McConnell Campbell R., Brue Stanley L., Barbiero Thomas P. Microeconomics. Ninth Edition

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chapter summary

terms and concepts

270 Part Two • Microeconomics of Product Markets

1. A pure monopolist is the sole producer of

a commodity for which there are no close

substitutes.

2. The existence of pure monopoly and other

imperfectly competitive market structures is

explained by barriers to entry, in the form of

(a) economies of scale, (b) patent ownership

and research, (c) ownership or control of

essential resources, and (d) pricing and other

strategic behaviour.

3. The pure monopolist’s market situation dif-

fers from that of a competitive ﬁrm in that the

monopolist’s demand curve is downsloping,

causing the marginal-revenue curve to lie

below the demand curve. Like the competitive

seller, the pure monopolist will maximize

proﬁt by equating marginal revenue and mar-

ginal cost. Barriers to entry may permit a

monopolist to acquire economic proﬁt even in

the long run. However, (a) the monopolist

does not charge the highest price it can get;

(b) the price that yields maximum total proﬁt

to the monopolist rarely coincides with the

price that yields maximum unit proﬁt; (c) high

costs and a weak demand may prevent the

monopolist from realizing any proﬁt at all;

and (d) the monopolist avoids the inelastic

region of its demand curve.

4. With the same costs, the pure monopolist will

ﬁnd it proﬁtable to restrict output and charge

a higher price than would sellers in a purely

competitive industry. This restriction of out-

put causes resources to be misallocated, as is

evidenced by the fact that price exceeds mar-

ginal cost in monopolized markets.

5. In general, monopoly increases income in-

equality by transferring income from con-

sumers to the owners of the monopoly.

6. The costs monopolists and competitive pro-

ducers face may not be the same. On the one

hand, economies of scale may make lower

unit costs available to monopolists but not

to competitors, and pure monopoly may be

more likely than pure competition to reduce

costs via technological advance because of

the monopolist’s ability to realize economic

proﬁt, which can be used to ﬁnance research.

On the other hand, X-inefﬁciency—the failure

to produce with the least costly combination

of inputs—is more common among monopo-

lists than among competitive firms. Also,

monopolists may make costly expenditures

to maintain monopoly privileges that are con-

ferred by government. Finally, the blocked

entry of rival ﬁrms weakens the monopolist’s

incentive to be technologically progressive.

7. A monopolist can increase its proﬁt by practis-

ing price discrimination, provided (a) it can seg-

regate buyers on the basis of elasticities of

demand and (b) its product or service cannot

be readily transferred between the segregated

markets. Other things being equal, the perfectly

discriminating monopolist will produce a larger

output than the nondiscriminating monopolist.

8. Price regulation can be invoked to eliminate

wholly or partially the tendency of monopo-

lists to underallocate resources and to earn

economic proﬁts. The socially optimal price is

determined where the demand and marginal-

cost curves intersect; the fair-return price is

determined where the demand and average-

total-cost curves intersect.

pure monopoly, p. 246

barriers to entry, p. 247

simultaneous consumption,

p. 259

network effects, p. 260

X-inefﬁciency, p. 260

rent-seeking behaviour,

p. 261

price discrimination, p. 263

socially optimal price, p. 267

fair-return price, p. 267

study questions

1. “No ﬁrm is completely sheltered from rivals;

all ﬁrms compete for consumer dollars. If that

is so, then pure monopoly does not exist.” Do

you agree? Explain. How might you use

Chapter 6’s concept of cross elasticity of

demand to judge whether monopoly exists?

chapter ten • pure monopoly 271

2. Discuss the major barriers to entry into an

industry. Explain how each barrier can foster

either monopoly or oligopoly. Which barri-

ers, if any, do you feel give rise to monopoly

that is socially justiﬁable?

3. How does the demand curve faced by a

purely monopolistic seller differ from that

confronting a purely competitive ﬁrm? Why

does it differ? Of what signiﬁcance is the dif-

ference? Why is the pure monopolist’s de-

mand curve not perfectly inelastic?

KEY QUESTION Use the demand

schedule that follows to calculate total rev-

enue and marginal revenue at each quan-

tity. Plot the demand, total-revenue, and

marginal-revenue curves, and explain the

relationships between them. Explain why the

marginal revenue of the fourth unit of output

is $3.50, even though its price is $5.00. Use

Chapter 6’s total-revenue test for price elas-

ticity to designate the elastic and inelastic

segments of your graphed demand curve.

What generalization can you make about the

relationship between marginal revenue and

elasticity of demand? Suppose the marginal

cost of successive units of output were zero.

What output would the proﬁt-seeking ﬁrm

produce? Finally, use your analysis to explain

why a monopolist would never produce in

the inelastic region of demand.

Quantity Quantity

Price (P) demanded (Q) Price (P) demanded (Q)

$7.00 0 $4.50 5

6.50 1 4.00 6

6.00 2 3.50 7

5.50 3 3.00 8

5.00 4 2.50 9

KEY QUESTION Suppose a pure

monopolist is faced with the demand sched-

ule shown in the next column and the same

cost data as the competitive producer dis-

cussed in question 4 at the end of Chapter 9.

Calculate the missing total-revenue and

marginal-revenue amounts, and determine

the profit-maximizing price and profit-

earning output for this monopolist. What

is the monopolist’s profit? Verify your

answer graphically and by comparing total

revenue and total cost.

Quantity Total Marginal

Price demanded revenue revenue

$115 0 $______

100 1 ______

$______

83 2 ______

______

71 3 ______

______

63 4 ______

______

55 5 ______

______

48 6 ______

______

42 7 ______

______

37 8 ______

______

33 9 ______

______

29 10 ______

______

KEY QUESTION If the ﬁrm described

in question 5 could engage in perfect price

discrimination, what would be the level of

output? of proﬁts? Draw a diagram showing

the relevant demand, marginal-revenue,

average-total-cost, and marginal-cost curves,

and the equilibrium price and output for a

nondiscriminating monopolist. Use the same

diagram to show the equilibrium position of

a monopolist that is able to practise perfect

price discrimination. Compare equilibrium

outputs, total revenues, economic proﬁts,

and consumer prices in the two cases. Com-

ment on the economic desirability of price

discrimination.

7. Assume that a pure monopolist and a purely

competitive ﬁrm have the same unit costs.

Contrast the two with respect to (a) price,

(b) output, (c) profits, (d) allocation of

resources, and (e) impact on the distribution

of income. Since both monopolists and com-

petitive ﬁrms follow the MC = MR rule in

maximizing proﬁts, how do you account for

the different results? Why might the costs of

a purely competitive ﬁrm and a monopolist

be different? What are the implications of

such a cost difference?

8. Critically evaluate and explain:

a. “Because they can control product price,

monopolists are always assured of prof-

itable production by simply charging the

highest price consumers will pay.”

b. “The pure monopolist seeks the out-

put that will yield the greatest per-unit

proﬁt.”

272 Part Two • Microeconomics of Product Markets

c. “An excess of price over marginal cost is

the market’s way of signalling the need

for more production of a good.”

d. “The more proﬁtable a ﬁrm, the greater

its monopoly power.”

e. “The monopolist has a pricing policy; the

competitive producer does not.”

f. “With respect to resource allocation, the

interests of the seller and of society coin-

cide in a purely competitive market but

conﬂict in a monopolized market.”

g. “In a sense the monopolist makes a proﬁt

for not producing; the monopolist pro-

duces proﬁt more than it does goods.”

9. Assume a monopolistic publisher has agreed

to pay an author 15 percent of the total rev-

enue from the sales of a text. Will the author

and the publisher want to charge the same

price for the text? Explain.

10. Explain verbally and graphically how price

(rate) regulation may improve the per-

formance of monopolies. In your answer

distinguish between (a) socially optimal

(marginal-cost) pricing and (b) fair-return

(average-total-cost) pricing. What is the

“dilemma of regulation”?

11.

KEY QUESTION It has been pro-

posed that natural monopolists should be

allowed to determine their proﬁt-maximizing

outputs and prices and then government

should tax their proﬁts away and distribute

them to consumers in proportion to their

purchases from the monopoly. Is this pro-

posal as socially desirable as requiring

monopolists to equate price with marginal

cost or average total cost?

12. (The Last Word) How was De Beers able to

control the world price of diamonds over the

past several decades even though it pro-

duced only 50 percent of the diamonds?

What factors ended its monopoly? What is

De Beers’ new strategy for earning economic

proﬁt, rather than just normal proﬁt?

internet application question

1. Use the information at <usvms.gpo.gov/

conclusions_index.html> to answer the fol-

lowing questions: On what basis did the

American Federal District Court conclude

that Microsoft was a monopoly? (See the

section on monopoly power.) What speciﬁc

percentage market share did it attribute to

Microsoft? Go to <usvms.gpo.gov> to dis-

cover the Court’s main remedy for reducing

Microsoft’s monopoly power. Finally, Micro-

soft has appealed the District Court decision

to a higher court. Use the Internet to deter-

mine the present status of the appeal. Is the

appeal still pending? Has the District Court

decision been upheld? overturned?

IN THIS CHAPTER

OU WILL LEARN:

The conditions necessary for

monopolistic competition to arise.

•

How the proﬁt-maximizing price

and output are determined in

monopolistic competition.

•

The necessary conditions for

oligopoly to arise.

•

About monopolistic competition

and non-price competition.

•

How game theory can help explain

the behaviour of oligopolists.

•

About three oligopoly models.

•

About the debate over the

impact of advertising on

consumers and ﬁrms.

•

Why oligopoly achieves neither

productive nor allocative efﬁciency.

Monopolistic

Competition

and

Oligopoly

ost market structures in the Cana-

dian economy fall between the two

extremes of pure competition and

pure monopoly. In this chapter we develop

models of monopolistic competition and oli-

gopoly that more closely approximate real-

world market structures.

ELEVEN

Monopolistic competition exhibits a considerable amount of competition mixed

with a small dose of monopoly power. For example, when you go out to eat, you

have an amazing variety of choices. You can get a meal at a fast-food place such as

McDonald’s, Subway, or Taco Bell. You can go to a restaurant with a fuller menu and

table service. For a special meal you can choose an Italian, a French, or a Japanese

ﬁne-food restaurant where your bill may be $30 or more per person. Each estab-

lishment serves food and beverages, but all have different menus and prices. Com-

petition among them is based not only on price but also on product quality, location,

service, and advertising.

Oligopoly, in contrast, displays a blend of greater monopoly power, less compe-

tition via entry, and more strategic behaviour. There are only a few ﬁrms in an oli-

gopolistic industry, and entry is difﬁcult. For example, when you ﬂy on a large

commercial aircraft you are probably ﬂying in a plane built by one of two world pro-

ducers: Airbus or Boeing. In many manufacturing, mining, and wholesaling indus-

tries only a few ﬁrms dominate, not the thousands of producers present in pure

competition, the many ﬁrms in monopolistic competition, or the single ﬁrm in

monopoly.

Let’s begin by examining monopolistic competition, which is characterized by (1) a

relatively large number of sellers, (2) differentiated products (often promoted by

heavy advertising), and (3) easy entry to, and exit from, the industry. The ﬁrst and

third characteristics provide the competitive aspect of monopolistic competition; the

second characteristic provides the monopolistic aspect. In general, however, monop-

olistically competitive industries are more competitive than they are monopolistic.

Relatively Large Number of Sellers

Monopolistic competition is characterized by a fairly large number of ﬁrms, say, 25,

35, 60, or 70, not by the hundreds or thousands of ﬁrms in pure competition. Con-

sequently, monopolistic competition involves

● Small market shares Each ﬁrm has a comparatively small percentage of the

total market and consequently has limited control over market price.

● No collusion The presence of a relatively large number of ﬁrms makes col-

lusion by a group of ﬁrms to restrict output and set prices unlikely.

● Independent action With numerous ﬁrms in an industry, there is little inter-

dependence among them; each ﬁrm can determine its own pricing policy with-

out considering the possible reactions of rival ﬁrms. A single ﬁrm may realize

a modest increase in sales by cutting its price, but the effect of that action

on competitors’ sales will be nearly imperceptible and will probably not trig-

ger a response.

Differentiated Products

In contrast to pure competition in which there is a standardized product, monopo-

listic competition is distinguished by product differentiation. Monopolistically

competitive ﬁrms turn out variations of a particular product. They produce prod-

ucts with slightly different physical characteristics; offer varying degrees of

274 Part Two • Microeconomics of Product Markets

Monopolistic Competition

monopolis-

tic competi-

tion

A market

structure in which

many ﬁrms sell a

differentiated prod-

uct and entry into

and exit from the

market is relatively

easy.

product dif-

ferentiation

A form of nonprice

competition in

which a ﬁrm tries

to distinguish its

product or service

from all competing

ones based on

attributes such as

design and quality.

<www.theshortrun.com/

classroom/glossary/

micro/monocomp.html>

Monopolistic

competition

customer service; provide varying amounts of location convenience; or proclaim

special qualities, real or imagined, for their products.

Let’s examine these aspects of product differentiation in more detail.

PRODUCT ATTRIBUTES

Product differentiation may take the form of physical or qualitative differences in

the products themselves. Real differences in functional features, materials, design,

and quality of work are vital aspects of product differentiation. Personal computers,

for example, differ in terms of storage capacity, speed, graphic displays, and

included software. There are dozens of competing principles of economics text-

books that differ in content, organization, presentation and readability, pedagogical

aids, and graphics and design. Most cities have a variety of retail stores selling

men’s and women’s clothing that differ greatly in styling, materials, and quality of

work. Similarly, one furniture manufacturer may feature its solid oak furniture,

while a competitor stresses its solid maple furniture.

SERVICE

Service and the conditions surrounding the sale of a product are forms of product

differentiation, too. One grocery store may stress the helpfulness of its clerks who

bag your groceries and carry them to your car. A warehouse competitor may leave

bagging and carrying to its customers but feature lower prices. Customers may pre-

fer one-day over three-day dry cleaning of equal quality. The prestige appeal of a

store, the courteousness and helpfulness of clerks, the ﬁrm’s reputation for servic-

ing or exchanging its products, and the credit it makes available are all service

aspects of product differentiation.

LOCATION

Products may also be differentiated through the location and accessibility of the

stores that sell them. Small convenience stores manage to compete with large super-

markets, even though these minimarts have a more limited range of products and

charge higher prices. They compete mainly on the basis of location—being close to

customers and situated on busy streets. A motel’s proximity to an interstate high-

way gives it a locational advantage that may enable it to charge a higher room rate

than nearby motels in less convenient locations.

BRAND NAMES AND PACKAGING

Product differentiation may also be created through the use of brand names and

trademarks, packaging, and celebrity connections. Most aspirin tablets are very

much alike, but many headache sufferers believe that one brand—for example,

Bayer, Anacin, or Bufferin—is superior and worth a higher price than a generic sub-

stitute. A celebrity’s name associated with jeans, perfume, or athletic equipment

may enhance the appeal of those products for some buyers. Many customers prefer

one style of ballpoint pen to another. Packaging touting natural spring bottled water

may attract additional customers versus other bottled waters.

SOME CONTROL OVER PRICE

Despite the relatively large number of ﬁrms, monopolistic competitors do have

some control over their product prices because of product differentiation. If con-

sumers prefer the products of speciﬁc sellers, then within limits they will pay more

to satisfy their preferences. Sellers and buyers are not linked randomly, as in a

chapter eleven • monopolistic competition and oligopoly 275

purely competitive market. But the monopolistic competitor’s control over price is

quite limited, since there are numerous potential substitutes for its product.

Easy Entry and Exit

Entry into monopolistically competitive industries is relatively easy compared to

oligopoly or pure monopoly. Because monopolistic competitors are typically small

ﬁrms, both absolutely and relatively, economies of scale are few and capital require-

ments are low. However, compared with pure competition, ﬁnancial barriers may

result from the need to develop and advertise a different product from one’s rivals.

Some ﬁrms may hold patents on their products or copyrights on their brand names,

making it difﬁcult and costly for other ﬁrms to imitate them.

Exit from monopolistically competitive industries is easier still. Nothing prevents

an unproﬁtable monopolistic competitor from holding a going-out-of-business sale

and shutting down.

Advertising

The expense and effort involved in product differentiation would be wasted if con-

sumers were not made aware of product differences. Thus, monopolistic competi-

tors advertise their products, often heavily. The goal of product differentiation and

advertising—so-called nonprice competition—is to make price less of a factor in

consumer purchases and product differences a greater factor. If successful, the

ﬁrm’s demand curve will shift to the right and will become less elastic.

Monopolistically Competitive Industries

Figure 11-1 lists several manufacturing industries that approximate monopolistic

competition in Canada. In addition, many retail establishments in metropolitan

areas are monopolistically competitive, including grocery stores, gasoline stations,

barbershops, dry cleaners, clothing stores, and restaurants.

We now analyze the price and output decisions of a monopolistically competitive

ﬁrm. Initially, we assume that each ﬁrm in the industry is producing a speciﬁc

differentiated product and engaging in a particular amount of advertising. Later

we’ll see how changes in the product and in the amount of advertising modify our

conclusions.

The Firm’s Demand Curve

Our explanation of the price and output decisions of a monopolistically competitive

ﬁrm is based on Figure 11-2 (Key Graph). The basic feature of that diagram is the

elasticity of demand, as shown by the individual ﬁrm’s demand curve. The demand

curve faced by a monopolistically competitive seller is highly, but not perfectly, elas-

tic. It is precisely this feature that distinguishes monopolistic competition from pure

monopoly and pure competition. The monopolistic competitor’s demand is more

elastic than the demand faced by a pure monopolist because the monopolistically

competitive seller has many competitors producing closely substitutable goods. The

276 Part Two • Microeconomics of Product Markets

nonprice

competition

A selling strategy in

which one ﬁrm tries

to distinguish its

product or service

from all competing

ones based on

attributes other

than price.

Price and Output in

Monopolistic Competition

pure monopolist has no rivals at all. Yet, for two reasons the monopolistic competi-

tor’s demand is not perfectly elastic like that of the pure competitor. First, the

monopolistic competitor has fewer rivals; second, its products are differentiated, so

they are not perfect substitutes.

The price elasticity of demand faced by the monopolistically competitive ﬁrm

depends on the number of rivals and the degree of product differentiation. The

larger the number of rivals and the weaker the product differentiation, the greater

the price elasticity of each seller’s demand; that is, the closer monopolistic compe-

tition will be to pure competition.

The Short Run: Proﬁt or Loss

The monopolistically competitive ﬁrm maximizes its proﬁt or minimizes its loss in the

short run just as the other ﬁrms we have discussed do: by producing the output at

which marginal revenue equals marginal cost (MR = MC). In Figure 11-2(a) the ﬁrm

produces output Q

, where MR = MC. As shown by demand curve D

, the ﬁrm then can

charge price P

. It realizes an economic proﬁt, shown by the grey area [= (P

– A

) × Q

But with less favourable demand or costs, the ﬁrm may incur a loss in the short

run. We show this possibility in Figure 11-2(b), where the ﬁrm’s best strategy is to

minimize its loss. It does so by producing output Q

(where MR = MC) and, as deter-

mined by demand curve D

, by charging price P

. Because price P

is less than aver-

age total cost A

, the ﬁrm incurs a per unit loss of A

– P

and a total loss represented

as the pink area [= (A

– P

) × Q

chapter eleven • monopolistic competition and oligopoly 277

FIGURE 11-1 PERCENTAGE OF OUTPUT PRODUCED BY

THE FOUR LARGEST FIRMS IN SELECTED LOW-

CONCENTRATION SECTORS*

Food

Wood industries

Knitting mills

Leather products

Finance

Machinery

Metal fabricating

Retail trade

Furniture industry

010515

Wholesale trade

Clothing industry

20 3025

Percentage of industry total

Source: Annual Report of the Ministry of Industry, Science and Technology Under the Corporations and Labour

Unions Resources Act, Industry Canada, March 1990, p. 94. Reproduced with the permission of the Minister

of Public Works and Government Services Canada, 2001.

*As measured by total revenue.

The Long Run: Only a Normal Proﬁt

In the long run, ﬁrms will enter a proﬁtable monopolistically competitive industry

and leave an unproﬁtable one. So, a monopolistic competitor will earn only a nor-

mal proﬁt in the long run. (Remember that the costs curves include both explicit and

implicit costs, including a normal proﬁt.)

PROFITS: FIRMS ENTER

In the case of short-run proﬁt in Figure 11-2(a), economic proﬁts attract new rivals

because entry to the industry is relatively easy. As new ﬁrms enter, the demand

curve faced by the typical ﬁrm shifts to the left (falls). Why? Because each ﬁrm has

a smaller share of total demand and now faces a larger number of close-substitute

products. This decline in the ﬁrm’s demand reduces its economic proﬁt. When entry

of new ﬁrms has reduced demand to the extent that the demand curve is tangent to

the average-total-cost curve at the proﬁt-maximizing output, the ﬁrm is just mak-

ing a normal proﬁt. This situation is shown in Figure 11-2(c), where demand is D

and the ﬁrm’s long-run equilibrium output is Q

. As Figure 11-2(c) indicates, any

greater or lesser output will entail an average total cost that exceeds product price

, meaning a loss for the ﬁrm. At the tangency point between the demand curve

and ATC, total revenue equals total costs. With the economic proﬁt gone, no further

incentive exists for additional ﬁrms to enter.

LOSSES: FIRMS LEAVE

When the industry suffers short-run losses, as in Figure 11-2(b), some ﬁrms will exit

in the long run. Faced with fewer substitute products and blessed with an expanded

share of total demand, the surviving ﬁrms will see their demand curves shift to the

right (rise), as to D

. Their losses will disappear and give way to normal proﬁts,

shown in Figure 11-2(c). (For simplicity we have assumed constant costs; shifts in

the cost curves as ﬁrms enter or leave would complicate our discussion slightly but

would not alter our conclusions.)

COMPLICATIONS

The representative ﬁrm in the monopolistic competition model earns only a normal

proﬁt in the long run. That outcome may not always occur, however, in the real

world of small ﬁrms as opposed to the theoretical model.

● Some ﬁrms may achieve sufﬁcient product differentiation that other ﬁrms can-

not duplicate them, even over time. One hotel in a major city may have the best

location relative to business and tourist activities. Or a ﬁrm may have devel-

oped a well-known brand name that gives it a slight but very long-lasting

advantage over imitators. Such ﬁrms may have sufﬁcient monopoly power to

realize modest economic proﬁts even in the long run.

● Entry to some monopolistically competitive industries is not as free in reality

as it is in theory. Because of product differentiation, greater ﬁnancial barriers

to entry are likely to exist than if the product were standardized. This suggests

some monopoly power, with small economic proﬁts continuing even in the

long run.

With all things considered, however, the normal proﬁt outcome—the long-run equi-

librium—shown in Figure 11-2(c) is a reasonable portrayal of reality.

278 Part Two • Microeconomics of Product Markets

chapter eleven • monopolistic competition and oligopoly 279

Price and costsPrice and costs

Economic

profit

MC ATC

ATC

MC ATC

Price and costs

(a) Short-run profits

Quantity

(b) Short-run losses

Quantity

Loss

ATC

MR = MC

The monopolistic competitor maximizes proﬁt or minimizes

loss by producing the output at which MR = MC. The eco-

nomic proﬁt shown in panel (a) will induce new ﬁrms to

enter, eventually eliminating economic proﬁt. The loss

shown in panel (b) will cause an exit of ﬁrms until normal

proﬁt is restored. After such entry and exit, the price will

settle in panel (c) to where it just equals average total cost

at the MR = MC output. At this price P

and output Q

, the

monopolistic competitor earns only a normal proﬁt, and the

industry is in long-run equilibrium.

FIGURE 11-2 A MONOPOLISTICALLY COMPETITIVE

FIRM: SHORT RUN AND LONG RUN

Key Graph

Quick Quiz

1. Price exceeds MC in

a. graph (a) only.

b. graph (b) only.

c. graphs (a) and (b) only.

d. graphs (a), (b), and (c).

2. Price exceeds ATC in

a. graph (a) only.

b. graph (b) only.

c. graphs (a) and (b) only.

d. graphs (a), (b), and (c).

3. The ﬁrm represented by Figure 11-2(c) is

a. making a normal proﬁt.

b. incurring a loss, once opportunity costs are considered.

c. producing at the same level of output as a purely competitive ﬁrm.

d. producing a standardized product.

4. Which of the following pairs are both competition-like elements in mon-

opolistic competition?

a. Price exceeds MR; standardized product.

b. Entry is relatively easy; only a normal proﬁt in the long run.

c. Price equals MC at the proﬁt-maximizing output; economic proﬁts are likely in

the long run.

d. The ﬁrms’ demand curve is downsloping; differentiated products.

Answers

1. d; 2. a; 3. a; 4. b