1. Chapter 10: Monopolistic Competition And Oligopoly
Econ 101: Microeconomics
Chapter 10:
Monopolistic Competition
And Oligopoly

2. Monopolistic Competition And Oligopoly
On any given day, you are probably exposed to hundreds of advertisements
Advertising is everywhere in the economy
So far in this book not much has been said about advertising
There is a good reason for this
In perfect competition and monopoly firms do little, if any, advertising
Where, then, is all the advertising coming from?
We must consider firms that are neither perfect competitors nor monopolists
Hall & Leiberman; Economics: Principles And Applications, 2004

3. The Concept of Imperfect Competition
Refers to market structures between perfect competition and monopoly
In imperfectly competitive markets, there is more than one seller, but too few to create a perfectly competitive market
Imperfectly competitive markets often violate other conditions of perfect competition
Such as the requirement of a standardized product or free entry and exit
Types of imperfectly competitive markets
Monopolistic competition
Oligopoly
Hall & Leiberman; Economics: Principles And Applications, 2004

4. Monopolistic Competition
Hybrid of perfect competition and monopoly, sharing some of features of each
A monopolistically competitive market has three fundamental characteristics
Many buyers and sellers
Sellers offer a differentiated product
Sellers can easily enter or exit the market
Hall & Leiberman; Economics: Principles And Applications, 2004

5. Many Buyers and Sellers
Under monopolistic competition, an individual buyer is unable to influence price he pays
But an individual seller, in spite of having many competitors, decides what price to charge
Our assumption of many sellers, however, has another purpose
To ensure that no strategic games will be played among firms in market
There are so many firms, each supplying such a small part of the market
That no one of them needs to worry that its actions will be noticed—and reacted to—by others
Hall & Leiberman; Economics: Principles And Applications, 2004

6. Sellers Offer a Differentiated Product
Each seller produces a somewhat different product from the others
Faces a downward-sloping demand curve
In this sense is more like a monopolist than a perfect competitor
When it raises its price a modest amount, quantity demanded will decline (but not all the way to zero)
Hall & Leiberman; Economics: Principles And Applications, 2004

7. Sellers Offer a Differentiated Product
What makes a product differentiated?
Quality of product
Difference in location
Product differentiation is a subjective matter
A product is different whenever people think that it is
Whether their perception is accurate or not
Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated
This perception may be real or illusory, but economic implications are the same in either case
Firm chooses its price
Hall & Leiberman; Economics: Principles And Applications, 2004

8. Hall & Leiberman; Economics: Principles And Applications, 2004
Easy Entry and Exit
This feature is shared by monopolistic competition and perfect competition
Plays the same role in both
Ensures firms earn zero economic profit in long-run
In monopolistic competition, however, assumption about easy entry goes further
No barrier stops any firm from copying the successful business of other firms
Hall & Leiberman; Economics: Principles And Applications, 2004

9. Monopolistic Competition in the Short-Run
Individual monopolistic competitor behaves very much like a monopoly
Key difference is this
While a monopoly is the only seller in its market, a monopolistic competitor is one of many sellers
When a monopolistic competitor raises its price, its customers have one additional option
Can buy similar good from some other firm
Hall & Leiberman; Economics: Principles And Applications, 2004

10. Figure 1: A Monopolistically Competitive Firm in the Short Run
Dollars
Homes Serviced per Month
1. Kafka services 250 homes per month, where MC and MR intersect . . . A MC
$70
ATC
2. and charges $70 per home. d1 30
3. ATC at 250 units is less than price, so profit per unit is positive.
MR1
4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle.
250
Hall & Leiberman; Economics: Principles And Applications, 2004

11. Monopolistic Competition in the Long-Run
Under monopolistic competition—in which there are no barriers to entry and exit—the firm will not enjoy its profit for long
Entry will continue to occur, and demand curve will continue to shift leftward
Under monopolistic competition, firms can earn positive or negative economic profit in short-run
But in long-run, free entry and exit will ensure that each firm earns zero economic profit just as under perfect competition
In real world, monopolistic competitors often earn economic profit or loss in the short-run
But—given enough time—profits attract new entrants, and losses result in an industry shakeout
Until firms are earning zero economic profit
Hall & Leiberman; Economics: Principles And Applications, 2004

12. Figure 2: A Monopolistically Competitive Firm in the Long Run
In the long run, profit attracts entry, which shifts the firm's demand curve leftward.
Dollars
Homes Serviced per Month MC
ATC E
Entry continues until P = ATC at the best output level, and economic profit is zero.
$40
The typical firm produces where its new MR crosses MC. d1
MR1
MR2 d2
100
250
Hall & Leiberman; Economics: Principles And Applications, 2004

13. Excess Capacity Under Monopolistic Competition
In long-run, a monopolistic competitor will operate with excess capacity
Will produce too little output to achieve minimum cost per unit
Excess capacity suggests that monopolistic competition is costly to consumers
May tempt you to leap to a conclusion
Consumers are better off under perfect competition; however
In order to get beneficial results of perfect competition, all firms must produce identical output
Consumers usually benefit from product differentiation
Hall & Leiberman; Economics: Principles And Applications, 2004

14. Non-price Competition
If monopolistic competitor wants to increase its output it can cut its price
Move along its demand curve
Any action a firm takes to increase demand for its output—other than cutting its price—is called non-price competition
Examples include better service, product guarantees, free home delivery, more attractive packaging
Non-price competition is another reason why monopolistic competitors earn zero economic profit in long-run
All this non-price competition is costly
Must pay for advertising, for product guarantees, for better staff training
Costs must be included in each firm’s ATC curve, shifting it upward
None of this changes conclusion that monopolistic competitors will earn zero economic profit in long-run
Hall & Leiberman; Economics: Principles And Applications, 2004

15. Hall & Leiberman; Economics: Principles And Applications, 2004
Oligopoly
When just a few large firms dominate a market
So that actions of each one have an important impact on the others
Would be foolish for any one firm to ignore its competitors’ reactions
In such a market, each firm recognizes its strategic interdependence with others
An oligopoly is a market dominated by a small number of strategically interdependent firms
Hall & Leiberman; Economics: Principles And Applications, 2004

16. Market Domination and Economies of Scale
Strategic interdependence requires that a few firms—whatever their number—dominate the market
Their share of market is large
When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market
A large firm—supplying a large share of the market—will have lower cost per unit than a small firm
Since small firms can’t compete, only a few large firms survive
Market becomes an oligopoly
Tends to happen on its own unless there is government intervention
Such a market is often called a natural oligopoly—analogous to natural monopoly
Hall & Leiberman; Economics: Principles And Applications, 2004

17. Reputation as a Barrier
A new entrant may suffer just from being new
Established oligopolists are likely to have favorable reputations
In some cases, where potential profits are great, investors may decide it is worth the risk and accept initial losses in order to enter industry
In other industries, the initial losses may be too great and probability of success too low for investors to risk their money starting a new firm
Hall & Leiberman; Economics: Principles And Applications, 2004

18. Hall & Leiberman; Economics: Principles And Applications, 2004
Strategic Barriers
Oligopoly firms often pursue strategies designed to keep out potential competitors
Maintain excess production capacity as a signal to a potential entrant that they could easily saturate market and leave new entrant with little or no revenue
Make special deals with distributors to receive best shelf space in retail stores
Make long-term arrangements with customers to ensure that their products are not displaced quickly by those of a new entrant
Spend large amounts on advertising to make it difficult for a new entrant to differentiate its product
Hall & Leiberman; Economics: Principles And Applications, 2004

19. Hall & Leiberman; Economics: Principles And Applications, 2004
Legal Barriers
Patents and copyrights—which can be responsible for monopoly—can also create oligopolies
Like monopolies, oligopolies are not shy about lobbying government to preserve their market domination
Government barriers can operate against domestic entrants, too
Hall & Leiberman; Economics: Principles And Applications, 2004

20. The Game Theory Approach
Oligopoly presents the greatest challenge to economists
Economist have had to modify tools used to analyze other market structures and to develop entirely new tools as well to analyze oligopoly behavior
Game theory
An approach to modeling strategic interaction of oligopolists in terms of moves and countermoves
In all games—except those of pure chance, such as roulette—a player’s strategy must take account of the strategies followed by other players
Game theory analyzes oligopoly decisions as if they were games by
Looking at the rules players must follow
Payoffs they are trying to achieve
Strategies they can use to achieve them
Hall & Leiberman; Economics: Principles And Applications, 2004

21. The Prisoner’s Dilemma
Easiest way to understand how game theory works is to start with a simple, non-economic example—the prisoner’s dilemma
Explains why a technique for obtaining confessions, commonly used by police, is so often successful
Each of four boxes in payoff matrix represents one of four possible strategy combinations that might be selected in this game
Upper left box: Both Rose and Colin confess
Lower left box: Colin confesses and Rose doesn’t
Upper right box: Rose confesses and Colin doesn’t
Lower right box: Neither Rose nor Colin confesses
Hall & Leiberman; Economics: Principles And Applications, 2004

22. Figure 3: The Prisoner’s Dilemma
Confess
Don’t Confess
Rose’s Actions
Colin gets
20 years
Rose
gets 20
years
30 years
3 years
5 years
Colin’s Actions
Hall & Leiberman; Economics: Principles And Applications, 2004

23. The Prisoner’s Dilemma
Regardless of Rose’s strategy Colin’s best choice is to confess
In this game, the strategy “confess” is an example of a dominant strategy
Strategy that is best for a player regardless of strategy of other player
Outcome of this game is an example of a Nash equilibrium—appropriately named after the mathematician John Nash, who originated the concept
Exists when each player is taking the best action—given actions taken by other players
As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them
Hall & Leiberman; Economics: Principles And Applications, 2004

24. Simple Oligopoly Games
Same method used to understand behavior of Rose and Colin in prisoner’s dilemma can be applied to a simple oligopoly market
Duopoly
Oligopoly market with only two sellers
Assume that Gus and Filip must make their decisions independently
Without knowing in advance what the other will do
No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy
Notice that outcome is a Nash equilibrium
Equilibrium price in market is the low price
Hall & Leiberman; Economics: Principles And Applications, 2004

25. Hall & Leiberman; Economics: Principles And Applications, 2004
Figure 4: A Duopoly Game
Low Price
High Price
Filip’s Actions
Gus’s profit
= $25,000
Filip’s
Profit =
$25,000
= –$10,000
= $75,000
= $50,000
$–10,000
$75,000
$50,000
Gus’s Actions
Hall & Leiberman; Economics: Principles And Applications, 2004

26. Oligopoly Games in the Real World
Will typically be more than two strategies from which to choose
Will usually be more than two players
In some games, one or more players may not have a dominant strategy
A game with two players will have a Nash equilibrium as long as at least one player has a dominant strategy
Whether the other has a dominant strategy or not
When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game
Hall & Leiberman; Economics: Principles And Applications, 2004

27. Oligopoly Games in the Real World
We’ve limited the players to one play of the game
In reality, for gas stations and almost all other oligopolies, there is repeated play
Where both players select a strategy
Observe the outcome of the trial
Play the game again and again, as long as they remain rivals
One possible result of repeated trials is cooperative behavior
Hall & Leiberman; Economics: Principles And Applications, 2004

28. Cooperative Behavior in Oligopoly
In real world, oligopolists will usually get more than one chance to choose their prices
The equilibrium in a game with repeated plays may be very different from equilibrium in a game played only once
Often, firms will evolve some form of cooperation in the long run
Hall & Leiberman; Economics: Principles And Applications, 2004

29. Hall & Leiberman; Economics: Principles And Applications, 2004
Explicit Collusion
Simplest form of cooperation is explicit collusion
Managers meet face-to-face to decide how to set prices
Most extreme form of explicit collusion is creation of a cartel
Group of firms that tries to maximize total profits of the group as a whole
If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it?
Usually illegal
Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways
Hall & Leiberman; Economics: Principles And Applications, 2004

30. Hall & Leiberman; Economics: Principles And Applications, 2004
Tacit Collusion
Any time firms cooperate without an explicit agreement, they are engaging in tacit collusion
Tit for tat
A game-theoretic strategy of doing to another player this period what he has done to you in previous period
However, gentle reminder of tit-for-tat is not always effective in maintaining tacit collusion
Oligopolist will sometimes go further
Attempting to punish a firm that threatens to destroy tacit cooperation
Hall & Leiberman; Economics: Principles And Applications, 2004

31. Hall & Leiberman; Economics: Principles And Applications, 2004
Tacit Collusion
Another form of tacit collusion is price leadership
One firm—the price leader—sets its price and other sellers copy that price
With price leadership, there is no formal agreement
Rather the decisions come about because firms realize—without formal discussion—that system benefits all of them
Decisions include
Choice of leader
Criteria it uses to set its price
Willingness of other firms to follow
Hall & Leiberman; Economics: Principles And Applications, 2004

32. The Limits to Collusion
Oligopoly power—even with collusion—has its limits
Even colluding firms are constrained by market demand curve
Collusion—even when it is tacit—may be illegal
Collusion is limited by powerful incentives to cheat on any agreement
Hall & Leiberman; Economics: Principles And Applications, 2004

33. Hall & Leiberman; Economics: Principles And Applications, 2004
The Incentive to Cheat
Go back to Gus and Filip for a moment
One way or another they arrive at high-price cooperative solution
Will the market stay there?
Maybe, and maybe not
Problem—each player may conclude that he can do even better by cheating
Two players would be back to noncooperative outcome based on their dominant strategies
May be in each player’s interest to cheat occasionally
Analyzing this sort of behavior requires some rather sophisticated game theory models
Economists are actively engaged in building them
Hall & Leiberman; Economics: Principles And Applications, 2004

34. When is Cheating Likely?
While no firm wants to completely destroy a collusive agreement by cheating
Since this would mean a return to the noncooperative equilibrium wherein each firm earns lower profit
Some firms may be willing to risk destroying agreement if benefits are great enough
Suggests that cheating is most likely to occur—and collusion will be least successful—under the following conditions
Difficulty observing other firms’ prices
Unstable market demand
Large number of sellers
Hall & Leiberman; Economics: Principles And Applications, 2004

35. The Future of Oligopoly
Some people think U.S. and other Western economies are moving toward oligopoly as dominant market structure
In 1932, two economists—Adolf Berle and Gardiner Means—noted trend toward big business
Predicted the 200 largest U.S. firms would control nation’s entire economy by 1970
Unless something were done to stop it
Prediction has not come true
Today, there are hundreds and thousands of ongoing businesses in United States
Hall & Leiberman; Economics: Principles And Applications, 2004

36. Antitrust Legislation and Enforcement
Antitrust enforcement has focused on three types of actions
Preventing collusive agreements among firms
Such as price-fixing agreements
Breaking up or limiting activities of large firms—oligopolists and monopolists—whose market dominance harms consumers
Preventing mergers that would lead to harmful market domination
Managers of other firms considering anticompetitive moves have to think long and hard about consequences of acts that might violate antitrust laws
While thrust of these policies is to preserve competition
Type of competition preserved—and zeal with which policies are applied—can shift
Hall & Leiberman; Economics: Principles And Applications, 2004

37. The Globalization of Markets
By enlarging markets from national ones to global ones, international trade can increase the number of firms in a market
Decreasing market dominance by a few, and increasing competition
Although oligopolists often try to prevent it, they face increasingly stiff competition from foreign producers
Entry of U.S. producers has helped to increase competition in foreign markets for movies, television shows, clothing, household cleaning products, and prepared foods
While consumers in each nation may have access to more firms, these may be larger and more powerful firms
Creating greater likelihood of strategic interaction and danger of collusion
Hall & Leiberman; Economics: Principles And Applications, 2004

38. Hall & Leiberman; Economics: Principles And Applications, 2004
Technological Change
Technological change works to increase competition by creating new substitute goods
Can reduce barriers to entry in much the same way that globalization does
By increasing size of market
Technology—the internet—has enabled residents in many smaller towns to choose among a dozen or more online sellers of the same merchandize
Trend can also be seen as encouraging oligopoly
Result could be strategic interaction, or collusion, among large national players
Finally, some technologies actually increase MES of typical firm
Thereby encouraging formation of oligopolies
Hall & Leiberman; Economics: Principles And Applications, 2004

39. Figure 5a: Advertising in Monopolistic Competition
1.Before advertising, long-run economic profit is zero.
2. In the short run, the first firms to advertise earn economic profit.
Dollars
Bottles of Perfume per Month
3. But in the long run, imitation and entry bring economic profit back to zero. B
$120 C
100
ATCads
ATCno ads A 60
4. Advertising can lead to a higher price in the long run, as in this panel . . .
dads
dall advertise
dno ads
1,000
6,000
2,000
Hall & Leiberman; Economics: Principles And Applications, 2004

40. Figure 5b: Advertising in Monopolistic Competition
5. or to a lower price in the long run, as in this panel.
Dollars
Bottles of Perfume per Month
dall advertise B
$120 A 60 C
ATCads 50
ATCno ads
dads
dno ads
1,000
6,000
2,000
Hall & Leiberman; Economics: Principles And Applications, 2004

41. Figure 6: An Advertising Game
Run Safety Ads
Don't Run Ads
United's Actions
American's Actions
American earns low profit
American earns high profit
United earns very low profit
United earns low profit
American earns very low profit
American earns medium profit
United earns medium profit
United earns high profit
Hall & Leiberman; Economics: Principles And Applications, 2004

42. Hall & Leiberman; Economics: Principles And Applications, 2004
Problem #8
In Promaine Flats, Nevada there are two restaurants: Sal Monella and Road Kill Café.
Current profit =$7000 each. If clean up will attract more customers, but profit becomes $5000 each.
However, if clean up and doesn’t clean up then $12000 and $3000.
a. What is the payoff matrix?
b. What is each player’s dominant strategy?
c. What will be the outcome of the game?
d. Suppose the two restaurants will face the decision repeatedly. How might the outcome differ?
e. Suppose the clean restaurant earns $6000 when one clean up and one stays dirty. What is the outcome?
Hall & Leiberman; Economics: Principles And Applications, 2004