Chapter 12/Between Competition and Monopoly
CHAPTER 12
BETWEEN COMPETITION AND MONOPOLY
This chapter deals with monopolistic competition and oligopoly, the market forms that lie
between the two polar cases of perfect competition and monopoly. It is here that the great
majority of firms are found. Special emphasis is given to game theoretic techniques and analysis.
CHAPTER OUTLINE
THREE PUZZLING OBSERVATIONS
1. Why are there so many retailers?
MONOPOLISTIC COMPETITION
Characteristics of Monopolistic Competition
There are four requirements for monopolistic competition:
1. Numerous participants – many buyers and sellers, each small compared to the
market
2. Freedom of entry and exit
3. Perfect information
4. Heterogeneous products
Price and Output Determination under Monopolistic Competition
The profit-maximizing firm sets output where marginal revenue equals marginal cost (MR =
MC).
The Excess Capacity Theorem and Resource Allocation
Under monopolistic competition, the firm in the long run will tend to produce an output
lower than that which minimizes its unit costs, and hence unit costs will be higher than
necessary.
Chapter 12/Between Competition and Monopoly
First Puzzle Resolved: Explaining the Abundance of Retailers
This excess capacity theorem explains the abundance of sellers in a monopolistically
competitive market.
OLIGOPOLY
An oligopoly is a market dominated by a few sellers, at least several of which are large
enough relative to the total market that they can influence the market price.
Second Puzzle Resolved: Why Oligopolists Advertise but Perfectly Competitive Firms
Generally Do Not
Firms in an oligopoly face a downward-sloping demand curve indicating that they cannot sell
Why Oligopolistic Behavior is So Hard to Analyze
Oligopolistic firms interact with each other in complex ways and almost anything can and
sometimes does happen under oligopoly.
The Mad Scramble to Differentiate a Product
A Shopping List
Models that analyze oligopoly behavior include the following:
1. Ignoring interdependence
Sales Maximization: An Oligopoly Model with Interdependence Ignored
When the control of a firm is separated from its ownership, and when the compensation of
managers is related to the size of the firm, firms may attempt to maximize revenue rather
than profit.
Chapter 12/Between Competition and Monopoly
Third Puzzle Resolved: The Kinked Demand Curve Model
Because the managers of a firm think that other firms will match any cut they make in price,
but not any increase, they may think they face an inelastic demand curve with respect to
The Game-Theory Approach
Each oligopolist is seen as a competing player in a game of strategy.
Games with Dominant Strategies
Some games have dominant strategies—strategies for the firms that are best no matter what
strategy their competitor chooses.
Games without Dominant Strategies
Some games have no dominant strategies to guide us to an easy solution.
Other Strategies: The Nash Equilibrium
A Nash equilibrium illustrates a situation in which both players adopt moves such that each
Zero-Sum Games
In this game, when one player wins, the other must lose by the same amount.
Repeated Games
Most markets feature repeat buyers rather than the one-time transactions we have discussed
in the maximin strategy and Nash equilibrium.
Chapter 12/Between Competition and Monopoly
MONOPOLISTIC COMPETITION, OLIGOPOLY, AND PUBLIC
WELFARE
Behavior is so varied that it is hard to come to a simple conclusion about welfare
implications.
A GLANCE BACKWARD: COMPARISON OF THE FOUR MARKET
FORMS
An overview of the main attributes of each of the market forms for comparison. It shows
that:
1. Perfect competition and pure monopoly are uncommon in reality. There are very
many monopolistically competitive firms, and oligopoly firms account for the largest
share of the economy’s output.
MARGIN DEFINITIONS
Monopolistic Competition: a market in which products are heterogeneous but which is
otherwise the same as a market that is perfectly competitive.
Oligopoly: a market dominated by a few sellers, at least several of which are large enough
relative to the total market to be able to influence the market price.
Cartel: a group of sellers of a product who have joined together to control its production, sale,
and price in the hope of obtaining the advantages of monopoly.
Price Leadership: one firm sets the price for the industry and the others follow.
Chapter 12/Between Competition and Monopoly
Payoff Matrix: shows how much each of two competitors (players) can expect to earn,
depending on the strategic choices each of them makes.
Dominant Strategy: a strategy for one of the competitors in a game that will yield a higher
payoff than any other strategies that are possible, no matter what choice of strategy is made by
competitors.
MAJOR IDEAS
1. Under monopolistic competition, there are numerous small buyers and sellers; each firm’s
product is at least somewhat different from every other firm’s product, and thus each firm
faces a downward-sloping demand curve; there is freedom of entry and exit; and there is
perfect information.
2. In monopolistic competition, in the long run, firms have excess capacity, and they do not
produce at the point of minimum average cost.
3. An oligopolistic industry is composed of a few large firms selling similar products in the
same market.
4. Under oligopoly, each firm carefully watches the major decisions of its rivals and often
plans counterstrategies. As a result, rivalry is often vigorous and direct, and the outcome
is difficult to predict.
Chapter 12/Between Competition and Monopoly
ON TEACHING THE CHAPTER
The two sections of this chapter on monopolistic competition and oligopoly are quite different.
The analysis of monopolistic competition is simply an application of the profit-maximizing
principles of Chapter 8. It is almost identical to the analysis of perfect competition in Chapter 10,
except that the demand curve facing the firm has a negative slope.
Once students understand the formal structure of a monopolistic competitor, it is interesting
to discuss with them the strengths and weaknesses of this form. On the one hand, there is excess
capacity and the wasting of resources. On the other hand, there are many attractive features of
monopolistic competition. As the text argues, the public may benefit from the variety of
differentiated products. Most observers would also put a positive value on small business
ownership as providing people with a stake in their community and an opportunity for enterprise.
Oligopoly represents the largest portion of economic activity in our society. The instructor
may wish to introduce this section simply by writing on the board the list of the top 50 industrial
corporations in the United States, taken from the current Fortune 500 that can be found in the
college library or on the Internet. Students will be interested to see what the biggest firms are,