Microeconomic Theory and Its Applications II
Module 1 Unit 2
Monopolistic Competition and Oligopoly
When you have completed this unit, you should be able to answer, in less than one page and in your
own words, the following questions:
What is meant by product differentiation and monopolistic competition?
What is the equilibrium price and output of a monopolistically competitive industry?
How does this equilibrium differ from that of a perfectly competitive industry?
Is there excess capacity in monopolistically competitive industries?
What is an oligopoly?
How does an oligopoly set an equilibrium price and quantity?
What is a cartel and what forms of collusion can sustain it?
What is a contestable industry?
Chapter 12 in the textbook.
Between the polar cases of perfect competition (many, many producers) and monopoly (one producer)
are two other cases of interest, monopolistic competition and oligopoly. You should be able to
recognize a number of industries that fall into these two new categories as we outline their
characteristics. Taken together, these four models of industry—perfect competition, monopoly,
monopolistic competition, and oligopoly—constitute an introduction to the theory of industrial
organization that should allow you to understand many aspects of business conduct.
Any shopping mall offers a variety of examples of small firms selling close substitutes: dress stores,
hamburger stands, gift shops, etc. These firms participate in industries that look much like perfect
competition (recall chapter 10) except that the product is not homogeneous and, indeed, firms devote
considerable resources to differentiating their product from their competitors by advertising, labelling,
packaging, etc. This
distinguishes monopolistically competition from perfect
competition by providing firms with a degree of price-setting power. [Try question 4.]
In a monopolistically competitive industry there are many firms producing close substitutes that form a
product group, or an industry of similar but differentiated products (such as different brands of
dresses). For simplicity, we assume that each firm has the same costs and faces the same demand
curve for its product. The important difference from perfect competition is that each firm faces a
downward-sloping demand curve as shown in figure 12.1 because, as the price rises, there is some
“brand loyalty,” arising from product differentiation, that causes consumers to still purchase the
product. Since there are close substitutes, the demand curve is likely to be fairly elastic. It is also likely
to shift as the prices of these substitutes change.
In the short run, the monopolistic competitor sets MR=MC to maximize profits (at Q