Transcript Lecture Week 10

Monopolistic Competition
• Many firms with relative ease of entry producing
differentiated products.
• Characteristics:
1. Large # of firms.
2. Each producer has a small % of the market and can 
ignore rivals action when setting price.
3. Product differentiation.
4. Each seller has some degree of market power since
each seller faces an elastic demand curve.
5. Non-price competition.
6. Ease of entry  0 long run profits
1
Product Differentiation
• The distinguishing between products through real or
imagined properties
–
–
–
–
–
Quality
Services
Location
Advertising
Packaging
More product differentiation
=
less elasticity of demand
2
Short-Run Equilibrium:
Monopolistic Competition
-Price (Pe) < ATC
-Economic loss
-Price (Pe) > ATC
-Economic profit
MC
ATC
Pe
ATC
d
Profits
Dollars per Unit
Dollars per Unit
ATC
MC
ATC
Pe
d
Losses
E
E
MR
MR
qe
Quantity
qe
Quantity
3
Long Run: Zero Economic
Profit
• The key difference between monopoly and monopolistic
competition lies in the long run.
– In Monopolistic Competition economic profit attracts new
entrants.
• the firm’s demand and marginal revenue start to shift leftward.
• firm’s demand becomes more elastic
• the profit-maximizing quantity and price fall until P=ATC in the LR
4
Long-Run
Equilibrium
• The greater the # of rivals and
the more similar the product,
• the more elastic will be the
demand and the closer the
monopolistically competitive
market will be to perfect
competition.
ATC
Dollars per Unit
MC
Pe =
ATC
d
E
qe
Quantity
-Price (Pe) = ATC
-Zero econ. profits
MR -Normal rate of return
5
Comparison of the Perfect Competitor
with the Monopolistic Competitor: Efficiency
Perfect Competition
Dollars per Unit
d
P1
MR = P
q1
Quantity per Time Period
Minimum ATC
ATC
ATC
MC
Dollars per Unit
MC
Minimum ATC
Monopolistic Competition
P2
d'
In Mon Comp:
PMC
Pmin ATC
MR
q2
Quantity per Time Period
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Price (dollars/unit)
Efficiency - Excess Capacity
P1
Profit120
maximizing
output
0
MR
• Excess Capacity
Theorem of
Monopolistic
Competition:
MC
ATC
• each firm is
producing an
output less than
the one for which
Excess
its ATC reaches
capacity
its minimum
point; i.e., it has
Capacity
excess capacity.
output
D
Q1
Quantity
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Efficiency: Monopolistic
Competition
 Monopolistically Competitive Markets tend to be
– overcrowded with firms,
– each of which tends to be underutilized
 “wastes” of monopolistic competition.
Qualifications to “wastes”/ inefficiency.
Consumers gain from
– variety and choice.
– advertising
•pros….•cons…
– product development…..
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Oligopoly
• Competition among the few.
– A market structure in which a small number of
producers compete with each other.
– 2 producers = Duopoly
• Numbers must be small enough that
– each firm has a significant share of the market
– each firm must consider the reactions of rivals in
formulating its best price and output decision.
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Which model applies?
• 1. Definition, table
• 2. 4 (8) firm concentration ratio;
– i.e., % of the value of sales accounted for by
the largest 4 (8) firms in the industry.
– helps to determine the degree of competition
• Concentration ratio must be applied with other
information such as:
– a) geographical scope
– b) barriers to entry & turnover
– c) correspondence between a market and an
industry.
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Characteristics of
Oligopoly
1. Few dominant producers.
2. Homogeneous or differentiated
product.
3. Advertising/Promotion.
4. Barriers to entry.
And
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Characteristics of Oligopoly
• 5. Mutual interdependence among
firms.
– No firm in oligopoly will alter its price without
trying to calculate the most likely reactions of
rivals
–Strategic Behaviour
“ Oligopolies are price searchers engaged
in a game of strategy.”
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Creating Barriers to Entry
1) Increasing Entry Costs (largely illegal)
2) Limit-Pricing
-setting a price that will cause losses to new
entrants (illegal in Canada)
3) Raising switching costs
-ie: incompatible components
-varying legality
4) Predatory Reputation
-illegal
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Characteristics of Oligopoly
– Notice
» there is no single model of
oligopoly.
 there is tension between co-operation
and self interest.
Models of Oligopoly
• 1.)Cartel
– cartel: a group of firms acting together to
minimize strategic behaviour behave like
monopoly
– collusion: agreement among firms in a market
about quantities to produce &/or prices to charge.
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Collusion will be most successful
when
1. Demand is inelastic  few substitutes outside
the cartel.
2. Members of the cartel play by the rules; e.g.,
no price cutting: obey quota
3. Number of members is low.
4. Market conditions are good.
5. Barriers to entry are strong.
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Colluding to Maximize Profits
• Maximize industry profits:
• agree to set the industry output level equal to
the monopoly output level.
• agree on how much of the monopoly output
each firm will produce.
• for each firm, price is greater than MC; for the
industry, MR = MC.
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Colluding to Maximize Profits
MC ATC
10
9
8
6
Economic
Profit
Price and cost (thous. of $/ unit)
Price and cost (thous. of $/ unit)
Individual Firm
Industry
10
9
6
D
Quota Output
for the firm
0
1
2
3
4
MC1
Collusion achieves
monopoly outcome
MR
5
Quantity (thous.
/week)
0
1
2
3
4
5
6
Quantity (thous.
17
/week)
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Colluding to Maximize
Profits
P$
Economic
profit
P$
Preferred firm
output, P=MC
MC
9.00
8.00
Collusion achieves
monopoly outcome
ATC
MC1
6.00
Additional
profit from
cheating
D
MR
0
2
3
(a) Individual firm
4
Q
(b) Industry
6
Q
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Incentive to cheat
•Since P > MC at quota,
• firms have an incentive to cheat, to
produce more until P(MR)=MC
•additional profit is available to a
single cheating firm provided price
doesn’t fall.
•If all firms cheat, an excess quantity
supplied in the market will cause the price
to fall.
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Models of Oligopoly
• 2.)Game Theory
– The analysis of strategic oligopoly
behaviour
–Behaviour that recognizes mutual
interdependence and takes
account of the expected
behaviour of others
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2. Game Theory
• In all conflict situations - games there are:
decision makers,
strategies and payoffs.
• Players choose strategies without
knowing with certainty what the
opposing player will do.
• Players construct BEST RESPONSES
-optimal actions given all possible
actions of other players
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Game Theory
•A special kind of Best Response.
DOMINANT STRATEGY
•Strategy that is best no matter what
the other player does.
•Eg. advertise
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Game Theory
Payoff Matrix
–table that shows the payoffs/
outcomes for every possible
action by each player for every
possible action by the other player.
Eg: Advertising where firms are assumed to anticipate how
rival firms might react
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Game Theory
B’s STRATEGY
A’s
STRATEGY
Don’t
advertise
Advertise
Don’t advertise
A’s profit=
$50 000
B’s profit =
$50 000
A’s profit=
$75 000
B’s loss =
$25 000
Advertise
A’s loss =
$25 000
B’s profit =
$75 000
A’s profit =
$10 000
B’s profit =
$10 000
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Game Theory
• The best strategy, resulting in the best
outcome for both players, would be to collude
and not advertise.
• “Nash” Equilibrium:
– when 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
• eg. In equilibrium both firms will advertise
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Game Theory
• This is an example of a prisoner’s dilemma
type of game.
– There is dominant strategy.
– The dominant strategy does not result in the best
outcome for either player.
– It is hard to cooperate even when it would be
beneficial for both players to do so
• eg., The dominant strategy: advertise
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Prisoners’ Dilemma Payoff Matrix
Rocky’s strategies
Deny
Deny
Ginger’s
strategies
Confess
1 year
1 year
7 years
Go free
Confess
Go free
7 years
5 years
Dominant
strategy:
confess, even
though they
would both be
better off if
they both
kept their
mouths shut.
5 years
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Game Theory
• Cooperation between players is
difficult to maintain because
cooperation is individually irrational.
• Dominant Strategy Equilibrium
– prisoners will confess, firms will
advertise, countries arm:
– eg, ban on cigarette advertising
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Solving the “dilemma”
• 1. Enforceable contract
• without an enforceable contract, is
cooperation possible?
– A solution to the “prisoner’s dilemma” can
emerge if the game is played more than
once; i.e., many times.
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Solving the “dilemma”
• 2. Repeated Games
– Most real-world games get played repeatedly
– Repeated games have a larger number of
strategies because a player can be punished for
not cooperating
– This suggests that real-world duopolists might find
a way of cooperating in order to increase profits
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Solving the “dilemma”
• 2. Tit-for-Tat Strategy
– a player should start by cooperating and
then do whatever the other player did last
time.
• e.g., player cooperates until the other
player cheats, the first player then
cheats until the other player co-operates
again.
– What is the Nash Equilibrium when
facing a tit-for-tat strategy?
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