Unit 5: Monopoly and Oligopoly

Up to this point, we have analyzed the operation of firms in a perfectly competitive market. However, there are many markets that are not competitive: either there is only one firm operating (a monopoly), or a small number of firms are present (an oligopoly). Firm behavior in the context of a monopoly or an oligopoly can be very different. In this unit, you will learn how to model the decisions made by firm in a monopoly and an oligopoly, and the implications of these alternate structures for consumer welfare.

Monopoly I

Image courtesy of William Boncher on Flickr.

Monopoly II

Image courtesy of John Taylor on Flickr.

Oligopoly I

Image courtesy of Sheep purple on Flickr.

Oligopoly II

Image courtesy of ElCapitan on Flickr.

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Session Overview

In the previous lectures, we began to learn about firms’ decisions in a competitive market where there are a large number of firms. However, different markets have different characteristics, and in some markets there may be only one or a few firms. In this lecture, we begin to learn about the operations of a monopoly market, where only one firm is producing a given good.

The game Monopoly is named after the economic concept, in which one firm dominates an entire market. Image courtesy of William Boncher on Flickr.

Keywords: Monopoly; marginal revenue; marginal cost; profit maximization; shutdown rule; market power; price discrimination.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 10, “Monopoly.”
[Perloff] Chapter 11, “Monopoly.” (optional)

Lecture Videos

View video page

Resources

Graphs and Figures (PDF)

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

What is the key defining feature of a monopoly?

All of these. check

Firms are price makers, not price takers. close

The demand curve is downward-sloping rather than horizontal. close

The market has only one firm. close

All three definitions are synonymous: monopolies are characterized by the presence of a single firm. This firm is then a price maker, rather than a price taker, and it faces a downward-sloping demand curve.

Question 2

What point defines the optimal quantity produced for a monopolist?

Marginal cost equal to marginal revenue. check

Marginal cost equal to price. close

None of these. close

Tangency of the isoquant and the isocost curve. close

The correct answer is that the optimal quantity produced for a monopolist is defined at the point where the marginal cost is equal to the marginal revenue. It is not the case that the marginal cost is equal to the price. This is accurate in a competitive market, where marginal revenue and price are equivalent, but not in a monopoly. The point of tangency between an isoquant and an isocost curve defines the optimal mix of inputs for a firm given a level of production (i.e., it solves the cost minimization problem), but it does not solve the problem of determining the optimal production level.

Question 3

In general, the mark-up charged by monopolists is higher when which of the following properties holds?

Demand for the good is highly elastic. close

Demand for the good is highly inelastic. check

The price is lower. close

There are close substitutes for the good produced by the monopolist. close

The correct answer is that the mark-up charged by monopolists is higher when demand for the good is highly inelastic. In this case, the monopolist can raise the price of the good considerably without losing many sales (think, for example, of a good such as a pharmaceutical drug for which there are few substitutes). Highly elastic demand for the good and the existence of close substitutes for the good are equivalent concepts. In this case, consumers will switch to another good when the monopolist attempts to raise the price (i.e., they will buy oranges instead of apples). The mark-up does not directly vary with the price level.

Question 4

If monopolists can perfectly price discriminate, what quantity is maximized?

Consumer surplus. close

Producer surplus. close

Social welfare and producer surplus. check

Social welfare. close

When monopolists can perfectly price discriminate, price and quantity sold are equal to the competitive market level (i.e., they are maximized). However, the entire surplus accrues to producers as producer surplus, while consumers have zero surplus.

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Session Overview

The analytical picture of monopolies presented in our last lecture may be too simple. Monopolies may not always charge the same price to every customer – they can choose to charge different prices, a phenomenon known as price discrimination. Monopolies are regulated by governments to limit their market power, yet in some cases governments may encourage the operation of monopolies. These cases are discussed in greater detail in this lecture.

The U.S. Department of Justice enforces antitrust laws. Image courtesy of John Taylor on Flickr.

Keywords: Monopoly; price discrimination; natural monopolies; price regulation; antitrust policy; mergers; contestable markets.

Session Activities

Readings

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Recitation: Price Ceilings and Price Floors (PDF)

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 10, “Monopoly.”
[R&T] Chapter 16, “Antitrust Policy and Business Regulation.”
[Perloff] Chapter 11, “Monopoly.” (optional)

Lecture Videos

View video page

Resources

Graphs and Figures (PDF)

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

Which of the following descriptions corresponds to a natural monopoly?

A firm for which average cost is declining everywhere in the relevant range. close

A firm that can produce at lower average cost than any other firm for all relevant quantities. close

A firm with extremely large fixed costs and tiny marginal costs. close

All of these. check

These descriptions are synonymous and all describe a firm that is likely to be a natural monopoly: firms such as utilities or large extraction industries in which the fixed costs far outweigh the marginal costs.

Question 2

What is an example of a firm using signals from consumers to gauge their willingness to pay and thus price discrimination?

Firms choosing to advertise in particular magazines. close

Firms choosing to be more capital-intensive or more labor-intensive. close

Firms offering a discount for senior citizens or students. check

Firms setting price equal to marginal cost. close

Given that senior citizens and students generally have lower disposable income, firms can offer them a discount and thus induce them to purchase a product without losing revenue on higher-income customers (who still pay full price). Firms set price equal to marginal cost if they operate in a competitive market, and will choose to be more capital- or labor-intensive based on the ratio of input prices. Advertising decisions are also irrelevant to price discrimination.

Question 3

What is the potential advantage of a patent system?

It drives the price of the good produced to the competitive market equilibrium. close

It eliminates a monopoly. close

It encourages innovation. check

It raises the level of output of the good. close

The correct answer is that a patent system encourages innovation, by increasing the profits available in the development of a new product. It does not drive the price to the competitive equilibrium, raise the level of output, or eliminate a monopoly. Instead, patent protection creates an artificial monopoly for the life of the patent.

Question 4

What is the main challenge in implementing a regulatory system that caps the monopoly price at the competitive market price?

Firms may cheat. close

It is challenging to accurately estimate what the competitive market price is. check

Some sales are not observed. close

The monopoly will resist the imposition of any price control. close

The correct answer is that it is challenging to accurately estimate what the competitive market price is. This would require accurately estimating the shape of both the supply and demand curves. The other problems mentioned may also be factors, but they are generally less important.

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Session Overview

We have already learned about the operation of two very different types of markets: perfectly competitive markets and monopolists. However, most markets don’t fall into either category. For example, think of the market for soda - both Pepsi and Coke are major producers, and they dominate the market. This type of market structure is known as an oligopoly, and it is the subject of this lecture.
Learn about the prisoner’s dilemma in this lecture. Image courtesy of Sheep purple on Flickr.

Keywords: Oligopoly; cartel; game theory; Nash equilibrium; Cournot model; duopoly; non-cooperative competition.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 11, “The World of Imperfect Competition.”
[Perloff] Chapter 12, “Pricing and Advertising.” (optional)

Lecture Videos

Lecture 16: Oligopoly I

Resources

Graphs and Figures (PDF)

Further Study

These optional resources are provided for students that wish to explore this topic more fully.

CONTENT	PROVIDER	NOTES
14.12 Economic Applications of Game Theory, Fall 2005.	MIT OpenCourseWare	An in-depth course on game theory.

Session Overview

So far, we have only analyzed one type of oligopoly. However, even when there are a small number of firms in a market, they can behave in a variety of different ways. We can compare the outcomes from these different types of competition to the competitive market. In this lecture, we learn more about different models of oligopoly.

Bertrand price competition can be applied to pricing cereal. Image courtesy of ElCapitan on Flickr.

Keywords: Cournot competition; cooperative competition; cartels; mergers; Bertrand competition.

Session Activities

Readings

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Recitation: Government Policy (PDF)

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 11, “The World of Imperfect Competition.”
[Perloff] Chapter 12, “Pricing and Advertising.” (optional)

Lecture Videos

View video page
- Download video
- Download transcript

Resources

Graphs and Figures (PDF)

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

How does the non-cooperative Cournot equilibrium in an oligopoly compare to the equilibrium in a competitive market?

It depends on the shape of the demand curve. close

Less output, less profits. close

Less output, more profits. check

More output, more profits. close

The correct answer is that the non-cooperative Cournot equilibrium results in less output and more profits compared to the competitive equilibrium. Each firm in Cournot equilibrium has some market power, which it exploits to raise profits by lowering the amount of production (and thus raising prices).

Question 2

As the number of firms in a Cournot equilibrium increases, what happens to the mark-up charged by each firm?

It becomes equal to zero. close

It decreases. check

It increases. close

It remains the same. close

The correct answer is that the mark-up charged by each firm in a Cournot equilibrium decreases as the number of firms becomes larger. However, the mark-up will only be equal to zero if the market is perfectly competitive.

Question 3

In a perfectly competitive market, the price of a good is equal to the marginal cost of producing it. This is also true in another market structure; which one?

Bertrand competition in an oligopoly. check

Competition on quantity in an oligopoly. close

Cournot competition in an oligopoly. close

Monopoly. close

The correct answer is Bertrand competition in an oligopoly, or competition on price. Cournot competition is equivalent to competition on quantity, and it does not result in a price set equal to marginal cost. In a monopoly, marginal revenue is set equal to marginal cost.

Question 4

What is a strategy firms can use to avoid Bertrand competition?

Differentiate their product. check

Lower the price of their product. close

Produce more of their product. close

Raise the price of their product. close

The correct answer is that firms can differentiate their product to avoid Bertrand competition, thus enabling them to set a price that is above marginal cost. Shifting the price does not alter the competitive structure: the firm will still ultimately be required to set the price at marginal cost to remain in the market. In Bertrand competition, it is assumed that firms produce whatever quantity of the good is demanded by consumers, so producing more of the product is not an available option.

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Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

Problem Set and Solutions

Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problems 3 and 4 from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

« Previous | Next »

Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

Problem Set and Solutions

Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problem 2a-e from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

View video page
- Download video
- Download transcript

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