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1 CHAPTER 7: CHAPTER 7: MARKET STRUCTURE: MARKET STRUCTURE: MONOPOLISTIC COMPETITION MONOPOLISTIC COMPETITION & & OLIGOPOLY OLIGOPOLY
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CHAPTER 7: CHAPTER 7: MARKET STRUCTURE: MARKET STRUCTURE:
MONOPOLISTIC COMPETITION MONOPOLISTIC COMPETITION &&
OLIGOPOLYOLIGOPOLY
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7.1 Characteristic of Monopolistic Competition
7.2 Short-run Decision: Profit Maximization
7.3 Short-run Decision: Minimizing Loss
7.4 Long-run Equilibrium
7.5 Economic Efficiency and Resource Allocation
Chapter Outline
7.6 Characteristic of Oligopoly
7.7 Oligopoly Model
7.8 Games Theory
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Chapter Outline
Definition:A common form of industry (market)
structure characterized by a large number of small firms, none of which can influence market price by virtue of size alone.
Some degree of market power is achieved by firms producing differentiated products.
New firms can enter and established firms can exit such an industry with ease.
For example: an individual restaurant
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MONOPILSTIC COMPETITION
Large number of sellersA large number of firms but it is less than
perfect competition.The size of each firm is small and therefore, no
individual firm can influence the market price.
Product differentiationThe firms produce goods which are
differentiated, that is, they are not identical.Each seller will use various methods to
differentiate their products from other sellers.Differentiation of the product may be through
the packaging, design, labeling, advertising and brand names.
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characteristic.. Free entry & exit
There are no barriers to entry in monopolistic competition, so firms cannot earn an economic profit in the long run.
AdvertisingEach firm tries to promote its product by
using different types of advertisements include banners, media advertisements, pamphlets etc.
provides consumers with the valuable information on product availability, quality, and price.
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characteristic..
Non-price competitionMonopolistic do not compete base on
price as they are price takers.They create a sense of brand
consciousness among customers.Types of non-price competition are
advertisements, promotions, discounts, free gifts and so on.
When MR = MC;
The profit-maximizing quantity occurs while the price is found up on the demand curve at that quantity .
The firm in monopolistic competition makes its output and price decision just like a monopoly firm does.
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Profit ???
SUPERNORMAL PROFIT
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Loss ???
SUBNORMAL PROFIT
NORMAL PROFIT?
There is not guaranteed an economic profit in the market.
When ATC > demand curve, no quantity allows the firm to escape a loss.Firm must decide whether to produce at a loss
or choose to shut down. Keep production:
As long as price exceeds AVC. Shut down:
If the price cannot cover the AVC.
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7.3 SHORT-RUN DECISION: MINIMIZING LOSS
Firm will continue to produce in the short run if the price exceeds AVC.
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SHORT-RUN DECISION: MINIMIZING LOSS
Free entry: If the firms are making supernormal
profit in the short-run, they will attract more firms to enter the market.
Decrease the demand for existing firms, so the demand curve will shift leftward.
The process will continue until all profits are eliminated and (P = ATC).
In the long-run, a monopolistic firm will earn normal profit.
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7.4 LONG-RUN EQUILIBRIUM
Free entry:
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LONG-RUN EQUILIBRIUM
Quantity
Price
MCATC
DD0 DD1 MR
P0
P1= ATC
Q
Free exit: If the firms are making subnormal profit
in the short-run, the existing firms will exit from the market.
Increase the demand for existing firms, so the demand curve will shift rightward.
The process will continue until all losses are eliminated and (P = ATC).
In the long-run, a monopolistic firm will earn normal profit.
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LONG-RUN EQUILIBRIUM
LONG-RUN EQUILIBRIUM
Free exit?
There are two noteworthy differences between monopolistic and perfect competition excess capacity and markup over MC.
Excess CapacityFree entry results in competitive firms
producing at the point where ATC is minimized, which is the efficient scale of the firm.
In monopolistic competition, the firm has excess capacity if its output is less than the efficient scale of perfect competition.
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7.5 ECONOMIC EFFICIENCY AND
RESOURCE ALLOCATION
Mark up over marginal cost
For a competitive firm, price equal marginal cost.
For a monopolistically competitive firm, price exceeds marginal cost because the firm has some market power.
Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically firm.
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Monopolistic versus perfect competition
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D
Quantity
Price
MCATC
MR
P
QMC
Price
Quantity
MCATC
P=MRP=MC
QPC
(efficient scale)
a) Monopolistic b) Perfect Competition
MC
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OLIGOPOLY• Definition:
– A form of industry (market) structure characterized by a few dominant firms.
– Products may be homogenous or differentiated.
– The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others (interdependent).
– For example: automobile industry/ petroleum
Few in number but large in sizeThe market share of each firm is large enough
to dominate the market and its controlled by a few firms.
InterdependentThe behavior of oligopoly firms depend on the
behavior of other firms in the industry before making the decision.
Homogeneous or differentiated productThe products sold may be homogeneous or
differentiated.Example: Petroleum (homogenous) and
automobiles (differentiated). 23
characteristic Barriers to entry
Advertising a new product enough to compete with established brands.
Incentive to colludeColluding firms usually reduce output,
increase price, and block the entry of new firms to achieve the monopoly power.
Price Rigidity and Kinked Demand Curve
Price rigidity explain the behavior of an oligopoly firm which has no incentive to either increase or decrease the price of its products.
The theory of a kinked demand curve is based on two assumptions: If an oligopoly reduces the price of his product, his
rivals will follow and reduces their price too, so as to avoid losing customers.
If an oligopolist increase the price of his products, his rival will not increase their price but instead maintain the same prices, thereby gaining customers from which firms which increase their price.
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Price Rigidity and Kinked Demand Curve (continue..)
Based on this two assumptions, oligopoly will face a kinked demand curve.
It assumes that rivals will match a price cut but ignore a price increase.
The kinked demand curve creates a gap in the MR curve, illustrates the price rigidity of a firm in an oligopoly.
Equilibrium price and quantity occur at P* and Q*, when MR = MC.
As long as MR intersect with MC curve in the gap, price and output will remain constant.
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• Demand is elastic above the kink, where an increase in price to more than P* will lead to a large drop in quantity as more customers switch to the rival’s lower priced product.
• Demand is inelastic below the kink where decreasing the price will only reflect a small increase in quantity since all the other firms have reduced their price to below P*.
Kinked Demand Curve
elastic
inelastic
Definition:Analyzes oligopolistic behavior as a complex
series of strategic moves and reactive countermoves among rival firms.
In game theory, firms are assumed to anticipate rival reactions.
Types:Dominant strategiesNash equilibriumPrisoners’ dilemma
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“If I believe that my competitors are rational and act to maximize their own profits, how should I take their behavior into account when making my own profit-maximizing decisions?”
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Definition:Dominant Strategy is one that is optimal no
matter what an opposition does. Example:
A & B sell competing productsThey are deciding whether to undertake
advertising campaigns.Their decision is interdependence on other firm
decision.
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Payoff Matrix for Advertising Game: (A,B)F
irm
A
AdvertiseNot
Advertise
Advertise
NotAdvertise
Firm B
10, 5 15, 0
10, 26, 8
Dominant Strategies
A A B
A
A
A
What strategy should each firm choose?
Game TheoryGame Theory
A B
A B A B
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Firm A:
If firm B does advertise, Firm A will earn a profit of 10 if it also advertise and 6 if it doesn’t.
Thus, firm A should advertise if firm B advertise.
If firm B doesn’t advertise, firm A would earn profit of 15 if it advertise and 10 if it doesn’t.
Thus, firm A should advertise whether firm B advertise or not.
Firm A has dominant strategy!
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Firm B:
If firm A does advertise, Firm B will earn a profit of 5 if it also advertise and 0 if it doesn’t.
Thus, firm B should advertise if firm A advertise.
If firm A doesn’t advertise, firm B would earn profit of 8 if it advertise and 2 if it doesn’t.
Thus, firm B should advertise whether firm A advertise or not
Firm B has dominant strategy!
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• Observations– Dominant
strategy for A & B is to advertise
– Do not worry about the other player
– Equilibrium in dominant strategy
Firm A
Advertise
NotAdvertise
Advertise
NotAdvertise
Firm B
10, 5 15, 0
10, 26, 8
Both firms with advertise.
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Equilibrium in dominant strategies
Outcome of a game in which each firm is doing the best it can regardless of what its competitors are doing.
Optimal strategy is determined without worrying about actions of other players.
However, not every game has a dominant strategy for each player
Definition:When all players are playing their best
strategy given what their competitors are doing.
Game Without Dominant StrategyThe optimal decision of a player without a
dominant strategy will depend on what the other player does.
Revising the payoff matrix we can see a situation where no dominant strategy exists.
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10, 5 15, 0
20, 26, 8
Fir
m A
Advertise
NotAdvertise
Advertise
NotAdvertise
Firm B
Nash Equilibrium
A
A
A
A
B
B
B
B
What strategy should each firm choose?
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10, 5 15, 0
20, 26, 8
Firm A
AdvertiseDon’t
Advertise
Advertise
Don’tAdvertise
Firm B
• Observations– A: No dominant
strategy; depends on B’s actions
– B: Dominant strategy is to Advertise
– Firm A determines B’s dominant strategy and makes its decision accordingly
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• In order for firm A to determine whether to advertise, firm A must first try to determine what firm B will do.
• If firm B advertises, firm A earns a profit of 10 if it advertises and 6 if it does not.
• If firm B does not advertise, firm A earns a profit of 15 if it advertises and 20 if it does not.
• Thus, firm A should advertise if firm B advertise, and it should not advertise if firm B doesn’t.
10, 5 15, 0
20, 26, 8
Firm A
Advertise
NotAdvertise
Advertise
NotAdvertise
Firm B
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• Firm A has to determines B’s dominant strategy and makes its decision accordingly.
• Firm B’s dominant strategy is to advertise, therefore, the optimal strategy for firm A is also to advertise. This is Nash equilibrium.– Only when each player
has chose its optimal strategy given the strategy of the other player do we have Nash equilibrium.
10, 5
15, 0
20, 26, 8
Firm A
Advertise
NotAdvertise
Advertise
NotAdvertise
Firm B
Definition:The players are prevented from cooperating
with each other;Each player in isolation has a dominant
strategy;The dominant strategy makes each player
worse off than in the case in which they could cooperate.
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Prisoners’ DilemmaF
irm
A
Low Price High Price
Low Price
High Price
Firm B
2, 2 5, 1
3, 3 1, 5
What strategy should each firm choose?
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Firm A:
• If firm B charged a low price, firm A would earn a profit of 2 if it also charged the low price and 1 if it charge a high price.
• If firm B charged the high price ,firm A would earn a profit of 5 if it charged the low price and 3 if it charged the high price.
• Thus, firm A should adopt its dominant strategy of charging the low price.
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Firm B:
• If firm A charged a low price, firm B would earn a profit of 2 if it also charged the low price and 1 if it charge a high price.
• If firm A charged the high price, firm B would earn a profit of 5 if it charged the low price and 3 if it charged the high price.
• Thus, firm B should adopt its dominant strategy of charging the low price.
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• However, both firms could do better (i.e., earn higher profit of 3) if they cooperated and both charged the higher price (the bottom right cell).
• Thus, both firms are in a prisoners’ dilemma:– Each firm will charge the lower price and
earn a smaller profit because if it charges the high price, it cannot trust its rival to also charge the high price.
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• Suppose that firm A charged the high price with the expectation that firm B would also charge the high piece (so that each firm would earn a profit of 3).
• Given that firm A has charged the higher, however, firm B now has an incentive to charge the low price, because by doing so it can increase its profits to 5.
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• Suppose that firm B charged the high price with the expectation that firm A would also charge the high piece (so that each firm would earn a profit of 3).
• Given that firm B has charged the higher, however, firm A now has an incentive to charge the low price, because by doing so it can increase its profits to 5.
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• The net result is that each firm charges the low price and earns a profit of only 2.
• Only if the two firms cooperate and both charge the high price will they earn the highest profit of 3 (and overcome their dilemma)
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• Conclusion:
• The concept of the prisoner’s dilemma can be used to analyze price and non-price competition in oligopolistic markets, as well as the incentive to cheat in a cartel (i.e., the tendency to secretly cut prices or to sell more than the allocated quota.
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Game TheoryGame Theory
• Ginger and Rocky have dominant strategies to confess even though they would be better off if they both kept their mouths shut.
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Comparison for Market Structure
Characteristics of Different Market Organizations
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