1. Chapter 13 Monopolistic Competition and Oligopoly
Output and price determination in SR and LR.
Explain why advertising costs are high in a monopolistically competitive industry
Oligopoly
Definition.
Price and output determination – game theory
Cartels
Anti-trust laws and regulation of markets
Understanding real world markets
Students have no difficulty seeing monopolistic competition in the world all around them.
Emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of monopolistic competition, as its name implies, is a mixture of both extremes.
Some of what they learned in each of the two previous chapters survives and operates in the middle ground of monopolistic competition.

2. Monopolistic Competition
Characteristics of Monopolistic competition
Large number of firms.
limited market power (demand relatively elastic).
Independent decision making
Collusion impossible
Each firm produces a differentiated product.
compete on product quality, price, and marketing.
Firms are free to enter and exit the industry.
Economic profits driven to zero in long run

3. Monopolistic Competition
Market Share in Monopolistic Competition
Red=4 largest. Green=5-8 Blue=9-20

4. Output and Price in Monopolistic Competition
The Firm’s Short-Run Output and Price Decision
Holding quality and marketing constant, profit maximization is achieved by choosing the price/quantity where
MR = MC
The demand for a firm’s differentiated product in monopolistic competition
Remind the students about the ceteris paribus condition that defines a demand curve. Along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, Head, K Swiss, Prince, Reebok, and Wilson tennis shoes are constant. Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people prefer some other brand and will buy Nike only if its price is low enough. Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher the price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded.

5. SR Output and Price in Monopolistic Competition
Use diagram to identify:
profit maximizing P & Q
Profit
Socially efficient Q
Deadweight loss

6. Output and Price in Monopolistic Competition
Long Run: Zero Economic Profit
In the long run, economic profit (loss) induces entry (exit).
Entry (exit) causes demand curve for existing firms to shift downward (upward).
Entry continues as long as firms in the industry earn an economic profit—as long as (P > ATC).

7. SR Output and Price in Monopolistic Competition
Given the short run equilibrium described, why does entry occur?
As entry occurs, demand shifts leftward until profit equals zero.

8. Output and Price in Monopolistic Competition
LR equilibrium for monopolistically competitive firm.
economic profits
Excess capacity
socially efficient output
deadweight loss
Effect of elasticity on
price mark-up (P vs MC)
excess capacity

9. Output and Price in Monopolistic Competition
Contrast to LR equilibrium for firms in perfect competition:
Economic profits?
Excess capacity?
Socially efficient?
Deadweight loss?
Source of difference: product differentiation.

10. Product Development and Marketing
Innovation and Product Development
To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development.
New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.

11. Product Development and Marketing
Advertising
Firms in monopolistic competition incur heavy advertising expenditures.
Why? How can advertising be “profitable”?
Changes in product demand versus changes in ATC.

12. Product Development and Marketing
Advertising could increase product demand and also make it more elastic.
Profits could rise or fall.
If product demand becomes more elastic, (P-MC) markup could fall.

13. Product Development and Marketing
Advertising expenditure shifts the average total cost curve upward, but may increase profit maximizing sales allowing firm to take advantage of scale economies.

14. What is Oligopoly? The distinguishing features of oligopoly are:
Natural or legal barriers that prevent entry of new firms
A “small” number of firms compete causing “interdependent” decision making.
Understanding real world markets. Students have no difficulty seeing oligopoly in the world around them. Again, emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of oligopoly can be better understood by building on some of the features of competition and monopoly. Again, some of what they learned in each of the two previous chapters survives and operates in oligopoly.
Traditional oligopoly models. Many instructors today want to skip the traditional models of oligopoly. Others want to teach only these models and skip the game theory approach. Your choice! This chapter is written in self-contained sections so that you can skip either approach.

15. What is Oligopoly? Barriers to Entry
Either natural or legal barriers to entry can create oligopoly.
With demand as drawn, there is a natural duopoly—a market with two firms.
How would answer change if demand increases?

16. What is Oligopoly? Small Number of Firms
With a small number of firms, each firm’s profit depends on every firm’s actions.
Firms are interdependent and face a temptation to collude.
Cartel:
group of firms acting together to limit output, raise price, and increase profit.
Can be illegal.
Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often “break down”.

17. What is Oligopoly? Examples of Oligopoly
An HHI that exceeds 1800 is generally regarded as an oligopoly by Department of Justice.
An HHI below 1800 is generally regarded as monopolistic competition.
Recall earlier caveats on HHI (e.g. geographic boundaries, entry barriers)

18. Two Traditional Oligopoly Models
The Kinked Demand Curve Model. SKIP IT.
Dominant Firm Oligopoly SKIP IT.

19. Oligopoly Games Game theory
a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence.
Game Theory
Game theory is an entirely different approach to modeling a firm’s output and price decisions. It allows for the expected actions of all other firms in the market to be explicitly considered in the firm’s decision-making process. Game theory is a big step for the student and need a significant amount of time to develop. This chapter is designed to be flexible and provide you with many options on just how far to go.
1.We noted above that if you wish you can avoid game theory completely and stop at page 288.
2.You might want to introduce only the prisoner’s dilemma game. Pages 289–290 enable you to do that.
3.You might want to spend serious time applying the prisoner’s dilemma to a cartel game. Pages 291–295 enable you to do that.
4.You might want to extend the range of examples and apply the prisoner’s dilemma to a real-world research and development game. Pages 295–296 enable you to do that.
5.Finally, you might want to introduce repeated and sequential games and some of their applications and implications. Pages 297–299 enable you to do that.
6.Each of the steps laid out above is optional, but cumulative. You can stop at any point, but shouldn’t try to skip one step with the exception that you can teach the R&D game based on the general introduction to the prisoner’s dilemma without teaching the longer and more complex cartel game.

20. Oligopoly Games The Prisoners’ Dilemma
Each prisoner is told that both are suspected of committing a more serious crime.
If one of them confesses, he gets a 1-year sentence for cooperating while his accomplice gets a 10-year sentence for both crimes.
If both confess to the more serious crime, each receives 3 years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the minor crime only.

21. Oligopoly Games Nash equilibrium first proposed by John Nash
if a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player.

22. What’s the Nash Equilibrium? What’s the “cooperative” equilibrium?
Be sure the students know how to read the payoff matrix.
Explain that Art’s payoff from each combination of actions is shown in the top of each payoff box, and Bob’s is shown as the bottom of each payoff box.
Note that there are four possible outcomes: Bob and Art both confess (top left box), both Bob and Art deny (bottom right box), Bob confesses but Art does not (top right box), and Art confesses but Bob does not (bottom left box).

23. Oligopoly Games An Oligopoly Price-Fixing Game: Cartels.
A Cartel Game. The prisoner’s dilemma to a cartel game on pages 291–295 has been carefully designed to get the maximum payoff from the knowledge your students have of the perfect competition and monopoly results of the two preceding chapters and to introduce them to game theory in a setting that is as close to the previously studied settings as possible.
1. The natural duopoly setting ensures that there is a zero profit equilibrium that corresponds to perfect competition and monopoly profit equilibrium.
2. Instead of just asserting a payoff matrix, the numbers in the matrix come directly from monopoly profit-maximizing and competitive outcomes. You need to do a bit of work (and so do your students) to generate the payoff numbers, but the whole story hangs together so much better when the student can see where the numbers come from and can see the connection between the oligopoly set up and those of competition and monopoly.
3. Start with Figure 13.8 (page 291) and after you’ve explained the cost and demand conditions shown in the figure, ask the students what they think the price and quantity will be in this industry. There will be differences of opinion. This diversity of opinion motivates the need for a model of the choices the firms make.
4. The game is set up so that the competitive equilibrium is the Nash equilibrium. You might want to emphasize, that this outcome is efficient even though it is not the best joint outcome for the firms.

24. Oligopoly Games Based on above diagram:
What is competitive price, firm output, industry output, profit?
What is cartel (“collusive agreement”) price, output, profit?
What is deadweight loss?
Effect on consumer?
Effect on producers?
What is “incentive to cheat”?
How is this like “prisoner’s dilemma”?
How do each of following affect ability to enforce cartel?
Entry restrictions.
Ability to monitor each other.

25. Oligopoly Games Other Oligopoly Games An R & D Game
Advertising and R & D games are prisoners’ dilemmas.
An R & D Game
Procter & Gamble and Kimberley Clark play an R & D game in the market for disposable diapers.
The R&D Game. This example really happened. You can flesh out the time line of developments in this industry at

26. Oligopoly Games
Here is the payoff matrix for the Pampers Versus Huggies game.
What’s the Nash Equilibrium?
What’s the collusive (cooperative) equilibrium?

27. Anti-trust policy Measuring concentration.
DOJ formed merger guidelines in early 1980s.
if post-merger HHI<1000==>industry competitive.
if 1000<HHI<1800==>merger scrutinized (gray area).
if HHI>1800==> merger likely to be challenged (red zone).
Difficulties in using concentration measures as indicators of competition for mergers.
geographic scope of market
product boundaries
firms produce multiple products.

28. Anti-trust policy Likelihood of collusion and DOJ anti-trust policy.
When HHI is in a questionable area, other factors are considered.
Barriers to entry
Ability to monitor each other’s behavior.
Is the game “repeated”?

29. Anti-trust policy Theories of regulation. Public interest theory
political process generates regulations designed to achieve “socially efficient” outcome.
Capture theory
regulations are designed to satisfy the demand of producers to maximize producer surplus.
benefit producers (concentrated group) at expense of consumers (disperse group).

30. Evidence on Deregulation of 1980s.
Anti-trust policy
Evidence on Deregulation of 1980s.
AIRLINES
prices fell and volume increased.
consumer surplus increased $11.8 billion
producer surplus increased $4.9 billion.
rapid change in structure of airline industry (hubs, excess capacity reduced, pricing changes, etc.)
TRUCKING
consumer surplus increased $15.4 billion
producer surplus decreased $4.8 billion.
truck driver’s wages fell.

31. Anti-trust policy Anti-trust policy. The Standard Oil Story:
John D. Rockefeller owned standard oil.
Able to extract discounts from the railroads for shipping
During the 1870s, Standard Oil increased its capacity from 10 to 90 percent of the U.S. total.
In 1882, the independent members of standard oil contributed shares to a central trust
Allowed a central body to manage all firms.
The central body shut down some refineries, restricted production, and drove up oil prices.

32. Anti-trust policy 1890: Sherman Act
passed partly in response to the monopolization of the oil industry.
Law prohibited “combination, trust, or conspiracy to restrict interstate or international trade”.
Sherman Act used in 1911 to break up Standard Oil (created Exxon, Sohio, Chevron, etc.)

33. Anti-trust policy 1914: Clayton Act.
prohibited interlocking directorates & tying contracts
1914: Federal Trade Commission Act
created FTC to prosecute “unfair competition”
outlawed misleading advertising.

34. Anti-trust policy 1936: Robinson-Patman Act (Chain store law)
made “quantity discounts” illegal
prevented stores from selling to public at “unreasonably low” prices.
1937: Miller-Tydings Act
allowed Resale Price Maintenace if state approved.
arguments against RPM (cartel enforcement)
argument for RPM (high quality service)
McTravel
Apple computer