Post on 29-Dec-2015
Principles of Economics
Ohio Wesleyan UniversityGoran Skosples
11. Imperfect Competition
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LEARNING OBJECTIVES
What market structures lie between perfect competition and monopoly, and what are their characteristics?
What outcomes are possible under oligopoly?
Why is it difficult for oligopoly firms to cooperate?
How is monopolistic competition similar to perfect competition? How is it similar to monopoly?
What are the social costs and benefits of advertising and brand names?
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Introduction: Between Monopoly and Competition
Two extremes• Competitive markets: ________ firms,
________ products• Monopoly: _____ firm
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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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 phone service with unlimited anytime minutes and free phone
Smalltown’s demand schedule
Two firms: T-mobile, 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
1,750
1,800
1,750
1,600
1,350
1,000
550
0
–650
–1,400
Profit
500
600
700
800
900
1,000
1,100
1,200
1,300
$1,400
Cost
2,250
2,400
2,450
2,400
2,250
2,000
1,650
1,200
650
$0
Revenue
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 = $_____
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EXAMPLE: Cell Phone Duopoly in Smalltown
One possible duopoly outcome: _________
Collusion: an agreement among firms in a market about quantities to produce or prices to charge
T-mobile 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, e.g., T-mobile and Verizon in the outcome with collusion
Can you name a cartel?
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A C T I V E L E A R N I N G 1: Collusion vs. self-interestA C T I V E L E A R N I N G 1: Collusion vs. self-interest
Duopoly outcome with collusion:Each firm agrees to produce Q = 30, earns profit = $900.
If T-mobile reneges on the agreement and produces Q = 40, what happens to the market price? T-mobile’s profits?
Is it in T-mobile’s interest to renege on the agreement?
If both firms renege and produce Q = 40, determine each firm’s profits.
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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
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A C T I V E L E A R N I N G 1: AnswersA C T I V E L E A R N I N G 1: Answers
If both firms stick to agreement, each firm’s profit = $
If T-mobile reneges on agreement and produces Q = 40:
Market quantity = ___, P = $___T-mobile’s profit = ___________________
T-mobile’s profits are _______ if it reneges.
Verizon will conclude the same, so both firms _______, each produces Q = __:
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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Collusion vs. Self-Interest Both firms would be _______ off if both stick to
the cartel agreement.
But each firm has incentive to __________ the agreement.
Lesson: It is ________ for oligopoly firms to form cartels and honor their agreements.
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A C T I V E L E A R N I N G 2: The oligopoly equilibriumA C T I V E L E A R N I N G 2: The oligopoly equilibrium
If each firm produces Q = 40,market quantity = 80 P = $30 each firm’s profit = $800
Is it in T-mobile’s interest to increase its output further, to Q = 50?
Is it in Verizon’s interest to increase its output to Q = 50?
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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
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A C T I V E L E A R N I N G 2: AnswersA C T I V E L E A R N I N G 2: Answers
If each firm produces Q = 40, then each firm’s profit = $800.
If T-mobile increases output to Q = 50:Market quantity = ___, P = $____T-mobile’s profit = ____________ = ________
T-mobile’s profits are ________ at Q = 40 than at Q = 50.
The _______ is true for Verizon.
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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
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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
Our duopoly example has a Nash equilibrium in which each firm produces Q = .
• Given that Verizon produces Q = 40, T-mobile’s best move is to produce Q = .
• Given that T-mobile produces Q = 40, Verizon’s best move is to produce Q = .
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Game Theory Game theory: the study of how people behave in
strategic situations
___________ strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players
_____________________: 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
Confessing is the dominant strategy for both players.
Nash equilibrium: both confess
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Prisoners’ Dilemma Example Outcome: Bonnie and Clyde both _________,
each gets _____ 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 _______________ interest takes over and leads them to confess.
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Oligopolies as a Prisoners’ Dilemma
When oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners’ dilemma.
Our earlier example:• Cingular and Verizon are duopolists in
Smalltown.• The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
Here is the “payoff matrix” for this example…
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Cingular & Verizon in the Prisoners’ Dilemma
Q = 30 Q = 40
Q = 30
Q = 40
Cingular
Verizon
Cingular’s profit = $900
Verizon’s profit = $900
Cingular’s profit = $1000
Cingular’s profit = $800
Cingular’s profit = $750
Verizon’s profit = $750
Verizon’s profit = $800
Verizon’s profit = $1000
Each firm’s dominant strategy: __________________,
produce Q = ____.
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A C T I V E L E A R N I N G 3: The “fare wars” gameA C T I V E L E A R N I N G 3: The “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.
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A C T I V E L E A R N I N G 3: AnswersA C T I V E L E A R N I N G 3: Answers
Nash equilibrium:both firms cut fares
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Cut fares Don’t cut fares
Cut fares
Don’t cut fares
American Airlines
United Airlines
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Other Examples of the Prisoners’ Dilemma
Ad Wars
Organization of Petroleum Exporting Countries
Arms race between military superpowers
Common resources
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A Comparison of Market Outcomes
When firms in an oligopoly individually choose production to maximize profit,
• Q is ________ than monopoly Q but ________ than competitive market Q
• P is ________ than competitive market P but _________ than monopoly P
What would happen if the number of firms increased?
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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 (style or type, location, quality).
Examples:
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Monopolistic Competition and Monopoly
Short run: Under monopolistic competition, firm behavior is ______________ monopoly.
Long run: In monopolistic competition, ____________ drive economic profit ________.
Monopolistic Competition and Welfare
Monopolistically competitive markets do not have all the desirable welfare properties of ___________________ markets.
Because P MC, the market quantity is ______ the socially efficient quantity.
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Comparison
perfect comp.
monopoly oligopoly monopol. comp.
no of sellers
free entry/exit
LR econ prof.
the products
mkt power
D curve
substitutes?
strategic inter.
competition?
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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.
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The Critique of Advertising
The Defense of Advertising
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Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts on advertising may signal the quality of its product to consumers, regardless of the content of ads.
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Brand Names In many markets, brand name products coexist with
generic ones.
Firms with brand names usually spend more on advertising, charge higher prices for the products.
As with advertising, there is disagreement about the economics of brand names…
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The Critique of Brand Names
The Defense of Brand Names
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CHAPTER SUMMARY
Oligopolists can maximize profits if they form a cartel and act like a monopolist.
Yet, self-interest leads each oligopolist to a higher quantity and lower price than under the monopoly outcome.
The larger the number of firms, the closer will be the quantity and price to the levels that would prevail under competition.
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CHAPTER SUMMARY
A monopolistically competitive market has many firms, differentiated products, and free entry.
Product differentiation and markup pricing lead to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to reduce competition and take advantage of consumer irrationality. Defenders argue that firms use them to inform consumers and to compete more vigorously on price and product quality.