chapter 10 monopolistic competition and oligopoly
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Chapter 10
Monopolistic Competition
and Oligopoly
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Monopolistic Competition
• Characteristics– many small buyers & sellers– nonhomogeneous or differentiated product– no barriers to entry/exit– perfect information– mobile resources– no public goods / externalities
The only difference between perfect competition and monopolistic competition is the nature of the product
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Monopolistic Competition
• Product differentiation– Physical differences, location, product
image
– Results in the firm facing a downward sloping demand for its own product
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Short-Run Profit Max. or Loss Min.
• Maximize profit– Produce q where MR=MC
– Price is found on firm’s D curve
(like a monopoly)
– Profit can be positive, zero or negative• Depends on AC
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Max. Profit or Min. Loss in Short-Run
• If P>AC– Economic profit
• If AC>P>AVC– Economic loss
– Produce in short run
• If P<AVC: AVC curve above D curve– Economic loss
– Shut down in short run
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Long-Run Profit Maximization
• If SR economic profit exists– New firms enter the market
– Draw customers away from other firms
– Reduce demand facing other firms• Shift firm’s demand to left
– Profit disappears in long run• Zero economic profit• P = LRAC • Demand is tangent to LRAC
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Long-Run Profit Maximization
• If SR economic loss exists– Some firms exit the market
– Their customers switch to other firms
– Increase demand facing the remaining firms• shift firm’s demand to right
– Loss is erased in the long run• Zero economic profit for remaining firms• P = LRAC• Demand is tangent to LRAC 7
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Profit Maximization
• In monopolistic competition equilibrium– P > MC
– Inefficient (deadweight loss exists)
– AC at q* > min AC
– Excess Capacity is the difference between the profit max. rate of output and the cost min. rate of output• “too many firms each producing too little”• diversity of products??
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Monopolistic vs. Perfect Competition
• Both– Zero economic profit in long run
– MR = MC for quantity• where D is tangent to AC
• Perfect competition– Firm’s demand is horizontal line
– Produces at minimum average cost
– Productive and allocative efficiency
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Advertising
• Occurs in monopolistic competition– Shifts demand for firm
• Increases demand• More inelastic demand
• Increasing potential for profit
– Increases costs to firm
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Oligopoly
• Few, large sellers• Homogeneous or differentiated product• May be barriers to entry
• Oligopolistic interdependence– each firm must take its rival’s behavior
into account in their own decision making
• Many models exist in oligopoly 11
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Models of Oligopoly
• Cartel / Collusion• Kinked Demand• Price leadership• Game theory
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Collusion and Cartels
• Collusion– Agreement among firms to
• Divide the market• Fix the price
• Cartel– Group of firms that agree to collude to
maximize industry profit• Act as monopoly• Increase economic profit
• Illegal in U.S. 13
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Cartel Example
• 5 firms in industry– Divide up output equally
– MCi = 5
• QM = 100,000
• Qi = 20,000
• PM = 10
• Πi = 20,000 (10 – 5) = $100,000
• ΠM = $500,000
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Cartel & Cheating
• Firm 1 cheats
– Q1 = 40,000
– QM = 120,000
– PM = 9
– Π1 = 40,000 (9 – 5) = $160,000
– Πi = 20,000 (9 – 5) = $80,000
– ΠM = $480,000
• Incentive exists to cheat!15
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Collusion and Cartels
• Difficulties to maintain a cartel:– Differences in average cost
– Increase # of firms
– Differentiated product
– Low barriers to entry
– Cheating by cartel members
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Kinked Demand
• Each firm assumes that– Rivals will follow all price decreases
– Rivals will not follow any price increases• Demand is more elastic for price increases
than for price decreases
– Results in price rigidity in the face of increasing costs
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Price Leadership
• 1 large firm• Many small firms (competitive fringe)• Price leader
– Sets the price for the industry
– Initiate price changes
– Followed by the other firms
• Tacit Price coordination18
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Price Leadership
• Obstacles– U.S. antitrust laws
– # & size of firms
– Nature of product
– Growth and innovation in industry
– Ease of entry/exit
• Contestable Market– costs of entry and exit are low
• Enough firms so P = MC19
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Game Theory
• Analyzes firm behavior as a series of strategic moves and countermoves
• Payoff matrix– Shows all possible outcomes for the
“players”
• Dominant-strategy equilibrium– Each player’s action does not depend on
what he thinks the other player will do
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Game Theory
• 2 firms• 2 strategies
– maintain current price
– raise price
• Goal– minimize the worst case outcome
• Can result in suboptimal solution– but is a dominant strategy
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Game Theory
• One-shot versus repeated games– One-shot game
• Game is played just once
– Repeated games• Establish reputation for cooperation• Tit-for-tat strategy
– Highest payoff results
• Coordination game
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Oligopoly vs. Perfect Competition
• Oligopoly– If firms collude or operate with excess
capacity• Higher price (P > MC)• Lower output
– If price wars • Lower price
– Higher profits in the long run
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