Perfect competition and monopoly are idealized paragons of market extremes. Most
markets do not fit either of these models. Missing, however, is the common sort of price
and non-price competition that is often observed in the real world. These are not the
behaviors of firms in perfect competition or monopoly. Rather, they are the results we
find in the in-between markets of imperfect competition. Monopolistic competition, with
many small firms offering similar but differentiated products, and oligopoly, where a few
large firms vie for market share, are the market structures ripe for competitive behavior;
especially price changes and self-promotion. Firms in monopolistic competition or
oligopoly markets have some degree of market power so they are price setters, not price
takers.
The essential problem of firms in markets under imperfect competition can be understood under a unified framework of profit maximization, with the problem being what the demand curve facing the firm looks like. Since we have already established that firms in oligopoly and monopolistic competition have market power, we know that they face downward sloping demand curves.
Firms in imperfectly competitive markets must consider two situations when changing price; that competitors will match any price changes, or that competitors will not meet price changes, instead ignoring the behavior of the firm in question.
Figure 12.1 indicates how the two demand curves differ. The current price is noted by P*, and the firm is selling Q*. If rivals match a firm's price movements then the firm will share only in quantity changes that occur at the market level. With 10 firms in a market the firm can expect its own quantity to change about one-tenth of the change in market quantity. If there are 20 firms, its share is approximately one-twentieth of the market response. Thus, the demand curve facing the firm is relatively steep, as shown by the curve labeled D.
Alternatively, a firm may find that others in the market ignore what it does. If the firm of concern raises its price, other firms hold their prices steady, and the firm loses market share; the price of its good is relatively more expensive. Similarly, if this firm lowers price while rivals do not, giving this firm a relative price advantage, it can expect its market share to increase. Since the prices of substitute goods affects elasticity, under this scenario the firm faces a more elastic demand curve, as shown by the curve labeled d.
As with any firm, once the demand curve is identified, we can find the marginal revenue curve, equate it to marginal cost, and find profit maximizing output and price. Since we are already given that the firm is producing Q*, we should expect that marginal revenue equals marginal cost at this output. If, for example, the firm knows that other firms in the market will follow price changes, we use the curve labeled D, find that marginal revenue is MR, as shown in figure 12.2, and can surmise that short run marginal cost intersects marginal revenue as shown. Average cost will be C*, and the firm makes a profit equal to the rectangle P*abC*.
MONOPOLISTIC COMPETITION
Monopolistic competition differs from perfect competition only in that products from different sellers have distinct traits which differentiate the goods of one seller from those of another seller. All other characteristics are the same. The product differentiation causes what is called brand loyalty.
Brand Loyalty and Monopoly Power
Brand loyalty is the willingness of a customer to pay a higher price to purchase the good from a particular seller. The goods must belong to the same class or market - the cross price elasticity of demand must be high. Brand loyalty comes from many sources, but it comes from the idea of differentiated products. The result of brand loyalty is that firms face downward sloping demand curves. Other brands are only imperfect substitutes, so if a firm raises its price, not all customers flee to competitors. Those with stronger brand loyalty stay on, even though the price is higher than comparable goods. Correspondingly, if a firm lowers its price it picks up some customers (those with weaker brand loyalty), yet some stay with other brands. The many similar but imperfect substitutes mean most firms face relatively flat demand curves.
Equilibrium in monopolistic competition
(figure 12.4) The firm sets output where marginal revenue equals marginal cost, Q0,
and charges what the market will bear, P0 according to the demand curve. In
this case, average cost is C0, and the firm is making a profit equal to the
rectangle P0abC0. Remember that the demand and marginal revenue
curves depend on the prices set by competing firms, but that those prices are ignored by
this firm. Competitors prices have already been accounted for by the location and
steepness of the demand curve. Thus, this firm can set its price without considering the
reaction of its rivals.
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Factor mobility and long run equilibrium
Profit plays the same role in monopolistic competition as it does in perfect
competition - it is a signal to entrepreneurs to enter or leave a market. And, as in
perfect competition, in the long run the incentives drive profit to zero. Entry and
expansion tend to decrease the monopoly power of firms. More choices erode brand loyalty
and make demand more elastic. Additionally, the market demand must be divided among more
firms, giving each a smaller share. Thus, we would expect that the demand curves facing
individual firms will shift in and get flatter. Entry and expansion (or exit and
contraction) keep going on until profit is zero. Figure 12.6 depicts the long run
equilibrium for the firm under monopolistic competition. The firm is maximizing profit -
MC equal MR. But demand has adjusted so profit is zero. At the output Qe the
firm charges Pe, which just equals both AC.
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OLIGOPOLY
Oligopoly differs from perfect competition and monopoly by having a few firms in the market. These firms compete for market share and profits. Firms in oligopolies derive their monopoly power from the lack of numerous competitors, poor information flow, and limited factor mobility. They may also promote real or perceived differences in their output. These traits breed the intense competitive behavior that we see all the time in oligopolistic markets. The same attributes that bring about rivalry between firms cause an interdependence. When one firm changes its price or output, other firms in the market feel the consequences.
Price rigidity - the kinked demand curve model
The most widely taught model of an oligopoly is the kinked demand curve model. The primary
result from this model is an extraordinary level of price stability, even in the face of
cost changes. The firm expects that competitors will follow price decreases, but not a
price increase. If the firm in question lowers its price (say from P0 in figure
12.14) other firms must follow, or they stand to lose a significant percentage of sales.
Thus, the initial firm only gains its share of new units demanded by the market as price
falls - a rather paltry elasticity, giving the steep section of the curve.
But rivals react differently to a price increase. If they can hold off on a price rise, they gain an advantage, and improve market share at the first firm's expense. Thus, if the first firm raises its price, other firms do not follow, and the first firm sees a big drop in quantity demanded - shown by the flat portion of the demand curve labeled D. An artifact of the kinked demand curve is that the marginal revenue curve has a discontinuity, often drawn as a vertical portion of the curve, at the current quantity.
One interesting consequence of the kinked demand curve is that price and output are stable, hence this is often called a rigid price model. We assume that the firm is maximizing profit when price is P0. That means marginal revenue equals marginal cost when output is Q0 so the marginal cost curve MC0 cuts the vertical portion of the marginal revenue curve. If costs increase to MC1 (and a corresponding average cost curve which is not shown) marginal cost still cuts the vertical portion of the marginal revenue curve, and there is no reason for the firm to change its price. This is the price rigidity. Only if cost change enough to move marginal cost beyond the vertical portion of marginal revenue is there a change in price. Firms absorb small cost increases without a rise in price, nor do they pass any small cost savings to consumers. When a cost shift moves out of the vertical portion there is an interval of instability in the market until a new equilibrium price is established, at which time a new period of price stability commences.