically competitive firm earn economic profits in the short run?
- Draw rectangle starting at point mc=mr, then straight up to demand curve, then bring rectangle over to y-axis, then label profit
Consider the market for college textbooks. Assume this market is monopolistically competitive. A representative firm’s demand, marginal revenue, marginal cost, and average cost curves are illustrated in the figure on the right. This industry:
- Is not in long-run equilibrium, because firms are earning profits, which will result in firms entering
Suppose there are five firms in an industry. Their sales are as follows:
1=92
2=52
3=34
4=16
5=6
Sum the total sales. We get 200
92 = 46%
52=26%
34=17%
16=8%
6=3%
Square the percentages and add them up.
2116+676+289++64+9= 3154
The HHI for this industry is:
- 3154
Two firms are planning to sell 10 or 20 units of their goods. What is the Nash equilibrium?
- Nash equilibrium is for firm 1 to produce 20 units and for firm 2 to produce 10 units. On the game tree, look for the combination that sums to most, then backtrack to see decisions
Suppose there are five firms in an industry, each with an equal market share. The HHI(Herfindahl-Hirschman index) for this industry is
- 2000
If the number if firms increases to 10, each with an equal market share, then the HHI is:
- 1000
Seller A increases the price of its good by 20 percent and still enjoys a high market demand. Due to the high demand, there is an increase in the number of similar sellers in the long run. This is an example of:
- Monopolistic competition
Which of the following is not a common characteristic between a monopoly and monopolistic competition?
- The products sold have close substitutes
Suppose good A belongs to a market where the firms earn zero economic profits in the long run and entry of new firms will result in price changes that operate through shifts in the market supply for good A. Which market structure does good A belong to?
- The perfectly competitive market
Suppose you and your friends decide to go to the beach during spring break. You need to fly from Kansas City to Miami but only two airlines provide the service. This market is best characterized as:
- Oligopoly
Fill in the type of market that matches each feature mentioned below.
Firm sets market price depending on other firms market price
- Oligopoly
Firm with zero ability to affect price
- Perfect competition
A product with no close substitutes
- Monopoly
Which of the following is not an example of monopolistic competition?
- Pharmaceuticals
Suppose you and your friends decide to go to the beach during spring break, You need to fly from Kansas City to Miami and over 12 separate airlines provide the service. This market is best characterized as:
- Monopolistic competition
You accept a new job for a wage of 30000. Each subscription sells for 200. Assuming the wage is determined by market forces, your boss must believe that your marginal product of labor is:
- At least equal to 150
Consider the following game with David and Jordan. Davids dominant strategy is:
- Low price
Jordan’s dominant strategy is:
- Low price
Nash equilibrium is:
- Box D
Suppose there are cable TV companies in your city, Astounding cable and Broadcast cable.
Astounding dominant strategy is:
- Medium
Broadcast’s dominant strategy is:
- No dominant strategy
The equilibrium is:
- medium/medium
How does the market for inputs like labor differ from the market for goods and services?
- Firms are sellers in the market for goods and services, while individuals are sellers in the market for inputs
- Firms are buyers in the market for inputs, while individuals are buyers in the market for goods and services
- The demand for inputs is derived from the demand for final goods and services
For a market to be characterized as monopolistically competitive, there must be:
- All of the above
- Zero economic profits in the long run
- Different products
- Many sellers
An example of a monopolistically competitive firm is the:
- Fast-food industry
A dominant strategy equilibrium is:
- The combination of strategies where each strategy is a dominant strategy
Economists study market structures that fall between the two extremes of perfect competition and monopoly for all of the following reasons except:
- Counting the number of firms tells us whether the market is competitive
A production functions shows:
- The number of workers employed and the corresponding output levels that will be produced
According to the law of diminishing returns:
- The marginal productivity of an additional unit of labor eventually decreases as the quantity of labor increases
The police confront Snoop and Charlie.
Snoop’s dominant strategy is:
- Confess
Charlie’s dominant strategy is:
- Confess
Nash equilibrium is:
- Box 4