Unit 4: Imperfect Competition

Monopoly

Characteristics of Monopoly

• A monopoly exists when a single firm dominates the entire market for a good or service, producing a product with no close substitutes. Because the firm is the sole producer, it faces the entire market demand curve directly, unlike firms in perfect competition. This gives it price-making power — the ability to influence the market price by choosing how much output to supply. Barriers to entry protect the monopolist from competition, allowing it to maintain market dominance. These barriers may be natural, legal, or strategic.
• Common examples include utility companies (like electricity or water), patented pharmaceutical drugs, or companies that control unique resources. In all cases, the absence of competition allows the firm to set prices above marginal cost, leading to higher profits. However, this also reduces consumer welfare and creates inefficiencies compared to competitive markets. On exams, always list and explain at least three characteristics to show mastery.

Sources of Market Power

• Monopolies arise because of high barriers to entry that prevent rival firms from entering the market. One source is control over key resources, such as De Beers historically controlling most diamond mines. Another is government regulation through patents, copyrights, and licenses, which legally grant exclusive production rights. These legal barriers are intended to encourage innovation but also create temporary monopolies.
• Natural monopolies occur when economies of scale are so significant that a single firm can produce at lower average costs than multiple smaller firms. For instance, building multiple water distribution systems in one city would be wasteful, so one firm provides the service. Network effects are another source, where a product’s value increases as more people use it (e.g., social media platforms). All these factors sustain monopoly power and reduce competition.

Profit Maximization in Monopoly

• Like all firms, monopolists maximize profit by producing where marginal revenue (MR) equals marginal cost (MC). However, because the monopolist faces the downward-sloping demand curve, MR is less than price. After determining Q_MR=MC, the monopolist charges the highest price consumers are willing to pay for that quantity from the demand curve. This means monopoly price (P_m) is greater than marginal cost (MC), unlike in perfect competition.
• This outcome creates both higher prices and lower output compared to competitive markets. Consumers face restricted choices and pay more, while producers earn greater profits. Graphically, you will always see the MR curve lying below the demand curve, and the profit area is the rectangle between P and ATC at the monopoly quantity. On AP exams, always demonstrate this by shading and labeling profit, consumer surplus, and deadweight loss areas.

Price Discrimination

• Price discrimination occurs when a monopolist charges different consumers different prices for the same product, not based on cost differences but on willingness to pay. First-degree (perfect) price discrimination charges each buyer their maximum willingness to pay, eliminating consumer surplus entirely. Second-degree charges different prices depending on the quantity consumed, like bulk discounts. Third-degree charges different groups different prices, such as student or senior discounts.
• Price discrimination increases producer surplus and can, in some cases, reduce or eliminate deadweight loss. By tailoring prices, the monopolist serves more of the market than it could at a single uniform price. While controversial, it often allows consumers who could not afford the uniform price to access goods. On exams, always link price discrimination to the goal of capturing consumer surplus and increasing efficiency compared to a single-price monopoly.

Inefficiency and Deadweight Loss

• Unlike perfectly competitive markets, monopolies fail to achieve allocative efficiency because P > MC at the monopoly output. This means society values the last unit produced more than it costs to produce, but the monopolist restricts output to maximize profit. They also fail to achieve productive efficiency because they do not produce at the minimum point of ATC. These inefficiencies lead to welfare losses in society.
• The deadweight loss (DWL) from monopoly is the lost total surplus that results from reduced output. It appears on graphs as the triangle between the demand curve and the MC curve over the range between monopoly output and competitive output. This DWL represents mutually beneficial trades that would occur in competition but do not under monopoly. Always shade and label this triangle on diagrams for full credit on exam questions.

Monopolistic Competition

Characteristics of Monopolistic Competition

• Monopolistic competition describes a market structure with many small firms, free entry and exit in the long run, and differentiated products. Unlike perfect competition, each firm’s product is slightly different through branding, quality, or features. Because of differentiation, firms face downward-sloping demand curves rather than perfectly elastic ones. This gives them limited market power, but not as much as a monopoly.
• Examples include restaurants, clothing brands, and consumer goods like toothpaste or cereal. Each firm’s product is unique enough that it is not a perfect substitute, but many close substitutes exist. This balance explains why monopolistic competition combines elements of competition (many firms, entry/exit) and monopoly (some pricing power). On AP exams, listing both similarities and differences is crucial.

Short-Run Equilibrium

• In the short run, firms behave much like monopolists: they maximize profit where MR = MC and charge the highest price consumers are willing to pay at that output. If P > ATC, they earn positive economic profit. If P = ATC, they earn normal profit. If P < ATC but ≥ AVC, they incur a loss but continue to operate. These outcomes mirror the profit/loss rules learned earlier.
• Graphically, you will see the firm’s demand curve (downward-sloping), MR below demand, and cost curves determining profit or loss. Shaded rectangles show profit or loss, while the equilibrium output is always where MR = MC. Remember that in monopolistic competition, even though firms are small, they can still exercise some pricing power due to product differentiation.

Long-Run Equilibrium

• In the long run, free entry and exit eliminate positive or negative economic profits. If firms earn profit, new competitors enter with similar products, shifting each firm’s demand curve leftward until P = ATC. If firms earn losses, some exit, shifting demand for the remaining firms rightward until they break even. In equilibrium, firms earn only normal profit, just like in perfect competition.
• However, unlike perfect competition, long-run equilibrium in monopolistic competition occurs where P = ATC > MC. This means firms produce at a price above marginal cost and with some excess capacity. As a result, the industry is not allocatively efficient (P ≠ MC) and not productively efficient (not at minimum ATC). The trade-off is that consumers gain variety, which is valuable but hard to measure in efficiency terms.

Excess Capacity and Inefficiency

• Excess capacity occurs because firms produce on the downward-sloping portion of the ATC curve, not at its minimum point. This means they could produce more at a lower average cost but do not because it would require lowering price too much. Firms sacrifice efficiency for the ability to maintain some market power. This is the main inefficiency of monopolistic competition.
• Despite inefficiencies, product differentiation creates consumer benefits. Variety in clothing, food, or technology provides utility beyond what a perfectly competitive, standardized product market could. This variety is why monopolistic competition is common in real life, even though it is less efficient on paper. On exams, always mention the trade-off between efficiency and variety.

Product Differentiation and Non-Price Competition

• Firms in monopolistic competition compete not just through price but through product differentiation. This includes differences in branding, advertising, packaging, service, quality, or product features. For example, fast food chains sell similar items but use advertising and brand identity to create loyalty. This makes demand less elastic than in perfect competition.
• Non-price competition is costly — advertising and product development increase expenses, which may shift cost curves upward. However, it allows firms to maintain market power even in the face of competition. This explains why firms like Nike or Coca-Cola spend heavily on marketing: the goal is not lower costs but stronger brand-based demand. Linking this concept to elasticity strengthens exam answers.

Oligopoly

Characteristics of Oligopoly

• An oligopoly is a market structure dominated by a few large firms that together control most of the market share. Because there are only a handful of significant players, each firm’s decisions about price and output affect competitors directly. This interdependence makes oligopoly behavior more complex than in monopoly or monopolistic competition. Industries such as airlines, cell phone providers, and automobile manufacturers are common examples.
• Barriers to entry are typically high, often due to economies of scale, control of resources, or strong brand loyalty. These barriers keep new firms from entering easily, allowing existing firms to sustain market power. Products may be standardized (like steel) or differentiated (like smartphones). The mix of few firms, barriers, and interdependence defines oligopoly as a unique market structure.

Interdependence and Game Theory

• Because firms in oligopoly are few, each must consider the potential reactions of rivals when making decisions. This interdependence is often analyzed using game theory, which studies strategic interactions. A firm’s optimal decision depends on what it expects its competitors to do, creating incentives to anticipate and respond to rivals’ strategies.
• The classic example is the prisoner’s dilemma: while collusion (cooperation) would yield the best joint outcome, self-interest leads firms to “cheat,” producing more than agreed to capture higher profits. The result is that all firms end up worse off than if they had cooperated. This dynamic helps explain why cartels are unstable even when legal barriers do not exist.

Collusion and Cartels

• Collusion occurs when firms coordinate pricing and output to behave collectively like a monopoly. The most formal type is a cartel, where firms sign agreements to restrict output and raise prices. OPEC (Organization of the Petroleum Exporting Countries) is the classic real-world example, though even it struggles to enforce quotas because members have incentives to cheat.
• Collusion increases producer profits but reduces consumer surplus and overall efficiency, creating deadweight loss similar to monopoly. In most countries, explicit collusion and cartels are illegal under antitrust laws. However, tacit collusion — when firms follow each other’s pricing without explicit agreements — is harder to regulate and often occurs in oligopolistic markets.

Price Leadership

• Price leadership is a form of tacit collusion in which one dominant firm sets a price and the others follow. This strategy avoids direct competition and reduces uncertainty. For example, in airline industries, one major carrier may announce fare changes, and competitors quickly match them.
• While not a formal cartel, price leadership creates similar outcomes: higher prices and reduced consumer surplus. It allows firms to avoid destructive price wars without the risks of explicit collusion. Recognizing this strategy helps explain why oligopoly prices tend to be rigid over time.

The Kinked Demand Curve Model

• The kinked demand curve is a theory that explains why prices in oligopoly are relatively stable. If a firm raises its price, rivals may not follow, causing the firm to lose many customers (demand is elastic above the kink). If a firm lowers its price, rivals match the cut, leading to only small gains in customers (demand is inelastic below the kink). This asymmetry creates a “kink” in the demand curve at the current market price.
• The result is a discontinuous MR curve, making firms reluctant to change prices because doing so risks either losing too many customers or sparking a price war. This explains why gas prices, airline fares, or phone plan rates often remain steady for long periods, despite cost fluctuations. The model emphasizes interdependence without requiring formal collusion.

Efficiency and Welfare Outcomes

• Like monopoly, oligopoly markets are generally inefficient compared to perfect competition. Prices tend to be higher, output lower, and deadweight loss exists. Firms may not produce at minimum ATC, so productive efficiency is not achieved. Allocative efficiency also fails since P > MC.
• However, product differentiation and innovation can be benefits of oligopoly. Because firms earn economic profits, they may invest heavily in research, development, and marketing. Many technological advances come from oligopolistic industries such as electronics or automobiles. This trade-off highlights both the drawbacks and potential advantages of oligopoly.

Game Theory in Oligopoly

Basics of Game Theory

• Game theory is the study of strategic interactions where the outcome for each player depends on the actions of all participants. In oligopoly, firms must anticipate competitors’ reactions when setting prices, outputs, or marketing strategies. Unlike perfect competition or monopoly, decisions are interdependent, meaning one firm’s best move depends on what rivals choose. This framework helps explain why oligopolies often avoid aggressive competition and sometimes engage in tacit or explicit collusion.
• Games are often represented with payoff matrices, which show the profits (payoffs) each firm receives depending on their combined choices. Each firm tries to maximize its own payoff, but because actions are linked, the best individual choice may not lead to the best overall outcome. This tension explains many real-world behaviors like price wars, advertising battles, or collusion attempts.

The Prisoner’s Dilemma and Oligopoly

• The prisoner’s dilemma is the most famous example of game theory and applies directly to oligopoly pricing. If both firms collude and restrict output, they can act like a monopoly and earn high profits. However, each firm has an incentive to cheat by producing more than agreed, because cheating increases individual profit — as long as the other firm sticks to the collusive plan. If both cheat, output rises, prices fall, and both earn lower profits than under cooperation.
• This dilemma shows why collusion and cartels are unstable in practice. Even when cooperation maximizes joint profit, the incentive to cheat is strong. The result is often a breakdown of collusion and a return to more competitive outcomes. OPEC’s history of oil production quotas illustrates this perfectly: members often agree on limits but secretly exceed them to gain extra revenue, undermining the cartel.

Dominant Strategies and Nash Equilibrium

• A dominant strategy is a strategy that gives a firm the best outcome regardless of what competitors do. In many oligopoly pricing games, the dominant strategy is to lower price, because undercutting rivals always increases market share. If both firms follow this logic, the result is a price war, driving profits down for everyone. This explains why oligopoly profits are often lower than expected despite barriers to entry.
• A Nash equilibrium occurs when no firm can improve its payoff by unilaterally changing its strategy, given what competitors are doing. In many oligopoly models, the Nash equilibrium leads to outcomes where firms compete rather than collude, even if cooperation would make them better off. The prisoner’s dilemma example shows a Nash equilibrium in which both cheat — it is stable but inefficient. Recognizing this concept is crucial for AP Micro FRQs.

Repeated Games and Cooperation

• When interactions are repeated over time, cooperation may become more stable. Firms may adopt “tit-for-tat” strategies: cooperating at first but punishing rivals if they cheat by lowering prices in return. This threat of retaliation can discourage cheating and sustain tacit collusion. Repeated games are more realistic for oligopolies, as firms often compete for years in the same markets.
• However, the stability of cooperation still depends on enforcement, transparency, and market conditions. If monitoring is difficult or demand fluctuates, cheating is harder to detect, making collusion fragile. On exams, be prepared to explain why collusion may succeed in some industries but not others (e.g., airlines struggle to collude due to fluctuating demand and frequent sales).

Real-World Applications

• Game theory explains price rigidity in oligopolies. Firms avoid price wars because they know rivals will retaliate, making everyone worse off. Instead, they may compete using advertising, branding, or product differentiation. This is why prices in industries like cell phone service or gasoline often remain steady despite cost changes — firms fear the consequences of changing prices.
• It also explains why cartels form and why they are unstable. Collusion maximizes profit, but incentives to cheat often lead to collapse. Regulatory bodies like the U.S. Department of Justice or the Federal Trade Commission monitor industries for collusive behavior because game theory shows the temptation to cheat is strong and harmful to consumers. Connecting these theoretical insights to policy analysis strengthens exam essays.