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Imperfect Competition

Did it ever occur to you that the burgers at McDonald's are not exactly the same as the burgers at Burger King? Do you know why that is? And what does the market of fast-food chains have in common with the market of electricity or the global oil market? Do you want to learn more about imperfect competition and how most markets work in the real world? Read on to find out the difference between perfect and imperfect competition and more!

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Imperfect Competition

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Did it ever occur to you that the burgers at McDonald's are not exactly the same as the burgers at Burger King? Do you know why that is? And what does the market of fast-food chains have in common with the market of electricity or the global oil market? Do you want to learn more about imperfect competition and how most markets work in the real world? Read on to find out the difference between perfect and imperfect competition and more!

Difference between Perfect and Imperfect Competition

The best way to understand imperfect competition is to look at the differences between perfect and imperfect competition.

In a perfectly competitive market, we have many firms that are selling the same undifferentiated products - think about produce: you can find the same vegetables sold at different grocery stores. In such a perfectly competitive market, firms or individual producers are price takers. They can only charge a price that is the market price; if they charge a higher price, they will lose their customers to all the other firms selling the same products at the market price. In the long-run equilibrium, firms in perfectly competitive markets don't make economic profits after we account for the opportunity costs of not being able to use the resources for other purposes.

You might be wondering: how is it possible that firms operate with no economic profits in the long run? That is not really how things work in the real world, right? Well, you are certainly not wrong - many firms in the real world do manage to make a handsome profit, even after accounting for opportunity costs. That's because most of the markets that we have in the real world are not perfectly competitive markets. In fact, we rarely have perfect competition in reality, save for the produce markets.

For a refresher, read our explanation: Perfect Competition.

Imperfect Competition Definition

Here is the definition of imperfect competition.

Imperfect competition refers to market structures that are less competitive than perfect competition. These include monopolistic competition, oligopoly, and monopoly.

Figure 1 below shows the different kinds of market structures on a spectrum. They range from the most competitive to the least competitive from left to right. In perfect competition, there are many firms selling the same product; in monopolistic competition, there are many firms competing with differentiated products; an oligopoly has only a couple or a few firms; and in a monopoly, there's only one firm serving the entire market.

Imperfect Competition, The spectrum of market structures, StudySmarterFig. 1 - The spectrum of market structures

You bet we have an explanation on all these topics!

Check out:

  • Perfect Competition
  • Monopolistic Competition
  • Oligopoly
  • Monopoly

Imperfect Competition Characteristics

Imperfect competition has some peculiar characteristics which make it different from perfect competition. Let's consider some of them!

Imperfect Competition: Marginal Revenue Below Demand

A hallmark of an imperfectly competitive market is that the marginal revenue (MR) curve facing the firms lies below the demand curve, as Figure 2 shows below. There is a smaller number of competing firms under imperfect competition - in the case of monopolistic competition, there are many firms, but they are not perfect competitors due to product differentiation. Firms in these markets have some influence over the demand for their products, and they can charge a price that is higher than the marginal cost of production. In order to sell more units of the product, the firm must lower the price on all units - this is why the MR curve is below the demand curve.

Imperfect Competition Marginal revenue curve in imperfect competition StudySmarterFig. 2 - Marginal revenue curve in imperfect competition

On the other hand, there are many firms selling homogeneous products in a perfectly competitive market. These firms have no influence over the demand they face and have to take the market price as given. Any individual firm that operates in such a perfectly competitive market faces a flat demand curve because if it charges a higher price, it will lose all its demand to competitors. For an individual firm under perfect competition, its marginal revenue (MR) curve is the demand curve, as shown in Figure 3. The demand curve is also the firm's average revenue (AR) curve because it can only charge the same market price no matter the quantity.

Imperfect Competition Graph of individual firm perfectly competitive market StudySmarterFig. 3 - An individual firm in a perfectly competitive market

Imperfect Competition: Economic Profits in the Long Run

One important implication of imperfect competition has to do with firms' ability to make economic profits. Recall that in the case of a perfectly competitive market, firms have to take the market price as given. Firms in perfect competition do not have a choice because as soon as they charge a higher price, they will lose all their customers to their competitors. The market price in perfectly competitive markets is equal to the marginal cost of production. As a result, firms in perfectly competitive markets are only able to break even in the long run, after all costs (including opportunity costs) are taken into account.

On the other hand, firms in imperfectly competitive markets have at least some power in setting their prices. The nature of imperfectly competitive markets means that consumers can't find perfect substitutes for these firms' products. This allows these firms to charge a price that is higher than the marginal cost and to turn a profit.

Imperfect Competition: Market Failure

Imperfect competition leads to market failures. Why is that? This actually has to do with the marginal revenue (MR) curve being below the demand curve. In order to maximize profit or minimize loss, all firms produce to the point where marginal cost equals marginal revenue. From a societal perspective, the optimal output is the point where marginal cost equals demand. Since the MR curve is always below the demand curve in imperfectly competitive markets, the output is always lower than the socially optimal level.

In Figure 4 below, we have an example of an imperfectly competitive market. The imperfect competitor faces a marginal revenue curve that is below the demand curve. It produces up to the point where marginal revenue equals marginal cost, at point A. This corresponds to point B on the demand curve, so the imperfect competitor charges consumers at a price of Pi. In this market, the consumer surplus is area 2, and area 1 is the profit that goes to the firm.

Contrast this situation to a perfectly competitive market. The market price is equal to the marginal cost at Pc. All the firms in this perfectly competitive market will take this price as given and jointly produce a quantity of Qc at point C, where the market demand curve for the entire industry intersects with the marginal cost curve. The consumer surplus under perfect competition would be the combination of areas 1, 2, and 3. So, the imperfectly competitive market leads to a deadweight loss of the size of area 3 - this is the inefficiency caused by imperfect competition.

Imperfect Competition Imperfect competition with inefficiency graph StudySmarterFig. 4 - Imperfect competition with inefficiency

Imperfectly Competitive Market Types

There are three types of imperfectly competitive market structures:

  • monopolistic competition
  • oligopoly
  • monopoly

Let's go through these, one by one.

Imperfect Competition Examples: Monopolistic Competition

You may have noticed that the term "monopolistic competition" has both the words "monopoly" and "competition" in it. This is because this market structure has some characteristics of a perfectly competitive market and also some characteristics of a monopoly. Like in a perfectly competitive market, there are many firms because the barriers to entry are low. But unlike in perfect competition, the firms in monopolistic competition are not selling identical products. Instead, they sell somewhat differentiated products, which gives the firms some degree of monopoly power over the consumers.

Fast-food chains

Fast-food chain restaurants are a classic example of monopolistic competition. Think about it, you have many fast-food restaurants to choose from on the market: McDonald's, KFC, Burger King, Wendy's, Dairy Queen, and the list goes on even longer depending on what region you are in the US. Can you imagine a world with a fast-food monopoly where there's just McDonald's that sells burgers?

Imperfect Competition, A cheeseburger, StudySmarterFig. 5 - A cheeseburger

All these fast-food restaurants sell essentially the same thing: sandwiches and other usual American fast-food items. But also not exactly the same. The burgers at McDonald's are not the same as the ones sold at Wendy's, and Dairy Queen has ice creams that you can't find from the other brands. Why? Because these businesses deliberately make their products a little bit different - that's product differentiation. It's certainly not a monopoly because you have way more than one choice, but when you are craving that specific kind of burger or ice cream, you have to go to that one specific brand. Because of this, the restaurant brand has the power to charge you a little more than in a perfectly competitive market.

We certainly invite you to learn more on this topic here: Monopolistic Competition.

Imperfect Competition Examples: Oligopoly

In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. When there are only two firms in the market, it's a special case of oligopoly called duopoly. In an oligopoly, firms do compete with one another, but the competition is different from the cases of perfect competition and monopolistic competition. Because there are only a small number of firms in the market, what one firm does affects the other firms. In other words, there is an interdependent relationship between the firms in an oligopoly.

Imagine that there are only two firms selling the same potato chips at the same price on the market. It's a duopoly of chips. Naturally, each firm would want to capture more of the market so that they can earn more profits. One firm can try to take customers from the other firm by lowering the price of its potato chips. Once the first firm does this, the second firm would have to lower its price further to try to take back the customers that it has lost. Then the first firm would have to lower its price again... all this back and forth until the price reaches the marginal cost. They can't lower the price further at this point without losing money.

You see, if oligopolists are to compete without cooperation, they might reach a point where they operate just like firms in perfect competition - selling with a price equal to the marginal cost and making zero profits. They don't want to make zero profits, so there is a strong incentive for oligopolists to cooperate with each other. But in the U.S. and many other countries, it is illegal for firms to cooperate with each other and fix prices. This is done to ensure that there's healthy competition and to protect consumers.

OPEC

It's illegal for firms to cooperate and fix prices, but when the oligopolists are countries, they can do just that. The Organization of Petroleum Exporting Countries (OPEC) is a group made up of oil-producing countries. The explicit aim of OPEC is for its member countries to agree on how much oil they produce so that they can keep the oil price at a level that they like.

To learn more, click here: Oligopoly.

Imperfect Competition Examples: Monopoly

On the very far end of the market competitiveness spectrum lies a monopoly.

A monopoly is a market structure where one firm serves the entire market. It is the polar opposite of perfect competition.

A monopoly exists because it's very difficult for other firms to enter such a market. In other words, high barriers to entry exist in this market. There are a number of reasons for a monopoly to exist in a market. It can be the case that a firm controls the resource that is required to make the product; governments in many countries often grant permission for only one state-owned firm to operate in a market; intellectual property protections give firms a monopoly right as a reward for their innovation. Besides these reasons, sometimes, it is "natural" that there's only one firm operating in the market.

A natural monopoly is when the economies of scale make sense for just one firm to serve the entire market. Industries where natural monopolies exist usually have a large fixed cost.

Utilities as natural monopolies

Utility companies are common examples of natural monopolies. Take the electric grid for example. It would be very expensive for another company to come in and build all the electric grid infrastructure. This large fixed cost essentially prohibits other firms from entering the market and becoming a grid operator.

Imperfect Competition, Photograph of a power grid infrastructure at sunset, StudySmarterFig. 6 - Power grid infrastructure

What are you waiting for? To learn more, click on our explanation: Monopoly.

Imperfect Competition and Game Theory

The interaction between oligopolistic firms is like playing a game. When you are playing a game with other players, how well you do in that game depends not only on what you do but also on what the other players do. One of the uses of game theory for Economists is to help understand the interactions between firms in oligopolies.

Game theory is the study of how players act in situations where one player's course of action influences the other players and vice versa.

Economists often use a payoff matrix to show how players' actions lead to different outcomes. Let's use the example of the potato chips duopoly. There are two firms selling the same potato chips at the same price on the market. The firms face a decision of whether to keep their prices at the same level or to lower the price in order to try and take customers from the other firm. Table 1 below is the payoff matrix for these two firms.

Game theory payoff matrix
Firm 1
Keep price as before
Drop price
Firm 2
Keep price as before
Firm 1 makes the same profit
Firm 2 makes the same profit
Firm 1 makes more profit
Firm 2 loses its market share
Drop price
Firm 1 loses its market share
Firm 2 makes more profit
Firm 1 makes less profitFirm 2 makes less profit

Table 1. Game theory payoff matrix of the potato chips duopoly example - StudySmarter

If both firms decide to keep their prices as they are, the outcome is the top left quadrant: both firms make the same profits as before. If either firm drops the price, the other will follow suit to try to recapture the market share that they lose. This will continue until they reach a point where they can't drop the price any lower. The outcome is the bottom right quadrant: both firms still split the market but make less profit than before - in this case, zero profit.

In the potato chips duopoly example, there is a tendency for both firms to lower their prices in an attempt to capture the entire market in the absence of an enforceable agreement between the two duopolists. The likely outcome is the one shown in the bottom right quadrant of the payoff matrix. Both players are worse off than if they have just kept their prices as they were. This kind of situation where players tend to make a choice that leads to a worse outcome for all the players involved is called the prisoners' dilemma.

To learn more about this, read our explanations: Game Theory and Prisoners' Dilemma.

Imperfectly Competitive Factor Markets: Monopsony

The markets that we usually talk about are product markets: the markets for goods and services that consumers buy. But let's not forget there's also imperfect competition in the factor markets as well. Factor markets are markets for the factors of production: land, labor, and capital.

There is one form of imperfectly competitive factor market: Monopsony.

Monopsony is a market where there's only one buyer.

A classic example of a monopsony is a large employer in a small town. Since people can't seek work elsewhere, the employer has market power over the local labor market. Similar to an imperfectly competitive product market where firms have to lower prices in order to sell more units, the employer in this case has to raise the wage to hire more workers. Since the employer has to raise the wage for every worker, it faces a marginal factor cost (MFC) curve that is above the labor supply curve, as shown in Figure 7. This results in the firm hiring a fewer number of workers Qm at a lower wage Wm than in a competitive labor market, where the number of workers hired would be Qc, and the wage would be Wc.

Imperfect Competition Monopsony labor market graph StudySmarterFig. 7 - A monopsony in a labor market

To learn more, read our explanation: Monopsonistic Markets.

Imperfect Competition - Key takeaways

  • Imperfect competition is the market structures that are less competitive than perfect competition.
  • Different types of imperfectly competitive product markets include monopolistic competition, oligopoly, and monopoly.
  • In monopolistic competition, there are many firms selling differentiated products.
  • In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. A duopoly is a special case of oligopoly where there are two firms operating in the market.
  • In a monopoly, there is only one firm selling to the entire market because of high barriers to entry. There are different kinds of reasons for a monopoly to exist.
  • Economists use game theory to understand the interactions between firms in an oligopoly.
  • An imperfectly competitive factor market takes the form of a monopsony, where there's a single buyer in the market.

Frequently Asked Questions about Imperfect Competition

Imperfect competition describes any market structures that are less competitive than perfect competition. These include monopolistic competition, oligopoly, and monopoly. 

In a monopoly, there is only one firm serving the entire market. There is no competition.

The marginal revenue curve lies below the demand curve. The firms can charge a price higher than the marginal cost. The output is lower than the social optimum. There are market inefficiencies created by imperfect competition.

In perfect competition, there are many firms selling a homogeneous good. In reality, this rarely happens, and we have different types of imperfectly competitive markets.

Product markets: monopolistic competition, oligopoly, and monopoly. Factor markets: monopsony.

Final Imperfect Competition Quiz

Imperfect Competition Quiz - Teste dein Wissen

Question

What is a firm’s main objective?

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Answer

Profit maximisation.

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Who are the customers of a firm?


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Answer

Individual customers, businesses, or governments.

Show question

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What are the financial goals of a firm?


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Answer

Profit maximisation, market share expansion.

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What is a firm's profit?


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Answer

The difference between the total costs and revenues.

Show question

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How to maximise a firm’s profit?


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Answer

 Profit is maximised when marginal costs equal marginal revenues.

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What are some non-financial objectives of a firm?


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Answer

Customer satisfaction, job satisfaction, corporate social responsibility.

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How to improve employees’ job satisfaction?


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Activities to boost job satisfaction can be taking care of employees’ well-being, offering incentives for good performance, providing an opportunity to learn, and communicating.

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Why is corporate social responsibility important?


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Answer

Corporate social responsibility (CSR) includes activities taken by companies to create a positive impact on the society and environment.

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What is monopolistic competition?

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Answer

Monopolistic competition is the market structure in which many firms compete to sell slightly differentiated products.

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What are the characteristics of monopolistic competition? 


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The characteristics are:

  • A large number of firms.
  • Slightly differentiated products.
  • No barriers to entry.
  • Firms are price makers. 

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What does the demand curve for individual firms in monopolistic competition look like?


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It is more elastic than the demand curve in monopoly, though not perfectly elastic as in perfect competition.

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Are firms in monopolistic competition price-takers or price-makers? 


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Price makers, though they have limited market power.

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How is the barrier to entry for a new firm in a monopolistic competition market?

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Low or no barrier to entry. Firms can enter and exit the market any time.

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How can firms in monopolistic competition differentiate their products? 


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Products in monopolistic competition can be differentiated with physical attributes such as taste, smell, and sizes, or intangible attributes such as brand reputation, and eco-friendly image.

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When does profit optimization happen in monopolistic competition? 


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Answer

At output Q where MC = MR.

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How can firms in monopolistic competition enjoy abnormal profit? 


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In the short-run, companies in a monopolistic market are able to earn abnormal profits at the output where marginal costs equal marginal revenues. 

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Do the abnormal profits in monopolistic competition last in the long run? 


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In the long, due to the increase in the number of firms, the price of the product will drop. Thus, the firms will only make normal profits. 

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What is a pure monopoly?

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A market that contains only one seller.

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What levels of competition do pure monopolists face?

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A pure monopolist has no competitors (does not face any competition) as they represent the entire industry. There are no other firms to compete within the market.

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What is a concentrated market?

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A concentrated market is one with very few firms present.

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What is monopoly power?

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Monopoly power can be characterised by a market that is dominated by one firm that produces most of the output in the industry.

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Where does competitive pressure come from?

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Competitive pressure can come from:

  • Competition within the market
  • Available substitutes in the market
  • Firms that are trying to enter the market and compete directly with the monopoly position of the firm

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Market factors that influence monopoly power include:

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All are correct.

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What are the two types of barriers to entry into a market?

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Natural and artificial.

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Name an example of a natural barrier to entry.

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Answer

Economies of scale.

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Name an example of an artificial barrier to entry.

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Strategic barriers.

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What is product differentiation?

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Product differentiation includes making a product different from another similar product through marketing, production, or usability.

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Name two sources of monopoly or monopoly power.

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Geographic disposition and the government.

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What is an example of a geographic monopoly?

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When a single country or region is the only possible supplier of raw materials or commodities. Also, when a region only has one supplier due to geographical reasons.

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Explain the idea of a monopoly being a 'price maker'.

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If the monopoly is the price maker, they set the price in the market and the demand curve will show the maximum quantity of the good or service that can be sold. 

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How does the profit maximisation for a monopoly differ in the short and long-run?

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They do not differ.

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Name two disadvantages of monopolies.

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Productive inefficiencies and the exploitation of consumers.

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What is monopolistic competition inefficiency?

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In the long run, with the entry of new firms, the abnormal profit in monopolistic competition is eroded and the firms only make normal profits. Here, the profit-maximising price equals the average total cost (P = ATC). Without the economies of scale, monopolistic competition suffers from productive and allocative inefficiencies. This is because over time a firm in monopolistic competition has to produce an output (Q1) less than the output at which the average total cost is lowest (Q2). 

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What is non-price competition?

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Competition in factors other than the price. 


Firms in monopolistic competition do not compete (or only compete) in terms of price. Instead, they take up non-price competition in various forms, including:

  • Marketing competition such as the use of exclusive outlets to distribute one's product. The extensive use of advertising, product differentiation, branding, packaging, fashion, style, and design. 
  • Quality competition such as providing post-sales services for customers.

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What is the difference between vertical and horizontal differentiation?

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  • Vertical differentiation is the differentiation via quality and price. For example, a company can split the product portfolio among different target groups. 
  • Horizontal differentiation is the differentiation via style, type, or location. For example, Coca-Cola can sell its beverage in glass bottles, cans, and plastic bottles. While the product type is different, the quality is the same. 

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When do new firms enter a monopolistic market?

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When they can make abnormal profits.

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Why does the demand curve in monopolistic competition represent individual firms instead of the whole market as in perfect competition?

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Answer

In monopolistic competition, each firm produces a slightly different product, which results in different customer demands. In the case of perfect competition, the demand is the same for all firms due to identical products. Thus, only one market demand curve is shown.  

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In which ways does monopolistic competition resemble perfect competition?

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Answer

  • A large number of firms in the market.
  • No barriers to entry and exit.
  • The availability of short-term abnormal profits which attract new firms to enter the market. Over time with more firms, the abnormal profits are eroded and firms only make normal profits. 

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What is a firm?

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Answer

A firm is an organisation that combines and organises resources to produce goods and services for sale at profits.


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What are the types of firms?

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  1. Private sector 

    1. Proprietary firms

    2. Partnerships

    3. Companies

    4. Cooperatives

  2. Public sector 

    1. Companies

    2. Corporations

    3. Departments

     3. Joint Sector

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What is the profit maximsation rule?

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Profit maximisation occurs when marginal cost is equal to marginal revenue. 

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State few reasons why firms should go for the sales maximization?

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Few reason why firms would go for sales maximization as their objectives are as follows:

  1. Economies of scale - When the firm increases the production levels to reduce its cost of production, it helps to create economies of scale and as the output increases, firms aim for higher sales

  2. Market flooding - This is the marketing tactic a firm uses to hammer the consumer's memory with the firm's product by seeing it everywhere possible. This kind of strategy helps the firms to gain more market share and at the same time loyal customers. 

  3. Limit Pricing - Here the firm prices its product at the break-even point where the price allows it to make an only normal profit, which results in taking away the incentive for the new firms to enter into the market. 


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What does satisficing principle mean?

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The satisficing principle refers to sacrificing profits to satisfy as many key stakeholders as possible. The word satisficing comes from 'Satisfy' and 'Sacrificing'. A satisficing principle often happens when stakeholders have conflicting interests. 

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What does the kinked demand curve illustrate?

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It illustrates the interdependence of firms in an oligopoly market.

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Who developed the kinked demand curve theory?

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It was developed by American economist Paul Sweezy.

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Why is there a kink in the demand curve?

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There are two demand curves: one that is inelastic and one that is elastic. The kink occurs when both demand curves intersect each other.

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What happens when a firm increases their prices in an oligopoly market?

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An increase in price causes the quantity demanded to decrease proportionally more than the increase in price. That firm will experience a decrease in market share because of the loss in quantity demanded, and this will also decrease their total revenue.

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What are the three main conclusions gathered from the kinked demand curve?

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Answer

Price competition: even though in theory it is not rational to increase or decrease prices in an oligopoly market, there can be price competition.

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What are the characteristics of an oligopolistic market?

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High barriers to entry and exit

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What are some assumptions and limitations of the kinked demand curve?

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There is an initial price in the market and there is no explanation as to why this price was set.

Show question

Test your knowledge with multiple choice flashcards

Market factors that influence monopoly power include:

What are the three main conclusions gathered from the kinked demand curve?

What are the characteristics of an oligopolistic market?

Next

Flashcards in Imperfect Competition937

Start learning

What is a firm’s main objective?

Profit maximisation.

Who are the customers of a firm?


Individual customers, businesses, or governments.

What are the financial goals of a firm?


Profit maximisation, market share expansion.

What is a firm's profit?


The difference between the total costs and revenues.

How to maximise a firm’s profit?


 Profit is maximised when marginal costs equal marginal revenues.

What are some non-financial objectives of a firm?


Customer satisfaction, job satisfaction, corporate social responsibility.

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