Monopolistic Competition

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Chapter 13

• Monopolistic Competition
• And
• Oligopoly

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Monopolistic Competition

• Monopolistic competition is a market structure in
  which
• A large number of (small) firms compete.
• Each firm produces a differentiated product.
• Each firm has some monopoly/ price power. Firms
  compete on product quality, price, and marketing.
• Firms are free to enter and exit the industry.

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Monopolistic competition

• firm faces downward-sloping demand curve
• MR curve ¹ demand curve
• firm can choose price and output

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• profit maximization choose Q where MC MR
  charge highest price (on demand curve)
• short-run economic profit possible, attract
  entry leftward shift demand curve facing each
  firm
• long-run economic profit 0, P ATC ATC not
  minimum (excess capacity)
• P ATC by amount of markup

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Monopolistic competition Large number of firms

• 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 others. So no one firms actions directly
  affect the actions of other firms.
• Collusion, or conspiring to fix prices, is
  impossible.

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Monopolistic competitionProduct differentiation
and free entry

• A firm in monopolistic competition practices
  product differentiation if the firm makes a
  product that is slightly different from the
  products of competing firms.
• Product differentiation enables firms to
  compete in three areas quality, price, and
  marketing.
• There are no barriers to entry in monopolistic
  competition, so firms cannot make an economic
  profit in the long run.

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Short-run Output and Price decision

• The firm in monopolistic competition operates
  much like a single-price monopoly. The firm
  produces the quantity at which MR equals MC and
  sells that quantity for the highest possible
  price (Price is determined from the demand curve
  for the firms product and is the highest price
  that the firm can charge for the
  profit-maximizing quantity)
• Firm earns an economic profit when P ATC, or
  might incur an economic loss in the short run .

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Long run decisionsprice, quantity and plant size

• Long Run Zero Economic Profit
• In the long run, economic profit induces entry.
  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. And
  entry continues as long as firms in the industry
  earn an economic profitas long as (P ATC).

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Monopolistic competition vs. perfect competition

• Two key differences between monopolistic
  competition and perfect competition are
• Excess capacity A firm has excess capacity if
  it produces less than the quantity at which ATC
  is a minimum.
• Markup A firms markup is the amount by which
  its price exceeds its marginal cost.

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Efficiency of monopolistic competition

• 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.
• Advertisement is a costly use of resources.
• Monopolistic competition brings the profitable
  and possibly efficient amount of variety to
  market.

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Advertising as a signal

• Firms in monopolistic competition incur heavy
  advertising expenditures. Selling costs, like
  advertising expenditures, fancy retail buildings,
  etc. are fixed costs selling costs increase
  average total costs at any given level of output
  but do not affect the marginal cost of
  production.
• Selling efforts such as advertising are
  successful if they increase the demand for the
  firms product.
• Advertising as a signal of quality A signal is
  an action taken by an informed person or firm to
  send a message to uninformed persons.

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Oligopoly

• Oligopoly is a model of market structure where
  few firms compete and strategically interact
• firm considers effects of its actions on
  behavior of others and actions of others on its
  own profit
• (natural or legal barriers prevent the entry of
  new firms)

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Oligopoly game

• 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.
• Games have four features
• rules setting of the game
• strategies decisions of the players
• payoffs profits and losses of players given the
  strategies
• Outcome

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Prisoners dilemma

• 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.
• Each is told that both are suspected of
  committing a more serious crime.

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• Strategies (all the possible actions of each
  player)
• Confess to the larger crime
• Deny having committed the larger crime.
• Outcomes
• Both confess
• Both deny
• Art confesses and Bob denies
• Bob confesses and Art denies

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• Payoffs
• 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.

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Nash Equilibrium

• 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.

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Equilibrium
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Oligopoly pricing game

• Duopoly is a model of market structure with 2
  firms where the firms can reach a collusive
  agreement.
• A collusive agreement is an agreement between
  two (or more) firms to restrict output, raise
  price, and increase profits. Firms in a collusive
  agreement operate a cartel.
• in duopoly game, each firm can comply with
  collusive agreement to restrict Q and P, or can
  cheat
• in one-time game, "prisoners' dilemma" solution
  occurs, each firm has dominant strategy of
  cheating. Unstable equilibrium because firms
  would be better off if could trust each other and
  comply

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Payoff Matrix
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Equilibrium
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Oligopoly pricing game

• The Nash equilibrium is where both firms cheat.
• The quantity and price are those of a competitive
  market, and the firms earn normal profit.
• Possibilities for collusion Repeated Game

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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 prisoners
  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.

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Repeated Duopoly Game

• 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.