Unit 12

Monopolistic competition and

Oligopoly

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Outcomes

• Define and explain monopolistic competition

• Define and explain oligopoly market structures

• Define and explain price competition• Describe difference between competition

and collusion• Discuss oligopolistic pricing

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Monopolistic competition

• Monopolistic competition:– Market in which firms can enter freely,– Each producing it’s own brand or version– Of a differentiated product.

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Monopolistic competition

• Two key characteristics:1. Firms compete by selling differentiated

products which is highly substitutable but not perfect substitutes.

2. There is free entry and exit.• When market is in equilibrium, firms are

doing their best and have no reason to change their price or output

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SR and LR equilibrium

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Monopolistic competition and economic efficiency

• Perfect competitive market are desirable because = economic efficient.

• Monopolistic competition is similar.• Two source of inefficiency in monopolistic

competition:1. Equilibrium price > MC: Value exceeds cost2. Output below minimizing average cost:

Excess capacity is inefficient.

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Monopolistic competition and economic efficiency

• Inefficiencies make consumers worse off:• Should this market be regulated? No,

why:1. Monopoly power is small.2. Important benefit: Product diversity.

Consumers value to choose between a wide variety.

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Monopolistic competition and economic efficiency

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Oligopoly

• Market in which only a few firms compete with one another, and entry by new firm is impeded.

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Oligopoly

• Behaviour of other firms always taken into account.

• Barriers to entry: Difficult or impossible for new firms to enter.

• If just 2 firms = Duopoly– For our purpose, only focus on duopolies:

One competitor to worry about.

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Equilibrium in oligopoly

• Equilibrium where MR=MC• Nash Equilibrium: Set of strategies or

actions in which each firm does the best it can given its competitors’ action.– And so will the competitor do the best they

can.

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The Cournot model

• Simple model of duopolies introduced by Augustin Cournot.– Firms produce homogenous goods– Know the market demand curve– Each firm must decide how much to produce– Two firms make their decision at the same

time– Take competitor into account

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Cournot model• Essence of model:

– Level of output for competitor fixed – When deciding how much to produce

• Reaction curve: Relationship between a firm’s profit maximizing output and the amount it thinks its competitor will produce.

• Cournot equilibrium: Each firm correctly assumes how much its competitor will produce and sets its own production level accordingly

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Firm 1’s output decisions

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The Cournot model

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The Stackelberg model- First mover advantage

• First assumed: Duopolist make output decision at the same time.

• Stackelberg model: Oligopoly module in which one firm sets its output before other firms do.

• See example page 455• Cournot and Stackleberg models are

alternative representations of oligopolistic behaviors

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Oligopoly: Setting the price- Price competition

• Oligopolistic firms compete by setting quantities.

• But, it can occur along price discrimination.• Nash equilibrium used to study price

competition.– First in a industry producing homogeneous

products,– Second, in a industry with some degree of

product differentiation.

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Price competition with homogeneous products

• The Bertrand Model:– Oligopoly model– In which firms produce a homogenous good– Each firm treats the price of it’s competitors as

fixed– All firms decide simultaneously what price to

charge.

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Bertrand model

• Firms choose price instead of quantity.• Will dramatically affect market outcome.• View example on page 458• Firm price at MC and make no profit!

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Bertrand model• Criticism:

– More natural to compete by setting quantities rather than price, as with a homogeneous good.

– If firms do set prices and choose the same price, what share of total sales will go to each one?

• Useful:– Shows how equilibrium output in oligopolies can

depend crucially on the firms’ choice of strategic variable.

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Price competition with differentiated products

• Some degree of product differentiation.– Example: Gas station differs in location and

service provided.• Market share not only determined by price

but also differences in:– Design– Performance– DurabilityNatural for firm to compete on price!

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Price competition with differentiated products

• Simple example on page 458

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Competition vs. Collusion:- The prisoner’s dilemma

• Nash equilibrium = non-cooperative equilibrium: – Each firm makes the decisions that give it the highest

possible profit, – given the actions of competitors

• Non-cooperative game: Game in which negotiation and enforcement of binding contracts are not possible.

• Collusion = Illegal: Coordinate prices and output levels to maximize joint profits = Cartel

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Competition vs. Collusion:- The prisoner’s dilemma

• Cooperation higher profits: Why not cooperate without explicitly colluding?– Set a price and hope competitor set the same

price!– Problem: Competitor will not choose to set

price at same level. Will do better by setting lower price.

• See example page 461

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Competition vs. Collusion:- The prisoner’s dilemma

Table showing profit/payoff to each firm given its

decision and decision of competitor

Game theory example in which 2 prisoners must decide

separately whether to confess to a crime.

Confess = Lighter sentence and accomplice heaver sentence

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Competition vs. Collusion:- The prisoner’s dilemma

• Oligopolistic firm often find themselves in a prisoner’s dilemma.– Compete aggressively, gain market share, or– Compete passively, coexist with competitor

and settle for market share.– Implicitly collude!

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Implications of the prisoners’ dilemma for oligopolistic pricing• Firms price over and over again.• Continually observe competitors.• And adjust!• Competitors can develop mistrust if one

firm ‘rocks the boat’ – by changing price or increase advertising.

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Price rigidity

• Definition:– Firms are reluctant to change prices even if

costs or demand change• Basis for the kinked demand curve model:

– Oligopoly model– Each firm faced a demand curve kinked at

prevailing price– At higher price demand is elastic and vice

versa

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Kinked demand curve

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Price signaling and price leadership

• Price signaling:– Form of implicit collusion– 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

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The dominant firm model

• Definition:– Firm with a large share of total sales– That sets price to maximize profits– Taking into account the supply response of

smaller firms.

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The dominant firm model

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Cartels

• Explicit agree to cooperate by setting price and output levels.

• Often international – law poorly enforced.• OPEC cartel = international agreement.• Conditions for success:

– Stable cartel organization must be formed, members agree on price and production levels, and must adhere to agreement.

– Potential monopoly power.

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Cartel