Lecture: Monopolistic Competition & Oligopoly
Lecture script · about 15–20 minutes spoken · Week 12
Opening
Think about the last time a shop near you ran a sale, and the store across the street matched it within a day. If you own a small business, you know the other side: match your rival's discount, or hold your price?
That question lives in the markets most of us shop in every week. They aren't lonely monopolies, and they aren't crowds of identical sellers. They sit in between.
Here's where we are. In Week 9 you built the chair workshop's costs. In Week 10 that workshop sold into a perfectly competitive market, took the price, and produced where price equals marginal cost. In Week 11 the town's one ferry had no rival at all. It produced where marginal revenue equals marginal cost and read its price from demand.
In this lecture we fill the space between those two cases: first monopolistic competition, then oligopoly, studied with a small table of payoffs for two coffee shops. We'll end by lining up all four market structures. Next week, in Week 13, the course turns from selling to hiring.
1. Many shops, each a little different
Picture the phone-repair shops in a city. They all fix cracked screens. But one is two blocks from your home, one promises a repair in an hour, and one gives you a longer warranty. Each shop could charge a bit more than the others and still keep some customers.
Economists call this monopolistic competition: a market structure with many sellers offering products that differ a little, by location, style, quality, or service, and with free entry. Each firm faces a downward-sloping demand curve, but entry drives economic profit to zero in the long run. The differences have their own name. Product differentiation is the ways a seller makes its product different from its rivals' in buyers' eyes.
Edward Chamberlin and Joan Robinson each set out this framework in 1933. The name sounds like a contradiction on purpose. "Monopolistic" points at each shop's small slice of pricing power. "Competition" points at the many rivals and the open door for new ones.
Pause and try this. A shop's demand curve slopes down. Does that make it a monopoly?
Think about how many close substitutes the shop has.
Here's the answer. No, because a monopolistic competitor has many close substitutes that aren't quite the same, while a monopolist has none.
2. The same rule, a smaller markup
Now ask how many repairs a shop should do each week. To win more customers, it has to lower its price a little, and it lowers it on every repair, not only the extra one. That's the ferry's situation again, on a smaller scale. So the shop's marginal revenue sits below its price.
The rule doesn't change. The shop produces where marginal revenue equals marginal cost, and then it reads its price from its own demand curve at that quantity. Because marginal revenue is below the price there, the price ends up above marginal cost. For the ferry, marginal revenue met a marginal cost of 4 dollars at a quantity of 8, and the fare was 12 dollars. A repair shop's markup is usually smaller, because its customers can walk to a close substitute.
A shop protects its slice of pricing power through differentiation and advertising, and economists debate what ads do. One side says they inform buyers and sharpen competition. The other says they build brand loyalty that lets a firm charge more. Which effect is larger can differ from market to market.
Pause and try this. Does a repair shop with many rivals produce where price equals marginal cost?
Think about whether its marginal revenue equals its price.
Here's the answer. No, because its demand slopes down, so marginal revenue is below the price, and it produces where marginal revenue equals marginal cost instead.
3. The door is open
Suppose the repair shops on one street are earning economic profit. Word gets around, and a new shop opens. Then another. Each newcomer takes a few customers from the shops already there.
On a graph, with repairs along the bottom and price up the side, each existing shop's demand curve shifts to the left. The shifting continues as long as there's economic profit to draw newcomers in. It stops when each shop's price equals its average total cost. That's the long-run zero-profit result: entry and exit continue until each firm's price equals its average total cost, so economic profit is zero even though price stays above marginal cost.
Losses run the other way. Some shops close, their customers spread to the survivors, and each survivor's demand shifts right until the losses are gone.
Picture the end point for one shop. Its sloping demand curve sinks until it barely touches the shop's bowl-shaped average-cost curve. Because demand slopes down, that touch lands on the falling side of the bowl, a little before the lowest point.
Pause and try this. Repair shops earn economic profit. Which way does each shop's demand curve shift over time?
Think about what newcomers do to each shop's customers.
Here's the answer. Left, because each new shop takes some customers, so every existing shop sells fewer repairs at each price.
4. Zero profit is a normal return
Remember from Week 9 that economic profit subtracts every cost, including the owner's own time and money. So zero economic profit means the owner earns exactly what that time and money could earn in their next-best use. The books still show an accounting profit.
So the repair shop ends up like Week 10's chair workshop in one way and unlike it in another. Like it, economic profit is zero. Unlike it, the price is still above marginal cost. The chair workshop's long-run price was the lowest average total cost, 36 dollars, with price equal to marginal cost. The repair shop charges a little more than one more repair costs it, and buyers get variety in return: a shop near home, a fast shop, a shop with a long warranty.
Is that variety worth the higher price? That's a normative question, and people weigh it differently. The positive prediction is the part the model settles.
Pause and try this. In the long run, is a monopolistic competitor's price equal to its marginal cost?
Think about the slope of its demand curve.
Here's the answer. No, its price equals its average total cost but stays above marginal cost, because its demand curve still slopes down.
5. A few rivals who watch each other
Now go to a corner with two coffee shops facing each other. A third shop would need a lease that nobody is offering. Each owner knows the other by name, and when one changes a price, the other notices within a day.
This is an oligopoly: a market structure dominated by a few firms whose choices are interdependent, usually protected by barriers to entry. The key word is interdependent. Interdependence is the condition in which one firm's best choice depends on what its rivals choose. The chair workshop never thought about any one rival. The ferry had none. These two coffee shops think about each other all the time.
One honest word about the coffee shops. They're a classroom model built for this course, not real companies, and their numbers are illustrative.
Pause and try this. Many small repair shops or two coffee shops on a corner: which one is the oligopoly?
Count the sellers, then check the door.
Here's the answer. The two coffee shops, because an oligopoly has a few interdependent sellers behind barriers, while the repair street has many sellers and an open door.
6. The temptation to collude
If the two shops could act as one, they could charge what a single seller would charge and split the profit. That's collusion: an agreement among rival firms to raise prices or restrict output instead of competing. A group of firms that makes such an agreement formally is a cartel, and together its members act like one monopolist.
A cartel faces two problems. The first is the law. Price-fixing agreements are illegal under U.S. antitrust law, the laws you met in Week 11. The second is temptation. Once every member is charging the high price, any one of them can do better by quietly cutting its own price and pulling in the others' customers. Each one knows the others feel the same pull, so trust is hard to keep.
Pause and try this. Everyone in a cartel earns more under the deal. Why might it still fall apart?
Think about what one member gains by breaking it.
Here's the answer. Because each member can earn even more by cheating while the others keep their promise, so the deal is unstable.
7. The payoff matrix
To put numbers on that temptation, economists use game theory, the study of choices whose payoffs depend on what others choose. Its basic tool is the payoff matrix, a table listing each player's payoff for every combination of choices.
Let me describe the coffee shops' table in words. Each shop picks a high price or a low price, so there are four outcomes. The payoffs are monthly profit in thousands of dollars, written with the first shop's number first and the second shop's number second. If both price high, each earns 10. If both price low, each earns 6. If one prices low and the other high, the low-price shop pulls customers across the street and earns 14, and the high-price shop earns only 4.
So picture two rows for the first shop's choices and two columns for the second shop's, with 10 and 10 at the top left and 6 and 6 at the bottom right.
Pause and try this. The first shop prices high and the second prices low. How much does the first shop earn?
Remember which number belongs to which shop.
Here's the answer. The first shop earns 4, because the low-price rival takes its customers and earns 14.
8. The dominant strategy
Put yourself in the first shop's place. You don't know what your rival will do, so check each possibility separately.
If the second shop prices high, you earn 10 by pricing high and 14 by pricing low. Low wins. If the second shop prices low, you earn 4 by pricing high and 6 by pricing low. Low wins again. Whatever your rival does, low pays you more.
That's a dominant strategy: a choice that gives a player a higher payoff than any other choice whatever the other player does. The second shop's numbers are the mirror image, so low is its dominant strategy too.
Here's the habit to build: compare within each column, not across the whole table. The biggest number in the table is 14, but that's not how you find a dominant strategy. You compare one possibility at a time.
Pause and try this. If the second shop prices low, which price pays the first shop more?
Look only at the first shop's numbers when its rival prices low.
Here's the answer. Low, because the first shop earns 6 by pricing low and only 4 by pricing high.
9. Where the game settles
So where does this game end up? Here's the test for a resting point: would either player want to change its own choice, if the other kept its choice?
A Nash equilibrium is a set of choices, one for each player, in which no player can raise its own payoff by changing its own choice while the others keep theirs. John Nash published the idea in 1950.
Test the outcome where both price low. Each earns 6. A shop that switches alone to high drops to 4, so neither moves. That's a Nash equilibrium. Now test both high. Each earns 10, but either shop could switch alone to low and earn 14. So both high is not a resting point, even though it looks attractive.
Pause and try this. Is the outcome where both shops price high a Nash equilibrium?
Ask whether either shop gains by switching on its own.
Here's the answer. No, because either shop could switch alone to low and raise its profit from 10 to 14.
10. The prisoner's dilemma
Now set the two outcomes side by side. At the Nash equilibrium each shop earns 6. If both priced high, each would earn 10. Both would be better off, yet each one's own best choice leads them to the low price. Together they earn 12 instead of 20.
That's a prisoner's dilemma: a game in which each player has a dominant strategy, yet the outcome when both follow it leaves every player worse off than if all had cooperated. The name comes from a story about two suspects questioned in separate rooms. Merrill Flood and Melvin Dresher framed the game in 1950, and Flood published a report of their experiments in 1958.
This also explains the cartel. If the two shops agree to price high, each can gain 4 a month by cheating. So the deal is unstable, and illegal too. Notice who loses: the shops. Their customers pay the low price.
Pause and try this. Both shops follow their dominant strategy. Do they end up with the outcome that pays them most?
Compare 6 each with 10 each.
Here's the answer. No, they each earn 6 instead of 10, which is exactly what makes the game a prisoner's dilemma.
11. When the game repeats
The coffee corner isn't a one-time meeting. The two shops face each other every month. When the same rivals meet again and again, the threat of a future price cut can sometimes hold a high price in place, because a shop that cheats now may face a rival's low price for a long time after. This course stops at that idea; formal models of oligopoly belong to later courses.
One honest caution: a single two-by-two game is a teaching model. It shows why cooperation is fragile, not how often it fails in any real industry.
Pause and try this. Does the one-time game prove that rivals always end up in a price war?
Think about what changes when the shops meet every month.
Here's the answer. No, it predicts the low price for a single round, and repeated meetings can change what each shop expects.
12. Four market structures, side by side
Let's line up all four market structures. A market structure is the type of market a firm sells in, described by the number of sellers, how alike their products are, and how easily new sellers can enter.
Perfect competition has many sellers, an identical product, and free entry, and its firms produce where price equals marginal cost, with zero long-run economic profit. That's the chair workshop. Monopolistic competition has many sellers, differentiated products, and free entry, with price above marginal cost and zero long-run profit. That's the repair street. Oligopoly has a few interdependent sellers behind barriers, with price usually above marginal cost and profit that can last. That's the coffee corner. Monopoly has one seller with no close substitutes and blocked entry, with price above marginal cost and profit that can last. That's the ferry.
Every one of them produces where marginal revenue equals marginal cost. Only the price taker's rule reads price equals marginal cost.
Pause and try this. Many sellers, differentiated products, free entry: which structure is that?
Check the product, not only the number of sellers.
Here's the answer. Monopolistic competition, because the products differ, which separates it from perfect competition.
13. The classic wrong turns
Most slips this week are a wrong comparison or the wrong rule. The cooperative outcome, both high, is not the Nash equilibrium, because either shop gains by switching. A dominant strategy is not the one with the biggest number; you compare within each column. A monopolistic competitor doesn't keep its economic profit in the long run, because entry takes it away. And oligopoly isn't monopolistic competition: a few interdependent firms differ from many small ones.
Pause and try this. Both shops chose low. Did they have to agree to do that?
Think about why each shop picks low on its own.
Here's the answer. No, each picks low on its own because low is its dominant strategy; only the high price would need an agreement.
Closing
Let's pull it together in the order we went. Monopolistic competition is many shops that each differ a little, with an open door. Each one produces where marginal revenue equals marginal cost and charges above marginal cost. Entry drives its long-run economic profit to zero, which is a normal return. Oligopoly is a few rivals who watch each other. A cartel is tempting and unstable, and price fixing is illegal. In the coffee game, low is each shop's dominant strategy, both low is the Nash equilibrium at 6 each, and the gap from 10 each is the prisoner's dilemma. Across all four structures, every firm uses marginal revenue equals marginal cost.
Next in this module come the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. Next week, in Week 13, we turn to factor and labor markets, where a firm decides how many workers to hire.
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