ME || Monopolistic Competition & Oligopoly

Monopolistic Competition and Oligopoly: Features, Equilibrium and the Kinked Demand Curve

Most real markets are neither perfectly competitive nor pure monopolies. Restaurants, salons and toothpaste brands fall under one type, and mobile networks and airlines fall under another. In this guide, we study monopolistic competition and oligopoly, the two market structures that surround us every day, including the famous kinked demand curve that explains why oligopoly prices stay sticky.

1. Monopolistic competition

Monopolistic competition is a market structure that combines elements of both monopoly and competitive markets. In this type of market, there are many sellers offering products or services that are similar, but differentiated (meaning they are close substitutes, but not identical).

Because each seller’s product has unique features, branding, or perceived quality, each firm has a mini-“monopoly” over its own brand, but it faces intense “competition” from close alternatives.

Features

• Many sellers, each with a small share of the market.
• Product differentiation: products are close substitutes but not identical. The Differences may be real (ingredients, design, build quality) or created through branding, packaging, and marketing.
• Free entry and exit in the long run.
• Selling costs: firms spend on advertising and promotion to persuade buyers that their product is special.
• Some control over price. Because the product is differentiated, each seller faces a downward-sloping but fairly elastic demand curve.
• Non-price competition: firms compete on quality, service, design and branding, not only on price.

Why “monopolistic” and why “competition”?

Each firm has a “monopoly” over its own brand (no one else sells exactly the same thing). But there is “competition” because many other brands are close substitutes.

Real-life examples

Restaurants & Cafés: Italian restaurants, local diners, or bakeries offer food, but each differentiates by menu, ambiance, taste, and service.

Personal Care Products: Toothpastes, soaps, and shampoos all perform similar basic tasks, but brands market specific flavors, herbal extracts, or anti-dandruff benefits.

Clothing & Salons: Hair styling shops and fashion boutiques differentiate based on stylist skill, interior design, and brand prestige.

Short-run equilibrium

The firm faces a downward-sloping demand curve, so it produces where Marginal Revenue (MR) = Marginal Cost (MC), then reads the price from its demand (AR) curve. In the short run, it can earn:

• Supernormal profit (if price is above average cost),
• Normal profit (price equals average cost) or
• Loss (price below average cost, but it continues if price covers average variable cost).

Long-run equilibrium

Free entry and exit again drive the result:

• If firms earn supernormal profit, new brands enter. Each existing firm loses some customers, so its demand curve shifts left.
• If firms make losses, some leave, and the remaining firms gain customers, so their demand curves shift right.

This adjustment goes on until each firm earns only normal profit. At that point, the demand (AR) curve just touches (is tangent to) the long-run average cost curve. So in long-run equilibrium: MR = MC and P = AC (AR = AC).

Excess capacity

In long-run equilibrium, the tangency happens on the falling part of the LAC curve, not at its minimum point. This means each firm produces less than the output that would minimise cost. The gap is called excess capacity. A small restaurant that is open all day but only half full is an example. Critics see this as wasteful. Defenders say it is the price paid for variety and choice.

Comparing with perfect competition

Role of advertising

In this market, advertising and branding are central. They create brand loyalty and make demand less elastic, but they also raise costs. Whether this is good or bad depends on whether the advertising gives useful information or just creates artificial differences.

2. Oligopoly and the kinked demand curve

Look at mobile network plans in India or airline fares. A handful of big companies dominate, and when one changes its prices, everyone else notices. This market form is called oligopoly, and the kinked demand curve is a popular model to explain why prices in such markets often stay unchanged for long periods.

What is oligopoly?

In an oligopoly, a few large firms dominate the market. The products may be identical (such as cement or steel) or differentiated (such as cars or smartphones).

Oligopoly is a market structure dominated by a small number of large firms. In this setup, each firm holds a significant share of the market, meaning the actions of one firm directly impact the decisions and profits of the others.

The products sold can be homogeneous (identical goods like crude oil, steel, or cement) or differentiated (brand-distinct goods like automobiles, smartphones, or passenger airlines).

Features of oligopoly

• Few sellers. Each firm is large enough to influence the market.
• Interdependence: this is the most important feature. Each firm must think about how rivals will react before changing price, output or advertising.
• Barriers to entry: large capital, patents, brand strength and economies of scale keep newcomers out.
• Non-price competition: advertising, product features and service matter a lot.
• Uncertainty: because rival reactions are hard to predict, there is no single theory of oligopoly. There are many models.
• Price rigidity: prices tend to be stable.

The kinked demand curve (Sweezy model)

Paul Sweezy (and, independently, Hall and Hitch) proposed this model in 1939 to explain price rigidity. It is based on a simple assumption about how rivals behave. Suppose the current price is P.

• If the firm raises its price above P: rivals do not follow. They happily take away its customers. So demand above P is elastic (sales fall a lot).
• If the firm cuts its price below P: rivals match the cut to protect their own share. So the firm gains few extra customers. Demand below P is inelastic (sales rise only a little).

The result is a demand curve with a kink at the current price: flatter (elastic) above the kink and steeper (inelastic) below it.

The discontinuous marginal revenue curve

Because the demand curve has two different slopes, the MR curve also has two parts, with a vertical gap (discontinuity) at the output of the kink. MR above the gap belongs to the elastic part; MR below the gap belongs to the inelastic part.

Why prices stay rigid

The firm maximises profit where MR = MC. If the MC curve passes through the vertical gap in the MR curve, the profit-maximising output and price stay the same, even if MC rises or falls within that gap. Therefore:

• A price rise loses a lot of customers, since rivals do not follow.
• A price cut brings little gain, since rivals follow and everyone earns less.

So firms prefer to keep the price steady and compete through advertising, quality and service instead.

Real example: if one telecom company raises its data tariff while others hold theirs, many customers may switch to the cheaper rivals. If it cuts its tariff, the others typically respond with similar offers within days, leaving everyone with lower revenue and little change in market shares. That is why we often see rival plans priced almost identically.

Criticisms of the model

• It does not explain how the original price is set; it only explains why it stays.
• Evidence is mixed: in practice, prices do change, especially in times of inflation or when a leader announces a change.
• Rivals do not always react the way the model assumes.

Other oligopoly behaviour (brief)

• Price leadership: one firm (often the largest) changes price, and others follow.
• Collusion and cartels: firms agree on prices or output. This is illegal in many countries because it harms consumers; OPEC is a well-known example of a cartel in the oil market.
• Game theory studies strategic choices in such interdependent situations.

This is the last part of the series.