Business Economics

Lecture -5

Dr. Muhammad Mehboob

Department of Business Administration
IQRA, Karachi

MBA
 Outline

Market Structure
Monopolistic
Competition
Profit Maximization and output decision in
monopolistic competition in both short- and long-run
Oligopoly

Dr
 Introduction: monopolistic Competition

Two extremes
Perfect competition: many firms, identical products
Monopoly: one firm

In between these extremes: imperfect competition

Oligopoly: only a few sellers offer similar or identical
products.
Monopolistic competition: many firms sell similar but not
identical products.

Most markets contain elements of both competition and monopoly.

 Introduction: Monopolistic Competition
Monopolistic Competition refers to markets in which the degree of
competition among sellers falls somewhere in between monopoly
and perfect competition

The importance of monopolistic competition is that it seems to

explain aspects of many important real world markets.

Characteristic of Monopolistic competition

Many sellers sell and produce the products
They sell products that are similar but not identical (products
Differentiation). Each firm produce a good that is slightly different
from those of other firms.
They are not a price taker, each firm faces a downward-sloping
demand
curve.
Free entry and exist
Examples: apartments, bottled water, clothing, fast food, night clubs
 Demand Curve
The demand curve facing a monopolistically competitive
firm looks very much like that facing a monopoly, but it is
very elastic due to the presence of many close substitutes.
$/Q

Ali’s Ice-
Cream
 Comparing Perfect & Monopolistic Competition

Perfect Monopolistic
competitio
n competition
number of sellers many many
free entry/exit yes yes
Long-run econ. Profits zero zero

the products firms sell identical differentiated

firm has market power none, price-taker yes
downward-
D curve facing firm horizontal
sloping
 Comparing Monopoly & Monopolistic Competition

Monopolistic
Monopoly
competition

number of sellers one many

free entry/exit no yes

long-run econ. profits positive zero

firm has market power? yes yes

downward-sloping
D curve facing firm downward-sloping
(market demand)

close substitutes none many

 Profit-Maximization and Output Determination in Monopolistic
Competition in the Short Run
The short-run analysis of the monopolistically competitive firm proceeds exactly
as for monopoly, because in the short-run entry and exit are not possible. The
firm can maximize profits by choosing output where MC = MR. In the short-run,
a monopolistically competitive firm will produce up to the point where MR =
MC.
The firm faces a Price profit MC
downward-
P AT
sloping D curve.
C
At each Q, MR < AT
P. The firm uses C D
the
D curve to set P. MR
To maximize profit, firm
produces Q where MR Q Quantit
This
= MC.firm is earning positive profits in
the short-run. y
A Monopolistically Competitive Firm With Losses in the
Short Run
Profits are not guaranteed. A firm with a similar cost structure is
shown
facing a weaker demand and suffering short-run losses.

For this firm, Price MC

P < ATC at the output
where MR = MC. losses AT
The best this firm can
C
AT
do is to minimize its
C
losses.
P
D
MR
Q Quantit
y
 Monopolistic Competition and Monopoly
Short run: Under monopolistic competition, firm behavior is very similar
to monopoly.

Long run: In monopolistic competition, entry and exit drive economic

profit to zero.

If existing firms can earn profits, there is an incentive for new firms
to enter.
If profits in the short run: New firms enter market, taking some
demand away from existing firms, prices and profits fall.

The process of entry will continue until the incentive to enter goes
away. That is, profit must be zero.

If losses in the short run: Some firms exit the market, remaining
firms enjoy higher demand and prices.
 Oligopoly
Oligopoly is a market structure in which

• Few sellers/firms in the market

• Individual firms can affect market price.
• The firms might produce almost identical products or
differentiated products.
• Barriers to entry, limit entry into the market.
• Interdependence of firms. The demand curves for the individual firms
are dependent on the pricing and marketing decisions of
competitors.
• Best off cooperating and acting like a monopolist by producing a
small quantity of output and charging a price above marginal
cost

 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.
 Cartel or collusion Model
Cartel: a group of firms acting in union or a group of firms that
gets together and makes price and output decisions to maximize
joint profits is called a cartel.

Cartel is a form of collusion in which the member firms in an industry

try to agree on all aspects of pricing and output for the individual
firms.

Collusion: an agreement among firms in a market about quantities

to produce or prices to charge.

E.g. OPEC
 The Equilibrium for an Oligopoly/Profit
Maximization (Cartel)
A cartel that wants to maximize the collective profits of the
members should operate just like a monopolist with more than
one plant.

Marginal cost (for each cartel member) must equal

marginal revenue in the market.

W hen firms in an oligopoly individually choose production to

maximize profit, they produce quantity of output greater than the
level produced by monopoly and less than the level produced
by competition.

The oligopoly price is less than the monopoly price but greater
than the competitive price (which equals marginal cost).
 Cartel or collusion Model

A OPEC cartel would set price and quantity at P* and Q*. Quotas would
be ideally allocated to the members by having them produce at the same
level of marginal cost.

$/ 
Q MC
P* This is the
sum of the
MC curves of
the members.

D
Q
Q*
MR
Oil MARKET
 SUMMARY OF MONOPOLISTIC COMPETITION

1) In the short-run firms choose price and output by setting MC

= MR.

2) In the long-run entry of new firms assures that profit will

be zero.

3) Some economic inefficiency exists because in

equilibrium price is higher than marginal cost.

4) Each firm in a monopolistically competitive market has

excess capacity. Produces less than the quantity that
minimizes ATC. Each firm charges a price above marginal
cost.