Many producers offer products that are either close substitutes but are not viewed as identical
Each supplier has some power over the price it charges : price makers
Low barriers to entry: firms in the long run can enter or leave the market with ease
Act independently of each other
Differentiate their products
Exhibit 1a: Maximizing Short-Run Profit
The monopolistically competitive firm produces the level of output at which marginal revenue equals marginal cost (point e ) and charges the price indicated by point b on the downward-sloping demand curve.
In panel (a), the firm produces q units, sells them at price p , and earns a short-run economic profit equal to ( p – c ) multiplied by q , shown by the blue rectangle.
Exhibit 1b: Minimizing Short-Run Loss
In panel (b), the average total cost exceeds the price at the output where marginal revenue equals marginal cost.
Thus, the firm suffers a short-run loss equal to ( c – p ) multiplied by q , shown by the pink rectangle.
Zero Economic Profit in the Long Run
Low barriers to entry in monopolistic competition: short-run economic profit will attract new entrants in the long run
With losses some competitors will leave the industry
Their customers will switch to the remaining firms, increasing the demand for each remaining firm’s demand curve and making it less elastic
Exhibit 2: Long-run Equilibrium p 0 q MC ATC MR D a b Quantity per period
In the long run, entry and exit will shift each firm’s demand curve until economic profit disappears and price equals ATC
Long-run outcome occurs where the MR curve intersects the MC curve at point a , where the ATC curve is tangent to the demand curve at point b and there is no economic profit
In the case of short-run losses, some firms will leave the industry and the demand curve shifts to the right, becoming less elastic until the loss disappears and the remaining firms earn a normal profit
Dollars per unit
Exhibit 3: Perfect Competition versus Monopolistic Competition
Point of tangency between d, MC and ATC in perfect competition means firm is producing at lowest possible average cost in the long run
In monopolistic competition, the price and average cost exceed those in pure competition – there is excess capacity
Firms in perfect competition are not producing at minimum average cost and are said to have excess capacity, because production falls short of the quantity that would achieve the lowest average cost.
Excess capacity means that each producer could easily serve more customers and in the process would lower average cost.
The marginal value of increased output would exceed its marginal cost, so greater output would increase social welfare.
Some argue that monopolistic competition results in too many suppliers and in product differentiation that is often artificial
Counterargument is that consumers are willing to pay a higher price for greater selection
Market structure that is dominated by just a few firms
Each must consider the effect of its own actions on competitors’ behavior the firms in an oligopoly are interdependent
Varieties of Oligopoly
Homogeneous or differentiated products
Interdependence: the behavior of any particular firm is difficult to analyze
Domination by a few firms can often be traced to some form of barrier to entry
Exhibit 4: Economies of Scale as a Barrier to Entry c a c b Autos per year S b a Long-run average cost 0
If a new entrant sells only S cars, the average cost per unit, c a , exceeds the average cost, c b , of a manufacturer that sells enough cars to reach the minimum efficiency scale, M.
If autos sell for a price less than c a , a potential entrant can expect to lose money.
M D o l l a r s p e r u n i t
High Costs of Entry
Total investment needed to reach the minimum size
Advertising a new product enough to compete with established brands
High start-up costs and presence of established brand names: the fortunes of a new product are very uncertain
Models of Oligopolies
Interdependence: no one model or approach explains the outcomes
At one extreme, the firms in the industry may try to coordinate their behavior so they act collectively as a single monopolist, forming a cartel
At the other extreme, they may compete so fiercely that price wars erupt
Collusion: an agreement among firms in the industry to divide the market and fix the price
Cartel: a group of firms that agree to collude so they can act as a monopolist and earn monopoly profits
Colluding firms usually reduce output, increase price, and block the entry of new firms
Exhibit 5: Cartel as a Monopolist
D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel).
Cartel profits are maximized when the industry produces quantity Q and charges price p .
Differences in Cost
The greater the differences in average costs across firms, the greater will be the differences in economic profits among firms
If cartel members try to equalize each firm’s total profit, a high-cost firm would need to sell more than a low-cost firm
This allocation scheme violates the cartel’s profit-maximizing condition of finding the output for each firm that results in identical marginal costs across firms
Number of Firms in the Cartel
The more firms in the industry, the more difficult it is to negotiate an acceptable allocation of output among them
Consensus becomes harder to achieve as the number of firms grows
New Entry Into the Industry
If a cartel cannot block the entry of new firms into the industry, new entry will eventually force prices down, squeezing economic profit and undermining the cartel
The profit of the cartel attracts entry, entry increases market supply and market price is forced down
Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement
By offering a price slightly below the established price, a firm can usually increase its sales and economic profit
Because oligopolists usually operate with excess capacity, some cheat on the established price
An informal, or tacit, type of collusion occurs in industries that contain price leaders who set the price for the rest of the industry
A dominant firm or a few firms establish the market price, and other firms in the industry follow that lead, thereby avoiding price competition
Price leader also initiates price changes
Violates U.S. antitrust laws
The greater the product differentiation among sellers, the less effective price leadership will be as a means of collusion
There is no guarantee that other firms will follow the leader
Some firms will try to cheat on the agreement by cutting price to increase sales and profits
Unless there are barriers to entry, a profitable price will attract entrants
Game theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms
It analyzes the behavior of decision-makers, or players, whose choices affect one another
Provides a general approach that allows us to focus on each player’s incentives to cooperate or not
Payoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues
Each prisoner pursues one of two strategies, confessing or clamming up
The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies
Exhibit 6: Payoff Matrix
Ben’s payoff is in red and Jerry’s in blue.
The incentive for both to confess is the dominant-strategy equilibrium of the game because each player’s strategy does not depend on what the other does.
Price Setting Game
The prisoner’s dilemma applies to a broad range of economic phenomena such as pricing policy and advertising strategy
Consider the market for gasoline in a rural community with only two gas stations: a duopoly
Suppose customers are indifferent between the two brands and consider only the price
Price Setting Game
Each station sets its daily price early in the morning before knowing the price set by the other
Suppose only two prices are possible: a low price and a high price
If both charge the low price, they split the market and each earns a profit of $500 per day
If both charge the high price, they also split the market and earn $700 profit
If one charges the high price but the other the low one, the low-price station earns a profit of $1,000 and the high-price station earns $200
Exhibit 7: Price-Setting Payoff Matrix
What price for each would maximize profits?
Texaco: If Exxon charges the low price, Texaco earns $500 by charging the low price, but only $200 by charging the high price: better off charging the low price.
If Exxon charges the high price, Texaco earns $1,000 by charging the low price and $700 by charging the high price: Texaco earns more by charging the low price.
Exxon faces the same incentives
Each seller will charge the low price, regardless of what the other does: each earns $500 a day.
One-Shot versus Repeated Games
The outcome of a game often depends on whether it is a one-shot game or the repeated game
The classic prisoner’s dilemma is a one-shot game: the game is to be played only once
However, if the same players repeat the prisoner’s dilemma, as would likely occur in the price setting game, other possibilities unfold
One-Shot versus Repeated Games
In a repeated-game setting, each player has a chance to establish a reputation for cooperation and thereby can encourage the other player to do the same
The cooperative solution makes both players better off than if they fail to cooperate
Exhibit 8: Cola War Payoff Matrix
Pepsi’s profit appears in red and Coke’s in blue
Pepsi’s decision: If Coke adopts a big promotional budget, Pepsi earns $2 billion by doing the same, but only $1 billion by adopting a moderate budget: Pepsi should adopt big budget
Coke faces the same incentives
Both will adopt the big budget
Experiments show that the strategy with the highest payoff in repeated games turns out to be the tit-for-tat strategy
You begin by cooperating in the first round of play
Every round thereafter, you cooperate if your opponent cooperated in the previous round, and
You cheat if your opponent cheated in the previous round
Oligopoly and Perfect Competition
Price is usually higher under oligopoly
Profits are higher under oligopoly
If there are barriers to entry into the oligopoly, profits will be higher than under perfect competition, in the long run