Monopolistic Competition Large number of firms producing differentiated products By differentiating its product from its competitors’ products, the firm can reduce the extent of price competition With differentiated products, a price reduction attracts some customers from competing firms but not all customers A firm faces a downward sloping demand curve for its product with competitors’ products being demand substitutes.

Since each firm faces a downward sloping demand curve for it’s product, it is as if the firm is a (small) monopolist in its product As a result, each firm chooses a price such that MR = MC, implying that P > MC, much as in a monopoly. Free entry of competitors implies that, in the long run, profits are zero

Advertising Persuasive: -increases perceived product differentiation -persuade customers to buy when they otherwise wouldn’t -persuade customers to pay more than they otherwise would

Informative: -direct information on price/characteristics/existence (allows new firms to enter) -indirect signal of product quality High quality firms will have more repeat purchases and so they can afford to advertise more

Repeated Games and Collusion Can Bertrand paradox be resolved if firms interact repeatedly? Is it a Nash Equilibrium to set p>mc in the first period of a repeated interaction in an effort to ‘signal’ willingness to ‘cooperate’? Depends on what we mean by repeated? -fixed number of times -infinite number of times

Fixed: -last period is same as one-shot game -no incentive to cooperate in any preceding period -cooperation unravels Infinite: -no last period so cooperation is possible -influence behaviour through use of punishment strategies

Cooperation more likely when: -there is a high probability of future interaction -actions of rivals can be monitored -defectors can be easily punished -interest rates are low

Cartels Firms work together to maximize their total profits Example: OPEC Each firm/country has incentive to cheat and produce too much So joint profit maximization is not an equilibrium without enforcement

Multistage Games Many economic situations exist in which one agent acts before the other Decision makers must consider the manner in which their rival will respond to their decision Decision makers should only consider credible responses

Entry and Exit Decisions Potential entrant is trying to decide whether or not to enter a market in which there is an incumbent Incumbent’s threat to flood the market if the entrant enters is not credible -once the entrant is in the market, the best the incumbent can do is accomodate The only subgame perfect equlibrium involves the entrant entering and the incumbent accommodating the entry

Can the incumbent do anything to credibly deter entry? -commit to larger output by investing in extra capacity Increased capacity allows for greater levels of production if necessary

Pricing Strategies Attempt to discourage entry by charging a low price -low price must somehow convey bad news to potential entrants about their post-entry profitability in the market -potential entrants must believe that the low price will persist after entry

Low price in second period is not credible—so the entrant should enter Is there any way to use price to deter entry? -low price can be signal of low costs What about signaling aggressive pricing behaviour? -would have to keep it up for ever—not profitable