Monopolistic Competition

Definition Monopolistic competition refers to the market organization in which there are many firms selling closely related but not identical commodities. An example is given by the many cigarette brands. Another example is given by the many different detergents available in the market. Because of this product differentiation, sellers have some degree of control over the prices they charge and thus face a negatively sloped demand curve. However, the existence of close substitutes, severely limits the monopoly power and results in a highly elastic demand curve. Short run Equilibrium The demand curve will be highly price elastic and negatively sloped.The MR curve will be below the demand curve. The short run equilibrium level of output for the firm is given by the point where its SMC curve intersects its MR curve frowm below (provided that at this output level price is atleast as high as the average variable cost. Long run equilibrium If the firm in the monopolistically competitive industry earned economic profics in the short run, firms will enter in the industry in the long run. This causes the demand curve of the typical firm to shift down since each firm now has a smaller share of the market. The demand curve will be tangent to the LAC curve indicating that there are no economic profits.

Oligopoly
Oligopoly is the market situation in which there are few sellers of a commodity. So, the actions of each seller will affect the other sellers. As a result, we cannot construct the demand curve of a firm unless we assume that unless we make assumptions about the reactions of other firms to the actions of the firm under study. For each specific behavioral assumption, we get a different solution. Thus, we have no general theory of oligopoly. Instead, we have many different models of oligopoly. In the Cournot model, we assume that there are two firms selling spring water under conditions of zero costs. Therefore, the profit maximizing output occurs at the mid-point of its negatively sloped straight line demand curve. At this point, elasticity of demand is unity and marginal revenue is zero. Thus, at this point MR = MC, which is zero. The basic behavioral assumption in the model is that each oligopolist assumes that the other will keep his output constant. After a number of moves and counter-moves by the oligopolists, each sells exactly one-third of the total quantity that will be sold if there is perfect competition. In other words, the total quantity sold by the two oligopolists will be two-thirds of the total output. If there are three

sellers, each will be selling one-fourth of the competitive output or the total sales will be 75% of the competitive output. The logic can be extended for any number of sellers. In the Bertrand model, each firm assumes that the other firm keeps its price constant. This assumption results in competitive equilibrium where price is zero. The Edgeworth model assumes that there are two firms selling a homogeneous commodity produced at zero cost. In addition, the following further assumptions are made: (1) each firm faces an identical straight line demand curve for its product, (2) each firm has a limited production capacity and cannot supply the entire market by itself, and (3) each firm, in attempting to maximize its TR or total profit, assumes that the other holds its price constant. The result of these assumptions is that there will be a continuous oscillation of the product price between the monopoly price and the maximum output price of each firm. Price oscillations are sometimes observed in the oligopoly markets and this model is consistent with those oscillations. In the Chamberlin model, both the duopolists recognize their mutual interdependence. All other assumptions of the Cournot model are also made in the model. The resulting solution is that without any form of agreement or collusion, the duopolists set identical prices, sell identical quantities, and maximize joint profits. As a further development toward more realistic models, we take kinked demand curve or Sweezy model. This model tries to explain price rigidity in the oligopolistic markets. Sweezy postulates that if an oligopolistic firm increases its price, others in the industry will not raise their prices and so the firm would lose most of its customers. On the other hand, an oligopolistic firm cannot increase its share of the market by lowering the price since the other oligopolists in the industry will match the price cut. Thus, there is a strong compulsion for the oligopolists not to change the prevailing price but rather to compete for a greater share of the market on the basis of quality, product design, advertisement, and service. The kink in the demand curve results in discontinuity in the MR curve. The oligopolist s marginal cost curve can raise or fall anywhere within the discontinuous portion of the MR curve without inducing the oligopolist to change sales level and the prevailing price. A cartel is a formal organization of producers within an industry that determines policies for all the firms in the cartel, with a view to increasing total profits for the cartel. There are many types of cartels. At one extreme, there is a cartel which takes all the decisions for all members. This is called centralized cartel. It leads to monopoly solution. The total market demand curve is given. The cartel s marginal cost curve is obtained by summing horizonally the members firms SMC curves. The best level of output for the cartel as a whole is obtained by equating marginal cost and marginal revenue. The price is determined from the demand curve. The cartel then decides on how distribute the profits in a manner agreeable to all the firms. Another type of cartel is the market sharing cartel, in which the member firms agree upon the share of the market each is to have. Under certain conditions, the market-sharing cartel can also result in the

monopoly solution. Suppose there are two firms selling a homogeneous commodity and they decide to share the market equally. We assume that the total demand curve is linear. We further assume that each has the same SMC curve. Each firm s demand curve will be half share curve. The marginal revenue curve for each will be half of the demand curve. The two firms together sell the monopoly output. In the price leadership model is the form imperfect collusion in which the firms in an oligopolistic industry tacitly (without formal agreement) decide to set the same price as the price leader. The leader may the dominant firm or the firm with least cost. The leader will set the price and the follower firms will sell as much output as they want at that price. The balance will be sold by the leader. In this case, the supply curve of the of all the follower firms will be determined and the demand curve of the leader is obtained by subtracting the supply curve of the follower firms at each price. From the dominant firms demand curve, we derive the marginal revenue curve. Price is determined by the intersection of marginal revue and marginal cost curve of the leader. Other firms take this price and sell as much as they want at this price. The balance will be sold by the leader firms. The Lerner index as measure of firm s monopoly power in an industry is the ratio of the difference between price and marginal cost to price. It is also equal to the reciprocal of elasticity of demand. The greater is the difference between the price and marginal cost, the greater is the monopoly power. The value can range from 0 (in the case of perfect competition) to unity (in the case of a monopolist). The Lerner index can seldom be equal to unity because elasticity of demand is unity in this case. It implies that MR = 0 in this case. One shortcoming of the Lerner index is that a firm with a great deal of monopoly power may keep the price low in order to avoid legal scrutiny or to deter entry into the industry. The Herfindahl index as a measure of monopoly power in an industry is given by the sum of squared values of the market sales of all the firms in the industry. The major shortcomings of Herfindahl index are: (1) The industries (such as automobiles) where imports are significant greatly overestimates the monopoly power. (2) The index for the nation as whole may not be relevant when the market is local (3) The index depends on how narrowly or broadly is the defined (4) The index does not give any indication of potential entrants into the market and of the degree of actual and potential competition in the industry Contestable market theory explains when an industry even with a single firm will operate as if it were a firm in perfect competition. This happens when entry absolutely free and exit is entirely costless. In this case, actual competition is less important than potential competition and the firms will charge a price that only covers average cost and earn zero economic profit. When the demand for commodity is or service is higher during some periods and the commodity is not storable like electricity, the cost of production will be higher during the peak load. There are two alternative ways of pricing in this situation. A uniform price equal to the average cost for both the

periods is one option. Another option is to charge marginal cost in both the periods. This is call ed peak load pricing. It will increase consumer welfare. Cost-plus pricing is a method of pricing. This is useful when the firm lacks information on MR and SMC. In this case, the firm estimates average variable cost for a normal level of output and then adds a markup over average variable cost. The mark up covers the average variable and fixed costs, and also provides profit margin for the firm. When there is perfect competition in both input and product markets, the condition for profit maximization and least cost combination of inputs is given by MPa/MPb = 1/MCx = 1/Px. Here a and b represent inputs and x indicates output. When there is monopolistic competition in the product market but perfect competition in the input market, the same formula is applicable with a slight change. Instead of taking price of the output, we have to take MR. Thus, the condition for profit maximization and efficient combination of inputs, the formula becomes: MPa/MPb = 1/MCx = 1/MRx. Here a and b represent inputs and x indicates output. The demand curve for the firm with only one input is determined by applying the principle of efficient input combination. The firm will equate the value of marginal product to input price (P.MPa = input price). The marginal product is a decreasing function of the quantity of input and hence input use increases as the input price falls. When there is monopolistic competition in the product market, the input is used up to the point where its price is equal to the marginal revenue product (MR.MP). The aggregate demand for an input is the horizontal summation of the individual demand curves. The supply of labour is an upward sloping curve as more work involves less leisure the marginal value of leisure increases. To compensate for high marginal value of leisure, the wage rate has to be increased. Thus, the labor supply curve is upward sloping. Equilibrium in the input market is determined by the equality of demand and supply curves. Monopsony When there is only one seller of a commodity in the market, the market is called monopoly. When there is only one buyer of an input, the market is called monopsony. In this case, the monopsonist faces an upward sloping input supply curve. He will calculate marginal cost which is called marginal resource cost (MRC). Equilibrium is achieved when marginal revenue product which is downward sloping is equated to upward sloping marginal resource cost.

Select Questions 1. Define monopolistic competition and give a few examples of it. 2. Identify the monopoly and competitive elements in monopolistic competition. 3. Why is it difficult or impossible to define the market demand curve or market supply curve and the equilibrium price under monopolistic competition? 4. Discuss the long run efficiency implications of monopolistic competition with respect of utilization of plant, allocation of resources, and advertising and product differentiation. 5. Why has the theory of monopolistic competition fallen into disrepute in recent times. 6. Define oligopoly and give the most single most important characteristic of oligopoly market. 7. What are the natural and artificial barriers to entry into certain oligopolistic industries? 8. What are the possible harmful and beneficial effects of oligopoly? 9. Compare the efficienty implications of lang run equilibria under different forms of market organization with respect to total profits, the proint of production on the LAC curve, allocation of resources, and sales promotion. 10. Critically examine the statement that most of the micro-economics is academic and irrelevant. 11. Explain the assumptions and conclusion of Cournot model. 12. Explain the assumptions and conclusions of Bertrand model. 13. Explain the assumptions and conclusions of Edgeworth model. 14. Explain the assumptions and conclusions of Chamberlin model. 15. Explain the assumptions and conclusions of Kinked demand curve model. 16. Explain the assumptions and conclusions of price leadership model. 17. What does the kinked demand curve model achieve? 18. Explain the Lerner index and the Herfindahl index in he measurement of monopoly power. What are their limitations? 19. What is the relationship between marginal revenue and price? 20. Explain the contestable market theory and explain the conditions under which the theory can be applied to airlines. Draw a figure showing three identical firms in the contestable market. 21. What is peak-load pricing? Give some examples of enterprises where peak-load pricing is applicable. 22. What is cost-plus pricing? What is the mark up that maximizes profit? Give the mark up when the elasticity of demand is (a) e = 2 or (b) e = 3 (c) e = 4 or (d) e = 5 Review Questions (Provide justification for your answer) 1. In monopolistic competition, we have (a) A few firms selling a differentiated product (b) Many firms selling a homogeneous product (c) Few firms selling a homogeneous product (d) Many firms selling a differentiated product 2. The short run equilibrium level of output for a monopolistic competitor is given by the point where

(a) P = SMC (b) P = SAC (c) the MR curve intersects the SMC curve (d) The SMC curve intersects the MR curve from below and P >= AVC. 3. The short-run supply 4. When he industry is long-run equilibrium, the monopolistic competitor 5.