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Chapter 10

Chapter 10. Monopolistic Competition and Oligopoly. Monopolistic Competition. Characteristics many small buyers & sellers nonhomogeneous or differentiated product no barriers to entry/exit perfect information mobile resources no public goods / externalities

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Chapter 10

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  1. Chapter 10 Monopolistic Competition and Oligopoly

  2. Monopolistic Competition • Characteristics • many small buyers & sellers • nonhomogeneous or differentiated product • no barriers to entry/exit • perfect information • mobile resources • no public goods / externalities The only difference between perfect competition and monopolistic competition is the nature of the product

  3. Monopolistic Competition • Product differentiation • Physical differences, location, product image • Results in the firm facing a downward sloping demand for its own product

  4. Short-Run Profit Max. or Loss Min. • Maximize profit • Produce q where MR=MC • Price is found on firm’s D curve (like a monopoly) • Profit can be positive, zero or negative • Depends on AC

  5. Max. Profit or Min. Loss in Short-Run • If P>AC • Economic profit • If AC>P>AVC • Economic loss • Produce in short run • If P<AVC: AVC curve above D curve • Economic loss • Shut down in short run

  6. Long-Run Profit Maximization • If SR economic profit exists • New firms enter the market • Draw customers away from other firms • Reduce demand facing other firms • Shift firm’s demand to left • Profit disappears in long run • Zero economic profit • P = LRAC • Demand is tangent to LRAC

  7. Long-Run Profit Maximization • If SR economic loss exists • Some firms exit the market • Their customers switch to other firms • Increase demand facing the remaining firms • shift firm’s demand to right • Loss is erased in the long run • Zero economic profit for remaining firms • P = LRAC • Demand is tangent to LRAC

  8. Profit Maximization • In monopolistic competition equilibrium • P > MC • Inefficient (deadweight loss exists) • AC at q* > min AC • Excess Capacity is the difference between the profit max. rate of output and the cost min. rate of output • “too many firms each producing too little” • diversity of products??

  9. Monopolistic vs. Perfect Competition • Both • Zero economic profit in long run • MR = MC for quantity • where D is tangent to AC • Perfect competition • Firm’s demand is horizontal line • Produces at minimum average cost • Productive and allocative efficiency

  10. Advertising • Occurs in monopolistic competition • Shifts demand for firm • Increases demand • More inelastic demand • Increasing potential for profit • Increases costs to firm

  11. Oligopoly • Few, large sellers • Homogeneous or differentiated product • May be barriers to entry • Oligopolistic interdependence • each firm must take its rival’s behavior into account in their own decision making • Many models exist in oligopoly

  12. Models of Oligopoly • Cartel / Collusion • Kinked Demand • Price leadership • Game theory

  13. Collusion and Cartels • Collusion • Agreement among firms to • Divide the market • Fix the price • Cartel • Group of firms that agree to collude to maximize industry profit • Act as monopoly • Increase economic profit • Illegal in U.S.

  14. Cartel Example • 5 firms in industry • Divide up output equally • MCi = 5 • QM = 100,000 • Qi = 20,000 • PM = 10 • Πi = 20,000 (10 – 5) = $100,000 • ΠM = $500,000

  15. Cartel & Cheating • Firm 1 cheats • Q1 = 40,000 • QM = 120,000 • PM = 9 • Π1 = 40,000 (9 – 5) = $160,000 • Πi = 20,000 (9 – 5) = $80,000 • ΠM = $480,000 • Incentive exists to cheat!

  16. Collusion and Cartels • Difficulties to maintain a cartel: • Differences in average cost • Increase # of firms • Differentiated product • Low barriers to entry • Cheating by cartel members

  17. Kinked Demand • Each firm assumes that • Rivals will follow all price decreases • Rivals will not follow any price increases • Demand is more elastic for price increases than for price decreases • Results in price rigidity in the face of increasing costs

  18. Price Leadership • 1 large firm • Many small firms (competitive fringe) • Price leader • Sets the price for the industry • Initiate price changes • Followed by the other firms • Tacit Price coordination

  19. Price Leadership • Obstacles • U.S. antitrust laws • # & size of firms • Nature of product • Growth and innovation in industry • Ease of entry/exit • Contestable Market • costs of entry and exit are low • Enough firms so P = MC

  20. Game Theory • Analyzes firm behavior as a series of strategic moves and countermoves • Payoff matrix • Shows all possible outcomes for the “players” • Dominant-strategy equilibrium • Each player’s action does not depend on what he thinks the other player will do

  21. Game Theory • 2 firms • 2 strategies • maintain current price • raise price • Goal • minimize the worst case outcome • Can result in suboptimal solution • but is a dominant strategy

  22. Game Theory • One-shot versus repeated games • One-shot game • Game is played just once • Repeated games • Establish reputation for cooperation • Tit-for-tat strategy • Highest payoff results • Coordination game

  23. Oligopoly vs. Perfect Competition • Oligopoly • If firms collude or operate with excess capacity • Higher price (P > MC) • Lower output • If price wars • Lower price • Higher profits in the long run

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