1. MARKET STRUCTURE: MONOPOLISTIC COMPETITION & OLIGOPOLY
CHAPTER 7:
MARKET STRUCTURE: MONOPOLISTIC COMPETITION & OLIGOPOLY
7.1 Characteristic
7.2 Short-run Decision: Profit Maximization
7.3 Short-run Decision: Minimizing Loss
7.4 Long-run Equilibrium
7.5 Oligopoly Model
7.6 Games Theory
7.7 Efficiency

2. Market structure compared:
More competing firms
Monopoly
Perfect Competition
Monopoly:
Single firm (firm = market).
Single unique product (no close substitute).
Restriction to entry.
Market power: the highest but still constraint by market demand.
Perfect competition:
Many firms.
Homogenous product.
Free entry & exit.
Market power: the lowest (firm as price taker).

3. Monopolistic Competition
Market structure compared:
More competing firms
Monopolistic Competition
Perfect Competition
Monopoly
Oligopoly
Oligopoly:
Few big firms.
Can be homogenous or differentiated.
Few restriction to entry.
Market power: Yes but may face fierce competition among few big firms (except collusion happen).
Strategic behavior.
Monopolistic competition:
Many firms.
Differentiated product.
Free entry & exit.
Market power: Yes but limited.
Price & quality competition.

4. 7.1 Characteristic
Monopolistic competition is a market structure in which:
(1A) A large number of independent firms compete.
(2A) Each firm produces a differentiated product.
(3A) Firms compete on product quality, price, and marketing.
(4A) Firms are free to enter and exit.
Oligopoly is a market type in which:
(1B) A small number of firms compete.
(2B) Product can be homogenous or differentiated.
(3B) Strategic behavior explained firms’ decisions. (Game Theory)
(4B) Natural or legal barriers prevent the new entry.

5. Monopolistic competition
(1A) The market that has a large number of firms (like in perfect competition) has three implications:
(i) small market share for each firm, therefore each firm has only a small market share and therefore has limited market power to influence the price of its product
(ii) Each firm is sensitive to the average market price, but no firm pays attention to the actions of the other, and no one firm’s actions directly affect the actions of other firms.
(iii) Collusion, or conspiring to fix prices, is impossible.

6. Monopolistic competition
(2A) Product differentiation is a strategy that firms use to achieve market power. Accomplished by producing products that have distinct positive identities in consumers’ minds (mean seen as slightly different). This differentiation is often accomplished through advertising.
(2A & 3A) Advertising provides consumers with the valuable information on product availability, quality, and price that they need to make efficient choices in the marketplace.
(4A) Free entry & exit: There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.

7. Monopolistic competition
(3A) 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, each firm has a downward-sloping demand curve for its own product. Thus, there are different prices for each differentiated products (but usually, the different in price is not too huge.
Differentiated products must be marketed using advertising and packaging. Branding will further differentiate the product and usually will enhance the perceived quality of the particular firm’s product.

8. Figure 7.1: Advertising Effect
Monopolistic Competition
(3A) Selling efforts such as advertising are successful if they increase the demand for the firm’s product. Advertising costs might lower the average total cost by increasing equilibrium output and spreading their fixed costs over the larger quantity produced.
Figure 7.1: With no advertising, the firm produces 25 units of output at an average total cost of $60.
With advertising, the firm produces 100 units of output at an average total cost of $40.
The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.
Figure 7.1: Advertising Effect

9. Identifying Monopolistic Competition Two indexes:
The four-firm concentration ratio
The Herfindahl-Hirschman Index
The four-firm concentration ratio
The percentage of the value of sales accounted for by the four largest firms in the industry.
The range of concentration ratio is from almost zero for perfect competition to 100 percent for monopoly.
A ratio that exceeds 40 percent: indication of oligopoly.
A ratio of less than 40 percent: indication of monopolistic competition.

10. ANTITRUST DIVISION ACTION
Monopolistic Competition
Herfindahl-Hirschman Index (HHI)
HHI is a mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government.
Example, four firms with market shares as 50 percent, 25 percent, 15 percent, and 10 percent.
HHI = = 3,450
A market with an HHI less than 1,000 is regarded as competitive.
An HHI between 1,000 and 1,800 is moderately competitive.
ANTITRUST DIVISION ACTION
Unconcentrated No challenge
Moderate Concentration Challenge if Index is raised by more than 100 points by the merger
HHI
1,800
1,000
Concentrated Challenge if Index is raised by more than 50 points by the merger

11. 7.1 Characteristic
Monopolistic competition is a market structure in which:
(1A) A large number of independent firms compete.
(2A) Each firm produces a differentiated product.
(3A) Firms compete on product quality, price, and marketing.
(4A) Firms are free to enter and exit.
Oligopoly is a market type in which:
(1B) A small number of firms compete.
(2B) Product can be homogenous or differentiated.
(3B) Strategic behavior explained firms’ decisions. (Game Theory)
(4B) Natural or legal barriers prevent the new entry.

12. Oligopoly Characteristic
(2B) In contrast to monopolistic competition and perfect competition, an oligopoly consists of a small number of firms:
Each firm has a large market share.
The firms are interdependent. Thus, the behavior of oligopoly firms depend on the behavior of other (oligopoly) firms in the industry. Before making a decision, each firm must consider how the other firms will react to its decision and influence its profit. (3B)
The firm have incentive to collude. [Collusion Model]. Collusion occurs when price- and quantity-fixing agreements are explicit. E.g is cartel (a group of firms that gets together and makes price and output decisions to maximize joint profits). Tacit collusion occurs when firms end up fixing price without a specific agreement, or when such agreements are implicit.

13. Oligopoly (4B) Barriers to Entry
Either natural or legal barriers to entry can create an oligopoly.
Natural barriers arise from the combination of the demand for a product and economies of scale in producing it.
If the demand for a product limits to a small number the firms that can earn an economic profit, there is a natural oligopoly.

14. Figure 7.2(a) show a natural duopoly situation.
Oligopoly
Figure 7.2(a) show a natural duopoly situation.
Here, where price equals minimum ATC, the lowest possible price, two firms can produce the quantity demanded in the market.
Figure 7.2(b) show a natural oligopoly with three firms.
Here, where price equals minimum ATC, the lowest possible price, three firms can produce the quantity demanded in the market.
Figure 7.2(a): Natural duopoly
Figure 7.2(b): Natural oligopoly with three firms

15. (4B) Contestable Market
Oligopoly
(4B) Contestable Market
A market is perfectly contestable if entry to it and exit from it are costless.
In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms. Prices are pushed to long-run average cost by competition, and positive profits do not persist.
Oligopolies are concentrated industries. At one extreme is the cartel, in essence, acting as a monopolist. At the other extreme, firms compete for small contestable markets in response to observed profits. In between are a number of alternative models, all of which stress the interdependence of oligopolies firms.

16. Figure 7.3: Monopolistic Competition
Another Characteristic: Demand Curve & Equilibrium Outcome
Figure 7.3: Monopolistic Competition
Demand Curve
The demand curve faced by a monopolistic competitor is likely to be less elastic than the demand curve faced by a perfectly competitive firm, but more elastic than the demand curve faced by a monopoly.

17. Figure 7.4:Possible Oligopoly Outcome
Competitive Outcome: Price equals marginal cost.
Monopoly Outcome: The firm would be a single-price monopoly.
Possible Oligopoly Outcomes: The extremes of perfect competition and monopoly provide the maximum range within which the oligopoly outcome might lie.

18. 7.2 Short-run Decision: Profit Maximization
Monopolistic Competition
7.2 Short-run Decision: Profit Maximization
The firm in monopolistic competition makes its output and price decision just like a monopoly firm does, that is
MR = MC.
Figure 7.2: Profit Maximization
In the short-run, a monopolistically competitive firm will produce up to the point where MR = MC.
This firm is earning positive profits in the short-run.

19. 7.3 Short-run Decision: Minimizing Loss
Monopolistic Competition
7.3 Short-run Decision: Minimizing Loss
The firm in monopolistic competition might incurred loses in the short-run. Profit are not guarantee. But, loss minimized when MR = MC.
Figure 7.3: Loss Minimization
Loss is minimized at MC = MR at 40 thousand of output.
The price = $40 per month which is less than ATC ($50). Therefore, the firm incurs losses.

20. 7.4 Long-run Decision: Monopolistic Competition
Long Run: Zero Economic Profit
Economic profit induces entry and economic loss induces exit, as in perfect competition.
Entry decreases the demand for the product of each firm. Exit increases the demand for the product of each firm.
In the long run, economic profit is competed away and firms earn normal profit.
Figure 7.4 illustrates long-run equilibrium where the firm’s demand curve is just tangent to its average cost curve.
Figure 7.4: Long-Run Equilibrium

21. Possible Behavior / Strategy
7.5 Oligopoly Model
Possible Behavior / Strategy
Compete
Not to compete
Collusion Model
Quantity leadership (Stackelberg Model)
Price Leadership Model
Simultaneous Quantity Setting (Cournot Model)
Simultaneous Price Setting (Bertrand Model)
Plus one general model: Kinked Demand Curve Model
<< Assumption for oligopoly model analysis: Identical product >>

22. The Kinked Demand Curve Model
Oligopoly
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 (the general assumption).
Figure 7.5: Kinked Demand Curve
Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firm’s quantity demanded (demand is elastic).
Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic).

23. Quantity leadership (Stackelberg Model)
Oligopoly
Quantity leadership (Stackelberg Model)
The dominant firm (leader) choose an output level that can maximize its profit
Then, the smaller firms (followers) response and choose their respective output level given the choice of their leader.
The leader is aware that its actions influence the output choices of its follower. Thus, its decision need to consider the expected reaction of its follower.
The equilibrium(s) for Stackelberg model reflects in the Nash equilibrium of games theory in which each player takes the best possible action given the action of the other player .

24. The dominant firm (leader) set a price level
Oligopoly
ii. Price leadership
The dominant firm (leader) set a price level
Then, the smaller firms (followers) follow its pricing policy due to assumption that products are identical. So, if firms charge different price, the customers would prefer the producer with the lowest price.
Thus, it is like a perfectly competitive market. Each follower firm takes the price as being outside of its control because it is only a small part of the market.

25. The price-leadership model outcome:
Oligopoly
The price-leadership model outcome:
The quantity demanded in the industry is split between the dominant firm and the group of smaller firms.
This division of output is determined by the amount of market power of the dominant firm.
The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly.

26. Oligopoly
Large, powerful firm (the leader) can drive smaller firms out of the market by temporarily selling at an artificially low price. This practice is called predatory pricing.
Such behavior became illegal in the United States with the passage of antimonopoly legislation around the turn of the century.

27. iii. Simultaneous Quantity Setting (Cournot Model)
Oligopoly
iii. Simultaneous Quantity Setting (Cournot Model)
The oligopoly firms simultaneously trying to decide what quantity to produce.
Each firm has to forecast what the other firm’s output will be in order to make a sensible decision itself.
A series of output adjustment lead to a final decision of output where every firm’s expectation about the other firms’ output choices is satisfied (called Cournot equilibrium).
In Cournot equilibrium, neither firms will find it profitable to change its output once it discovers the choice actually made by other firms (satisfied with this discovery).
Cournot equilibrium can be generalized in the Nash equilibrium (one of the Game Theory strategy).

28. iv. Simultaneous Price Setting (Bertrand Model)
Oligopoly
iv. Simultaneous Price Setting (Bertrand Model)
The oligopoly firms simultaneously trying to decide what price to produce.
Interestingly, the Bertrand equilibrium is the same as perfect competition equilibrium. The logic?
No firm will be setting its price below its MC as they will suffer losses. (assuming same cost structure and product identical).
If Firm A is believed to set price above MC, Firm B (or other firms) can under-cut to set a slightly lower than Firm A price to gain customers.
However, this knowledge is also known by Firm A and other firms (not only Firm B). So, what is the price that give no chance for other to under-cut?
It is when price equal MC!!! (the perfect competitive profit maximization condition).

29. 7.6 Game Theory
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.
What Is a Game?
All games share four features:
Rules
Strategies
Payoffs
Outcome.

30. In game theory, firms are assumed to anticipate rival reactions.
Game theory analyzes oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms.
In game theory, firms are assumed to anticipate rival reactions.

31. Payoff Matrix for Advertising Game
Game Theory
Payoff Matrix for Advertising Game
The strategy that firm A will actually choose depends on the information available about B’s likely strategy.
Regardless of what B does, it pays for A to advertise. This is the dominant strategy, or the strategy that is best no matter what the opposition does.

32. The Prisoners’ Dilemma is a game in which:
Game Theory
The Prisoners’ Dilemma is a game in which:
The players are prevented from cooperating with each other;
Each player in isolation has a dominant strategy;
The dominant strategy makes each player worse off than in the case in which they could cooperate.

33. Game Theory
Ginger and Rocky have dominant strategies to confess even though they would be better off if they both kept their mouths shut.

34. Game Theory
In game theory, when all players are playing their best strategy given what their competitors are doing, the result is called Nash equilibrium.

35. Game Theory
When uncertainty and risk are introduced, the game changes. A maximin strategy is a strategy chosen to maximize the minimum gain that can be earned.

36. Most real-world games get played repeatedly.
Game Theory
While explicit collusion violates the antitrust statutes, strategic reaction does not.
Strategic reaction in a repeated game may still have the same effect as tacit collusion.
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 learning to cooperate so they can enjoy monopoly profit.
The larger the number of players, the harder it is to maintain the monopoly outcome.

37. Game Theory
The strategy to respond in a way that lets your competitors know you will follow their lead is called tit-for-tat strategy. If one leads and the competitor follows, both will be better off.

38. 7.7 Efficiency of Monopolistic Competition
In the long-run, positive economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however:
Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product.
Average total cost is not minimized. The typical firm will not realize all the economies of scale available. Smaller and smaller market share results in excess capacity. (A firm has excess capacity if it produces less than the quantity at which ATC is a minimum).

39. 7.7 Efficiency of Oligopoly
Oligopolies, or concentrated industries, are likely to be inefficient for the following reasons:
Profit-maximizing oligopolists are likely (but not always) to price above marginal cost. So, the quantity produced is less than the efficient quantity (like in perfect competition market).
Strategic behavior can force firms into deadlocks that waste resources.
Product differentiation and advertising may pose a real danger of waste and inefficiency.

40. Further Example of Game Theory
Table 8.2: Dominant Equilibrium
Table 8.3: Nash Equilibrium & Cournot Model
Table 8.4: Nash Equilibrium & Stackelberg Model
Table 8.5: No Nash Equilibrium
Table 8.7: Prisoner’s Dilemma: Price War Decision
End