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 competitive—many sellers, free entry—but 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 firm’s product is a close but not perfect substitute for other firm’s 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 firm’s actions have negligible effect on others • No collusion is possible • Each firm’s 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 firm’s demand curve in until no economic profit remains

6. Monopolistic Competition and Efficiency MC ATC P’ P” D MR Excess capacity Q’ Q” Monopolistic competition—higher prices, P > MC and excess capacity. Cost of product differentiation

7. Oligopoly • Small number of firms in the market • Barriers to entry • Interdependence—what 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. Game Theory • Not all games have dominant strategies • Games may have more than one Nash equilibrium • Coordination game—which side of the road to drive on A Right Left 10 -20 Left 10 -20 B -20 10 -20 10 Right

12. Prisoners’ Dilemma Game A don’t confess confess -5 -2 don’t 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.

13. 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

14. 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

15. 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. Nash equilibrium is cheat/ cheat cell.

16. 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 • This could have been arrived at tacitly

17. Kinked Demand Curve Model • Based on an assumption concerning the firm’s beliefs about what other firms will do in response to its own price changes • If it raises its price—others 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 price—MR is discontinuous below the kink

18. Kinked Demand Curve P MC’ MC” P’ D MR Q Q’ Firm’s price and quantity will not change as long as MC lies between MC’ and MC”

19. Some other Oligopoly Games • Product differentiation • Competitive advertising • Other forms of non-price competition • Price leadership—largest firm sets the price and other firms follow • Oligopolies and restrictive trade practices • Rent seeking activity