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?

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?

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.

Monopolistic Competition Market Structures Perfect Competition Monopolistic Competition Oligopoly Monopoly # 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

A Monopolistically Competitive Firm Earning Profits in the Short Run MC 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

A Monopolistically Competitive Firm with Losses in the Short Run MC 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

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.

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

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

EXAMPLE: Cell Phone Duopoly in Smalltown P 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

EXAMPLE: Cell Phone Duopoly in Smalltown 50 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 =

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 P 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

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

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, Cingular’s best move is to produce Q = 40. Given that Cingular produces Q = 40, Verizon’s 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 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

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 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

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

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.

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 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

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.

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