MONOPOLY

1. 1
3
MONOPOLISTIC
COMPETITION
AND OLIGOPOLY
O u t l i n e
PC War Games
A. Each PC maker tellsus thatthey have the bestproductat the best
price.
B. Justtwo big chip makers produce almost allthe processorand
me mory chips inour PCs.
C. Firms inthese markets are neitherpricetakerslikethose inperfect
competition,nor are they protected from competitionby barriersto
entrylikea monopoly.How do such firms choose the quantityto
produce and price?
I. Monopolistic Competition
A. Monopolistic competition isa market with the following
characteristics:
1. There are a large number offirms,with each firm producing a
differentiatedproduct.
2. Firms compete on productquality,price,and marketing.
3. Firms are free to enterand exitthe industry.
B. MonopolisticCo mpetition
The presence ofa large number offirms inthe market implies:
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2. 1 9 8 C H A P T E R 1 3
1. Each firm has only a smallmarket share and thereforehas
limited market power to influence the priceof itsproduct.
2. Each firm issensitiveto the average market price,but no firm
pays attentionto the actionsofthe other,and no one firm’s
actionsdirectlyaffectthe actionsofotherfirms.
3. Collusion ,or conspiringto fixprices,isimpossible.
C. Product Differentiation
Firms inmonopolisticcompetitionpracticeproduct
differentiation ,which means thateach firm makes a productthat
isslightlydifferentfrom the productsofcompeting firms.
D. Competing on Quality,Price, and Marketing
Productdifferentiationenables firms to compete inthree areas:
quality,price,and marketing.
1. Qualityincludes design,reliability,and service.
2. Because firms produce differentiatedproducts,each firm has a
downward-sloping demand curve foritsown product.But there
isa tradeoffbetween priceand quality.
3. Differentiatedproductsmust be marketed using advertisingand
packaging.
E. Entryand Exit
There are no barriersto entryinmonopolisticcompetition,so firms
cannot earn an economic profitinthe long run.
F. Entry and Exit
Figure 13.1 (page 281) shows market share of the largestfourfirms
and the HHI foreach often industriesthatoperate inmonopolistic
competition.
II. Output and Price in Monopolistic Competition
A. Short-Run Econo mic Profit
1. A firm thathas decided the qualityofitsproductand its
marketing program produces the profitmaximizing quantityat
which itsmarginalrevenue equalsitsmarginalcost(MR = MC ).
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3. a) Priceisdetermined from the demand curve forthe firm’s
productand isthe highestpricethe firm can charge forthe
profit-maximizing quantity.
b) A firm inmonopolisticcompetitioncan earn an economic
profitinthe shortrun if:P > ATC.Itoperates much likea
single-pricemonopolist.
2. Figure 13.2a (page 282) shows a short-run equilibrium output
and pricefora firm inmonopolisticcompetition.
B. Long Run: Zero Econo mic Profit
1. Inthe long run,economic profitinduces entry.And entry
continues as long as firms inthe industryearn an economic
profit—as long as (P > ATC).
a) Inthe long run,a firm inmonopolisticcompetition
maximizes itsprofitby producing the quantityat which its
marginalrevenue equalsitsmarginalcost,MR = MC .
b) As firms enterthe industry,each existingfirm loses some of
itsmarket share.The demand foritsproductdecreases and
the demand curve foritsproductshiftsleftward.
c) The decrease indemand decreases the quantityat which MR
= MC and lowers the maximum pricethatthe firm can
charge to sellthisquantity.Priceand quantityfallwith firm
entryuntilP = ATC and firms earn zero economic profit.
2. Figure 13.2b (page 282) shows a long-run equilibrium output
and pricefora firm inmonopolisticcompetition.
3. Iffirms incuran economic loss,firms exitto restorethe long-run
equilibrium justdescribed.
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4. 2 0 0 C H A P T E R 1 3
C. MonopolisticCo mpetition and Efficiency
1. Firms inmonopolisticare inefficientand operate with excess
capacity.
2. Figure 13.3 (page 283) illustratesthese propositions.
a) Because they productdifferentiateand face a downward-
sloping demand curve fortheirproducts,firms in
monopolisticcompetitionreceive a marginalrevenue thatis
lessthan price,MR < P,foralllevelsofoutput.
b) Firms maximize profitby settingmarginalrevenue equalto
marginalcost,MR = MC ,so with marginalrevenue lessthan
price,MR < P,marginalcostislessthan price,MC < P.
Because priceequalsthe marginalbenefit,P = MB ,marginal
costislessthan marginalbenefit,MC < MB .
Underproduction inmonopolisticcompetitioncreates
deadweight loss.
3. A firm’scapacity output isthe outputat which average total
costisat itsminimum. At the long-run profitmaximizing output
MR = MC and P = ATC. But recallthatMR < P,which means that
MC < ATC.Also recall(from Chapter10) thatifMC < ATC,then
ATC fallsas outputincrease.Ifoutputisinthe range offalling
ATC,outputmust be lessthan capacityoutput.Goods are not
produced at the minimum unitcostofproduction inthe long
run.
III. Product Development and Marketing
A. Innovation and Product Development
1. We’ve looked at a firm’sprofitmaximizing output decisioninthe
shortrun and the long run ofa given productand with given
marketing effort.To keep earning an economic profit,a firm in
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5. monopolisticcompetitionmust be ina stateof continuous
productdevelopment.
2. New productdevelopment allows a firm to gain a competitive
edge, ifonly temporarily,before competitorsimitatethe
innovation.
3. Innovation iscostly,but italso increases totalrevenue.
a) Firms pursue productdevelopment untilthe marginal
revenue from innovation equalsthe marginaldevelopment
cost.
4. Production development may benefitthe consumer by providing
improvements inproductquality,or itmay mislead the
consumer by giving only the appearance ofchange inproduct
quality.Regardlessof whether a productimprovement isrealor
imagined,itsvalue to the consumer isitsmarginalbenefit,
which isthe amount the consumer iswillingto pay forthe
improvement.
B. Marketing
1. A firm’smarketing program uses advertisingand packaging as
the two principalmethods to market itsdifferentiated products
to consumers.
2. Firms inmonopolisticcompetitionincurheavy marketing and
advertisingexpendituresto enhance the perception of quality
differences between theirproductand rivalproducts.These
costsmake up a large portionof the priceforthe product.
Figure 13.4 (page 285) shows estimates ofthe percentage of
salepricefordifferentmonopolisticcompetitionmarkets.
3. SellingCostsand TotalCosts
a) Sellingcosts,likeadvertisingexpenditures,fancy retail
buildings,etc.are fixed costs.Average fixed costsdecrease
as production increases,so sellingcostsincrease average
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totalcostsat any given levelofoutput but do not affectthe
marginalcostofproduction.
b) Sellingeffortssuch as advertisingare successfulifthey
increase demand forthe firm’sproduct.But a firm’sdemand
and profitscan only increase inthe shortrun.Economic
profitslead to the entryof more firms,which decrease the
demand foreach firm’sproductinthe long run.
4. To the extentthatadvertisingand sellingcostsprovide
consumers with information and servicesthatthey value more
highlythan theircost,these activitiesare efficient.
IV. Oligopoly
A. Oligopoly isa market inwhich a smallnumber of firms compete.
1. Inoligopoly,the quantitysold by one firm depends on the firm’s
own priceand the pricesand quantitiessold by the otherfirms.
2. The response of otherfirms to a firm’spriceand output
influence the firm’sprofitmaximizing decision.
B. The Kinked De mand Curve Model
1. Inthe kinked demand curve model ofoligopoly,each firm
believes thatifitraisesitsprice,itscompetitorswillnot follow,
but ifitlowers itspriceallof itscompetitorswillfollow.
2. Figure 13.6 (page 287) shows the kinked demand curve model.
a) The demand curve thata firm believes itfaces has a kink at
the currentpriceand quantity.Above the kink,demand is
relativelyelasticbecause allotherfirm’spricesremain
unchanged; and below the kink,demand isrelatively
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7. inelasticbecause allotherfirm’spriceschange inlinewith
the priceofthe firm shown inthe figure.
b) The kink inthe demand curve means thatthe MR curve is
discontinuous at the currentquantity.FluctuationsinMC
thatremain withinthe discontinuous portionofthe MR curve
leave the profit-maximizing quantityand priceunchanged.
3. The beliefsthatgenerate the kinked demand curve are not
always correctand firms can figureout thisfact:ifMC increases
enough, allfirms raisetheirpricesand the kink vanishes.A firm
thatbases itsactionson wrong beliefsdoesn’tmaximize profit.
C. Do minant Firm Oligopoly
1. Ina dominant firm oligopoly,there isone large firm thathas a
significantcostadvantage over many other,smallercompeting
firms.
a) The large firm operates as a monopoly,settingitspriceand
output to maximize itsprofit.
b) The smallfirms actas perfectcompetitors,taking as given
the market pricesetby the dominant firm.
2 Figure 13.7 (page 288) shows a dominant firm industry.
V. Oligopoly Games
A. Game theory isa toolforstudying strategicbehavior,which is
behaviorthattakes intoaccount the expected behaviorofothers
and the mutual recognitionofinterdependence.
B. What Is a Ga me?
1. Allgames share fourfeatures:
a) rules,
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8. 2 0 4 C H A P T E R 1 3
b) strategies,
c) payoffs,and
d) an outcome.
C. The Prisoners’ Dilem ma
1. The prisoners’dilemma game illustratesthe fourfeaturesofa
game.
a) The rulesdescribe the settingofthe game, the actionsthe
playersmay take,and the consequences ofthose actions.
i) Inthe prisoners’dilemma game, two prisoners(Art
and Bob) have been caught com mitting a petty
crime.
ii) Each isheld ina separate celland cannot
com municate with each other.
iii)Each istoldthatboth are suspected ofcom mitting a
more seriouscrime ifone ofthem confesses,he will
get a 1-year sentence forcooperating whilehis
accomplice get a 10-year sentence forboth crimes.If
both confess to the more seriouscrime,each
receives3 years injailforboth crimes.Ifneither
confesses,each receivesa 2-year sentence forthe
minor crime only.
b) The strategies forboth prisonersare to eitherto confess or
deny com mitting the seriouscrime.
c) The game’s payoff matrix isa table,likethe one inTable
13.1 (page 290),thatshows the payoffsforevery possible
action by each playerforevery possibleaction by the other
player.
i) Art’spayofffrom each combination ofactionsis
shown inthe top ofeach payoffbox,and Bob’s is
shown as the bottom ofeach payoffbox.
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9. ii) There are fourpossibleoutcomes: Bob and Artboth
confess (top leftbox),both Bob and Artdeny (bottom
rightbox),Bob confesses but Artdoes not (top right
box),and Artconfesses but Bob does not (bottom left
box).
d) Ifa playermakes a rationalchoice inpursuitofhisown best
interest,he chooses the action thatisbestforhim, given
any action taken by the otherplayer.Ifboth playersare
rationaland choose theiractionsinthisway, the outcome is
an equilibrium calledNash equilibrium —firstproposed by
John Nash.
2. Inthe prisoners’dilemma game, the beststrategy isforeach
prisonerto confess.RegardlessofBob’s decision,Art’sbest
outcome occursby confessing.RegardlessofArt’sdecision,
Bob’s bestoutcome occurs by confessing.So both prisoners
confess and each gets 3 years injailforcom mitting both crimes.
3. Thisoutcome isnot the bestforeitherplayer.Both players
would be betteroffifeach had denied.But because they can’t
com municate about theirdecisions,there isno way to strikea
dealthatenables them to cooperate and get the bestjoint
outcome.
D. An Oligopoly Price-Fixing Ga me
1. A game likethe prisoners’dilemma isplayed induopoly.A
duopoly isa market inwhich there are only two producers that
compete.Duopoly captures the essence of oligopoly.
2. Figure 13.8 (page 291) describesthe demand and cost
conditionsina naturalduopoly.Given the market demand, two
firms can produce the good at a lower average totalcostthan
eitherone firm or three firms.
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10. 2 0 6 C H A P T E R 1 3
3. The firms ina duopoly can enterintoa collusive agreement in
which two (ormore) competitorsagree to restrictoutput,raise
the price,and increase profits.Firms thathave entered intoa
collusiveagreement have formed a cartel .(Cartelsare illegalin
the United States.)
4. Ina cartel,each firm has two strategies:comply with the
agreement or cheat.
a) Ifboth firms comply,they maximize industryprofitby
producing the same outputas a monopoly would,charging
the monopoly price,and sharing the resultingeconomic
profit.Figure 13.9 (page 292) shows thisoutcome.
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11. b) Ifone firm cheats and the othercomplies,the firm that
compliesincursan economic loss,and the firm thatcheats
makes an economic profitthatislargerthan itsshare ofthe
maximum industryprofitifitcomplies.Figure 13.10 (page
293)shows thisoutcome: part(a)shows the complier’sloss
and part(b)shows the cheat’seconomic profit.
c) Ifboth firms cheat,they each earn normal profit(zero
economic profit).Figure 13.11 (page 294) shows this
outcome.
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5. Table 13.2 (page 295) shows the payoffmatrixforthisgame.
The Nash equilibrium iswhere both firms cheat,the quantity
and priceare those of a competitivemarket,and the firms earn
normal profit.
6. Ifboth firms cheat,they each earn normal profit(zeroeconomic
profit).Figure 13.11 (page 294) shows thisoutcome.
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13. 7. A similarprisoner’sdilemma research and development game
describesthe outcome inthe market fordisposable diapers.
Table 13.3 (page 296) describesthe payoffmatrixforthisgame.
VI. Repeated Games and Sequential Games
A. A Repeated Duopoly Ga me
1. Ifa game isplayed repeatedly,itispossibleforduopoliststo
successfullycollude and earn a monopoly profit.Ifthe players
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take turns and move sequentially(ratherthan simultaneouslyas
inthe prisoner’sdilemma, many outcomes are possible.
2. Ina repeated prisoners’dilemma duopoly game, additional
punishment strategiesenable the firms to comply and achieve a
cooperative equilibrium ,inwhich the firms make and share
the monopoly profit.
a) One possiblepunishment strategy isa tit-for-tatstrategy,in
which one playercooperates thisperiod ifthe otherplayer
cooperated inthe previous period but cheats inthe current
period ifthe otherplayercheated inthe previous period.
b) A more severe punishment strategy isa triggerstrategy in
which a playercooperates ifthe otherplayercooperates but
plays the Nash equilibrium strategy foreverthereafterifthe
otherplayercheats.
3. Table 13.4 (page 297) shows thata tit-for-tatstrategy is
sufficientto produce a cooperativeequilibrium ina repeated
duopoly game.
4. Pricewars might resultfrom a tit-for-tatstrategy where there is
an additionalcomplication—uncertaintyabout changes in
demand. A fallindemand might lower the priceand bring forth
a round oftit-for-tatpunishment.
B. A SequentialEntry Ga me in a Contestable Market
1. Ina contestable market —a market inwhich firms can enter
and leave so easilythatfirms inthe market face competition
from potentialentrants—firms play a sequentialentrygame.
2. Figure 13.12 (page 299) shows the game tree fora sequential
entrygame ina contestablemarket.
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15. a) Inthisentrygame, the firm inthe market setsa competitive
priceand earns a normal profitto keep the potentialentrant
out.
b) A lesscostlystrategy islimit pricing ,which setsthe priceat
the highestlevelthatisconsistentwith keeping the potential
entrantout.
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