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MONOPOLISTIC
COMPETITION AND
OLIGOPOLY
13
CHAPTER
Objectives
After studying this chapter, you will able to
 Define and identify monopolistic competition
 Explain how output and price are determined in a
monopolistically competitive industry
Objectives
After studying this chapter, you will able to
 Define and identify oligopoly
 Explain two traditional oligopoly models
 Use game theory to explain how price and output are
determined in oligopoly
 Use game theory to explain other strategic decisions
Monopolistic Competition
Monopolistic competition is a market with the following
characteristics:
 A large number of firms.
 Each firm produces a differentiated product.
 Firms compete on product quality, price, and marketing.
 Firms are free to enter and exit the industry.
Monopolistic Competition
Large Number of Firms
The presence of a large number of firms in the market
implies:
 Each firm has only a small market share and therefore
has limited market power to influence the price of its
product.
 Each firm is sensitive to the average market price, but no
firm pays attention to the actions of the other, and no one
firm’s actions directly affect the actions of other firms.
 Collusion, or conspiring to fix prices, is impossible.
Monopolistic Competition
Product Differentiation
Firms in monopolistic competition practice product
differentiation, which means that each firm makes a
product that is slightly different from the products of
competing firms.
Monopolistic Competition
Competing on Quality, Price, and Marketing
Product differentiation enables firms to compete in three
areas: quality, price, and marketing.
Quality includes design, reliability, and service.
Because firms produce differentiated products, each firm
has a downward-sloping demand curve for its own
product.
But there is a tradeoff between price and quality.
Differentiated products must be marketed using
advertising and packaging.
Monopolistic Competition
Entry and Exit
There are no barriers to entry in monopolistic competition,
so firms cannot earn an economic profit in the long run.
Examples of Monopolistic Competition
Figure 13.1 on the next slide shows market share of the
largest four firms and the HHI for each of ten industries
that operate in monopolistic competition.
Monopolistic Competition
The red bars
refer to the 4
largest firms.
Green is the
next 4.
Blue is the
next 12.
The numbers
are the HHI.
Output and Price in Monopolistic
Competition
The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its
marketing program produces the profit maximizing
quantity at which its marginal revenue equals its marginal
cost (MR = MC).
Price is determined from the demand curve for the firm’s
product and is the highest price the firm can charge for the
profit-maximizing quantity.
Output and Price in Monopolistic
Competition
Figure 13.2 shows a
short-run equilibrium for a
firm in monopolistic
competition.
It operates much like a
single-price monopolist.
Output and Price in Monopolistic
Competition
The firm produces the
quantity at which price
equals marginal cost and
sells that quantity for the
highest possible price.
It earns an economic
profit (as in this example)
when P > ATC.
Output and Price in Monopolistic
Competition
Profit Maximizing Might
be Loss Minimizing
A firm might incur an
economic loss in the short
run.
Here is an example.
In this case, P < ATC.
Output and Price in Monopolistic
Competition
Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn
an economic profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition
maximizes its profit by producing the quantity at which its
marginal revenue equals its marginal cost, MR = MC.
Output and Price in Monopolistic
Competition
As firms enter the industry, each existing firm loses some
of its market share. The demand for its product decreases
and the demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which
MR = MC and lowers the maximum price that the firm can
charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and
firms earn zero economic profit.
Output and Price in Monopolistic
Competition
Figure 13.4 shows a firm
in monopolistic
competition in long-run
equilibrium.
If firms incur an economic
loss, firms exit to achieve
the long-run equilibrium.
Output and Price in Monopolistic
Competition
Monopolistic Competition and Perfect Competition
Two key differences between monopolistic competition
and perfect competition are:
 Excess capacity
 Markup
A firm has excess capacity if it produces less than the
quantity at which ATC is a minimum.
A firm’s markup is the amount by which its price exceeds
its marginal cost.
Output and Price in Monopolistic
Competition
Firms in monopolistic
competition operate with
excess capacity in longrun equilibrium.
The downward-sloping
demand curve for their
products drives this result.
Output and Price in Monopolistic
Competition
Firms in monopolistic
competition operate with
positive mark up.
Again, the downwardsloping demand curve for
their products drives this
result.
Output and Price in Monopolistic
Competition
In contrast, firms in perfect
competition have no
excess capacity and no
markup.
The perfectly elastic
demand curve for their
products drives this result.
Output and Price in Monopolistic
Competition
Is Monopolistic Competition Efficient
Because in monopolistic competition P > MC, marginal
benefit exceeds marginal cost.
So monopolistic competition seems to be inefficient.
But the markup of price above marginal cost arises from
product differentiation.
People value variety but variety is costly.
Monopolistic competition brings the profitable and possibly
efficient amount of variety to market.
What is Oligopoly?
The distinguishing features of oligopoly are:
 Natural or legal barriers that prevent entry of new firms
 A small number of firms compete
What is Oligopoly?
Barriers to Entry
Either natural or legal
barriers to entry can create
oligopoly.
Figure 13.9 shows two
oligopoly situations.
In part (a), there is a
natural duopoly—a
market with two firms.
What is Oligopoly?
In part (b), there is a
natural oligopoly market
with three firms.
A legal oligopoly might
arise even where the
demand and costs leave
room for a larger number
of firms.
What is Oligopoly?
Small Number of Firms
Because an oligopoly market has a small number of firms,
the firms are interdependent and face a temptation to
cooperate.
Interdependence: With a small number of firms, each
firm’s profit depends on every firm’s actions.
Cartel: A cartel and is an illegal group of firms acting
together to limit output, raise price, and increase profit.
Firms in oligopoly face the temptation to form a cartel, but
aside from being illegal, cartels often break down.
What is Oligopoly?
Examples of Oligopoly
Figure 13.10 shows some
examples of oligopoly.
An HHI that exceeds 1800
is generally regarded as
an oligopoly.
An HHI below 1800 is
generally regarded as
monopolistic competition.
Two Traditional Oligopoly Models
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm
believes that if it raises its price, its competitors will not
follow, but if it lowers its price all of its competitors will
follow.
Two Traditional Oligopoly Models
Figure 13.11 shows the
kinked demand curve
model.
The demand curve that a
firm believes it faces has a
kink at the current price
and quantity.
Two Traditional Oligopoly Models
Above the kink, demand is
relatively elastic because
all other firm’s prices
remain unchanged.
Below the kink, demand is
relatively inelastic because
all other firm’s prices
change in line with the
price of the firm shown in
the figure.
Two Traditional Oligopoly Models
The kink in the demand
curve means that the MR
curve is discontinuous at
the current quantity—shown
by that gap AB in the figure.
Two Traditional Oligopoly Models
Fluctuations in MC that
remain within the
discontinuous portion of the
MR curve leave the profitmaximizing quantity and
price unchanged.
For example, if costs
increased so that the MC
curve shifted upward from
MC0 to MC1, the profit
maximizing price and
quantity would not change.
Two Traditional Oligopoly Models
The beliefs that generate
the kinked demand curve
are not always correct and
firms can figure out this
fact
If MC increases enough,
all firms raise their prices
and the kink vanishes.
A firm that bases its
actions on wrong beliefs
doesn’t maximize profit.
Two Traditional Oligopoly Models
Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that
has a significant cost advantage over many other, smaller
competing firms.
The large firm operates as a monopoly, setting its price
and output to maximize its profit.
The small firms act as perfect competitors, taking as given
the market price set by the dominant firm.
Two Traditional Oligopoly Models
Figure 13.12 shows a dominant firm industry. On the left
are 10 small firms and on the right is one large firm.
Two Traditional Oligopoly Models
The demand curve, D, is the market demand curve and the
supply curve S10 is the supply curve of the 10 small firms.
S10
Two Traditional Oligopoly Models
At a price of $1.50, the 10 small firms produce the quantity
demanded. At this price, the large firm would sell nothing.
Two Traditional Oligopoly Models
But if the price was $1.00, the 10 small firms would supply
only half the market, leaving the rest to the large firm.
Two Traditional Oligopoly Models
The demand curve for the large firm’s output is the curve
XD on the right.
Two Traditional Oligopoly Models
The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.
Two Traditional Oligopoly Models
The large firm maximizes profit by setting MR = MC. Let’s
suppose that the marginal cost curve is MC in the figure.
Two Traditional Oligopoly Models
The profit maximizing quantity for the large firm is 10 units.
The price charged is $1.00.
Two Traditional Oligopoly Models
The small firms take this price and supply the rest of the
quantity demanded.
Two Traditional Oligopoly Models
A dominant firm oligopoly can arise only if one firm has
lower costs than the others.
Two Traditional Oligopoly Models
In the long run, such an industry might become a monopoly
as the large firm buys up the small firms and cuts costs.
Oligopoly Games
Game theory is a tool for studying strategic behavior,
which is behavior that takes into account the expected
behavior of others and the mutual recognition of
interdependence.
What Is a Game?
All games share four features:
 Rules
 Strategies
 Payoffs
 Outcome.
Oligopoly Games
The Prisoners’ Dilemma
The prisoners’ dilemma game illustrates the four features
of a game.
The rules describe the setting of the game, the actions the
players may take, and the consequences of those actions.
In the prisoners’ dilemma game, two prisoners (Art and
Bob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicate
with each other.
Oligopoly Games
Each is told that both are suspected of committing a more
serious crime.
If one of them confesses, he will get a 1-year sentence for
cooperating while his accomplice get a 10-year sentence for
both crimes.
If both confess to the more serious crime, each receives 3
years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the
minor crime only.
Oligopoly Games
In game theory, strategies are all the possible actions of
each player.
Art and Bob each have two possible actions:
 Confess to the larger crime
 Deny having committed the larger crime.
Because there are two players and two actions for each
player, there are four possible outcomes:
 Both confess
 Both deny
 Art confesses and Bob denies
 Bob confesses and Art denies
Oligopoly Games
Each prisoner can work out what happens to him—can work
out his payoff—in each of the four possible outcomes.
We can tabulate these outcomes in a payoff matrix.
A payoff matrix is a table that shows the payoffs for every
possible action by each player for every possible action by
the other player.
The next slide shows the payoff matrix for this prisoners’
dilemma game.
Oligopoly Games
If a player makes a rational choice in pursuit of his own
best interest, he chooses the action that is best for him,
given any action taken by the other player.
If both players are rational and choose their actions in this
way, the outcome is an equilibrium called Nash
equilibrium—first proposed by John Nash.
The following slides show how to find the Nash equlibrium.
Bob’s
view
of the
world
Bob’s
view
of the
world
Art’s
view
of the
world
Art’s
view
of the
world
Equilibrium
Oligopoly Games
An Oligopoly Price-Fixing Game
A game like the prisoners’ dilemma is played in duopoly.
A duopoly is a market in which there are only two
producers that compete.
Duopoly captures the essence of oligopoly.
Figure 13.13 on the next slide describes the demand and
cost situation in a natural duopoly.
Oligopoly Games
Part (a) shows each firm’s cost curves.
Part (b) shows the market demand curve.
Oligopoly Games
This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.
Oligopoly Games
How does this market work?
What is the price and quantity produced in equilibrium?
Oligopoly Games
Suppose that the two firms enter into a collusive
agreement.
A collusive agreement is an agreement between two (or
more) firms to restrict output, raise price, and increase
profits.
Such agreements are illegal in the United States and are
undertaken in secret.
Firms in a collusive agreement operate a cartel.
Oligopoly Games
The possible strategies are:
 Comply
 Cheat
Because each firm has two strategies, there are four
possible outcomes:
 Both comply
 Both cheat
 Trick complies and Gear cheats
 Gear complies and Trick cheats
Oligopoly Games
The first possible outcome—both comply—earns the
maximum economic profit, which is the same as a monopoly
would earn.
Oligopoly Games
To find that profit, we set marginal cost for the cartel equal to
marginal revenue for the cartel. Figure 13.14 shows this
outcome.
Oligopoly Games
The cartel’s marginal cost curve is the horizontal sum of the
MC curves of the two firms and the marginal revenue curve
is like that of a monopoly.
Oligopoly Games
The firm’s maximize economic profit by producing the
quantity at which MCI = MR.
Oligopoly Games
Each firm agrees to produce 2,000 units and each firm
shares the maximum economic profit.
Oligopoly Games
When each firm produces 2,000 units, the price is greater
than the firm’s marginal cost, so if one firm increased
output, its profit would increase.
Oligopoly Games
Figure 13.15 shows what happens when one firm cheats
and increases its output to 3,000 units. Industry output
rises to 5,000 and the price falls.
Oligopoly Games
For the complier, ATC now exceeds price.
For the cheat, price exceeds ATC.
Oligopoly Games
For the complier incurs an economic loss.
The cheat earns an increased economic profit.
Oligopoly Games
Either firm could cheat, so this figure shows two of the
possible outcomes.
Next, let’s see the effects of both firms cheating.
Oligopoly Games
Figure 13.16 shows the outcome if both firms cheat and
increase their output to 3,000 units.
Oligopoly Games
Industry output is 6,000 units, the price falls, and both
firms earn zero economic profit—the same as in perfect
competition.
Oligopoly Games
You’ve now seen the four possible outcomes:
 If both comply, they make $2 million a week each.
 If both cheat, they earn zero economic profit.
 If Trick complies and Gear cheats, Trick incurs an
economic loss of $1 million and Gear makes an economic
profit of $4.5 million.
 If Gear complies and Trick cheats, Gear incurs an
economic loss of $1 million and Trick makes an economic
profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly
game.
Payoff
Matrix
Trick’s
view
of the
world
Trick’s
view
of the
world
Gear’s
view
of the
world
Gear’s
view
of the
world
Equilibrium
Oligopoly Games
The Nash equilibrium is where both firms cheat.
The quantity and price are those of a competitive market,
and the firms earn normal profit.
Other Oligopoly Games
Advertising and R & D games are also prisoners’
dilemmas.
An R & D Game
Procter & Gamble and Kimberley Clark play an R & D
game in the market for disposable diapers.
Oligopoly Games
Here is the payoff matrix for the Pampers Versus Huggies
game.
Oligopoly Games
The Disappearing Invisible Hand
In all the versions of the prisoners’ dilemma that we’ve
examined, the players end up worse off than they would if
they were able to cooperate.
The pursuit of self-interest does not promote the social
interest in these games.
Oligopoly Games
A Game of Chicken
In the prisoners’ dilemma game, the Nash equilibrium is a
dominant strategy equilibrium, by which we mean the
best strategy for each player is independent of what the
other player does.
Not all games have such an equilibrium.
One that doesn’t is the game of “chicken.”
Payoff
Matrix
KC’s
view
of the
world
KC’s
view
of the
world
P&G’s
view
of the
world
P&G’s
view
of the
world
Equilibrium
Repeated Games and Sequential Games
A Repeated Duopoly Game
If a game is played repeatedly, it is possible for duopolists
to successfully collude and earn a monopoly profit.
If the players take turns and move sequentially (rather
than simultaneously as in the prisoner’s dilemma), many
outcomes are possible.
In a repeated prisoners’ dilemma duopoly game, additional
punishment strategies enable the firms to comply and
achieve a cooperative equilibrium, in which the firms
make and share the monopoly profit.
Repeated Games and Sequential Games
One possible punishment strategy is a tit-for-tat strategy,
in which one player cooperates this period if the other
player cooperated in the previous period but cheats in the
current period if the other player cheated in the previous
period.
A more severe punishment strategy is a trigger strategy in
which a player cooperates if the other player cooperates
but plays the Nash equilibrium strategy forever thereafter if
the other player cheats.
Repeated Games and Sequential Games
Table 13.5 shows that a tit-for-tat strategy is sufficient to
produce a cooperative equilibrium in a repeated duopoly
game.
Price wars might result from a tit-for-tat strategy where
there is an additional complication—uncertainty about
changes in demand.
A fall in demand might lower the price and bring forth a
round of tit-for-tat punishment.
Repeated Games and Sequential Games
A Sequential Entry Game in a Contestable Market
In a contestable market—a market in which firms can
enter and leave so easily that firms in the market face
competition from potential entrants—firms play a
sequential entry game.
Repeated Games and Sequential Games
Figure 13.17 shows the game tree for a sequential entry
game in a contestable market.
Repeated Games and Sequential Games
In the first stage, Agile decides whether to set the
monopoly price or the competitive price.
Repeated Games and Sequential Games
In the second stage, Wanabe decides whether to enter or
stay out.
Repeated Games and Sequential Games
In the equilibrium of this entry game, Agile sets a
competitive price and earns a normal profit to keep
Wanabe out.
A less costly strategy is limit pricing, which sets the price
at the highest level that is consistent with keeping the
potential entrant out.
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Common Resources