13sg Monopoly Oligopoly

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13MONOPOLISTICCOMPETITIONANDOLIGOPOLY

K e y C o n c e p t s

Monopolistic Competition

The market structure of most industries lies betweenthe extremes of perfect competition and monopoly.Monopolistic competition is one such “intermediate“industry structure. Monopolistic competition is amarket structure in which:

♦ A large number of firms compete.♦ Each firm produces a differentiated product (prod-

uct differentiation is when a firm makes a goodthat is slightly different from the products of com-peting firms).

♦ Firms compete on product quality, price, and mar-keting. Brand-name products advertise their superi-ority to generics and generics advertise their low price.

♦ Firms are free to enter or exit the industry.A monopolistically competitive firm faces a downwardsloping demand curve because it produces a differenti-ated product. As a result, a monopolistically competi-tive firm’s marginal revenue curve lies below its de-mand curve.

Output and Price in MonopolisticCompetition

In the short run:

♦ The firm maximizes its profit by producing the levelof output such that MR = MC.

♦ The firm might earn an economic profit. If it does,free entry means that competitors eventually enterthe industry. Alternatively, the firm might incur aneconomic loss. If it does, it (or other firms) eventu-ally exit the industry.

In the long run:

♦ The firm maximizes its profit by producing theamount of output that sets MR = MC.

♦ The firm does not earn an economic profit or incuran economic loss, so P = ATC.

Figure 13.1 shows the long-run equilibrium for amonopolistically competitive firm.

F I G U R E 1 3 . 1

The Long Run in Monopolistic Competition

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MinimumATC

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Capacity output is the output at which average totalcost is at its minimum. A monopolistically competitivefirm has excess capacity because, as Figure 13.1 shows, inthe long run it does not produce at the minimum ATC.

From a social standpoint, monopolistically competitivefirms are not efficient. However monopolistically com-petitive firms produce a large variety of differentiatedproducts and consumers value variety.

Product Development and Marketing

Monopolistically competitive firms constantly strive todifferentiate their products and (temporarily) earn aneconomic profit. The extent of innovation and productdevelopment is determined by the marginal cost andmarginal revenue of innovation and development.

Monopolistically competitive firms spend hugeamounts on marketing. Such selling costs are fixedcosts, which shift the firm’s ATC curve upward. Be-cause all firms advertise, the effect of advertising on thedemand for any particular firm’s product is ambiguous.

The efficiency of monopolistic competition is unclear:

♦ On the plus side, consumers value variety and ad-vertising might provide valuable information.

♦ On the minus side, advertising is costly andmonopolistically competitive firms have highercosts because of their excess capacity.

Oligopoly

Oligopoly is a market structure in which a few firmscompete. Each firm considers the effects of its actionson the behavior of the others and the actions of theothers on its own profit.

The kinked demand curve model:

♦ The firm believes that, if it raises its price, no com-petitors will follow but that, if it lowers its price, allits competitors will follow. The firm faces a kinkeddemand curve, with the kink at the current priceand quantity, as illustrated in Figure 13.2.

♦ The kink causes a break in the MR curve. As long asthe MC curve remains within this break, the firm’sprice and quantity do not vary.

♦ The model fails to tell what happens if firms dis-cover that their beliefs are incorrect.

The dominant firm oligopoly model:

♦ One large firm has a substantial cost advantage overits many small competitors.

F I G U R E 1 3 . 2

The Kinked Demand Curve Oligopoly

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♦ The large firm acts like a monopoly and sets itsprofit-maximizing price. The small firms take thisprice as given and act like perfect competitors.

Oligopoly Games

Game theory is a tool for studying strategic behavior.Games have rules, strategies, payoffs, and an outcome:

♦ Rules specify permissible actions by players.

♦ Strategies are actions, such as raising or loweringprice, output, advertising, or product quality.

♦ Payoffs are the profits and losses of the players. Apayoff matrix is a table that shows the payoffs forevery possible action by each player.

♦ The outcome is determined by the players’ choices.In a Nash equilibrium, Player A takes the best pos-sible action given the action of Player B, and B takesthe best possible action given the action of A.

A “prisoners’ dilemma” is a two-person game. In a one-time prisoners’ dilemma game, each player has a domi-nant strategy of cheating, that is, confessing. A domi-nant strategy occurs when each player has a unique beststrategy independent of the other player’s action. Theoutcome is not the best equilibrium for the prisoners.

♦ Duopoly is a market with two competitors.

In a duopoly, the firm’s might have a collusive agree-ment to decrease output and raise price. A cartel is agroup of firms that have engaged in a collusive agree-ment. In this game, each firm can comply with theagreement or can cheat by lowering its price and in-

M O N O P O L I S T I C C O M P E T I T I O N A N D O L I G O P O L Y 2 2 5

creasing its output. In a one-time game, a prisoners’dilemma Nash equilibrium emerges, in which each firmhas the dominant strategy of cheating. Each firm earnszero economic profit.

Other decisions of a firm — how much to spend inresearch and development, how much to spend on ad-vertising, and so on — can often be analyzed usinggame theory.

Repeated Games and Sequential Games

In a repeated game, other strategies can create a coop-erative equilibrium, an equilibrium in which the play-ers make and share the monopoly profit.

♦ A “tit-for-tat” strategy consists of taking the sameaction (cheating or not cheating) the other playertook last period.

♦ A trigger strategy cooperates until the other playercheats and then plays the Nash equilibrium strategy(cheating) forever after.

In a repeated game the players might be able to attainthe cooperative equilibrium because the long-run profitfrom colluding is greater than the short-run profit fromcheating. But price wars can occur when new firmsenter an industry, and the industry finds itself in a pris-oners’ dilemma game.

A game tree, which shows the decisions made at thefirst stage and second stage of a game, can be used toanalyze a sequential game, such as a contestable market.A contestable market is a market in which one firm(or a small number operate) but in which entry and exitare free, so the existing firm(s) face competition frompotential entrants. The company (or companies) in themarket can play an entry-deterrence game:

♦ In an entry-deterrence game the firm in the marketsets a competitive price (rather than a monopolyprice) and earns a normal profit to order to keeppotential competitors from entering the market.

♦ Limit pricing refers to the situation in which a firmcharges a price lower than the monopoly price (andearns less than the monopoly profit) to keep poten-tial competitors out of the market.

H e l p f u l H i n t s

1.1.1.1. MARGINAL ANALYSIS IN DIFFERENT INDUSTRY

STRUCTURES : Firms in any type of market struc-

ture follow the same rule to maximize profit: Pro-duce the level of output that sets MC = MR. Thisrule applies in perfect competition, monopoly, mo-nopolistic competition, and kinked demand curveand dominant firm oligopolies. The essential reasonfor its widespread applicability is that the rule doesnot depend on industry structure. The frameworkof the MR = MC rule is marginal analysis: As longas another unit of output adds more to the firm’srevenue than to its cost (MR > MC ), producingmore output adds its total profit. The fact thatMR = MC applies to all industry structures reflectsthe importance of marginal analysis. (More prag-matically, it also means that you do not have to re-member a separate profit-maximizing rule for eachtype of industry structure!)

2.2.2.2. BARRIERS TO ENTRY AND LONG-RUN ECONOMIC

PROFIT : Free entry leads to zero long-run eco-nomic profits both in perfect competition and mo-nopolistic competition. If a monopoly is earning aneconomic profit, other firms would like to enter themonopoly’s industry, but barriers to entry keepthem out. Whether a business can earn an eco-nomic profit in the long run revolves around thepresence or absence of barriers to entry.

3.3.3.3. HOW TO DETERMINE THE EQUILIBRIUM IN A

PRISONERS’ DILEMMA GAME : Learning how tofind the equilibrium of a prisoners’ dilemma-typegame is important. Take the example of Chris andLoren in a prisoner’s dilemma. Each player has tochoose between two strategies, confess or deny.First, set up the payoff matrix. Then look at thepayoff matrix from Chris’s point of view. Chrisdoes not know whether Loren is going to confess ordeny, so Chris asks two questions: (1) Assumingthat Loren confesses, do I get a better payoff if Iconfess or deny? (2) Assuming that Loren denies,do I get a better payoff if I confess or deny? IfChris’s best strategy is to confess, regardless ofwhether Loren confesses or denies, confessing isChris’s dominant strategy.

Next, look at the payoff matrix from Loren’s pointof view. Let Loren ask the equivalent two questions,and determine whether Loren has a dominant strat-egy. The combination of Chris’s strategy andLoren’s strategy comprises the equilibrium outcomeof the game.

4.4.4.4. THE PRISONERS’ DILEMMA GAME AND THE REAL

WORLD : The key insight of the prisoners’ di-

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lemma game is the tension between the equilibriumoutcome (in which both players’ best strategy is toconfess because they can’t trust each other) and thefact that both players could make themselves betteroff if only they would cooperate. This tension helpsexplain complex events in the real world.

The Organization of Petroleum Exporting Coun-tries (OPEC) provides a classic example of this ten-sion. OPEC is a cartel that controls a large fractionof the world’s oil. Looking at OPEC as a whole, re-stricting the supply of petroleum and keeping theprice of petroleum high is in OPEC’s interest.Keeping the price of petroleum high, perhaps near$40 a barrel, which was the price about 20 yearsago, would maximize the total revenues and profitsof the OPEC nations. But when the price is thishigh, the individual interest of each nation lies inpumping more oil than the amount allocated to itunder the OPEC agreement. Each nation figuresthat if it — and it alone — cheats on the output re-striction imposed by the cartel agreement, the effecton the world price of oil would be small but thepositive impact on its profit from selling more oilwould be large. So each nation is tempted to cheaton the cartel.

Q u e s t i o n s

True/False and Explain


11. Product differentiation gives each monopolisticallycompetitive firm a downward sloping demandcurve.

12. Monopolistically competitive firms compete onlyon price.

13. Similar to a monopoly, a monopolistically com-petitive industry has large barriers to entry.

Output and Price in Monopolistic Competition

14. In the short run, to maximize its profit, a monopo-listically competitive firm produces the level of out-put that sets P = ATC.

15. Monopolistically competitive firms can earn aneconomic profit in the long run.

16. Free entry is the basic reason that monopolisticallycompetitive firms have excess capacity.

17. Monopolistically competitive firms have excesscapacity in the long run.


18. A monopolistically competitive firm can earn aneconomic profit if it develops new products.

19. Monopolistically competitive firms have large mar-keting and selling costs.

Oligopoly

10. An oligopolist will consider the reactions of otherfirms before it decides to cut its price.

11. The kinked demand curve model of oligopoly pre-dicts that the firm will change its price only infre-quently.

Oligopoly Games

12. Game theory is used to analyze the behavior ofmonopolistically competitive firms.

13. In a one-time only prisoners’ dilemma game, thebest strategy for a prisoner is to confess only if theprisoner believes that the other player will confess.

14. If oligopolistic firms are able to sustain an output-restricting, price-increasing collusive agreement,they will produce the efficient level of output.


15. Repeated games are more likely to have a coopera-tive equilibrium than one-time only games.

16. Price wars can break out when a small number ofnew firms enter an industry.

17. A single firm in a contestable market might be un-able to earn an economic profit.

18. Limit pricing refers to attempts by firms to set theirprice at the highest possible limit.


Multiple Choice


11. A monopolistically competitive firm is like amonopoly firm insofar as

a. both face perfectly elastic demand.b. both earn an economic profit in the long run.c. both have MR curves that lie below their demand

curves.d. neither is protected by high barriers to entry.

12. A monopolistically competitive firm is like a perfectlycompetitive firm insofar as

a. both face perfectly elastic demand.b. both earn an economic profit in the long run.c. both have MR curves that lie below their demand

curves.d. neither is protected by high barriers to entry.

13. Product differentiation

a. means that monopolistically competitive firmscan compete on quality and marketing.

b. occurs when a firm makes a product that isslightly different from that of its competitors.

c. makes the firm’s demand curve downward slop-ing.

d. All of the above answers are correct.


Figure 13.3 represents a monopolistically competitivefirm in the short run. Use it for the next four questions.

F IGURE 13 .3

Multiple Choice Questions 10, 11, 12, 13

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14. How much output does the firm produce?

a. � �

b. � �

c. � �d. None of the above

15. What price does the firm charge?

a. ��b. ��c. ��d. None of the above

16. What type of profit or loss is the firm earning?

a. An economic profitb. A normal profitc. An economic lossd. An accounting loss

17. In the long run,

a. new firms will enter, and each existing firm’sdemand decreases.

b. new firms will enter, and each existing firm’sdemand increases.

c. existing firms will leave, and each remainingfirm’s demand decreases.

d. existing firms will leave, and each remainingfirm’s demand increases.

18. A monopolistically competitive firm has excess ca-pacity because in the

a. short run MR = MC.b. short run the firm’s average total cost does not

equal the minimum average total cost.c. long run the firm’s average total cost does not

equal the minimum average total cost.d. long run the firm earns an economic profit.

19. In the long run, a monopolistically competitivefirm’s economic profits are zero because of

a. product differentiation.b. the lack of barriers to entry.c. excess capacity.d. the downward-sloping demand curve of each

firm.

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10. Monopolistically competitive firms constantly de-velop new products in an effort to

a. make the demand for their product more elastic.b. increase the demand for their product.c. increase the marginal cost of their product.d. None of the above answers is correct.

11. When deciding upon how much to spend on prod-uct development, a firm will consider

a. only the marginal revenue from product devel-opment.

b. only the marginal cost of product development.c. both the marginal revenue and marginal cost of

product development.d. the price and average total cost of product devel-

opment.

12. Which of the following statements about monopo-listically competitive firms is correct?

a. They produce more than the capacity amount ofoutput.

b. They have high selling costs.c. They produce the efficient amount of output.d. They rarely advertise.

Oligopoly

13. A firm that has a kinked demand curve assumesthat, if it raises its price, ____ of its competitors willraise their prices and that, if it lowers its price, ____of its competitors will lower their prices.

a. all; allb. none; allc. all; noned. none; none

14. In the dominant firm model of oligopoly, the largefirm acts like

a. an oligopolist.b. a monopolist.c. a monopolistic competitor.d. a perfect competitor.

15. In the dominant firm model of oligopoly, thesmaller firms act like

a. oligopolists.b. monopolists.c. monopolistic competitors.d. perfect competitors.

Oligopoly Games

16. A game always contains all of the followingEXCEPT

a. rules.b. a dominant strategy.c. strategies.d. payoffs.

17. In the prisoners’ dilemma game with a Nash equilib-rium,

a. only one prisoner confesses.b. neither prisoner confesses.c. both prisoners confess.d. any confession is thrown out of court.

18. If a collusive agreement in a duopoly maximizes theindustry’s profit,

a. each firm must produce the same amount.b. the industry level of output is efficient.c. industry marginal revenue must equal industry

marginal cost at the level of total output.d. total output will be greater than without collu-

sion.

Firms A and B are in a duopoly game, so they can eithercomply with a cartel agreement or cheat on the agree-ment. The cartel agreement calls for each firm to boostits price and restrict the amount it produces. For the next5 questions, use the following payoff matrix that showsthe firms’ economic profits.

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19. If firm A cheats on the cartel and firm B complieswith the agreement, firm A’s profit is

a. $3 million.b. $2 million.c. zero.d. –$1 million.


20. If firm A cheats on the cartel and firm B complieswith the agreement, firm B’s profit is

a. $3 million.b. $2 million.c. zero.d. –$1 million

21. If this game is played only once,

a. both firms A and B will cheat.b. firm A will cheat and firm B will not cheat.c. firm A will not cheat and firm B will cheat.d. neither firm A nor firm B will cheat.

22. The equilibrium in question 21 is called a

a. credible strategy equilibrium.b. Nash equilibrium.c. duopoly equilibrium.d. cooperative equilibrium.

23. If this game is played repeatedly and both firmsadopt trigger strategies so that the cooperative equi-librium emerges,

a. both firms A and B will cheat.b. firm A will cheat and firm B will not cheat.c. firm A will not cheat and firm B will cheat.d. neither firm A nor firm B will cheat.

24. In a duopoly with a collusive agreement, when is theindustry-wide profit as large as possible?

a. When both firms comply with the collusiveagreement.

b. When one firm cheats on the cartel and the otherfirm does not.

c. When both firms cheat on the collusive agree-ment.

d. The answer is indeterminate because it dependson the industry’s MR curve.

25. In a duopoly with a collusive agreement, when canone firm have the maximum possible profit?

a. When both firms comply with the collusiveagreement.

b. When one firm cheats on the agreement and theother firm does not cheat.

c. When both firms cheat on the agreement.d. The answer is indeterminate because it depends

on the firm’s MR curve.

26. A prisoners’ dilemma equilibrium is most likely toemerge when

a. a monopolistically competitive industry is domi-nated by a dominant firm.

b. an oligopolistic industry faces a repeated game.c. a monopoly is forced to compete repeatedly with

an oligopolistic industry.d. an oligopolistic industry plays a game once.


27. A strategy in which a firm takes the same action thatthe other firm did in the last period is a

a. dominant strategy.b. trigger strategy.c. tit-for-tat strategy.d. wimp’s strategy.

28. Price wars can be the result of

a. a cooperative equilibrium.b. a firm playing a tit-for-tat strategy in which last

period the competitors complied with a collusiveagreement.

c. new firms entering the industry and immediatelyagreeing to abide by a collusive agreement.

d. new firms entering an industry and all firms thenfinding themselves in a prisoners’ dilemma.

29. In a contestable market,

a. the HHI is usually quite low.b. the firm in the market usually earns a large eco-

nomic profit.c. the firm in the market might play an entry-

deterrence game.d. two of the above answers are correct.

30. Limit pricing refers to

a. the fact that a monopoly firm always sets thehighest price possible.

b. a situation in which a firm might lower its priceto keep potential competitors from entering itsmarket.

c. how the price is determined in a kinked demandcurve model of oligopoly.

d. none of the above.

Short Answer Problems

1. In Figure 13.4 (on the next page) draw a diagramillustrating a monopolistically competitive firm that

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is earning an economic profit in the short run.Identify the area that equals the economic profit.

2. In Figure 13.5 (on the next page) draw the long-run equilibrium for a monopolistically competitivefirm. What conditions must be satisfied for long-run equilibrium?

F I G U R E 1 3 . 4

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Short Answer Problem 1

F I G U R E 1 3 . 5

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3. Suppose that a monopolistically competitive firm isinitially in long-run equilibrium and it succeeds infurther differentiating its product. As a result, thedemand for its product increases. In Figure 13.6show what happens to this firm in the short run.

Without drawing a diagram, describe what happensin the long run.

4. Compare the advantages and disadvantages of per-fect competition and monopolistic competition interms of how they benefit society.

F I G U R E 1 3 . 6

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F I G U R E 1 3 . 7

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5. In Figure 13.7 draw a diagram showing a kinkeddemand curve oligopoly. Indicate the range be-tween which the marginal cost can vary and stillleave the firm’s output and price the same.

6. How can a price war that eliminates profits be ex-plained with game theory?


7. Two firms — Tom’s Taxis and Chet’s Cabs — arethe only two taxicab companies in a small collegetown. These firms are engaged in a duopoly game.If they both adhere to a collusive cartel agreementto restrict the number of their cabs and raise their

Payoff Matrix for Short Answer Problem 7

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price, each can earn an economic profit of $2 mil-lion. However, if one company cheats on theagreement — by shading its price a bit and perhapsquietly acquiring some more taxis — and the othercomplies with the agreement, the cheater earns aneconomic profit of $2.5 million and the compilersuffers an economic loss of $1 million. If bothcheat, both earn $0 economic profit; that is, bothearn a normal profit.

a. Use the description of the situation to completethe payoff matrix above. Put Tom’s payoffs inthe darker triangles and Chet’s in the other tri-angles.

b. If this game is played only once, what is Tom’sbest strategy? What is Chet’s best strategy?What will be the equilibrium outcome?

c. When is the joint total profit the largest? Whenis Tom’s profit the largest? Chet’s profit?

8. Suppose that the taxi firm duopoly game played inproblem 7 changes: The payoffs are the same asbefore except when one player cheats and the otherdoes not. Now the cheating player earns an eco-nomic profit of $2.5 million, and the player com-plying with the agreement earns an economic profitof $0.5 million.

a. Complete the second payoff matrix above forthe new taxi firm duopoly game.

b. Does Tom have a clear-cut best strategy? DoesChet? Is there a clear equilibrium outcome inthis game?


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9. The taxi market changes again so that the payoffmatrix is as shown in the matrix for problem 9 be-low. Chet and Tom now see that they will beplaying a repeated game. Chet knows that Tom hasadopted a tit-for-tat strategy. Last period Chet didnot cheat on the cartel agreement.

a. If Chet cheats this period, what is his profit? Ifhe cheats this period, what is the maximumprofit he can earn next period? What is hismaximum two-period profit if he cheats?

b. If Chet complies with the agreement, what isthe maximum profit he earns this period? If hecomplies next period, what will be his profit? Ifhe does not cheat in either period, what is thetwo-period total profit he earns?

c. Is Chet likely to cheat this period? Why?

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You’re the Teacher

1. “You know, I’ve really been studying the book andthis study guide and now a lot of this stuff is mak-ing sense. I liked the helpful hint that pointed outthat firms in all types of industries actually had onlyone profit-maximization rule, what it called theMR = MC rule. It sure makes it easy if we don’thave to memorize different rules for different in-dustries! Can you think of any other rules that arethe same across all industries?” This student is cor-rect: Common rules ease your work. Perhaps moreimportantly, common rules also show you thatthere are factors in common to all firms regardlessof their industry structure. There is another rulethat is common across all types of industries; itdeals with when a firm earns an economic profit.With this hint, explain the other rule to the eagerstudent.


A n s w e r s

True/False Answers


11. T By making its product different from those of itscompetitors, each monopolistically competitivefirm has a unique product and hence a down-ward-sloping demand curve.

12. F Because its product is differentiated, monopolis-tically competitive firms compete on productquality and marketing, as well as on price.

13. F Similar to a perfectly competitive industry, amonopolistically competitive industry has manyfirms in it because there are no barriers to entry.


14. F Monopolistically competitive firms use the samerule as all firms: to maximize their profit, pro-duce so that MR equals MC.

15. F The firms cannot earn an economic profit in thelong run because of the absence of barriers toentry.

16. F Monopolistically competitive firms have excesscapacity because they produce differentiatedgoods.

17. T Because they do not produce at the minimumATC, monopolistically competitive firms haveexcess capacity, that is, if they boosted their pro-duction, their average total costs would fall.


18. T Monopolistically competitive firms constantlytry to further differentiate their products, anddeveloping new products is one method theyuse.

19. T Marketing and advertising play key roles inmonopolistically competitive firms’ efforts todifferentiate their products.

Oligopoly

10. T This mutual interdependence makes oligopoly adifficult industry structure to analyze.

11. T Shifts in the MC curve that do not move it be-yond the vertical section of the MR curve haveno effect on the price that the firm charges noron the quantity it produces.

Oligopoly Games

12. F Game theory is used to analyze the behavior ofoligopolistic firms.

13. F In a prisoners’ dilemma game, the dominantstrategy is to confess; that is, regardless of theother players’ action, each player will confess.

14. F The collusive agreement described in the prob-lem decreases output below its efficient level.


15. T Repeated games have strategies absent fromgames played only once, such as the tit-for-tatstrategy, that can support the cooperative equi-librium. So, repeated games are more likely tohave a cooperative equilibrium.

16. T When a small number of new firms enter a mar-ket, the firms might find themselves in a prison-ers’ dilemma in which competition forces theprice of the product down.

17. T In a contestable market, if the firm sets its priceso that it earns an economic profit, competitorsenter the market.

18. F Limit pricing refers to the situation in which anestablished firm sets a low price in order to keepnew competitors out of the market.

Multiple Choice Answers


11. c Both have downward-sloping demand curves, soboth have MR curves that lie below their de-mand curves.

12. d The absence of high barriers to entry accountsfor the large number of firms in each industry.

13. d Answer b is the definition of product differen-tiation and answers a and c are results of productdifferentiation.


14. a The monopolistically competitive firm maxi-mizes its profit by producing so that MR = MC.

15. c With the firm producing � � output, the de-mand curve shows that a price of �� is the high-est price that can be charged and still sell all thatis produced.

16. a The firm earns an economic profit because, atoutput of � � � P > ATC.

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17. a New firms enter because they, too, want to earnan economic profit. As these firms enter, theydecrease the demand for the existing firms’products, which reduces the economic profit.

18. c The firm produces less output than that whichminimizes its long-run ATC.

19. b If firms in the industry are earning an economicprofit, the absence of barriers to entry meansthat new firms enter the industry and competeaway the economic profit.


10. b If the firm can increase the demand for its prod-uct, it can temporarily earn an economic profit.

11. c For virtually all business decisions, a firm com-pares the marginal revenue and marginal cost re-sulting from the decision.

12. b Monopolistically competitive firms incur largeselling costs trying to differentiate their products.

Oligopoly

13. b With this set of assumptions, the business be-lieves that it will lose a large amount of sales ifraises its price, but pick up only a small amountif it lowers its price.

14. b When setting its price and quantity, the domi-nant firm acts as if it were a monopoly.

15. d The smaller firms are unable to affect the pricecharged by the large firm.

Oligopoly Games

16. b A game might or might not have a dominantstrategy.

17. c Both players confess even though it is in theirjoint interest for neither to confess.

18. c To maximize its profit, the industry behaves as amonopoly, which means that it produces thelevel of output needed for MR = MC.

19. a Firm A’s profits are in the darkened triangle inthe square at the lower left.

20. d Firm B’s profits are in the white triangle in thesquare at the lower left.

21. a Both firms adopt the strategy of cheating.

22. b A Nash equilibrium occurs when each playertakes the best action possible, given the action ofthe other player.

23. d The cooperative equilibrium maximizes eachfirm’s profit over the long haul.

24. a The interest of the industry as a whole is tomaintain the cartel.

25. b Each firm’s individual interest is to be the lonecheater on the cartel agreement. Compare thisanswer to the previous answer.

26. d In one-time only games, a dominant strategy foreach firm likely is to cheat, so this strategyemerges as the Nash equilibrium.


27. c Tit-for-tat implies that “I’ll do to you what youdid to me.”

28. d Neither the new firms nor the old ones want aprice war, but a prisoners’ dilemma game mightmake a price war inevitable.

29. c By playing an entry-deterrence game, the firm inthe market sets a low price to keep competitorsfrom entering the market.

30. b Limit pricing can occur in contestable marketswhen the firm plays an entry deterrence game.

Answers to Short Answer Problems

F I G U R E 1 3 . 8

Pric

e an

d co

st (d

olla

rs)

Quantity

D

P

MR

Q

ATC

MC


Economicprofit

1. Figure 13.8 shows the short-run equilibrium of amonopolistically competitive firm. To maximize itsprofit, the firm produces so that MR = MC. At thislevel of output, P > ATC, so the firm earns an eco-nomic profit, as illustrated by the darkened rectan-gle. This diagram is identical to that of a monopolyfirm earning an economic profit. Both monopoly


and monopolistically competitive firms face down-ward-sloping demand curves, both produce so thatMR = MC, and, as long as P > ATC, both firmsearn an economic profit.

F I G U R E 1 3 . 9


Pric

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Quantity

MC ATC

P

Q

MR

D

2. Figure 13.9 shows the long-run equilibrium for amonopolistically competitive firm. Two conditionsmust be satisfied for this diagram to show the long-run equilibrium. Think of these requirements as afirm condition and a market condition. For the firmto be satisfied, it must maximize its profit, which re-quires that it be producing the amount of output sothat MR = MC. Then, for there to be long-runequilibrium in the market, firms must have no in-centive either to enter or exit the industry. As a re-sult, there can be no economic profit, so P = ATC.(This second condition is not a choice of the firm;the firm would rather earn an economic profit. Butfor the market to be in long-run equilibrium, it isrequired.) Both conditions — production atMR = MC and P = ATC — are met in Figure 13.9so Figure 13.9 illustrates the long-run equilibrium.

3. Figure 13.10 shows the effect when a monopolisti-cally competitive firm succeeds in further differenti-ating its product. The demand for the firm’s goodincreases, thereby shifting the demand curve and theMR curve rightward. As a result, the firm increasesits output from � � to � and raises its price from�� to �� The firm earns an economic profit.

In the long run, other firms copy its product. Asthey copy, the demand for the initial firm’s good

F I G U R E 1 3 . 1 0


Pric

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Quantity

MC ATC

D1

D2

MR1

MR2

Q2Q1

P1

P2

decreases; that is, the demand curve and MR curveshift leftward. Ultimately, demand decreases enoughthat the pioneering firm — and all other “copier”firms — no longer earn an economic profit. At thispoint, other firms do not have an incentive to copythe good and the market is in long-run equilibrium.

4. An advantage of perfect competition is that it pro-duces at minimum average total cost, whereas mo-nopolistic competition produces at a higher averagetotal cost because of its excess capacity. Another ad-vantage is that a perfectly competitive industry is ef-ficient; it produces the level of output that sets themarginal social benefit equal to the marginal socialcost. A monopolistically competitive industry, how-ever, is not efficient because the price of the product(which equals the marginal social benefit) exceedsthe marginal social cost (which equals the marginalcost).

The advantage of monopolistic competition is thatproduct differentiation leads to greater product vari-ety, which consumers value. In addition, monopo-listically competitive firms have a greater incentiveto innovate new and improved products and meth-ods of production. Monopolistically competitivefirms must do more advertising and sales promotionthan perfectly competitive firms. To the extent thatthese activities provide valued services to consumers,they benefit society.

So, the loss in efficiency and the higher ATC thatoccurs in monopolistic competition must be

2 3 6 C H A P T E R 1 3

weighed against the gain of greater product variety,greater incentives to innovate, and potentially valu-able promotional activity.

F I G U R E 1 3 . 1 1


Pric

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Quantity

MC

P

Q MR

D

Range ofMC

5. Figure 13.11 illustrates a kinked demand curve oli-gopoly and the range over which the MC canchange and not affect the price, P, or quantity, Q.

6. Game theory explains price wars as the consequenceof firms in a colluding industry responding to thecheating of a firm or as the response to new firmsentering the industry. If one firm cheats by cuttingits price, all other firms will cut their prices, and aprice war ensues. After the price has fallen suffi-ciently (perhaps so the firms earn zero economicprofit), they have an incentive to rebuild their collu-sion. Alternatively, if new firms (or even just one)enter an industry, the old and new players mightfind themselves playing a prisoners’ dilemma game.Neither set of firms wants the price to fall and prof-its to shrink, but they might be unable to colludesuccessfully to keep the price and profit high.

7. a. The payoff matrix is given above.

b. Tom’s best strategy is to cheat without regard towhat Chet does. If Chet adheres to the agree-ment and does not cheat, Tom will cheat be-cause his profit when cheating ($2.5 million) ex-ceeds his profit when he does not cheat ($2million). And, if Chet cheats, Tom also willcheat because his profit ($0) is higher than the

Short Answer Problem 7 (a)

��

��

��

��

��

��

��

��

��

��

��

loss he would incur by not cheating (–$1 mil-lion). Tom has a dominant strategy: cheat.

In exactly the same way, Chet’s profits are higherif he cheats regardless of what Tom does. So,Chet also has a dominant strategy of cheating.The equilibrium outcome is for both Tom andChet to cheat on the cartel agreement.

c. The industry’s total profits are highest ($4 mil-lion) when neither Tom nor Chet cheat. Tom’sprofit is largest if he cheats and Chet does not.Similarly, Chet’s profit is greatest if he alonecheats. Though each player’s individual interestis to cheat, their joint interest is to comply.

Short Answer Problem 8 (a)

��

� ��

��

��

��

��

��

��

��

��

��

8. a. The new payoff matrix is given above.

b. Tom and Chet no longer have a dominant strat-egy. In particular, if Chet complies with theagreement, Tom wants to cheat because in this


case his profit by cheating ($2.5 million) exceedshis profit by complying ($2 million). But, ifChet cheats on the agreement, Tom will want tocomply. If Chet is cheating, Tom earns a profitof $0.5 million by complying but $0 by cheat-ing. Hence Tom’s best strategy depends on whatChet does. Chet is in the same situation: Hisbest strategy depends on what Tom does. Unlikethe situation in problem 7, the outcome is notclear-cut. The equilibrium depends on whichstrategy Chet and Tom decide to pursue.

9. a. Last period Chet did not cheat, so Tom’s tit-for-tat strategy means that Tom will not cheat thisperiod. Because Tom will comply with the cartelagreement, Chet’s profit this period by cheatingis $2.5 million. Next period Tom will cheat be-cause Chet cheated this period. Therefore nextperiod the most profit that Chet can earn is $0by also cheating. (If Chet complied with agree-ment and Tom cheated, Chet loses –$2 million.)Over the two periods, Chet’s total profit if hecheats in the first period is $2.5 million.

b. If Chet does not cheat this period, this period hewill earn $2 million. Because Chet compliedwith the agreement this period, Tom’s tit-for-tatstrategy means that next period Tom will com-ply with the agreement. Then, if Chet also com-plies next period, he will earn $2 million. Bycomplying each period Chet earns a total of $4million over the two periods.

c. Chet is not likely to cheat. If he does, his totalprofits over the two periods are significantly lessthan if he complies over the two periods. Soplayers in a repeated game are more likely toreach the cooperative equilibrium than players ina one-time game.

You’re the Teacher

1. “One other rule works for a firm in any type of in-dustry structure. In particular, if P > ATC, the firmearns an economic profit; if P = ATC, the firm earnsa normal profit; and if P < ATC, the firm suffers aneconomic loss. Let’s take the case of P > ATC andfind out why it means that the firm earns an eco-nomic profit. If we multiply both sides of the ine-quality by q, the amount of output the firm pro-duces, we get Pq ATC q> ( ) . Now, Pq (the pricetimes the amount produced) equals the firm’s totalrevenue. And ATC = �� so multiplying ATCtimes q gives TC, the firm’s total cost. Hence whenP > ATC, total revenue exceeds total cost. Becausethe firm’s normal profit is already included in itstotal cost, the fact that the firm’s total revenue ex-ceeds its total cost means that the ‘extra’ profit is aneconomic profit.

“But look, the main point of what I am saying isthat we do have it easy: Here’s another case wherewe don’t have to memorize a bunch of differentrules. If any firm finds that P exceeds ATC, it’searning an economic profit.”

2 3 8 C H A P T E R 1 3

C h a p t e r Q u i z

11. In a duopoly game that is repeated many times, eachplayer tries to

a. maximize the industry’s total profit.b. minimize the other player’s profit.c. maximize its market share.d. maximize its profit.

12. If P > MR for each firm in an industry, the industryis NOT

a. perfectly competitive.b. monopolistically competitive.c. an oligopoly.d. a monopoly.

13. An industry with one large firm with a large costadvantage over its many smaller competitors is called

a. a dominant firm oligopoly.b. a kinked demand curve oligopoly.c. a monopolistically competitive market.d. a near-monopoly oligopoly.

14. The major distinction between a monopolisticallycompetitive industry and a perfectly competitiveindustry is that firms in a monopolistically competi-tive industry

a. produce identical products.b. are protected by high barriers to entry.c. produce at the minimum ATC in the long run.d. produce a product that is different from those

produced by its competitors.

15. If firms in a monopolistically competitive industryearn an economic profit,

a. other firms will enter the industry.b. some firms will leave the industry.c. firms will neither enter nor exit.d. The premise of the question is wrong because

monopolistically competitive firms cannot earnan economic profit.

16. A firm in which type of industry always has excesscapacity in the long run?

a. Perfect competitionb. Monopolistic competitionc. Oligopolyd. Monopoly

17. According to the kinked demand curve theory ofoligopoly, each firm believes that if it lowers its price

a. its competitors will not lower their prices.b. its competitors will lower their prices.c. its profit will rise.d. its marginal revenue will exceed its marginal cost.

18. In the long run, a monopolistically competitive firm___ earn an economic profit and a monopoly ____earn an economic profit.

a. can; canb. can; cannotc. cannot; cand. cannot; cannot

19. When each player selects his or her best strategytaking as given what the other player will do, theresulting equilibrium is called a

a. cooperative equilibrium.b. tit-for-tat equilibrium.c. Nash equilibrium.d. trigger strategy equilibrium.

10. A strategy in which a player cooperates in the cur-rent period if the other player cooperated in theprevious period, but cheats in the current period ifthe other player cheated in the previous period iscalled a

a. tit-for-tat strategy.b. trigger strategy.c. duopoly strategy.d. dominant firm strategy.

The answers for this Chapter Quiz are on page 368

13sg Monopoly Oligopoly

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