Microeconomics guide, Unit 4, step 18 of 28Previous step Next step

Step 18: Monopolistic Competition and Oligopoly

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Micro 4.4–4.5 · Cambridge 7.6 · IB 2.11 (HL)

In 30 seconds

Most real markets sit between perfect competition and monopoly. Monopolistic competition means many firms selling slightly different products. Oligopoly means a few big firms that watch each other closely.
Both structures maximise profit where $ MC = MR $. Profit is $ (P – ATC) \times Q $.
In monopolistic competition, free entry pushes long-run profit to zero: the demand curve is tangent to ATC, leaving excess capacity and $ P > MC $.
In oligopoly, interdependence is the key idea. The kinked demand curve explains sticky prices, and the prisoner’s dilemma explains why cartels break down.

Video lesson coming soonA short animated lesson for this step will appear here.

Monopolistic competition: many firms, different products

Think about the cafés near your school. There are lots of them, and anyone with some savings can open one. But they differ: better coffee, faster Wi-Fi, closer to the bus stop. If your favourite café raises the price of a latte slightly, you might stay loyal, but some customers will switch to the café across the road.

That is monopolistic competition: many firms and free entry, as in perfect competition, but each firm sells a slightly different product and so faces a downward-sloping demand curve, like a “mini-monopolist”.

Key termMonopolistic competition: a market structure with many sellers, differentiated products, free entry and exit, and a small amount of market power.

Key termProduct differentiation: making your product different from rivals’ through quality, features, branding, location or service. It is the source of market power in monopolistic competition.

The four characteristics to learn are:

Many firms. Each is too small to affect the whole market.
Differentiated products. Each product is a bit different, which gives each firm a little pricing power.
Free entry and exit. If profits are high, new cafés, shops or apps appear.
Some market power. Demand slopes down, but it is fairly elastic (price-sensitive) because close substitutes exist.

Short run versus long run

In the short run, the firm acts like a monopolist on its own small patch of the market. It produces where marginal cost (MC) equals marginal revenue (MR), then reads the price off its demand curve. If price is above average total cost (ATC, cost per unit), it makes economic profit.

\[ \text{Profit} = (P – ATC) \times Q \]

Worked example

A new bubble-tea shop sets output where $ MC = MR $. It sells 400 drinks a week at a price of $6. Its average total cost at that output is $4.50. What is its weekly economic profit?

Step 1$ P – ATC = 6 – 4.50 = 1.50 $ profit per drink

Step 2$ \text{Profit} = 1.50 \times 400 $

Step 3$ \text{Profit} = \$600 $ per week

The shop earns $600 a week, and that profit signals others to open bubble-tea shops nearby.

So short-run profit does not last. New firms enter, each taking some customers, so each firm’s demand curve shifts left and becomes more elastic (more substitutes). Entry continues until economic profit is zero: $ P = ATC $.

Key termTangency condition: in long-run equilibrium, the demand curve just touches (is tangent to) the ATC curve, so $ P = ATC $ and profit is zero.

The twist: because demand slopes down, it touches the U-shaped ATC curve on its falling part, to the left of the lowest point. So output is below the level with the lowest cost per unit.

Key termExcess capacity: the gap between the firm’s actual output and the output that would minimise ATC. It is the “price” society pays for product variety.

Worked example

A restaurant in long-run equilibrium has $ P = \$15 $, $ ATC = \$15 $, $ MC = \$10 $ and serves $ Q = 200 $ meals. Its ATC would reach its minimum of $12 at $ Q = 350 $. Find its profit and excess capacity, and check allocative efficiency.

Step 1$ \text{Profit} = (15 – 15) \times 200 = \$0 $

Step 2$ \text{Excess capacity} = 350 – 200 = 150 \text{ meals} $

Step 3$ P = 15 > MC = 10 $, so not allocatively efficient

Profit is zero, as long-run theory predicts. The restaurant could serve 150 more meals at a lower cost per meal but cannot sell them at the current price, and since $ P > MC $, society would value more output.

Exam tipOn a long-run diagram, demand must be tangent to ATC, not crossing it (crossing means profit or loss remains). Mark the tangency left of minimum ATC to show excess capacity.

Is monopolistic competition inefficient?

By the textbook measures, yes, in two ways:

Allocatively inefficient: $ P > MC $, so consumers value the last unit more than it costs to make.
Productively inefficient: the firm is not at minimum ATC (excess capacity).

But it gives you something perfect competition cannot: variety. A city with 200 identical restaurants might be “efficient”, but a city with Thai, Italian, Mexican, vegan and fast-food places gives you real choice. Most economists argue that the small efficiency loss is a cost worth paying for that variety.

	Perfect competition (long run)	Monopolistic competition (long run)
Economic profit	Zero	Zero
Demand curve	Horizontal	Downward-sloping, tangent to ATC
Output	At minimum ATC	Left of minimum ATC (excess capacity)
P and MC	$ P = MC $	$ P > MC $
Variety	None (identical products)	Lots

Oligopoly: a few big firms that watch each other

Now picture the cola market. Coca-Cola and PepsiCo dominate, and when one launches a promotion the other responds within days. Neither decides anything without asking, “What will my rival do?”

Key termOligopoly: a market dominated by a few large firms whose decisions are strategically interdependent. Products can be identical (oil, steel) or differentiated (cars, smartphones).

Key termInterdependence: each firm’s best strategy depends on what its rivals do. This is the defining feature of oligopoly.

Other examples include aircraft (Boeing and Airbus, a duopoly), smartphones and cloud computing. Oligopolies survive because of high barriers to entry: huge economies of scale, brand loyalty built by advertising, patents, control of supply chains and government licences.

Dominance is measured by the concentration ratio: the share of total market sales made by the largest firms. A 4-firm ratio above 60% usually signals an oligopoly; a car industry at 78% qualifies, while restaurants at around 12% fit monopolistic competition.

Sticky prices: the kinked demand curve

Oligopoly prices tend to stay the same for long periods. The kinked demand curve model (Sweezy, 1939) explains why, using two assumptions about how rivals react:

If a firm raises its price, rivals do not follow. They keep their lower prices and steal its customers. So demand above the current price is elastic: a small price rise loses many sales.
If a firm cuts its price, rivals do follow. They match the cut so they do not lose customers. So demand below the current price is inelastic: a price cut wins very few extra sales.

The demand curve therefore has a kink at the current price, and the MR curve has a vertical gap beneath it. Neither raising nor cutting the price helps, so the firm leaves price where it is. Firms compete instead through non-price competition: advertising, branding, new products, service and exclusive deals. Coke Zero and Pepsi Max are classic examples.

Common mistakeSaying the kinked demand curve explains how the oligopoly price is set. It does not. It only explains why the price, once reached, tends to stay put. Strong essay answers point out this limitation.

Collusion, cartels and the prisoner’s dilemma

Oligopolists are tempted to collude: agree to cut output and raise prices together, acting like one monopoly. A formal agreement is a cartel; OPEC is the best known. Price-fixing is illegal in most countries, but profitable, so the temptation remains.

Key termCartel: a formal agreement among firms to co-ordinate prices and output. Tacit collusion is co-ordination without any explicit agreement, often through price leadership.

The problem: every member is tempted to cheat by secretly producing more than agreed. The prisoner’s dilemma captures this: both do well if both co-operate, but each does even better by cheating while the other sticks to the deal.

Worked example

Two firms, A and B, each choose a High or Low price. Profits ($ millions) are: both High: 10 each. A High, B Low: A 2, B 15. A Low, B High: A 15, B 2. Both Low: 5 each. What will happen?

Step 1If B plays High, A compares $ 15 \text{ (Low)} > 10 \text{ (High)} $: A picks Low

Step 2If B plays Low, A compares $ 5 \text{ (Low)} > 2 \text{ (High)} $: A picks Low

Step 3Low is best for A whatever B does; by symmetry the same holds for B, so the outcome is (Low, Low) = ($5M, $5M)

Both would earn $10M by agreeing on High, but each is tempted to switch to Low and grab $15M. Neither trusts the other, so both end up with $5M. That is why cartels tend to collapse, and why OPEC members often exceed their quotas.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. List the four characteristics of monopolistic competition and give one example of such a market. Show worked answer

1. Many firms. 2. Differentiated products. 3. Free entry and exit. 4. Some market power (downward-sloping but fairly elastic demand).
Example: the restaurant industry in a large city (also clothing brands, hair salons, apps).

EasyQ2. The five largest supermarkets have market shares of 25%, 18%, 14%, 10% and 6%. Calculate the 4-firm concentration ratio. Show worked answer

Use only the four largest firms: $ CR_4 = 25 + 18 + 14 + 10 = 67\% $.
The fifth firm (6%) is not included. Since 67% is above 60%, the market is likely an oligopoly.

MediumQ3. A clothing boutique sells 250 jackets a month at $80 each. Its ATC is $68. Calculate its economic profit and explain what will happen in the long run. Show worked answer

Profit per jacket: $ 80 – 68 = \$12 $.
Total profit: $ 12 \times 250 = \$3{,}000 $ per month.
Long run: the profit attracts new boutiques. Each existing firm’s demand curve shifts left and becomes more elastic until $ P = ATC $ and economic profit is zero (demand tangent to ATC).

MediumQ4. Explain why a monopolistically competitive firm has excess capacity in the long run, but a perfectly competitive firm does not. Show worked answer

In perfect competition, demand is horizontal, so it touches ATC exactly at its minimum point: the firm produces at the lowest cost.
In monopolistic competition, demand slopes down, so the tangency with ATC happens to the left of minimum ATC.
The firm could cut its ATC by producing more, but it cannot sell more at the current price. The gap between actual output and minimum-ATC output is excess capacity, the cost of product variety.

MediumQ5. Using the kinked demand curve, explain why an oligopolist might keep its price unchanged even when its marginal cost rises a little. Show worked answer

Above the current price, demand is elastic (rivals will not follow a rise). Below it, demand is inelastic (rivals match cuts).
This creates a vertical gap (discontinuity) in the MR curve at the current output.
If MC rises but still passes through that gap, $ MC = MR $ still occurs at the same output and price, so the firm has no reason to change its price. Prices are “sticky”.

ExamQ6. A firm in monopolistic competition has $ P = \$20 $, $ ATC = \$20 $, $ MC = \$14 $, $ Q = 300 $, and minimum ATC of $16 at $ Q = 420 $. (a) Is this short-run or long-run equilibrium? (b) Calculate economic profit. (c) Calculate excess capacity. (d) Is the firm allocatively efficient? [5 marks] Show worked answer

(a) Long-run equilibrium, because $ P = ATC = \$20 $, so economic profit is zero. [1]
(b) $ (20 – 20) \times 300 = \$0 $. [1]
(c) $ 420 – 300 = 120 $ units of excess capacity. [1]
(d) No. $ P = \$20 > MC = \$14 $. [1] Consumers value the last unit at more than it costs to make, so society would gain from more output; the firm’s downward-sloping demand stops it selling more at the current price. [1]

Check yourself

1. In long-run equilibrium, a monopolistically competitive firm:

Free entry shifts each firm’s demand left until it is tangent to ATC, so P = ATC and profit is zero.

2. The feature that sets oligopoly apart from all other market structures is:

With only a few big firms, each one’s best decision depends on how rivals will react.

3. In a prisoner’s dilemma between two oligopolists, the Nash equilibrium is usually:

Defecting is each firm’s best move whatever the other does, so both defect, even though both would gain from co-operating.

Your score: 0 out of 3

The short version

Monopolistic competition: many firms, differentiated products, free entry, some market power. Short-run profit is possible where $ MC = MR $ and $ P > ATC $.
In the long run, entry drives profit to zero: demand is tangent to ATC, with excess capacity and $ P > MC $. The trade-off is product variety.
Oligopoly: a few dominant firms, high barriers to entry and interdependence. A 4-firm concentration ratio above 60% usually signals oligopoly.
The kinked demand curve explains sticky prices (rivals match cuts, not rises), so firms rely on non-price competition.
Collusion pays, but the prisoner’s dilemma tempts each member to cheat, so cartels tend to break down. The full chapter in Economics Made Simple has 15 exam-style questions with complete answers.

Step 18: Monopolistic Competition and Oligopoly

Monopolistic competition: many firms, different products

Short run versus long run

Is monopolistic competition inefficient?

Oligopoly: a few big firms that watch each other

Sticky prices: the kinked demand curve

Collusion, cartels and the prisoner’s dilemma

Practise: 6 questions

Check yourself

The short version

Further reading on EconTutorials

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