Presentation on theme: "10 Monopolistic Competition and Oligopoly What market structures lie between perfect competition and monopoly, and what are their characteristics? How."— Presentation transcript:
10 Monopolistic Competition and Oligopoly 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?
10 Monopolistic Competition and Oligopoly 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?
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.
Market Structures Perfect Competition Monopolistic Competition OligopolyMonopoly # of firms type of product control over price free entry/exit long run
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
profit ATC P A Monopolistically Competitive Firm Earning Profits in the Short Run 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. Quantity Price ATC D MR MC Q
losses A Monopolistically Competitive Firm with Losses in the Short Run For this firm, P < ATC at the output where MR = MC. The best this firm can do is to minimize its losses. Quantity Price ATC Q P MC D MR
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.
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. Quantity Price ATC D MR Q MC P = ATC markup
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.
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.
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?
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
PQ $ EXAMPLE: Cell Phone Duopoly in Smalltown Smalltown has 140 residents The good: cell service with unlimited anytime minutes and free phone Smalltowns demand schedule Two firms: Cingular, Verizon (duopoly: an oligopoly with two firms) Each firms costs: FC = $0, MC = $10
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
A C T I V E L E A R N I N G 1 : Collusion vs. self-interest 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? Cingulars profits? Is it in Cingulars interest to renege on the agreement? If both firms renege and produce Q = 40, determine each firms profits. 16 PQ $
A C T I V E L E A R N I N G 1 : Answers If both firms stick to agreement, each firms profit = If Cingular reneges on agreement and produces Q = 40: Market quantity =, P = Cingulars profit = Verizon will conclude the same, so both firms renege, each produces Q = 40: Market quantity =, P = Each firms profit = PQ $
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
Collusion vs. Self-Interest Our duopoly example has a Nash equilibrium in which each firm produces Q = 40. Given that Verizon produces Q = 40, Cingulars best move is to produce Q = 40. Given that Cingular produces Q = 40, Verizons best move is to produce Q = 40.
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.
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
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
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
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.
Prisoners Dilemma Example Confess Remain silent Confess Remain silent Bonnies decision Clydes decision Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde goes free Clyde gets 1 year Clyde gets 20 years
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.
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 airlines profit = $400 million If neither airline cuts fares, each airlines profit = $600 million If only one airline cuts its fares, its profit = $800 million the other airlines profits = $200 million Draw the payoff matrix, find the Nash equilibrium. 27
A C T I V E L E A R N I N G 2 : Answers 28 Cut fares Dont cut fares Cut fares Dont cut fares American Airlines United Airlines $600 million $200 million $800 million $200 million $400 million
Other Examples of the Prisoners Dilemma Advertising Wars Two firms spend millions on TV ads to steal business from each other. Each firms 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.
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.
Game of Chicken Swerve Stay Swerve Stay Player Ones decision Player Twos decision
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 Cut fares Dont cut fares Cut fares Dont cut fares American Airlines United Airlines $600 million $200 million $800 million $200 million $400 million Why a Tit-for-Tat Strategy Works