1. Monopolistic Competition & Oligopoly

2. Unit Objectives
Describe the characteristics of monopolistic competition and oligopoly
Discover how monopolistic competitors can earn a normal profit in the long run
Apply game theory to oligopolies

3. Monopolistic Competition
Relatively large number of sellers
Each with small market shares
No collusion
Independent action
Differentiated products
Reliance on advertising
Nonprice competition
Ease of entry and exit

4. Product Differentiation
Variations on a particular product
Product attribute
Service
Location
Brand names and packaging
Some control over price

5. Four Firm Concentration Ratio
Four Firm Concentration Ratio: Output of the 4 largest firms Total industry output
Ratio is very low in purely competitive industries
Ratios above 40% are considered oligopolies
Ratios below 40% are considered monopolistic competitive industries

6. Monopolistic Competitive Industries
Industry concentration: the degree to which the largest firms account for the bulk of the industry’s output

7. Herfindahl Index
The sum of the squared percentage market shares of all firms In the industry
Takes into consideration highly localized industries
Gives more weight to larger firms
An index approaching 0 is purely competitive
An index of 10,000 (1002) is a monopoly

8. The Firm’s Demand Curve
Demand curve is highly but not perfectly elastic
Close substitutability of goods
Not perfect substitutes
Elasticity depends on number of rivals and degree of product differentiation

9. Oligopoly A few large producers Homogeneous or differentiated products
Control over price, but mutual interdependence
Strategic behavior
Barriers to entry
Economies of scale
Role of mergers

10. Oligopolistic Industries
Shortcomings of concentration ratios:
Localized markets, interindustry competition, import competition, & dominant firms (Herfindahl index)

11. Short Run: Profit or Loss Graphs

12. Short Run: Profit or Loss
Same profit maximizing (loss minimizing) criteria: MR=MC
Price is determined on the demand curve
Compare price with ATC to determine short term profit or loss

13. Long Run: Normal Profit Only
In the long run, firms enter a profitable industry and may exit industries with losses
In the real world:
Sufficient product differentiation creates “unique” opportunities and barriers to entry

14. Monopolistic Competition and Efficiency
P=MC=minimum ATC
P=min. ATC is productive efficiency
P=MC is allocative efficiency
Neither occurs in long-run equilibrium for this market structure
Firm’s ATC at profit max. is higher than “optimal”
Profit max. price is higher than marginal cost
Under allocation of resources

15. Efficiency Graphs

16. Oligopolistic Behavior: Game Theory
The study of how people behave in strategic situations
Pattern behavior according to actions and expected reactions of rivals
Duopoly – two firm industry
Payoff matrix – shows the payoff that results from each combination of strategies
Collusion- cooperation between rivals
Incentive to cheat

17. The Payoff Matrix

18. The One Time Game
Firms select their optimal strategies in a single time period without regard to possible interactions in subsequent time periods
Simultaneous game – both firms pick their strategies at the same time
Positive sum game – Sum of outcomes in >0
Zero-sum game, negative-sum game

19. Strategies and Equilibrium
Dominant strategy: an option that is better than any alternative option regardless of what the other firm does
Nash equilibrium (did you see A Beautiful Mind?) is an outcome from which neither rival wants to deviate
Strategy is optimal given the other firm’s strategic choice
Stable solution

20. Textbook Example

21. Three Oligopoly Models
Diversity of oligopolies
Tight and loose
Interdependence makes determining profit maximizing decisions difficult
Kinked demand
Collusive pricing
Cartels are most extreme case
Price leadership

22. Oligopoly and Efficiency
P=MC=Minimum ATC
Oligopolies can earn economic profits year after year
Output is where P>MC and min. ATC
Neither productive nor allocative efficiencies occur
At least monopolies are regulated
Caveats: increased foreign competition, limit pricing, and technological advance

23. Oligopoly Efficiency Graph