Monopolistic Competition
This type of market structure is characterized by the following:
- Many firms: There are multiple businesses operating within the market.
- Differentiated products: Each firm offers products that are unique in some way—like different brands of toothpaste or coffee. While products are not perfect substitutes, they are close enough that customers can switch easily if prices change.
- Free entry and exit: New firms can easily join the market if profits are high, while unprofitable firms can leave without much difficulty.
Even though these firms have some monopoly power—because they are the only producers of their specific brand—the power is limited. If one firm raises prices too much, consumers will shift to alternatives. A toothpaste brand like Crest, for instance, may attract loyal customers but not enough to charge prices far above competitors. As a result, firms in this structure tend to earn only modest profits.
Short-Run vs. Long-Run Equilibrium
In the short run, firms can make a profit because they face downward-sloping demand curves. The price charged is above marginal cost, meaning they enjoy some level of profit. However, as new firms enter the market, competition increases, which drives profits down.
In the long run, new competitors push profits to zero. The firm’s demand curve shifts until the price equals the average cost, $$P = AC$$, and economic profit becomes zero. Although each firm maintains some monopoly power by differentiating their products, the ease of entry ensures that no firm can earn large, sustained profits.
Efficiency and Product Diversity
Compared to perfect competition, monopolistic competition can lead to inefficiencies:
- Price exceeds marginal cost: This means additional units that could provide value to consumers are not produced, creating a deadweight loss.
- Excess capacity: Firms operate at a level below the minimum average cost, meaning production could be more efficient if there were fewer firms.
However, these inefficiencies are often tolerated because monopolistic competition fosters product diversity—consumers value the variety offered in these markets, such as different flavors of coffee or brands of shampoo.
Oligopoly
Oligopolies consist of a few firms that dominate the market. Examples include industries like automobiles, steel, and computers. Unlike monopolistic competition, entry into oligopolistic markets is difficult due to barriers like high production costs, patents, or the need for strong brand recognition.
Strategic Decision-Making
In oligopolies, firms must carefully consider how their decisions—whether related to pricing, production, or marketing—will affect their competitors. For instance, if Ford lowers car prices by 10%, it must anticipate whether competitors like Toyota will follow suit, remain passive, or undercut even more aggressively. This strategic interdependence complicates decision-making.
Possible Outcomes in Oligopoly
- Cooperation vs. Competition: Firms may either cooperate to keep prices high or engage in aggressive competition, which can lead to lower profits.
- Price wars: If one firm significantly lowers prices, others may retaliate, resulting in reduced profits for the entire industry.
- Cartels: Sometimes, firms explicitly collude to act like a monopoly and maximize joint profits. However, these arrangements are often unstable because members have incentives to cheat by secretly undercutting prices.
Conclusion
Both monopolistic competition and oligopoly demonstrate how real-world markets function between the extremes of perfect competition and monopoly. Monopolistic competition provides variety at the cost of some inefficiency, while oligopoly shows how strategic behavior among a few firms can shape market outcomes.
