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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 1 Product Differentiation • The distinguishing between products through real or imagined properties – – – – – Quality Services Location Advertising Packaging More product differentiation = less elasticity of demand 2 Short-Run Equilibrium: Monopolistic Competition -Price (Pe) < ATC -Economic loss -Price (Pe) > ATC -Economic profit MC ATC Pe ATC d Profits Dollars per Unit Dollars per Unit ATC MC ATC Pe d Losses E E MR MR qe Quantity qe Quantity 3 Long 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 4 Long-Run Equilibrium • 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. ATC Dollars per Unit MC Pe = ATC d E qe Quantity -Price (Pe) = ATC -Zero econ. profits MR -Normal rate of return 5 Comparison of the Perfect Competitor with the Monopolistic Competitor: Efficiency Perfect Competition Dollars per Unit d P1 MR = P q1 Quantity per Time Period Minimum ATC ATC ATC MC Dollars per Unit MC Minimum ATC Monopolistic Competition P2 d' In Mon Comp: PMC Pmin ATC MR q2 Quantity per Time Period 6 Price (dollars/unit) Efficiency - Excess Capacity P1 Profit120 maximizing output 0 MR • Excess Capacity Theorem of Monopolistic Competition: MC ATC • each firm is producing an output less than the one for which Excess its ATC reaches capacity its minimum point; i.e., it has Capacity excess capacity. output D Q1 Quantity 7 Efficiency: Monopolistic Competition Monopolistically Competitive Markets tend to be – overcrowded with firms, – each of which tends to be underutilized “wastes” of monopolistic competition. Qualifications to “wastes”/ inefficiency. Consumers gain from – variety and choice. – advertising •pros….•cons… – product development….. 8 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. 9 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. 10 Characteristics of Oligopoly 1. Few dominant producers. 2. Homogeneous or differentiated product. 3. Advertising/Promotion. 4. Barriers to entry. And 11 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.” 12 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 13 Characteristics of Oligopoly – Notice » there is no single model of oligopoly. there is tension between co-operation and self interest. Models of Oligopoly • 1.)Cartel – cartel: a group of firms acting together to minimize strategic behaviour behave like monopoly – collusion: agreement among firms in a market about quantities to produce &/or prices to charge. 14 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. 15 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. 16 Colluding to Maximize Profits MC ATC 10 9 8 6 Economic Profit Price and cost (thous. of $/ unit) Price and cost (thous. of $/ unit) Individual Firm Industry 10 9 6 D Quota Output for the firm 0 1 2 3 4 MC1 Collusion achieves monopoly outcome MR 5 Quantity (thous. /week) 0 1 2 3 4 5 6 Quantity (thous. 17 /week) 7 Colluding to Maximize Profits P$ Economic profit P$ Preferred firm output, P=MC MC 9.00 8.00 Collusion achieves monopoly outcome ATC MC1 6.00 Additional profit from cheating D MR 0 2 3 (a) Individual firm 4 Q (b) Industry 6 Q 18 Incentive to cheat •Since P > MC at quota, • firms have an incentive to cheat, to produce more until P(MR)=MC •additional profit is available to a single cheating firm provided price doesn’t fall. •If all firms cheat, an excess quantity supplied in the market will cause the price to fall. 19 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 20 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 21 Game Theory •A special kind of Best Response. DOMINANT STRATEGY •Strategy that is best no matter what the other player does. •Eg. advertise 22 Game Theory Payoff Matrix –table that shows the payoffs/ outcomes for every possible action by each player for every possible action by the other player. Eg: Advertising where firms are assumed to anticipate how rival firms might react 23 Game Theory B’s STRATEGY A’s STRATEGY Don’t advertise Advertise Don’t advertise A’s profit= $50 000 B’s profit = $50 000 A’s profit= $75 000 B’s loss = $25 000 Advertise A’s loss = $25 000 B’s profit = $75 000 A’s profit = $10 000 B’s profit = $10 000 24 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 25 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 26 Prisoners’ Dilemma Payoff Matrix Rocky’s strategies Deny Deny Ginger’s strategies Confess 1 year 1 year 7 years Go free Confess Go free 7 years 5 years Dominant strategy: confess, even though they would both be better off if they both kept their mouths shut. 5 years 27 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 28 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. 29 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 30 Solving the “dilemma” • 2. Tit-for-Tat Strategy – a player should start by cooperating and then do whatever the other player did last time. • e.g., player cooperates until the other player cheats, the first player then cheats until the other player co-operates again. – What is the Nash Equilibrium when facing a tit-for-tat strategy? 31