Presentation on theme: "Part 8 Monopolistic Competition and Oligopoly"— Presentation transcript:
1 Part 8 Monopolistic Competition and Oligopoly Most markets are not pure monopolies or perfectly competitive, but lie in-betweenMonopolistic competition is a model of a market that is competitive—many sellers, free entry—but with differentiated productsOligopoly has few sellers and involves strategic interaction between them which is difficult to predict
2 Monopolistic Competition Large number of firmsEach firm produces a differentiated productEach firm’s product is a close but not perfect substitute for other firm’s productsFirms 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 marketOne firm’s actions have negligible effect on othersNo collusion is possibleEach firm’s demand curve for its own brand will be downward sloping but highly elasticIn 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 thatThe demand curve will be more elastic
5 Long Run Equilibrium P MC ATC P* D MR Q* Q Long run equilibrium. New entry occurs whichshifts each firm’s demand curve in until noeconomic profit remains
6 Monopolistic Competition and Efficiency MCATCP’P”DMRExcess capacityQ’Q”Monopolistic competition—higher prices,P > MC and excess capacity. Cost ofproduct 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 doOligopolists may try to colludeCollusion may be formal (as in a cartel) or tacitIndividual 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 profitNon-cooperative duopolyBertrand duopoly modelEach firm sets a price taking the price of the other firm as givenThis leads to price warsZero profit (competitive) equilibrium
9 Duopoly Models Cournot duopoly model Each firm sets a quantity of output given the output of the other firmThis 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 ofRulesPossible strategiesPayoffsEquilibrium of a gameNash Equilibrium: where each player is doing the best he can given what the other player is doingDominant 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 equilibriumCoordination game—which side of the road to drive onALeftRight10-20Left10-20B-2010Right-2010
12 Prisoners’ Dilemma Game don’t confessconfessdon’tconfess-5-2-20-5B-20-15confess-2-15The prisoners cannot communicate.Given these payoffs each person will confesseven although they would be better off if theyboth 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 pricesEach firm has a choice of sticking with the collusive agreement or cheating on the agreement by producing extra to increase its own profitStrategies to collude or to cheat
14 CartelsIf both firms collude they behave like a monopolist and share the monopoly profitIf both cheat the market becomes competitive and they both earn normal profitIf 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 Cheat 4.5 Firm B 4.5 2 Cheat4.5Firm B4.52Comply2-1Dominant strategy is for each firm to cheat,despite the fact that both would be better offif 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” strategyResult will be a collusive equilibriumThis 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 changesIf it raises its price—others will not followIf it lowers its price others will followDemand is elastic above the current price and inelastic belowDemand 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 changeas long as MC lies between MC’ and MC”
19 Some other Oligopoly Games Product differentiationCompetitive advertisingOther forms of non-price competitionPrice leadership—largest firm sets the price and other firms followOligopolies and restrictive trade practicesRent seeking activity
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