INDUSTRIAL ORGANIZATION

Perfect Competition, Monopoly, Monopolistic

Competition, and Oligopoly

EMDRCM 2020
Asian Institute of Management
18 February 2020
 Four Types of Market Structure
Economists who study
industrial organization divide
markets into four types
➢Perfect competition
➢Monopoly
➢Monopolistic competition
➢Oligopoly

Source: Mankiw, N. Gregory. 2012. Principles of Economics, sixth

edition. South-Western Cengage Learning.
 Perfect Competition
A perfectly competitive market
assumes that
➢There are many buyers and many
sellers in the market so that all
buyers and sellers are price-takers,
i.e., there is no market power by
any buyer or seller
➢The goods offered by the various
sellers are largely the same, i.e.,
relatively homogeneous products
➢Firms can freely enter or exit the
market
Source: Mankiw, N. Gregory. 2018. Principles of Economics, 8th edition. Cengage.
 Perfect Competition
Output Decisions in the Short Run and Long Run

In the short run, the competitive firm’s supply curve is its
marginal-cost curve (MC) above average variable cost
(AVC). If the price falls below average variable cost, the
firm is better off shutting down.
➢ In the long run, the competitive firm’s supply curve is
its marginal-cost curve (MC) above average total cost
(ATC). If the price falls below average total cost, the
firm is better off exiting the market.
Source: Mankiw, N. Gregory. 2018. Principles of Economics, 8th edition. Cengage.
 Monopoly

➢A monopoly maximizes
profit by choosing the
quantity at which marginal
revenue equals marginal cost
(point A) then uses the
demand curve to find the
price that will induce
consumers to buy that
quantity (point B).

Source: Mankiw, N. Gregory. 2018. Principles of Economics, eighth

edition. Cengage.
 Monopoly
The Efficient Level of Output

➢A benevolent social planner who

wants to maximize total surplus in
the market would choose the level of
output where the demand curve and
marginal cost curve intersect. Below
this level, the value of the good to the
marginal buyer (as reflected in the
demand curve) exceeds the marginal
cost of making the good. Above this
level, the value to the marginal buyer
is less than marginal cost.
Source: Mankiw, N. Gregory. 2018. Principles of Economics, eighth edition. Cengage.
 Monopoly
Deadweight Loss
➢A monopoly charges a price above
marginal cost resulting in consumers
who value the good but unable to
afford it. Thus, the quantity produced
and sold by a monopoly is below the
socially efficient level. The deadweight
loss is represented by the area of the
triangle between the demand curve
(which reflects the value of the good to
consumers) and the marginal-cost
curve (which reflects the costs of the
monopoly producer). Source: Mankiw, N. Gregory. 2018. Principles of Economics, eighth edition. Cengage.
 Monopolistic Competition
➢In a monopolistically competitive
market, if firms are making profit,
new firms enter, and the demand
curves for the incumbent firms shift to
the left. Similarly, if firms are making
losses, old firms exit, and the demand
curves of the remaining firms shift to
the right. Due to these shifts in
demand, a monopolistically
competitive firm eventually finds
itself in the long-run equilibrium
shown here. In this long-run
equilibrium, price equals average total
cost, and the firm earns zero profit. Source: Mankiw, N. Gregory. 2018. Principles of Economics, eighth edition. Cengage.
Source: Mankiw, N. Gregory. 2018. Principles of Economics, 8th edition. Cengage.
 Oligopoly
➢An oligopolistic market has only a small group of sellers and a key
feature of oligopoly is the tension between cooperation and self-interest.
➢The oligopolists are best off when they cooperate and act like a
monopolist—producing a small quantity of output and charging a price
above marginal cost. Yet because each oligopolist cares only about its
own profit, there are powerful incentives at work that hinder a group of
firms from maintaining the cooperative outcome.
➢As the number of sellers in an oligopoly grows larger, an oligopolistic
market looks more and more like a competitive market. The price
approaches marginal cost, and the quantity produced approaches the
socially efficient level.
Source: Mankiw, N. Gregory. 2018. Principles of Economics, 8th edition. Cengage.
 Oligopoly Models
➢The Cournot model is an oligopoly model in which firms produce a
homogeneous product, each firm treats the output of its competitors as
fixed, and all firms decide simultaneously how much to produce.
➢The equilibrium in the Cournot model occurs when each firm
correctly assumes how much its competitors will produce and sets
its own production level accordingly.
➢The Stackelberg model is an oligopoly model in which one firm sets
its output before other firms do.
➢The Bertrand model is an oligopoly model in which firms produce a
homogeneous product, each firm treats the price of its competitors as
fixed, and all firms decide simultaneously what price to charge.
Source: Pindyck, Robert and Daniel Rubinfeld. 2013. Microeconomics, 8th edition. Pearson
 Game Theory
➢Game theory is the study of mathematical models of strategic interaction
between rational decision-makers.
➢Prisoners’ dilemma is a particular “game” between two captured
prisoners that illustrates why cooperation is difficult to maintain even
when it is mutually beneficial.
➢Dominant strategies
“ I am doing the best I can no matter what you do.”
“You are doing the best you can no matter what I do.”
➢Nash equilibrium
“I am doing the best I can given what you are doing.”
“You are doing the best you can given what I am doing.”

Source: Mankiw, N. Gregory. 2018. Principles of Microeconomics, 8th edition. Cengage. Pindyck, Robert and Daniel Rubinfeld. 2013. Microeconomics, 8th edition. Pearson.
 Class Exercise 1
➢Two firms are in the chocolate market. Each can choose to go for the high end
market (high quality) or the low end (low quality). Resulting profits are given by
the following payoff matrix.

FIRM 2
Low quality High quality
FIRM 1 Low quality -20, -30 900, 600
High quality 100, 800 50, 50

➢What outcomes, if any, are Nash equilibria?

➢What is the cooperative outcome? How do you interpret the cooperative
outcome?
➢Which firm benefits most from the cooperative outcome? How much would
that firm offer the other to persuade it to collude?
Source: Pindyck, Robert and Daniel Rubinfeld. 2013. Microeconomics, 8th edition. Pearson
 Class Exercise 2
➢We can think of the United States and Japanese trade policies as a prisoners’
dilemma. The two countries are considering to open or close their import markets.
The payoff matrix is shown below.
JAPAN
Open Close
UNITED Open 10, 10 5, 5
STATES
Close -100, 5 1, 1
➢Assume that each country knows the payoff matrix and believes that the other
country will act in its own interest. Does either country have a dominant
strategy? What will be the equilibrium policies if each country acts rationally
to maximize its welfare?

Source: Pindyck, Robert and Daniel Rubinfeld. 2013. Microeconomics, 8th edition. Pearson
 Class Exercise 2
continued

➢We can think of the United States and Japanese trade policies as a prisoners’
dilemma. The two countries are considering to open or close their import markets.
The payoff matrix is shown below.
JAPAN
Open Close
UNITED Open 10, 10 5, 5
STATES
Close -100, 5 1, 1
➢Now assume that Japan is not certain that the United States will behave
rationally. In particular, Japan is concerned that politicians in the United States
may want to penalize Japan even if that does not maximize the welfare of the
United States. How might this concern affect Japan’s choice of strategy? How
might this change the equilibrium?
Source: Pindyck, Robert and Daniel Rubinfeld. 2013. Microeconomics, 8th edition. Pearson