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?

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?

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.

Market Structures

Perfect Competition

Monopolistic Competition

Oligopoly Monopoly

# of firms

type of product

control over price

free entry/exit

long run

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

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

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

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.

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

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.

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.

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?

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

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

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

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

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

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

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

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.

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.

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

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

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

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.

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

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.

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

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

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.

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.

Game of Chicken

Swerve Stay

Swerve

Stay

Player One’s decision

Player Two’s

decision

0

0

5

-50-5

-5

-505

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.

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