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.
