| CHAPTER 26 Monopolistic Competition and Oligopoly
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CHAPTER 26 Monopolistic Competition and Oligopoly

  1. Monopolistic Competition
  2. This is a market structure in which there are a large number of firms, the products produced by the firms are differentiated, and entry and exit occur easily.
    Teaching Strategy: Place a summary of the differences between monopolistic competition and perfect competition on the blackboard (see Table 1).
    1. Profits and entry: Firms use product differentiation more than price to compete.
      Teaching Strategy: Cite the example of The Gap introducing Town and Country to compete with other retailers.
      Entry into the market causes the demand curve for all other competitors' products to decrease. New products are introduced as long as economic profits are positive.
      1. In the short run: Demand is price elastic.
        Teaching Strategy: Carefully draw and explain Figures 1(a), 1(b), and 1(c) in terms of entry and exit in the market.
      2. In the long run: Free entry and exit allow the firm only normal profit in the long run.
        Teaching Strategy: Cite Figure 2 at zero economic (normal) profit. Expansion and entry into this industry cease when normal profits are made.
    2. Monopolistic competition versus perfect competition: In the long run Qmc is less than Qpc, Pmc is greater than Ppc, ATCmc is greater than Qmc.
      Teaching Strategy: Compare the two markets by citing Figure 3. Although allocative efficiency does not occur in monopolistic competition, stress that this is due to consumer desires for product differentiation.
    3. Non-price competition—product differentiation: Product differentiation reduces price elasticity of demand because of brand loyalty.
      Teaching Strategy: Cite Figure 4(a). Product differentiation could allow the firm to slightly raise price and profits due to the market demand curve rotating from D1 to D2. Cite Figure 4(b). Profits may not rise because of cost increases, however. Refer to Figure 5. Differentiation can result from style, quality, and location. Advertising is used intensively to advise consumers of product differences.
      1. Brand name: Brand names provide value to consumers. They are willing to pay a higher price than they would for similar products without the brand name.
  3. Oligopoly and Interdependence

  4. This is a market structure in which few firms exist, producing either a standardized or a differentiated product, and entry is difficult. A key factor is that firms act interdependently—that is, firms change product quantity and price after considering what other firms are likely to do in response.
    Teaching Strategy: Discuss how interdependence operates in the automobile industry as firms change models, styles, accessories, and prices each model year.
    1. The creation of oligopolies: Oligopolies can arise because of government regulations or because of economies of scale.
    2. Oligopoly and competition: Strategic behavior occurs when what is best for A depends on what B does, and vice versa.
      1. The kinked demand curve: This occurs when firms follow or copy market price decreases but not price increases.
        Teaching Strategy: Construct the kinked demand curve of Figure 6. This is quite complex, so construct it slowly.
        The kinked demand curve predicts price rigidity in oligopoly.
        Teaching Strategy: Explain why new-car sticker prices are held constant for the model year.
      2. Prisoner?s dilemma: Dominant strategy is a strategy that produces the best results for a firm no matter what strategy the opposing player follows.
        Teaching Strategy: Carefully explain the dominant game analysis for the example in Figure 7.
    3. Cooperation
      1. Price-leadership oligopoly: Firms follow the pricing behavior of one firm, thus eliminating the kink in the demand curve.
        Teaching Strategy: Cite U.S. Steel as the price leader in the steel industry.
      2. Cartels and other cooperative mechanisms: Cartels occur when firms divide the market, and each acts as a monopoly. Their purpose is to control and limit production, and maintain or increase prices and profits. A secretive, cooperative agreement to form a cartel is known as collusion and is illegal in the United States.
        Teaching Strategy: Discuss the example of OPEC from a historical and operational aspect. Explain why oil prices fell to $12/barrel in 1988 and rose to more than $35/barrel in 1990.
      3. The theory of cartels: The extra profits from collusion increase the incentive that firms will cheat on their agreements. In most cartels, the strongest member takes over as police officer.
      4. Facilitating practices: When firms have no formal agreement but still cooperate and effectively collude—for example, cost-plus pricing or most-favored customer policies—these policies discourage price competition.
        Teaching Strategy: Discuss the behavior of firms that produced antiknock gasoline in the 1970s.
  5. Summary of Market Structures

  6. Teaching Strategy: Review Table 2, which summarizes the similarities and differences among the four market structures.

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