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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 MCD2020 2 MCD2020 3 COMPARING MARKET STRUCTURES WHAT ARE SOME WAYS FIRMS DIFFERENTIATE THEIR PRODUCTS? • Style or type • Location • Quality MCD2020 4 • Perfect competition: o Low prices o Efficient level of output • Monopoly: oHigh prices o Inefficient level of output • Monopolistic competition: o ? MCD2020 5 DIFFERENCES AMONG THE THREE MARKET TYPES MCD2020 6 MONOPOLISTIC COMPETITION IN THE SHORT RUN MCD2020 7 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 MCD2020 8 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. MCD2020 9 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. MCD2020 10 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. MCD2020 11 • 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? MCD2020 12 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. MCD2020 13 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? MCD2020 14 NEGATIVE EFFECTS OF ADVERTISING $43 $300 MCD2020 15 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 MCD2020 16 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. MCD2020 17 MCD2020 18 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)? MCD2020 19 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? MCD2020 20 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. MCD2020 21 • 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. MCD2020 22 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. MCD2020 23 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. MCD2020 24 HOW DOES GAME THEORY EXPLAIN STRATEGIC BEHAVIOR? MCD2020 25 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. MCD2020 26 MCD2020 27 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. MCD2020 28 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. MCD2020 29 GAME THEORY: SOME EXTENSIONS MARKET STRUCTURES – FINAL COMPARISON MCD2020 30 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