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

Product Differentiation• The distinguishing between products through real or

imagined properties– Quality– Services– Location– Advertising– Packaging

More product differentiation =

less elasticity of demand

3

Short-Run Equilibrium: Monopolistic Competition

MC

Quantity

Dol

lars

per

Uni

t

d

MR

ATC

Profits

-Price (Pe) > ATC

-Economic profit

E

ATC

Pe

qe

Quantity

Dol

lars

per

Uni

t

d

MR

MCATC

Losses

-Price (Pe) < ATC

-Economic loss

E

ATC

Pe

qe

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

Long-Run Equilibrium

ATC

Quantity

Dol

lars

per

Uni

t

d

MR

MC

--Price (Pe) = ATC-Zero econ. profits-Normal rate of return

E

Pe =ATC

qe

• 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

MR

d'

Quantity per Time Period

Dol

lars

per

Uni

t

Comparison of the Perfect Competitorwith the Monopolistic Competitor: Efficiency

Perfect Competition Monopolistic Competition

Quantity per Time Period

Dol

lars

per

Uni

t

ATCMC

d

MR = P

P1

q1

Minimum ATC ATCMC

P2

q2

Minimum ATC

In Mon Comp:PMCPmin ATC

7

Efficiency - Excess CapacityP

rice

(do

llars

/un

it)

0

D

MR

ATC

Quantity

120

P1

Q1

MC

Excesscapacity

Capacityoutput

Profit-maximizingoutput

• 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

Efficiency: Monopolistic Competition

Monopolistically Competitive Markets tend to be Monopolistically Competitive Markets tend to be

– overcrowded overcrowded with firms, with firms, – each of which tends to be each of which tends to be underutilized underutilized

“ “wastes”wastes” of monopolistic competition. of monopolistic competition.

Consumers gain from – variety and choice. – advertising

•pros….•cons…– product development…..

Qualifications to “wastes”/ inefficiency.

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

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

Characteristics of Oligopoly

1. Few dominant producers.

2. Homogeneous or differentiated product.

3. Advertising/Promotion.

4. Barriers to entry.And

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

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

Models of Oligopoly• 1.)Cartel1.)Cartel

– cartelcartel: a group of firms acting together to minimize strategic behaviour behave like monopoly

– collusioncollusion: 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

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

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.

17Quantity (thous. /week)

Pric

e a

nd c

ost (

thou

s. o

f $/ u

nit)

0

6

10

Colluding to Maximize Profits

Quantity (thous. /week)

Pric

e a

nd c

ost (

thou

s. o

f $/ u

nit)

0

10

1 2 3 4 5 1 2 3 4 5 6 7

6

D

99

8

MR

EconomicProfit

Collusion achievesmonopoly outcome

Individual Firm Industry

MC ATC

MC1

Quota Output for the firm

18

Colluding to Maximize ProfitsP$

MC

Q0

ATC

D

MC1

Q

P$

(a) Individual firm (b) Industry

3

6.00

6

MR

Preferred firm output, P=MC

9.00

4

Collusion achievesmonopoly outcome

Economicprofit

2

8.00

Additionalprofit fromcheating

19

Incentive to cheat

•additional profit is available to a single cheating firm provided priceprovided price doesn’t falldoesn’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

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

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

Game Theory

•A special kind of Best Response.

•Strategy that is best no matter what the other player does.

•Eg. advertise

DOMINANT STRATEGY

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

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 AdvertiseB’s STRATEGY

A’s STRATEGY

Don’t advertise

Advertise

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

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

Prisoners’ Dilemma Payoff MatrixRocky’s strategies

ConfessDeny

Ginger’sstrategies

Confess5 years

5 years

7 years

Go free

1 year

1 year 7 years

Go freeDenyDominant strategy: confess, even though they would both be better off if they both kept their mouths shut.

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

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

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

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?