Monopolistic Competition and Oligopoly

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1. What are the characteristics of a monopolistically competitive market? What happens to the equilibrium price and quantity in such a market if one firm introduces a new, improved product?

The two primary characteristics of a monopolistically competitive market are (1) that firms compete by selling differentiated products which are highly, but not perfectly, substitutable and (2) that there is free entry and exit from the market. When a new firm enters a monopolistically competitive market (seeking positive profits), the demand curve for each of the incumbent firms shifts inward, thus reducing the price and quantity received by the incumbents. Thus, the introduction of a new product by a firm will reduce the price received and quantity sold of existing products.

2. Why is the firm’s demand curve flatter than the total market demand curve in monopolistic competition? Suppose a monopolistically competitive firm is making a profit in the short run. What will happen to its demand curve in the long run?

The flatness or steepness of the firm’s demand curve is a function of the elasticity of demand for the firm’s product. The elasticity of the firm’s demand curve is greater than the elasticity of market demand because it is easier for consumers to switch to another firm’s highly substitutable product than to switch consumption to an entirely different product. Profit in the short run induces other firms to enter; as firms enter the incumbent firm’s demand and marginal revenue curves shift inward, reducing the profit-maximizing quantity. Eventually, profits fall to zero, leaving no incentive for more firms to enter.

3. Some experts have argued that too many brands of breakfast cereal are on the market. Give an argument to support this view. Give an argument against it.

Pro: Too many brands of any single product signals excess capacity, implying an output level smaller than one that would minimize average cost.

Con: Consumers value the freedom to choose among a wide variety of competing products.

(Note: In 1972 the Federal Trade Commission filed suit against Kellogg, General Mills, and General Foods. It charged that these firms attempted to suppress entry into the cereal market by introducing 150 heavily advertised brands between 1950 and 1970, crowding competitors off grocers’ shelves. This case was eventually dismissed in 1982.)

4. Why is the Cournot equilibrium stable (i.e., why don’t firms have any incentive to change their output levels once in equilibrium)? Even if they can’t collude, why don’t firms set their outputs at the joint profit-maximizing levels (i.e., the levels they would have chosen had they colluded)?

A Cournot equilibrium is stable because each firm is producing the amount that maximizes its profits, given what its competitors are producing. If all firms behave this way, no firm has an incentive to change its output. Without collusion, firms find it difficult to agree tacitly to reduce output. Once one firm reduces its output, other firms have an incentive to increase output and increase profits at the expense of the firm that is limiting its sales.

5. In the Stackelberg model, the firm that sets output first has an advantage. Explain why.

The Stackelberg leader gains the advantage because the second firm must accept the leader’s large output as given and produce a smaller output for itself. If the second firm decided to produce a larger quantity, this would reduce price and profit. The first firm knows that the second firm will have no choice but to produce a smaller output in order to maximize profit, and thus, the first firm is able to capture a larger share of industry profits.

6. Explain the meaning of a Nash equilibrium when firms are competing with respect to price. Why is the equilibrium stable? Why don’t the firms...
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