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Overview

- Monopolistic Competition
- Product Differentiation
- Price and Output Determination in Monopolistic

Competition - Economic Efficiency and Resource Allocation
- Oligopoly
- Oligopoly Models
- Game Theory
- Repeated Games
- Oligopoly and Economic Performance
- The Role of Government
- Regulation of Mergers

MONOPOLISTIC COMPETITION

- monopolistic competition
- A form of industry (market) structure,

characterized by a large number of firms. - Each firm is small relative to the market.
- Some degree of market power is achieved by firms

producing differentiated products. - No barriers to entry and exit.

MONOPOLISTIC COMPETITION

- product differentiation
- A strategy that firms use to achieve market

power. - Accomplished by giving products certain

characteristics that distinguish them from

competitors products. - Firms make their products characteristics known

to the public by way of advertising. - Is product differentiation good

MONOPOLISTIC COMPETITION

- The Case for Product Differentiation and

Advertising - Advocates claim
- Increases the variety of products available to

accommodate consumers different preferences - Advertising provides consumers with valuable and

meaningful information on product availability,

quality, and price that they need to make

efficient choices in the marketplace.

MONOPOLISTIC COMPETITION

- The Case against Product Differentiation and

Advertising - Critics claim
- Product differentiation and advertising waste

societys scarce resources - Enormous sums of money are spent to create

minute, meaningless differences among products. - These increased expenditures on advertising only

serve to increase the price that consumers pay

MONOPOLISTIC COMPETITION

- No Right Answer
- Empirical evidence yields to conflicting

conclusions. - Some studies show that advertising leads higher

profits, and others, that advertising improves

the functioning of the market.

MONOPOLISTIC COMPETITION

- A monopolistic competitor has a monopoly of its

own unique product but there are many close

substitutes for the good. - Although the demand curve faced by a monopolistic

competitor is likely to be less elastic than the

demand curve faced by a perfectly competitive

firm, it is likely to be more elastic than the

demand curve faced by a monopoly because of the

availability of substitutes.

MONOPOLISTIC COMPETITION

Product Differentiation and Demand Elasticity

FIGURE 14.2 Product Differentiation Reduces the

Elasticity of Demand Facing a Firm

MONOPOLISTIC COMPETITION

- Price/Output Determination in the Short Run
- Like all other firms, a monopolistic competitor

will profit maximize by producing the quantity

where MRMC. - Since the Demand curve is downward sloping, MR is

below price.

MONOPOLISTIC COMPETITION

Price/Output Determination in the Short Run

FIGURE 14.3 Monopolistic Competition in the

Short Run

MONOPOLISTIC COMPETITION

- In the short run, the firm will shutdown if the

profit maximizing price is below AVC and it will

exit in the long run as long as the profit

maximizing price is below ATC.

MONOPOLISTIC COMPETITION

- In the long run, because there are no barriers to

entry or exit, if firms are making positive

economic profits, there will be entry of new

types of products which are close substitutes. - This makes the demand curve for a particular

firms product more elastic (flatter). - Entry will occur until zero profits are being

earned. In other words in a long run equilibrium,

the profit maximizing price will have to equal

ATC.

MONOPOLISTIC COMPETITION

MONOPOLISTIC COMPETITION

Price/Output Determination in the Long Run

FIGURE 14.4 Monopolistically Competitive Firm at

Long-Run Equilibrium

The firms demand curve must end up tangent to

its average total cost curve for profits to equal

zero. This is the condition for long-run

equilibrium in a monopolistically competitive

industry.

MONOPOLISTIC COMPETITION

- ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION
- Even though there are zero economic profits in

the long run, the final outcome is not

efficient. - First, the profit-maximizing strategy is to

restrict production relative to the perfectly

competitive case, and to charge a price above

marginal cost. So it does not produce the

efficient amount of output. - Second, final equilibrium in a monopolistically

competitive firm is necessarily to the left of

the low point on its average total cost curve.

OLIGOPOLY

oligopoly A form of industry (market) structure

characterized by a few dominant firms.

Products may be homogenous or differentiated.

The behavior of any one firm in an oligopoly

depends to a great extent on the behavior of

others.

OLIGOPOLY

OLIGOPOLY

- OLIGOPOLY MODELS
- Because many different types of oligopolies

exist, a number of different oligopoly models

have been developed. - All kinds of oligopoly have one thing in common
- The behavior of any given oligopolistic firm

depends on the behavior of the other firms in the

industry comprising the oligopoly.

OLIGOPOLY

- Oligopoly Models that we will study
- Collusion/Cartel
- Game Theory
- One shot Game
- Repeated Interaction

OLIGOPOLY Collusion Model

- The Collusion Model (also know as the

Monopoly/Cartel Model) - cartel A group of firms that gets together and

makes joint price and output decisions to

maximize joint profits - The different firms get together and act like

they are a monopolist (one firm) and decide what

is the total output that will be produced, and

what will each firm produce, and what will be the

price charged by each firm.

OLIGOPOLY Collusion Model Ex 14.1

- Example Suppose there are 2 identical firms in

the industry. - The firms decide to form a cartel and maximize

industry profits, and will each produce an equal

share of output. - To find what individual firms do, first see what

a monopolist would do. - Given the following market demand and MC curve

(next), find what each firm will produce

and charge. Also, what are each firms profits

OLIGOPOLY Collusion Model Ex 14.1

A monopolist would produce 400 units of output

and charge a price of 10. Profits would be (P-

ATC)Q (10-5)4002000.

P()

10

9

MCATC

5

MR

D

Q

400

500

OLIGOPOLY Collusion Model Ex 14.1

- A monopolist would produce 400 units of output

and charge a price of 10. Profits would be

(10-5)4002000. - Each firm in the cartel will produce 200 units,

charge the same price of 10, and will each have

an equal share of profits of 1000 each.

OLIGOPOLY Collusion Model Ex 14.1

- The problem with the collusion/cartel model is

that each firm has an incentive to cheat and

produce a little bit more than its competitors. - By doing so, it could increase its own profits at

the expense of the other firms in the market. - To see this consider what would happen if firm 1,

cheats and makes 300 units of output, but the

other firm sticks to the agreement and makes 200

each. - Total output in the industry will now be

300200500 which means a new market price will

prevail.

OLIGOPOLY Collusion Model Ex 14.1

Total output in the industry will now be 500

which means a new market price will prevail equal

to 9.

P()

10

9

8

MCATC

5

MR

D

Q

400

500

600

OLIGOPOLY Collusion Model Ex 14.1

- What are each firms profits now
- Firm 1 makes 300 units and charges a price of 9
- Profits for firm1(9-5)3001500, so Firm 1s

profits increased. - The other firm makes 200 and also sells at a

price of 9 per unit. - Its profits (9-5)200800, so its profits

decrease. - The cheating firm gains at the faithful firms

expense.

OLIGOPOLY Collusion Model

- Since each firm has an incentive to cheat on the

cartel, it is very hard to keep cartel contracts

working. - If all firms cheat on the contract, all of them

will be worse off then under the cartel. (They

will each make a profit of 900) - To see when cartels will or will not work, we use

Game Theory.

OLIGOPOLY Game Theory

- GAME THEORY
- Mathematical technique used to study choices in

situations when the outcomes of your choices

depend on the choices of everyone else. - In game theory, firms are assumed to anticipate

rival reactions. - Example Suppose there is a duopoly (only two

firms in the industry). Should one firm form a

cartel, collude, stay faithful to the cartel The

answer (and profits) depend on what other firms

do and how they might react.

OLIGOPOLY Game Theory

- Elements of a Game
- Players (individual decision makers, firms in

previous example) - Strategies (all possible choices that can be made

by the players) - Payoffs (all possible outcomes given what all

players choose. This will be profits when talking

about firm behavior.)

OLIGOPOLY Game Theory

- Assumptions
- Players act independently and dont know what the

other player will choose. - Game is played just once (one-shot game)
- (Later we will consider when the game is played

repeatedly. This will allow players to punish

each other for cheating- and this will be what is

needed to get cartels to work)

OLIGOPOLY Game Theory

- Normal Form Representation of a game

2s payoff

2s payoff

1s payoff

1s payoff

2s payoff

2s payoff

1s payoff

1s payoff

OLIGOPOLY Game Theory

- The first game we look at is what is known as the

prisoners dilemma. - prisoners dilemma
- Players Ginger and Rocky, two prisoners accused

of shoplifting. - Strategies The police give them a choice of two

alternatives (Confess, Dont confess) - Payoffs
- If neither confesses, they each get exactly one

year. - If only one confesses, the confessor goes free,

and the silent one gets 7 years. - If both confess, each will get 5 years.

OLIGOPOLY Game Theory

What is the best strategy

FIGURE 14.7 The Prisoners Dilemma

OLIGOPOLY Game Theory

- dominant strategy
- In game theory, a strategy that is best no matter

what the opposition does. - In the above example, no matter what the other

player does, both prisoners choose confess. This

is their dominant strategy.

OLIGOPOLY Game Theory

- What will be the outcome
- We look for an equilibrium where no player has an

incentive to change behavior given what the other

is doing. This concept is called a Nash

equilibrium. - Nash equilibrium In game theory, the result of

all players playing their best strategy given

what their competitors are doing.

OLIGOPOLY Game Theory

- Finding a Nash Equilibrium
- To find a Nash equilibrium, consider what each

player would choose given the action of the other

player (circle the payoff for player 1 of this

strategy). - Then consider what the other player would do

given the actions of the other player (circle the

payoff for player 2 of this strategy). - If there is a grid with both payoffs circled,

then this is a Nash Equilibrium. - (Note there may more than one or no Nash

equilibrium)

OLIGOPOLY Game Theory

Find the Nash Equilibrium

FIGURE 14.7 The Prisoners Dilemma

OLIGOPOLY Game Theory

- In the prisoners dilemma, the players are

prevented from cooperating and each has a

dominant strategy that leaves them both worse off

than if they could cooperate. - The only strategy in which neither has an

incentive to change his or her behavior, given

what the other is doing is to (confess,

confess). - Confess, Confess is the Nash equilibrium of this

game. Any game that leads to a similarly

inefficient outcome where players do not find it

optimal to cooperate is considered a prisoners

dilemma game.

OLIGOPOLY Game Theory

- Example 14.1 Continued.
- We could consider the example of whether a cartel

will hold or not as a type of prisoners dilemma

game. - If the game is only played once, the Nash

equilibrium is where both firms cheat, and both

are worse off than they would be under the cartel.

OLIGOPOLY Game Theory

Example 14.1 Continued. The Nash Equilibrium is

(Cheat, Cheat)

1000

1200

1000

800

800

900

900

1200

OLIGOPOLY Game Theory-Repeated Interaction

- So how is it that cartels like OPEC are able to

get their members to not cheat and stay faithful

to the collusion contract - KEY Need repeated interaction (that the game is

repeatedly played time after time). If you have

this additional dimension, then firms are able to

punish cheaters in future periods.

OLIGOPOLY Game Theory-Repeated Interaction

- Two types of strategies could be used to punish

cheaters - Grim Trigger Strategy
- One firm says I will not cheat as long as you

dont. If you ever cheat, I will cheat forever

after. - This strategy now decreases the gains from

cheating. Even if cheats the first year, (and

gets higher profits), will be worse off in future

years because he knows the other firm will not be

faithful to the agreement. - Tit for Tat
- One firm says Whatever you do, I will do next

period

OLIGOPOLY Game Theory-Repeated Interaction

- These strategies may be implicit rather than

explicit agreements. - Since in the US, tacit collusion is strictly

illegal, some firms try to imply that they are

willing to cooperate and collude rather than

expressly agree. - For example, consider what the Nash Equilibrium

would be for the two airlines Lufthansa and

British Airways competing in flights between New

York and London.

OLIGOPOLY

Payoffs are Weekly Profits What is the Nash Equil

ibrium of a one-shot game How might the tit for

tat strategy work here

FIGURE 14.9 Payoff Matrix for Airline Game

OLIGOPOLY and Economic Performance

- Oligopolistic, or concentrated, industries are

likely to be inefficient. - First, profit-maximizing oligopolists are likely

to price above marginal cost. When price is above

marginal cost, there is underproduction from

societys point of view. - Second, to the extent that oligopolies

differentiate their products and advertise, there

is the promise of new and exciting products. At

the same time, however, there remains a real

danger of waste and inefficiency.

Market Structure Summary Chart

FIGURE 14.1 Characteristics of Different Market

Organizations

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