# Monopolistic competition and oligopoly

> IB Economics Higher Level · IB Economics HL Unit 2: Microeconomics
> Source: https://www.owlsprep.com/study/ib-economics-hl-u2-monopolistic-competition-and-oligopoly/

This subtopic covers two key imperfectly competitive market structures between perfect competition and monopoly. You will learn their characteristics, equilibrium outcomes, efficiency, and strategic behaviour in oligopoly.

**Prerequisites:** [Perfect competition and monopoly market structures](https://www.owlsprep.com/study/ib-economics-hl-u2-perfect-competition-and-monopoly/)

## Learning objectives

- Distinguish characteristics of monopolistic competition and oligopoly
- Analyze short-run and long-run equilibrium in monopolistic competition
- Evaluate efficiency and welfare outcomes for both market structures
- Apply game theory to model strategic behaviour in oligopoly

## Monopolistic Competition: Characteristics and Equilibrium

**Monopolistic Competition** — An imperfectly competitive market structure with many firms, low barriers to entry and exit, and differentiated products

*Example:* Local restaurants, clothing boutiques, hair salons

Product differentiation gives each firm a small degree of monopoly power over its brand, leading to a downward-sloping demand curve. Firms compete on price, quality, and marketing, just like other imperfect competitors.

**Worked example:** A new coffee shop earns short-run supernormal profit in a busy city. Show how the market adjusts to long-run equilibrium.

1. In the short run, the coffee shop produces where $MR = MC$, sets price from its downward-sloping demand curve, and earns supernormal profit.
2. Low barriers to entry mean supernormal profit attracts new coffee shops to enter the market.
3. As new firms enter, demand for the existing coffee shop shifts left and becomes more elastic, as customers have more alternatives.
4. Entry continues until the demand curve is tangent to the average total cost (ATC) curve at the profit-maximizing output. At this point, $P = ATC$, so economic profit is zero (normal profit) and the market is in long-run equilibrium.

> **Exam tip:** Always draw the demand curve tangent to ATC for long-run equilibrium, not intersecting. Examiners penalize incorrect tangent placement.

## Efficiency in Monopolistic Competition

Unlike perfect competition, monopolistic competition does not achieve productive or allocative efficiency in long-run equilibrium. Productive inefficiency arises because firms produce below the output of minimum ATC, creating excess capacity. Allocative inefficiency arises because price is higher than marginal cost ($P > MC$), creating a small deadweight loss to society.

Offsetting this inefficiency is the benefit of product variety: consumers value having a wide range of differentiated products to choose from, which can increase overall welfare despite the deadweight loss.

**Check your understanding**

Which of the following is true of long-run equilibrium in monopolistic competition?

1. Which statement is correct?

   - A. $P = MC$
   - B. $P = \text{minimum } ATC$
   - C. $P = ATC$
   - D. Supernormal profit is positive

   *Why:* Free entry drives economic profit to zero, so $P = ATC$ in the long run. However, $P > MC$ and $P > \text{minimum } ATC$, so neither productive nor allocative efficiency is achieved.

## Oligopoly: Core Characteristics

**Oligopoly** — A market structure dominated by a small number of large firms, with high barriers to entry, and mutual interdependence between firms

*Example:* Global auto manufacturing, commercial airlines, soft drink brands

The defining feature of oligopoly is mutual interdependence: every firm's pricing, output, and marketing decisions directly impact the profits of other firms in the market. This means firms must always anticipate competitor responses when making choices.

**Worked example:** Explain why the kinked demand curve model predicts price rigidity in oligopoly.

1. The model assumes that if a firm raises price above the current market price, other firms will not follow, so demand is very elastic for price increases.
2. If a firm cuts price below the current market price, other firms will match the cut to avoid losing customers, so demand is very inelastic for price cuts.
3. This creates a kink in the demand curve at the current price, which leads to a gap in the marginal revenue (MR) curve.
4. As long as changes in marginal cost (MC) stay within the gap in MR, the profit-maximizing price and output do not change, leading to price rigidity.

## Game Theory and Strategic Behaviour

Game theory is the standard tool HL students use to model strategic interdependence in oligopoly. It analyses interactions between players (firms) where each player's outcome depends on the choices of other players.

**Nash Equilibrium** — A stable outcome where no player has an incentive to change their own strategy, given the strategies chosen by all other players

**Worked example:** Two oligopolistic airlines can choose to charge a high or low price for the same route. Find the Nash equilibrium.

1. First, find Airline A's dominant strategy: If B charges high, A earns 
10m high vs 
15m low → A chooses low. If B charges low, A earns 
2m high vs 
5m low → A always chooses low.
2. Next, find Airline B's dominant strategy: By the same logic, B also always chooses low price regardless of A's choice.
3. Both firms have a dominant strategy of charging low, so the Nash equilibrium is both charging low, each earning 
5m profit.
4. This is a Prisoner's Dilemma outcome: both would earn higher profit (
10m each) if they both charged high, but individual incentives lead to a worse joint outcome.

> **Exam tip:** Always label payoffs clearly in exam answers and explicitly state why your outcome is a Nash equilibrium.

## Common pitfalls

- **Wrong:** Claiming monopolistic competition earns supernormal profit in the long run
  - Why it fails: Confuses monopolistic competition with monopoly, ignoring low barriers to entry
  - Correct: Remember low barriers to entry mean entry drives long-run economic profit to zero for monopolistic competition
- **Wrong:** Drawing the long-run demand curve intersecting ATC instead of tangent
  - Why it fails: If demand intersects ATC, there is still a range of output with supernormal profit, so more entry will occur
  - Correct: Long-run equilibrium requires zero economic profit at the profit-maximizing output, so demand must be tangent to ATC
- **Wrong:** Selecting the best joint outcome as the Nash equilibrium
  - Why it fails: Nash equilibrium accounts for individual incentives, not joint welfare, so the best joint outcome is rarely an equilibrium
  - Correct: Always check each player's best response to the other's strategy to confirm the equilibrium
- **Wrong:** Claiming all oligopolies have stable collusive agreements
  - Why it fails: Collusion is illegal in most countries, and cartels are unstable because members have an incentive to cheat on price agreements
  - Correct: Oligopolies can either collude or compete; collusion is never guaranteed even if it would be profitable

## Cheatsheet

| Feature | Monopolistic Competition | Oligopoly |
| --- | --- | --- |
| Number of firms | Many | Few large |
| Barriers to entry | Low | High |
| Product type | Differentiated | Homogeneous or differentiated |
| Mutual interdependence | No | Yes |
| Long-run economic profit | Zero (normal) | Can be supernormal |
| Efficiency | Productively/allocatively inefficient | Usually inefficient |
| Key model | Tangent long-run equilibrium | Game theory, kinked demand |

## What's next

Understanding these two imperfectly competitive market structures is critical for analyzing most real-world markets, which rarely fit the extremes of perfect competition or pure monopoly. These concepts are frequently tested in both Paper 1 (essay) and Paper 2 (data response) IB Economics exams, so you should practice drawing equilibrium diagrams and applying game theory to real market examples. Building on your knowledge of market structures, you can now explore market failure, policy responses to market power, and other advanced microeconomic topics that connect directly to the concepts you learned here.

- [Game theory for oligopoly (HL only)](https://www.owlsprep.com/study/ib-economics-hl-u2-game-theory-for-oligopoly/)
- [Microeconomics quantitative analysis (HL only)](https://www.owlsprep.com/study/ib-economics-hl-u2-microeconomics-quantitative-analysis/)

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