2. Profit Maximization in Monopolistic Competition

If the firm in an imperfectly competitive market has profit maximization as an objective, they will produce the output where marginal cost is equal to the marginal revenue. Short run profit maximization is shown in Figure 2.

In the long run, above normal profits will attract the entry of firms into monopolistic competition. Below normal profits will encourage firms to exit. As firms enter the market demand is split among a larger number of firms which will shift the demand for each firm to the left (decrease) and probably make it more inelastic. There are more substitutes. Exit of firms will shift the demand for each firm’s output to the right (increase). Entry to and exit from the industry occur until the profits for each firm are normal, i.e. the AR = AC. The results of long run equilibrium in a monopolistically competitive market are shown in Figure 3.

The logical result of profit maximizing monopolistically competitive markets is to encourage firms to build plants that are smaller than optimal, i.e. a larger plant can produce with fewer inputs per unit of output (or costs per unit of output). Further inefficiency is expected since the inefficient plant is operated at an output level that is less than the minimum point on the SRAC. This result is due to the fact that the MR must be lower than AR when AR is negatively sloped.

Therefore MR=MC at less than the price which lies on the demand (or AR) function. Since the demand is negatively sloped and AC is usually U-shaped, the point of tangency between AR and LRAC (normal profits) will lie to the left of the minimum cost per unit of output. This is sometimes called the “excess capacity theorem;” firms build plants that are too small and operate them at less than full capacity.

3. Oligopoly

An oligopoly is a market that is characterized by the interdependence of firms. The typical characteristics that constitute an oligopoly are:

1) A “few” firms; the concept of “few” means that there are few enough sellers that they recognize their interdependence.

2) The output may be homogeneous or differentiated. Primary metals industries are examples of oligopolies with homogeneous goods. Instant breakfast drink mixes are an example of an oligopoly with differentiated products.

3) In an oligopoly there are usually significant barriers to entry.

4) The outcomes that follow from the decisions of one firm are dependent on what the other firms do.

Augustin Cournot (1801-1877), a French mathematician/economist developed the theory of monopoly and then considered the effects of two interdependent competitors (sellers) in a duopoly. Cournot’s analysis of two sellers of spring water clearly established that the price and output of one seller was a reaction to the price and output of the other seller. If the two collude they can act as a single monopolist and divide monopoly profits.

Cournot’s recognition of the interdependence of sellers provided the foundation for a variety of approaches to explain the interdependent behavior of oligopolists. In the 1930’s the “kinked demand” model (published by Paul Sweezy in August 1939 and by R.L. Hall and C.J. Hitch in May 1939) and the “administered price hypothesis” (Gardner C. Means in 1935) were developed as an attempt to explain price rigidities in some markets during the great depression. In 1943 John von Neumann and Oskar Morgenstern published a path breaking work on game theory. Game theory has been used to try to explain the behavior of independent competitors. There have been a variety of other models that attempted to explain the interdependent behavior in oligopolies. The number of models is evidence that it is a difficult task and there are problems with most approaches. The kinked demand model is used here to emphasize the interdependence of oligopolistic behavior rather than to explain the determination of price.