Monopolistic competition and oligopoly
Most real markets lie between perfect competition and monopoly: many firms with differentiated products, or a few large firms watching each other closely.
Monopolistic competition
Monopolistic competition has many firms selling differentiated products, with free entry and exit. Restaurants, clothing brands, and hair salons are examples. Each firm has a little market power over its own version, so it faces a downward-sloping demand curve, but close substitutes keep that demand fairly elastic.
Short and long run
In the short run, a monopolistically competitive firm can earn profits like a monopolist, producing where MR = MC. Profits attract new firms with similar products, taking customers and shifting each firm's demand left. In the long run, economic profit falls to zero, with price equal to average total cost.
Excess capacity and variety
In long-run equilibrium, monopolistically competitive firms produce below the output that minimises ATC (excess capacity) and charge a price above marginal cost. The cost is some inefficiency; the benefit is product variety that consumers value. Advertising and branding are important ways to differentiate.
Oligopoly
An oligopoly is a market dominated by a few large firms, often protected by barriers to entry. Examples include airlines, mobile networks, and car manufacturing. Each firm's best choice depends on what its rivals do: firms are interdependent, which is what makes oligopoly distinctive.
Measuring concentration
Concentration ratios measure the share of sales held by the largest firms; a four-firm ratio above 60% suggests a tight oligopoly. The Herfindahl-Hirschman Index (HHI) sums the squared market shares of all firms; regulators use it to assess mergers. A monopoly scores 10,000.
Collusion and cartels
Oligopolists can earn more by cooperating to restrict output and raise prices, acting like a monopoly. A formal agreement to do so is a cartel, illegal in most countries. OPEC, an organisation of oil-exporting countries, coordinates production. Cartels are unstable because each member is tempted to cheat by producing more.
Competition among oligopolists
Without collusion, oligopolists may compete fiercely on price, leading toward competitive outcomes, or avoid price wars and compete through advertising, quality, and innovation. Prices may be 'sticky', changing infrequently, because firms fear rivals' reactions. Game theory, the next unit, models these strategic choices.
Worked example
A market has four firms with shares of 40%, 30%, 20%, and 10%. The four-firm concentration ratio is 100%. The HHI is 40 squared + 30 squared + 20 squared + 10 squared = 1600 + 900 + 400 + 100 = 3000, which regulators would consider highly concentrated.
Key takeaways
Monopolistic competition has many firms with differentiated products and free entry; long-run profit is zero, with excess capacity but valued variety. Oligopoly has a few interdependent firms. Concentration ratios and the HHI measure market power. Collusion and cartels raise prices but are illegal and unstable. Oligopolists often compete through non-price means.
Flashcard
Many firms, differentiated products, free entry
Check your understanding
Why do cartels tend to break down over time?