1. Chapter 7: Monopolistic Competition and Oligopoly
Objectives of chapter 7:
Monopolistic competition
Price and output in monopolistic competition
Monopolistic competition and efficiency
Product variety
Oligopoly and its behavior- a game theory overview
Three oligopoly models
Oligopoly and advertising
Oligopoly and efficiency
Chapter 7 by TITH Seyla

2. What Is Monopolistic Competition?
Monopolistic competition is a market structure in which
A large number of firms compete.
Each firm produces a differentiated product.
Firms compete on product quality, price, and marketing.
Firms are free to enter and exit the industry.
Chapter 7 by TITH Seyla

3. Monopolistic Competition
Large Number of Firms
The presence of a large number of firms in the market implies:
Each firm has only a small market share and therefore has limited market power to influence the price of its product
Each firm is sensitive to the average market price, but no firm pays attention to the actions of others. So no one firm’s actions directly affect the actions of others.
Collusion, or conspiring to fix prices, is impossible.
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4. What Is Monopolistic Competition?
Product Differentiation
A firm in monopolistic competition practices product differentiation if the firm makes a product that is slightly different from the products of competing firms.
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5. What Is Monopolistic Competition?
Competing on Quality, Price, and Marketing
Product differentiation enables firms to compete in three areas: quality, price, and marketing.
Quality includes design, reliability, and service.
Because firms produce differentiated products, the demand for each firm’s product is downward sloping. But there is a tradeoff between price and quality.
Because products are differentiated, a firm must market its product. Marketing takes the two main forms: advertising and packaging.
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6. Monopolistic Competition
Entry and Exit
There are no barriers to entry in monopolistic competition, so firms cannot make an economic profit in the long run.
Examples of Monopolistic Competition
Producers of audio and video equipment, clothing, jewelry, computers, and sporting goods operate in monopolistic competition.
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7. Price and Output in Monopolistic Competition
The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing program produces the profit-maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC).
Price is determined from the demand curve for the firm’s product and is the highest price that the firm can charge for the profit-maximizing quantity.
Figure 14.1 shows a firm’s economic profit in the short run.
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8. Price and Output in Monopolistic Competition
The firm in monopolistic competition operates like a single-price monopoly.
The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price.
It earns an economic profit (as in this example) when P > ATC.
Chapter 7 by TITH Seyla

9. Price and Output in Monopolistic Competition
Profit Maximizing Might Be Loss Minimizing
A firm might incur an economic loss in the short run.
Here is an example.
At the profit-maximizing quantity, P < ATC and the firm incurs an economic loss.
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10. Price and Output in Monopolistic Competition
Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition maximizes its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC.
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11. Price and Output in Monopolistic Competition
As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.
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12. Price and Output in Monopolistic Competition
Figure 14.3 shows a firm in monopolistic competition in long-run equilibrium.
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13. Price and Output in Monopolistic Competition
Monopolistic Competition and Perfect Competition
Two key differences between monopolistic competition and perfect competition are:
Excess capacity
Markup
A firm has excess capacity if it produces less than the quantity at which ATC is a minimum.
A firm’s markup is the amount by which its price exceeds its marginal cost.
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14. Price and Output in Monopolistic Competition
Firms in monopolistic competition operate with excess capacity in long-run equilibrium.
Firms produce less than the efficient scale—the quantity at which ATC is a minimum.
The downward-sloping demand curve for their products drives this result.
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15. Price and Output in Monopolistic Competition
Firms in monopolistic competition operate with positive markup.
Again, the downward-sloping demand curve for their products drives this result.
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16. Price and Output in Monopolistic Competition
In contrast, firms in perfect competition have no excess capacity and no markup.
The perfectly elastic demand curve for their products drives this result.
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17. Price and Output in Monopolistic Competition
Is Monopolistic Competition Efficient?
Price equals marginal social benefit.
The firm’s marginal cost equals marginal social cost.
Price exceeds marginal cost, so marginal social benefit exceeds marginal social cost.
So the firm in monopolistic competition in the long run produces less than the efficient quantity.
Chapter 7 by TITH Seyla

18. Price and Output in Monopolistic Competition
Making the Relevant Comparison
The markup that drives a gap between price and marginal cost arises from product differentiation.
People value product variety, but product variety is costly.
The efficient degree of product variety is the one for which the marginal social benefit of product variety equals its marginal social cost.
The loss that arises because the quantity produced is less than the efficient quantity is offset by the gain that arises from having a greater degree of product variety.
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19. Product Development and Marketing
Innovation and Product Development
We’ve looked at a firm’s profit-maximizing output decision in the short run and in the long run, for a given product and with given marketing effort.
To keep making an economic profit, a firm in monopolistic competition must be in a state of continuous product development.
New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.
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20. Product Development and Marketing
Innovation is costly, but it increases total revenue.
Firms pursue product development until the marginal revenue from innovation equals the marginal cost of innovation.
The amount of production development is efficient if the marginal social benefit of an innovation (which is the amount the consumer is willing to pay for the innovation) equals the marginal social cost that firms incur to make the innovation.
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21. Product Development and Marketing
Advertising
A firm with a differentiated product needs to ensure that customers know that its product differs from its competitors.
Firms use advertising and packaging to achieve this goal.
A large proportion of the price we pay for a good covers the cost of selling it.
Advertising expenditures affect the firm’s profit in two ways:
They increase costs, and they change demand.
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22. Product Development and Marketing
Selling Costs and Total Costs
Selling costs, like advertising expenditures, fancy retail buildings, etc. are fixed costs.
Average fixed costs decrease as production increases, so selling costs increase average total costs at any given quantity but do not affect the marginal cost of production.
Selling efforts such as advertising are successful if they increase the demand for the firm’s product.
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23. Product Development and Marketing
Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced.
Here, with no advertising, the firm produces 25 units of output at an average total cost of $60.
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24. Product Development and Marketing
With advertising, the firm produces 100 units of output at an average total cost of $40.
The advertising expenditure shifts the ATC curve upward, but the firm operates at a higher output and lower average total cost than it would without advertising.
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25. Product Development and Marketing
Advertising might also decrease the markup.
In Fig. 14.6(a), with no advertising, demand is not very elastic and the markup is large.
In Fig. 14.6(b), advertising makes demand more elastic, increases the quantity, and lowers the price and markup.
Chapter 7 by TITH Seyla

26. Product Development and Marketing
Using Advertising to Signal Quality
Why do Coke and Pepsi spend millions of dollars a month advertising products that everyone knows?
One answer is that these firms use advertising to signal the high quality of their products.
A signal is an action taken by an informed person or firm to send a message to uninformed people.
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27. Product Development and Marketing
Coke is a high quality cola, and Oke is a low quality cola.
If Coke spends millions on advertising, people think “Coke must be good.”
If it is truly good, when they try it, they will like it and keep buying it.
If Oke spends millions on advertising, people think “Oke must be good.”
If it is truly bad, when they try it, they will hate it and stop buying it.
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28. Product Development and Marketing
So if Oke knows its product is bad, it will not bother to waste millions on advertising it.
And if Coke knows its product is good, it will spend millions on advertising it.
Consumers will read the signals and get the correct message.
None of the ads need mention the product. They just need to be flashy and expensive.
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29. Product Development and Marketing
Brand Names
Why do firms spend millions of dollars to establish a brand name or image?
Again, the answer is to provide information about quality and consistency.
You’re more likely to overnight at a Holiday Inn than at Joe’s Motel because Holiday Inn has incurred the cost of establishing a brand name and you know what to expect if you stay there.
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30. Product Development and Marketing
Efficiency of Advertising and Brand Names
To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are efficient.
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31. What Is Oligopoly? Oligopoly is a market structure in which
Natural or legal barriers prevent the entry of new firms.
A small number of firms compete.
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32. What Is Oligopoly? Barriers to Entry
Either natural or legal barriers to entry can create oligopoly.
Figure 15.1 shows two oligopoly situations.
In part (a), there is a natural duopoly—a market with two firms.
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33. What Is Oligopoly?
In part (b), there is a natural oligopoly market with three firms.
A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms.
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34. What Is Oligopoly? Small Number of Firms
Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate.
Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions.
Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit.
Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.
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35. Two Traditional Oligopoly Models
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.
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36. Two Traditional Oligopoly Models
Figure 15.2 shows the kinked demand curve model.
The firm believes that the demand for its product has a kink at the current price and quantity.
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37. Two Traditional Oligopoly Models
Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged.
Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.
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38. Two Traditional Oligopoly Models
The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by that gap AB in the figure.
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39. Two Traditional Oligopoly Models
Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.
For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit-maximizing price and quantity would not change.
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40. Two Traditional Oligopoly Models
The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact.
If MC increases enough, all firms raise their prices and the kink vanishes.
A firm that bases its actions on wrong beliefs doesn’t maximize profit.
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41. Two Traditional Oligopoly Models
Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms.
The large firm operates as a monopoly, setting its price and output to maximize its profit.
The small firms act as perfect competitors, taking as given the market price set by the dominant firm.
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42. Two Traditional Oligopoly Models
Figure 15.3 shows10 small firms in part (a). The demand curve, D, is the market demand and the supply curve S10 is the supply of the 10 small firms.
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43. Two Traditional Oligopoly Models
At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing.
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44. Two Traditional Oligopoly Models
But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm.
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45. Two Traditional Oligopoly Models
The demand curve for the large firm’s output is the curve XD on the right.
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46. Two Traditional Oligopoly Models
The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.
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47. Two Traditional Oligopoly Models
The large firm maximizes profit by setting MR = MC. Let’s suppose that the marginal cost curve is MC in the figure.
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48. Two Traditional Oligopoly Models
The profit-maximizing quantity for the large firm is 10 units. The price charged is $1.00.
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49. Two Traditional Oligopoly Models
The small firms take this price and supply the rest of the quantity demanded.
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50. Two Traditional Oligopoly Models
In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.
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51. Oligopoly Games
Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence.
The Prisoners’ Dilemma
The prisoners’ dilemma game illustrates the four features of a game.
Rules
Strategies
Payoffs
Outcome
Chapter 7 by TITH Seyla

52. Oligopoly Games
Rules
The rules describe the setting of the game, the actions the players may take, and the consequences of those actions.
In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicate with each other.
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53. Oligopoly Games
Each is told that both are suspected of committing a more serious crime.
If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes.
If both confess to the more serious crime, each receives 3 years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the minor crime only.
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54. Oligopoly Games Strategies
Strategies are all the possible actions of each player.
Art and Bob each have two possible actions:
1. Confess to the larger crime.
2. Deny having committed the larger crime.
With two players and two actions for each player, there are four possible outcomes:
1. Both confess.
2. Both deny.
3. Art confesses and Bob denies.
4. Bob confesses and Art denies.
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55. Oligopoly Games Payoffs
Each prisoner can work out what happens to him—can work out his payoff—in each of the four possible outcomes.
We can tabulate these outcomes in a payoff matrix.
A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player.
The next slide shows the payoff matrix for this prisoners’ dilemma game.
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56. Oligopoly Games
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57. Oligopoly Games Outcome
If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player.
If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibrium—first proposed by John Nash.
Finding the Nash Equilibrium
The following slides show how to find the Nash equilibrium.
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58. Bob’s view of the world
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59. Bob’s view of the world
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60. Art’s view of the world
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61. Art’s view of the world
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62. Equilibrium
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63. Oligopoly Games An Oligopoly Price-Fixing Game
A game like the prisoners’ dilemma is played in duopoly.
A duopoly is a market in which there are only two producers that compete.
Duopoly captures the essence of oligopoly.
Cost and Demand Conditions
Figure 15.4 on the next slide describes the cost and demand situation in a natural duopoly.
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64. Oligopoly Games Part (a) shows each firm’s cost curves.
Part (b) shows the market demand curve.
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65. Oligopoly Games This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.
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66. Oligopoly Games How does this market work?
What is the price and quantity produced in equilibrium?
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67. Oligopoly Games Collusion
Suppose that the two firms enter into a collusive agreement.
A collusive agreement is an agreement between two (or more) firms to restrict output, raise the price, and increase profits.
Such agreements are illegal in the United States and are undertaken in secret.
Firms in a collusive agreement operate a cartel.
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68. Oligopoly Games
The strategies that firms in a cartel can pursue are to
Comply
Cheat
Because each firm has two strategies, there are four possible combinations of actions for the firms:
1. Both comply.
2. Both cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.
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69. Oligopoly Games Colluding to Maximize Profits
Firms in a cartel act like a monopoly and maximum economic profit.
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70. Oligopoly Games
To find that profit, we set marginal cost for the cartel equal to marginal revenue for the cartel.
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71. Oligopoly Games
The cartel’s marginal cost curve is the horizontal sum of the MC curves of the two firms and the marginal revenue curve is like that of a monopoly.
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72. Oligopoly Games
The firm’s maximize economic profit by producing the quantity at which MCI = MR.
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73. Oligopoly Games
Each firm agrees to produce 2,000 units and each firm shares the maximum economic profit.
The blue rectangle shows each firm’s economic profit.
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74. Oligopoly Games
When each firm produces 2,000 units, the price is greater than the firm’s marginal cost, so if one firm increased output, its profit would increase.
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75. Oligopoly Games One Firm Cheats on a Collusive Agreement
Suppose the cheat increases its output to 3,000 units. Industry output increases to 5,000 and the price falls.
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76. Oligopoly Games For the complier, ATC now exceeds price.
For the cheat, price exceeds ATC.
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77. Oligopoly Games The complier incurs an economic loss.
The cheat makes an increased economic profit.
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78. Oligopoly Games Both Firms Cheat
Suppose that both increase their output to 3,000 units.
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79. Oligopoly Games
Industry output is 6,000 units, the price falls, and both firms make zero economic profit—the same as in perfect competition.
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80. Oligopoly Games Possible Outcomes
If both comply, each firm makes $2 million a week.
If both cheat, each firm makes zero economic profit.
If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million.
If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly game.
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81. Payoff Matrix
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82. Trick’s view of the world
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83. Trick’s view of the world
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84. Gear’s view of the world
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85. Gear’s view of the world
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86. Equilibrium
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87. Oligopoly Games Nash Equilibrium in Duopolists’ Dilemma
The Nash equilibrium is that both firms cheat.
The quantity and price are those of a competitive market, and the firms make zero economic profit.
Other Oligopoly Games
Advertising and R&D games are also prisoners’ dilemmas.
An R&D Game
Procter & Gamble and Kimberley Clark play an R&D game in the market for disposable diapers.
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88. Oligopoly Games The payoff matrix for the Pampers Versus Huggies game.
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89. Oligopoly Games The Disappearing Invisible Hand
In all the versions of the prisoners’ dilemma that we’ve examined, the players end up worse off than they would if they were able to cooperate.
The pursuit of self-interest does not promote the social interest in these games.
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90. Oligopoly Games A Game of Chicken
In the prisoners’ dilemma game, the Nash equilibrium is a dominant strategy equilibrium, by which we mean the best strategy for each player is independent of what the other player does.
Not all games have such an equilibrium.
One that doesn’t is the game of “chicken.”
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91. Payoff Matrix
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92. KC’s view of the world
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93. KC’s view of the world
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94. P&G’s view of the world
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95. P&G’s view of the world
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96. Equilibrium
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97. Repeated Games and Sequential Games
A Repeated Duopoly Game
If a game is played repeatedly, it is possible for duopolists to successfully collude and make a monopoly profit.
If the players take turns and move sequentially (rather than simultaneously as in the prisoner’s dilemma), many outcomes are possible.
In a repeated prisoners’ dilemma duopoly game, additional punishment strategies enable the firms to comply and achieve a cooperative equilibrium, in which the firms make and share the monopoly profit.
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98. Repeated Games and Sequential Games
One possible punishment strategy is a tit-for-tat strategy.
A tit-for-tat strategy is one in which one player cooperates this period if the other player cooperated in the previous period but cheats in the current period if the other player cheated in the previous period.
A more severe punishment strategy is a trigger strategy.
A trigger strategy is one in which a player cooperates if the other player cooperates but plays the Nash equilibrium strategy forever thereafter if the other player cheats.
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99. Repeated Games and Sequential Games
Table 15.5 shows that a tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game.
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100. Repeated Games and Sequential Games
Price wars might result from a tit-for-tat strategy where there is an additional complication—uncertainty about changes in demand.
A fall in demand might lower the price and bring forth a round of tit-for-tat punishment.
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101. Repeated Games and Sequential Games
A Sequential Entry Game in a Contestable Market
In a contestable market—a market in which firms can enter and leave so easily that firms in the market face competition from potential entrants—firms play a sequential entry game.
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102. Repeated Games and Sequential Games
Figure 15.8 shows the game tree for a sequential entry game in a contestable market.
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103. Repeated Games and Sequential Games
In the first stage, Agile decides whether to set the monopoly price or the competitive price.
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104. Repeated Games and Sequential Games
In the second stage, Wanabe decides whether to enter or stay out.
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105. Repeated Games and Sequential Games
In the equilibrium of this entry game,
Agile sets a competitive price and makes zero economic profit to keep Wanabe out.
A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out.
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106. Antitrust Law
Antitrust law provides an alternative way in which the government may influence the marketplace.
The Antitrust Laws
The first antitrust law, the Sherman Act, was passed in It outlawed any “combination, trust, or conspiracy that restricts interstate trade,” and prohibited the “attempt to monopolize.”
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107. Antitrust Law
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108. Antitrust Law
A wave of merger activities at the beginning of the twentieth century produced a stronger antitrust law, the Clayton Act, and created the Federal Trade Commission.
The Clayton Act was passed in 1914.
The Clayton Act made illegal specific business practices such as price discrimination, interlocking directorships, and acquisition of a competitor’s shares if the practices “substantially lessen competition or create monopoly.”
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109. Antitrust Law
Table 15.7 (next slide) summarizes the Clayton Act and its amendments, the Robinson-Patman Act passed in 1936 and the Cellar-Kefauver Act passed in 1950.
The Federal Trade Commission, formed in 1914, looks for cases of “unfair methods of competition and unfair or deceptive business practices.”
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110. Antitrust Law
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111. Antitrust Law Price Fixing Always Illegal
Price fixing is always a violation of the antitrust law.
If the Justice Department can prove the existence of price fixing, there is no defense.
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112. Antitrust Law Three Antitrust Policy Debates
But some practices are more controversial and generate debate. Three of them are
Resale price maintenance
Tying arrangements
Predatory pricing
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113. Antitrust Law Resale Price Maintenance
Most manufacturers sell their product to the final consumer through a wholesale and retail distribution chain.
Resale price maintenance occurs when a manufacturer agrees with a distributor on the price at which the product will be resold.
Resale price maintenance is inefficient if it promotes monopoly pricing.
But resale price maintenance can be efficient if it provides retailers with an incentive to provide an efficient level of retail service in selling a product.
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114. Antitrust Law Tying Arrangements
A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another different product as well.
Some people argue that by tying, a firm can make a larger profit.
Where buyers have a differing willingness to pay for the separate items, a firm can price discriminate and take a larger amount of the consumer surplus by tying.
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115. Antitrust Law Predatory Pricing
Predatory pricing is setting a low price to drive competitors out of business with the intention of then setting the monopoly price.
Economists are skeptical that predatory pricing actually occurs.
A high, certain, and immediate loss is a poor exchange for a temporary, uncertain, and future gain.
No case of predatory pricing has been definitively found.
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116. Antitrust Law Merger Rules
The Federal Trade Commission (FTC) uses guidelines to determine which mergers to examine and possibly block.
The Herfindahl-Hirschman index (HHI) is one of those guidelines (explained in Chapter 9).
If the original HHI is between 1,000 and 1,800, any merger that raises the HHI by 100 or more is challenged.
If the original HHI is greater than 1,800, any merger that raises the HHI by more than 50 is challenged.
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