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10 Monopolistic Competition and Monopolistic Competition and OligopolyOligopoly
What market structures lie between perfect competition and monopoly, and what are their characteristics?
How is monopolistic competition similar to perfect competition? How is it similar to monopoly?
How do monopolistically competitive firms choose price and quantity? Do they earn economic profit?
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10 Monopolistic Competition and Monopolistic Competition and OligopolyOligopoly
What is game theory?
How is game theory related to oligopoly?
What outcomes are possible under oligopoly?
Why is it difficult for oligopoly firms to cooperate?
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Introduction: Between Monopoly and
Competition
Two extremes
• Competitive markets: many firms, identical products
• Monopoly: one firm, unique product
In between these extremes
• Oligopoly: only a few sellers offer similar or identical products.
• Monopolistic competition: many firms sell similar but not identical products.
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Market Structures
Perfect Competition
Monopolistic Competition
Oligopoly Monopoly
# of firms
type of product
control over price
free entry/exit
long run
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Introduction to Monopolistic Competition
Monopolistic competition: a market structure in which many firms sell products that are similar but not identical.
Examples:
• apartments, books, bottled water, clothing, fast food, night clubs, gasoline
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profit
ATC
P
A Monopolistically Competitive Firm Earning Profits in the Short
RunThe firm faces a downward-sloping D curve.
At each Q, MR < P.
To maximize profit, firm produces Q where MR = MC.
The firm uses the D curve to set P. Quantity
Price
ATC
D
MR
MC
Q
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losses
A Monopolistically Competitive Firm with Losses in the Short
Run
For this firm, P < ATC at the output where MR = MC.
The best this firm can do is to minimize its losses.
Quantity
Price
ATC
Q
P
ATC
MC
D
MR
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Comparing MonopolisticCompetition and Monopoly
Short run: Under monopolistic competition, firm behavior is very similar to monopoly.
Long run: In monopolistic competition, entry and exit drive economic profit to zero (similar to PC).
• If > 0 in the short run: New firms enter market, lowering the demand faced by existing firms, prices and profits fall.
• If < 0 in the short run:Some firms exit the market, remaining firms enjoy greater demand and prices.
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A Monopolistic Competitorin the Long Run
Entry and exit occurs until P = ATC and profit = zero.
Notice that the firm charges a price that is greater than MC, and does not produce at minimum ATC.
Quantity
Price
ATC
D
MR
Q
MC
MC
P = ATC
markup
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Why Monopolistic Competition Is Less Efficient than Perfect
Competition1. Excess capacity (No Productive Efficiency)
• The monopolistic competitor operates on the downward-sloping part of its ATC curve, and produces less than the cost-minimizing output.
• Under perfect competition, firms produce the quantity that minimizes ATC.
2. Markup over marginal cost (No Allocative Efficiency)
• Under monopolistic competition, P > MC.
• Under perfect competition, P = MC.
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Deadweight Loss of Monopolistic Competition
Monopolistically competitive markets do not have all the desirable properties of perfectly competitive markets.
• Because P > MC, the market quantity is below the socially efficient quantity.
• But, we get variety.
It is not easy for policymakers to fix this problem: Firms earn zero profits, so policymakers cannot require them to reduce prices.
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Advertising In monopolistically competitive industries,
product differentiation and markup pricing lead naturally to the use of advertising.
In general, the more differentiated the products, the more advertising firms buy.
Economists disagree about the social value of advertising. Does it:
• waste resources and manipulate consumers?
• provide information and induce competition?
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Oligopoly
The most important feature of an oligopolistic market is the interdependence between firms.
• Each firm knows that any change it makes (regarding price, output, quality, advertising, etc.) will lead to a reaction from its competitors.
Products sold may be
• differentiated: cereals, airlines, cars
• undifferentiated: crude oil, raw steel
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P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
EXAMPLE: Cell Phone Duopoly in Smalltown
Smalltown has 140 residents
The “good”: cell service with unlimited anytime minutes and free phone
Smalltown’s demand schedule
Two firms: Cingular, Verizon(duopoly: an oligopoly with two firms)
Each firm’s costs: FC = $0, MC = $10
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5045
6040
7035
8030
9025
10020
11015
12010
1305
140$0
QP
EXAMPLE: Cell Phone Duopoly in Smalltown
Competitive outcome:P =Q =Profit =
Competitive outcome:P =Q =Profit =
Monopoly outcome:P = Q =Profit =
Monopoly outcome:P = Q =Profit =2,250
2,400
2,450
2,400
2,250
2,000
1,650
1,200
650
$0
TR
500
600
700
800
900
1,000
1,100
1,200
1,300
$1,400
TC
1,750
1,800
1,750
1,600
1,350
1,000
550
0
–650
–1,400
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EXAMPLE: Cell Phone Duopoly in Smalltown
One possible duopoly outcome: collusion
Collusion: an agreement among firms in a market about quantities to produce or prices to charge
Cingular and Verizon could agree to each produce half of the monopoly output:
• For each firm: Q = , P = , profits =
Cartel: a group of firms acting in unison
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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Collusion vs. self-interestCollusion vs. self-interest
Duopoly outcome with collusion:Each firm agrees to produce Q = 30, earns profit = $900.
If Cingular reneges on the agreement and produces Q = 40, what happens to the market price? Cingular’s profits?
Is it in Cingular’s interest to renege on the agreement?
If both firms renege and produce Q = 40, determine each firm’s profits.
17
P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers
If both firms stick to agreement, each firm’s profit =
If Cingular reneges on agreement and produces Q = 40:
Market quantity = , P =
Cingular’s profit =
Verizon will conclude the same, so both firms renege, each produces Q = 40:
Market quantity = , P =
Each firm’s profit =
P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
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The Equilibrium for an Oligopoly
Nash equilibrium: a situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen
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Collusion vs. Self-Interest
Our duopoly example has a Nash equilibrium in which each firm produces Q = 40.
• Given that Verizon produces Q = 40, Cingular’s best move is to produce Q = 40.
• Given that Cingular produces Q = 40, Verizon’s best move is to produce Q = 40.
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Collusion vs. Self-Interest
Both firms would be better off if both stick to the cartel agreement.
But each firm has incentive to renege on the agreement.
Lesson: It is difficult for oligopoly firms to form cartels and honor their agreements.
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A Comparison of Market Outcomes
When firms in an oligopoly individually choose production to maximize profit,
• Q is greater than monopoly Q but smaller than competitive market Q
• P is greater than competitive market P but less than monopoly P
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The Size of the Oligopoly
As the number of firms in the market increases,
• the oligopoly looks more and more like a competitive market
• P approaches MC
• the market quantity approaches the socially efficient quantity
Another benefit of international trade: Another benefit of international trade: Trade increases the number of firms competing, Trade increases the number of firms competing,
increases increases QQ, keeps , keeps PP closer to marginal cost closer to marginal cost
Another benefit of international trade: Another benefit of international trade: Trade increases the number of firms competing, Trade increases the number of firms competing,
increases increases QQ, keeps , keeps PP closer to marginal cost closer to marginal cost
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Game Theory
Game theory: the study of how people behave in strategic situations
Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players
Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial
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Prisoners’ Dilemma Example
The police have caught Bonnie and Clyde, two suspected bank robbers, but only have enough evidence to imprison each for 1 year.
The police question each in separate rooms, offer each the following deal:
• If you confess and implicate your partner, you go free.
• If you do not confess but your partner implicates you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.
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Prisoners’ Dilemma Example
Confess Remain silent
Confess
Remain silent
Bonnie’s decision
Clyde’s decision
Bonnie gets
8 yearsClyde gets 8 years
Bonnie gets
20 years
Bonnie gets
1 year
Bonnie goes free
Clyde goes free
Clyde gets 1 year
Clyde gets 20 years
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Prisoners’ Dilemma Example
Outcome: Bonnie and Clyde both confess, each gets 8 years in prison.
Both would have been better off if both remained silent.
But even if Bonnie and Clyde had agreed before being caught to remain silent, the logic of self-interest takes over and leads them to confess.
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AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : The “fare wars” gameThe “fare wars” game
The players: American Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone.
• If both airlines cut fares, each airline’s profit = $400 million
• If neither airline cuts fares, each airline’s profit = $600 million
• If only one airline cuts its fares, its profit = $800 millionthe other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium. 28
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AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : AnswersAnswers
29
Cut fares Don’t cut fares
Cut fares
Don’t cut fares
American Airlines
United Airlines
$600 million
$600 million
$200 million
$800 million
$800 million
$200 million
$400 million
$400 million
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Other Examples of thePrisoners’ Dilemma
Advertising WarsTwo firms spend millions on TV ads to steal business from each other. Each firm’s ad cancels out the effects of the other, and both firms’ profits fall by the cost of the ads.
Organization of Petroleum Exporting Countries Member countries try to act like a cartel, agree to limit oil production to boost prices & profits. But agreements sometimes break down when individual countries renege.
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Another Example – A Game of Chicken
Game of Chicken:
Two hooligans with something to prove drive at each other on a narrow road. The first to swerve loses faces among his peers. If neither swerves, however, a terminal fate plagues both.
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Game of Chicken
Swerve Stay
Swerve
Stay
Player One’s decision
Player Two’s
decision
0
0
5
-50-5
-5
-505
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Why People Sometimes Cooperate
When the game is repeated many times, cooperation may be possible.
“Tit-for-tat” Whatever move your rival takes in one round you do the same move in the next round.
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34
Cut fares Don’t cut fares
Cut fares
Don’t cut fares
American Airlines
United Airlines
$600 million
$600 million
$200 million
$800 million
$800 million
$200 million
$400 million
$400 million
Why a Tit-for-Tat Strategy Works