Oligopoly and Monopolistic Market

Monopolistic Competition And
Oligopoly
On any given day, you are probably
exposed to hundreds of advertisements
In perfect competition and monopoly firms

do little, if any, advertising
Where, then, is all the advertising coming

from?
Hall & Leiberman; 1
Economics: Principles
The Concept of Imperfect
Competition
Refers to market structures between
perfect competition and monopoly
Types of imperfectly competitive markets

Monopolistic competition
Oligopoly
Hall & Leiberman; 2

Monopolistic Competition
Hybrid of perfect competition and
monopoly, sharing some of features of
each
A monopolistically competitive market has
three fundamental characteristics
Many buyers and sellers
Sellers offer a differentiated product
Sellers can easily enter or exit the market
Hall & Leiberman; 3

Many Buyers and Sellers
Under monopolistic competition, an individual
buyer is unable to influence price he pays
But an individual seller, in spite of having many

competitors, decides what price to charge
Hall & Leiberman; 4

Sellers Offer a Differentiated
Product
Each seller produces a somewhat different
product from the others
Faces a downward-sloping demand curve
In this sense is more like a monopolist than a
perfect competitor
When it raises its price a modest amount,
quantity demanded will decline (but not all the
way to zero)
Hall & Leiberman; 5

Sellers Offer a Differentiated
Product
What makes a product differentiated?
Product differentiation is a subjective

matter
Thus, whenever a firm (that is not a

monopoly) faces a downward-sloping
demand curve, we know buyers perceive
its product as differentiated
Hall & Leiberman; 6
Easy Entry and Exit
Same as in perfect competition
Ensures firms earn zero economic profit in
long-run
In monopolistic competition, however,
assumption about easy entry goes further
No barrier stops any firm from copying the
successful business of other firms
Hall & Leiberman; 7

Monopolistic Competition in the
Short-Run
Individual monopolistic competitor
behaves very much like a monopoly
Key difference is this

When a monopolistic competitor raises its
price, its customers have one additional
option to buy from another seller
Hall & Leiberman; 8

Figure 1: A Monopolistically
Competitive Firm in the Short Run
Dollars 1. Kafka services 250 homes
per month, where MC and
MR intersect . . .
A MC
$70 ATC
2. and charges
$70 per home.
d1
30
MR1 3. ATC at 250 units is less
4. Kafka's monthly than price, so profit per
profit$10,000is unit is positive.
the area of the
shaded rectangle.
250 Homes Serviced per Month
Hall & Leiberman; 9
The Long-Run
No barriers to entry and exitthe firm will
not enjoy its profit for long
Under monopolistic competition, firms can

earn positive or negative economic profit
in short-run
But in long-run, free entry and exit will

ensure that each firm earns zero economic
profit just as under perfect competition
Hall & Leiberman; 10
Figure 2: A Monopolistically
Competitive Firm in the Long Run
Dollars In the long run, profit attracts
entry, which shifts the firm's
demand curve leftward.
MC
ATC
E Entry continues until P = ATC

$40
at the best output level, and
The typical firm economic profit is zero. d1
produces where
its new MR MR1
crosses MC. MR2 d2
100 250 Homes Serviced

per Month
Excess Capacity Under
In long-run, a monopolistic competitor will
operate with excess capacity
Excess capacity suggests that monopolistic

competition is costly to consumers
Does that mean consumers prefer perfect

competition to monopolistic competition?

Nonprice Competition
Any action a firm takes to increase
demand for its outputother than cutting
its priceis called nonprice competition
Nonprice competition is another reason

why monopolistic competitors earn zero
economic profit in long-run
All this nonprice competition is costly

Oligopoly
An oligopoly is a market dominated by a
small number of strategically
interdependent firms
In such a market, each firm recognizes its

strategic interdependence with others

Number of Firms
Oligopoly requires that a few firms
dominate the market
No absolute number at which oligopoly

ends and monopolistic competition begins

Market Domination
Strategic interdependence requires that a
few firms dominate the market
As combined market share shrinks,
strategic interdependence becomes
weaker
Oligopoly is a matter of degree
Not an absolute classification

Economies of Scale: Natural
Oligopolies
When minimum efficient scale (MES) for a
typical firm is a relatively large percentage
of market
A large firm will have lower cost per unit than
a small firm
Does it remind you of monopoly? How is

this different?

Barriers to entry
Reputation - A new entrant may suffer just
from being new
Strategic barriers - Oligopoly firms often

pursue strategies designed to keep out
potential competitors
Legal barriers - Patents and copyrights,

Govt. legislation

Oligopoly vs. Other Market
Structures
Oligopoly presents the greatest challenge to
economists
Essence of oligopoly is strategic

interdependence
Need new tools of modeling
One approachgame theoryhas yielded rich

insights into oligopoly behavior

The Game Theory Approach
Game theory
In all games, except those of pure chance,

a players strategy must take account of
the strategies followed by other players
Game theory analyzes oligopoly decisions

as if they were games

The Prisoners Dilemma
Each of four boxes in payoff matrix represents
one of four possible strategy combinations that
might be selected in this game
Upper left box: Both Rose and Colin confess
Lower left box: Colin confesses and Rose
doesnt
Upper right box: Rose confesses and Colin
doesnt
Lower right box: Neither Rose nor Colin
confesses

Figure 3: The Prisoners Dilemma
Colins Actions
Confess Dont Confess
Colin gets Colin gets
20 years 30 years
Confess Rose Rose
gets 20 gets 20
years years
Roses Actions
Colin gets Colin gets
3 years 5 years
Dont Confess Rose Rose
gets 20 gets 20
years years
The Prisoners Dilemma
Regardless of Roses strategy Colins best choice is to
confess
Confess is the dominant strategy for both
Outcome of this game is an example of a Nash

equilibrium
As long as each player acts in an entirely self-interested

manner Nash equilibrium is best outcome for both of
them

Simple Oligopoly Games
To apply the same method to a simple oligopoly
market
Duopoly - Oligopoly market with only two sellers
Assume that Gus and Filip must make their
decisions independently
No matter what Filip does, Guss best move is to
charge a low pricehis dominant strategy
The same holds for Filip
The outcome is a Nash equilibrium

Figure 4: A Duopoly Game
Guss Actions
Confess Dont Confess
Guss profit Guss profit
= $25,000 = $10,000
Confess Filips Filips
Profit = Profit =
$25,000 $75,000
Filips Actions
Guss profit Guss profit
= $75,000 = $50,000
Dont Confess
Filips Filips
Profit = Profit =
$10,000 $50,000

Oligopoly Games in the Real World
Will typically be more than two strategies from
which to choose
Will usually be more than two players
In some games, one or more players may not
have a dominant strategy
A game with two players will have a Nash equilibrium
as long as at least one player has a dominant
strategy
When neither player has a dominant strategy, we

need a more sophisticated analysis to predict an
outcome to the game
Oligopoly Games in the Real World
Weve limited the players to one play of
the game
In reality, for gas stations and almost all other
oligopolies, there is repeated play
Where both players select a strategy
Observe the outcome of the trial
Play the game again and again, as long as they
remain rivals
One possible result of repeated trials is
cooperative behavior
Cooperative Behavior in Oligopoly
In real world, oligopolists will usually get
more than one chance to choose their
prices
The equilibrium in a game with repeated

plays may be very different from
equilibrium in a game played only once

Explicit Collusion
Simplest form of cooperation is explicit collusion
Most extreme form of explicit collusion is

creation of a cartel
If explicit collusion to raise prices is such a good

thing for oligopolists, why dont they all do it?
But oligopolists can collude in other, implicit

ways

Tacit Collusion
Any time firms cooperate without an explicit
agreement, they are engaging in tacit collusion
Tit for tat
A game-theoretic strategy of doing to another player
this period what he has done to you in previous
period
However, gentle reminder of tit-for-tat is not
always effective in maintaining tacit collusion

Tacit Collusion
Another form of tacit collusion is price
leadership
With price leadership, there is no formal

agreement

The Limits to Collusion
Oligopoly powereven with collusion
has its limits
Even colluding firms are constrained by
market demand curve
Collusioneven when it is tacitmay be
illegal
Collusion is limited by powerful incentives to
cheat on any agreement

The Incentive to Cheat
Go back to Gus and Filip for a moment
One way or another they arrive at high-price
cooperative solution
Will the market stay there?
Each player has an incentive to cheat
Analyzing this sort of behavior requires some

rather sophisticated game theory models

When is Cheating Likely?
Cheating is most likely to occurand collusion
will be least successfulunder the following
conditions
Difficulty observing other firms prices
Unstable market demand
Large number of sellers

Figure 5a: Advertising in
1.Before advertising, long-run 2. In the short run, the first firms to
economic profit is zero. advertise earn economic profit.
Dollars 3. But in the long run, imitation

B and entry bring economic
$120
C profit back to zero.
100
ATCads
ATCno ads
A
60
4. Advertising dads
can lead to a
higher price dall advertise
in the long dno ads
run, as in this
panel . . . 1,000 6,000 Bottles of Perfume
2,000 per Month
Figure 5b: Advertising in
Dollars dall advertise 5. or to a lower price

B in the long run, as
$120
in this panel.
A
60 C ATCads
50 ATCno ads
dno ads dads
1,000 6,000 Bottles of Perfume

2,000 per Month
Using the Theory: Advertising in
Monopolistic Competition and Oligopoly
Perfect competitors never advertise and
monopolies advertise relatively little
But advertising is almost always found under
monopolistic competition and very often in oligopoly
Why?
All monopolistic competitors, and many oligopolists,
produce differentiated products
Since other firms will take advantage of
opportunity to advertise, any firm that doesnt
advertise will be lost in shuffle
Advertising and Collusion in
Oligopoly
Oligopolists have a strong incentive to
engage in tacit collusion
Take airline industry as an example

In theory, any airline should be able to
claim superior safety
Yet no airline has ever run an advertisement
with information about its security policies or
attacked those of a competitor
Figure 6: An Advertising Game
American's Actions
Run Safety Ads Don't Run Ads
American American
earns low earns very
profit low profit
Run Safety Ads
United United
earns low earns high
profit profit
United's Actions American American
earns high earns
profit medium
Don't Run Ads United
profit
United earns
earns very medium
low profit profit
The Four Market Structures: A
Postscript
Different market structures
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Market structure models help us organize
and understand apparent chaos of real-
world markets


Oligopoly and Monopolistic Market

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Monopolistic Competition And

In perfect competition and monopoly firms

Where, then, is all the advertising coming

Types of imperfectly competitive markets

Hall & Leiberman; 2

Hall & Leiberman; 3

But an individual seller, in spite of having many

Hall & Leiberman; 4

Hall & Leiberman; 5

Product differentiation is a subjective

Thus, whenever a firm (that is not a

Hall & Leiberman; 7

Key difference is this

Hall & Leiberman; 8

Under monopolistic competition, firms can

But in long-run, free entry and exit will

E Entry continues until P = ATC

100 250 Homes Serviced

Excess capacity suggests that monopolistic

Does that mean consumers prefer perfect

Hall & Leiberman; 12

Nonprice competition is another reason

All this nonprice competition is costly

Hall & Leiberman; 13

In such a market, each firm recognizes its

Hall & Leiberman; 14

No absolute number at which oligopoly

Hall & Leiberman; 15

Hall & Leiberman; 16

Does it remind you of monopoly? How is

Hall & Leiberman; 17

Strategic barriers - Oligopoly firms often

Legal barriers - Patents and copyrights,

Hall & Leiberman; 18

Essence of oligopoly is strategic

Need new tools of modeling

One approachgame theoryhas yielded rich

Hall & Leiberman; 19

In all games, except those of pure chance,

Game theory analyzes oligopoly decisions

Hall & Leiberman; 20

Hall & Leiberman; 21

Confess is the dominant strategy for both

Outcome of this game is an example of a Nash

As long as each player acts in an entirely self-interested

Hall & Leiberman; 23

Hall & Leiberman; 24

Hall & Leiberman; 25

When neither player has a dominant strategy, we

The equilibrium in a game with repeated

Hall & Leiberman; 28

Most extreme form of explicit collusion is

If explicit collusion to raise prices is such a good

But oligopolists can collude in other, implicit

Hall & Leiberman; 29

Hall & Leiberman; 30

With price leadership, there is no formal

Hall & Leiberman; 31

Hall & Leiberman; 32

Analyzing this sort of behavior requires some

Hall & Leiberman; 33

Hall & Leiberman; 34

Dollars 3. But in the long run, imitation

Dollars dall advertise 5. or to a lower price