Chapter 13 monopolistic competition and

oligopoly

Outline
I. What is Monopolistic Competition?
A. Monopolistic competition is a market with the following
characteristics:
1. A large number of firms compete.
2. Each firm produces a differentiated product.
3. Firms compete on product quality, price, and marketing.
4. Firms are free to enter and exit.
B. The presence of a large number of firms in the market implies:
1. Each firm supplies only a small part of the total industry output and
so has only limited power to influence the price of its product.
2. Each firm is sensitive to the average market price but pays no
attention to any one individual competitor.
3. No one firm can dictate market conditions and no one firms actions
directly affect the actions of another.
4. Collusion, or conspiring to fix prices, is impossible.
C. Firms in monopolistic competition practice product differentiation,
which means that each firm makes a product that is slightly different
from the products of competing firms.
D. Product differentiation enables firms to compete in three areas: quality,
price, and marketing.
1. The quality of a product is the physical attributes that make it
different from the products of other firms. Examples include product
design, reliability, and service.
2. Each firm faces a downward-sloping demand curve for its own
product because each firm produces a differentiated product. This
allows each firm to set its own price. The price is related to quality:
A higher quality product allows the firm to set a higher price.
3. A firm in monopolistic competition must market its product because
all other firms offer differentiated products. This fact means the
product must be marketed using advertising and packaging.
E. There are no barriers to entry or exit in monopolistic competition, so
firms cannot earn an economic profit in the long run.
1. Examples of a monopolistically competitive industry include audio
and video equipment, computers, frozen foods, mens clothing, and
sporting goods.
 2. Figure 13.1 shows market share of the largest four firms for each of
ten industries that operate in monopolistic competition.

II. Price and Output in Monopolistic Competition

A. Similar to a monopoly, the MR curve for a firm in monopolistic
competition is downward sloping and lies under its demand curve. In
the short run, a firm in monopolistic competition makes its output and
price decision just like monopoly firm does.
1. A firm that has decided the quality of its product and its marketing
program produces the profit maximizing quantity at which MR =
MC.
2. A firm in monopolistic
competition can earn an
economic profit in the short run
only if P > ATC.
3. Figure 13.2 shows a short-run
equilibrium output and price
decision for a firm in
monopolistic competition
making a positive economic
profit.
B. In the long run, firms in
monopolistic competition will be
unable to earn economic profit.
1. When firms are earning
economic profit (that is, when P
> ATC), the existence of the
economic profit induces entry
by new firms, which continues as long as firms in the industry earn
an economic profit.
 a) As firms enter the industry, each existing firm loses some of its
market share. The demand for its product decreases and the
demand curve shifts leftward.
b) The decrease in demand decreases the quantity at which MR =
MC and lowers the maximum price that the firm can charge to
sell this quantity.
c) The price the firm charges and the quantity it sells falls as firms
enter. Eventually entry results in P = ATC and the firms earn zero
economic profit (normal profit).
2. When firms are incurring an
economic loss (that is, when P
< ATC), the economic loss will
induce firms to leave the
market, which continues as
long as firms in the industry
bear an economic loss. Figure
13.3 illustrates a firm in
monopolistic competition
making an economic loss.
a) As firms exit the industry,
each remaining firm gains
some of its market share.
The demand for its product
increases and the demand
curve shifts rightward.
b) The increase in demand
increases the quantity at which MR = MC and raises the
maximum price that the firm can charge to sell this quantity.
 c) The price that each
remaining firm charges and
the quantity it sells rise as
firms exit. Eventually exist
results in P = ATC and firms
again earn zero economic
profit (normal profit).
d) Figure 13.4 shows the long
run output and price
decision for a firm in
monopolistic competition.
C. Comparing Monopolistic
Competition with Perfect
Competition
1. Firms in monopolistic are
inefficient and operate with
excess capacity, which means
the firm produces a quantity less than the minimum efficient scale.
a) Figure 13.5 illustrates this proposition.

2. Firms maximize profit by choosing to produce output where MR =

MC.
a) The firm in monopolistic competition retains some market
power, which means MR < P for all quantities.
b) The fact that the firm has some market power means that at the
profit maximizing level of output chosen by the firm P > MC.
c) A firms markup is the amount by which price exceeds marginal
cost.
 3. Because a firm in monopolistic competition has P > MC, the firm
produces where MC < MB since price equals the marginal benefit to
society.
a) The under-production in monopolistic competition creates a
deadweight loss.
b) Monopolistically competitive firms produce at inefficient levels
of output relative to perfect competition.
c) But firms in monopolistic competition produce a variety of
different goods whereas firms in perfect competition produce
identical goods. People value variety, so monopolistic
competition is not necessarily inferior to perfect competition.

III. Product Development and Marketing

A. A firm in monopolistic competition must be in a state of continuous
product development to keep earning an economic profit.
1. New product development allows a firm to gain a competitive edge,
if only temporarily, before competitors imitate the innovation.
2. Firms pursue product development until the marginal revenue from
innovation equals the marginal development cost.
3. Production development may benefit the consumer (by providing
improvements in product quality) or it may mislead the consumer
(by giving only the appearance of change in product quality).
4. Regardless of whether a product improvement is real or imagined,
its value to the consumer is its marginal benefit, which is the
amount the consumer is willing to pay for the improvement.
B. Firms use advertising and
packaging as the two principal
methods to differentiate its
products from competitors by
actively marketing their
products to consumers.
1. Firms in monopolistic
competition incur heavy
advertising expenditures
which make up a large
portion of the price it
charges for the product.
2. Figure 13.6 shows
estimates of this
percentage of sale price for
different monopolistic
competition markets.
 3. These selling costs (like
advertising expenditures,
fancy retail buildings, etc.)
are fixed costs.
a) This fact means selling
costs increase average
total costs at any given
level of output but do not
affect the variable costs
(including the marginal
cost) of production.
b) Figure 13.7 shows how an
advertising expenditures
shift the ATC curve
upward.
C. Selling efforts such as
advertising are successful only if they increase demand for the firms
product.
1. When each firm advertises its product, the advertising increases the
price the firm can charge but it also makes the demand more
elastic.
2. A firms increased demand and profits can only be experienced by
firms in the short run.
3. Profits lead to the entry of more firms into the market, which
decreases the demand for each firms product in the long run and
lowers the price each firm can charge.
D. To the extent that advertising and selling costs provide consumers with
information and services that they value more highly than their cost,
these activities are an efficient allocation of resources.
1. Similarly, developing and marketing a brand name provides
information about the quality of a product to consumers and an
incentive to the producer to achieve a high and consistent quality
standard.
2. Heavy marketing and advertising expenditures by a firm are a
signal to consumers that their product is of high quality. A signal is
an action taken by an informed person (or firm) to send a message
to uninformed people.

IV. Oligopoly
A. The distinguishing features of an oligopoly are that:
1. Natural or legal barriers prevent the entry of new firms.
2. A small number of firms compete.
B. Oligopoly markets share some characteristics of other market
structures:
1. Oligopoly is similar to a monopoly in that each firm has market
power to determine its own price.
 2. Oligopoly might be similar to monopolistic competition in that each
firm makes a differentiated product, but this is not a necessary
condition for oligopoly.
C. The number of firms in a natural oligopoly can be determined by the
minimum efficient scale of the firms and the total size of the market.
1. The minimum efficient scale, combined with the size of the total
market demand for the product, will determine how many firms
survive in the market.
2. If only two firms operate in an oligopoly market, it is called a
duopoly.
D. The quantity sold by one firm in an oligopoly depends on each firms
own price and the prices and quantities sold by all the other firms.
1. This interdependence between firms motivates each firm to behave
cooperatively instead of competitively toward each other in an
attempt to maximize profits for all firms.
2. A cartel is a group of firms acting togethercolludingto limit
output, raise price, and increase economic profit.
E. There are two traditional oligopoly models
1. The kinked demand curve model of oligopoly is based on the
assumption that each firm believes that if it raises its price, others
will not follow but that if it cuts
its own price, so will the other
firms.
a) Figure 13.11 shows the
kinked demand curve
model. The demand curve
that an oligopoly firm
believes it faces has a kink
at the current price and
quantity.
b) Above the kink, demand is
relatively elastic because all
other firms prices remain
unchanged and below the
kink, demand is relatively
inelastic because all other
firms prices change in line
with the price of the firm shown in the figure.
c) The kink in the demand curve means that the MR curve is
discontinuous at the current quantity.
d) Fluctuations in MC that remain within the discontinuous portion
of the MR curve leave the profit-maximizing quantity and price
unchanged.
e) The beliefs that generate the kinked demand curve are not
always correct. In particular, if MC increases enough, all firms
raise their prices and the kink vanishes.
 2. In the dominant firm oligopoly model, there is one large firm that
has a significant cost advantage over the other, smaller competing
firms and it produces a large part of the industry output.
a) The large firm operates as a monopoly, setting its price and
output to maximize its profit.
b) The small firms act as perfect competitors, taking as given the
market price set by the dominant firm and producing output to
satisfy the remaining demand in the market.
c) Figure 13.12 shows a dominant firm industry.

V. Oligopoly Games
A. Game theory is a tool for studying strategic behavior, which is
behavior that takes into account the expected behavior of others and
the recognition of mutual interdependence.
B. All games share four important features:
1. The rules of a game describe the setting of the game, the actions
the players may take, and the consequences of those actions.
2. The strategies are all the possible actions of each player in the
game.
3. The payoffs are described in a payoff matrix, which is a table that
shows the payoffs for every possible action by each player for every
possible action by each other player.
4. The outcomes of a game are the results produced by the
interaction of all the choices made by each of the players
decisions. In a 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.
C. The prisoners dilemma is a good game for illustrating these four
features. The following is an example.
1. Art and Bob have been caught stealing cars. The rules of their
prisoners dilemma game are as follows:
a) Both have been convicted of committing this crime and will be
sentenced to two years in jail.
b) Both prisoners are also strongly suspected of committing a more
serious crime for which there exists insufficient evidence for a
conviction.
c) During interrogation for the more serious crime, Art and Bob are
held in a separate cell and they cannot communicate with each
other.
d). Each is told that they are both suspected of committing the
more serious crime and that the other is being asked to confess
in return for a lighter prison sentence for the more serious
crime.
e) Each prisoner is given a deal to consider: Each prisoner is told
that he will receive only a 1-year jail sentence for the serious
crime and no time for the less serious crime (for a total of 1 year
jail time for both crimes) if he cooperates by giving up a
confession that implicates them both and the other prisoner
denies the crime. However, if he refuses to confess and his
partner does confess, then he will get the full 8 years jail term
for the serious crime a total of a 10-year sentence to be served
for committing both crimes.
f) Each prisoner knows that if they both confess to the more
serious crime, each will receive a total of 3 years in jail for
committing both crimes. Otherwise, if neither confesses, each
prisoner will serve only a 2-year sentence for the minor crime.
2. The strategies for both prisoners are the same:
a) Each can confess to committing the serious crime.
b) Each can deny committing the serious crime.
3. The games payoff matrix
is a table, like the one in
Table 13.1, that shows the
payoffs for every possible
action by each player for
every possible action by
the other player.
a) In Table 13.1, Arts
payoff from each
combination of actions
is shown in the top of
each payoff box, and
Bobs payoff is shown in
the bottom of each
payoff box.
 b) There are four possible outcomes: Bob and Art both confess (top
left payoff box), Bob and Art both deny (bottom right payoff
box), Bob confesses but Art does not (top right payoff box), and
Art confesses but Bob does not (bottom left payoff box).
c) If a player makes a rational choice in pursuit of his own best
interest, he chooses the action that is best for him given any
possible action to be taken by the other player. If both players
are rational and choose their actions in this way, the outcome is
called a Nash equilibriumfirst proposed by John Nash.
4. The dilemma of the prisoners dilemma game is that the best
strategy is for each prisoner to confess, which does not create the
best outcome for either prisoner.
a) Regardless of Bobs decision, Arts best payoff occurs by
confessing.
b) Regardless of Arts decision, Bobs best payoff occurs by
confessing.
c) So both prisoners confess and the Nash Equilibrium outcome
that results is that each prisoner gets 3 years in jail for
committing both crimes.
d) Both players would be better off if each had denied the crime,
but because they cant communicate about their decisions,
there is no way to strike a deal that enables them to cooperate
and get the best joint outcome.
D. An application of the prisoners dilemma can help us understand the
behavior of firms in a natural duopoly, which captures the essence of
an oligopoly market.
1. Figure 13.13 shows a natural duopoly:

a) Demand and cost conditions are such that two firms can
produce the good to satisfy demand at a lower ATC than only
one firm or three firms.
b) The firms in a duopoly can enter into a collusive agreement,
which is an agreement in which two (or more) competitors agree
to restrict output, raise the price, and increase profits.
 c) Firms that have entered into a collusive agreement have formed
a cartel (which is illegal in the United States.)
2. In a cartel, each firm has two strategies:
a) Comply with the agreement
b) Cheat on the agreement
3. There are four possible payoffs depending upon the strategy
followed by each player:
a) If both firms comply, they maximize industry profit by producing
the same output as a monopoly would, charging the monopoly
price, and sharing the resulting economic profit. Figure 13.14
shows this outcome.

b) If one firm cheats and the other complies, the firm that complies
incurs an economic loss, and the firm that cheats makes an
economic profit that is larger than its share of the maximum
industry profit if it complies. Figure 13.15 shows this outcome.

c) If both firms cheat, they each earn a normal profit (zero

economic profit). Figure 13.16 shows this outcome.
 4. Table 13.2 shows the payoff
matrix for this game.
a) The Nash equilibrium is
where both firms cheat.
b) The quantity and price
are those of a
competitive market, and
the firms earn normal
profit.
E. Another application of the
prisoners dilemma can also
help us understand the
behavior of two firms operating
in a market of monopolistic
competition that are engaged in developing and marketing rival
products. Consider the situation facing both Procter & Gamble and
Kimberly-Clark as they compete in the disposable diaper market:
1. The key to success for each firm is to develop a product that is more
highly valued by consumers and less costly to produce than the
rival firm.
a) Higher valued products increase market share and increase the
price and total revenues for the firm.
b) Lower costs and higher prices combine to increase profits.
c) However, research and development (R&D) costs are high and
must be subtracted from these higher profits.
2. There are two different strategies that each firm can pursue:
a) Spend money on R&D.
b) Do not spend money on R&D.
3. The payoff matrix in Table
13.3 illustrates the four
different payoffs that can
arise in this game. The
payoff for Procter and
Gamble appear in the top
of each box and the payoff
for Kimberly-Clark appears
in the bottom of each box.
The payoff matrix has four
boxes, representing the
four possible outcomes:
a) Both firms spend
money on R&D.
b. Neither firm spends
money on R&D.
c) Procter & Gamble spends on R&D and Kimberly-Clark will not.
d) Kimberly-Clark spends on R&D and Procter & Gamble will not.
 4. The Nash equilibrium outcome is that both firms spend money on
R&D.
a) Regardless of what Kimberly-Clark decides to do, the best
strategy for Procter & Gamble is to spend money on R&D.
b) Regardless of what Procter & Gamble decides to do, the best
strategy for Kimberly-Clark is to spend money on R&D.
c) Both firms create innovative products that are cheaper to
produce, which benefits the consumer but fails to maximize joint
profits.
d) A dominant strategy equilibrium is a Nash Equilibrium
outcome where the best strategy for any player in the game is
to cheat on the agreement (act non-cooperatively) regardless of
the strategy of the other player.
F. A Game of Chicken
A game of chicken is exemplified by two cars racing toward each
other.
1. The first driver to swerve and avoid crashing is chicken.
2. The payoffs are a big loss for both players if no one chickens, zero
for both if both chicken, and if one chickens, a loss for the chicken
and a gain for the other player.
3. R&D that creates a new technology that any firm can use is an
economic example of the game of chicken.
4. There are two equilibrium outcomes, one in which each player
chickens (that is, each player undertakes the research) and the
other player does not. This equilibrium is not a Nash equilibrium.

VI. Repeated Games and Sequential Games

A. If a game is played repeatedly, it is possible for players of the game
(like in the two firms in the duopolies game) to act cooperatively and
successfully collude (to earn a monopoly profit).
1. Knowing that multiple chances to play the same game will occur
changes the dominant strategy for players in this type of sequential
game.
2. Many different outcomes are possible because information about
players behavior in prior games can be incorporated into current
games.
B. For example, additional punishment strategies in a repeated prisoners
dilemma duopoly game enable the firms to comply and achieve a
cooperative equilibrium, in which the firms make and share the
monopoly profit.
1. One possible punishment strategy is a tit-for-tat strategy, in which
one 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.
 2. A more severe punishment strategy is a trigger strategy, in which a
player cooperates if the other player cooperates but plays the Nash
equilibrium strategy forever thereafter if the other player cheats.
C. A tit-for-tat strategy is sufficient to produce a cooperative equilibrium in
a repeated duopoly game, allowing all firms to enjoy economic profit.
1. If each firm cooperates in the first period, then this cooperation
might provide evidence of trustworthiness that the other firms can
rely upon in choosing their second period strategy.
2. However, a price war might result from relying on a tit-for-tat
strategy, especially when there is the additional complication of
uncertainty about unforeseen changes in consumer demand.
a) A random decrease in demand might convince some firms to
lower their price
b) It is difficult for the firms to determine if the low price is the
result of weaker demand or of non-cooperative behavior on the
part of those firms lowering their price.
c) This fall in price might result in a round of tit-for-tat punishment
by all firms.
D. However, non-cooperative outcomes are also possible if the firms
operate in a contestable market.
1. A contestable market is a market in which firms can enter and
leave so easily that those firms in the market face competition from
potential entrants. These firms play a sequential entry game.
2. Figure 13.17 shows the game tree for a sequential entry game in a
contestable market.

a. In this entry game, the firms in the market set a competitive

price and earn only a normal profit to keep the potential entrant
out.
b. However, a less costly strategy is limit pricing, which sets the
price at the highest level that inflicts a loss on the entrant. This
strategy will keep the potential entrant out while allowing the
existing firms to earn economic profit.