Economics - Monopolistic Competition and Oligopoly - Quick Guides

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Study GuideEconomics–Monopolistic Competition and Oligopoly1. Monopolistic Competition in the Long-run1.1Entry of Firms in the Long RunIn amonopolistically competitive market, firms are free toenter and exit the marketin the longrun. This is a key difference from monopoly.•In theshort run, firms may earnpositive economic profits.•These profits attractnew firmsinto the market.•Because there areno barriers to entry, entering the market is relatively easy.This feature makes monopolistic competition very different from monopoly.1.2Effect of Entry on DemandAs new firms enter the market:•The number ofdifferentiated productsincreases.•Consumers now havemore choices.•Each existing firm loses some customers.Because of this, themarket demand curve faced by each firm shifts to the left.

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Study Guide1.3Long-Run Equilibrium of the FirmEntry continues as long as firms are earning economic profits. Eventually:•The firm’sdemand curve becomes tangent to the average total cost (ATC) curve.•This tangency occurs at theprofit-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 thelong run, monopolistically competitive firms earnnormal profits, just like firms in perfectcompetition.1.4Excess Capacity: A Key OutcomeEven though firms earn only normal profits in the long run, monopolistic competition still has adrawback.•The firm producesless than its minimum efficient scale.•This output level is shown aspoint bin the figure.•Producing below this level means the firm isnot using its resources fully.This situation is calledexcess capacity.

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Study Guide1.5Why 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 capacityis considered themajor social costof monopolistic competition.Key Takeaways•In the long run,free entry eliminates economic profits.•Firms earnnormal profits, not supernormal profits.•Demand becomestangent to ATCat the profit-maximizing output.•Firms operate withexcess capacity, which is the main inefficiency of this market structure.This explains how monopolistic competition combines features of bothmonopolyandperfectcompetitionin the long run.2. Conditions for an Oligopolistic MarketAnoligopolyis one of the more complex market structures, and economists do not have a singletheory that explains all oligopolistic behavior. This is because firms in an oligopoly often react to oneanother’s decisions, making outcomes harder to predict.Even so, economists generally agree onthree key conditionsthat define an oligopolistic market.1.A Few Large Firms Dominate the MarketAn oligopolistic market is made up ofonly a small number of large firms.Each firm holds a significant share of the market, so the actions of one firm can strongly affect theothers.This feature clearly separates oligopoly from:•Monopoly, where there is onlyone firm•Markets with many small firms, where no single firm has much influence

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Study Guide2.High Barriers to EntryOligopolistic markets havehigh barriers to entry, which prevent new firms from easily entering theindustry.These barriers may include:•High start-up costs•Control over important resources•Strong brand loyalty•Government regulationsBecause of these barriers, existing firms facelittle threat from new competitors.This condition distinguishes oligopoly fromperfect competitionandmonopolistic competition,where firms can enter and exit the market freely.3.Products May Be Differentiated or HomogeneousFirms 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 structuresdepending on the industry.Examples of Oligopolistic IndustriesCommon examples of oligopolistic markets include:•Automobile manufacturers•Oil producers•Steel manufacturers•Passenger airlinesIn each of these industries, asmall number of large firms dominate the market, facehigh entrybarriers, and carefully watch one another’s decisions.

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Study GuideKey TakeawayAn oligopolistic market is defined by:•Afew large firms•High barriers to entry•Differentiated or homogeneous productsUnderstanding these conditions helps explain why competition in oligopolies is limited and why firms’decisions are closely linked.3. Kinked-Demand Theory of Oligopoly3.1Understanding OligopolyIn anoligopoly, there areonly a few firmsin the market. Each firm sells adifferentiated product,meaning products are similar but not identical. Because there are so few firms,each firm’sdecisions strongly affect the others.There isno single theorythat fully explains oligopoly behavior. However, economists often discusstwo main theories:

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Study Guide•Thekinked-demand theory•Thecartel theoryThis section focuses on thekinked-demand theory.3.2Basic Idea of the Kinked-Demand TheoryAccording to the kinked-demand theory, an oligopolistic firm facestwo different demand curvesforits product:•One demand curve applies when the firmraises its price•Another demand curve applies when the firmcuts its priceThese two demand curves create akinkin the overall demand curve faced by the firm.3.3Demand at Higher Prices (Above P)Athigher prices, the firm faces arelatively elastic demand curve, labeledMD₁in the figure.•This demand is elastic because if the firmraises its price, other oligopolists areunlikely toraise their prices•Consumers will thenswitch to cheaper rival products•As a result, the firm loses customers quickly when it increases priceCorresponding to this demand curve is themarginal revenue curve MR₁.3.4Demand at Lower Prices (Below P)Atlower prices, the firm faces arelatively inelastic demand curve, labeledMD₂in the figure.•If the firmcuts its price, competitors are expected tomatch the price cut•Since all firms lower prices together, consumers haveless reason to switch brands•Demand becomesless sensitive to price changes.The marginal revenue curvecorresponding to this demand isMR₂.

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