Monopolistic Competition and Oligopoly

1. Survey of ECON Robert L. Sexton Monopolistic Competition and Oligopoly Chapter 9 ied or duplicated, or posted to a publicly accessible website, in whole or in part.

2. Chapter 9 Sections – Monopolistic Competition – Price and Output Determination in Monopolistic Competition – Monopolistic Competition versus Perfect Competition – Oligopoly – Collusion and Cartels – Game Theory and Strategic Behavior

3. Monopolistic Competition

4. Section 1 SECTION 1 QUESTIONS

5. Monopolistic Competition MONOPOLISTIC COMPETITION a market structure with many firms selling differentiated products

6. Monopolistic competition has features in common with both monopoly and perfect competition. Like monopoly, individual sellers believe that they have some market power. Monopolistic Competition

7. Monopolistic competition is similar to perfect competition. Relatively free entry of new firms Long-run price and output behavior Zero long-run economic profits However, the monopolistically competitive firm produces a differentiated product, which leads to some degree of monopoly power. Monopolistic Competition: Characteristics

8. In a sense, each seller in a market of monopolistic competition may be regarded as a “monopolist” of its own particular brand of the commodity. Unlike a firm in the monopoly model, there is competition by many firms selling similar (but not identical) brands. Monopolistic Competition

9. The Three Basic Characteristics of Monopolistic Competition

10. Product differentiation is the accentuation of unique product qualities, real or perceived, to develop a specific product identity. With differentiation, buyers believe that the products of the various sellers are not the same, whether the products are actually different or not. Product Differentiation

11. Product differentiation leads to preferences among buyers to deal with particular sellers or to purchase the products of particular sellers. Sources of differentiation: Physical differences Prestige considerations Location Service considerations Product Differentiation

12. When many firms compete for the same customers, any particular firm has little control over or interest in what other firms do. Impact of Many Sellers

13. Entry in monopolistic competition is relatively unrestricted. New firms may easily start the production of close substitutes for existing products. Economic profits tend to be eliminated in the long run, as is the case in perfect competition. Significance of Free Entry

14. Section 1

15. Price and Output Determination in Monopolistic Competition

16. Section 2 SECTION 2 QUESTIONS

17. Monopolistically competitive sellers are price makers rather than price takers, they do not regard price as a given by market conditions like perfectly competitive firms. The cost and revenue curves of a typical seller are shown in Exhibit 9.1. Determining Short-Run Equilibrium

18. Exhibit 9.1: Short-Run Equilibrium in Monopolistic Competition

19. The intersection of the marginal revenue and marginal cost curves indicates that the short-run profit-maximizing output will be q*. By observing how much will be demanded at that output level, we find our profit-maximizing price, P*. That is, at the equilibrium quantity, q*, we go vertically to the demand curve and read the corresponding price on the vertical axis, P*. Determining Short-Run Equilibrium

20. 1. Find where MR = MC and proceed straight down to the horizontal quantity axis to find q*, the profit-maximizing output level. 2. Go up to the demand curve then to the left to find the market price. Once P* and q* are identified, total revenue can be found, TR = P × q. 3. To find total costs, go straight up from q* to the ATC curve, then left to the vertical axis to compute the ATC per unit. (TC = ATC × q). If TR > TC at q*, the firm is generating total economic profits. If TR < TC at q*, the firm is generating total economic losses. Three-Step Method for Monopolistic Competition

21. If we take the product price at P* and subtract the average cost at q*, this will give us per-unit profit. If we multiply this by output, we will arrive at total economic profit, that is, (P* − ATC) × q* = total profit. The cost curves include implicit and explicit costs—that is, even at zero economic profits the firm is covering the total opportunity costs of its resources and earning a normal profit or rate of return. Three-Step Method for Monopolistic Competition

22. Short-Run Profits and Losses in Monopolistic Competition • In Exhibit 9.1(a), the total revenue is greater than total cost so the firm has a total economic profit. • In Exhibit 9.1(b), price is below average total cost, so the firm is minimizing its economic loss.

23. Determining Long-Run Equilibrium The short-run equilibrium situation, whether involving profits or losses, will probably not last long, because there is entry and exit in the long run. If market entry and exit are sufficiently free: New firms will enter when there are economic profits. Some firms will exit when there are economic losses. © MARCUS LINDSTRÖM/ISTOCKPHOTO.COM

24. Determining Long-Run Equilibrium If existing firms are earning economic profits, new firms enter to take advantage of the economic profits. The demand curves for each of the existing firms will fall and become more elastic due to increasing substitutes.

25. Long‑run equilibrium will occur when demand is equal to average total cost for each firm at a level of output at which each firm’s demand curve is just tangent to its ATC curve. Achieving Long-Run Equilibrium

26. The point of tangency will always occur at the same level of output as where MR = MC. At this equilibrium point, there are: Zero economic profits No incentives for firms to either enter or exit the industry Achieving Long-Run Equilibrium

27. Exhibit 9.2: Long-Run Equilibrium for a Monopolistically Competitive Firm

28. Section 2

29. Monopolistic Competition versus Perfect Competition

30. Section 3 SECTION 3 QUESTIONS

31. Monopolistic Competition versus Perfect Competition Both monopolistic competition and perfect competition have many buyers and sellers and relatively free entry. However, product differentiation allows a monopolistic competitor the ability to have some influence over price.

32. A monopolistic competitive firm has a downward-sloping demand curve, but it tends to be more elastic than the demand curve for a monopolist because of the large number of good substitutes for its product. Monopolistic Competition versus Perfect Competition

33. The Significance of Excess Capacity Because of the downward slope of the demand curve, its point of tangency with ATC will not and cannot be at the lowest level of average cost. Therefore, even when long-run adjustments are complete, firms will not be operating at a level that permits the lowest average cost of productionthe efficient scale of the firm.

34. The existing plant, even though optimal for the equilibrium volume of output, will not be used to capacity. The Significance of Excess Capacity EXCESS CAPACITY occurs when the firm produces below the level at which average total cost is minimized

35. Unlike a perfectly competitive firm, a monopolistically competitive firm could increase output and lower its average total costs. However, increasing output to attain lower average costs would be unprofitable. The price reduction necessary to sell the greater output would cause MR to fall below MC of the increased output. The Significance of Excess Capacity

36. Consequently, in monopolistic competition, there is a tendency toward too many firms in the industry, each producing a volume of output less than that which would allow lowest cost. Economists call this tendency a failure to reach productive efficiency. The Significance of Excess Capacity

37. Failing to Meet Allocative Efficiency, Too In monopolistic competition, firms are not operating where P = MC. At the intersection of MC and MR, curves (q*), P > MC . This means that society is willing to pay more for the product (the price, P*) than it costs society to produce it (MC at q*). The firm is not allocatively efficient, (where P = MC). Too many firms are producing at output levels that are less than full capacity.

38. Perfectly competitive firms reach Productive efficiency (P = ATC at the minimum point on the ATC curve). Allocative efficiency (P = MC). Failing to Meet Allocative Efficiency, Too

39. In monopolistic competition, the higher average costs and the slightly higher price and lower output may just be the price we pay for differentiated productsvariety. Just because we have not met the conditions of productive and allocative efficiencies, it is not obvious that society is better off. Failing to Meet Allocative Efficiency, Too

40. Exhibit 9.3: Comparing Long-Run Perfect Competition and Monopolistic Competition

41. What are the Real Costs of Monopolistic Competition? Perfect competition meets the test of allocative and productive efficiency and monopolistic competition does not. A remedy for a monopolistically competitive firm to look more like an efficient, perfectly competitive firm might entail using government regulation, as in the case of a natural monopoly.

42. However, this process would be costly because a monopolistically competitive firm makes no economic profits in the long run. Therefore, asking monopolistically competitive firms to equate price and marginal cost would lead to economic losses, because long-run ATC would be greater than price at P = MC. Consequently, the government would have to subsidize the firm. What are the Real Costs of Monopolistic Competition?

43. The monopolistically competitive firm does not operate at the minimum point of the ATC curve, whereas the perfectly competitive firm does. The excess capacity that exists in monopolistic competition is the price we pay for product differentiation. In short, the inefficiency of monopolistic competition is a result of product differentiation. What are the Real Costs of Monopolistic Competition?

44. Because consumers value variety—the ability to choose from competing products and brands—the loss in efficiency must be weighed against the gain in increased product variety. The gains from product diversity can be large and may easily outweigh the inefficiency associated with a downward-sloping demand curve. Firms differentiate their products to meet consumers’ demand. What are the Real Costs of Monopolistic Competition?

45. Section 3

46. Oligopoly

47. Section 4 SECTION 4 QUESTIONS

48. Oligopoly The products may be homogeneous or differentiated, but the barriers to entry are often very high, which makes it very difficult for firms to enter into the industry. Firms in the industry may earn long-run economic profits. OLIGOPOLY a market structure in which relatively few firms control all or most of the production and sale of a product

49. Mutual Interdependence Oligopolists must strategize, much like good chess or bridge players, constantly observing and anticipating the moves of their rivals. MUTUAL INTERDEPENDENCE when a firm shapes its policy with an eye to the policies of competing firms

50. Oligopoly occurs when the number of firms in an industry is so small that any change in output or price by one firm appreciably impacts the sales of competing firms, so competitors respond directly to these actions in determining their own policy. Mutual Interdependence