Chapter 12:
Monopolistic
Competition,
Oligopoly, and
Strategic Pricing
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Chapter Objectives

1. Describe two methods of determining
market structure.

2. List four distinguishing characteristics of
monopolistic competition.

3a. Demonstrate graphically the equilibrium
of a monopolistic competitor.
3b. Discuss how differentiated products relate
to the excess capacity theorem.
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2
Chapter Objectives

4. State the central element of oligopoly.

5a. Explain sticky prices using the kinked
demand model of oligopoly.
5b. Explain why decisions in the cartel model
depend on market share and decisions in the
contestable market model depend on barriers
to entry.
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3
Chapter Objectives

6. Illustrate a strategic decision facing a
duopolist using the prisoner’s dilemma payoff
matrix.
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4
Introduction

Market structure involves the number of firms
in the market and the barriers to entry.
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5
Defining a Market

Defining a market has problems:

What is an industry and what is its
geographic market?


Local, national, or international?
What products are to be included in the
definition of an industry?
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6
Classifying Industries

One of the ways in which economists classify
markets is by cross-price elasticities.

Cross-price elasticity measures the
responsiveness of the change in demand for
a good to change in the price of a related
good.
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7
Classifying Industries

Industries are classified by government using
the North American Industry Classification
System (NAICS).

The North American Industry
Classification System (NAICS) is a
classification system of industries adopted by
Canada, Mexico, and the U.S. in 1997.
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Concentration Ratio

The concentration ratio is the percentage of
industry sales by the top few firms.
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Herfindahl Index

The Herfindahl index is an index of market
concentration calculated by adding the
squared values of the individual market
shares of all the firms in the industry.
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10
Monopolistic Competition

The four distinguishing characteristics of
monopolistic competition are:

Many sellers.

Differentiated products.

Multiple dimensions of competition.

Easy entry of new firms in the long run.
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11
Output, Price, and Profit

A monopolistically competitive firm produces
in the same manner as a monopolist—to
maximize profit, it chooses the quantity where
MC = MR.

Having determined output, the firm will
charge what consumers are willing to pay
(determined by the demand curve).
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Output, Price, and Profit

If price exceeds ATC, the firm will earn
positive economic profits.

These profits attract entry.

Some customers of the existing firms switch
to become customers of the new firm.
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Output, Price, and Profit

Entry causes the existing firm’s demand
curve to shift left (decrease) as they lose
customers.

Competition, therefore, implies zero
economic profit in the long run.
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Output, Price, and Profit

At the long-run equilibrium, ATC equals price
and economic profits are zero.

This occurs at the point of tangency of the
ATC and demand curve at the output chosen
by the firm.
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Monopolistic Competition: Short Run
Price
P1
C1
MC

MR
0
Q1
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D1
Quantity
16
Monopolistic Competition: Short Run
Price
MC
P1
P2
C2
C1
0
Q2 Q1
MR1
D2
D1
Quantity
MR2
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Monopolistic Competition: Long Run
Price
MC
P1
P2
P3 =C3
C2
C1
ATC3
ATC2
MR2
MR3
0
Q3
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D2
D3
Quantity
18
Comparing Monopolistic Competition
and Perfect Competition

Both the monopolistic competitor and the
perfect competitor make zero economic profit
in the long run.

A monopolistic competitor produces less than
a perfect competitor.
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Comparing Monopolistic Competition
and Perfect Competition
Perfect Competition
Price
Price
MC
ATC
D
PC
0
Monopolistic Competition
QC
Quantity
MC
ATC
PM
PC
0
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QM
MR
D
QC Quantity
20
Excess Capacity

The Excess Capacity theorem indicates
that a monopolistically competitive firm will
have excess capacity in long-run equilibrium.

It occurs because of product differentiation.
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21
Characteristics of Oligopoly

Oligopolies are made up of a small number of
very large firms.

Products may be homogeneous or
differentiated

Firms are mutually interdependent.

Each firm must take into account the
expected reaction of other firms.
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22
Cartel Model

In the cartel model of oligopoly,

Oligopolies act as if they were monopolists

That have assigned output quotas to individual
member firms

So that total output is consistent with joint profit
maximization.
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23
Implicit Price Collusion

Formal collusion is illegal in Canada, but
informal collusion is permitted.

Implicit price collusion exists when multiple
firms make the same pricing decisions even
though they have not consulted with one
another.
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24
Why Are Prices Sticky?

Sticky prices are prices that don’t change
very much.

Informal collusion is an important reason why
prices are sticky.

Another is the kinked demand curve.
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25
Kinked Demand Curve Model

Assumption 1:
If a firm raises its price, no other firms will
raise their prices.

This make the firm’s own demand curve very
elastic.
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26
Kinked Demand Curve Model

Assumption 2:
If a firm lowers its price, all the other firms will
lower their prices too.

This make the firm’s own demand curve very
inelastic.
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27
Kinked Demand Curve Model
No-one follows a price increase.
Price
a
P
b
MC0
c
MC1
Q
D1
MR1
d
0
All firms lower price.
MR2
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D2
Quantity
28
Kinked Demand Curve Model

A high-cost firm and a low-cost firm will both
produce the same quantity and charge the
same price.

If a firm’s costs decrease, consumers will not
see any change.


Price will not decrease.
The firm’s profits will increase.
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29
Contestable Market Model

According to the contestable market model,
barriers to entry and barriers to exit
determine a firm’s price and output decisions.

Even if the industry contains a very small number
of firms, it could still be a competitive market if
entry is open.
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Strategic Pricing and Oligopoly

Both the cartel and contestable market
models use strategic pricing decisions –
firms set their prices based on the expected
reactions of other firms.
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31
Cooperative Equilibrium
MC ATC
$800
700
700
600
600
500
500
Price
575
Price
$800
400
300
D
100
100
2
3
4
5
6
7
8
Competitive
solution
300
200
1
0
MR
1
2
Quantity (in thousands)
(a) Firm's cost curves
MC
400
200
0
Monopolist
solution
3
4
5
6
7
8
9 10 11
Quantity (in thousands)
(b) Industry: Competitive and monopolist solution
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32
One Firm Cheats
$900
$800
$800
800
700
700
700
600
550
500
600
550
500
600
550
500
400
300
A
400
Price
A
Price
Price
MC ATC
MC ATC
300
200
200
100
100
100
1
2 3 4
5 6 7
Quantity (in thousands)
(a) Noncheating firm’s loss
0
1
2 3 4
5
6 7
Quantity (in thousands)
(b) Cheating firm’s profit
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B
A
NonCheating
400 cheating
firm’s
firm’s
output
300 output
200
0
C
0
1
2 3
4 5 6
7 8
Quantity (in thousands)
(c) Cheating solution
33
Payoff Matrix
A Does not cheat
A Cheats
A +$200,000
A $75,000
B Does not
cheat
B $75,000
B – $75,000
A – $75,000
A0
B Cheats
B +$200,000
B0
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34
Payoff Matrix

If both firms cooperate, they can both get
higher profits.


$75,000 each.
However, both firms have an incentive to
cheat on their agreement.

$200,000 for the one that cheats.
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35
Payoff Matrix

A dominant strategy is one which always
yields the highest payoff, no matter what the
other player does.

The dominant strategy is to not cooperate.

i.e. to cheat.
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36
Payoff Matrix

If both firms choose to cheat on their
agreement, the outcome will be a Nash
equilibrium, a non-cooperative equilibrium in
which no player can achieve a better
outcome by switching strategies, given the
strategy of the other player.
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38
Monopolistic Competition,
Oligopoly, and Strategic
Pricing
End of Chapter 12
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rights reserved.
39