The Intermediate Cases: Monopolistic Competition and Oligopoly

The distinguishing characteristics of monopolistic competition are (a) firms that produce differentiated products, (b) low barriers to entry into and exit from the market, and (c) a substantial number of independent, rival firms.

Monopolistically competitive firms face a gently downward-sloping demand curve. They often use product quality, style, convenience of location, advertising, and price as competitive weapons. Since all rivals within a monopolistically competitive industry are free to duplicate another's products (or services), the demand for the product of any one firm is highly elastic.

A profit-maximizing firm will expand output as long as marginal revenue exceeds marginal cost. Thus, a firm under monopolistic competition will lower its price so that output can be expanded until MR = MC. The price charged by the profit-maximizing monopolistic competitor will be greater than its marginal cost.

If monopolistic competitors are making economic profits, rival firms will be induced to enter the market. They will expand the supply of the product (and similar products), enticing some customers away from established firms. The demand curve faced by an individual firm will fall (shift inward) until the profits have been eliminated.

Economic losses will cause monopolistic competitors to exit from the market. The demand for the products of each remaining firm will rise (shift outward) until the losses have been eliminated.

Since barriers to entry are low, firms in a monopolistically competitive industry will make only normal profits in the long-run. In the short run, they may make either economic profits or losses, depending on market conditions. 

Traditional economic theory has emphasized that monopolistic com petition is inefficient because (a) price exceeds marginal cost at the long-run equilibrium output level; (b) long-run average cost is not minimized; and (c) excessive advertising is sometimes encouraged. However, other economists have argued more recently that this criticism is misdirected. According to the newer view, firms under monopolistic competition have an incentive to (a) produce efficiently; (b) undertake production if and only if their actions will increase the value of resources used; and (c) offer a variety of products.

Oligopolistic market structure is characterized by (a) an interdependence among firms, (b) substantial economies of scale that result in only a small number of firms in the industry, and (c) significant barriers to entry. Oligopolists may produce either homogeneous or differentiated  products.

There is no general theory of price, output, and equilibrium for oligopolistic markets. If rival oligopolists acted totally independently of their competitors, they would drive price down to the level of cost of production. Alternatively, if they used collusion to obtain perfect cooperation, price would rise to the level that a monopolist would charge. The actual outcome lies between these two extremes.

Collusion is the opposite of competition. Oligopolists have a strong incentive to collude and raise their prices. However, the interests of individual firms will conflict with those of the industry as a whole. Since the demand curve faced by individual firms is far more elastic than the industry demand curve, each firm could gain by cutting its price (or raising product quality) by a small amount so that it could attract customers from rivals. If several firms tried to do this, however, the collusive agreement would break down.

Oligopolistic firms- are less likely to collude successfully against the interests of consumers if (a) the number of rival firms is large; (b) it is costly to prohibit competitors from offering secret price cuts (or quality improvements) to customers; (c) entry barriers are low; (d) market demand conditions tend to be unstable; and/or (e) the threat of antitrust action is present.

Competition can come from potential, as well as actual rivals. If entry and exit are not expensive, and if there are no legal barriers to entry, the theory of contestable markets indicates that competitive result may occur even if only one or a few firms are actually in the market.

The kinked demand curve helps explain why oligopolistic price may tend to be inflexible. Under the basic assumption of the kinked demand curve-rivals will match price reductions but not increases-a firm's price rise leads to a sharp reduction in its sales, but a price reduction attracts a few new customers. Thus, once a price is established, it remains inflexible for extended periods of time.

Analysis of concentration ratios suggest that, on balance, there has been an increase in the competitiveness of the U.S. economy in recent decades. 

Accounting profits as a share of stockholder equity are probably slightly greater in highly concentrated industries than in those that are less concentrated. The relationship between profits and concentration however, is not a close one. This suggests that several other factors, such as changing market conditions, quality competition, risk, and ability to exclude rivals, are the major determinants of profitability.

The after-tax accounting profits of business firms average about 5 cents of each dollar of sales, substantially less than most Americans believe to be the case. Accounting profits average approximately 12 percent of stockholder equity. This rate of return (accounting profit) provides investors with the incentive to sacrifice current consumption, assume the risk of undertaking a business venture, and supply the funds to purchase buildings, machines, and other assets.