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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
Product Differentiation
• The distinguishing between products through real or imagined properties
– Quality – Services – Location – Advertising – Packaging
More product differentiation
=
less elasticity of demand
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Short-Run Equilibrium:
Monopolistic Competition
MC
Quantity
D ol la rs p er U ni t
d
MR
ATC
Profits
- Price (P
e) > ATC -Economic profit
E
ATC
P
eq
eQuantity
D ol la rs p er U ni t
d
MR
MC ATC
Losses
-Price (P
e) < ATC -Economic loss
E
ATC
P
eq
eLong 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
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Long-Run Equilibrium
ATC
Quantity
D ol la rs p er U ni t
d
MR MC
-Price (P -
e) = ATC -Zero econ. profits -Normal rate of return
E P
e=
ATC
q
e• 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.
MR
d'
Quantity per Time Period
Dollars per Unit
Comparison of the Perfect Competitor with the Monopolistic Competitor:
Efficiency
Perfect Competition Monopolistic Competition
Quantity per Time Period
Dollars per Unit
MC ATC
d
MR = P
P
1q
1Minimum ATC MC ATC
P
2q
2Minimum ATC
In Mon Comp:
PMC Pmin ATC
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Efficiency - Excess Capacity
P ri ce ( do lla rs /u n it)
0
D MR
ATC
Quantity 120
P
1Q
1MC
Excess capacity
Capacity output Profit-
maximizing output
• 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.
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.
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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.
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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 .
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Characteristics of Oligopoly
1. Few dominant producers.
2. Homogeneous or differentiated product.
3. Advertising/Promotion.
4. Barriers to entry.
And
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.”
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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
Models of Oligopoly
• 1.)Cartel 1.)Cartel
– cartel: a group of firms acting together to cartel minimize strategic behaviour behave like monopoly
– collusion: agreement among firms in a market collusion 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.
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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.
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.
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Quantity (thous.
/week)
Price and cost (thous. of $/ unit
)
0 6 10
Colluding to Maximize Profits
Quantity (thous.
/week)
Price and cost (thous. of $/ unit
)
0 10
1 2 3 4 5 1 2 3 4 5 6 7
6
D
9 9
8
MR
Economic Profit
Collusion achieves monopoly outcome
Individual Firm Industry
MC ATC
MC
1Quota Output for the firm
Colluding to Maximize Profits
P$
MC
0 Q
ATC
D MC
1Q P$
(a) Individual firm (b) Industry 3
6.00
6 MR
Preferred firm output, P=MC
9.00
4
Collusion achieves monopoly outcome Economic
profit
2 8.00
Additional
profit from
cheating
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Incentive to cheat
•additional profit is available to a single cheating firm provided price provided price
doesn’t fall doesn’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
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
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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
Game Theory
•A special kind of Best Response.
•Strategy that is best no matter what the other player does.
•Eg. advertise
DOMINANT STRATEGY
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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
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 Adverti
se
B’s STRATEGY A’s
STRATEG
Don’t Y
adverti se
Advertis
e
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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
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
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Prisoners’ Dilemma Payoff Matrix
Rocky’s strategies
Confess Deny
Ginger’s strategies
Confess 5 years
5 years 7 years
Go free
1 year
1 year 7 years
Go free
Deny
Dominant strategy:
confess, even
though they
would both be
better off if
they both kept
their mouths
shut.
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
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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.
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
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