5.3 Monopolistic Competition (MKM
As previously noted if any of the four strict assumption
for Perfect Competition do not hold then imperfect competition
We will now examine Monopolistic Competition
by changing the assumptions of
and determine its
short and long run equilibrium and compare results with
i - Anonymity
Perfect Competition there is a large number of sellers under
Monopolistic Competition. Unlike Perfect Competition,
however, the goods & services offered by producers are seen by consumers
as different from one another. There is product differentiation.
In fact, firms under Monopolistic Competition producing differentiated
goods can be clustered into product groups or niches, e.g., the
restaurant industry can be broken down into clusters like Chinese, fish
& chips, French, German, Greek, hamburgers, Indian, Japanese, steak,
vegetarian, Vietnamese, etc.
ii - No Market Power
While there is a large number of firms,
product differentiation offers sellers a degree of market power.
Given that some consumers prefer the goods & services of one producer over another permits, as will be seen, a price higher than under Perfect
In effect the market demand curve is disaggregated into
distinct market clusters, segments or niches, e.g., restaurants.
It is important to note, however, that the
demand curve for one firm or one niche is affected by the price of other
firms and other niches. Thus an increase in price by a competitor
shifts the firm's demand curve up to the right; a decrease causes a
shift down to the left (cross elasticity). This is because while
differentiated, output of one firm or niche is a close substitute for
those of other firms and niches. Compared to Monopoly, market
power is therefore more limited.
iii -Perfect Knowledge
Under Monopolistic Competition the assumption of perfect knowledge holds.
Free Entry & Exit
As in Perfect Competition there is free entry and
exit. If excess profits are earned in a given 'niche' firms in
other niches can easily convert their capital plant & equipment,
e.g., a Greek restaurant has a fully equipped kitchen, tables &
chairs, cutlery, cash
registers and can, relatively easily, be converted into a fish & chips
2. Marginal Revenue
Let us assume a firm, entrant or existing
firm, innovates a newly differentiated product, e.g., Afghani
roast lamb. In the short run that firm is the only producer.
In effect, it is a monopolist facing the niche demand alone. It
can sell more if it lowers price; it loses sales if it raises its price.
Like a monopolist it therefore has a downward sloping marginal revenue
curve. Furthermore, its marginal cost curve is the niche supply curve.
3. SR Equilibrium
In the short-run
equilibrium of the initial entrant will be reached where marginal cost equals marginal revenue,
i.e., profit maximizing - the cost of the last unit equals how
much it earns but all previous units cost less (MKM C16/Fig. 16.2).
MKM C16/Fig's 16.2a &
The outcome is identical, in the short-run,
to Monopoly. This includes similar costs. Output is less
than under Perfect Competition. Price is higher. There is a
deadweight loss of both consumer and producer surplus. Finally, part of
consumer surplus is appropriated as economic profit. These excess
profits allow monopolistic competitors to advertise in an attempt to
further differentiate their products. More will be said about
advertising, below, under Oligopoly.
4. LR 4. Long Equilibrium
In the long-run, however, excess or economic
profits attract entrants. When a new entrant arrives in effect the
niche demand curve is split between two producers. Some consumer
prefer the original; some the new. The demand curve for original firm
shifts to the left. As long as excess profits exist new entrants
will arrive and the originating firm's demand curve will continue to
shift to the left until it is tangent (just touching) the average total
cost curve (ATC). Excess profits are eliminated and there is no
incentive to enter. Long-run equilibrium is established where price (P) is
equal to average total cost (ATC) and only normal profit is earned yet
price is higher, quantity is lower and there is a deadweight loss of
consumer & producer surplus compared to Perfect Competition (P&B 4th Ed.
14.2; 5th Ed. Fig. 13.2; 7th Ed
Fig. 14.1 &
R&L 13th Ed
Fig. 11-2; MKM Fig's
16.2 a &
16.3). The question arises: Are these costs and allocative
inefficiencies justified by satisfying the differentiated tastes of
Again if any of the four strict assumption
for Perfect Competition do not hold then Imperfect Competition
We will now examine Oligopoly
by changing the assumptions of
and determine its
short and long run equilibrium and compare results with Perfect
i - Anonymity
Monopolistic Competition the goods & services offered by producers
under Oligopoly are seen by consumers
as different from one another. There is product differentiation.
Furthermore, a small number of large firms dominate the industry
surrounded by a competitive fringe of smaller firms. Think the
automobile industry in which the majors -Toyota, Ford, GM, Volkswagen,
etc. - compete with niche players like Alpha Romeo, Austin
Martin, Ferrari, Smartcar and Telsa. The level of dominance by the
majors is measured by a concentration ratio reporting what percentage of
industry output is contributed by the largest 3, 4, 5... producers (MKM
C16/352). Most importantly, the actions of any major player is perceptible to rivals, i.e.
interdependency of sellers whereby action of one results in reaction of
ii - No Market Power
A few large dominant firms contributing a
significant part of market supply combined with product differentiation
gives such firms significant market power.
That some consumers prefer the goods & services of one major over another
means the market demand curve is,
in effect, disaggregated into distinct market shares. Some people
will buy only Cheer while others will only buy Tide.
In effect, such committed consumers are the most important asset of
oligopolistic firms. They guarantee it remains a 'going concern'
with customers coming back again and again.
iii -Perfect Knowledge
As will be seen, under
Oligopoly the assumption of perfect knowledge breaks down. Under
Perfect Competition there is symmetric information, i.e., buyers
and sellers share the same information. Under Oligopoly,
information (MKM C22/492-9) is more common, i.e., producers have
information to which consumers have no access. The collusive
behaviour of oligopolists described below is an example. Such
behaviour can include price fixing and terms and conditions of sale of
which the consumer is generally unaware.
Free Entry & Exit
Given large firms often enjoy
economies of scale and/or network economies together with product
differentiation there can be significant barriers to entry in
oligopolistic industries. Resulting excess profits permit
oligopolists to indulge in extensive advertising, product & process
innovation (R&D) and anti-competitive legal tactics, as will be seen
It is with Oligopoly that the geometric
precision of the Standard Model of Market Economics breaks down.
It does so because of the interdependence of the players. Under
Perfect Competition, Monopoly and Monopolistic Competition it is the
choices made by firms that determine a precise quantity/price profit
maximizing outcome. In Oligopoly it is the reaction of rivals that
makes a profit maximizing choice much more difficult. For example,
Ford, to maximize profits, decides to offer zero percent APR financing
of its cars. APR refers to 'Above Prime Rate'. The prime
rate of interest is what the big banks charge their best customers.
The next day Toyota follows suit effectively nullifying Ford's efforts.
This is what I call 'the dance of the oligopolistis'. Many
solutions have been proposed by economists but only two will concern us:
the Cournot/Nash Solution and the Sweezy Kinked Demand Curve.
i - Cournot/Nash Solution
The Cournot Solution proposes that firms choose an output
that will maximize profits assuming the output of rivals is fixed. The
solution concludes that there is a determinant and stable price-quantity
equilibrium that varies according to the number of sellers. In effect each
firm makes assumptions about its rival's output that are tested in the
market. Adjustment or reaction follows reaction until each firm
successfully guesses the correct output of its rivals.
A more sophisticated and complex solution known as the
equilibrium was proposed by
John Forbes Nash, the protagonist of the movie 'A Beautiful Mind'.
It involves long and complex calculations all of which depend on correct
assumptions about actions/reactions. Change one assumption and the
ii - Sweezy's Kinked Demand Curve Solution
Sweezy solution postulates that oligopolists face two
subjectively determined demand curves that assume:
rivals will maintain their prices; and,
rivals will exactly match any price change.
A key assumption is that rivals will choose the alternative
least favorably to the initiator. If initiator raises its price, rivals will not
follow; if it lowers price everyone follows. The result is that price will be
relative rigid or sticky (P&B 4th Ed.
14.6; 5th Ed. Fig. 13.6;
7th Ed Fig. 15.2). This implies that oligopolists tend not to
compete by price.
c) Non-Price Competition
If oligopolist do not compete by price then how
do the compete? There are at least 6 alternative patterns
of industrial conduct:
Collusive behaviour among sellers as well as buyers especially
in oligopolistic and oligopsonistic industries is historically
and at present common practice. The small
number of majors makes collusion relatively easy:
“People of the same trade seldom meet
together, even for merriment and diversion, but the conversation
ends in a conspiracy against the public, or in some contrivance
to raise prices.”
Adam Smith, The Wealth of Nations,
price fixing which involves agreement to buy or sell
a good only at a fixed price and to manipulate supply and/or
demand to maintain that price. The result of such cartels
approximates the outcome of monopoly. It also includes
agreements to geographically divide up markets. Maintaining
discipline among members of the cartel is, however, often
difficult because of the incentive to cheat. It should be noted
that imperfect knowledge is involved. Cartel members know
prices are fixed but the public does not.
A recent example of such collusive behaviour
occurred in 2012 with the rate rigging scandal concerning the
Libor, the London Interbank Offer Rate. Some fifteen blue-chip
banks ‘guess’ their borrowing costs, throw out high and low, and
use the resulting rate as the benchmark against which to mark up
riskier loans. These firms have already been fined billions of
dollars for manipulation of the Libor rate. Such behaviour has
recently, included price fixing of integrated chips, dynamic
random access memory (DRAM) chips, liquid crystal display
panels, lysine, citric acid, graphite electrodes, bulk vitamins,
perfume as well as airlines in various countries around the
world. The result of collusive industrial behaviour has been
the institutionalization of government anti-trust and
anti-combines policies around the world beginning in the United
States with the Sherman Anti-Trust Act of 1890.
A profit maximizing price/quantity solution for
oligopoly cannot be found within the Standard Model of Market
Economics. To treat the indeterminacy of oligopoly,
economists, beginning with Cournot in the 1830s, have struggled
for a solution. The outcome, however, depends not only on the
decisions of a given firm but also the reaction of its
competitors. To get around the problem Cournot suggested a firm
should guess what competitors would do. If it guessed correctly
it would maximize profits; if not, then it would guess again and
again until it guessed right. Hardly an elegant solution!
What I call the dance of the oligopolists with one step being
matched by a counter-move also led in the 1950s to the Nash-Cournot
solution which involves page upon page of mathematical equations
(the Nash Program) that generates a solution if the underlying
assumptions are correct. If not, the search for a solution also
The ‘action-reaction’ nature and the complexity of oligopoly
with a variety of possible ‘profit maximizing’ outcomes led
economics to ‘spin off’ a whole new sub-field called Game
Theory. For a brief history of Game Theory please see:
An Outline of the History of Game Theory by Paul Walker
Today it is claimed that video games, as an industry,
is larger than the motion picture and music industries
combined. Apps for smart phones are being designed around game
theory to encourage everything from weight loss and exercise to
saving. Modern corporations and the military actively engage in
game playing including role playing to anticipate outcomes of
competition, bargaining and other actions. Even the Arts are
involved in that actors are often hired by businesses,
governments, medicine, the military and other institutions to
‘role play’ in games to hone the skills of personnel. For
example, actors are used to prepare physicians for the range of
possible reactions of a patient being told they have terminal
cancer. In many ways the contemporary ethos or zeitgeist is
game playing. This sentiment is summed up in the neologism ‘gamification’. This has
resulted from economic game
theory developed in response to the indeterminancy of
Legal tactics includes
the threat of litigation, rather than the market, to settle or
foreclose disputes with consumers, suppliers and competitors,
e.g., the EULA software agreement that limits liability,
e.g., downtime suffered by users. Legal tactics embrace
contract law, non-contractual liabilities or the law of torts
as well as intellectual property rights and property rights in
general. Over the last few
property rights or IPRs have increasingly become a tool of
predatory competition as opposed to an incentive for
innovation. It has been claimed that major American
corporations now spend more on the legal defense of IPRs than on
research & development. The many cases filed by Apple
against Samsung in courts around the world is only the tip of
the iceberg. For those interested, please see the
Copyright & Patent Abuse
Patent Thickets & Wars
includes the choice between short- or long-run profit
maximization as well as between single and tied goods, e.g.,
selling printers cheap but ink at a high price. Strict price
competition, however, is restricted to perfect competition.
Under imperfect competition firms are price makers rather than
price takers. Another example of pricing policy concerns Microsoft Windows 95 to XP.
Initially there was no online authentication required, only a
product code on the disc cover. This meant it was easy to
pirate but led to an ever widening group of users who became
path dependent. Once online authentication was introduced
owners of pirated copies were effectively compelled to buy
Windows 2000 and subsequent editions to preserve their
accumulated work. Pirated use of previous versions also
increased the 'network
economies' enjoyed by Windows.
Advertising is intended to persuade consumers – final or
intermediary – to buy a particular brand. Sometimes brands are
technically similarly but advertising can differentiate them in
the minds of consumers, e.g.,
Tide vs. Cheer, effectively splitting off part of the industry
demand curve as its ‘owned’ share. In the Standard Model of
Market Economics only factual product information qualifies as a
legitimate expense. Attempting to ‘persuade’ or influence
consumer taste is ‘allocatively inefficient’ betraying the
principle of ‘consumer sovereignty’, i.e., human wants,
needs and desires are the roots of the economic process.
This mainstream view connects with consumer behaviour research
which calls this approach the ‘information processing’ model. A
consumer has a problem, a producer has the solution and the
advertiser brings them together. It is a calculatory process.
An alternative consumer behavior school of thought, ‘hedonics’
argues that people buy products to fulfill fantasy, e.g., people
do not buy a Rolls Royce for transportation but rather to
fulfill a lifestyle self-image
(Holbrook & Hirschman 1982; Holbrook 1987). Thus product
placement, i.e., placing a product in a socially
desirable context, enhances sales (McCracken
1988). In this regard the proximity of
Broadway and especially off- and off-off-Broadway (the centre of
live theatre) and Madison Ave. (the centre of the advertising
world) in New York City is no coincidence. Marketeers search
the artistic imagination for the latest ‘cool thing’, ‘style’,
‘wave’, etc. Such pattern recognition is embodied in the
new professional ‘cool hunter’ (Gibson 2003). In fact
peer-to-peer brand approval is consumer business success in the age
Take the case of advertising biotechnology. The ‘advertising &
marketing’ of GM products, specifically food vs.
medicine, highlights these divergent approaches. In reaching
out to the final consumer GM food advertising and marketing
generally takes the form of well researched and well meaning
‘risk assessments’. Such cost-benefit analyses are presented to
a public that generally finds calculatory rationalism
distasteful and the concept of probability unintelligible,
e.g., everyone knows the odds of winning the lottery yet
people keep on buying tickets. It would appear that the chances
of winning are over-rated. By contrast the even lower
probability of losing the GM ‘cancer’ sweepstakes are similarly
over-rated. Attempts have been made to place this question
within the context of known/unknown contingencies such as GM
food safety within Kuhn’s ‘normal science’ (Khatchatourians
2002). The labeling debate also illustrates the
‘information processing’ view. At a minimum it would require all GM food products to be labeled as such. At a maximum it would
require that all GM food products be traceable back to the
actual field from which they grew.
While attempts have been made to highlight the health and safety
of GM foods little has been done to demonstrate that they
‘taste’ better. This may be the final hurdle, maybe not.
Observers have noted, however, that the GM agrifood industry has
been rather inept in its ‘communication’ with the general public
2001). For whatever reasons, to this point in
the industry’s development, GM foods appear to feed nightmares,
a.k.a., Frankenfood, not pleasant fantasies in the mind of the final
By contrast the ‘advertising & marketing’ of medical GM products
and services has fed the fantasies of millions with the hope for
cures to previously untreatable diseases and the extension of
life itself. Failed experiments do not diminish these hopes.
Even religious reservations appear more about tactics, e.g., the
use of embryonic or adult stem cells, rather than the strategy
of using stem cells to cure disease and extend life.
Given that intermediate rather than final demand currently feeds
the biotechnology sector one must also consider what might be
called ‘intermediate advertising & marketing’. Such activities
are conducted by trade associations and lobbyists. The audience
is not the consumer but rather decision makers in other
industries and in government. Such associations exist at both
the national, e.g.,
BIOTECanada, and regional level, e.g.,
Ag.West Bio Inc.
A firm may also indulge in both
vertical and horizontal product differentiation.
Vertical differentiation involves designing a product to be sold
at very levels of consumer income. The classic example is
Josiah Wedgewood in the late 18th century who used the same
molds to make dinner settings for the royal court, aristocracy
and the gentry by minimizing decoration as he moved down market.
Horizontal differentiation involves, for example, offering the
same product but in different colours.
Another technique to achieve product
differentiation in the minds of consumers is ‘design’. Apple is
the outstanding example today. In effect design technology
involves making the best looking thing that works. Picture
going into a computer store and seeing two technically identical
systems, one is ugly, the other attractive. Which do you buy?
Economist Robert H. Frank’s economic guidebook unlocks everyday
design enigmas. An explanation of his findings is available on
YouTube a lecture at Google HQ.
What is important to realize is that product differentiation
through advertising or design require an investment that a lean,
mean perfectly competitive firm cannot afford. It is excess or
economic profit that allows a firm to make such investments.
With respect to process/product
innovation I begin with a distinction between
and innovation. Invention involves creating something new;
innovation involves successfully bringing it to market. To
paraphrase Einstein: it is 1% inspiration (invention) and 99%
Process/product innovation forms part of what economist Joseph
Alesoph Schumpeter called
destruction or the:
… process of
industrial mutation - if I may use that biological term - … that
incessantly revolutionizes the economic structure from within,
incessantly destroying the old one, incessantly creating a new …
Creative destruction is the essential fact about capitalism. It
is what capitalism consists in and what every capitalist concern
has got to live in.
of business strategy acquires its true significance only against
the background of … the perennial gale of creative destruction;
it cannot be understood irrespective of it or, in fact, on the
hypothesis that there is a perennial lull. (pp. 83-84)
From this observation, and other evidence, Schumpeter concluded
that the Standard Model of Market Economics missed the point.
Competition was not about long run lowest average cost per unit
output but rather about innovation and surviving the perennial
gale of creative destruction. For those interested, please
Observation #9: Economic Concepts of Technological Change.
In oligopoly the excess profits
earned, relative to normal profit of a competitive firm, are
used to finance all forms of non-price competition.