MONOPOLISTIC COMPETITION AND OLIGOPOLY

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MONOPOLISTIC COMPETITION AND OLIGOPOLY
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MONOPOLISTIC COMPETITION

• There are many firms and it is relatively easy to
  enter and exit from the market.
• Product differentiation enables firms to set
  their prices.
• If the firm can convince the customer that its
  product is different from the others in the
  market, then the firm can set a price higher than
  that is established by the forces of market
  demand and supply.

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• Firms follow the MR MC rule to maximize profits
  or minimize losses in the short-run.
• Unlike perfect competition, the monopolistically
  competitive firms are able to achieve some degree
  of product differentiation and they expect their
  rivals to react to their actions.
• Unlike monopoly, the existence of economic
  profits in the short-run will cause other firms
  to enter the market allowing the firms in
  monopolistic competition to earn only normal
  profits in the long-run.

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MC
TL/
economic profit
AC
P
D
AC
Q 6
MR
Short-run, economic profit.
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Economic Profits in the Short-Run

• If the firm is earning above-normal profits,
  newcomers will be attracted to the market.
• The entry of additional firms in the market will
  decrease the market share for the individual firm
  and thus reduce the demand for its product.
• The entry by new firms will continue until all
  the firms in the market are earning normal
  profits and there are no economic profits left to
  attract newcomers.

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MC
TL/
AC
P
D1(original)
AC
D2(new, LR demand due to entry of new firms)
Q 6
MR1
Long-run, normal profit
MR2
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Economic Loss in the Short-Run

• If the firms are incurring economic losses in the
  short-run, some firms will exit from the market.
• Exit by some firms will increase the market share
  for the remaining firms and thus increase the
  demand for their products.
• Exit will continue until the remaining firms in
  the market can earn normal profits.

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AC
Economic loss
MC
TL/
AC
P
D
Short-run or long-run loss because demand is
below the level at which the firm can set a price
to earn normal or economic profit.
MR
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Examples of Monopolistic Competition

• Restaurants, grocery stores, dry cleaners,
  stationery stores, florists, hardware stores,
  pharmacies.
• In all these markets, the number of firms is
  relatively large and it is fairly easy to enter
  these markets.
• Firms in these markets try to differentiate
  themselves by using factors like location, type
  of service, ambiance.

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Oligopoly

• It is a market dominated by a relatively small
  number of firms.
• The products sold by these firms may be
  standardized or differentiated.
• The control over the price of the product comes
  partly from the ability of the oligopolist firm
  to differentiate its product.
• Part of the power to set prices may come from the
  sheer size and dominance of the largest firm in
  an oligopolistic market.

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Examples of Oligopoly

• Most oligopolies are in the manufacturing sector.
• Automobiles, appliances, mainframe computers,
  many types of processed foods, beverages such as
  soft drinks and beer are examples from
  manufacturing.
• Banking, private hospitals, airlines are examples
  from services.

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Definition of Oligopoly Revisited

• Relatively small number of firms is not a
  precise definition of oligopoly.
• There is no specific number or size of firms
  needed for a market to qualify as an oligopoly.
• The critical question to answer in defining an
  oligopoly is
• whether each firm determines its price and
  output while contemplating the action or reaction
  of its competitors.

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Pricing in Oligopoly

• Since each oligopolist tries to anticipate the
  competitors response to a price action, who
  actually sets the price?
• In an oligopoly, it is very likely that all firms
  will end up charging the same price.

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• If you set a price that is higher than those of
  your competition, you will lose sales because
  customers can buy the same product from other
  firms at a lower price.
• If you set a lower price, you might gain some
  sales at the expense of your competitors, but you
  also risk a retaliatory price cut or a price war
  among all the firms in the market.

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TL/
A
P1
B
P2
D1
D2
D3
Q2
Q1
Q3
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• All firms are charging P1 initially.
• Your firms sells Q1 at this price.
• You consider lowering your price to P2 to
  increase your market share (by attracting
  customers away from your competitors).
• The decision to decrease price from P1 to P2
  assumes that the demand is elastic between these
  two price levels.
• If the demand is elastic, ? in Q gt ? in P
• and total revenue (TR) increases.
• If the demand is inelastic, ? in Q lt ? in P
• and total revenue (TR) decreases.

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• Your competitors will follow your price reduction
  since they do not want to lose market share.
• The effect of your competitors price reduction
  will be a decrease in the demand for your
  product.
• Your demand curve will shift downward to D2.
• In the long-run, your demand curve will look like
  D3 since that is the new demand curve that
  depicts the price-output combinations you were
  able to achieve in the market (A,B).

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• The composite demand curve D3 is inelastic
  between P1 and P2.
• If you are going to end up with an inelastic
  demand curve like D3, then it is not worthwhile
  to lower your price.
• Lowering your price causes your competitors to
  respond and this response renders your demand
  curve inelastic.
• If the demand curve is inelastic, it does not pay
  for a firm to reduce its price (TR will ?).

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KINKED DEMAND CURVE MODEL OF OLIGOPOLY

• A competitor (or competitors) will follow a price
  decrease but will not make a change in reaction
  to a price increase.
• The firm planning to increase or decrease its
  price may change this decision for the fear that
  any change will result in decreased profits.

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• If a firm lowers its price, competitors will
  quickly follow the price cut in order to maintain
  their market share.
• The reaction by the competitors will lower the
  demand for the firm and thus the total revenues
  will decline as a result of a now more inelastic
  demand.

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• If the firm increases its price, the competitors
  will not follow and thus the demand for the firm
  will fall drastically since now the consumers can
  buy the substitute product from the competitors
  at a lower price.
• Once again, the total revenue of the firm will
  decline.

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TL/
P3
A
P
P1
Df
Di
Q2
Q3
Q
Q1
Q4
Df is the relevant demand curve if the firm
decides to lower its price and the competitors
do not retaliate (? from Q to Q1). Di is the
relevant demand curve if the firm decides to
lower its price and the competitors retaliate (?
from Q to Q2).
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TL/
P3
A
P
P1
Df
Di
Q2
Q3
Q
Q1
Q4
Df is the relevant demand curve if the firm
decides to increase its price and the competitors
do not retaliate (? from Q to Q4). Di is the
relevant demand curve if the firm decides to
increase its price and the competitors retaliate
(? from Q to Q3).
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• The appropriate demand curve is Di if price is
  lowered since the firm expects the rivals to
  retaliate.
• The appropriate demand curve is Df if price is
  increased since the firm does not expect the
  rivals to retaliate.

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Profit Maximization in Oligopoly

• Profit maximization occurs where MR MC.
• Since the demand curve has a kink, the associated
  marginal revenue curve will be discontinuous and
  have a gap at the point where the kink occurs.

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TL/
MC3
MC2
MC1
P
D
Q
MR
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• The three marginal cost curves all imply the same
  price and quantity for profit maximization.
• A significant change could occur in costs for the
  firm but the firm does not have to react by
  changing its price.
• A significant change could occur in demand but
  the firm does not have to react as long as the
  kink remains at the same price level.

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