Chapter 13 monopolistic competition and oligopoly

Outline
I. What is Monopolistic Competition? A. Monopolistic competition is a market with the following characteristics: 1. A large number of firms compete. 2. Each firm produces a differentiated product. 3. Firms compete on product quality, price, and marketing. 4. Firms are free to enter and exit. B. The presence of a large number of firms in the market implies: 1. Each firm supplies only a small part of the total industry output and so has only limited power to influence the price of its product. 2. Each firm is sensitive to the average market price but pays no attention to any one individual competitor. 3. No one firm can dictate market conditions and no one firms actions directly affect the actions of another. 4. Collusion, or conspiring to fix prices, is impossible. C. 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. D. Product differentiation enables firms to compete in three areas: quality, price, and marketing. 1. The quality of a product is the physical attributes that make it different from the products of other firms. Examples include product design, reliability, and service. 2. Each firm faces a downward-sloping demand curve for its own product because each firm produces a differentiated product. This allows each firm to set its own price. The price is related to quality: A higher quality product allows the firm to set a higher price. 3. A firm in monopolistic competition must market its product because all other firms offer differentiated products. This fact means the product must be marketed using advertising and packaging. E. There are no barriers to entry or exit in monopolistic competition, so firms cannot earn an economic profit in the long run.

1. Examples of a monopolistically competitive industry include audio and video equipment, computers, frozen foods, mens clothing, and sporting goods. 2. Figure 13.1 shows market share of the largest four firms for each of ten industries that operate in monopolistic competition.

II. Price and Output in Monopolistic Competition A. Similar to a monopoly, the MR curve for a firm in monopolistic competition is downward sloping and lies under its demand curve. In the short run, a firm in monopolistic competition makes its output and price decision just like monopoly firm does. 1. A firm that has decided the quality of its product and its marketing program produces the profit maximizing quantity at which MR = MC. 2. A firm in monopolistic competition can earn an economic profit in the short run only if P > ATC. 3. Figure 13.2 shows a short-run equilibrium output and price decision for a firm in monopolistic competition making a positive economic profit. B. In the long run, firms in monopolistic competition will be unable to earn economic profit. 1. When firms are earning economic profit (that is, when P

> ATC), the existence of the economic profit induces entry by new firms, which continues as long as firms in the industry earn an economic profit. a) As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve shifts leftward. b) 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. c) The price the firm charges and the quantity it sells falls as firms enter. Eventually entry results in P = ATC and the firms earn zero economic profit (normal profit). 2. When firms are incurring an economic loss (that is, when P < ATC), the economic loss will induce firms to leave the market, which continues as long as firms in the industry bear an economic loss. Figure 13.3 illustrates a firm in monopolistic competition making an economic loss. a) As firms exit the industry, each remaining firm gains some of its market share. The demand for its product increases and the demand curve shifts rightward. b) The increase in demand increases the quantity at which MR = MC and raises the maximum price that the firm can charge to sell this quantity.

c) The price that each remaining firm charges and the quantity it sells rise as firms exit. Eventually exist results in P = ATC and firms again earn zero economic profit (normal profit). d) Figure 13.4 shows the long run output and price decision for a firm in monopolistic competition. C. Comparing Monopolistic Competition with Perfect Competition 1. Firms in monopolistic are inefficient and operate with excess capacity, which means the firm produces a quantity less than the minimum efficient scale . a) Figure 13.5 illustrates this proposition.

2. Firms maximize profit by choosing to produce output where MR = MC. a) The firm in monopolistic competition retains some market power, which means MR < P for all quantities. b) The fact that the firm has some market power means that at the profit maximizing level of output chosen by the firm P > MC. c) A firms markup is the amount by which price exceeds marginal cost.

3. Because a firm in monopolistic competition has P > MC, the firm produces where MC < MB since price equals the marginal benefit to society. a) The under-production in monopolistic competition creates a deadweight loss. b) Monopolistically competitive firms produce at inefficient levels of output relative to perfect competition. c) But firms in monopolistic competition produce a variety of different goods whereas firms in perfect competition produce identical goods. People value variety, so monopolistic competition is not necessarily inferior to perfect competition. III. Product Development and Marketing A. A firm in monopolistic competition must be in a state of continuous product development to keep earning an economic profit. 1. New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation. 2. Firms pursue product development until the marginal revenue from innovation equals the marginal development cost. 3. Production development may benefit the consumer (by providing improvements in product quality) or it may mislead the consumer (by giving only the appearance of change in product quality). 4. Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which is the amount the consumer is willing to pay for the improvement. B. Firms use advertising and packaging as the two principal methods to differentiate its products from competitors by actively marketing their products to consumers. 1. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product. 2. Figure 13.6 shows estimates of this percentage of sale price for different monopolistic competition markets.

3. These selling costs (like advertising expenditures, fancy retail buildings, etc.) are fixed costs. a) This fact means selling costs increase average total costs at any given level of output but do not affect the variable costs (including the marginal cost) of production. b) Figure 13.7 shows how an advertising expenditures shift the ATC curve upward. C. Selling efforts such as advertising are successful only if they increase demand for the firms product. 1. When each firm advertises its product, the advertising increases the price the firm can charge but it also makes the demand more elastic. 2. A firms increased demand and profits can only be experienced by firms in the short run. 3. Profits lead to the entry of more firms into the market, which decreases the demand for each firms product in the long run and lowers the price each firm can charge. D. To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are an efficient allocation of resources. 1. Similarly, developing and marketing a brand name provides information about the quality of a product to consumers and an incentive to the producer to achieve a high and consistent quality standard. 2. Heavy marketing and advertising expenditures by a firm are a signal to consumers that their product is of high quality. A signal is an action taken by an informed person (or firm) to send a message to uninformed people. IV. Oligopoly A. The distinguishing features of an oligopoly are that: 1. Natural or legal barriers prevent the entry of new firms. 2. A small number of firms compete. B. Oligopoly markets share some characteristics of other market structures: 1. Oligopoly is similar to a monopoly in that each firm has market power to determine its own price.

2. Oligopoly might be similar to monopolistic competition in that each firm makes a differentiated product, but this is not a necessary condition for oligopoly. C. The number of firms in a natural oligopoly can be determined by the minimum efficient scale of the firms and the total size of the market. 1. The minimum efficient scale, combined with the size of the total market demand for the product, will determine how many firms survive in the market. 2. If only two firms operate in an oligopoly market, it is called a duopoly. D. The quantity sold by one firm in an oligopoly depends on each firms own price and the prices and quantities sold by all the other firms. 1. This interdependence between firms motivates each firm to behave cooperatively instead of competitively toward each other in an attempt to maximize profits for all firms. 2. A cartel is a group of firms acting togethercolludingto limit output, raise price, and increase economic profit. E. There are two traditional oligopoly models 1. The kinked demand curve model of oligopoly is based on the assumption that each firm believes that if it raises its price, others will not follow but that if it cuts its own price, so will the other firms. a) Figure 13.11 shows the kinked demand curve model. The demand curve that an oligopoly firm believes it faces has a kink at the current price and quantity. b) Above the kink, demand is relatively elastic because all other firms prices remain unchanged and below the kink, demand is relatively inelastic because all other firms prices change in line with the price of the firm shown in the figure. c) The kink in the demand curve means that the MR curve is discontinuous at the current quantity. d) Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged. e) The beliefs that generate the kinked demand curve are not always correct. In particular, if MC increases enough, all firms raise their prices and the kink vanishes.

2. In the dominant firm oligopoly model , there is one large firm that has a significant cost advantage over the other, smaller competing firms and it produces a large part of the industry output. a) The large firm operates as a monopoly, setting its price and output to maximize its profit. b) The small firms act as perfect competitors, taking as given the market price set by the dominant firm and producing output to satisfy the remaining demand in the market. c) Figure 13.12 shows a dominant firm industry.

V. Oligopoly Games A. Game theory is a tool for studying strategic behavior , which is behavior that takes into account the expected behavior of others and the recognition of mutual interdependence. B. All games share four important features: 1. The rules of a game describe the setting of the game, the actions the players may take, and the consequences of those actions. 2. The strategies are all the possible actions of each player in the game. 3. The payoffs are described in a payoff matrix, which is a table that shows the payoffs for every possible action by each player for every possible action by each other player. 4. The outcomes of a game are the results produced by the interaction of all the choices made by each of the players decisions. In a Nash equilibrium , 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.

C. The prisoners dilemma is a good game for illustrating these four features. The following is an example. 1. Art and Bob have been caught stealing cars. The rules of their prisoners dilemma game are as follows: a) Both have been convicted of committing this crime and will be sentenced to two years in jail. b) Both prisoners are also strongly suspected of committing a more serious crime for which there exists insufficient evidence for a conviction. c) During interrogation for the more serious crime, Art and Bob are held in a separate cell and they cannot communicate with each other. d). Each is told that they are both suspected of committing the more serious crime and that the other is being asked to confess in return for a lighter prison sentence for the more serious crime. e) Each prisoner is given a deal to consider: Each prisoner is told that he will receive only a 1-year jail sentence for the serious crime and no time for the less serious crime (for a total of 1 year jail time for both crimes) if he cooperates by giving up a confession that implicates them both and the other prisoner denies the crime. However, if he refuses to confess and his partner does confess, then he will get the full 8 years jail term for the serious crime a total of a 10-year sentence to be served for committing both crimes. f) Each prisoner knows that if they both confess to the more serious crime, each will receive a total of 3 years in jail for committing both crimes. Otherwise, if neither confesses, each prisoner will serve only a 2-year sentence for the minor crime. 2. The strategies for both prisoners are the same: a) Each can confess to committing the serious crime. b) Each can deny committing the serious crime. 3. The games payoff matrix is a table, like the one in Table 13.1, that shows the payoffs for every possible action by each player for every possible action by the other player. a) In Table 13.1, Arts payoff from each combination of actions is shown in the top of each payoff box, and Bobs payoff is shown in the bottom of each payoff box.

b) There are four possible outcomes: Bob and Art both confess (top left payoff box), Bob and Art both deny (bottom right payoff box), Bob confesses but Art does not (top right payoff box), and Art confesses but Bob does not (bottom left payoff box). c) 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 possible action to be taken by the other player. If both players are rational and choose their actions in this way, the outcome is called a Nash equilibriumfirst proposed by John Nash. 4. The dilemma of the prisoners dilemma game is that the best strategy is for each prisoner to confess, which does not create the best outcome for either prisoner. a) Regardless of Bobs decision, Arts best payoff occurs by confessing. b) Regardless of Arts decision, Bobs best payoff occurs by confessing. c) So both prisoners confess and the Nash Equilibrium outcome that results is that each prisoner gets 3 years in jail for committing both crimes. d) Both players would be better off if each had denied the crime, but because they cant communicate about their decisions, there is no way to strike a deal that enables them to cooperate and get the best joint outcome. D. An application of the prisoners dilemma can help us understand the behavior of firms in a natural duopoly, which captures the essence of an oligopoly market. 1. Figure 13.13 shows a natural duopoly:

a) Demand and cost conditions are such that two firms can produce the good to satisfy demand at a lower ATC than only one firm or three firms. b) The firms in a duopoly can enter into a collusive agreement, which is an agreement in which two (or more) competitors agree to restrict output, raise the price, and increase profits.

c) Firms that have entered into a collusive agreement have formed a cartel (which is illegal in the United States.) 2. In a cartel, each firm has two strategies: a) Comply with the agreement b) Cheat on the agreement

3. There are four possible payoffs depending upon the strategy followed by each player: a) If both firms comply, they maximize industry profit by producing the same output as a monopoly would, charging the monopoly price, and sharing the resulting economic profit. Figure 13.14 shows this outcome.

b) If one firm cheats and the other complies, the firm that complies incurs an economic loss, and the firm that cheats makes an economic profit that is larger than its share of the maximum industry profit if it complies. Figure 13.15 shows this outcome.

c) If both firms cheat, they each earn a normal profit (zero economic profit). Figure 13.16 shows this outcome.

4. Table 13.2 shows the payoff matrix for this game. a) The Nash equilibrium is where both firms cheat. b) The quantity and price are those of a competitive market, and the firms earn normal profit. E. Another application of the prisoners dilemma can also help us understand the behavior of two firms operating in a market of monopolistic competition that are engaged in developing and marketing rival products. Consider the situation facing both Procter & Gamble and Kimberly-Clark as they compete in the disposable diaper market: 1. The key to success for each firm is to develop a product that is more highly valued by consumers and less costly to produce than the rival firm. a) Higher valued products increase market share and increase the price and total revenues for the firm. b) Lower costs and higher prices combine to increase profits. c) However, research and development (R&D) costs are high and must be subtracted from these higher profits. 2. There are two different strategies that each firm can pursue: a) Spend money on R&D. b) Do not spend money on R&D. 3. The payoff matrix in Table 13.3 illustrates the four different payoffs that can arise in this game. The payoff for Procter and Gamble appear in the top of each box and the payoff for Kimberly-Clark appears in the bottom of each box. The payoff matrix has four boxes, representing the four possible outcomes: a) Both firms spend money on R&D. b. Neither firm spends money on R&D. c) Procter & Gamble spends on R&D and Kimberly-Clark will not. d) Kimberly-Clark spends on R&D and Procter & Gamble will not.

4. The Nash equilibrium outcome is that both firms spend money on R&D. a) Regardless of what Kimberly-Clark decides to do, the best strategy for Procter & Gamble is to spend money on R&D. b) Regardless of what Procter & Gamble decides to do, the best strategy for Kimberly-Clark is to spend money on R&D. c) Both firms create innovative products that are cheaper to produce, which benefits the consumer but fails to maximize joint profits. d) A dominant strategy equilibrium is a Nash Equilibrium outcome where the best strategy for any player in the game is to cheat on the agreement (act non-cooperatively) regardless of the strategy of the other player . F. A Game of Chicken A game of chicken is exemplified by two cars racing toward each other. 1. The first driver to swerve and avoid crashing is chicken. 2. The payoffs are a big loss for both players if no one chickens, zero for both if both chicken, and if one chickens, a loss for the chicken and a gain for the other player. 3. R&D that creates a new technology that any firm can use is an economic example of the game of chicken. 4. There are two equilibrium outcomes, one in which each player chickens (that is, each player undertakes the research) and the other player does not. This equilibrium is not a Nash equilibrium. VI. Repeated Games and Sequential Games A. If a game is played repeatedly, it is possible for players of the game (like in the two firms in the duopolies game) to act cooperatively and successfully collude (to earn a monopoly profit). 1. Knowing that multiple chances to play the same game will occur changes the dominant strategy for players in this type of sequential game. 2. Many different outcomes are possible because information about players behavior in prior games can be incorporated into current games. B. For example, additional punishment strategies in a repeated prisoners dilemma duopoly game enable the firms to comply and achieve a cooperative equilibrium , in which the firms make and share the monopoly profit. 1. One possible punishment strategy is a tit-for-tat strategy , in which one player cooperates in the current 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.

2. 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. C. A tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game, allowing all firms to enjoy economic profit. 1. If each firm cooperates in the first period, then this cooperation might provide evidence of trustworthiness that the other firms can rely upon in choosing their second period strategy. 2. However, a price war might result from relying on a tit-for-tat strategy, especially when there is the additional complication of uncertainty about unforeseen changes in consumer demand. a) A random decrease in demand might convince some firms to lower their price b) It is difficult for the firms to determine if the low price is the result of weaker demand or of non-cooperative behavior on the part of those firms lowering their price. c) This fall in price might result in a round of tit-for-tat punishment by all firms. D. However, non-cooperative outcomes are also possible if the firms operate in a contestable market. 1. A contestable market is a market in which firms can enter and leave so easily that those firms in the market face competition from potential entrants. These firms play a sequential entry game. 2. Figure 13.17 shows the game tree for a sequential entry game in a contestable market.

a. In this entry game, the firms in the market set a competitive price and earn only a normal profit to keep the potential entrant out. b. However, a less costly strategy is limit pricing, which sets the price at the highest level that inflicts a loss on the entrant. This strategy will keep the potential entrant out while allowing the existing firms to earn economic profit.