1. 1 Monopolistic Competition Many firms with relative ease of entry producing differentiated products. Characteristics: 1. Large # of firms. 2. Each producer has a small % of the market and can  ignore rivals action when setting price. 3. Product differentiation. 4. Each seller has some degree of market power since each seller faces an elastic demand curve. 5. Non-price competition.  6. Ease of entry  0 long run profits

2. 2 Product Differentiation The distinguishing between products through real or imagined properties –Quality –Services –Location –Advertising –Packaging More product differentiation = less elasticity of demand

3. 3 Short-Run Equilibrium: Monopolistic Competition MC Quantity Dollars per Unit d MR ATC Profits - Price (P e ) > ATC -Economic profit E ATC PePe qeqe Quantity Dollars per Unit d MR MC ATC Losses -Price (P e ) < ATC -Economic loss E ATC PePe qeqe

4. 4 Long Run: Zero Economic Profit The key difference between monopoly and monopolistic competition lies in the long run. –In Monopolistic Competition economic profit attracts new entrants. the firm’s demand and marginal revenue start to shift leftward. firm’s demand becomes more elastic the profit-maximizing quantity and price fall until P=ATC in the LR

5. 5 Long-Run Equilibrium ATC Quantity Dollars per Unit d MR MC - -Price (P e ) = ATC -Zero econ. profits -Normal rate of return E P e = ATC qeqe The greater the # of rivals and the more similar the product, the more elastic will be the demand and the closer the monopolistically competitive market will be to perfect competition.

6. 6 MR d' Quantity per Time Period Dollars per Unit Comparison of the Perfect Competitor with the Monopolistic Competitor: Efficiency Perfect CompetitionMonopolistic Competition Quantity per Time Period Dollars per Unit ATC MC d MR = P P1P1 q1q1 Minimum ATC ATC MC P2P2 q2q2 Minimum ATC In Mon Comp: P  MC P  min ATC

7. 7 Efficiency - Excess Capacity Price (dollars/unit) 0 D MR ATC Quantity 120 P1P1 Q1Q1 MC Excess capacity Capacity output Profit- maximizing output Excess Capacity Theorem of Monopolistic Competition: each firm is producing an output less than the one for which its ATC reaches its minimum point; i.e., it has excess capacity.

8. 8 Efficiency: Monopolistic Competition  Monopolistically Competitive Markets tend to be –overcrowded with firms, –each of which tends to be underutilized  “wastes” of monopolistic competition. Consumers gain from –variety and choice. –advertising pros….cons… –product development….. Qualifications to “wastes”/ inefficiency.

9. 9 Oligopoly Competition among the few. –A market structure in which a small number of producers compete with each other. –2 producers = Duopoly Numbers must be small enough that –each firm has a significant share of the market –each firm must consider the reactions of rivals in formulating its best price and output decision.

10. 10 Which model applies? 1. Definition, table 2. 4 (8) firm concentration ratio; –i.e., % of the value of sales accounted for by the largest 4 (8) firms in the industry. –helps to determine the degree of competition Concentration ratio must be applied with other information such as: –a) geographical scope –b) barriers to entry & turnover –c) correspondence between a market and an industry.

11. 11 Characteristics of Oligopoly 1. Few dominant producers. 2. Homogeneous or differentiated product. 3. Advertising/Promotion. 4. Barriers to entry. And

12. 12 Characteristics of Oligopoly 5. Mutual interdependence among firms. –No firm in oligopoly will alter its price without trying to calculate the most likely reactions of rivals –Strategic Behaviour “ Oligopolies are price searchers engaged in a game of strategy.”

13. 13 Creating Barriers to Entry 1)Increasing Entry Costs (largely illegal) 2)Limit-Pricing -setting a price that will cause losses to new entrants (illegal in Canada) 3) Raising switching costs -ie: incompatible components -varying legality 4) Predatory Reputation -illegal

14. 14 Models of Oligopoly 1.)Cartel1.)Cartel – cartel – cartel: a group of firms acting together to minimize strategic behaviour  behave like monopoly – collusion – collusion: agreement among firms in a market about quantities to produce &/or prices to charge. Characteristics of Oligopoly –Notice »  there is no single model of oligopoly.  there is tension between co-operation and self interest.

15. 15 Collusion will be most successful when 1. Demand is inelastic  few substitutes outside the cartel. 2. Members of the cartel play by the rules; e.g., no price cutting: obey quota 3. Number of members is low. 4. Market conditions are good. 5. Barriers to entry are strong.

16. 16 Colluding to Maximize Profits Maximize industry profits: agree to set the industry output level equal to the monopoly output level. agree on how much of the monopoly output each firm will produce. for each firm, price is greater than MC; for the industry, MR = MC.

17. 17 Quantity (thous. /week) Price and cost (thous. of $/ unit ) 0 6 10 Colluding to Maximize Profits Quantity (thous. /week) Price and cost (thous. of $/ unit ) 0 10 123451234567 6 D 99 8 MR Economic Profit Collusion achieves monopoly outcome Individual Firm Industry MC ATC MC 1 Quota Output for the firm

18. 18 Colluding to Maximize Profits P$ MC Q 0 ATC D MC 1 Q P$ (a) Individual firm(b) Industry 3 6.00 6 MR Preferred firm output, P=MC 9.00 4 Collusion achieves monopoly outcome Economic profit 2 8.00 Additional profit from cheating

19. 19 Incentive to cheat provided price doesn’t fall.additional profit is available to a single cheating firm provided price doesn’t fall. If all firms cheat, an excess quantity supplied in the market will cause the price to fall. Since P > MC at quota, firms have an incentive to cheat, to produce more until P(MR)=MC

20. 20 Models of Oligopoly 2.)Game Theory –The analysis of strategic oligopoly behaviour –Behaviour that recognizes mutual interdependence and takes account of the expected behaviour of others

21. 21 2. Game Theory In all conflict situations - games - there are: decision makers, strategies and payoffs. Players choose strategies without knowing with certainty what the opposing player will do. Players construct BEST RESPONSES -optimal actions given all possible actions of other players

22. 22 Game Theory A special kind of Best Response. Strategy that is best no matter what the other player does. Eg. advertise DOMINANT STRATEGY

23. 23 Payoff Matrix –table that shows the payoffs/ outcomes for every possible action by each player for every possible action by the other player. Game Theory Eg: Advertising where firms are assumed to anticipate how rival firms might react

24. 24 Game Theory A’s profit= $50 000 A’s loss = $25 000 A’s profit= $75 000 A’s profit = $10 000 B’s profit = $50 000 B’s profit = $75 000 B’s loss = $25 000 B’s profit = $10 000 Don’t advertise Advertise B’s STRATEGY A’s STRATEGY Don’t advertise Advertise

25. 25 Game Theory The best strategy, resulting in the best outcome for both players, would be to collude and not advertise. “Nash” Equilibrium: –when player A takes the best possible action given the action of player B and player B takes the best possible action given the action of player A eg. In equilibrium both firms will advertise

26. 26 Game Theory This is an example of a prisoner’s dilemma type of game. –There is dominant strategy. –The dominant strategy does not result in the best outcome for either player. –It is hard to cooperate even when it would be beneficial for both players to do so eg., The dominant strategy: advertise

27. 27 Prisoners’ Dilemma Payoff Matrix Rocky’s strategies ConfessDeny Ginger’s strategies Confess 5 years 7 years Go free 1 year 7 years Go free Deny Dominant strategy: confess, even though they would both be better off if they both kept their mouths shut.

28. 28 Game Theory Cooperation between players is difficult to maintain because cooperation is individually irrational. Dominant Strategy Equilibrium –prisoners will confess, firms will advertise, countries arm: –eg, ban on cigarette advertising

29. 29 Solving the “dilemma” 1. Enforceable contract without an enforceable contract, is cooperation possible? –A solution to the “prisoner’s dilemma” can emerge if the game is played more than once; i.e., many times.

30. 30 Solving the “dilemma” 2. Repeated Games –Most real-world games get played repeatedly –Repeated games have a larger number of strategies because a player can be punished for not cooperating –This suggests that real-world duopolists might find a way of cooperating in order to increase profits

31. 31 Solving the “dilemma” 2. Tit-for-Tat Strategy –a player should start by cooperating and then do whatever the other player did last time. e.g., player cooperates until the other player cheats, the first player then cheats until the other player co-operates again. –What is the Nash Equilibrium when facing a tit-for-tat strategy?