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Monopolistic Competition
and Oligopoly
CHAPTER
10
© 2003 South-Western/Thomson Learning
1
Characteristics of Monopolistic Competition
Characteristics
Many producers offer products that are
either close substitutes but are not viewed
as identical
Each supplier has some power over the price
it charges  are price makers
Low barriers to entry  firms in the long
run can enter or leave the market with ease
 enough sellers that they behave
competitively
Sellers act independently of each other
2
Product Differentiation
Sellers differentiate their products in
four basic ways
Physical differences and qualities
Location
Accompanying services
Product image
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Short-Run Profit Maximization or Loss Minimization
Because products are a somewhat
different product, each has some
control over price  each firm’s demand
curve slopes downward
Since many firms are selling close
substitutes, any firm that raises its price
can expect to lose some customers, but
not all, to rivals  demand is more
elastic than a monopolist’s but less
elastic than a perfect competitors
4
Price Elasticity of Demand
The price elasticity of the monopolistic
competitor’s demand depends on
The number of rival firms that produce
similar products
The firm’s ability to differentiate its product
from those of its rivals
A firm’s demand curve will be more
elastic the greater the number of
competing firms and the less
differentiated its product
5
Marginal Revenue Equals Marginal Cost
The downward-sloping demand curve
means that the marginal revenue curve
also slopes downward and lies beneath
the demand curve
The cost curves are similar to those
developed in perfect competition and
monopoly
Exhibit 1 depicts the relevant curves for
the monopolistic competitor
6
Exhibit 1a: Profit Maximization
In the short run, a firm that can at least
cover its variable cost will increase output
as long as marginal revenue exceeds
marginal cost  profits are maximized
where marginal revenue equals marginal
cost. This occurs at point e.
The profit maximizing price for that
quantity is found on the demand curve 
point b. Average total cost is measured as
c which is below the price. Price minus
average total cost is the firm’s profit per
unit, which, when multiplied by the
quantity is economic profit, shown by the
blue shaded rectangle.
The monopolistic competitor, like the
monopolist, has no supply curve  there
is no curve that uniquely relates price
and quantity supplied.
MC
b
p
c
Profit
ATC
c
D
e
MR
0
q
Quantity per period
7
The monopolistic competitor is not assured
economic profit. Here the firm’s average
total cost curve lies entirely above the
demand curve  all quantities result in
losses  the firm must decide whether to
shut down temporarily.
The rule here is the same: as long as the
price covers average variable cost, the
firm should produce in the short run.
Alternatively, it should shut down if no
price covers average variable cost.
D ollars per unit
Exhibit 1b: Loss Minimization
c
p
c
MC
ATC
b
AVC
D
e
The loss-minimization solution is for the
firm to produce quantity q and charge the
price p. However, since per unit costs are c,
the firm incurs a loss shown by the red
shaded area.
MR
0
q
Quantity per period
8
Zero Economic Profit in the Long Run
Since there are low barriers to entry in
monopolistic competition, short-run
economic profit will attract new
entrants in the long run
Because new entrants offer products
that are similar to those offered by
existing firms, they draw some
customers away from existing firms 
the demand facing each firm declines
and becomes more elastic since there
are more substitutes for each firm’s
product
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Zero Economic Profit in the Long Run
Because of the ease of entry,
monopolistically competitive firms earn
zero economic profit in the long run
In the cases of losses that persist, some
monopolistic competitors will leave the
industry  their customers will switch
to the remaining firms  increasing the
demand for each remaining firm’s
demand curve and making it less elastic
Exhibit 2 shows long-run equilibrium
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Exhibit 2: Long-run Equilibrium
In the long run, entry and exit will shift
each firm’s demand curve until
economic profit disappears  price
equals average total cost.
MC
This long-run outcome occurs
where the marginal revenue curve
intersects the marginal cost curve
at point a  equilibrium q, and the
average total cost curve is tangent
to the demand curve at point b 
no economic profit.
Dollars per unit
ATC
p
b
a
D
In the case of short-run losses, some
firms will leave the industry  the
demand curve shifts to the right and
become less elastic until the loss
disappears and remaining firms earn
just a normal profit.
MR
0
q Quantity per period
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Comparison
How does monopolistic competition
compare with perfect competition in
terms of efficiency?
In the long run, neither can earn
economic profit
However, a difference arises because of
the different demand curves facing
individual firms in each of two market
structures
Exhibit 3 presents the comparison
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Exhibit 3: Monopolistic Competition Versus
Perfect Competition
(a) Perfect Competition)
(b) Monopolistic Competition
ATC
p
d=
Marginal
revenue=
Average
revenue
Dollarsperunit
Dollarsper unit
MC
MC
ATC
p'
MR
0
q Quantity per period
0
q'
D=
Average
revenue
Quantity per period
Here we are assuming that the two firms have identical cost curves. In each case, the
marginal cost curve intersects the marginal revenue curve at the quantity where the
average total cost curve is tangent to the firm’s demand curve.
The point of tangency between d, MC and ATC in perfect competition implies that the firm
is producing at the lowest possible average cost in the long run.
In monopolistic competition, the price and average cost, identified as p’ in the right panel,
exceed the price and average cost under perfect competition, identified as p in the left panel.
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Comparison
Firms in monopolistic competition are
said to have excess capacity, since
production is lower than the rate that
would be associated with the lowest
average cost
Alternatively, excess capacity means
that each producer could easily produce
more and in the process would lower
the average cost  the marginal value
of increased output would exceed its
marginal cost  greater output would
increase economic welfare
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Comparison
Another differences is that although the
cost curves in the previous exhibit are
identical, firms in monopolistic
competition spend more on advertising
and other promotional expenses to
differentiate their products
These higher costs shift up their
average cost curves
15
Comparison
Some argue that monopolistic
competition results in too many
suppliers and in product differentiation
that is often artificial
The counterargument is that consumers
are willing to pay a higher price for
greater selection
That is, consumers are willing to pay a
higher price for greater selection
Consumers benefit from the wider choice
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Oligopoly
Oligopoly refers to a market structure
that is dominated by just a few firms
Because an oligopoly has only a few
firms, each must consider the effect of
its own actions on competitors’
behavior  the firms in an oligopoly are
interdependent
There are a variety of oligopolies
17
Varieties of Oligopoly
The product can be homogeneous
across producers or differentiated
across producers
The more homogeneous the products,
the greater the interdependence among
the few dominant firms in the industry
Products can be differentiated by
physical qualities, sales locations,
services provided with the product and
the image of the product
18
Varieties of Oligopoly
Because of interdependence among
firms in an industry, the behavior of any
particular firm is difficult to analyze
Each firm knows that any changes in its
product quality, price, output, or
advertising policy may prompt a
reaction from its rivals
Domination by a few firms can often be
traced to some form of barrier to entry
19
Economies of Scale
Perhaps the most significant barrier to
entry is economies of scale
Recall that the minimum efficient scale
is the lowest rate of output at which the
firm takes full advantage of economies
of scale
If a firm’s minimum efficient scale is
relatively large compared to industry
output, then only one or a few firms are
needed to produce the total output
demanded in the market
Exhibit 4 presents this situation
20
Exhibit 4: Economies of Scale as a Barrier to Entry
Here we have a long-run
average cost curve for a
typical firm in the industry.
If autos sell for a price less
than ca, a potential entrant
can expect to lose money.
This tends to discourage
entry into the industry.
Dollars per unit
If a new entrant sells
only S cars, the average
cost per unit, ca, far
exceeds the average cost,
cb, of a manufacturer
that sells enough cars to
reach the minimum
efficiency scale, M.
a
ca
b
cb
0
S
M
Long-run
average
cost
Autos per year
21
High Cost of Entry
The total investment needed to reach
the minimum size is often gigantic
which may pose another problem for
potential entrants into oligopolistic
industries
Advertising a new product enough to
compete with established brands may
also require enormous outlays
High start-up costs and established
brand names can create substantial
barriers to entry, especially since the
fortunes of a new product are so
uncertain
22
High Cost of Entry
Product differentiation expenditures
create barriers to entry
Oligopolists often compete with existing
rivals and try to block new entry by
offering a variety of models and
products
Firms often spend billions trying to
differentiate their products
Some of these expenditures have the
beneficial effects of providing valuable
information to consumers and offering them
a wide variety of products
23
Models of Oligopolies
The interdependence of firms in an
oligopoly makes analyzing their
behavior complicated  no one model
or approach explains the outcomes
At one extreme, the firms in the industry
may try to coordinate their behavior so they
act collectively as a single monopolist,
forming a cartel
At the other extreme, they may compete so
fiercely that price wars erupt
24
Models of Oligopoly
While there are many theories, we will
focus our attention on three of the
better-known approaches
Collusion
Price Leadership
Game Theory
Each approach has some relevance,
although none is entirely satisfactory as
a general theory
Each is based on the diversity of observed
behavior in an interdependent market
25
Collusion
Collusion is an agreement among firms
in the industry to divide the market and
fix the price
A cartel is a group of firms that agree to
collude so they can act as a monopolist
and earn monopoly profits
Colluding firms usually reduce output,
increase price, and block the entry of
new firms
26
Collusion
Collusion and cartels are illegal in the
United States; some other countries are
more tolerant and some countries even
promote cartels  OPEC
Exhibit 5 provides us with an illustration
of the impact of firms colluding and
forming a cartel
27
Exhibit 5: Cartel Model
The market demand curve is shown as D.
The two key issues are:
•what price will maximize the cartel’s profit
•how will production be allocated among
participating firms?
p
c
Profit maximization occurs where the
cartel’s marginal cost curve intersects the
market’s marginal revenue curve. This
intersection yields price p, industry output
Q, and marginal cost of production c.
Dollars per unit
The first task of the cartel is to determine
its marginal cost of production. Since the
cartel acts as a monopoly operating many
plants, the marginal cost curve is the
horizontal sum of the marginal cost curves
of all firms in the cartel .
MC
There is no curve that uniquely relates
0
price and quantity supplied.
D
MR
Q
Quantity per period
28
Cartel Model
To maximize cartel profit, output must
be allocated so that the marginal cost
for the final unit produced by each firm
is identical
Any other allocation would lower cartel
profits
However, this is much easier said than
done in practice
29
Differences in Cost
If all firms have identical costs, output
and profit are easily allocated across
firms  each firm produces the same
quantity
However, if costs differ, as is normally
the case, problems arise
The greater the differences in average
costs across firms, the greater will be
the differences in economic profits
among firms
30
Differences in Cost
If cartel members try to equalize each
firm’s total profit, a high-cost firm
would need to sell more than a low-cost
firm
But this allocation scheme violates the
cartel’s profit-maximizing condition of
finding the output for each firm that
results in identical marginal costs
across firms  if average costs differ
across firms, the output allocation that
maximizes cartel profit will yield
unequal profit across cartel members
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Number of Firms in the Cartel
The more firms in the industry, the
more difficult it is to negotiate an
acceptable allocation of output among
them
Consensus becomes harder to achieve
as the number of firms grows  the
greater the chances are that one or
more will become dissatisfied with the
cartel and break the agreement
32
New Entry Into the Industry
If a cartel cannot block the entry of new
firms into the industry, new entry will
eventually force prices down, squeezing
economic profit and undermining the
cartel
The profit of the cartel attracts entry,
entry increases market supply 
market price is forced down
33
Cheating
Perhaps the biggest obstacle to keeping
the cartel running smoothly is the
powerful temptation to cheat on the
agreement
By offering a price slightly below the
established price, a firm can usually
increase its sales and economic profit
Because oligopolists usually operate
with excess capacity, some cheat on the
established price
34
Summary
Establishing and maintaining an
effective cartel will be more difficult
If the product is differentiated among firms
If costs differ among firms
If there are many suppliers in the industry
If entry barriers are low, and
If cheating on the agreement becomes
widespread
35
Price Leadership
An informal, or tacit, type of collusion
occurs in industries that contain price
leaders who set the price for the rest of
the industry
A dominant firm or a few firms establish
the market price, and other firms in the
industry follow that lead, thereby
avoiding price competition
Price leader also initiates price changes
36
Price Leadership
Obstacles in price leadership industries
The practice usually violates U.S. antitrust
laws
The greater the product differentiation
among sellers, the less effective price
leadership will be as a means of collusion
There is no guarantee that other firms will
follow the leader  if other firms do not
follow, the leader risks losing sales
Some firms will try to cheat on the
agreement by cutting price to increase sales
and profits
Unless there are barriers to entry, a
profitable price will attract entrants
37
Game Theory
Game theory examines oligopolistic
behavior as a series of strategic moves
and countermoves among rival firms
It analyzes the behavior of decisionmakers, or players, whose choices affect
one another
Provides a general approach that allows
us to focus on each player’s incentives
to cooperate or not
38
Prisoner’s Dilemma
Two thieves, Ben and Jerry, are caught
near the scene of a robbery
The police believe they are guilty but
they need a confession
Each thief faces a choice of confessing
or denying any knowledge of the crime
If only one confesses he is granted
immunity and goes free  other gets
the maximum of 10 years
If both deny the crime, each gets a 1year sentence and if both confess, each
gets 5 years
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Prisoner’s Dilemma
What will each do?
The answer depends on the
assumptions about their behavior 
that is, what strategy each pursues
A strategy reflects a player’s game plan
In the prisoner’s dilemma, each player
tries to save his own skin by minimizing
his time in jail, regardless of what
happens to the other
Exhibit 6 shows the payoff matrix for
the game
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Payoff Matrix
Payoff matrix is a table listing the rewards
or penalties that each can expect based on
the strategy that each pursues
Each prisoner pursues one of two
strategies, confessing or clamming up
Ben’s strategies are shown along the left
margin and Jerry’s across the top
The numbers in the matrix indicate the
prison sentence in years for each based on
the corresponding strategies
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Payoff Matrix
The number above the diagonal shows Ben’s
sentence in years and the number below the
diagonal show Jerry’s sentence
What strategies are rational assuming that
each player tries to minimize jail time?
Ben’s perspective: you know that Jerry will
either confess or clam up. Suppose Jerry
confesses, if you confess also, you both get
5 years, but if you deny involvement you get
10 years while Jerry walks  if Ben thinks
Jerry will confess, he should also
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Exhibit 6: Payoff Matrix
J ERRY
Confess
Confess
B
E
N
Clam Up
0
5
10
5
Clam
Up
10
1
0
1
If Jerry clams up and Ben confesses, Ben gets
no time, but if Ben clams up too, each get one
year in jail  if Ben thinks that Jerry will clam
up, he is better off confessing.
In short, whatever Jerry does, Ben is better off
confessing. The same incentives hold for Jerry 
he is better off confessing, regardless of what Ben
does.
Each has an incentive to confess and both get 5 years. This is called the
dominant-strategy equilibrium of the game because each player’s strategy does
not depend on what the other does.
Notice that if each thief would clam up, both would be better off because they
would get only 1 year in jail  if Ben and Jerry trust each other to clam up, they
would adopt this strategy.
43
Price Setting Game
The prisoner’s dilemma applies to a
broad range of economic phenomena
such as pricing policy and advertising
strategy
Consider the market for gasoline in a
rural community with only two gas
stations  a duopoly
Suppose customers are indifferent
between the two brands and consider
only the price
44
Price Setting Game
Each station sets its daily price early in
the morning before knowing the price
set by the other
Suppose only two prices are possible 
a low price and a high price
If both charge the low price, they split the
market and each earns a profit of $500 per
day
If both charge the high price, they also split
the market and earn $700 profit
If one charges the high price but the other
the low one, the low price station earns a
profit of $1,000 and the other $200
45
Exhibit 7: Price-Setting Payoff Matrix
Exxon
Low Price
$1000
$500
Low
Price
High Price
$500
$200
Texaco
$200
$700
High
Price
$1000
$700
Texaco’s strategy is shown down the left-hand
margin and Exxon’s across the top. Texaco’s profit
appears above the diagonal, and Exxon’s below it.
What price would each charge to maximize
profits?
Texaco’s perspective:
If Exxon charges the low price, Texaco earns $500
charging the low price but only $200 by charging
the high price  better off by charging the low
price.
If Exxon charges the high price, Texaco earns
$1,000 by charging the low price and $700
charging the high price  earn more by charging
the low price.
Exxon faces the same incentives
Each seller will charge the low price, regardless of
what the other does  each earns $500 a day
46
Price Setting Game
If each firm thinks other firms in the
cartel will stick with their quotas, they
can increase their profits by cutting
price and increasing quantities
If you think other firms will cheat and
overproduce, they you should too
Either way your incentive as a cartel
member is to cheat on the quota
47
One-Shot versus Repeated Games
The outcome of a game often depends
on whether it is a one-shot game or the
repeated game
The classic prisoner’s dilemma is a oneshot game  the game is to be played
only once
However, if the same players repeat the
prisoner’s dilemma, as would likely
occur in the price setting game, other
possibilities unfold
48
One-Shot versus Repeated Games
In a repeated-game setting, each player
has a chance to establish a reputation
for cooperation and thereby can
encourage the other player to do the
same
The cooperative solution makes both
players better off than if they fail to
cooperate
49
Tit-for-Tat Strategy
Experiments show that the strategy
with the highest payoff in repeated
games turns out to be the tit-for-tat
strategy
You begin by cooperating in the first
round of play
On every round thereafter you
cooperate if the other player cooperated
in the previous round, and you cheat if
your opponent cheated in the previous
round
50
Oligopoly and Perfect Competition
Since there is no typical model of
oligopoly, no direct comparison with
perfect competition is available
However, we can imagine an
experiment in which we took the many
firms in a competitive industry and,
through a series of mergers, combine
them to form, say, four firms
How would the behavior of firms in this
industry differ before and after the
merger
51
Oligopoly and Perfect Competition
Price is usually higher under oligopoly
With fewer competitors after the merger,
remaining firms would become more
interdependent  they will try to coordinate
pricing policies  if they engage in some
sort of implicit or explicit collusion, industry
output would be lower and price would be
higher than under perfect competition
Higher profits under oligopoly
If there are barriers to entry into the
oligopoly, profits will be higher than under
perfect competition in the long run
52