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PRINCIPLES OF ECONOMICS Third Edition
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CHAPTER
8
MARKET STRUCTURE 2:
MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
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MONOPOLISTIC
COMPETITION


Definition
– Market structure in which there are large numbers of
small sellers selling differentiated products but these
are close substitute products and have easy entry into
and exit from the market.
Characteristics
– Large number of and sellers – there is a large
number of sellers under the monopolistic competition
and no individual firm can influence the market price.
However, each firm follows an independent priceoutput policy.
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MONOPOLISTIC
COMPETITION (cont.)
– Differentiated products – product differentiation could be
through packaging, design, labelling, advertising and
brand name.
– Free of entry and exit into the market – not as easy as
perfect competition because of the existence of product
differentiation.
– Role of non-price competition is significant – various
methods used to attract the customers to buy a particular
brand.
– Selling cost – different types of expenditure on
advertisement would incur additional cost.
PRINCIPLES OF ECONOMICS Third Edition
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MONOPOLISTIC
COMPETITION (cont.)
The demand curve for monopolistic competitive firm is
downward sloping due to product differentiation.
Price
AR=P
Demand curve for monopolistic
competitive firm is more elastic
than demand curve for
monopolist firm because in
monopolistic competition there
are many firms and many
substitutes.
MR
Quantity
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PROFIT MAXIMIZATION IN
SHORT RUN
Monopolistic competitive firm earns economic profit
At this output, the firm earns
economic profit or supernormal
profit equal to the shaded area.
Price (RM)
The profit maximization
level occurs where MR
curve and MC curve
intersects at Point A.
MC
To find the price, we use the
same vertical line with
output up to the demand
curve. The profit maximizing
price and output is
ATC
AR
AC
P* and Q*.
PROFIT
A
DD = AR
MR
Q*
PRINCIPLES OF ECONOMICS Third Edition
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Economic profit or
supernormal profit
is the profit earned
by a monopolist
competitive firm
when TR > TC.
Quantity
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PROFIT MAXIMIZATION IN
SHORT RUN (cont.)
Monopolistic competitive firm at break-even
Price (RM)
The profit maximization
level occurs where MR
curve and MC curve
intersects at Point A.
At this output, monopolistic
competitive firm is at the breakeven or earns normal profit.
MC
ATC
The profit maximizing price
and output is P* and Q*.
AC/AR
Normal profit or break-even is
earned when TR = TC.
A
DD = AR
MR
Q*
PRINCIPLES OF ECONOMICS Third Edition
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PROFIT MAXIMIZATION IN
SHORT RUN (cont.)
Monopolistic competitive firm suffers economic losses
Price (RM)
Economic losses or subnormal
profit is the losses incurred by a
monopolistic competitive firm when
TR < TC.
AC
AR
At this output, monopolist suffers economic losses
or subnormal profit equal to the shaded area.
ATC
MC
The profit maximization level
occurs where MR curve and
MC curve intersect at Point
A.
LOSSES
The profit maximizing price
and output is P* and Q*.
A
DD = AR
MR
Q*
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PROFIT MAXIMIZATION IN
LONG RUN
Monopolistic competitive firm earns normal profit in long run
Price (RM)
A monopolistic competitive
firm earns normal profit in
the long run due to free
entry and exit.
LRMC
LRATC
P*
A
DD = LRAR
LRMR
Q*
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Quantity
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OLIGOPOLY

Definition
– Market structure in which there are only a few firms selling
either standardized or differentiated products and it
restricts the entry into and exit from the market.

Characteristics
– Few numbers of firms – the number of firms is small but
size of the firms is large.
– Homogeneous or differentiated product
– Mutual interdependence – firms in an oligopoly market
always consider the reaction of their rivals when choosing
price, sales target, advertising budgets and other business
policies.
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OLIGOPOLY (cont.)
– Barriers to entry – restrict new entrants into the market
through various types of barriers to entry such as control of
certain resources, ownership of patent and copyright,
exclusive financial requirements and other legal barriers.

Price Rigidity and Kinked Demand Curve
– Since there is mutual interdependence between oligopoly
firms, the prices in the market are more stable. This is
called price rigidity in oligopoly market.
– The price rigidity explains the behaviour of an oligopoly
firm that has no incentive to increase or decrease the
price.
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OLIGOPOLY (cont.)
– The theory of the kinked demand curve is based on two
assumptions.
1.
2.
First assumption: If an oligopolist reduces its price, its rivals will
follow and cut their prices to prevent losing the customers.
Second assumption: If an oligopolist increases its price, its rivals
do not increase the price and keep their prices the same, thereby
they gain customers from the firm that increases the price.
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OLIGOPOLY (cont.)

Price Leadership
– Price leadership means the pricing strategy in which the
firms in an oligopolistic industry follow the price set by the
leading firm.
– Price leadership is one form of collusion under oligopoly.
– There is no formal or tacit agreement.
– There are two types of price leadership:
• Dominant price leadership
– The dominant price leadership firm may be the largest
firm that dominates the overall industry.
– The dominant price leader firm can act as a monopoly
where it sets its price to maximize profits; other firms will
set their prices at the same level.
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OLIGOPOLY (cont.)
• Barometric price leadership
– One firm will be the first to announce price change. This
firm does not dominate the industry.
– Its price will be followed by others.

Cartel
– A cartel is a group of firms whose objective is to limit the
scope of competitiveness in the market.
– Cartel arises because firms want to eliminate uncertainty
and improve profits by stabilizing market shares and
prices, reducing competitiveness and eliminating
promotional cost.
– The most famous cartel is Organization of Petroleum
Exporting Countries (OPEC).
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OLIGOPOLY (cont.)
– Cartel agreement is an arrangement among the oligopoly
firms to cooperate with one another to act together as a
monopoly.
– An ideal cartel will be powerful to establish monopoly
price and earns supernormal profits.
– Profits are divided among firms based on their individual
level of production.
– Each firm sells at different quantities and obtains different
profits depending on the level of AC at the point of
production.
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OLIGOPOLY (cont.)

Non-price Competition
– Non-price competition is the means for growing market
share and profitability in the face of new rivals through
advertising, marketing, after sales service, free gift and
others.
– The difference with price cuts by oligopoly firm and nonprice competition.
– Opting for price cut – If a firm reduces a price of a
product, it can attract customers, and establish in the
industry.
• Reactions of competitors – the reaction from rivals are quick
by reducing their prices. There is a risk of price war if the
price reduction continues. However, customers are better off.
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OLIGOPOLY (cont.)
– Opting for non-price competition – This strategy will
attract more customers to the firm.
• Reactions of competitors – the reaction from rivals toward
non-price competition is slow and less direct. The firms will
gain more advantages if it practices non-price competition
because product variation, improvements in quality and
successful advertising techniques cannot be duplicated so
easily. Some consumers are more attracted to the
advertisement and quality of the product compared to price.
PRINCIPLES OF ECONOMICS Third Edition
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SUMMARY OF MARKET
STRUCTURE
Characteristics
Number of sellers
Perfect
competition
Monopoly
Monopolistic
competition
Large
One
Type of product
Identical or
homogenous
Unique or no
Differentiated
close substitution
Homogenous or
differentiated
Entry condition
Very easy
Impossible
Easy
Difficult
Control
price
None
Some
Some
Considerable
Examples
Wheat, corn
Local phone
Food, clothing
service, electricity
Automobiles,
cigarettes
Profit
maximization
MR = MC
MR = MC
MR = MC
over
PRINCIPLES OF ECONOMICS Third Edition
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Many
Oligopoly
MR = MC
Few
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SUMMARY OF MARKET
STRUCTURE (cont.)
Characteristics
Perfect
competition
Monopoly
Monopolistic
competition
Oligopoly
Subnormal,
supernormal or
normal profit
Normal profit due
to free entry and
exit
Subnormal,
supernormal or
normal profit
Supernormal
profit because of
barriers to entry
Subnormal,
supernormal or
normal profit
Normal profit due
to free entry and
exit
Subnormal,
supernormal or
normal profit
Supernormal
profit because of
barriers to entry
Production
efficiency (at
minimum AC)
Yes
No
No
No
Shut down
S/run: AR<AVC
L/run: AR< AC
S/run AR<AVC
L/run: AR< AC
S/run: AR<AVC
L/run: AR< AC
S/run: AR<AVC
L/run: AR< AC
Short run
equilibrium
Long run
equilibrium
PRINCIPLES OF ECONOMICS Third Edition
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