Monopolistic Competition and Oligopoly

1. 0 Monopolistic Competition and Oligopoly 10 • What market structures lie between perfect competition and monopoly, and what are their characteristics? • How is monopolistic competition similar to perfect competition? How is it similar to monopoly? • How do monopolistically competitive firms choose price and quantity? Do they earn economic profit?

2. 0 Monopolistic Competition and Oligopoly 10 • What is game theory? • How is game theory related to oligopoly? • What outcomes are possible under oligopoly? • Why is it difficult for oligopoly firms to cooperate?

3. Introduction: Between Monopoly and Competition 0 Two extremes • Competitive markets: many firms, identical products • Monopoly: one firm, unique product In between these extremes • Oligopoly: only a few sellers offer similar or identical products. • Monopolistic competition: many firms sell similar but not identical products.

4. Market Structures

5. Introduction to Monopolistic Competition 0 • Monopolistic competition: a market structure in which many firms sell products that are similar but not identical. • Examples: • apartments, books, bottled water, clothing, fast food, night clubs, gasoline

6. Price MC profit ATC P ATC D MR Quantity Q A Monopolistically Competitive Firm Earning Profits in the Short Run 0 The firm faces a downward-sloping D curve. At each Q, MR < P. To maximize profit, firm produces Q where MR = MC. The firm uses the D curve to set P.

7. Price MC losses ATC D MR Quantity A Monopolistically Competitive Firm with Losses in the Short Run 0 For this firm, P < ATCat the output where MR = MC. The best this firm can do is to minimize its losses. ATC P Q

8. Comparing MonopolisticCompetition and Monopoly 0 • Short run: Under monopolistic competition, firm behavior is very similar to monopoly. • Long run: In monopolistic competition, entry and exit drive economic profit to zero (similar to PC). • If  > 0 in the short run: New firms enter market, lowering the demand faced by existing firms, prices and profits fall. • If  < 0 in the short run:Some firms exit the market, remaining firms enjoy greater demand and prices.

9. Price MC ATC markup Quantity A Monopolistic Competitorin the Long Run 0 Entry and exit occurs until P = ATC and profit = zero. Notice that the firm charges a price that is greater than MC, and does not produce at minimum ATC. P = ATC D MC MR Q

10. Why Monopolistic Competition Is Less Efficient than Perfect Competition 0 1.Excess capacity (No Productive Efficiency) • The monopolistic competitor operates on the downward-sloping part of its ATC curve, and produces less than the cost-minimizing output. • Under perfect competition, firms produce the quantity that minimizes ATC. 2.Markup over marginal cost (No Allocative Efficiency) • Under monopolistic competition, P > MC. • Under perfect competition, P = MC.

11. Deadweight Loss of Monopolistic Competition 0 • Monopolistically competitive markets do not have all the desirable properties of perfectly competitive markets. • Because P > MC, the market quantity is below the socially efficient quantity. • But, we get variety. • It is not easy for policymakers to fix this problem: Firms earn zero profits, so policymakers cannot require them to reduce prices.

12. Advertising 0 • In monopolistically competitive industries, product differentiation and markup pricing lead naturally to the use of advertising. • In general, the more differentiated the products, the more advertising firms buy. • Economists disagree about the social value of advertising. Does it: • waste resources and manipulate consumers? • provide information and induce competition?

13. Oligopoly • The most important feature of an oligopolistic market is the interdependence between firms. • Each firm knows that any change it makes (regarding price, output, quality, advertising, etc.) will lead to a reaction from its competitors. • Products sold may be • differentiated: cereals, airlines, cars • undifferentiated: crude oil, raw steel

14. EXAMPLE: Cell Phone Duopoly in Smalltown 0 • Smalltown has 140 residents • The “good”: cell service with unlimited anytime minutes and free phone • Smalltown’s demand schedule • Two firms: Cingular, Verizon(duopoly: an oligopoly with two firms) • Each firm’s costs: FC = $0, MC = $10

15. P Q TR TC  $0 140 $0 $1,400 –1,400 5 130 650 1,300 –650 10 120 1,200 1,200 0 15 110 1,650 1,100 550 20 100 2,000 1,000 1,000 25 90 2,250 900 1,350 30 80 2,400 800 1,600 35 70 2,450 700 1,750 40 60 2,400 600 1,800 45 50 2,250 500 1,750 EXAMPLE: Cell Phone Duopoly in Smalltown 0 Competitive outcome: P = Q = Profit = Monopoly outcome: P = Q = Profit =

16. EXAMPLE: Cell Phone Duopoly in Smalltown 0 • One possible duopoly outcome: collusion • Collusion: an agreement among firms in a market about quantities to produce or prices to charge • Cingular and Verizon could agree to each produce half of the monopoly output: • For each firm: Q = , P = , profits = • Cartel: a group of firms acting in unison

17. ACTIVE LEARNING 1: Collusion vs. self-interest 0 Duopoly outcome with collusion:Each firm agrees to produce Q = 30, earns profit = $900. If Cingular reneges on the agreement and produces Q = 40, what happens to the market price? Cingular’s profits? Is it in Cingular’s interest to renege on the agreement? If both firms renege and produce Q = 40, determine each firm’s profits. 16

18. ACTIVE LEARNING 1: Answers 0 If both firms stick to agreement, each firm’s profit = If Cingular reneges on agreement and produces Q = 40: Market quantity = , P = Cingular’s profit = Verizon will conclude the same, so both firms renege, each produces Q = 40: Market quantity = , P = Each firm’s profit =

19. The Equilibrium for an Oligopoly 0 • Nash equilibrium: a situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen

20. Collusion vs. Self-Interest 0 • Our duopoly example has a Nash equilibrium in which each firm produces Q = 40. • Given that Verizon produces Q = 40, Cingular’s best move is to produce Q = 40. • Given that Cingular produces Q = 40, Verizon’s best move is to produce Q = 40.

21. Collusion vs. Self-Interest 0 • Both firms would be better off if both stick to the cartel agreement. • But each firm has incentive to renege on the agreement. • Lesson:It is difficult for oligopoly firms to form cartels and honor their agreements.

22. A Comparison of Market Outcomes 0 When firms in an oligopoly individually choose production to maximize profit, • Q is greater than monopoly Qbut smaller than competitive market Q • P is greater than competitive market Pbut less than monopoly P

23. The Size of the Oligopoly 0 • As the number of firms in the market increases, • the oligopoly looks more and more like a competitive market • P approaches MC • the market quantity approaches the socially efficient quantity Another benefit of international trade: Trade increases the number of firms competing, increases Q, keeps P closer to marginal cost

24. Game Theory 0 • Game theory: the study of how people behave in strategic situations • Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players • Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial

25. Prisoners’ Dilemma Example 0 • The police have caught Bonnie and Clyde, two suspected bank robbers, but only have enough evidence to imprison each for 1 year. • The police question each in separate rooms, offer each the following deal: • If you confess and implicate your partner, you go free. • If you do not confess but your partner implicates you, you get 20 years in prison. • If you both confess, each gets 8 years in prison.

26. Prisoners’ Dilemma Example 0 Bonnie’s decision Confess Remain silent Bonnie gets 8 years Bonnie gets 20 years Confess Clyde gets 8 years Clyde goes free Clyde’s decision Bonnie goes free Bonnie gets 1 year Remain silent Clyde gets 1 year Clyde gets 20 years

27. Prisoners’ Dilemma Example 0 • Outcome: Bonnie and Clyde both confess, each gets 8 years in prison. • Both would have been better off if both remained silent. • But even if Bonnie and Clyde had agreed before being caught to remain silent, the logic of self-interest takes over and leads them to confess.

28. ACTIVE LEARNING 2: The “fare wars” game 0 The players: American Airlines and United Airlines The choice: cut fares by 50% or leave fares alone. • If both airlines cut fares, each airline’s profit = $400 million • If neither airline cuts fares, each airline’s profit = $600 million • If only one airline cuts its fares, its profit = $800 millionthe other airline’s profits = $200 million Draw the payoff matrix, find the Nash equilibrium. 27

29. ACTIVE LEARNING 2: Answers 0 American Airlines Cut fares Don’t cut fares $200 million $400 million Cut fares United Airlines $800 million $400 million $600 million $800 million Don’t cut fares $600 million $200 million 28

30. Other Examples of thePrisoners’ Dilemma 0 Advertising WarsTwo firms spend millions on TV ads to steal business from each other. Each firm’s ad cancels out the effects of the other, and both firms’ profits fall by the cost of the ads. Organization of Petroleum Exporting CountriesMember countries try to act like a cartel, agree to limit oil production to boost prices & profits. But agreements sometimes break down when individual countries renege.

31. Another Example – A Game of Chicken 0 • Game of Chicken: Two hooligans with something to prove drive at each other on a narrow road. The first to swerve loses faces among his peers. If neither swerves, however, a terminal fate plagues both.

32. Game of Chicken 0 Player One’s decision Swerve Stay 0 5 Swerve 0 -5 Player Two’s decision -5 -50 Stay 5 -50

33. Why People Sometimes Cooperate 0 • When the game is repeated many times, cooperation may be possible. • “Tit-for-tat” Whatever move your rival takes in one round you do the same move in the next round.

34. Why a Tit-for-Tat Strategy Works 0 American Airlines Cut fares Don’t cut fares $200 million $400 million Cut fares United Airlines $800 million $400 million $600 million $800 million Don’t cut fares $600 million $200 million 33