Monopolistic Competition and Oligopoly

In the early 1930s a third market structure model-monopolistic competition-was introduced. Monopolistic competition describes a market in which there are many sellers, each selling a somewhat differentiated product. 

Just as in pure competition and pure monopoly, monopolistically competitive firms make all of their decisions independently of each other. Each firm believes that any action on its part will not cause a reaction on the part of its competitors. 

Some actual industries come close to being monopolistically competitive. However, upon closer inspection, it is usually found that the firms do not completely ignore each other, and so the crucial market characteristic of independent action is not met. 

The product differentiation characteristic of monopolistic competition is related to the contro-versial subject of advertising. Advertising is claimed to be, on the one hand, a pillar that supports free enterprise and, on the other, an obstacle to economic freedom since it threatens consumer sovereignty. Advertising can be valuable by providing information, but it can also be wasteful when it provides very little information. Because advertising is an important form of nonprice competition, it encourages more vigorous competition among firms. Yet if successful, it can result in less competition, since it can cause the demand for a firm's product to become less elastic. Advertising uses scarce resources, and so it adds to the cost of producing products. But it may also stimulate sales so that firms are able to take advantage of economies of scale.

Similar to pure competition, monopolistically competitive firms may earn an economic profit, an economic loss, or a normal profit in the short run, but may earn only a normal profit in the long run. Long-run equilibrium is assured by a combination of entry and exit and changes in the amount that firms spend on advertising.

Though neither pure competition nor monopolistic competition characterizes most real world industries, economists debate about which one would provide greater consumer welfare and thus about which model should be considered the more appropriate ideal. Those who favor pure competition point out that purely competitive firms produce more output and charge a lower price. Their opponents argue that some sacrifice in output and price is not too much to pay for the differentiation of products provided by monopolistically competitive firms.

Oligopoly describes a market in which there are few firms. "Fewness" here means interdependence. An industry is said to be oligopolistic when it is made up of few enough firms to have each one consider its rivals reactions before taking any action itself.

Real-world industries are more often oligopolies than any other market type. Interdependence among firms in an industry is the usual case, not the exception. In a large country like the United States, even when thousands of different firms sell the same product, they are often broken down into hundreds of different, geographically separated, oligopolistic industries. 

Oligopolists do not determine the amounts that they produce and the prices that they charge by examining only consumer demands and production costs. Oligopolists also consider what their rivals are likely to do in reaction to the output levels and prices that they choose. Thus, in order to determine oligopolists' demand curves, "experience variables" such as the toughness of rival managers must also be considered. 

Early duopoly models introduced the concept of rival firms reacting to each other. The earliest was an output reaction model presented by Augustin Cournot. These models were not directly applicable to real-world oligopolies, however, since they assumed that firms were unable to learn from experience and to anticipate each other's re actions.

The kinked-demand-curve theory of oligopoly pricing is based on the expectation that rival firms are more likely to match price reductions than price increases. This causes the demand segment above the existing price to be more elastic than the demand segment below the existing price. Since neither prospect is attractive to oligopolists, the theory predicts fairly rigid prices.

Game theory helps to identify the conflict relationship among competing oligopolists and the incentive that they have to cooperate. Depending upon the rules of the game (assumptions about behavior), a specific solution can be determined.

Oligopolistic coordination models ( including collusive agreement, price leadership, and rules of thumb) are helpful in predicting price and output equilibria in oligopolies. Collusion is a cooperative effort by competing oligopolists to gain monopoly control. Price leadership is the oligopolistic practice of having one firm in an industry announce a price change, and all the other firms quickly following the price leader's action. Price leadership may be of the dominant-firm, barometric-firm, or avoidance-of-price-competition variety. Rules of thumb are industry conventions such as cost-plus pricing or a certain pattern of pricing that has the effect of keeping rivals in the same mold.

In the short run oligopolists may earn economic profit, just normal profit, or suffer economic losses. They may be able to improve their profit situation in the long run. Firms that in the short run earned economic profit may now earn greater economic profit, those that earned normal profit may now earn economic profit, and firms that suffered economic losses in the short run might be able to earn normal or even economic profit. Of course, as in all markets, firms that cannot at least earn normal profit in the long run, will exit from the industry.

Oligopolists may earn a normal profit or an economic profit in the long run. They will re  strict output and charge a price in excess of marginal cost. Prices in oligopoly tend to be more rigid than in any other market structure. Average total cost in oligopoly may or may not be high, depending on the amount of competition among rivals. Given the degree of competitiveness, oligopoly firms are usually large enough to take advantage of economies of scale Oligopolies are expected to be quite progressive since they usually face some competition or potential competition and have the means to engage actively in research and development,