ECO 204
Chapter 10 
MONOPOLISTIC COMPETITION AND OLIGOPOLY

Perfect competition is a model of a market characterized by extremely high levels of competition; monopoly is a model of a market characterized by the lack of competition. They are both based upon extreme assumptions that are only very rarely found in markets today.
In this chapter, two alternative market structures are analyzed that some feel better represent firms existing in the marketplace. These models share some attributes of perfect competition and some attributes of monopoly. First, monopolistic competition is characterized by the existence of many small firms and free entry and exit, but firms are able to differentiate their product and have some control over market price. Optimal output and price are found by setting marginal revenue equal to marginal cost; price is dependent upon the strength of consumer demand. As with perfect competition, ease of entry and exit provides only normal profits for firms in the long run.
Second, oligopoly is characterized by the existence of a few large firms and barriers to entry, but no firm is able to eliminate all close substitutes for its product. Therefore, mutual interdependence among all firms in the industry exists, as well as heavy nonprice competition.
No universal model of oligopoly behavior exists. Because there are many different ways to define mutual interdependence, a set of models has been developed, each with its own set of assumptions that define the behavior of firms. These include the kinked demand model, collusion, and price leadership curve. Under given circumstances, any of these may do a good job of predicting market events.
Before leaving this chapter, take some time to compare the results produced by all four models of competitive behavior. How are they alike? How do they differ? 
Outline
I.      Monopolistic Competition

        A.      The characteristics of monopolistic competition
                1.      Many sellers market their own version of a product that is unique but has close substitutes
                        a.      The firm may differentiate the product by altering physical characteristics
                        b.      The firm may differentiate the product by advertising to the public that a product is unique
                        c.      There are enough sellers so that their actions are independent
                2.      There are free entry into and exit out of the industry
        B.      Equilibrium in the Short Run
                1.      As with perfect competition and monopoly, the optimal level of output is found by setting marginal revenue equal to marginal cost
                2.      Price is found by looking to the demand curve
                3.      The shutdown point occurs at minimum average variable cost
        
        C.      Long-run equilibrium results are as with perfect competition
                1.      Free entry and exit of rivals lead to only normal profits for firms in the long run
                2.      Economic profits lure rivals in the long run
                3.      Losses encourage exit from the industry
        D.      Nonprice competition becomes a very important attribute of monopolistic competition
                1.      Nonprice competition includes product development, packaging, and advertising
                2.      Firms spend millions on advertising; there are pros and cons to these expenditures
II.     Oligopoly

        A.      The characteristics of oligopoly
                1.      Few firms compete in the industry
                2.      Firms may produce a homogeneous or a differentiated product
                3.      Barriers to entry exist in order to keep rivals out of the industry
                4.      Given the existence of only a few competitors, mutual interdependence among these firms is important
        B.      Because of the difficulty of defining mutual interdependence among oligopolists, a set of models has been developed to explain 
                behavior, each based on its own set of assumptions

III.    Formal Models of Oligopoly

        A.      The Kinked Demand Curve Model
                1.      Based on the assumption that firms ignore the price increases of rivals but match their price decreases
                
        B.      Collusion
                1.      Based on the assumption that firms collude and cooperate in making output and price decisions
                2.      Cartel agreements are illegal in U.S. markets
                3.      Collusion is designed to increase industry profits by raising prices and/or restricting supply
                4.      The success of a cartel agreement depends upon a variety of factors, including the number of firms, heterogeneity of products, 
                        and antitrust laws
        C.      Price Leadership
                1.      Based on the assumption that firms copy the behavior of a firm chosen to be the "leader"
                2.      The price leader may be the firm that dominates the market, the low-cost firm, or a "barometric" firm
        D.      An Evaluation of Oligopoly
                1.      According to the Schumpeter-Galbraith Hypothesis, innovation requires both massive investment and lots of research and 
                        development, so firms must be large in order to support innovation
                2.      Because there is such a small number of firms, collusion among competitors can be a problem
ECO 204