56. Product Development and Marketing
Innovation and Product Development
Monopolistically competitive firms compete through product development and marketing. New product development allows a firm to gain a temporary competitive edge and economic profit before competitors imitate the innovation.
Advertising
Advertising and packaging allow a firm to differentiate its product. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product.
Selling costs, such as advertising, are fixed costs that increase the ATC at any given level of output but do not affect the MC. Advertising efforts are successful if they increase demand, which can lead to increased profit. But if all firms advertise, more firms might survive and so the demand for any one firm is less than otherwise.
Heavy marketing and advertising expenditures are a signal to consumers of a high-quality product. A signal is an action taken by an informed person (or firm) to send a message to uninformed people.
Advertising and brand names might be efficient if they provide consumers with information about the precise nature of product differences and about product quality. So the final verdict about the efficiency of monopolistic competition is ambiguous.
57.What is Oligopoly?
The distinguishing features of an oligopoly are the presence of natural or legal barriers that prevent the entry of new firms and so only a small number of firms compete.
Barriers to Entry and Small Number of Firms
A natural oligopoly market occurs when the efficient scale of production allows only a few firms to meet the market demand. A duopoly is an oligopoly market with two firms.
Because there are a small number of firms, the firms in an oligopoly market are interdependent—each firm’s profit depends on its actions and the actions of its competitors. The firms have a temptation to form a cartel, which is a group of firms acting together—colluding—to limit output, raise price, and increase economic profit. Such collusion is illegal in the United States but it still occurs.
Examples of Oligopoly
Examples of oligopoly include cigarettes, batteries, and automobiles.
58.Two Traditional Oligopoly Models
Kinked Demand Curve Model
The figure illustrates the kinked demand curve model. The demand curve is kinked at the current price and quantity. Demand is relatively elastic above the kink because the firm assumes that if it raises its price, no other firm will change its price. Demand is relatively inelastic below the kink because the firm assumes that if it lowers its price, all the other firms will lower their prices. The kink creates a break in the marginal revenue curve.
Small changes in marginal cost lead to no changes in the price and quantity. But large changes lead all firms to change their prices and quantities, at which point the initial firm realizes its initial beliefs were incorrect.
Dominant Firm Model
There is one large firm producing a large part of the industry output because it has a cost advantage over the other, smaller firms. The small firms act as perfect competitors, taking as given the market price set by the dominant firm. The large firm operates as a monopoly, using as its demand the excess demand not met by the smaller firms.