1. Monopolistic Competition And Oligopoly
Chapter 10
Monopolistic Competition
And Oligopoly
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western

2. Imperfect Competition
A market structure
More than one firm
One or more of the requirements of perfect competition is violated
Monopolistic competition
Oligopoly

3. Monopolistic Competition
Many buyers and sellers
A buyer has no influence on the price
A seller has market power
A seller - Price setter
Sellers act independently of each other
No strategic games

4. Monopolistic Competition
Sellers offer a differentiated product
Downward-sloping demand curve
Product differentiation
Quality
Location
A product is different whenever people think that it is
Sellers can easily enter or exit the market
No significant barriers to entry

5. Monopolistic Competition in the Short Run
Maximize profit
Produce the quantity where MR = MC
An increase in price - The customers can buy a similar good from other firm
Demand curve
Is flatter under monopolistic competition than under monopoly
Economic profit
Economic loss

6. Monopolistic Competition in the Short Run
Figure 1 A Monopolistically Competitive Firm in the Short Run
1. Kafka services 250 homes per month: MR=MC
Dollars
Homes Serviced per Month
2. and charges $70 per home A MC
$70
ATC d1 30
MR1
3. ATC at 250 units is less than price, so profit per unit is positive.
4. Kafka's monthly profit: $10,000
250

7. Monopolistic Competition in the Long Run
No barriers to entry and exit
Economic profit in the short run
New sellers enter the market
Demand curve - shift leftward
Economic loss in the short run
Sellers exit the market
Demand curve - shift rightward
Each firm earns zero economic profit in the long run

8. Monopolistic Competition in the Long Run
Figure 2 A Monopolistically Competitive Firm in the Long Run
Dollars
Homes Serviced per Month
1. In the long run, profit attracts entry, the firm's demand curve shifts leftward MC
ATC E
$40 d1
MR1
MR2 d2
100
250
3. The typical firm produces where its new MR = MC
2. Entry continues until P = ATC, and economic profit is zero.

9. Monopolistic Competition
Excess Capacity
Never produce at minimum average cost
Monopolistic competition
Higher costs
Higher prices
Product differentiation
Nonprice Competition
Any action a firm takes to shift its demand curve rightward

10. Oligopoly
A market structure in which a small number of firms are strategically interdependent - produce the dominant share of output in the market
Market definition
Number of firms
Market domination

11. How Oligopolies Arise Barriers to entry Economies of scale Reputation
Strategic barriers
Legal barriers

12. Barriers to Entry Economies of scale Reputation
Natural oligopoly - the market tends naturally toward oligopoly
A large firm supplies a large share of the market - lower cost per unit than a small firm
Reputation
Established oligopolists are likely to have favorable reputations
Initial high advertising costs

13. Barriers to Entry Strategic Barriers Legal barriers
Excess production capacity
Saturate the market
Special deals with distributors
Long-term arrangements with customers
Spend large amounts on advertising
Legal barriers
Patents and copyrights; Lobby
Zoning regulations

14. Oligopoly vs. Other Market Structures
Strategic interdependence
Anticipate the reactions of rivals when making decisions
Game theory
An approach to modeling the strategic interaction of oligopolists in terms of moves and countermoves.

15. The Game Theory Approach
Game theory analyzes oligopoly decisions
Rules
Payoffs
Strategies
Payoff matrix
A table showing the payoffs to each of two players for each pair of strategies they choose

16. The Prisoner’s Dilemma
Figure 3 The Prisoner’s Dilemma
Confess
Don’t
Rose’s
Actions
Colin
gets
20 years
Rose
30 years
3 years
5 years
Colin’s Actions
Don’t Confess

17. The Prisoner’s Dilemma
Regardless of Rose’s strategy, Colin’s best choice is to confess
Dominant strategy
A strategy that is best for a player no matter what strategy the other player chooses.
The outcome – a Nash equilibrium
Each player is taking the best action, given actions taken by other players

18. Simple Oligopoly Games
Duopoly
Oligopoly market with only two sellers
Situations duopolists might face:
both players have dominant strategies,
only one player has a dominant strategy,
neither player has a dominant strategy

19. Both Players Have Dominant Strategies
Figure 4 A Duopoly Game: Both Players Have Dominant Strategies
Low Price
Low
price
High
Filip’s
Actions
Gus’s profit=
$25,000
profit=
-$10,000
$75,000
$50,000
Gus’s Actions
High Price

20. Only One Player Has a Dominant Strategy
Figure 5 A Duopoly Game: Only One Player Has a Dominant Strategy
Low Price
Low
price
High
Filip’s
Actions
Gus’s profit=
$25,000
profit=
-$10,000
$75,000
$50,000
Gus’s Actions
High Price
$40,000

21. Neither Player Has a Dominant Strategy
Figure 6 A Duopoly Game: Neither Player Has a Dominant Strategy
Low Price
Low
price
High
Filip’s
Actions
Gus’s profit=
$25,000
profit=
-$10,000
$75,000
$50,000
Gus’s Actions
High Price
$40,000

22. Repeated play Repeated play Both players Cooperative behavior
Strategically interdependent sellers compete over many time periods
Both players
Select a strategy
Observe the outcome of the trial
Play the game again and again, as long as they remain rivals
Cooperative behavior

23. Explicit collusion
Cooperation involving direct communication between competing firms about setting prices
Cartel
Group of firms
Select a common price
Maximize total industry profits
Usually illegal
Severe penalties

24. Tacit Collusion Oligopolistic cooperation Tit-for-tat Price leadership
does not involve an explicit agreement
Tit-for-tat
Do to another player this period what he has done to you in the previous period
Price leadership
One firm sets a price that other firms copy

25. The Limits to Collusion
The market demand curve
May be illegal
Powerful incentives to cheat on any agreement
Each player - can do even better by cheating
Two players would be back to noncooperative outcome based on their dominant strategies
May be in each player’s interest to cheat

26. The Future of Oligopoly
Antitrust Legislation and Enforcement
Prevent collusive agreements
Break up or limit activities of large
Prevent mergers
The Globalization of Markets
Technological Change

27. Advertising in Monopolistic Competition
Firms advertise to
Shift the demand curve rightward
Less elastic demand
But it will affect the firm’s ATC curve
Market
Demand for the product in general will increase
Each firm - sell more units at any given price
The demand curve facing each firm shifts rightward.

28. Advertising in Monopolistic Competition
Increase the size of the market
Sell more
Long run
Each firm earns zero economic profit
The price to the consumer may either rise or fall

29. Advertising in Monopolistic Competition
Figure 7 Advertising in Monopolistic Competition a)
1. Before advertising, long-run
economic profit is zero
Dollars
Bottles of Perfume per Month
2. With advertising, in the long run,
economic profit returns to zero.
dads
ATCads
100
1,750 B
dno ads
ATCno ads
1,000 A 60
3. Advertising can
lead to a higher
price in the long run
as in this panel …

30. Advertising in Monopolistic Competition
Figure 7 Advertising in Monopolistic Competition b)
4. or to a lower price
in the long run,
as in this panel
Dollars
Bottles of Perfume per Month
dads
ATCads
dno ads
ATCno ads
1,000 A 60 B 50
2,000

31. Advertising and Collusion in Oligopoly
Oligopolists have a strong incentive to engage in tacit collusion
Difficult to detect
Use simple game theory model prove collusion

32. Advertising and Collusion in Oligopoly
Figure 8 An Advertising Game
Run Safety Ads
Run
Safety
Ads
Don't
United's
Actions
American's Actions
Don't Run Ads
American earns low profit
American earns high profit
United earns very low profit
United earns low profit
American earns very low profit
American earns medium profit
United earns medium profit
United earns high profit

33. The Four Market Structures: A Postscript
Different market structures
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Market structure models help us organize and understand apparent chaos of real-world markets