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Part 8 Monopolistic Competition and Oligopoly

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Equilibrium of a game ... If one cheats and the other sticks with the agreement, the cheater makes large ... Can overcome the prisoners' dilemma in a repeated game ... – PowerPoint PPT presentation

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Title: Part 8 Monopolistic Competition and Oligopoly


1
Part 8 Monopolistic 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
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