1. Monopolistic Competition
Characteristics
1) Many firms
2) Free entry and exit
3) Differentiated product (but high degree of substitutability)
The amount of monopoly power depends on the degree of differentiation.
Examples of this common market structure include:
Toothpaste; Soap; Cold remedies; Soft Drinks; Coffee
Chapter 12 4

2. A Monopolistically Competitive Firm in the Short and Long Run
$/Q
Short Run
$/Q
Long Run MC AC MC AC
DSR
MRSR
QSR
PSR
DLR
MRLR
QLR
PLR
Quantity
Quantity 12

3. Monopolistic Competition in the SR
Observations (short-run)
Downward sloping demand - differentiated product
Demand is relatively elastic - good substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits
Chapter 12 13

4. Monopolistic Competition in the LR
Observations (long-run)
Profits will attract new firms to the industry (no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC -- some monopoly power
Chapter 12 14

5. Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium
Perfect Competition
Monopolistic Competition
$/Q
$/Q
Deadweight
loss MC AC MC AC
DLR
MRLR
QMC P QC PC
D = MR
Quantity
Quantity 17

6. Monopolistic Competition
Reduction in Economic Efficiency
The monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, total surplus would increase by the yellow triangle.
Although there are no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.
Chapter 12 18

7. Oligopoly Characteristics Small number of firms
Product differentiation may or may not exist
Barriers to entry
Examples: Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers
Chapter 12 24

8. Oligopoly Barriers to entry include: Management Challenges
Scale economies; Patents; Technology; Name recognition
Strategic action: Flooding the market; Controlling an essential input
Management Challenges
Strategic actions
Rival behavior
Chapter 12 26

9. Oligopoly Equilibrium in an Oligopolistic Market
In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price.
In oligopoly the producers must consider the response of competitors when choosing output and price.
Chapter 12 29

10. Oligopoly Equilibrium in an Oligopolistic Market Nash Equilibrium
Defining Equilibrium
Firms do the best they can and have no incentive to change their output or price
All firms assume competitors are taking rival decisions into account.
Nash Equilibrium
Each firm is doing the best it can given what its competitors are doing.
Chapter 12 30

11. Quantity Competition: Cournot
The Cournot Model
Duopoly
Two firms competing with each other
Homogeneous good
The output of the other firm is assumed to be fixed
Chapter 12 32

12. Firm 1’s Output Decision
MR1(0)
If Firm 1 thinks Firm 2 will
produce nothing, its demand
curve, D1(0), is the market
demand curve. P1
D1(50)
MR1(50) 25
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(75)
D1(75)
12.5
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MC1 50 Q1
Chapter 12 38

13. Reaction Curves and Cournot Equilibrium
Firm 1’s Reaction
Curve Q*1(Q2) x
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous example. Q1
100
Firm 2’s Reaction
Curve Q2*(Q1)
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce. 75
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits.
Cournot
Equilibrium 50 25 Q2 25 50 75
100
Chapter 12 43

14. Price Competition: Bertrand
Competition in an oligopolistic industry may occur with price instead of output.
The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods.
How will consumers respond to a price differential? (Hint: Consider homogeneity)
Chapter 12 63

15. Price Competition Bertrand Model
Why not charge a higher price to raise profits?
How does the Bertrand outcome compare to the Cournot outcome?
The Bertrand model demonstrates the importance of the strategic variable (price versus output).
Chapter 12 66

16. Price Competition Price Competition with Differentiated Products
Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product.
Chapter 12 70

17. Nash Equilibrium in Prices
Firm 2’s Reaction Curve $4
Nash Equilibrium
Firm 1’s Reaction Curve P2
Chapter 12 77

18. Competition Versus Collusion: Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $6
Charge $4
$12, $12
$20, $4
$16, $16
$4, $20
Firm 1
Charge $6
Chapter 12 88

19. Competition Versus Collusion: The Prisoners’ Dilemma
These two firms are playing a noncooperative game.
Each firm independently does the best it can taking its competitor into account.
Question
Why will both firms both choose $4 when $6 will yield higher profits?
An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.
Chapter 12 89

20. Competition Versus Collusion: The Prisoners’ Dilemma
Scenario
Two prisoners have been accused of collaborating in a crime.
They are in separate jail cells and cannot communicate.
Each has been asked to confess to the crime.
Chapter 12 91

21. Payoff Matrix for Prisoners’ Dilemma
Prisoner B
Confess
Don’t confess
Confess
-5, -5
-1, -10
-2, -2
-10, -1
Prisoner A
Would you choose to confess?
Don’t
confess
Chapter 12 92

22. Payoff Matrix for the Prisoners’ Dilemma
Conclusions: Oligopolistic Markets
1) Collusion will lead to greater profits
2) Explicit and implicit collusion is possible
3) Once collusion exists, the profit motive to break and lower price is significant
Chapter 12 95

23. Payoff Matrix for the P&G Pricing Problem
Unilever and Kao
Charge $1.40
Charge $1.50
Charge
$1.40
$12, $12
$29, $11
$3, $21
$20, $20
P&G
What price should P & G choose?
Charge
$1.50
Chapter 12 97

24. Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership
Price Signaling: Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit.
Price Leadership: Pattern of pricing in which one firm regularly announces price changes that other firms then match.
Chapter 12
110