0. 10 Monopolistic Competition and Oligopoly
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?

1. 10 Monopolistic Competition and Oligopoly What is game theory?
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?

2. Introduction: Between Monopoly and Competition
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.

3. Monopolistic Competition
Market Structures
Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
# of firms
type of product
control over price
free entry/exit
long run 

4. Introduction to Monopolistic Competition
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

5. A Monopolistically Competitive Firm Earning Profits in the Short RunMC
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.
ATC
Quantity
Price
profit D P MR
ATC Q

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

7. Comparing Monopolistic Competition and Monopoly
Comparing Monopolistic Competition and Monopoly
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.

8. A Monopolistic Competitor in the Long Run
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. MC
ATC
Quantity
Price
P = ATC
markup D MC MR Q

9. Why Monopolistic Competition Is Less Efficient than Perfect Competition
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.

10. Deadweight Loss of Monopolistic Competition
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.

11. Advertising
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?

12. 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

13. EXAMPLE: Cell Phone Duopoly in SmalltownP Q $0
140 5
130 10
120 15
110 20
100 25 90 30 80 35 70 40 60 45 50
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

14. EXAMPLE: Cell Phone Duopoly in Smalltown50 45 60 40 70 35 80 30 90 25
100 20
110 15
120 10
130 5
140 $0 Q P
2,250
2,400
2,450
2,000
1,650
1,200
650 $0 TR
500
600
700
800
900
1,000
1,100
1,200
1,300
$1,400 TC
1,750
1,800
1,600
1,350
1,000
550
–650
–1,400 
Competitive outcome:
P =
Q =
Profit =
Monopoly outcome:
P =
Q =
Profit =

15. EXAMPLE: Cell Phone Duopoly in Smalltown
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

16. A C T I V E L E A R N I N G 1: Collusion vs. self-interestP Q $0
140 5
130 10
120 15
110 20
100 25 90 30 80 35 70 40 60 45 50
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

17. A C T I V E L E A R N I N G 1: Answers
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 = P Q $0
140 5
130 10
120 15
110 20
100 25 90 30 80 35 70 40 60 45 50

18. The Equilibrium for an Oligopoly
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

19. Collusion vs. Self-Interest
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.

20. Collusion vs. Self-Interest
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.

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

22. The Size of the Oligopoly
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

23. Game Theory
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

24. Prisoners’ Dilemma Example
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.

25. Prisoners’ Dilemma Example
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 20 years
Clyde gets 1 year

26. Prisoners’ Dilemma Example
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.

27. A C T I V E L E A R N I N G 2: The “fare wars” game
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 million the other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium. 27

28. A C T I V E L E A R N I N G 2: Answers
American Airlines
Cut fares
Don’t cut fares
$400 million
$200 million
Cut fares
United Airlines
$400 million
$800 million
$800 million
$600 million
Don’t cut fares
$200 million
$600 million 28

29. Other Examples of the Prisoners’ Dilemma
Advertising Wars Two 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 Countries Member 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.

30. Another Example – A Game of Chicken
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.

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

32. Why People Sometimes Cooperate
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.

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