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MICROECONOMICS
TOPIC 9
i. Monopolistic competition
ii.Oligopoly
AFTER LEARNING TOPIC 9, YOU SHOULD BE ABLE TO:
1. Explain what is monopolistic competition
2. Understand the differences among monopolistic competition, competitive
markets, and monopoly?
3. Explain why advertising is prevalent in monopolistic competition
4. Explain what is oligopoly
5. Understand how game theory explains strategic behavior
6. Explain how government policies affect oligopoly behavior
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COMPARING MARKET STRUCTURES
WHAT ARE SOME WAYS FIRMS DIFFERENTIATE THEIR PRODUCTS?
• Style or type
• Location
• Quality
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• Perfect competition:
o Low prices
o Efficient level of output
• Monopoly:
oHigh prices
o Inefficient level of output
• Monopolistic competition:
o ?
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DIFFERENCES AMONG THE THREE MARKET TYPES
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MONOPOLISTIC COMPETITION IN THE SHORT RUN
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Since there is free entry and exit:
• If there are short-run profits, new firms
will enter.
o A firm’s demand curve will decrease
and become more elastic.
o Entry will continue until profits are equal
to zero.
• If there are short-run losses, new firms
will exit.
o A firm’s demand curve will increase and
become less elastic.
o Exit will continue until profits are equal
to zero.
MONOPOLISTIC COMPETITION IN THE LONG RUN
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LR EQUILIBRIUM IN TWO MARKET STRUCTURES - 1
• Perfect competition: P = MC.
oMonopolistic competition: P > MC.
oMarkup: P – MC.
• Perfect competition: P = min. ATC.
oMonopolistic competition: P > min. ATC.
• Scale and output
o Perfect competition: In the long run, a firm produces at minimum efficient scale.
o Monopolistic competition: In the long run, a firm produces with excess capacity.
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MONOPOLISTIC COMPETITION AND COMPETITIVE MARKETS
INEFFICIENCY AND SOCIAL WELFARE
• Is monopolistic competition efficient? No
o Two sources of inefficiency:
❖ATC is higher compared to perfect competition.
❖Markup: P > MC.
• Inefficiency here can be thought of as:
oReduced number of transactions (compared to perfect competition).
o Existence of DWL (compared to zero in perfect competition).
oHowever, this inefficiency is small compared to monopoly inefficiency.
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WHY IS ADVERTISING PREVALENT IN MONOPOLISTIC COMPETITION?
• Why do firms advertise?
o To change the demand for the product.
• Draws new demand. Demand increases (shifts right) in response to the additional
demand created by the advertising.
• The demand curve becomes more inelastic.
o Advertising makes a product more attractive to specific customers who are now more
likely to want it.
o Since demand is more inelastic, the firm has more market power and can increase the
price it charges.
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• Perfect competition:
o Firms that advertise will have higher costs than rivals, without any gains.
o Advertising at the industry level.
• Monopolistic competition:
o Advertising can increase demand for single firm’s product.
oGains from advertising go to the firm.
oWant some pizza?
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ADVERTISING IN DIFFERENT MARKETS - 1
• Monopoly:
o Advertising less likely since the product has no close substitutes and consumer choice
is limited.
oMay advertise simply to inform consumer about the product and stimulate demand.
• Sometimes, a monopoly may try to increase demand just by letting “unaware”
consumers know about the product.
• Other times, it may just be a “reminder” of the product
to stimulate demand.
• Think about diamond commercials around Valentine’s Day.
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ADVERTISING IN DIFFERENT MARKETS - 2
• The paradox of advertising:
• Suppose Domino’s advertises.
• All else equal, its sales will increase, and it will be able to recover its costs.
• But, Pizza Hut will respond with its own advertising campaign.
• Net result: sales remain the same, but both firms have higher costs.
• Inspires brand loyalty:
• More inelastic demand,
• Raises prices to consumers.
Want to buy some pearls?
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NEGATIVE EFFECTS OF ADVERTISING
$43 $300
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OLIGOPOLY AND STRATEGIC BEHAVIOR
WHAT IS OLIGOPOLY
A market structure with
❖Small number of firms
❖With high barriers to entry, and
❖Often selling a differentiated product
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COOPERATION VERSUS SELF INTEREST – AN EXAMPLE
• Two cell phone carriers in a small town: Horizon and AT-Phone.
• Each firm has excess capacity, so marginal cost of additional customer is
zero.
• Want to see how the outcome under duopoly compares to the competitive
and monopoly outcome.
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CELL PHONE MARKET - 1
Monopoly Outcome
Competitive Outcome
CELL PHONE MARKET - 2
Duopoly outcome:
• What do Horizon and AT-Phone do if they collude (form a cartel)?
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Cartel Outcome
Why is this collusive outcome likely to fail?
Collusive outcome fails because:
• If AT-Phone believes that Horizon will maintain the agreement, they will
want to cut prices in order to be able to serve more customers.
• But if AT-Phone cuts their price, Horizon would want to cut their price as
well, to maintain their market share.
• So what price will each firm set? How many customers will they serve?
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CELL PHONE MARKET - 3
MUTUAL INTERDEPENDENCE
• A market situation in which the actions of one firm have an impact on the
price and output of its competitors.
• AT-Phone’s response depends on the actions of Horizon, and Horizon’s
response depends on the actions of AT-Phone.
• Interdependence occurs in oligopoly due to the size of each individual firm.
• When one firm owns a sizable share of the market, the decisions made by
that one firm affect the market in a noticeable way and therefore affect the
decisions of competing firms.
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• How many customers will each firm serve? What price will each firm
charge (In Tutorial)
• What we want to do is find a pair of outputs (customers), so that neither
firm has an incentive to change their output: Nash equilibrium.
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CELL PHONE MARKET - 4
• Suppose a third firm enters the market, builds a new cell tower, and increases
supply. It is harder to maintain a cartel as the number of firms increases. Why?
• Two effects:
o Price effect: Reflects how a change in price affects the firm’s revenue.
oOutput effect: Occurs when a change in price affects the number of customers.
• With more firms, the market share of each firm gets smaller, and when the cheater
expands its output, the impact on the market price will be smaller
o Price effect is smaller relative to output effect.
• Cheating by smaller firms will have less of an impact than larger firms.
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OLIGOPOLY - MORE THAN TWO FIRMS
• Game theory:
o Branch of mathematics that economists use to analyze strategic behavior of
decision-makers.
• Basic components of a game:
o Players, strategies, and payoffs.
• Games can be played simultaneously or sequentially.
• Prisoner’s dilemma:
o Two suspects are interrogated separately.
o Each has the option to testify or keep quiet.
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HOW DOES GAME THEORY EXPLAIN STRATEGIC BEHAVIOR?
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PRESENTING THE PRISONER’S DILEMMA
GAME THEORY
• Dominant strategy:
o A best response for a player to choose no matter what the other player
chooses.
o If each player has a dominant strategy, that makes up a dominant strategy
equilibrium.
• Nash equilibrium:
o Each decision-maker is choosing his or her best response to what the other decision-
maker has chosen.
o A pair of strategies, one for each player, so that neither player will want to unilaterally
deviate. This means that there is no incentive for either decision- maker to change what
he or she is doing.
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ANALYZING THE PRISONER’S DILEMMA
TO DO IN TUTORIAL
• The prisoner’s dilemma captures the idea that cooperation is unstable.
• But firms do collude, and people do cooperate, so what’s wrong with our
analysis?
o It’s only played once. Most interactions occur over the long run.
o Players play a repeated game.
oCompare the short-run gains from cheating to the long-run losses you would
suffer if cooperation breaks down.
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ESCAPING THE PRISONER’S DILEMMA
• So far all the games we’ve seen had a dominant strategy.
• We also saw that if both players have a dominant strategy, that outcome is
a Nash equilibrium.
• In many games, neither player has a dominant strategy.
• And in some games, there is either no Nash equilibrium or multiple Nash
equilibria.
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GAME THEORY: SOME EXTENSIONS
MARKET STRUCTURES – FINAL COMPARISON
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Price Taking
Perfect Competition
Price Making
Monopolistic
Competition
Price Making
Oligopoly
Price Making
Monopoly
Number of firms Many firms Many firms Few firms One firm
Market power Firms are so small
that no single buyer
or seller has ANY
control over price
Each firm has some
control over price
Medium-to-high
barriers to entry; the
firm has more
control over price
Extremely high
barriers to entry; the
firm has significant
control over price
Product/output Homogeneous
output
Product
differentiation
Output can be
homogeneous or
differentiated
The firm IS the
industry
Barriers to entry Easy entry/exit Weak/no barriers Strong barriers Very strong barriers
Other features Perfect information Long-run economic
profit not possible
Mutual
interdependence
Long-run economic
profit possible