Chapter 13
Imperfect Competition:
A Game-Theoretic
Approach
Monopolistic Competition
13-1
The Chamberlin Model
 Assumption: a clearly defined “industry group,” which
consists of a large number of producers of products that
are close, but imperfect substitutes for one another.
 Two implications:
1. Because the products are viewed as close substitutes,
each firm will confront a downward-sloping demand
schedule.
2. Each firm will act as if its own price and quantity
decisions have no effect on the behavior of other firms
in the industry. That is, its competitors do not respond
to its pricing and output decisions. But symmetry
makes sense for other firms to respond to this
behavior.
Thus, the firm faces 2 demand curves: (a) when the firm alone
changes price, and (b) when prices change in unison.
Since the goods are perceived as close substitutes, each firm
perceives the demand curve facing it as highly elastic.
13-2
The Chamberlin Model
(a) The firm alone
changes the price (dd)
and (b) when all firms
change prices (DD)
Gain when ALL firms change
prices along DD
Advantage of being 1st mover
alone along the dd curve
Figure 13.11: The Monopolistic
Competitor’s Two Demand Curves
Figure 13.12: Short-Run Equilibrium
for the Chamberlinian Firm
At the initial price, P’, each firm sells Q’. If the firm lowers P to P”, it sells Q”’ along
dd curve.
BUT if ALL prices change, then each firm sells only Q” along DD curve
Figure 13.12: In the SR, assume the firm has dd curve and the equilibrium is Q* at P*
with ATCQ*. Since P* > ATCQ*. , it follows that the green rectangle is short-term profits.
As in PC, profits invites entry into the industry (free entry & exit)
13-3
Figure 13.13: Long-Run Equilibrium
in the Chamberlin Model
Entry leads to a leftward shift of the demand
curve, i.e. after entry, each firm contributes
proportionately less to industry output. In the
LR, entry drives profits to zero ( just as in PC).
Recall: PC = Perfect Competition
E
PPC
E’
QPC
13-4
Perfect Competition Versus Chamberlinian
Monopolistic Competition
 Competition meets the test of allocative efficiency(P=MC), while monopolistic
competition does not (P>MC).
 Monopolistic competition is less efficient than perfect competition because in
the former case firms do not produce at the minimum points of their long-run
average cost (LAC) curves (E > E’)
 In terms of long-run profitability the equilibrium positions of both the perfect
competitor and the Chamberlinian monopolistic competitor are precisely the
same (P = ATC in both)
13-5
Criticisms of the Chamberlin Model
1. Arbitrary definition of an “industry group.” Chamberlin
thought of group of products that are different from each
other and providing variety (Stigler)
2. It complicates PC without changing its fundamental results
(Friedman)
3. Too closely resembles the PC especially its assumption that any
firm can attract any buyers in an industry.
These criticisms have lead to the development of models that yield
different results than the Chamberlin model.
EXAMPLE
Suppose each of the 20 firms in monopolistic competition faces a dd curve of
the form: P = 10 – 0.001Q. What is each firm’s dd curve following the entry of
5 firms?
Before Entry: MR = 10 –0. 002Q and set = 0 and solve for Q = 5,000. Divide
5000 by 20 firms to get a firm’s share: 5000/20 = 250. Thus, in % terms, each
firm has 250/5000 = 1/20 = 5%.
P=10, and Q = 10,000
After entry: Divide 5000 by 25 = 200 and in % terms, the share is 200/5000
=1/25 = 4%. Thus, at each price, quantity demanded will be 20% less, i.e.
P = 10 – 0.00125Q so that P =10 but Q = 8,000 (where 0.000125 = 1/8000)
P=10
8,000
10,000
Criticisms of the Chamberlin Model
1. Arbitrary definition of an “industry group.” Chamberlin
thought of group of products that are different from each
other and providing variety (Stigler)
2. It complicates PC without changing its fundamental results
(Friedman)
3. Too closely resembles the PC especially its assumption that any
firm can attract any buyers in an industry.
These criticisms have lead to the development of models that yield
different results than the Chamberlin model.
Figure 13.14: An Industry in Which Location is the
Important Differentiating Feature
The Optimal Number
of Locations
The number of outlets
4 equally space outlets
(green); circumference
that emerges from the
= 1mile
independent actions of
profit-seeking firms
will in general be
related to the optimal
number of outlets in
Distance as reducing substitutability
the following simple
way 
Any environmental change that leads to a change in the optimal
number of outlets (here, any change in population density,
transportation cost, or fixed cost) will lead to a change in the
same direction in the equilibrium number of outlets.
13-9
Figure 13.16: The Optimal Number of Outlets
Optimal N* = where the slopes of the 2 curves are equal
# CMtrans – total transportation costs ; declines with the number of outlets
(restaurants in this case)(N)
# CMMeals – total cost of meals served ; increases with the number of outlets N)
#N* - optimal number of restaurants, i.e. the one that minimizes the sum of
these costs. At t (transportation costs ) rises, so do N as people economize on
transportation by going to nearer restaurants. Similarly, if L (population) rises,
high density in the area increases N (see Natomas). If restaurant start-up costs
tL
(F) increase, N decreases (e.g. zoning costs)
N* 
2F
13-10
Figure 13.17: A Spatial Interpretation
of Airline Scheduling
5 P.M.
Preference for a 5
PM flight can be
easily
accommodated by
the closet
substitute – flight
at 6P.M. in the
airline ‘product
space.’
Why not have a flight leaving every 5 minutes, so that no one would be
forced to travel at an inconvenient time?
The larger an aircraft is, the lower its average cost per seat is.
If people want frequent flights, airlines are forced to use
smaller planes and charge higher fares (commuter airlines)
13-11
Figure 13.18: Distributing the Cost
of Variety
Desire for variety increases with income; those with a preference for a
wide variety have the income to back-up their demands, i.e. automobile
market.
Buyers who care more about special features will buy the higher priced
Cadillac while the opposite is true of those who might care but have low
incomes
Note that by charging more for Cadillac's, the producer is able to recoup
the cost of “variety” even if the MC of both types are hardly different.
Note that the cost of ‘variety’ is not evenly distributed across consumers
13-12
Consumer Preferences And Advertising
 Because products are differentiated, producers can
often shift their demand curves outward
significantly by advertising.
 The revised sequence -- the corporation decides
which products are cheapest and most convenient
to produce, and then uses advertising and other
promotional devices to create demand for them.
13-13