Presentation on theme: "10 Monopolistic Competition and Oligopoly What is game theory?"— Presentation transcript:
0 10 Monopolistic Competition and Oligopoly Monopolistic Competition and Oligopoly10What 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 Oligopoly10What 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 extremesCompetitive markets: many firms, identical productsMonopoly: one firm, unique productIn between these extremesOligopoly: only a few sellers offer similar or identical products.Monopolistic competition: many firms sell similar but not identical products.
3 Monopolistic Competition Market StructuresPerfect CompetitionMonopolistic CompetitionOligopolyMonopoly# of firmstype of productcontrol over pricefree entry/exitlong 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 Run MCThe 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.ATCQuantityPriceprofitDPMRATCQ
6 A Monopolistically Competitive Firm with Losses in the Short Run MCFor this firm, P < ATC at the output where MR = MC.The best this firm can do is to minimize its losses.ATCQuantityPricelossesATCDPMRQ
7 Comparing Monopolistic Competition and Monopoly Comparing Monopolistic Competition and MonopolyShort 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.MCATCQuantityPriceP = ATCmarkupDMCMRQ
9 Why Monopolistic Competition Is Less Efficient than Perfect Competition1. 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 AdvertisingIn 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 OligopolyThe 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 bedifferentiated: cereals, airlines, carsundifferentiated: crude oil, raw steel
13 EXAMPLE: Cell Phone Duopoly in Smalltown PQ$0140513010120151102010025903080357040604550Smalltown has 140 residentsThe “good”: cell service with unlimited anytime minutes and free phoneSmalltown’s demand scheduleTwo firms: Cingular, Verizon (duopoly: an oligopoly with two firms)Each firm’s costs: FC = $0, MC = $10
15 EXAMPLE: Cell Phone Duopoly in Smalltown One possible duopoly outcome: collusionCollusion: an agreement among firms in a market about quantities to produce or prices to chargeCingular 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-interest PQ$0140513010120151102010025903080357040604550Duopoly 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 =PQ$0140513010120151102010025903080357040604550
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 QP 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 marketP approaches MCthe market quantity approaches the socially efficient quantityAnother benefit of international trade: Trade increases the number of firms competing, increases Q, keeps P closer to marginal cost
23 Game TheoryGame theory: the study of how people behave in strategic situationsDominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other playersPrisoners’ 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.
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 AirlinesThe choice: cut fares by 50% or leave fares alone.If both airlines cut fares, each airline’s profit = $400 millionIf neither airline cuts fares, each airline’s profit = $600 millionIf only one airline cuts its fares, its profit = $800 million the other airline’s profits = $200 millionDraw 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 AirlinesCut faresDon’t cut fares$400 million$200 millionCut faresUnited Airlines$400 million$800 million$800 million$600 millionDon’t cut fares$200 million$600 million28
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 decisionSwerveStay5Swerve-5Player Two’s decision-5-50Stay5-50
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 WorksAmerican AirlinesCut faresDon’t cut fares$400 million$200 millionCut faresUnited Airlines$400 million$800 million$800 million$600 millionDon’t cut fares$200 million$600 million33