MONOPOLISTIC COMPETITION AND OLIGOPOLY
Practice Problems

Answer Key

1. Consider each of the following statements and tell whether they are TRUE or FALSE. Explain why.

Comparing monopoly to monopolistic competition, we can tell that…

a. …in both cases the firm is facing a downward sloping demand curve.

TRUE. Monopoly is the only firm in the market, hence the demand curve it faces is regularly shaped, i.e. downward sloping. In monopolistic competition, firms try to differentiate their products and by doing so gain some degree of market power, reflected in the ability in varying its price somewhat. Hence the demand curves for those firms will be downward sloping, too.

b. …in both cases the firm will earn economic profit in the long run.

FALSE. In monopoly, there are strong barriers to entry. Therefore the profit or loss a monopolist is facing in the short run will persist in the long run as well. And economic profit is not guaranteed. In monopolistic competition, nothing prevents firms from entering or leaving the market of interest. The incentives to do so will disappear only when economic profit in this market equals zero, which is the long-run equilibrium.

c. …allocation of resources in both market structures is inefficient.

TRUE. The long-run equilibrium in a monopolistically competitive market corresponds to the case when the demand curve each firm is facing is tangent to its ATC curve. Due to the negative slope of the demand curve, such tangency never occurs at the minimum of ATC. Hence allocation is inefficient. (It would be if the demand curve was horizontal.)
A monopolist is concerned only about profit maximization (MR=MC), and cost minimization is not necessary. The quantity where MR=MC can be anywhere on the ATC curve.

2. In the long run, firms in monopolistic competition
a. produce at the point where the average total cost curve is tangent to the demand curve.
b. earn positive economic profits.
c. produce at the minimum point of their average total cost curves.
d. face steeper demand curves than in the short run.
e. produce at a point where MC>MR.

3. What is the major difference between perfect competition and monopolistic competition? How does this difference explain the shape of the demand curve faced by firms in each of these two market structures?

Perfect competition and monopolistic competition have three common features. The only feature that they differ in is, in perfect competition goods produced by different firms are identical, whereas in monopolistic competition they are differentiated.
As a result, in perfect competition firms can compete only in price, and due to their small size firms are price takers - the demand curve each of them is facing is horizontal. In monopolistic competition, firms have some market power, since consumers pay attention to factors other than price as well. Each firm's demand curve is downward sloping.

4. Suppose there are five firms in the market for thingumabobs, each producing an equal share of the entire market output.
a. Calculate the four-firm concentration ratio for the thingumabob industry.

The presence of five firms of equal size means each of them has a 20% market share. Therefore any four of them will add to 80% of market output, so the four-firm concentration ratio is 80%.

b. Calculate the Herfindahl index for this industry.

HI = 20*20 + 20*20 + 20*20 + 20*20 + 20*20 = 2000

c. What market structure does this industry represent? Draw the demand curve each firm typically faces in this market structure and explain why the curve has this shape.

Since the four-firm concentration ratio is greater than 40%, this market is best described as oligopoly.
The demand curve of an oligopolistic firm is kinked at the price it charges at the current moment. The reason for the difference in the slope of the demand curve above and below the current price is the following:
When the firm raises its price, it makes the other firms in this market better off, since their sales increase. As a result, firms are unlikely to follow the price increase, and the firm of interest loses many costomers. The demand curve is relatively flat (elastic).
If the firm drops its price, it attracts consumers who used to by from its rivals. In order to avoid the loss in sales, the rival firms drop their price as well. As a result, the firms continue to split the market in about the same proportion as before the price cut, so the increase in quantity demanded for each firm will not be substantial. as a result, this part of the curve is relatively steep (inelastic).

5. Is it easier to collude in a monopolistically competitive industry or in an oligopolistic industry? Explain.

Usually, the fewer firms are trying to collude, the easier it is to come to an agreement and to monitor cheating. Since oligopoly market is more concentrated than monopolistically competitive market, it is easier to collude in oligopoly.

 

 


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