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Explain how the different features of monopolistic competition and oligopoly affect price and output determination in these market structures. [10]


This is a special contribution by WY in response to the ‘A’ Level H2 Economics November 2011, Essay Question 3 on monopolistic competition and oligopoly

This paper explains how the characteristics of the monopolistic competition and oligopoly firms account for their levels of price and output. There are five main characteristics which serve as assumptions for these two market structures. They include the number of buyers and sellers in the market, type of product sold, level of barriers to entry, price setting ability of the firms, and information level. These traits of each market structure would determine what level of price and output they produce at.

A monopolistic competitive firm refers to a firm that sells a slightly differentiated product with many close substitutes, in a market with many buyers and sellers, with relatively low barriers to entry and exit of the market, and imperfect information in the market. We take each of the features to be explained in turn. Product differentiation can be based on real or imaginary differences. Real differences mean that the product is actually different in terms of its design, composition of materials, and substance. Imaginary differences, on the other hand, mean that the product is perceived to be different, due to persuasive advertising, branding, and marketing differences, which create a psychological difference. Monopolistic competitive firms are price setters, but have limited price setting ability due to the presence of many other competitors in the market selling differentiated but similar products.

What economics diagram would you draw here, and why?

According to the diagram, a profit maximising monopolistic competitive firm would produce at marginal cost (MC) = marginal revenue (MR), at price P and output level Q. In the short run, the firm could earn supernormal profits as long as average cost (AC) is below P. However, in the long run, because of the relatively low barriers of entry and exit of the market, the supernormal profits of the short run would be competed away due to many competitors entering the market. Therefore in the long run, monopolistic competitive firms earn normal profits.

A monopolistic competitive firm operates in a market with many buyers and sellers. Barriers to entry refers to any man-made or natural barriers to entry which are strong enough to prevent new rival firms from competing on an equal basis with existing firms, and prevent these firms from entering or exiting the industry. There are two types of barriers to entry, namely natural and artificial barriers to entry. Natural barriers to entry refer to barriers which are intrinsic to the industry, such as economies of scale. Artificial barriers to entry refer to laws, legislations, patents, and other obstacles to entering or exiting an industry, and are not intrinsic to an industry itself. Low barriers to entry and exit of a monopolistic competitive industry also allows potential entrepreneurs to capitalise profitable opportunities by providing easy access into the market, resulting in the presence of many sellers in the market. These conditions – many buyers and sellers in the market, low barriers to entry and firms selling slightly differentiated product – coupled with imperfect information in the market allows for  monopolistic competitive to have limited price setting ability. 

An illustration of monopolistic competitive firms would be chicken rice stalls located in the multitude of food courts and coffee shops in Singapore. There are many consumers of chicken rice and many chicken rice sellers, each selling a slightly differentiated form of chicken rice – Hainanese chicken rice, and lemon chicken rice, for instance. Low barriers to entry exist because of the relatively low rental and start-up costs of chicken rice stalls in coffee shops, as compared to those of restaurants, which would have to spend relatively more to hire more qualified employees such as chiefs and waiters for instance. Imperfect information could be illustrated in the form of special recipes withheld by different stall owners, and this coupled with the abovementioned conditions, allows for each chicken rice stall to have small market power and thus some degree of price setting ability. These conditions together, results in monopolistic competitive firms producing at MC=MR, at price P and output level Q and earning normal profits in the long run.

On the other hand, an oligopoly refers to a firm that sells either a homogenous or differentiated product depending on the particular or specific industry, in a market with many buyers but relatively few sellers, each mutually interdependent on each other, with relatively high barriers to entry and exit of the market, and imperfect information in the market. Due to the high barriers to entry and market power of the firms, oligopolies are price setters with high degree of pricing power. Mutual interdependence means that each of the firm in a oligopolistic industry will take into account each other’s price and non-price behaviour when making their strategies. This strategic or game theoretic behaviour occurs because each firm in such an industry is not a competitor, but rather a rival to the other firms. Oligopolies can be either collusive or non-collusive, where collusive means that the firms act in a concerted manner and co-operate with each other, while non-collusive means that each oligopoly operates on its own accord, taking care to strategically consider their rival’s likely behaviour. As collusive oligopolies will form a cartel and behave just like a monopoly, it would not be discussed in this essay.

What economics diagram would you draw here, and why?

Non-collusive oligopolies also produce at the maximising point MC=MC, at price P and output Q. Taking into account their rival’s actions, these oligopolies would not raise their prices as their rivals would simply benefit from such actions. On the other hand, they would not lower their prices and cause a price war as their rivals would have little choice but to follow. According to the kinked-demand curve model, due to rival’s strategic behaviour and mutual interdependence, there would be a situation of sticky prices at price P, where oligopolies would not have any incentive to raise nor lower prices. The only way in which a price war is sustainable is if the MC curve fell for a firm, due to innovation or dynamic efficiency. That way, an oligopoly could lower its prices and trigger a price war with the other firms, and if its rivals are unable to match its lower marginal costs, it would win in the long run. Therefore, due to high barriers to entry and market power of the firms, oligopolies earn supernormal profits in the long run.

Non-collusive oligopolies operate in an industry where there are many buyers but relatively few sellers, due to high barriers to entry. This, coupled with imperfect information in the industry, and the type of product sold – homogenous or differentiated – results in oligopolies having a high degree of pricing power. In the e-commerce industry, examples of non-collusive oligopolies include firms like Amazon, Alibaba, eBay etc. Barriers to entry in the e-commerce industry is relatively high, because it requires a lot of capital to set-up the firm, such as the search engine required to cater to global demand, and the logistics required to handle the delivery and shipping of thousands of product worldwide. Hence, only a few oligopolies dominate this industry, each selling a myriad of differentiated products. Imperfect information could exist in the industry where firms have no information regarding the operations of their rivals, such as how they innovate for instance. Therefore, these five characteristics of non-collusive oligopolies lead to these firms producing at MC=MR, at price P and output level Q, thereby earning supernormal profits in the long run.

In conclusion, the five characteristics of the two market structures ultimately determine their pricing strategy and what level of price and output they produce.

JC Economic Essays – This is a H2 Economics essay response on a market structure question, for the N2011 economics examination, Essay Question 3. Special thanks once again to WY for his kind contribution, which will help many economics students learn economics through model economics essays. Thank you to WY and SS for their kind contributions of economics essays.

This economics answer is really good, albeit detailed. As a model, this essay is clearly structured, focuses on the features (“structure”) of the market structures (both of them), and argues about the resultant P and Q. There is a good and strong use of examples, and economics diagrams as well. This economics response also refers explicitly to the P and Q, which are the focus of the question.

Just for discussion and improvement: What could the author have done differently to make this economics essay sharper and more focused? What could he have done slightly differently, or better, to make improvements to his response? There is always room for improvement. Always think of how you could have approached the economics question, and what you could have learnt from reading this model essay, and from other economics essays on this site. What synthesis or syntheses can you make? 

Thank you for reading and cheers.


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