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C h a p t e r 1 3 m o n o p o l i s t i c c o m p e t i t i o n a n d

o l i g o p o l y

O u t l i n e

I. What is Monopolistic Competition?

A. Monopolistic competition is a market with the followingcharacteristics:

1. A large number of firms compete.

2. Each firm produces a differentiated product.

3. Firms compete on product quality, price, and marketing.

4. Firms are free to enter and exit.

B. The presence of a large number of firms in the market implies:1. Each firm supplies only a small part of the total industry output and

so has only limited power to influence the price of its product.

2. Each firm is sensitive to the average market price but pays noattention to any one individual competitor.

3. No one firm can dictate market conditions and no one firms actionsdirectly affect the actions of another.

4. Collusion, or conspiring to fix prices, is impossible.

C. Firms in monopolistic competition practice product differentiation,which means that each firm makes a product that is slightly differentfrom the products of competing firms.

D. Product differentiation enables firms to compete in three areas: quality,price, and marketing.

1. The quality of a product is the physical attributes that make itdifferent from the products of other firms. Examples include productdesign, reliability, and service.

2. Each firm faces a downward-sloping demand curve for its ownproduct because each firm produces a differentiated product. Thisallows each firm to set its own price. The price is related to quality:A higher quality product allows the firm to set a higher price.

3. A firm in monopolistic competition must market its product becauseall other firms offer differentiated products. This fact means theproduct must be marketed using advertising and packaging.

E. There are no barriers to entry or exit in monopolistic competition, sofirms cannot earn an economic profit in the long run.

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1. Examples of a monopolistically competitive industry include audioand video equipment, computers, frozen foods, mens clothing, andsporting goods.

2. Figure 13.1shows market share of the largest four firms for each often industries that operate in monopolistic competition.

II. Price and Output in Monopolistic Competition

A. Similar to a monopoly, the MR curve for a firm in monopolisticcompetition is downward sloping and lies under its demand curve. Inthe short run, a firm in monopolistic competition makes its output andprice decision just like monopoly firm does.

1. A firm that has decided the quality of its product and its marketing

program produces the profit maximizing quantity at which MR =MC.

2. A firm in monopolisticcompetition can earn aneconomic profit in the short runonly ifP >ATC.

3. Figure 13.2shows a short-runequilibrium output and pricedecision for a firm inmonopolistic competitionmaking a positive economicprofit.

B. In the long run, firms inmonopolistic competition will beunable to earn economic profit.

1. When firms are earningeconomic profit (that is, when P

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>ATC), the existence of the economic profit induces entry by newfirms, which continues as long as firms in the industry earn aneconomic profit.

a) As firms enter the industry, each existing firm loses some of itsmarket share. The demand for its product decreases and thedemand curve shifts leftward.

b) The decrease in demand decreases the quantity at which MR =MC and lowers the maximum price that the firm can charge tosell this quantity.

c) The price the firm charges and the quantity it sells falls as firmsenter. Eventually entry results in P =ATC and the firms earnzero economic profit (normal profit).

2. When firms are incurring aneconomicloss (that is, when P

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c) The price that eachremaining firm charges andthe quantity it sells rise asfirms exit. Eventually existresults in P =ATC and firmsagain earn zero economic

profit (normal profit).d) Figure 13.4 shows the long

run output and pricedecision for a firm inmonopolistic competition.

C. Comparing MonopolisticCompetition with PerfectCompetition

1. Firms in monopolistic areinefficient and operate withexcess capacity, which meansthe firm produces a quantity less than the minimum efficient scale.

a) Figure 13.5illustrates this proposition.

2. Firms maximize profit by choosing to produce output where MR =MC.

a) The firm in monopolistic competition retains some marketpower, which means MR < P for all quantities.

b) The fact that the firm has some market power means that at the

profit maximizing level of output chosen by the firm P > MC.c) A firms markup is the amount by which price exceeds marginal

cost.

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3. Because a firm in monopolistic competition has P > MC, the firmproduces where MC < MB since price equals the marginal benefit tosociety.

a) The under-production in monopolistic competition creates adeadweight loss.

b) Monopolistically competitive firms produce at inefficient levels

of output relative to perfect competition.

c) But firms in monopolistic competition produce a variety ofdifferent goods whereas firms in perfect competition produceidentical goods. People value variety, so monopolisticcompetition is not necessarily inferior to perfect competition.

III. Product Development and Marketing

A. A firm in monopolistic competition must be in a state of continuousproduct development to keep earning an economic profit.

1. New product development allows a firm to gain a competitive edge,if only temporarily, before competitors imitate the innovation.

2. Firms pursue product development until the marginal revenue frominnovation equals the marginal development cost.

3. Production development may benefit the consumer (by providingimprovements in product quality) or it may mislead the consumer(by giving only the appearance of change in product quality).

4. Regardless of whether a product improvement is real or imagined,its value to the consumer is its marginal benefit, which is theamount the consumer is willing to pay for the improvement.

B. Firms use advertising andpackaging as the two principalmethods to differentiate itsproducts from competitors by

actively marketing theirproducts to consumers.

1. Firms in monopolisticcompetition incur heavyadvertising expenditureswhich make up a largeportion of the price itcharges for the product.

2. Figure 13.6 showsestimates of thispercentage of sale price fordifferent monopolistic

competition markets.

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3. These selling costs (likeadvertising expenditures,fancy retail buildings, etc.)are fixed costs.

a) This fact means sellingcosts increase average

total costs at any givenlevel of output but do notaffect the variable costs(including the marginalcost) of production.

b) Figure 13.7 shows howan advertisingexpenditures shift the

ATC curve upward.

C. Selling efforts such asadvertising are successful only if they increase demand for the firmsproduct.

1. When each firm advertises its product, the advertising increases theprice the firm can charge but it also makes the demand moreelastic.

2. A firms increased demand and profits can only be experienced byfirms in the short run.

3. Profits lead to the entry of more firms into the market, whichdecreases the demand for each firms product in the long run andlowers the price each firm can charge.

D. To the extent that advertising and selling costs provide consumers withinformation and services that they value more highly than their cost,these activities are an efficient allocation of resources.

1. Similarly, developing and marketing a brand name provides

information about the quality of a product to consumers and anincentive to the producer to achieve a high and consistent qualitystandard.

2. Heavy marketing and advertising expenditures by a firm are asignal to consumers that their product is of high quality. A signal isan action taken by an informed person (or firm) to send a messageto uninformed people.

IV. Oligopoly

A. The distinguishing features of an oligopoly are that:

1. Natural or legal barriers prevent the entry of new firms.

2. A small number of firms compete.B. Oligopoly markets share some characteristics of other market

structures:

1. Oligopoly is similar to a monopoly in that each firm has marketpower to determine its own price.

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2. Oligopoly might be similar to monopolistic competition in that eachfirm makes a differentiated product, but this is nota necessarycondition for oligopoly.

C. The number of firms in a natural oligopolycan be determined by theminimum efficient scale of the firms and the total size of the market.

1. The minimum efficient scale, combined with the size of the total

market demand for the product, will determine how many firmssurvive in the market.

2. If only two firms operate in an oligopoly market, it is called aduopoly.

D. The quantity sold by one firm in an oligopoly depends on each firmsown price and the prices and quantities sold by all the other firms.

1. This interdependence between firms motivates each firm to behavecooperatively instead of competitively toward each other in anattempt to maximize profits for all firms.

2. A cartel is a group of firms acting togethercolludingto limitoutput, raise price, and increase economic profit.

E. There are two traditional oligopoly models1. The kinked demand curve model of oligopoly is based on the

assumption that each firm believes that if it raises its price, otherswill not follow but that if it cutsits own price, so will the otherfirms.

a) Figure 13.11shows thekinked demand curvemodel. The demand curvethat an oligopoly firmbelieves it faces has a kinkat the current price and

quantity.b) Above the kink, demand is

relatively elastic because allother firms prices remainunchanged and below thekink, demand is relativelyinelastic because all otherfirms prices change in linewith the price of the firm shown in the figure.

c) The kink in the demand curve means that the MR curve isdiscontinuous at the current quantity.

d) Fluctuations in MC that remain within the discontinuous portion

of the MR curve leave the profit-maximizing quantity and priceunchanged.

e) The beliefs that generate the kinked demand curve are notalways correct. In particular, ifMC increases enough, all firmsraise their prices and the kink vanishes.

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2. In the dominant firm oligopoly model, there is one large firm thathas a significant cost advantage over the other, smaller competingfirms and it produces a large part of the industry output.

a) The large firm operates as a monopoly, setting its price andoutput to maximize its profit.

b) The small firms act as perfect competitors, taking as given the

market price set by the dominant firm and producing output tosatisfy the remaining demand in the market.

c) Figure 13.12shows a dominant firm industry.

V. Oligopoly Games

A. Game theory is a tool for studying strategic behavior, which isbehavior that takes into account the expected behavior of others andthe recognition of mutual interdependence.

B. All games share four important features:

1. The rules of a game describe the setting of the game, the actionsthe players may take, and the consequences of those actions.

2. The strategies are all the possible actions of each player in thegame.

3. Thepayoffs are described in a payoff matrix, which is a table thatshows the payoffs for every possible action by each player for everypossible action by each other player.

4. The outcomes of a game are the results produced by the

interaction of all the choices made by each of the playersdecisions. In a Nash equilibrium, player A takes the best possibleaction given the action of player B and player B takes the bestpossible action given the action of player A.

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C. Theprisoners dilemma is a good game for illustrating these fourfeatures. The following is an example.

1. Art and Bob have been caught stealing cars. The rules of theirprisoners dilemma game are as follows:

a) Both have been convicted of committing this crime and will besentenced to two years in jail.

b) Both prisoners are also strongly suspected of committing a moreserious crime for which there exists insufficient evidence for aconviction.

c) During interrogation for the more serious crime, Art and Bob areheld in a separate cell and they cannot communicate with eachother.

d). Each is told that they are both suspected of committing themore serious crime and that the other is being asked to confessin return for a lighter prison sentence for the more seriouscrime.

e) Each prisoner is given a deal to consider: Each prisoner is told

that he will receive only a 1-year jail sentence for the seriouscrime and no time for the less serious crime (for a total of 1 yearjail time for both crimes) if he cooperates by giving up aconfession that implicates them both and the other prisonerdenies the crime. However, if he refuses to confess and hispartner does confess, then he will get the full 8 years jail termfor the serious crime a total of a 10-year sentence to be servedfor committing both crimes.

f) Each prisoner knows that if they both confess to the moreserious crime, each will receive a total of 3 years in jail forcommitting both crimes. Otherwise, if neither confesses, eachprisoner will serve only a 2-year sentence for the minor crime.

2. The strategies for both prisoners are the same:

a) Each can confess to committing the serious crime.

b) Each can denycommitting the serious crime.

3. The games payoff matrixis a table, like the one in

Table 13.1, that shows thepayoffs for every possibleaction by each player forevery possible action bythe other player.

a) In Table 13.1, Artspayoff from each

combination of actionsis shown in the top ofeach payoff box, andBobs payoff is shown inthe bottom of eachpayoff box.

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b) There are fourpossible outcomes: Bob and Art both confess (topleft payoff box), Bob and Art both deny (bottom right payoffbox), Bob confesses but Art does not (top right payoff box), andArt confesses but Bob does not (bottom left payoff box).

c) If a player makes a rational choice in pursuit of his own bestinterest, he chooses the action that is best for him given any

possible action to be taken by the other player. If both playersare rational and choose their actions in this way, the outcome iscalled a Nash equilibriumfirst proposed by John Nash.

4. The dilemma of the prisoners dilemma game is that the beststrategy is for each prisoner to confess, which does not create thebest outcome for either prisoner.

a) Regardless of Bobs decision, Arts best payoff occurs byconfessing.

b) Regardless of Arts decision, Bobs best payoff occurs byconfessing.

c) So both prisoners confess and the Nash Equilibrium outcomethat results is that each prisoner gets 3 years in jail for

committing both crimes.

d) Both players would be better off if each had denied the crime,but because they cant communicate about their decisions,there is no way to strike a deal that enables them to cooperateand get the best joint outcome.

D. An application of the prisoners dilemma can help us understand thebehavior of firms in a natural duopoly, which captures the essence ofan oligopoly market.

1. Figure 13.13 shows a natural duopoly:

a) Demand and cost conditions are such that two firms can

produce the good to satisfy demand at a lowerATC than onlyone firm or three firms.

b) The firms in a duopoly can enter into a collusive agreement,which is an agreement in which two (or more) competitors agreeto restrict output, raise the price, and increase profits.

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c) Firms that have entered into a collusive agreement have formeda cartel (which is illegal in the United States.)

2. In a cartel, each firm has two strategies:

a) Comply with the agreement

b) Cheat on the agreement

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3. There are four possiblepayoffs depending upon the strategyfollowed by each player:

a) If both firms comply, they maximize industry profit by producingthe same output as a monopoly would, charging the monopolyprice, and sharing the resulting economic profit. Figure 13.14shows this outcome.

b) If one firm cheats and the other complies, the firm that compliesincurs an economic loss, and the firm that cheats makes aneconomic profit that is larger than its share of the maximumindustry profit if it complies. Figure 13.15 shows this outcome.

c) If both firms cheat, they each earn a normal profit (zeroeconomic profit). Figure 13.16shows this outcome.

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4. Table 13.2 shows thepayoff matrix for this game.

a) The Nash equilibrium iswhere both firms cheat.

b) The quantity and priceare those of a

competitive market,and the firms earnnormal profit.

E. Another application of theprisoners dilemma can alsohelp us understand thebehavior of two firms operatingin a market of monopolisticcompetition that are engaged in developing and marketing rivalproducts. Consider the situation facing both Procter & Gamble andKimberly-Clark as they compete in the disposable diaper market:

1. The key to success for each firm is to develop a product that is

more highly valued by consumers and less costly to produce thanthe rival firm.

a) Higher valued products increase market share and increase theprice and total revenues for the firm.

b) Lower costs and higher prices combine to increase profits.

c) However, research and development (R&D) costs are high andmust be subtracted from these higher profits.

2. There are two different strategies that each firm can pursue:

a) Spend money on R&D.

b) Do not spend money on R&D.

3. The payoffmatrix in Table

13.3 illustrates the fourdifferent payoffs that canarise in this game. Thepayoff for Procter andGamble appear in the topof each box and the payofffor Kimberly-Clark appearsin the bottom of each box.

The payoff matrix has fourboxes, representing thefour possible outcomes:

a) Both firms spend

money on R&D.b. Neither firm spends

money on R&D.

c) Procter & Gamble spends on R&D and Kimberly-Clark will not.

d) Kimberly-Clark spends on R&D and Procter & Gamble will not.

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4. The Nash equilibrium outcome is that both firms spend money onR&D.

a) Regardless of what Kimberly-Clark decides to do, the beststrategy for Procter & Gamble is to spend money on R&D.

b) Regardless of what Procter & Gamble decides to do, the beststrategy for Kimberly-Clark is to spend money on R&D.

c) Both firms create innovative products that are cheaper toproduce, which benefits the consumer but fails to maximize jointprofits.

d) A dominant strategy equilibrium is a Nash Equilibriumoutcome where the best strategy for any player in the game isto cheat on the agreement (act non-cooperatively) regardless ofthe strategy of the other player.

F. A Game of Chicken

A game of chicken is exemplified by two cars racing toward eachother.

1. The first driver to swerve and avoid crashing is chicken.

2. The payoffs are a big loss for both players if no one chickens, zerofor both if both chicken, and if one chickens, a loss for the chickenand a gain for the other player.

3. R&D that creates a new technology that any firm can use is aneconomic example of the game of chicken.

4. There are two equilibrium outcomes, one in which each playerchickens (that is, each player undertakes the research) and theother player does not. This equilibrium is nota Nash equilibrium.

VI. Repeated Games and Sequential Games

A. If a game is played repeatedly, it is possible for players of the game(like in the two firms in the duopolies game) to act cooperatively andsuccessfully collude (to earn a monopoly profit).

1. Knowing that multiple chances to play the same game will occurchanges the dominant strategy for players in this type of sequentialgame.

2. Many different outcomes are possible because information aboutplayers behavior in prior games can be incorporated into currentgames.

B. For example, additional punishment strategies in a repeated prisonersdilemma duopoly game enable the firms to comply and achieve acooperative equilibrium, in which the firms make and share themonopoly profit.

1. One possible punishment strategy is a tit-for-tat strategy, in whichone player cooperates in the current period if the other playercooperated in the previous period, but cheats in the current periodif the other player cheated in the previous period.

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2. A more severe punishment strategy is a trigger strategy, in which aplayer cooperates if the other player cooperates but plays the Nashequilibrium strategy forever thereafter if the other player cheats.

C. A tit-for-tat strategy is sufficient to produce a cooperative equilibriumin a repeated duopoly game, allowing all firms to enjoy economicprofit.

1. If each firm cooperates in the first period, then this cooperationmight provide evidence of trustworthiness that the other firms canrely upon in choosing their second period strategy.

2. However, a price war might result from relying on a tit-for-tatstrategy, especially when there is the additional complication ofuncertainty about unforeseen changes in consumer demand.

a) A random decrease in demand might convince some firms tolower their price

b) It is difficult for the firms to determine if the low price is theresult of weaker demand or of non-cooperative behavior on thepart of those firms lowering their price.

c) This fall in price might result in a round of tit-for-tat punishmentby all firms.

D. However, non-cooperative outcomes are also possible if the firmsoperate in a contestable market.

1. A contestable market is a market in whichfirms can enter andleave so easily that those firms in the market face competition from

potential entrants. These firms play a sequentialentrygame.

2. Figure 13.17 shows the game tree for a sequential entry game in acontestable market.

a. In this entry game, the firms in the market set a competitiveprice and earn only a normal profit to keep the potential entrantout.

b. However, a less costly strategy is limit pricing, which sets theprice at the highest level that inflicts a loss on the entrant. Thisstrategy will keep the potential entrant out while allowing theexisting firms to earn economic profit.