6.2 Oligopoly and Monopolistic Competition

Oligopoly and monopolistic competition are key market structures in imperfect competition. They sit between perfect competition and monopoly, each with unique characteristics that shape firm behavior and market outcomes.

These structures impact pricing, output, and competitive strategies. Understanding their dynamics is crucial for grasping how real-world markets function and the implications for consumers, firms, and economic efficiency.

Oligopoly vs Monopolistic Competition

Key Characteristics

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• Oligopoly involves a small number of large firms dominating the market with significant barriers to entry
• Monopolistic competition features many firms producing differentiated products with low barriers to entry and exit
• Oligopolistic firms engage in non-price competition (advertising, product differentiation, innovation) to gain market share
• Monopolistically competitive firms face downward-sloping demand curves indicating some price-setting ability
• Oligopolistic markets exhibit price rigidity ("sticky prices") due to interdependence of firms' pricing decisions
• Both structures lead to excess capacity in the long run operating below minimum efficient scale

Market Dynamics

• Oligopolistic firms' decision-making processes demonstrate interdependence
• Monopolistically competitive firms have some degree of market power from product differentiation
• Oligopolistic markets face potential for price wars if firms change prices
• Monopolistically competitive firms experience high price elasticity due to close substitutes
• Oligopolistic firms carefully consider competitors' reactions when making decisions
• Product differentiation in monopolistic competition allows firms to maintain some pricing power

Strategic Interactions in Oligopoly

Game Theory Concepts

• Game theory analyzes strategic decision-making in oligopolistic markets with interdependent firm actions
• Prisoner's dilemma model illustrates tension between cooperation and competition
• Nash equilibrium represents situation where no firm can unilaterally improve its position
• Repeated games can lead to tacit collusion through implicit coordination
• Dominant strategy predicts firm behavior under various competitive scenarios
• Cournot model examines simultaneous output decisions
• Stackelberg model explores sequential output decisions and market leadership

Oligopoly Models

• Kinked demand curve model explains price rigidity through asymmetric responses to price changes
• Bertrand model focuses on price competition leading to marginal cost pricing
• Edgeworth model incorporates capacity constraints into price competition
• Hotelling model examines spatial competition and product differentiation
• Conjectural variations approach considers firms' beliefs about competitors' reactions

Efficiency of Imperfect Competition

Economic Inefficiencies

• Allocative inefficiency arises as prices exceed marginal costs creating deadweight loss
• Productive inefficiency occurs with firms operating above minimum average costs due to excess capacity
• Market power allows short-run economic profits potentially leading to inequitable surplus distribution
• Excess capacity results in underutilization of resources and higher average costs
• Deadweight loss represents forgone consumer and producer surplus

Potential Benefits

• Product differentiation in monopolistic competition increases consumer welfare through variety
• Oligopolistic markets benefit from economies of scale and scope lowering average costs
• Dynamic efficiency incentivizes innovation and product development
• Research and development investments can lead to technological advancements
• Product variety caters to diverse consumer preferences

Policy Considerations

• Regulatory interventions like antitrust policies address potential welfare losses
• Promote competition in oligopolistic markets through merger control and anti-collusion measures
• Balance between market power and innovation incentives in patent policy
• Consumer protection regulations ensure product quality and information transparency
• Trade policies impact domestic market structures and competitive dynamics

Pricing and Output Decisions

Profit Maximization Across Structures

• Perfect competition firms produce where price equals marginal cost (price takers)
• Monopoly, oligopoly, and monopolistic competition firms have price-setting ability
• Profit-maximizing condition (MR = MC) applies to all structures with different interpretations
• Oligopolistic firms consider competitors' reactions in pricing and output decisions
• Monopolistically competitive firms set prices above marginal cost with limited market power
• Long-run equilibrium in perfect competition results in zero economic profit
• Monopolistic competition tends towards zero economic profit in long run
• Oligopolies may sustain positive economic profits long-term

Pricing Strategies

• Price discrimination more feasible in oligopoly and monopolistic competition
• Product differentiation influences pricing decisions and markup potential
• Non-linear pricing strategies (quantity discounts, two-part tariffs) used in imperfect competition
• Limit pricing deters market entry in oligopolistic markets
• Predatory pricing attempts to drive out competitors (requires deep pockets)
• Peak-load pricing addresses demand fluctuations in industries with capacity constraints
• Bundle pricing leverages complementary products or services