Part 8 Monopolistic Competition and Oligopoly

1
Part 8Monopolistic Competition and Oligopoly

• Most markets are not pure monopolies or perfectly
  competitive, but lie in-between
• Monopolistic competition is a model of a market
  that is competitivemany sellers, free entrybut
  with differentiated products
• Oligopoly has few sellers and involves strategic
  interaction between them which is difficult to
  predict

2
Monopolistic Competition

• Large number of firms
• Each firm produces a differentiated product
• Each firms product is a close but not perfect
  substitute for other firms products
• Firms compete on product quality, price and
  marketing (advertising and packaging)
• Firms are free to enter and exit

3
Monopolistic Competition

• Large number of firms means each firm is small
  relative to the whole market
• One firms actions have negligible effect on
  others
• No collusion is possible
• Each firms demand curve for its own brand will
  be downward sloping but highly elastic
• In the long run entry and exit will occur unless
  profits are just normal

4
Short Run Equilibrium
P
MC
ATC
P
D
Economic profit
MR
Q
Q
Same as monopoly equilibrium except that The
demand curve will be more elastic
5
Long Run Equilibrium
P
MC
ATC
P
D
MR
Q
Q
Long run equilibrium. New entry occurs
which shifts each firms demand curve in until no
economic profit remains
6
Monopolistic Competition and Efficiency
MC
ATC
P
P
D
MR
Excess capacity
Q
Q
Monopolistic competitionhigher prices, P MC
and excess capacity. Cost of product
differentiation
7
Oligopoly

• Small number of firms in the market
• Barriers to entry
• Interdependencewhat each firm will want to do
  will depend on what other firms do
• Oligopolists may try to collude
• Collusion may be formal (as in a cartel) or tacit
• Individual firms may have incentives to try to
  gain larger market share

8
Duopoly Models

• Two firms
• If they cooperate (collude) the result is the
  same as a monopoly and they share monopoly profit
• Non-cooperative duopoly
• Bertrand duopoly model
• Each firm sets a price taking the price of the
  other firm as given
• This leads to price wars
• Zero profit (competitive) equilibrium

9
Duopoly Models

• Cournot duopoly model
• Each firm sets a quantity of output given the
  output of the other firm
• This leads to an equilibrium with a total output
  larger than a monopoly output but less than a
  perfectly competitive output

10
Game Theory

• Game theory looks at strategic behaviour
• A Game consists of a set of
• Rules
• Possible strategies
• Payoffs
• Equilibrium of a game
• Nash Equilibrium where each player is doing the
  best he can given what the other player is doing
• Dominant Strategy Equilibrium where each player
  has a unique best strategy regardless of what the
  other player does

11
Prisoners Dilemma Game
A
dont confess
confess
-5
-2
dont confess
-20
-5
B
-20
-15
confess
-2
-15
The prisoners cannot communicate. Given these
payoffs each person will confess even although
they would be better off if they both denied.
Confess is a dominant strategy.
12
Application to a Cartel

• A cartel is a group of firms who enter into a
  collusive agreement to raise prices
• Each firm has a choice of sticking with the
  collusive agreement or cheating on the agreement
  by producing extra to increase its own profit
• Strategies to collude or to cheat

13
Cartels

• If both firms collude they behave like a
  monopolist and share the monopoly profit
• If both cheat the market becomes competitive and
  they both earn normal profit
• If one cheats and the other sticks with the
  agreement, the cheater makes large profits and
  the colluder makes a loss

14
Duopoly Payoff Matrix
Firm A
Cheat
Comply
-1
0
Cheat
4.5
0
Firm B
4.5
2
Comply
2
-1
Dominant strategy is for each firm to cheat,
despite the fact that both would be better off
if they colluded.
15
Repeated Games

• Can overcome the prisoners dilemma in a repeated
  game
• This allows for strategies that elicit
  cooperation
• Tit for tat strategy
• Result will be a collusive equilibrium that has
  been arrived at tacitly

16
Kinked Demand Curve Model

• Based on an assumption concerning the firms
  beliefs about what other firms will do in
  response to its own price changes
• If it raises its priceothers will not follow
• If it lowers its price others will follow
• Demand is elastic above the current price and
  inelastic below
• Demand curve is kinked at the current priceMR is
  discontinuous below the kink

17
Kinked Demand Curve
P
MC
MC
P
D
MR
Q
Q
Firms price and quantity will not change as long
as MC lies between MC and MC
18
Some other Oligopoly Games

• Product differentiation
• Competitive advertising
• Other forms of non-price competition
• Price leadershiplargest firm sets the price and
  other firms follow
• Oligopolies and restrictive trade practices
• Rent seeking activity