Part 8 Monopolistic Competition and Oligopoly Most markets are not pure monopolies or perfectly competitive, but lie in-between Monopolistic competition is a model of a market that is competitive—many sellers, free entry—but with differentiated products Oligopoly has few sellers and involves strategic interaction between them which is difficult to predict

Monopolistic Competition Large number of firms Each firm produces a differentiated product Each firm’s product is a close but not perfect substitute for other firm’s products Firms compete on product quality, price and marketing (advertising and packaging) Firms are free to enter and exit

Monopolistic Competition Large number of firms means each firm is small relative to the whole market One firm’s actions have negligible effect on others No collusion is possible Each firm’s demand curve for its own brand will be downward sloping but highly elastic In the long run entry and exit will occur unless profits are just normal

Short Run Equilibrium P MC ATC P* D Economic profit MR Q* Q Same as monopoly equilibrium except that The demand curve will be more elastic

Long Run Equilibrium P MC ATC P* D MR Q* Q Long run equilibrium. New entry occurs which shifts each firm’s demand curve in until no economic profit remains

Monopolistic Competition and Efficiency MC ATC P’ P” D MR Excess capacity Q’ Q” Monopolistic competition—higher prices, P > MC and excess capacity. Cost of product differentiation

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 do Oligopolists may try to collude Collusion may be formal (as in a cartel) or tacit Individual firms may have incentives to try to gain larger market share

Duopoly Models Two firms If they cooperate (collude) the result is the same as a monopoly and they share monopoly profit Non-cooperative duopoly Bertrand duopoly model Each firm sets a price taking the price of the other firm as given This leads to price wars Zero profit (competitive) equilibrium

Duopoly Models Cournot duopoly model Each firm sets a quantity of output given the output of the other firm This leads to an equilibrium with a total output larger than a monopoly output but less than a perfectly competitive output

Game Theory Game theory looks at strategic behaviour A “Game” consists of a set of Rules Possible strategies Payoffs Equilibrium of a game Nash Equilibrium: where each player is doing the best he can given what the other player is doing Dominant Strategy Equilibrium: where each player has a unique best strategy regardless of what the other player does

Game Theory Not all games have dominant strategies Games may have more than one Nash equilibrium Coordination game—which side of the road to drive on A Left Right 10 -20 Left 10 -20 B -20 10 Right -20 10

Prisoners’ Dilemma Game don’t confess confess don’t confess -5 -2 -20 -5 B -20 -15 confess -2 -15 The prisoners cannot communicate. Given these payoffs each person will confess even although they would be better off if they both denied. Confess is a dominant strategy.

Application to a Cartel A cartel is a group of firms who enter into a collusive agreement to raise prices Each firm has a choice of sticking with the collusive agreement or cheating on the agreement by producing extra to increase its own profit Strategies to collude or to cheat

Cartels If both firms collude they behave like a monopolist and share the monopoly profit If both cheat the market becomes competitive and they both earn normal profit If one cheats and the other sticks with the agreement, the cheater makes large profits and the colluder makes a loss

Duopoly Payoff Matrix Firm A Cheat Comply -1 Cheat 4.5 Firm B 4.5 2 Cheat 4.5 Firm B 4.5 2 Comply 2 -1 Dominant strategy is for each firm to cheat, despite the fact that both would be better off if they colluded. Nash equilibrium is cheat/ cheat cell.

Repeated Games Can overcome the prisoners’ dilemma in a repeated game This allows for strategies that elicit cooperation “Tit for tat” strategy Result will be a collusive equilibrium This could have been arrived at tacitly

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 changes If it raises its price—others will not follow If it lowers its price others will follow Demand is elastic above the current price and inelastic below Demand curve is kinked at the current price—MR is discontinuous below the kink

Kinked Demand Curve P MC’ MC” P’ D MR Q Q’ Firm’s price and quantity will not change as long as MC lies between MC’ and MC”

Some other Oligopoly Games Product differentiation Competitive advertising Other forms of non-price competition Price leadership—largest firm sets the price and other firms follow Oligopolies and restrictive trade practices Rent seeking activity