1. Hall & Leiberman; Economics: Principles And Applications, 2004 1 Monopolistic Competition And Oligopoly On any given day, you are probably exposed to hundreds of advertisements In perfect competition and monopoly firms do little, if any, advertising Where, then, is all the advertising coming from?

2. Hall & Leiberman; Economics: Principles And Applications, 2004 2 The Concept of Imperfect Competition Refers to market structures between perfect competition and monopoly Types of imperfectly competitive markets –Monopolistic competition –Oligopoly

3. Hall & Leiberman; Economics: Principles And Applications, 2004 3 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

4. Hall & Leiberman; Economics: Principles And Applications, 2004 4 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

5. Hall & Leiberman; Economics: Principles And Applications, 2004 5 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)

6. Hall & Leiberman; Economics: Principles And Applications, 2004 6 Sellers Offer a Differentiated Product What makes a product differentiated? Product differentiation is a subjective matter Thus, whenever a firm (that is not a monopoly) faces a downward-sloping demand curve, we know buyers perceive its product as differentiated

7. Hall & Leiberman; Economics: Principles And Applications, 2004 7 Easy Entry and Exit Same as in perfect competition –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

8. Hall & Leiberman; Economics: Principles And Applications, 2004 8 Monopolistic Competition in the Short-Run Individual monopolistic competitor behaves very much like a monopoly Key difference is this –When a monopolistic competitor raises its price, its customers have one additional option – to buy from another seller

9. Hall & Leiberman; Economics: Principles And Applications, 2004 9 Figure 1: A Monopolistically Competitive Firm in the Short Run MR 1 $70 30 250 d1d1 A MC ATC Dollars Homes Serviced per Month 2.and charges $70 per home. 4.Kafka's monthly profit–$10,000–is the area of the shaded rectangle. 1.Kafka services 250 homes per month, where MC and MR intersect... 3.ATC at 250 units is less than price, so profit per unit is positive.

10. Hall & Leiberman; Economics: Principles And Applications, 2004 10 The Long-Run No barriers to entry and exit—the firm will not enjoy its profit for long 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

11. Hall & Leiberman; Economics: Principles And Applications, 2004 11 Figure 2: A Monopolistically Competitive Firm in the Long Run d2d2 MR 2 E MC $40 100250 Dollars Homes Serviced per Month ATC MR 1 In the long run, profit attracts entry, which shifts the firm's demand curve leftward. The typical firm produces where its new MR crosses MC. d1d1 Entry continues until P = ATC at the best output level, and economic profit is zero.

12. Hall & Leiberman; Economics: Principles And Applications, 2004 12 Excess Capacity Under Monopolistic Competition In long-run, a monopolistic competitor will operate with excess capacity Excess capacity suggests that monopolistic competition is costly to consumers Does that mean consumers prefer perfect competition to monopolistic competition?

13. Hall & Leiberman; Economics: Principles And Applications, 2004 13 Nonprice Competition Any action a firm takes to increase demand for its output—other than cutting its price—is called nonprice competition Nonprice competition is another reason why monopolistic competitors earn zero economic profit in long-run All this nonprice competition is costly

14. Hall & Leiberman; Economics: Principles And Applications, 2004 14 Oligopoly An oligopoly is a market dominated by a small number of strategically interdependent firms In such a market, each firm recognizes its strategic interdependence with others

15. Hall & Leiberman; Economics: Principles And Applications, 2004 15 Number of Firms Oligopoly requires that a few firms dominate the market No absolute number at which oligopoly ends and monopolistic competition begins

16. Hall & Leiberman; Economics: Principles And Applications, 2004 16 Market Domination Strategic interdependence requires that a few firms dominate the market As combined market share shrinks, strategic interdependence becomes weaker Oligopoly is a matter of degree –Not an absolute classification

17. Hall & Leiberman; Economics: Principles And Applications, 2004 17 Economies of Scale: Natural Oligopolies When minimum efficient scale (MES) for a typical firm is a relatively large percentage of market –A large firm will have lower cost per unit than a small firm Does it remind you of monopoly? How is this different?

18. Hall & Leiberman; Economics: Principles And Applications, 2004 18 Barriers to entry Reputation - A new entrant may suffer just from being new Strategic barriers - Oligopoly firms often pursue strategies designed to keep out potential competitors Legal barriers - Patents and copyrights, Govt. legislation

19. Hall & Leiberman; Economics: Principles And Applications, 2004 19 Oligopoly vs. Other Market Structures Oligopoly presents the greatest challenge to economists Essence of oligopoly is strategic interdependence Need new tools of modeling One approach—game theory—has yielded rich insights into oligopoly behavior

20. Hall & Leiberman; Economics: Principles And Applications, 2004 20 The Game Theory Approach Game theory In all games, except those of pure chance, a player’s strategy must take account of the strategies followed by other players Game theory analyzes oligopoly decisions as if they were games

21. Hall & Leiberman; Economics: Principles And Applications, 2004 21 The Prisoner’s Dilemma 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

22. 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 Colin gets 30 years Colin gets 3 years Colin gets 5 years Rose gets 20 years Rose gets 20 years Rose gets 20 years Colin’s Actions Don’t Confess

23. Hall & Leiberman; Economics: Principles And Applications, 2004 23 The Prisoner’s Dilemma Regardless of Rose’s strategy Colin’s best choice is to confess “Confess” is the dominant strategy for both Outcome of this game is an example of a Nash equilibrium As long as each player acts in an entirely self-interested manner Nash equilibrium is best outcome for both of them

24. Hall & Leiberman; Economics: Principles And Applications, 2004 24 Simple Oligopoly Games To apply the same method to a simple oligopoly market Duopoly - Oligopoly market with only two sellers Assume that Gus and Filip must make their decisions independently No matter what Filip does, Gus’s best move is to charge a low price—his dominant strategy The same holds for Filip The outcome is a Nash equilibrium

25. Hall & Leiberman; Economics: Principles And Applications, 2004 25 Figure 4: A Duopoly Game Confess Don’t Confess Filip’s Actions Gus’s profit = $25,000 Filip’s Profit = $25,000 Gus’s profit = –$10,000 Gus’s profit = $75,000 Gus’s profit = $50,000 Filip’s Profit = $–10,000 Filip’s Profit = $75,000 Filip’s Profit = $50,000 Gus’s Actions Don’t Confess

26. 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 –When neither player has a dominant strategy, we need a more sophisticated analysis to predict an outcome to the game

27. 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

28. 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

29. Hall & Leiberman; Economics: Principles And Applications, 2004 29 Explicit Collusion Simplest form of cooperation is explicit collusion Most extreme form of explicit collusion is creation of a cartel If explicit collusion to raise prices is such a good thing for oligopolists, why don’t they all do it? But oligopolists can collude in other, implicit ways

30. Hall & Leiberman; Economics: Principles And Applications, 2004 30 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

31. Hall & Leiberman; Economics: Principles And Applications, 2004 31 Tacit Collusion Another form of tacit collusion is price leadership With price leadership, there is no formal agreement

32. 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

33. Hall & Leiberman; Economics: Principles And Applications, 2004 33 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? Each player has an incentive to cheat Analyzing this sort of behavior requires some rather sophisticated game theory models

34. Hall & Leiberman; Economics: Principles And Applications, 2004 34 When is Cheating Likely? 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

35. Hall & Leiberman; Economics: Principles And Applications, 2004 35 Figure 5a: Advertising in Monopolistic Competition 1,000 C A 60 100 $120 2,000 6,000 B 1.Before advertising, long-run economic profit is zero. 2.In the short run, the first firms to advertise earn economic profit. d ads d no ads ATC ads ATC no ads d all advertise Dollars Bottles of Perfume per Month 3.But in the long run, imitation and entry bring economic profit back to zero. 4.Advertising can lead to a higher price in the long run, as in this panel...

36. Hall & Leiberman; Economics: Principles And Applications, 2004 36 Figure 5b: Advertising in Monopolistic Competition Dollars Bottles of Perfume per Month 1,000 A 60 d all advertise d no ads B $120 6,000 C 50 2,000 d ads ATC ads ATC no ads 5.or to a lower price in the long run, as in this panel.

37. Hall & Leiberman; Economics: Principles And Applications, 2004 37 Using the Theory: Advertising in Monopolistic Competition and Oligopoly Perfect competitors never advertise and monopolies advertise relatively little –But advertising is almost always found under monopolistic competition and very often in oligopoly Why? –All monopolistic competitors, and many oligopolists, produce differentiated products Since other firms will take advantage of opportunity to advertise, any firm that doesn’t advertise will be lost in shuffle

38. Hall & Leiberman; Economics: Principles And Applications, 2004 38 Advertising and Collusion in Oligopoly Oligopolists have a strong incentive to engage in tacit collusion Take airline industry as an example In theory, any airline should be able to claim superior safety –Yet no airline has ever run an advertisement with information about its security policies or attacked those of a competitor

39. Hall & Leiberman; Economics: Principles And Applications, 2004 39 Figure 6: An Advertising Game Run Safety Ads Don't Run Ads United's Actions American's Actions Don't Run Ads 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

40. Hall & Leiberman; Economics: Principles And Applications, 2004 40 The Four Market Structures: A Postscript Different market structures –Perfect competition –Monopoly –Monopolistic competition –Oligopoly Market structure models help us organize and understand apparent chaos of real- world markets