Monopolistic Competition and Oligopoly

This is Unit Nine of Principles of Microeconomics, part one of two: the markets between the poles, where many firms sell varieties or a few firms watch each other. Unit seven built the benchmark and unit eight broke it with a single seller. Most markets sit between those poles. This part takes the two cases in order: monopolistic competition, where entry drives profit to zero but leaves excess capacity, and oligopoly, where each firm's best choice depends on its rivals and the tools for that are games. By the end you will be able to define monopolistic competition and describe the demand curve one firm sees. To find the short-run choice and trace entry to the tangency. To state the efficiency verdict and weigh it against variety and advertising. To define oligopoly and compute two measures of concentration. And to explain interdependence, collusion and the cartel's temptation, and read a payoff matrix for a dominant strategy.

Four entries on monopolistic competition: the markets in between, the case defined, how products differ, and the demand curve one firm sees.

Between the poles.

MIC 0801 Between the Poles: Imperfect Competition

Most markets sit between perfect competition and monopoly. Firms there have some power over price, less than a monopolist's, and the two main cases are monopolistic competition and oligopoly: restaurants and hair salons on one side, airlines and phone carriers on the other. Both are measured against the competitive benchmark, and both fall short of it.

The first case.

MIC 0802 Monopolistic Competition Defined

Monopolistic competition has many firms, easy entry and exit, and differentiated products: each firm's good is a little different, so each is a small monopoly on its own variety. Every pizza shop in town competes with every other, and none sells the same pizza. Many firms and easy entry are the competitive part; differentiation is the monopoly part.

How products differ.

MIC 0803 Four Sources of Differentiation

Products differ in four ways: physical features, location, intangibles such as reputation and service, and perceptions shaped by habit and advertising. Two nearly identical colas sell as different drinks to loyal buyers. A difference need only exist in buyers' minds to give a firm some pricing room.

The demand curve such a firm sees.

MIC 0804 The Perceived Demand Curve

A monopolistic competitor faces a downward-sloping demand curve for its own variety, one slice of the market, and more elastic than a monopolist's because close substitutes exist. Raise the pizza price a little and some customers stay; raise it a lot and most leave. It is not the market demand curve, and rivals' choices move it, which a monopolist's never do.

Five entries from the short run to the long: the monopoly method on a slice, and entry pulling the firm to the tangency.

The firm's choice.

MIC 0805 Profit Maximization in the Short Run

In the short run the firm behaves like a monopolist on its own demand curve: produce where marginal revenue equals marginal cost, read the price from demand, compare price with average cost. The pizza shop sells forty a day at sixteen dollars and earns a profit. Same three steps as monopoly; the difference arrives in the long run, when profit draws entry.

The computation.

MIC 0806 A Monopolistic Competitor's Quantity, Price and Profit

From the firm's own demand schedule, compute total revenue and marginal revenue between rows, take every step where marginal revenue is at least marginal cost, read the price from demand at that quantity, and take price minus average total cost times quantity for profit: the monopoly method applied to a slice of the market. The pizza shop's revenue is four hundred, five forty, six forty, seven hundred and seven twenty at twenty through sixty pizzas, so marginal revenue per pizza for each added ten is fourteen, ten, six and two, against marginal cost of six, eight, ten and twelve. The second ten pays, the third pays, the fourth does not: quantity forty, price sixteen from demand, average total cost thirteen, profit three dollars a pizza, one hundred twenty a day. Read the price from demand, compute marginal revenue from the change in total revenue, and record the profit, since it is the signal the next entry acts on.

What profit invites.

MIC 0807 Entry Shifts the Firm's Demand Left

Profit attracts new varieties. Each entrant takes some customers, so the existing firm's demand curve shifts left and grows more elastic, and its marginal revenue shifts with it; a fourth pizza shop opens and the others each sell fewer at every price. Entry shifts the firm's own demand, not the market's, and that is the mechanism monopoly lacks.

Where entry stops.

MIC 0808 Long-Run Equilibrium: The Tangency

Entry stops when the firm's demand curve has shifted to touch its average cost curve at one point. There price equals average cost: zero economic profit, and no reason to enter or leave. Losses run it backward, since exit shifts survivors' demand right to the same tangency. Zero economic profit, not zero accounting profit; the owners earn what they would elsewhere.

Tracing entry through.

MIC 0809 Tracing Entry to the Tangency

Start with a firm earning profit. Entry shifts its demand curve left; marginal revenue shifts with it, the profit-maximizing quantity falls, and the price read from the new curve falls. Compare the new price with average total cost at the new quantity: if price still exceeds it, entry continues; when they are equal, the tangency is reached and the process stops, with a smaller quantity, a lower price and zero economic profit. The pizza shop earned one hundred twenty a day at forty pizzas and sixteen dollars. New shops open until its demand has shifted left to thirty pizzas at fourteen dollars, where average total cost is also fourteen: profit is zero and entry stops. It sells ten fewer at two dollars less, and covers its costs, including the owner's forgone wage, exactly. The demand curve shifts and the cost curves do not; shifting average cost up to meet the old demand describes a cost increase, not entry. And the tangency is on the falling part of average cost, which is the next entry's point.

Five entries on the verdict and the benefit: excess capacity, the efficiency verdict, variety, and advertising.

What the tangency costs.

MIC 0810 Excess Capacity

At the tangency the firm sits left of minimum average cost, producing less than the output that makes each unit cheapest, and that gap is excess capacity. The pizza shop's cheapest output is fifty a day; it settles at thirty. The witness calls it the price of variety, the anchor draws it unnamed, and the exam uses the name.

The efficiency verdict.

MIC 0811 The Efficiency Verdict

Monopolistic competition fails both tests. Price exceeds marginal cost, so too little is produced: not allocatively efficient. Output sits above minimum average cost: not productively efficient. The gap is smaller than monopoly's, since substitutes keep the price down, and the failures follow from differentiation itself, not from any firm's size or misconduct.

What buyers get in exchange.

MIC 0812 Variety: The Benefit

The inefficiency buys variety: different pizzas, locations and hours. Whether markets produce too much variety, and whether differentiation wastes resources, is an unresolved dispute among economists; forcing every shop to sell the same pizza would cut cost and choice at once. The course reports both positions and takes neither, and perfect competition is a model, not a goal.

Advertising in the model.

MIC 0813 Advertising in the Model

Advertising does two things to a firm's demand curve: shifts it right, so more sells at each price, or makes it less elastic, so price can rise with fewer lost customers. Loyalty steepens the curve; announcing a new shop shifts it. Advertising is a cost too, and it pays only if the revenue it adds exceeds its cost.

Whether it helps or hurts competition.

MIC 0814 Advertising: Two Views

Critics say advertising raises costs and builds brand loyalty that bars entry. Defenders say it informs buyers, enables price competition and lets entrants be noticed at all; one attributed study found eyeglasses cheaper where advertising was allowed than where it was banned. Both views are attributed positions. A world with advertising is likely more competitive than one without; how much is contested.

Five entries on oligopoly and concentration: the second case defined, why it exists, and two measures of fewness.

The second case.

MIC 0815 Oligopoly Defined

An oligopoly is a market dominated by a few large firms, with high barriers to entry. Products may be identical, as in steel, or differentiated, as in cars: two airplane makers, three wireless carriers, four cereal firms. Few is not a number. The test is whether each firm must watch what the others do.

Why a few firms end up in charge.

MIC 0816 Why Oligopolies Exist

Oligopolies form where monopoly's barriers combine with differentiation, and where economies of scale leave room for a few firms: a market two or three times minimum efficient scale holds two or three. Building a brand or a jet plant costs so much that few can try. The cost curve of unit six decides the firm count here, as it did for monopoly.

The first measure of fewness.

MIC 0817 Measuring Concentration: The Four-Firm Ratio

The four-firm concentration ratio adds the market shares of the four largest firms. Near one hundred means a tight oligopoly; near zero means many small firms. Shares of thirty, twenty-five, twenty and ten give a ratio of eighty-five. It ignores how the four shares are split, and everything below the fourth firm.

The measure that fixes that.

MIC 0818 The Herfindahl-Hirschman Index

The Herfindahl-Hirschman Index squares every firm's percentage share and adds them. A monopoly scores ten thousand; a hundred equal firms score one hundred; squaring weights the largest firms, so five firms at twenty each give two thousand while one at seventy-seven and many at one give far more. Both measures assume the market is correctly defined, and that is where most disputes live.

Computing both.

MIC 0819 Computing Both Measures

From a table of shares, add the largest four for the ratio, and square every share and add all the squares, small firms included, for the index. To test a merger, combine the merging firms' shares, recompute both, and report the index's new level and the increase. Two industries with the same ratio can have very different indexes, which is why regulators use the index. Shares of thirty, twenty-five, twenty, ten, ten and five give a ratio of eighty-five and an index of two thousand one hundred fifty. Merge the two ten-percent firms into one at twenty: the ratio is still eighty-five, and the index becomes two thousand three hundred fifty, an increase of two hundred. Square the percentages as whole numbers, thirty as thirty, since the zero-to-ten-thousand scale depends on it, and include every firm; leaving out the small ones understates the index, though usually by little.

Six entries on interdependence and games: rivals who watch each other, the temptation to act together, and the first tools of game theory.

What fewness does to behavior.

MIC 0820 Interdependence

In an oligopoly each firm's best choice depends on what its rivals do, and every firm knows it. That interdependence is the defining feature, and why no single model fits; one carrier's price cut is answered by the others within days. A competitive firm responds to the market, a monopolist to its demand, and only an oligopolist responds to named rivals.

The temptation to act together.

MIC 0821 Collusion and Cartels

Collusion is firms acting together to restrict output and raise price toward the monopoly level, and a cartel is a formal agreement to do so. Collusion is illegal in most countries, so most is tacit; price leadership, where rivals follow one firm's changes, needs no meeting. Prices moving together is not proof of collusion, since competitive prices move together when costs change.

Why cartels are fragile.

MIC 0822 The Cartel's Temptation

A cartel that fixes the monopoly output leaves each member tempted to produce a little more at the high price. If enough give in, output rises and price falls toward the competitive level: each member gains by cheating if others hold, and all lose if all cheat. Outsiders, entrants and the law add pressure. Cartels need enforcement they cannot legally obtain.

The tool for analyzing such choices.

MIC 0823 Game Theory and Payoffs

Game theory studies choices whose outcomes depend on what other players choose. A payoff matrix lists each player's strategies and the result, usually profit, for every combination: two firms, two strategies each, four cells, two numbers in every cell. Read the matrix one player at a time, asking what each does best given each thing the other might do.

The classic game.

MIC 0824 The Prisoner's Dilemma

Two suspects, questioned apart, each do better by confessing whatever the other does, so both confess and serve longer than if both had stayed silent: silent together, two years each; both confess, five each; one confesses, one against eight. Self-interest beats cooperation though cooperation pays more. The dilemma is the gap between the cell they reach and the one both would prefer.

The strategy that drives it.

MIC 0825 Dominant Strategy

A dominant strategy is the choice that is best for a player whatever the other player does. When every player has one, the outcome where each plays it is a dominant strategy equilibrium; confessing is dominant for each suspect, so both confess. Not every game has a dominant strategy, and many do not, which is why part two's first idea is needed.

Look at what you can now do. You can define monopolistic competition as many firms, easy entry and differentiated products, name the four sources of difference, and describe the demand curve for one slice of the market. You can run the monopoly method on that slice, then let entry shift the firm's demand left until it touches average cost at the tangency, with zero economic profit. You can name excess capacity, say the structure fails both efficiency tests by a little, and report the disputes over variety and advertising without a verdict. You can define oligopoly by whether each firm must watch the others, say why scale leaves room for a few, and compute the four-firm ratio and the Herfindahl-Hirschman Index from a table of shares. And you can explain interdependence, why collusion is mostly tacit and why cartels tempt their members, and read a payoff matrix one player at a time for a dominant strategy. Part two takes up the games that have none.