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Economics - Monopolistic Competition and Oligopoly

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    Study Guide Economics – Monopolistic Competition and Oligopoly 1. Monopolistic Competition in the Long - run 1.1 Entry of Firms in the Long Run In a monopolistically competitive market , firms are free to enter and exit the market in the long run. This is a key difference from monopoly. • In the short run , firms may earn positive economic profits . • These profits attract new firms into the market. • Because there are no barriers to entry , entering the market is relatively easy. This feature makes monopolistic competition very different from monopoly. 1.2 Effect of Entry on Demand As new firms enter the market: • The number of differentiated products increases. • Consumers now have more choices . • Each existing firm loses some customers. Because of this, the market demand curve faced by each firm shifts to the left .

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    Study Guide 1.3 Long - Run Equilibrium of the Firm Entry continues as long as firms are earning economic profits. Eventually: • The firm’s demand curve becomes tangent to the average total cost (ATC) curve . • This tangency occurs at the profit - maximizing level of output (where MR = MC). • At this point, economic profit becomes zero . Since firms are no longer earning extra profits, there is no incentive for new firms to enter . In the long run , monopolistically competitive firms earn normal profits , just like firms in perfect competition. 1.4 Excess Capacity: A Key Outcome Even though firms earn only normal profits in the long run, monopolistic competition still has a drawback. • The firm produces less than its minimum efficient scale . • This output level is shown as point b in the figure. • Producing below this level means the firm is not using its resources fully . This situation is called excess capacity .

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    Study Guide 1.5 Why Excess Capacity Matters • The firm could produce more at a lower average cost. • However, due to product differentiation and downward - sloping demand, it does not. • Excess capacity is considered the major social cost of monopolistic competition. Key Takeaways • In the long run, free entry eliminates economic profits . • Firms earn normal profits , not supernormal profits. • Demand becomes tangent to ATC at the profit - maximizing output. • Firms operate with excess capacity , which is the main inefficiency of this market structure. This explains how monopolistic competition combines features of both monopoly and perfect competition in the long run. 2. Conditions for an Oligopolistic Market An oligopoly is one of the more complex market structures, and economists do not have a single theory that explains all oligopolistic behavior. This is because firms in an oligopoly often react to one another’s decisions, making outcomes harder to predict. Even so, economists generally agree on three key conditions that define an oligopolistic market. 1. A Few Large Firms Dominate the Market An oligopolistic market is made up of only a small number of large firms . Each firm holds a significant share of the market, so the actions of one firm can strongly affect the others. This feature clearly separates oligopoly from: • Monopoly , where there is only one firm • Markets with many small firms, where no single firm has much influence

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    Study Guide 2. High Barriers to Entry Oligopolistic markets have high barriers to entry , which prevent new firms from easily entering the industry. These barriers may include: • High start - up costs • Control over important resources • Strong brand loyalty • Government regulations Because of these barriers, existing firms face little threat from new competitors . This condition distinguishes oligopoly from perfect competition and monopolistic competition , where firms can enter and exit the market freely. 3. Products May Be Differentiated or Homogeneous Firms in an oligopoly may produce: • Differentiated products (slightly different brands or styles), or • Homogeneous products (nearly identical goods) This flexibility is another unique feature of oligopoly, as it can resemble different market structures depending on the industry. Examples of Oligopolistic Industries Common examples of oligopolistic markets include: • Automobile manufacturers • Oil producers • Steel manufacturers • Passenger airlines In each of these industries, a small number of large firms dominate the market , face high entry barriers , and carefully watch one another’s decisions.

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    Study Guide Key Takeaway An oligopolistic market is defined by: • A few large firms • High barriers to entry • Differentiated or homogeneous products Understanding these conditions helps explain why competition in oligopolies is limited and why firms’ decisions are closely linked. 3. Kinked - Demand Theory of Oligopoly 3.1 Understanding Oligopoly In an oligopoly , there are only a few firms in the market. Each firm sells a differentiated product , meaning products are similar but not identical. Because there are so few firms, each firm’s decisions strongly affect the others . There is no single theory that fully explains oligopoly behavior. However, economists often discuss two main theories:

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    Study Guide • The kinked - demand theory • The cartel theory This section focuses on the kinked - demand theory . 3.2 Basic Idea of the Kinked - Demand Theory According to the kinked - demand theory, an oligopolistic firm faces two different demand curves for its product: • One demand curve applies when the firm raises its price • Another demand curve applies when the firm cuts its price These two demand curves create a kink in the overall demand curve faced by the firm. 3.3 Demand at Higher Prices (Above P) At higher prices , the firm faces a relatively elastic demand curve , labeled MD ₁ in the figure. • This demand is elastic because if the firm raises its price , other oligopolists are unlikely to raise their prices • Consumers will then switch to cheaper rival products • As a result, the firm loses customers quickly when it increases price Corresponding to this demand curve is the marginal revenue curve MR ₁ . 3.4 Demand at Lower Prices (Below P) At lower prices , the firm faces a relatively inelastic demand curve , labeled MD ₂ in the figure. • If the firm cuts its price , competitors are expected to match the price cut • Since all firms lower prices together, consumers have less reason to switch brands • Demand becomes less sensitive to price changes . The marginal revenue curve corresponding to this demand is MR ₂ .

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