Monopolists: Profit Maximization

An illustration of the monopolistically competitive firm's profit‐maximizing decision is provided in Figure .

The firm maximizes its profits by equating marginal cost with marginal revenue. The intersection of the marginal cost and marginal revenue curves determines the firm's equilibrium level of output, labeled Q in this figure. The firm finds the price that it can charge for this level of output by looking at the market demand curve; if it provides Q units of output, it can charge a price of $ P per unit of output. The firm is shown earning positive economic profits equal to the area of the rectangular box, abcd. Negative economic profits (losses) are also possible.

The monopolistically competitive firm's behavior appears to be no different from the behavior of a monopolist. In fact, in the short‐run, there is no difference between the behavior of a monopolistically competitive firm and a monopolist. However, in the long‐run, an important difference does emerge.

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Demand in a Monopolistic Market

 

Because the monopolistically competitive firm's product is differentiated from other products, the firm will face its own downward‐sloping “market” demand curve. This demand curve will be considerably more elastic than the demand curve that a monopolist faces because the monopolistically competitive firm has less control over the price that it can charge for its output. The firm's control over its price will depend on the degree to which its product is differentiated from competing firms' products. If the firm's product is not differentiated from other products, the firm will face a relatively elastic demand curve and will have less control over the price it can charge. If the firm's product is differentiated compared to a competing firm's products, the firm will face a relatively inelastic demand curve and will have more control over the price that it can charge.

Price‐searching behavior. The monopolistically competitive firm will be a price‐searcher rather than a price‐taker because it faces a downward‐sloping demand curve for its product. The firm searches for the price that it will charge in the same way that a monopolist does, by comparing marginal revenue with marginal cost at each possible price along the market demand curve.

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Conditions for Monopoly

 

Perfect competition and pure monopoly represent the two extreme possibilities for a market's structure. The structure of almost all markets, however, falls somewhere between these two extremes. This section considers two market structures, monopolistic competition and oligopoly, which lie between the extreme cases of perfect competition and monopoly. Monopolistic competition, as its name suggests, is a combination of monopoly and competition. However, monopolistic competition is more closely related to perfect competition than to monopoly. Oligopoly is also a combination of monopoly and competition, but it is more closely related to monopoly than to perfect competition.

Three conditions characterize a monopolistically competitive market. First, the market has many firms, none of which is large. Second, there is free entry and exit into the market; there are no barriers to entry or exit. Third, each firm in the market produces a differentiated product. This last condition is what distinguishes monopolistic competition from perfect competition. Examples of monopolistically competitive firms include restaurants, retail clothing stores, and gasoline service stations.

Differentiated products and monopolistic behavior. In many markets, competing firms sell products that can be differentiated from one another. A firm's product can be differentiated in a number of different ways: by its quality, its convenience, its size, its color, its look, its taste—even by its brand name! As a firm's product becomes more and more differentiated, the firm faces less and less competition and will be able to act more like a monopolist in its output and pricing decisions. Thus, in a monopolistically competitive industry, firms seek to differentiate their products as much as possible. Much of this differentiation is accomplished through advertising.

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Cartel Theory of Oligopoly

 

A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum‐exporting countries (OPEC) is perhaps the best‐known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.

Oligopolistic firms join a cartel to increase their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will charge. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oil‐producing firms form a cartel like OPEC to determine their output and price, they will jointly face a downward‐sloping market demand curve, just like a monopolist. In fact, the cartel's profit‐maximizing decision is the same as that of a monopolist, as Figure reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel's profits are equal to the area of the rectangular box labeled abcd in Figure . Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.

Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel's profits. Hence, there is a built‐in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist.

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Kinked-Demand Theory of Oligopoly

 

As mentioned above, there is no single theory of oligopoly. The two that are most frequently discussed, however, are the kinked‐demand theory and the cartel theory. The kinked‐demand theory is illustrated in Figure and applies to oligopolistic markets where each firm sells a differentiated product. According to the kinked‐demand theory, each firm will face two market demand curves for its product. At high prices, the firm faces the relatively elastic market demand curve, labeled MD ₁ in Figure .

Corresponding to MD ₁ is the marginal revenue curve labeled MR _1. At low prices, the firm faces the relatively inelastic market demand curve labeled MD _2. Corresponding to MD ₂ is the marginal revenue curve labeled MR _2.

The two market demand curves intersect at point b. Therefore, the market demand curve that the oligopolist actually faces is the kinked‐demand curve, labeled abc. Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. The oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an equilibrium output of Q units and an equilibrium price of P.

The oligopolist faces a kinked‐demand curve because of competition from other oligopolists in the market. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other oligopolists in the market will not follow with price increases of their own. The oligopolist will then face the more elastic market demand curve MD ₁.

The oligopolist's market demand curve becomes more elastic at prices above P because at these higher prices consumers are more likely to switch to the lower‐priced products provided by the other oligopolists in the market. Consequently, the demand for the oligopolist's output falls off more quickly at prices above P; in other words, the demand for the oligopolist's output becomes more elastic.

If the oligopolist reduces its price below P, it is assumed that its competitors will follow suit and reduce their prices as well. The oligopolistic will then face the relatively less elastic (or more inelastic) market demand curve MD ₂. The oligopolies' market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. When oligopolists follow each others pricing decisions, consumer demand for each oligopolist's product will become less elastic (or less sensitive) to changes in price because each oligopolist is matching the price changes of its competitors.

The kinked‐demand theory of oligopoly illustrates the high degree of interdependence that exists among the firms that make up an oligopoly. The market demand curve that each oligopolist faces is determined by the output and price decisions of the other firms in the oligopoly; this is the major contribution of the kinked‐demand theory.

The kinked‐demand theory, however, is considered an incomplete theory of oligopoly for several reasons. First, it does not explain how the oligopolist finds the kinked point in its market demand curve. Second, the kinked‐demand theory does not allow for the possibility that price increases by one oligopolist are matched by other oligopolists, a practice that has been frequently observed. Finally, the kinked‐demand theory does not consider the possibility that oligopolists collude in setting output and price. The possibility of collusive behavior is captured in the alternative theory known as the cartel theory of oligopoly.

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Conditions for an Oligopolistic Market

 

Oligopoly is the least understood market structure; consequently, it has no single, unified theory. Nevertheless, there is some agreement as to what constitutes an oligopolistic market. Three conditions for oligopoly have been identified. First, an oligopolistic market has only a few large firms. This condition distinguishes oligopoly from monopoly, in which there is just one firm. Second, an oligopolistic market has high barriers to entry. This condition distinguishes oligopoly from perfect competition and monopolistic competition in which there are no barriers to entry. Third, oligopolistic firms may produce either differentiated or homogeneous products. Examples of oligopolistic firms include automobile manufacturers, oil producers, steel manufacturers, and passenger airlines.

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Monopolistic Competition in the Long-run

The difference between the short‐run and the long‐run in a monopolistically competitive market is that in the long‐run new firms can enter the market, which is especially likely if firms are earning positive economic profits in the short‐run. New firms will be attracted to these profit opportunities and will choose to enter the market in the long‐run. In contrast to a monopolistic market, no barriers to entry exist in a monopolistically competitive market; hence, it is quite easy for new firms to enter the market in the long‐run.

The monopolistically competitive firm's long‐run equilibrium situation is illustrated in Figure .

The entry of new firms leads to an increase in the supply of differentiated products, which causes the firm's market demand curve to shift to the left. As entry into the market increases, the firm's demand curve will continue shifting to the left until it is just tangent to the average total cost curve at the profit maximizing level of output, as shown in Figure . At this point, the firm's economic profits are zero, and there is no longer any incentive for new firms to enter the market. Thus, in the long‐run, the competition brought about by the entry of new firms will cause each firm in a monopolistically competitive market to earn normal profits, just like a perfectly competitive firm.

Excess capacity. Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level of output that is below its minimum efficient scale, labeled as point b in Figure . When the firm produces below its minimum efficient scale, it is under‐utilizing its available resources. In this situation, the firm is said to have excess capacity because it can easily accommodate an increase in production. This excess capacity is the major social cost of a monopolistically competitive market structure.

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