6355 Lecture Notes - Lecture 7: Nash Equilibrium, Game Theory, Monopolistic Competition
5 Jun 2018
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In perfect competition, competing firms have no power to set prices. In a monopoly, the firm does
have the power to set prices by no competition occurs.
Markets in which competition firms have power to set their prices are called imperfect competition.
Monopolistic competition is the realistic version of perfect competition: many small firms, and
consumers can distinguish between the firms and/or the products sold by each frim.
Oligopoly is the realistic version of monopoly: a few very large firms which struggle to gain
dominance over the market.
Monopolistic Competition Assumptions:
• A large number of firms compete
• Each firm produces a differentiated product.
• Firms compete on product quality, price, marketing and branding.
• There are no barrier to entry and exit.
Monopolistic Competition Implications:
• Small market share: each firm supplies a small part of the total industry output. Thus, each
firm has limited market power to influence the price of its product.
• Can ignore other firms: because all the firms are relatively small, no one firm's action directly
affects the actions of other firms.
• Collusion is impossible: firms would like to conspire to fix a higher price, but there are too
many firms to make this possible.
Eg: clothing stores, petrol stations, hair dressers.
In these industries a large number of firms compete, selling differentiated products that are heavily
advertised, and firms come and go under the pressure of competition.
A monopolistic competitive firm earning positive economic profits will attract new firms into the
industry in the long run.
New entering firms split up the market and eventually each firm's market share is so small that only
normal profits are being earned in the long run.
Barriers to entry prevented this scenario in a monopoly.
Differences between perfect competition and monopolistic competition
1. Monopolistically competitive firms charge a price greater than marginal cost.
2. Monopolistically competitive firms do no produce at minimum average cost.
Monopolistically competitive firms usually operate at higher average cost levels than do perfectly
competitive ones.
Allocative efficiency requires the marginal benefit of the consumer to equal the marginal cost of the
producer.
Price measures marginal benefit, so efficiency requires price to equal marginal cost. P=MC.
In monopolistic competition, prices exceed marginal cost. The amount by which the price exceeds
marginal cost is called a firm's mark up.
Product differentiation gives rise to the firm having some market power and facing a slightly
downward sloping demand curve.
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Document Summary
In perfect competition, competing firms have no power to set prices. In a monopoly, the firm does have the power to set prices by no competition occurs. Markets in which competition firms have power to set their prices are called imperfect competition. Monopolistic competition is the realistic version of perfect competition: many small firms, and consumers can distinguish between the firms and/or the products sold by each frim. Oligopoly is the realistic version of monopoly: a few very large firms which struggle to gain dominance over the market. Monopolistic competition assumptions: a large number of firms compete, each firm produces a differentiated product, there are no barrier to entry and exit. Firms compete on product quality, price, marketing and branding. Small market share: each firm supplies a small part of the total industry output. In these industries a large number of firms compete, selling differentiated products that are heavily advertised, and firms come and go under the pressure of competition.
