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Monopolistic Competition and Oligopoly

Microeconomics class presentation on monopolistic competition and oligopoly

Michael Ungar

on 25 October 2018

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Transcript of Monopolistic Competition and Oligopoly

Monopolistically Competitive Market
Similar to perfect competition in that:
there are many buyers and sellers
there are relatively low barriers to entry or exit
Similar to monopoly in that:
each firm is the sole producer of a particular product (although there are close substitutes)
each firm faces a downward sloping demand curve for its product
Demand curve facing a monopolistically competitive firm
What happens to the demand curve facing a typical monopolistically competitive firm when new firms enter the market?
A) Demand facing each firm rises and becomes more elastic.
B) Demand facing each firm rises and becomes less elastic.
C) Demand facing each firm falls and becomes more elastic.
D) Demand facing each firm falls and becomes less elastic.
As firms enter a monopolistically competitive market, the demand facing a typical firm declines and becomes more elastic.
Typical firm in a monopolistically competitive market
Short-run equilibrium
Long-run Equilibrium
This equilibrium is often referred to as a “tangency equilibrium.”
Short-run equilibrium
(economic losses)
Monopolistic Competition vs.
Perfect Competition
A monopolistically competitive firm, in the long run, has “excess capacity” – (i.e., it produces a level of output that is below the least-cost level).
This is a cost of product variety.
Product differentiation and advertising
Monopolistically competitive firms may receive short-run economic profit from successful product differentiation and advertising.
These profits are, however, expected to disappear in the long run as other firms copy successful innovations.
Location decisions
a small number of firms produce most output
a standardized or differentiated product
recognized mutual interdependence, and
difficult entry.
Strategic behavior
Strategic behavior occurs when the best outcome for one party depends upon the actions and reactions of other parties.
Game Theory
Examines the payoffs associated with alternative choices of each participant in the “game.”
Dominant Strategy
A dominant strategy is one that provides the highest payoff for an individual for each and every possible action by rivals.
Confession is the dominant strategy in the prisoners’ dilemma game. A low price is the dominant strategy in the duopoly pricing game.
It is more difficult to predict the outcome when no dominant strategy exists or when the game is repeated with the same players.
What is the dominant strategy in this game if it is played only once?
A) Confess.
B) Do not confess.
C) There is no dominant strategy.
What is Price Leadership?
The “dominant firm”—usually the largest or most efficient in the industry— initiates price changes and all other firms more or less automatically follow the leader.
Such a cartel arrangement is illegal in the U.S.
Legal alternatives:
Price leadership
Cartels are legal in some countries
A cartel arrangement can maximize industry profits
Each firm can increase its profits by violating the agreement
Cartel agreements have generally been unstable.
Why do cartels form?
A) The dominant strategy of each firm is to abide by a cartel agreement.
B) The dominant strategy of each firm is to break a cartel agreement.
C) The combined profits of all firms in an industry are maximized under a cartel agreement.
D) Most governments require firms to participate in cartels.
Why do cartels break down?
A) The dominant strategy of each firm is to abide by a cartel agreement.
B) The dominant strategy of each firm is to break a cartel agreement.
C) The combined profits of all firms in an industry are maximized under a cartel agreement.
D) Most governments require firms to participate in cartels.
Which of the following industries is most likely to be an oligopoly?
A) restaurants in Chicago
B) corn
C) smartphones
D) None of the above
Facilitating practices (e.g., cost-plus pricing, recommended retail prices, etc.)
many buyers and sellers
differentiated products
easy entry and exit
Monopolistic Competition & Oligopoly
Each firm has a comparatively small percentage of the total market & limited control over market price.
• No collusion possible with many firms
• Independent action - each firm can determine its own pricing policy without considering the possible reactions of rival firms. A single firm may realize a modest increase in sales by cutting its price, but the effect of that action
on competitors’ sales will be nearly imperceptible
and will probably trigger no response.
Pure competition
= standardized product

Monopolistic competition
product differentiation
, variations of a particular product: slightly different physical characteristics, varying degrees of customer service, provide varying amounts of locational convenience, or proclaim special qualities, real or imagined, for their products.
Product Differentiation - created through the use of brand names and trademarks, packaging, and celebrity connections.
Since monopolistic competitors are typically small firms - economies of scale are few and capital requirements are low.

Monopolistic competitor’s demand is more elastic than the demand faced by a pure monopolist b/c it has many competitors producing closely substitutable goods.
Pure monopolist has no rivals at all.
Contrast to pure competition, monopolistic
competitor has fewer rivals & its products
are differentiated, so they are not perfect substitutes.

Price elasticity of demand faced by the monopolistically competitive firm depends on the number of rivals & degree of product differentiation.

The larger the number of rivals and the weaker the product differentiation, the _________________ the price elasticity of each seller’s demand.

Any financial barriers result from the need to develop and advertise a product that differs from rivals’ products.

Some firms have trade secrets relating to their products or hold trademarks on their brand names, making it difficult and costly for other firms to imitate them.
The monopolistic competitor maximizes
profit or minimizes loss by producing the output at which MR = MC.
Economic profit will induce new firms to enter, eventually eliminating economic profit. The loss will cause an exit of firms
until normal profit is restored. After such entry and exit, the price will settle
in to where it just equals average total cost at the MR= MC output. The monopolistic competitor earns only a normal
profit, and the industry is in long-run equilibrium.
The monopolistic competitor’s
demand is more
than the demand faced by a pure monopolist b/c the monopolistically competitive seller
has many competitors
closely substitutable goods
The pure monopolist has no rivals at all.
But the monopolistic competitor’s demand is not perfectly elastic like that of the pure competitor.
a) monopolistic competitor has fewer rivals;
b) its products are differentiated, so they are not perfect substitutes.
Economic efficiency requires the triple equality
P =MC = minimum ATC.

The equality of price and minimum average total cost yields
productive efficiency
. The good is being produced in the least costly way, and the price is just sufficient to cover average total cost, including a normal profit.

The equality of price and marginal cost yields
allocative efficiency
. The right amount of output is being produced, and thus the
right amount of society’s scarce resources is being devoted
to this specific use.
In monopolistic competition, neither productive nor
allocative efficiency occurs in long-run equilibrium.
Productive efficiency is not realized because production occurs where the average total cost A3 exceeds the minimum average total cost A4 .
Allocative efficiency is not realized because the product price P3 exceeds the marginal cost M3 .
Monopolistic Competitive Firms

- avoid new competitors eliminating profit by imitating
product, matching customer service, and copying advertising.

Each firm has a product that is distinguishable in some way from those of the other producers. So the firm can attempt
to stay ahead of competitors & sustain its profit through
further product differentiation and better advertising. By
developing or improving its product, it may be able to postpone, at least for a while, the outcome of normal profit.
Product differentiation creates a tradeoff
between consumer choice and productive efficiency.

The stronger the product differentiation, the greater is the excess capacity and, hence, the greater is the productive inefficiency.

But the greater the product differentiation, the more
likely the firms will satisfy the great diversity of consumer
tastes. The greater is the excess-capacity problem, the
wider the range of consumer choice.
The monopolistically competitive firm juggles three factors—price, product, and advertising—in seeking maximum profit.

It must determine what variety of product, selling at what
price, and supplemented by what level of advertising will
result in the greatest profit.

Each possible combination of price, product, and advertising poses a different demand and cost (production cost plus advertising cost) situation for the firm and that one combination yields the maximum profit.

In practice, this optimal combination cannot be readily
forecast but must be found by trial and error.
Because firms are few in oligopolistic industries, each firm is a “price maker”; like the monopolist, it can set its price and output levels to maximize its profit.

But unlike the monopolist, which has no rivals, the oligopolist must consider how its rivals will react to any change in its price, output, product characteristics, or advertising. Oligopoly is thus characterized by strategic behavior and mutual interdependence.
Can somebody tell me why there always has to be a Walgreens next to CVS?
But because rivals are few, there is mutual interdependence:
each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms. So oligopolistic firms base their decisions on how they think rivals will react.
When the largest four firms in an industry control
40 percent or more
of the market that industry is considered oligopolistic.
About one-half of all U.S. manufacturing industries are
Measuring Oligopolies
Concentration Ratio
= the percentage of total output produced and sold by an industry’s largest firms.
Herfindahl Index
= the sum of the squared percentage market shares of all firms in the industry. In equation form the Herfindahl index is:
(%S 1 ) + (%S 2 ) + (%S 3 ) + . . . +(%S n )
Many small businesses operate under conditions of monopolistic competition, including independently owned and operated retail stores and restaurants. In the case of restaurants, each one offers something different and possesses an element of uniqueness, but all are essentially competing for the same customers.
The model of monopolistic competition describes a common market structure in which firms have many competitors, but each one sells a slightly different product.
Demand and Cost Differences
When oligopolists face different costs and demand curves, it is difficult for
them to agree on a price. This is particularly the case in industries where products are differentiated and change frequently.
The larger the number of firms, the more difficult it is to create a cartel or
some other form of price collusion.
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