Chapter 13
A monopolistically competitive market is characterized by:
· many buyers and sellers,
· differentiated products, and
· easy entry and exit.
The monopolistically competitive market is similar to perfect
competition in that there are many buyers and sellers who can
enter or leave the market easily in response to economic profits
or losses. A monopolistically competitive firm, though, is
similar to a monopoly in that it produces a product that is
different from that produced by all other firms in the market.
The restaurant market in New York City provides a good
example of a monopolistically competitive market. Each
restaurant has its own recipes, decor, ambiance, etc. but also
must compete with many other similar restaurants.
Because each firm produces a differentiated product, it won't
lose all of its customers if it raises its prices. Thus, a
monopolistically competitive firm faces a downward sloping
demand curve for its product. As noted in Chapters 8 and 10,
whenever a firm faces a downward sloping demand curve, its
marginal revenue curve lies below its demand curve. The
diagram below illustrates the relationship that exists between a
monopolistically competitive firm's demand and marginal
revenue curves.
While the diagram above seems similar to the demand and
marginal revenue curves facing a monopolist, there is a critical
difference. In a monopolistically competitive market, the
number of firms changes as firms enter or leave the industry.
When new firms enter the market, the customers are spread over
a larger number of firms and the demand for each firm's product
declines. An increase in the number of firms also tends to result
in an increase in the elasticity of demand for each firm's
products (since demand is more elastic when more substitutes

are available). The diagram below illustrates the shift in a
typical firm's demand curve that occurs when additional firms
enter a monopolistically competitive market.
Short-run and long-run equilibrium in monopolistically
competitive markets
Let's examine the determination of short-run equilibrium in a
monopolistically competitive output market.
The diagram below illustrates a possible short-run equilibrium
for a typical firm in a monopolistically competitive market. As
with any profit-maximizing firm, a monopolistically
competitive firm maximizes its profits by producing at a level
of output at which MR = MC. In the diagram below, this occurs
at an output level of Qo. The price is determined by the amount
that customers are willing to pay to buy Qo units of output. In
the example below, the demand curve indicates that a price of
Po will be charged when Qo units of output are sold.
In a monopoly industry, economics profits could persist
indefinitely due to the existence of barriers to entry. In a
monopolistically competitive industry, however, the existence
of economic profits results in the entry of additional firms into
the industry. As additional firms enter, the demand for each
firm's product will fall and become more elastic. This reduction
in demand, though, results in a reduction in the level of
economic profit received by a typical firm. Entry into the
market continues until a typical firm receives zero economic
profits. This possibility is illustrated in the diagram below.
The diagram above depicts a monopolistically competitive firm
in a state of long-run equilibrium. This firm maximizes its
profit by producing an output level of Q'. The equilibrium price
is P'. Since the price equals average total cost at this level of
output, a typical firm receives a level of economic profit equal
to zero. This long-run equilibrium situation is often referred to
as a "tangency equilibrium" since the demand curve is tangent

to the ATC curve at the profit-maximizing level of output.
In the short run, a monopolistically competitive firm may
receive economic losses in the short run. This possibility is
illustrated in the diagram below. While each firm will continue
operations in the short run, firms will leave the industry in the
long run. As firms leave, the demand curves facing the
remaining firms will shift to the right and become less elastic.
(To see this, note that when firms leave the industry, the
remaining firms will receive some of the customers that used to
purchase the commodity at the firms that have left the industry.)
Exit from the industry will continue until economic profits
again equal zero (as illustrated in the diagram below).
Monopolistic competition vs. perfect competition
As noted in Chapter 10, perfectly competitive markets result in
economic efficiency since P = MC and firms produce at the
minimum level of ATC. The diagram below compares price and
output levels for perfectly competitive and monopolistically
competitive firms. As this diagram suggests, a perfectly
competitive firm produces output at a price (P
pc
) that is less than the price that would be charged by a
monopolistically competitive firm (P
mc
). A perfectly competitive firm will also produce a larger
quantity of output (Q
pc
) than would be produced by a monopolistically competitive
firm (Q
mc
).
Because monopolistically competitive firms produce at a level
of cost that exceeds the minimum level of ATC, they are less

efficient than perfectly competitive firms. This efficiency loss,
however, is a cost that society must bear if it wishes to have
differentiated products. One of the costs of having variety in
restaurants, clothing, most types of prepared foods, etc., is that
average production costs will be higher than they would be if a
homogenous product were produced.
It should be noted, though, that the larger the number of firms
in the market, the more elastic will be the demand for each
firm's product. As the number of firms grows very large, the
demand curve facing a monopolistically competitive firm will
approach the perfectly elastic demand curve that is faced by a
perfectly competitive firm. In such a situation, the efficiency
cost of product differentiation will be relatively small.
In the short run, monopolistically competitive firms may receive
economic profits by successfully differentiating their product.
Successful product differentiation, however, will soon be copied
by other firms. It is expected that such profits will disappear in
the long run. Advertising campaigns may raise the profits of a
firm in this industry in the short run, but will successful
advertising campaigns will lead to similar efforts by other firms
in the industry.
As your text notes, monopolistically competitive firms in the
same industry often locate near each other in communities as a
result of their attempts to appeal to the median customer in a
geographic region. This is why we often see car dealerships and
fast-food restaurants locating near each other on a particular
street.
Outline
I.Oligopoly: An oligopoly is a market structure in which there
are very few sellers. Each seller knows the other sellers will
react to its changes in prices and quantities. An oligopoly
market structure can exist for either a homogeneous or a
differentiated product.
A. Characteristics of Oligopoly

1.Small Number of Firms: An oligopoly exists when the few top
firms account for an overwhelming percentage of total industry
output.
2.Interdependence: This is also called strategic dependence,
which is a situation in which one firm’s actions with respect to
output, price, quality, advertising, and related changes may be
strategically countered by one or more other firms in the
industry. Such dependence can only exist when there are a few
major firms in an industry.
B. Why Oligopoly Occurs
1.Economies of Scale: The strongest reason that has been
offered for the existence of oligopoly is economies of scale.
Economies of scale are defined as a production situation in
which a doubling of output results in less than a doubling of
total costs. The firm’s average total cost curve will slope
downward as it produces more and more output. Average total
cost can be reduced by continuing to expand the scale of
operation.
2.Barriers to Entry: These barriers include legal barriers, such
as patents, and control and ownership over critical supplies.
3.Oligopoly by Merger: A merger is the joining of two of more
firms under a single ownership or control. There are two types
of mergers. A horizontal merger involves firms producing or
selling a similar product. A vertical merger occurs when one
firm merges with another from which it purchases an input or to
which it sells an output.
II.Measuring Industry Concentration
A.Concentration Ratio: The percentage of all sales contributed
by the leading four or leading eight firms in an industry:
sometimes called the industry concentration ratio. The concept
of an industry is necessarily arbitrary. As a consequence,
concentration ratios rise as we narrow the definition of an
industry and fall as we broaden it. (See Table 26-1 and Table
26-2.)
B. The Herfindahl-Hirschman Index:
1. Limitation of the Centration Ratio: Concentration ratios

fail to reflect differences in the relative sizes of firms within an
industry. (See Table 26-3.)
2. Defining and Computing the Herfindahl-Hirschman Index:
The sum of the squared percentage sales shares of all firms in
an industry. (See Table 26-3.)
III.Strategic Behavior and Game Theory: When there are
relatively few firms in an industry, each reacts to the price,
quantity, quality, and new product innovations that the others
undertake. Each oligopolist has a reaction function, which is the
manner in which one oligopolist reacts to a change in price (or
output or quality) of another oligopolist. Game theory is the
analytical framework in which two or more individuals,
companies, or nations compete for certain payoffs that depend
on the strategy that the others employ. The plans made by these
individuals are known as game strategies.
A. Some Basic Notions about Game Theory: Games can be
cooperative or noncooperative. They are classified by whether
the payoffs are negative, zero, or positive. A cooperative game
is one in which players explicitly collude to make themselves
better off. With firms, it involves companies colluding in order
to make higher than competitive rates of return. A
noncooperative game is a game in which players neither collude
nor negotiate in any way. Applied to firms, it is a situation in
which there are few firms and each firm has some ability to
change price. A zero-sum game is a game in which one player’s
losses are exactly offset by the other player’s gains. A negative-
sum game is a game in which both players are worse off at the
end of the game. A positive-sum game is a game in which both
players are better off at the end of the game.
1.Strategies in Noncooperative Games: A strategy is any rule
that is used to make a choice, e.g., always pick heads. The goal
is to devise a dominant strategy. A dominant strategy will yield
the highest benefit for the player using it. These strategies are
generally successful no matter what actions other players take.
B.The Prisoner’s Dilemma: An example of game theory in
which two people involved in a bank robbery are caught.

1. The Structure of the Prisoner’s Dilemma: The payoff
matrix shows two possibilities for each of the two prisoners:
“confess” and “don’t confess.” (See Figure 26-1.)
2. The Predicted Prisoner’s Dilemma Outcomes: To confess
is a dominant strategy for each of the two prisoners. This is a
dilemma because the prisoners know that both of them will be
better off if nether confesses. (See Figure 26-1.)
C.Applying Game Theory to Pricing Strategies: An example of
the use of game theory is presented. (See Figure 26-2.)
D.Opportunistic Behavior: Actions that ignore possible long-run
benefits of cooperation and focus solely on short-run gains.
This kind of behavior can be contrasted to tit-for-tat strategic
behavior when repeat transactions are likely. Here, a player will
behave well as long as others do likewise.
IV.The Cooperative Game: A Collusive Cartel: This section
looks at why firms collude to increase prices, how they work to
do so, and what they have to do to be successful.
A.Collusive Production and Pricing and the Seeds of a Cartel’s
Undoing: Firms in an industry must collude if they decide to
form a cartel so that they can achieve the same outcome as a
monopoly and increase their profits above a competitive level.
1. Collusive Price and Output Determination by Firms in a
Cartel: To operate a
profit-maximizing cartel, member firms must be willing and
able to set up and maintain an arrangement for coordinating
overall cartel production at a common price. Then they can
share the maximized profits. (See Figure 26-3.)
a. The Pre-Cartel, Noncoordinated Market: In the absence of
collusion among firms, the market clearing price in the long-run
equilibrium equals the firm’s minimum average total cost. (See
Figure 26-3 (a).)
b. Boosting Economic Profits via a Collusive Cartel Price: If
firms in the market form a joint cartel enterprise, they
coordinate their production and regard the sum of their marginal
costs as the overall marginal cost of the cartel. All firms will
agree to charge the price at which the market marginal revenue

equals the cartel’s overall marginal cost. (See Figure 26-3 (b).)
c.Profit-Maximizing Collusion Requires Reducing Total
Production: The cartel production is lower than output under
perfect competition. Firms thereby will raise
its economic profits from zero under perfect competition to a
positive amount.
(See Figure 26-3.)
2. The Temptation to Cheat on a Cartel Agreement: Any one
member of the cartel can increase its total own revenues and
profits by lowering price slightly as long as all of the other
firms in the cartel honor their agreement to reduce production.
B. Enforcing a Cartel Agreement: There are four conditions
that make it more likely that firms will be able to coordinate
their efforts to restrain output successfully and deter cheating.
1. A Small Number of Firms in the Industry: The smaller the
number of firms in the industry, the easier it is to prevent
cheating.
2. Relatively Undifferentiated Products: If the cartel
members sell a homogeneous or nearly homogeneous product, it
is easier for them to agree on how much each firm should
reduce production.
3.Easily Observable Prices: If the terms of industry transactions
are publically available, cartel members can more readily
observe a firm’s efforts to cheat.
4. Little Variations in Prices: Stable demand and cost
conditions help a cartel form and continue to operate
effectively.
C.Why Cartel Agreements Usually Break Down: Most cartels
usually do not last for more than 10 years. Monopoly profits
attract new entrants to the industry, and price falls. In addition,
downturns in overall economic activity cause the cartel’s
demand and thus the demand for all member firms to decrease.
This increases the incentive to cheat on the cartel agreement.
V.Network Effects and Two-Sided Markets: A network effect is
a situation in which a consumer’s willingness to purchase a
good or service is influenced by how many others also buy or

have bought the item.
A.Network Effects and Market Feedback: Industries in which
network effects are important can experience sudden surges in
growth as well as significant and sudden reversals.
1.Positive Market Feedback: A tendency for a good or service to
come into favor with additional consumers because other
consumers have chosen to buy them.
2. Negative Market Feedback: A tendency for a good or
service to fall out of favor with more consumers because other
consumers have stopped purchasing the item.
B.Network Effects and Industry Concentration: In an industry
that produces and sells products subject to network effects,
oligopoly is likely to emerge. The reason is that in an industry
that sells differentiated products subject to network effects,
when the products of a few firms catch on, these will capture
the bulk of the sales of the industry.
C. Two-Sided Markets, Network Effects, and Oligopoly: A
two-sided market is a market in which an intermediary firm
provides services that link groups of producers and consumers.
1.Types of Two-Sided Markets: In a two-sided market, the
intermediary firm is a platform and the groups of producers and
consumers are end users. (See Figure 26-4.)
a.Audience Seeking Markets: Media platforms link advertisers
to audiences.
b. Matchmaking Markets: Platform firms, such as real estate
agents and online dating firms, bring end users together.
c. Transaction-based Markets: Banks, credit- and debit-card
companies are platforms that finalize transactions between
retailers and card holders.
d. Shared-Input Markets: Groups of end users utilize a key
input obtained from a platform.
2.Network Effects in Two-Sided Markets: Network effects are a
common feature of two-sided markets. Groups of end users
benefit from the network effects in different types of two-sided
markets.
3.Two-Sided Oligopolistic Pricing: Oligopoly is the most

common industry structure in two-sided markets with network
effects. In these markets, a few firms are often able to capture
most of the payoffs associated with market feedback. In a two-
sided market, platform firms that set prices must consider group
differences in network effects. In some two-sided markets,
platform firms maximize profits by charging an explicit price of
zero or even negative prices, or subsidies, for one group of end
users.
D. Comparing Market Structures: Market structures are
compared in Table 26-4.