Weekly Lecture: Week 07
Chaps 13 –Monopolistic Competition and Oligopoly
CHAPTER ROADMAP
 What
’
sNe
wi
nt
hi
sEdi
t
i
on?
Chapter 13 has been slightly revised.
 Where We Are
In this chapter, we examine two more market structures, monopolistic competition
and oligopoly. The profit-maximizing quantity and price for monopolistic competition
is discussed. The chapter shows why firms in monopolist competition decide to
advertise, use brand names, and develop new products. Then the chapter moves to
oligopoly. It expla
i
nst
heol
i
g
opol
i
s
t
s
’di
l
e
mmaa
ndt
he
nus
e
sga
met
he
or
yt
oe
xpl
or
e
the behavior of oligopolists.
 Whe
r
eWe
’
veBe
e
n
The previous chapters studied perfectly competitive firms and monopoly firms. The
material dealing with monopoly is used in this chapter because monopolistic
competition is similar in some regards to monopoly.
 Whe
r
eWe
’
r
eGoi
ng
The next chapter starts to study macroeconomics.
CHAPTER LECTURE
13.1 What is Monopolistic Competition?
Monopolistic competition is a market structure in which
 A large number of firms compete. Each firm has a small market share and
collusion is impossible.
 Each firm produces a differentiated product. Product differentiation means
that each firm makes a product that is slightly different from the products of
competing firms. Some people will pay more for one variety of a product, so
t
hede
ma
ndc
ur
vef
ort
hef
i
r
m’
spr
oduc
ti
sdownwa
r
ds
l
oping.
 Firms compete on product quality, price, and marketing.
 Firms are free to enter and exit the market.
Identifying Monopolistic Competition
There are two measures of market concentration used to help identify whether a
market is competitive or dominated by a small number of firms:
 The four-firm concentration ratio is the percentage of the total revenue
accounted for by the four largest firms in the industry. The four-firm
1
concentration ratio ranges between near 0 (extremely competitive) to 100 (not
very competitive).
 The Herfindahl–Hirschman Index (HHI) is the square of the percentage
market share of each firm summed over the largest 50 firms (or summed over
all the firms if there are fewer than 50) in a market. The HHI ranges between
near 0 (extremely competitive) to 10,000 (a monopoly).
 The U.S. Justice Department uses the HHI to classify markets:
 Markets with an HHI of less than 1,000 are regarded as highly
competitive
 Markets with an HHI of between 1,000 and 1,800 are regarded as
moderately competitive.
 Markets with an HHI above 1,800 are regarded as concentrated.
TheFi
r
m’
sPr
of
i
t
-Maximizing Decisions
 In the short run, a monopolistically
competitive firm makes its output
and price decisions just like a
monopoly firm. The figure shows a
monopol
i
s
t
i
c
a
l
l
yc
ompe
t
i
t
i
vef
i
r
m’
s
downward sloping demand curve and
the downward sloping MR curve that
lies below the demand curve.
 The firm maximizes its profit by
producing the quantity where MR =
MC and using the demand curve to
set the highest price at which people
will buy the quantity it produces. In the figure, the firm produces 20 pizzas per
hour and sets a price of $16 per pizza.
 The firm in the figure makes an economic profit because P > ATC. The
amount of the economic profit is equal to the area of the darkened rectangle.
 If P < ATC, the firm incurs an economic loss. The firm will shut down if P <
AVC, so the maximum loss the firm will incur is equal to its fixed costs.
2
Long Run: Zero Economic Profit
 Unlike a monopoly, firms in
monopolistic competition cannot
make an economic profit in the long
run. If the firms are making an
economic profit, other firms enter
the market. Entry continues as long
as firms in the industry make an
economic profit. As firms enter,
each existing firm loses some of its
market share. The demand for each
f
i
r
m’
spr
oduct decreases and the
f
i
r
m’
sde
ma
ndc
ur
ves
hi
f
t
sl
e
f
tward.
 Eventually the demand decreases enough so that the firms make zero
economic profit, where P = ATC. Entry then stops. This outcome is illustrated
in the figure, in which the firm produces 13 pizzas per hour (where MR=MC)
and sets a price of $12 per pizza.
Monopolistic Competition and Perfect Competition
Because price exceeds marginal cost, monopolistic competition creates
deadweight loss. Firms in monopolistic competition have higher costs than
firms in perfect competition, but firms in monopolistic competition produce
variety, which is valued by consumers. So compared to the alternative of
complete uniformity, monopolistic competition is efficient.
Unlike firms in perfect competition, firms in monopolistic competition have
excess capacity:
 Excess Capacity: A firm has excess capacity if it produces less than the
quantity at which average total cost is a minimum. The quantity at
which average total cost is a minimum is the efficient scale. A firm in
perfect competition produces at the efficient scale but, as the figure
above shows, a firm in monopolistic competition produces less than
the efficient scale of output.
13.2 Product
Development and Marketing
Innovation and Product Development
Monopolistically competitive firms compete through product development
and marketing. New product development allows a firm to gain a temporary
competitive edge and economic profit before competitors imitate the
3
innovation. A firm decides upon the extent of innovation and product
development by comparing the marginal cost of innovation or product
development to its marginal revenue.
Marketing
 Marketing and packaging allow a firm to differentiate its product.
Firms in monopolistic competition incur heavy advertising
expenditures which make up a large portion of the price it charges for
the product.
 Selling costs, such as advertising, are fixed costs that increase the ATC
at any given level of output but do not affect the MC. The ATC curve
shifts upward but the MC curve does not shift. Advertising efforts are
successful if they increase demand, which can lead to increased profit.
But if all firms advertise, more firms might survive and so the demand
for any one firm is less than otherwise.
 Advertising and marketing names are expensive. To the extent that they
provide the consumer with valuable information, they are a benefit of
monopolistic competition. But in some instances it seems as if the cost
exceeds the benefit. So, ultimately the total efficiency of monopolistic
competition is ambiguous.

13.3 Oligopoly
Oligopoly is characterized by having a small number of firms competing and natural
or legal barriers preventing the entry of new firms.
Collusion
 Because there are a small number of firms, the firms are interdependent so that
e
a
c
hf
i
r
m’
sa
ctions influence the profits of the other firms.
 Because there are a small number of firms, the firms in an oligopoly might
form a cartel. A cartel is a group of firms acting together to limit output, raise
price, and increase economic profit. Cartels are illegal in the United States.
 A duopoly is a market with only two producers.
Range of Possible Oligopoly Outcomes
An oligopoly might operate like a monopoly, like perfect competition, or somewhere
between these two alternatives:
 Competitive Outcome
4
A competitive outcome occurs when the firms produce the level of output
determined by the intersection of the industry supply curve (the marginal
cost curve) and the market demand curve.
The price is the lowest and the joint total profit is the smallest with this
outcome.
 Monopoly Outcome
The firms form a cartel in order to reach the monopoly outcome. A
monopoly outcome occurs when the firms produce the same level of
output as a single-price monopoly at the intersection of the marginal cost
and marginal revenue curves.
The price is highest and the joint total profit is the largest with this outcome.
TheDuopol
i
s
t
s
’Di
l
e
mma
 If an oligopoly has formed a cartel that sets the monopoly price and quantity,
then each firm has the incentive to cheat on the agreement by increasing its
out
puta
ndc
ut
t
i
ngi
t
spr
i
c
ebe
c
a
us
et
hi
sa
c
t
i
onboos
t
st
hef
i
r
m’
spr
of
i
t
.I
fa
l
l
the firms cheat, the cartel can break down and the outcome will be closer to, or
the same as, the competitive outcome.
 13.4 Game Theory
Game theory is a tool for studying strategic behavior—behavior that takes into
account the expected behavior of others and the recognition of mutual
interdependence. Games have rules, strategies, payoffs, and outcomes.
ThePr
i
s
one
r
s
’Di
l
emma
 Art (A) and Bob (B) have been caught stealing cars. Both men are scheduled
to be sentenced to two years in jail for this crime. Both are suspected of
committing a more serious crime for which the prosecutor has insufficient
evidence for a conviction. The two men are each interrogated for the more
serious crime in separate cells. Each prisoner is told that if he confesses and
his partner denies, he will serve 1 year in jail and his partner will serve 15
years, while if both confess, both serve 4 years.
5
 Thega
me
’
spayoff matrix is to
the right. In it are the payoffs
f
r
ome
a
c
hma
n’
sstrategies,
which are to confess or deny
involvement in the serious
crime. In general, strategies
are all the possible actions of
each player.
A’
ss
t
r
at
e
gi
e
s
Confess
2 years
Confess
B’
s
strategies
2 years
Deny
15 years
1 year
1 year
4 years
Deny
15 years
4 years
 In the Nash equilibrium,
player A takes the best
possible action given the action of player B and player B takes the best
possible action given the action of player A. The Nash equilibrium for the
pr
i
s
one
r
s
’di
l
e
mmai
sf
orb
ot
hpl
a
y
e
r
st
oc
onf
e
s
s
.Thi
sout
c
omei
sba
df
or
them because both would be better off if each denied.
The Duopolists’Di
l
e
mma
 Fi
r
msi
na
nol
i
g
opol
yc
a
nf
a
c
eapr
i
s
one
r
s
’di
l
e
mmaga
me
.Suppos
et
he
r
ea
r
e
two firms, A and B. The firms could make a collusive (and illegal) agreement
to jointly boost their price and
A’
ss
t
r
at
e
gi
e
s
decrease their output. Once
Comply
Cheat
the agreement is made, each
$1 million
$0
firm must select its strategy:
Cheat
cheat on the agreement or
B’
s
$0
$5 million
comply with the agreement.
strategies
 The payoff matrix is to the
r
i
g
ht
.Ea
c
hf
i
r
m’
spr
of
i
t
depends on its strategy and
that of its competitor.
$5 million
$3 million
Comply
$1 million
$3 million
 The Nash equilibrium for the game is for both firms to cheat on the agreement.
The outcome is bad for them because both would be better off if each
complied with the agreement.
 Collusion is profitable but is difficult to maintain.
Advertising and Research Games in Oligopoly
 Fi
r
ms
’de
c
i
s
i
onsa
bouta
dve
r
t
i
s
i
nga
ndc
onduc
t
i
ngr
e
s
e
a
r
c
ha
ndde
ve
l
opme
nt
can be studied using game theory.
6
 In an advertising game, two firms can advertise or not advertise. Advertising is
costly but if one firm advertises and the other does not, the one not advertising
loses market share and profit while the one advertising gains market share and
profit. Both firms would be better if neither advertised but the Nash
equilibrium is that both firms advertise.
 In a research and development (R&D) game, two firms can conduct or not
conduct R&D.Ea
c
hf
i
r
m’
sstrategies are to conduct the R&D or not conduct
the R&D. A firm that conducts the R&D must pay for the R&D. Both firms
would be better if neither firm conducted research and development but the
Nash equilibrium is that both firms conduct research and development.
Repeated Games
 If a game is played repeatedly, it is possible for players of the game to
cooperate and make and share the monopoly profit. Because the game is
played repeatedly, a player can use a tit-for-tat strategy, in which the player
cooperates in the current period if the other player cooperated in the previous
period, but cheats in the current period if the other player cheated in the
previous period.
 A tit-for-tat strategy used with the previous payoff matrix leads to a
cooperative equilibrium.
Is Oligopoly Efficient?
 If the oligopoly can restrict its output, it is inefficient.
7