Monopolistic Competition and Oligopoly: Structured Study Notes

Chapter 12: Monopolistic Competition and Oligopoly

12.1 Monopolistic Competition

Monopolistic competition is a market structure in which many firms compete by selling differentiated products that are close but not perfect substitutes. Entry and exit are relatively easy, and each firm has some degree of market power due to product differentiation.

• Key Characteristics:

  • Firms sell differentiated products with high cross-price elasticities of demand, but not infinite.

  • Free entry and exit: New firms can enter with their own brands, and existing firms can leave if unprofitable.

• Short-Run Equilibrium: Each firm faces a downward-sloping demand curve and sets price above marginal cost, earning profits.

• Long-Run Equilibrium: Profits attract new entrants, shifting demand leftward until price equals average cost and profits are zero.

• Economic Efficiency:

  • Under perfect competition, price equals marginal cost and the demand curve is horizontal.

  • Under monopolistic competition, price exceeds marginal cost, resulting in deadweight loss (inefficiency).

  • Product diversity is a benefit that may outweigh inefficiency.

• Example: Monopolistic Competition in the Markets for Colas and Coffee

  • Brands differ slightly but are close substitutes. Elasticities of demand for colas and coffees are high (e.g., RC Cola: -2.4, Coke: -5.2 to -5.7, Folgers: -4.4).

  • Most brands have limited monopoly power, typical of monopolistic competition.

Brand	Elasticity of Demand
RC Cola	-2.4
Coke	-5.2 to -5.7
Folgers	-4.4
Maxwell House	-6.2
Chock Full O' Nuts	-3.6

12.2 Oligopoly

Oligopoly is a market structure in which a few firms account for most or all of total production. Products may be homogeneous or differentiated, and entry is often impeded by barriers such as scale economies, patents, or reputation.

• Key Features:

  • Few firms dominate the market.

  • Barriers to entry can be natural (scale economies, patents) or strategic (advertising, reputation).

  • Strategic decision-making: Firms must consider competitors' actions when setting price, output, advertising, and investment.

• Equilibrium in Oligopoly:

  • Firms set price/output based on competitors' behavior.

  • Nash Equilibrium: Each firm does the best it can given competitors' actions; no incentive to change output or price.

  • Duopoly: Market with two competing firms.

• The Cournot Model:

  • Firms produce a homogeneous good and choose output simultaneously.

  • Each firm treats the other's output as fixed.

  • Profit maximization leads to a reaction function for each firm.

  • Cournot equilibrium is reached when neither firm wants to change its output.

• Cournot Model Assumptions:

  • Homogeneous product

  • Duopoly (two firms)

  • Barriers to entry

  • No price regulation

• Example: Oligopoly Cournot Example

Q1	Q2	P	PS1	PS2	PStot
5	5	20	70	70	140
6	6	18	72	72	144
7	7	16	70	70	140
8	8	14	64	64	128
9	9	12	54	54	108

Additional info: PS1 and PS2 are producer surpluses for firms 1 and 2, respectively. PStot is total producer surplus.

• Cournot Model Solution:

  • Suppose $Q_d = 240 - 2P$, so $P = 120 - Q/2$

  • Suppose $MC_a = 4Q_a$ and $MC_b = 5Q_b$

  • Find total revenue (TR) for each firm, set marginal revenue (MR) equal to marginal cost (MC), and solve reaction curves simultaneously to get $Q_a$ and $Q_b$.

• Reaction Curves: Show each firm's profit-maximizing output as a function of the competitor's output.

• Cournot Equilibrium: Each firm produces an amount that maximizes its profit given the competitor's output.

• Example: Linear Demand Curve

  • Market demand: $P = 30 - Q$

  • Marginal cost: $MC_1 = MC_2 = 0$

  • Total revenue: $R = PQ = (30 - Q)Q = 30Q - Q^2$

  • Marginal revenue: $MR = \frac{dR}{dQ} = 30 - 2Q$

  • Setting $MR = 0$ gives $Q = 15$ (collusion curve)

  • If firms share profits equally: $Q_1 = Q_2 = 7.5$

• Stackelberg Model: One firm sets output first (leader), the other follows (follower). The leader can achieve higher profits.

12.3 Price Competition

Price competition in oligopoly can be modeled by the Bertrand model, where firms produce homogeneous goods and simultaneously choose prices.

• Bertrand Model:

  • Firms set price equal to marginal cost in Nash equilibrium.

  • Market price: $P = 30 - Q$; $MC_1 = MC_2 = 3$

  • Each firm produces 9 units; market price is $12$in Cournot equilibrium, $3$ in Bertrand equilibrium.

  • In Bertrand equilibrium, firms earn zero profit; in Cournot, they earn positive profit.

• Example: Pricing Problem for Procter & Gamble

P&G's Price ($)	Competitors' Price ($)	P&G's Profit (thousands $/month)
1.10	1.10	-10
1.20	1.20	0
1.30	1.30	10
1.40	1.40	12
1.50	1.50	12

Additional info: Nash equilibrium occurs when all firms set the same price; profits are maximized at $1.40$ or $1.50$.

12.4 Competition versus Collusion: The Prisoners' Dilemma

The prisoners' dilemma illustrates why firms in oligopoly may fail to cooperate, even when collusion would increase their profits. Each firm has an incentive to cheat, leading to lower profits for all.

• Payoff Matrix: Shows profits for each firm based on their pricing decisions.

	Firm 2: Charge $4	Firm 2: Charge $6
Firm 1: Charge $4	$12, $12	$4, $20
Firm 1: Charge $6	$20, $4	$16, $16

• Noncooperative Game: Negotiation and enforcement of binding contracts are not possible.

• Prisoners' Dilemma: Each firm has an incentive to undercut the other, leading to a suboptimal outcome.

12.5 Implications of the Prisoners' Dilemma for Oligopolistic Pricing

Oligopolistic firms may not always engage in aggressive price competition. Price rigidity and kinked demand curves can result from strategic behavior and the potential for cooperation.

• Price Rigidity: Firms are reluctant to change prices even if costs or demand change.

• Kinked Demand Curve Model: Demand is elastic at higher prices, inelastic at lower prices, leading to stable prices.

• Cooperation: Trust and repeated interaction can allow for coordination and higher profits.

12.6 Cartels

A cartel is a group of firms that explicitly collude to coordinate prices and output to maximize joint profits. Cartel success depends on market demand elasticity and the ability to control supply.

• Conditions for Cartel Success:

  • Organizational ability to enforce agreements.

  • Potential for monopoly power (inelastic demand, control of supply).

• Example: OPEC and CIPEC

  • OPEC has succeeded in raising oil prices above competitive levels due to control over supply and inelastic demand.

  • CIPEC (copper cartel) was less successful due to more elastic demand and less control over supply.

Additional info: Cartels are often illegal in the U.S. and difficult to maintain due to incentives to cheat and enforcement challenges.