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Monopolistic Competition

Characteristics
1) Many firms
2) Free entry and exit
3) Differentiated product (but high degree of
substitutability)

The amount of monopoly power depends on the
degree of differentiation.

Examples of this common market structure include:
 Toothpaste; Soap; Cold remedies; Soft Drinks;
Coffee
Chapter 12
Slide 1
A Monopolistically Competitive
Firm in the Short and Long Run
$/Q
Short Run
$/Q
MC
Long Run
MC
AC
AC
PSR
PLR
DSR
DLR
MRSR
QSR
Quantity
MRLR
QLR
Quantity
Monopolistic Competition in the SR

Observations (short-run)

Downward sloping demand - differentiated
product

Demand is relatively elastic - good
substitutes

MR < P

Profits are maximized when MR = MC

This firm is making economic profits
Chapter 12
Slide 3
Monopolistic Competition in the LR

Observations (long-run)

Profits will attract new firms to the industry
(no barriers to entry)

The old firm’s demand will decrease to DLR

Firm’s output and price will fall

Industry output will rise

No economic profit (P = AC)

P > MC -- some monopoly power
Chapter 12
Slide 4
Comparison of Monopolistically Competitive
Equilibrium and Perfectly Competitive Equilibrium
Monopolistic Competition
Perfect Competition
$/Q
$/Q
MC
Deadweight
loss
AC
MC
AC
P
PC
D = MR
DLR
MRLR
QC
Quantity
QMC
Quantity
Monopolistic Competition

Reduction in Economic Efficiency
 The
monopoly power (differentiation) yields
a higher price than perfect competition. If
price was lowered to the point where
MC = D, total surplus would increase by
the yellow triangle.
 Although
there are no economic profits in
the long run, the firm is still not producing
at minimum AC and excess capacity exists.
Chapter 12
Slide 6
Oligopoly


Characteristics

Small number of firms

Product differentiation may or may not exist

Barriers to entry
Examples: Automobiles, Steel, Aluminum,
Petrochemicals, Electrical equipment,
Computers
Chapter 12
Slide 7
Oligopoly


Barriers to entry include:

Scale economies; Patents; Technology; Name
recognition

Strategic action: Flooding the market; Controlling
an essential input
Management Challenges

Strategic actions

Rival behavior
Chapter 12
Slide 8
Oligopoly

Equilibrium in an Oligopolistic Market

In perfect competition, monopoly, and
monopolistic competition the producers did
not have to consider a rival’s response
when choosing output and price.

In oligopoly the producers must consider
the response of competitors when
choosing output and price.
Chapter 12
Slide 9
Oligopoly

Equilibrium in an Oligopolistic Market


Defining Equilibrium
 Firms do the best they can and have no
incentive to change their output or price
 All firms assume competitors are taking rival
decisions into account.
Nash Equilibrium

Chapter 12
Each firm is doing the best it can given what its
competitors are doing.
Slide 10
Quantity Competition: Cournot

The Cournot Model

Chapter 12
Duopoly

Two firms competing with each other

Homogeneous good

The output of the other firm is assumed
to be fixed
Slide 11
Firm 1’s Output Decision
If Firm 1 thinks Firm 2 will
produce nothing, its demand
curve, D1(0), is the market
demand curve.
P1
D1(0)
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(0)
D1(75)
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MR1(75)
MC1
MR1(50)
12.5 25
Chapter 12
D1(50)
50
Q1
Slide 12
Reaction Curves and Cournot Equilibrium
Q1
100
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous example.
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce.
75
Firm 2’s Reaction
Curve Q2*(Q1)
50 x
25
Cournot
Equilibrium
Firm 1’s Reaction
Curve Q*1(Q2)
25
Chapter 12
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits.
x
50
x
75
x
100
Q2
Slide 13
Price Competition: Bertrand

Competition in an oligopolistic industry may
occur with price instead of output.

The Bertrand Model is used to illustrate price
competition in an oligopolistic industry with
homogenous goods.

How will consumers respond to a price
differential? (Hint: Consider homogeneity)
Chapter 12
Slide 14
Price Competition
Bertrand Model

Why not charge a higher price to raise
profits?

How does the Bertrand outcome compare to
the Cournot outcome?

The Bertrand model demonstrates the
importance of the strategic variable (price
versus output).
Chapter 12
Slide 15
Price Competition

Price Competition with Differentiated
Products

Chapter 12
Market shares are now determined not just
by prices, but by differences in the design,
performance, and durability of each firm’s
product.
Slide 16
Nash Equilibrium in Prices
P1
Firm 2’s Reaction Curve
$4
Firm 1’s Reaction Curve
Nash Equilibrium
$4
Chapter 12
P2
Slide 17
Competition Versus Collusion:
Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $4
Charge $6
$12, $12
$20, $4
$4, $20
$16, $16
Firm 1
Charge $6
Chapter 12
Slide 18
Competition Versus Collusion:
The Prisoners’ Dilemma

These two firms are playing a noncooperative
game.


Question


Each firm independently does the best it can
taking its competitor into account.
Why will both firms both choose $4 when $6 will
yield higher profits?
An example in game theory, called the
Prisoners’ Dilemma, illustrates the problem
oligopolistic firms face.
Chapter 12
Slide 19
Competition Versus Collusion:
The Prisoners’ Dilemma

Scenario

Two prisoners have been accused of
collaborating in a crime.

They are in separate jail cells and cannot
communicate.

Each has been asked to confess to the
crime.
Chapter 12
Slide 20
Payoff Matrix for Prisoners’ Dilemma
Prisoner B
Confess
Confess
Prisoner A
Don’t
confess
Chapter 12
-5, -5
Don’t confess
-1, -10
Would you choose to confess?
-10, -1
-2, -2
Slide 21
Payoff Matrix for the Prisoners’ Dilemma

Conclusions: Oligopolistic Markets
1) Collusion will lead to greater profits
2) Explicit and implicit collusion is
possible
3) Once collusion exists, the profit
motive to break and lower price is
significant
Chapter 12
Slide 22
Payoff Matrix for the P&G Pricing Problem
Unilever and Kao
Charge $1.40
Charge
$1.40
P&G
$12, $12
Charge $1.50
$29, $11
What price should P & G choose?
Charge
$1.50
Chapter 12
$3, $21
$20, $20
Slide 23
Implications of the Prisoners’
Dilemma for Oligopolistic Pricing
Price Signaling & Price Leadership

Price Signaling: Implicit collusion in which a
firm announces a price increase in the hope
that other firms will follow suit.

Price Leadership: Pattern of pricing in which
one firm regularly announces price changes
that other firms then match.
Chapter 12
Slide 24