Pp-Monopolistic and Oligopoly

CHAPTER 8
MARKET STRUCTURE :
MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
Principles of Economics second edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T) 2010 Ch. 8: 1
MONOPOLISTIC COMPETITION
Definition
 Market structure in which there are large numbers of
small sellers selling differentiated products but these are
close substitute products and have easy entry into and
exit from the market.
Characteristics
Large number of and sellers – there is a large number
of sellers under the monopolistic competition and no
individual firm can influence the market price. However,
each firm follows an independent price-output policy.
Differentiated products – product differentiation could
be through packaging, design, labelling, advertising and
brand name.
MONOPOLISTIC COMPETITION
(cont.)
Free of entry and exit into the market – not as easy as
perfect competition because of the existence of product
differentiation.
Role of non-price competition is significant – various
methods used to attract the customers to buy a particular
brand.
Selling cost – different types of expenditure on
advertisement would incur additional cost.

MONOPOLISTIC COMPETITION (cont.)
The demand curve for monopolistic competitive firm is

Price
downward sloping due to product differentiation.
AR=P
MR
Quantity
Demand curve for monopolistic competitive firm

is more elastic than demand curve for monopolist
firm because in monopolistic competition there are
many firms and many substitutes.

PROFIT MAXIMIZATION IN SHORT
RUN
Monopolistic competitive firm earns economic profit
At this output, the firm earns
Economic profit or economic profit or supernormal The profit maximization
supernormal profit profit equal to the shaded area. level occurs where MR
is the profit earned curve and MC curve
Price (RM) MC
by a monopolist intersects at Point A.
competitive firm
when TR > TC. ATC
To find the price, we use the
same vertical line with
output up to the demand
curve. The profit maximizing
P*
PROFIT price and output is
AC P* and Q*.
A
DD = AR
MR
Quantity
Q*
RUN (cont.)
Monopolistic competitive firm at break-even
Normal profit or break-even is The profit maximization
earned when TR = TC. level occurs where MR
curve and MC curve
Price (RM) At this output, monopolistic intersects at Point A.
MC
competitive firm is at the break-
even or earns normal profit. ATC
The profit maximizing price

and output is P* and Q*.
AC/ P*
DD = AR
MR
Quantity
Q*
RUN (cont.)
Monopolistic competitive firm suffers economic losses
Economic losses or subnormal At this output, monopolist suffers economic losses
profit is the losses incurred by a or subnormal profit equal to the shaded area.
monopolistic competitive firm when
Price (RM) ATC
MC
TR < TC.
The profit maximization

level occurs where MR
AC curve and MC curve
P*
LOSSES intersect at Point A.
The profit maximizing price

A and output is P* and Q*.
DD = AR
MR
Quantity
Q*
PROFIT MAXIMIZATION IN LONG RUN
Monopolistic competitive firm earns normal profit in long

run
A monopolistic competitive
firm earns normal profit in
Price (RM) the long run due to free LRMC
entry and exit.
LRATC
P*
DD = LRAR
LRMR
Q*
Quantity
OLIGOPOLY
Definition
 Market structure in which there are only a few firms selling
either standardized or differentiated products and it
restricts the entry into and exit from the market.
Characteristics
Few numbers of firms – the number of firms is small but
size of the firms is large.
Homogeneous or differentiated product
Mutual interdependence – firms in an oligopoly market
always consider the reaction of their rivals when choosing
price, sales target, advertising budgets and other business
policies.
OLIGOPOLY (cont.)
Barriers to entry – restrict new entrants into the

market through various types of barriers to entry such
as control of certain resources, ownership of patent
and copyright, exclusive financial requirements and
other legal barriers.

OLIGOPOLY (cont.)
Price Rigidity and Kinked Demand Curve

 Since there is mutual interdependence between oligopoly firms, the
prices in the market are more stable. This is called price rigidity in
oligopoly market.
 The price rigidity explains the behaviour of an oligopoly firm that has
no incentive to increase or decrease the price. The theory of the
kinked demand curve is based on two assumptions.
1. First assumption: If an oligopolist reduces its price, its rivals will

follow and cut their prices to prevent losing the customers.
2. Second assumption: If an oligopolist increases its price, its rivals
do not increase the price and keep their prices the same, thereby
they gain customers from the firm that increases the price.

OLIGOPOLY (cont.)
Because of this According to the assumption, An oligopoly firm faces

assumption, an when the firm increases the two demand curve,
oligopolist faces kinked price (P*), no other firms will individual demand
Price (RM) demand curve. follow. Above P*, the firm will curve (dd) and industry
follow the dd curve. demand curve (DD).
If the firm decreases the price,
other firms will follow. Below
P*, the firm follow the DD
curve.
P*
dd
DD
Q*
Quantity

OLIGOPOLY (cont.)
This shows the price At this range of MR, any The kinked demand
rigidity in the oligopoly change in the MC does not curve below Point E
market. reflect changes in the profit creates a gap in the
Price (RM)
maximizing price and MR, which is indicated
output. by the dotted line ab.
MC1
MC2
E
P*
b DD
Q*
MR Quantity

OLIGOPOLY (cont.)
Price Leadership
 Price leadership means the pricing strategy in which the
firms in an oligopolistic industry follow the price set by the
leading firm.
 Price leadership is one form of collusion under oligopoly.
 There is no formal or tacit agreement.
 There are two types of price leadership:
1. Dominant price leadership
 The dominant price leadership firm may be the largest
firm that dominates the overall industry.
 The dominant price leader firm can act as a monopoly
where it sets its price to maximize profits; other firms
will set their prices at the same level.
OLIGOPOLY (cont.)
2. Barometric price leadership

 One firm will be the first to announce price change.
This firm does not dominate the industry.
 Its price will be followed by others.

OLIGOPOLY (cont.)
Cartel
A cartel is a group of firms whose objective is to limit the
scope of competitiveness in the market.
Cartel arises because firms want to eliminate uncertainty
and improve profits by stabilizing market shares and
prices, reducing competitiveness and eliminating
promotional cost.
The most famous cartel is Organization of Petroleum
Exporting Countries (OPEC).
Cartel agreement is an arrangement among the
oligopoly firms to cooperate with one another to act
together as a monopoly.

OLIGOPOLY (cont.)
An ideal cartel will be powerful to establish monopoly

price and earns supernormal profits.
Profits are divided among firms based on their individual
level of production.
Each firm sells at different quantities and obtains different
profits depending on the level of AC at the point of
production.

OLIGOPOLY (cont.)
Non-Price Competition
Non-price competition is the means for growing market
share and profitability in the face of new rivals through
advertising, marketing, after sales service, free gift and
others.
The difference with price cuts by oligopoly firm and non-
price competition.
 Opting for price cut – If a firm reduces a price of a product, it can
attract customers, and establish in the industry.
Reactions of competitors – the reaction from rivals are quick by
reducing their prices. There is a risk of price war if the price
reduction continues. However, customers are better off.

OLIGOPOLY (cont.)
 Opting for non-price competition – This strategy will attract more

customers to the firm.
Reactions of competitors – the reaction from rivals toward non-price
competition is slow and less direct. The firms will gain more
advantages if it practices non-price competition because product
variation, improvements in quality and successful advertising
techniques cannot be duplicated so easily. Some consumers are
more attracted to the advertisement and quality of the product
compared to price.

SUMMARY OF MARKET
STRUCTURE
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Number of sellers
Large One Many Few
Identical or Unique or no Homogenous or

Type of product Differentiated
homogenous close substitution differentiated
Entry condition Very easy Impossible Easy Difficult

Control over
None Some Some Considerable
price
Local phone Automobiles,
Examples Wheat, corn Food, clothing
service, electricity cigarettes
Profit
MR = MC MR = MC MR = MC MR = MC
maximization
Subnormal, Subnormal, Subnormal, Subnormal,
Short run
supernormal or supernormal or supernormal or supernormal or
equilibrium
normal profit normal profit normal profit normal profit

SUMMARY OF MARKET
STRUCTURE (cont.)
Perfect Monopolistic
Characteristics Monopoly Oligopoly
competition competition
Normal profit due Supernormal Normal profit due Supernormal

Long run
to free entry and profit because of to free entry and profit because of
equilibrium
exit barriers to entry exit barriers to entry
Production
efficiency (at Yes No No No
minimum AC)
S/run: AR<AVC S/run AR<AVC S/run: AR<AVC S/run: AR<AVC
Shut down
L/run: AR< AC L/run: AR< AC L/run: AR< AC L/run: AR< AC
Where S/run = Short run and L/run = Long run


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CHAPTER 8

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

The demand curve for monopolistic competitive firm is

Demand curve for monopolistic competitive firm

Principles of Economics second edition All Rights Reserved

The profit maximizing price

The profit maximization

The profit maximizing price

Monopolistic competitive firm earns normal profit in long

Barriers to entry – restrict new entrants into the

Principles of Economics second edition All Rights Reserved

Price Rigidity and Kinked Demand Curve

1. First assumption: If an oligopolist reduces its price, its rivals will

Principles of Economics second edition All Rights Reserved

Because of this According to the assumption, An oligopoly firm faces

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

2. Barometric price leadership

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

An ideal cartel will be powerful to establish monopoly

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

 Opting for non-price competition – This strategy will attract more

Principles of Economics second edition All Rights Reserved

Identical or Unique or no Homogenous or

Entry condition Very easy Impossible Easy Difficult

Principles of Economics second edition All Rights Reserved

Normal profit due Supernormal Normal profit due Supernormal

Where S/run = Short run and L/run = Long run

Principles of Economics second edition All Rights Reserved

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