Putting It Together: Monopolistic Competition and Oligopoly

Monopolistically competitive industries consist of a significant number of firms, which each produce a differentiated (or heterogeneous) production. In other words, Colgate, AIM, and Tom’s of Maine each produce toothpaste, but they are not identical products. Like firms in any market structure, if a monopolistically competitive firm wishes to maximize profits, it will supply the quantity of output where marginal revenue equals marginal cost. Like perfectly competitive firms, competition prevents monopolistically competitive firms from earning positive economic profits in the long run, unless those firms create innovative new products and/or use advertising to convince customers they have done so.

Side-by-side picture of McDonald's Big Mac and Burger King's Whopper

Big Mac versus Whopper. Big Mac Snip by Ian Burt, CC-BY. Burger King Whopper by Mike Mozart, CC-BY.

Returning to some of the questions posed in the “Why it Matters” feature at the beginning of this module:

  • Why do gas stations charge different prices for a gallon of gasoline? Some gasoline companies use different additives to make their products at least appear different.  This allows them to charge higher prices than companies that don’t make as good a case for their product. Location also matters. A gas station just off the highway can charge higher prices than stations further away, because travelers perceive and are willing to pay for the convenience of the former.
  • What determines how far apart the prices of Colgate and Crest toothpaste can be? The answer is brand name loyalty.  To the extent that Colgate users believe Colgate is superior to Crest, they will be willing to pay more for Colgate than for Crest. By contrast, if the two products are perceived to be close substitutes, the prices should be similar.
  • Why did fast food restaurants start offering salads? Fast food restaurants added salads to their menus to differentiate their product by appealing to health conscious diners.
  • Why did McDonalds come up with the Big Mac sandwich? McDonalds invented the Big Mac because its competitors offered similar enough regular burgers that McDonalds lost its monopoly profits. The Big Mac restored those profits, at least until Burger King came up with the Whopper and other fast food restaurants developed their own special burgers.

While oligopoly is defined as an industry consisting of, or dominated by a small number of firms, the key characteristic is interdependence among firms. Oligopolies can be characterized by collusion, where firms act jointly like a monopolist to share industry profits, or by competition, where firms compete aggressively for individual profits, or something in between. The computer operating system, dominated by Microsoft, fits the former profile with persistent high economic profits. The airline industry (e.g. United) fits the latter profile, leading to prices barely above costs and low profits.

Oligopolies are inefficient for the same reasons that monopolies are—in order to reap economic profits, they produce too little output so they create deadweight losses to society. The more like a monopoly a given oligopoly is, the higher their profits and the greater the deadweight loss. This is why strong oligopolies usually generate antitrust action by the government.