Understanding Monopolistic Competition and Oligopoly Models

1. 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

2. Product Differentiation • The distinguishing between products through real or imagined properties • Quality • Services • Location • Advertising • Packaging More product differentiation = less elasticity of demand

3. -Price (Pe) < ATC -Economic loss -Price (Pe) > ATC -Economic profit MC MC ATC ATC ATC Pe Dollars per Unit Pe Dollars per Unit d d ATC Losses E E Profits MR MR qe qe Quantity Quantity Short-Run Equilibrium: Monopolistic Competition

4. 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

5. MC ATC Pe = ATC Dollars per Unit d E -Price (Pe) = ATC -Zero econ. profits -Normal rate of return MR qe Quantity 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.

6. Minimum ATC d MR = P Comparison of the Perfect Competitorwith the Monopolistic Competitor: Efficiency Perfect Competition Monopolistic Competition MC ATC Minimum ATC ATC MC P2 P1 Dollars per Unit Dollars per Unit d' In Mon Comp: PMC Pmin ATC MR q2 q1 Quantity per Time Period Quantity per Time Period

7. MC Excess capacity Capacity output Profit- maximizing output Efficiency - Excess Capacity • Excess Capacity Theorem of Monopolistic Competition: • each firm is producing an output less than the one for which its ATC reaches its minimum point; i.e., it has excess capacity. Price (dollars/unit) ATC P1 120 MR D Quantity 0 Q1

8. 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…..

9. 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.

10. 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.

11. Characteristics of Oligopoly 1. Few dominant producers. 2. Homogeneous or differentiated product. 3. Advertising/Promotion. 4. Barriers to entry. And

12. 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.”

13. Creating Barriers to Entry • Increasing Entry Costs (largely illegal) • 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

14. Characteristics of Oligopoly Models of Oligopoly • Notice •  there is no single model of oligopoly.  there is tension between co-operation and self interest. • 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.

15. 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.

16. 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.

17. Collusion achieves monopoly outcome Economic Profit Quota Output for the firm Colluding to Maximize Profits Individual Firm Industry MC ATC 10 10 9 9 MC1 8 Price and cost (thous. of $/ unit) Price and cost (thous. of $/ unit) 6 6 D MR 0 1 2 3 4 5 0 1 2 3 4 5 6 7 Quantity (thous. /week) Quantity (thous. /week)

18. Economic profit Collusion achieves monopoly outcome Preferred firm output, P=MC 9.00 8.00 6.00 Additional profit from cheating 2 3 4 6 Colluding to Maximize Profits P$ P$ MC ATC MC1 D MR 0 Q Q (a) Individual firm (b) Industry

19. 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 pricedoesn’t fall. • If all firms cheat, an excess quantity supplied in the market will cause the price to fall.

20. 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

21. 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

22. Game Theory • A special kind of Best Response. DOMINANT STRATEGY • Strategy that is best no matter what the other player does. • Eg. advertise

23. 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

24. Game Theory B’sSTRATEGY Don’t advertise Advertise A’s STRATEGY A’s profit= $50 000 A’s loss = $25 000 Don’t advertise B’s profit = $50 000 B’s profit = $75 000 A’s profit= $75 000 A’s profit = $10 000 Advertise B’s loss = $25 000 B’s profit = $10 000

25. 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

26. 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

27. 1 year Go free 1 year 7 years 7 years 5 years Go free 5 years Prisoners’ Dilemma Payoff Matrix Rocky’s strategies Deny Confess Dominant strategy: confess, even though they would both be better off if they both kept their mouths shut. Deny Ginger’s strategies Confess

28. 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

29. 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.

30. 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

31. 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?