Monopolistic Competition And

Oligopoly
On any given day, you are probably
exposed to hundreds of advertisements
In perfect competition and monopoly firms
do little, if any, advertising
Where, then, is all the advertising coming
from?
Hall & Leiberman;
Economics: Principles

The Concept of Imperfect

Competition
Refers to market structures between
perfect competition and monopoly
Types of imperfectly competitive markets
Monopolistic competition
Oligopoly

Hall & Leiberman;

Economics: Principles

Monopolistic Competition
Hybrid of perfect competition and
monopoly, sharing some of features of
each
A monopolistically competitive market has
three fundamental characteristics
Many buyers and sellers
Sellers offer a differentiated product
Sellers can easily enter or exit the market

Hall & Leiberman;

Economics: Principles

Many Buyers and Sellers

Under monopolistic competition, an individual
buyer is unable to influence price he pays

But an individual seller, in spite of having many

competitors, decides what price to charge

Hall & Leiberman;

Economics: Principles

Sellers Offer a Differentiated

Product
Each seller produces a somewhat different
product from the others
Faces a downward-sloping demand curve
In this sense is more like a monopolist than a
perfect competitor
When it raises its price a modest amount,
quantity demanded will decline (but not all the
way to zero)
Hall & Leiberman;
Economics: Principles

Sellers Offer a Differentiated

Product
What makes a product differentiated?
Product differentiation is a subjective
matter
Thus, whenever a firm (that is not a
monopoly) faces a downward-sloping
demand curve, we know buyers perceive
its product as differentiated
Hall & Leiberman;
Economics: Principles

Easy Entry and Exit

Same as in perfect competition
Ensures firms earn zero economic profit in
long-run

In monopolistic competition, however,

assumption about easy entry goes further
No barrier stops any firm from copying the
successful business of other firms

Hall & Leiberman;

Economics: Principles

Monopolistic Competition in the

Short-Run
Individual monopolistic competitor
behaves very much like a monopoly
Key difference is this
When a monopolistic competitor raises its
price, its customers have one additional
option to buy from another seller

Hall & Leiberman;

Economics: Principles

Figure 1: A Monopolistically
Competitive Firm in the Short Run
Dollars

$70

1. Kafka services 250 homes

per month, where MC and
MR intersect . . .
A

MC
ATC
2. and charges
$70 per home.
d1

30
4. Kafka's monthly
profit$10,000is
the area of the
shaded rectangle.
Hall & Leiberman;
Economics: Principles

MR1 3. ATC at 250 units is less

than price, so profit per
unit is positive.
250

Homes Serviced per Month

9

The Long-Run
No barriers to entry and exitthe firm will
not enjoy its profit for long
Under monopolistic competition, firms can
earn positive or negative economic profit in
short-run
But in long-run, free entry and exit will
ensure that each firm earns zero economic
profit just as under perfect competition
Hall & Leiberman;
Economics: Principles

10

Figure 2: A Monopolistically
Competitive Firm in the Long Run
In the long run, profit attracts
entry, which shifts the firm's
demand curve leftward.

Dollars

MC

$40

The typical firm

produces where
its new MR
crosses MC.

Hall & Leiberman;

Economics: Principles

Entry continues until P = ATC

at the best output level, and
economic profit is zero. d1
MR2

100

ATC

d2
250

MR1
Homes Serviced
per Month
11

Excess Capacity Under

Monopolistic Competition
In long-run, a monopolistic competitor will
operate with excess capacity
Excess capacity suggests that monopolistic
competition is costly to consumers
Does that mean consumers prefer perfect
competition to monopolistic competition?

Hall & Leiberman;

Economics: Principles

12

Nonprice Competition
Any action a firm takes to increase
demand for its outputother than cutting
its priceis called nonprice competition
Nonprice competition is another reason
why monopolistic competitors earn zero
economic profit in long-run
All this nonprice competition is costly
Hall & Leiberman;
Economics: Principles

13

Oligopoly
An oligopoly is a market dominated by a
small number of strategically
interdependent firms
In such a market, each firm recognizes its
strategic interdependence with others

Hall & Leiberman;

Economics: Principles

14

Number of Firms
Oligopoly requires that a few firms
dominate the market
No absolute number at which oligopoly
ends and monopolistic competition begins

Hall & Leiberman;

Economics: Principles

15

Market Domination
Strategic interdependence requires that a
few firms dominate the market
As combined market share shrinks,
strategic interdependence becomes
weaker
Oligopoly is a matter of degree
Not an absolute classification

Hall & Leiberman;

Economics: Principles

16

Economies of Scale: Natural

Oligopolies
When minimum efficient scale (MES) for a
typical firm is a relatively large percentage
of market
A large firm will have lower cost per unit than
a small firm

Does it remind you of monopoly? How is

this different?
Hall & Leiberman;
Economics: Principles

17

Barriers to entry
Reputation - A new entrant may suffer just
from being new
Strategic barriers - Oligopoly firms often
pursue strategies designed to keep out
potential competitors
Legal barriers - Patents and copyrights,
Govt. legislation
Hall & Leiberman;
Economics: Principles

18

Oligopoly vs. Other Market

Structures
Oligopoly presents the greatest challenge to
economists
Essence of oligopoly is strategic
interdependence
Need new tools of modeling
One approachgame theoryhas yielded rich
insights into oligopoly behavior
Hall & Leiberman;
Economics: Principles

19

The Game Theory Approach

Game theory
In all games, except those of pure chance,
a players strategy must take account of
the strategies followed by other players
Game theory analyzes oligopoly decisions
as if they were games
Hall & Leiberman;
Economics: Principles

20

The Prisoners Dilemma

Each of four boxes in payoff matrix represents
one of four possible strategy combinations that
might be selected in this game
Upper left box: Both Rose and Colin confess
Lower left box: Colin confesses and Rose
doesnt
Upper right box: Rose confesses and Colin
doesnt
Lower right box: Neither Rose nor Colin
confesses
Hall & Leiberman;
Economics: Principles

21

Figure 3: The Prisoners Dilemma

Colins Actions
Confess
Dont Confess
Colin gets
20 years
Confess

Roses Actions

Dont Confess

Hall & Leiberman;

Economics: Principles

Rose
gets 20
years
Colin gets
3 years
Rose
gets 20
years

Colin gets
30 years
Rose
gets 20
years
Colin gets
5 years
Rose
gets 20
years
22

The Prisoners Dilemma

Regardless of Roses strategy Colins best choice is to
confess
Confess is the dominant strategy for both
Outcome of this game is an example of a Nash
equilibrium
As long as each player acts in an entirely self-interested
manner Nash equilibrium is best outcome for both of
them
Hall & Leiberman;
Economics: Principles

23

Simple Oligopoly Games

To apply the same method to a simple oligopoly
market
Duopoly - Oligopoly market with only two sellers
Assume that Gus and Filip must make their
decisions independently
No matter what Filip does, Guss best move is to
charge a low pricehis dominant strategy
The same holds for Filip
The outcome is a Nash equilibrium
Hall & Leiberman;
Economics: Principles

24

Figure 4: A Duopoly Game

Guss Actions
Confess
Dont Confess
Guss profit
= $25,000
Confess

Filips Actions

Dont Confess

Hall & Leiberman;

Economics: Principles

Filips
Profit =
$25,000
Guss profit
= $75,000
Filips
Profit =
$10,000

Guss profit
= $10,000
Filips
Profit =
$75,000
Guss profit
= $50,000
Filips
Profit =
$50,000
25

Oligopoly Games in the Real World

Will typically be more than two strategies from
which to choose
Will usually be more than two players
In some games, one or more players may not
have a dominant strategy
A game with two players will have a Nash equilibrium
as long as at least one player has a dominant strategy
When neither player has a dominant strategy, we
need a more sophisticated analysis to predict an
outcome to the game
Hall & Leiberman;
Economics: Principles

26

Oligopoly Games in the Real World

Weve limited the players to one play of
the game
In reality, for gas stations and almost all other
oligopolies, there is repeated play
Where both players select a strategy
Observe the outcome of the trial
Play the game again and again, as long as they
remain rivals

One possible result of repeated trials is

cooperative behavior
Hall & Leiberman;
Economics: Principles

27

Cooperative Behavior in Oligopoly

In real world, oligopolists will usually get
more than one chance to choose their
prices
The equilibrium in a game with repeated
plays may be very different from
equilibrium in a game played only once

Hall & Leiberman;

Economics: Principles

28

Explicit Collusion
Simplest form of cooperation is explicit collusion
Most extreme form of explicit collusion is
creation of a cartel
If explicit collusion to raise prices is such a good
thing for oligopolists, why dont they all do it?
But oligopolists can collude in other, implicit
ways
Hall & Leiberman;
Economics: Principles

29

Tacit Collusion
Any time firms cooperate without an explicit
agreement, they are engaging in tacit collusion
Tit for tat
A game-theoretic strategy of doing to another player
this period what he has done to you in previous period

However, gentle reminder of tit-for-tat is not

always effective in maintaining tacit collusion

Hall & Leiberman;

Economics: Principles

30

Tacit Collusion
Another form of tacit collusion is price
leadership
With price leadership, there is no formal
agreement

Hall & Leiberman;

Economics: Principles

31

The Limits to Collusion

Oligopoly powereven with collusion
has its limits
Even colluding firms are constrained by
market demand curve
Collusioneven when it is tacitmay be
illegal
Collusion is limited by powerful incentives to
cheat on any agreement
Hall & Leiberman;
Economics: Principles

32

The Incentive to Cheat

Go back to Gus and Filip for a moment
One way or another they arrive at high-price
cooperative solution
Will the market stay there?

Each player has an incentive to cheat

Analyzing this sort of behavior requires some
rather sophisticated game theory models

Hall & Leiberman;

Economics: Principles

33

When is Cheating Likely?

Cheating is most likely to occurand collusion
will be least successfulunder the following
conditions
Difficulty observing other firms prices
Unstable market demand
Large number of sellers

Hall & Leiberman;

Economics: Principles

34

Figure 5a: Advertising in

Monopolistic Competition
1.Before advertising, long-run
economic profit is zero.
Dollars
$120

B
C

100

3. But in the long run, imitation

and entry bring economic
profit back to zero.
ATCads
ATCno ads

60
4. Advertising
can lead to a
higher price
in the long
run, as in this
panel . . .

2. In the short run, the first firms to

advertise earn economic profit.

dads
dall advertise

dno ads
1,000
2,000

Hall & Leiberman;

Economics: Principles

6,000

Bottles of Perfume
per Month
35

Figure 5b: Advertising in

Monopolistic Competition
Dollars
$120

5. or to a lower price
B
in the long run, as
in this panel.

dall advertise

60
50

ATCads
ATCno ads
dads

dno ads
1,000
2,000
Hall & Leiberman;
Economics: Principles

6,000

Bottles of Perfume
per Month
36

Using the Theory: Advertising in

Monopolistic Competition and Oligopoly
Perfect competitors never advertise and
monopolies advertise relatively little
But advertising is almost always found under
monopolistic competition and very often in oligopoly

Why?
All monopolistic competitors, and many oligopolists,
produce differentiated products

Since other firms will take advantage of

opportunity to advertise, any firm that doesnt
advertise will be lost in shuffle
Hall & Leiberman;
Economics: Principles

37

Advertising and Collusion in

Oligopoly
Oligopolists have a strong incentive to
engage in tacit collusion
Take airline industry as an example
In theory, any airline should be able to
claim superior safety
Yet no airline has ever run an advertisement
with information about its security policies or
attacked those of a competitor
Hall & Leiberman;
Economics: Principles

38

Figure 6: An Advertising Game

American's Actions
Run Safety Ads Don't Run Ads

Run Safety Ads

United's Actions
Don't Run Ads

Hall & Leiberman;

Economics: Principles

American
earns low
profit
United
earns low
profit
American
earns high
profit
United
earns very
low profit

American
earns very
low profit
United
earns high
profit
American
earns
medium
United
profit
earns
medium
profit
39

The Four Market Structures: A

Postscript
Different market structures
Perfect competition
Monopoly
Monopolistic competition
Oligopoly

Market structure models help us organize

and understand apparent chaos of realworld markets
Hall & Leiberman;
Economics: Principles

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