Business and Economics

ECW1101
Introductory Microeconomics

Week 11: Monopolistic Competition;

Oligopoly
ECW1101 - Lecture Week 11 1
 Week 11 – Learning objectives
On completing Week 11 you will be able to:
Describe how firms in monopolistic competition determine price
and output in the short and long run
Discuss the welfare implications of monopolistic competition.
Compare and contract the monopolistic competition with perfect
competition
Discuss the role played by advertising in monopolistic
competition
Identify what outcomes are possible when a market is an
oligopoly
Describe the prisoners’ dilemma and how it applies to oligopoly
and other issues
Discuss how the antitrust laws try to foster competition in
oligopolistic markets
ECW1101 - Lecture Week 11 2
Week 11- Reading
Mankiw (2012)
Chapter 16: Monopolistic competition
Chapter 17: Oligopoly

Your note taking from this chapter should focus on making sure you
have an understanding of the weekly learning objectives.

ECW1101 - Lecture Week 11 3

 The Four Types of Market Structure

Economists who study industrial organization divide markets into four types—monopoly, oligopoly,
monopolistic competition, and perfect competition.
4
 Business and Economics

Part 1: Monopolistic Competition

Monopolistic competition: https://www.youtube.com/watch?v=XG6jWY0SvC0

5
Introduction
Monopolistic competition
Many firms selling products that are similar but
not identical

Falls between perfect competition and pure

monopoly

ECW1101 - Lecture Week 11 6

ECW1101 - Lecture Week 11 7
Monopolistic competition

Product
differentiation

Attributes of
monopolistic
competition
Free
Many
entry and
sellers
exit

ECW1101 - Lecture Week 11 8

Monopolistic competition
Many sellers
There are many
<insert Shutterstock
firms competing for Image ID: 70758169> Young
the same group of woman offering book in the
customers. bookshop

• Product examples
include books,
CDs, films, etc.

ECW1101 - Lecture Week 11 9

Monopolistic competition
Product differentiation Free entry or exit
Each firm produces a
product that is at least
slightly different from
those of other firms
Each firm faces a
downward-sloping
demand curve (not
price taker)
Firms can enter or exit
the market without
restriction
Number of firms in the
market adjusts until
economic profits are
zero
ECW1101 - Lecture Week 11 10
 Short Run Equilibrium
Profit maximization
Produce the quantity where marginal revenue =
marginal cost
Price: on the demand curve
If P > ATC: profit
If P < ATC: loss
Similar to monopoly

ECW1101 - Lecture Week 11 11

 Monopolistic Competitors in the Short Run

(a) Firm makes profit

Price

MC

ATC
Price

ATC
Profit Demand

MR

0 Profit-maximizing Quantity
quantity

12
Monopolistic Competitors in the Short Run

(b) Firm makes losses

Price

MC ATC

ATC

Price

Losses

Demand

MR
0 Loss-minimizing Quantity
quantity

13
 Long Run Equilibrium
For monopolistically competitive firms, short-run
economic profits encourage new firms to enter the
market
This increases the number of products offered
This reduces demand faced by firms already in
the market
Incumbent firms’ demand curves shift to the
left
Demand for the incumbent firms’ products
fall, and their profits decline
Each firm’s profit declines until: zero economic
profit
ECW1101 - Lecture Week 11 14
Loss in the short-run in monopolistic competition

Number of Remaining
Some firms
products for firms’ demand
exit
sale decrease increases

Remaining
Profits firms’ demand
increase curve shifts
right

ECW1101 - Lecture Week 11 15

Profit in the short-run in monopolistic competition

Number of Incumbent
New firms
products for firms’ demand
enter
sale increase decreases

Incumbent
firms’ demand
Profits decline
curve shifts
left

ECW1101 - Lecture Week 11 16

 A Monopolistic Competitor in the Long Run

Price
MC ATC

Price = ATC

Demand
MR

0 Profit- maximizing Quantity

quantity

17
 Long-run equilibrium
Zero economic profit
Demand curve
• Tangent to average total cost curve
• At quantity where marginal revenue =
marginal cost
Price = average total cost
Price exceeds marginal cost

ECW1101 - Lecture Week 11 18

Long-run equilibrium: Two characteristics

Monopolistic Perfect competition

competition Quantity: at
Quantity: not at minimum ATC
minimum ATC • Efficient scale
• Excess capacity P = MC
P > MC, markup over
marginal cost

ECW1101 - Lecture Week 11 19

 Monopolistic versus Perfect Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
ATC

Price ATC
P=MC
P=MR
Markup
(demand curve)
MC

Demand

MR

0 Quantity Efficient Quantity 0 Quantity produced Quantity

produced scale = Efficient scale
Excess capacity

20
 Welfare of Society
Mark-up pricing generates a deadweight loss to
society
The administrative burden of regulating such
prices would be overwhelming
Policymakers typically prefer to live with the
loss

The number of firms may be inefficient

Can be too much or too little entry
Entry creates two types of externalities

ECW1101 - Lecture Week 11 21

Monopolistic competition and the welfare of society

Product variety Business stealing

New products are New firms compete with
introduced incumbents

Consumer welfare rises Incumbents’ profits fall

Positive externality on Negative externality on

consumers other firms

ECW1101 - Lecture Week 11 22

Advertising

<insert Shutterstock Image ID: 11307037>

It is nearly impossible to go through a typical day without being exposed to

advertising. Such behaviour is a natural feature of monopolistic competition

ECW1101 - Lecture Week 11 23

Advertising
• In monopolistic competition firms can increase
profit by increasing sales. Advertising tries to lift
sales.
• Advertising levels vary substantially across
products.
– Firms that sell highly differentiated consumer goods
spend between 10 and 20 per cent of revenue for
advertising.
• For the economy as a whole, about 1 to 2 per cent
of total firm revenue is spent on advertising.

ECW1101 - Lecture Week 11 24

The Advertising debate

Critics Defenders

Provides information to
Manipulates tastes consumers

Increases competition
by expanding variety
Impedes competition by
exaggerating Signals quality to
differences consumers

ECW1101 - Lecture Week 11 25

Brand names
 Advertising is linked to brand names.
 Critics claim brand names cause consumers to
perceive differences that don’t really exist.
 Brand names may be a useful way for consumers
to ensure that the goods they are buying are of
high quality.
– they provide information about quality
– they give firms incentive to maintain high quality.

ECW1101 - Lecture Week 11 26

Brand names and reputation

• Companies risk losing sales if brand

name is damaged.
– Perrier dominated bottled water
sales in 1980s.
– Benzene contamination in 1990
led to recall of 160m bottles.
– Company response was still
judged tardy.
– Perrier sales have not returned to
pre-1990 level.

ECW1101 - Lecture Week 11 27

 Business and Economics

Part 2: Oligopoly

28
 Oligopoly
Oligopoly
A market structure in which only a few sellers
offer similar or identical products
Interdependent
Game theory
The study of how people behave in strategic
situations
• Choose among alternative courses of action
• Must consider how others might respond to the
action he takes
ECW1101 - Lecture Week 11 29
 Markets with Only a Few Sellers
A small group of sellers
A key features of oligopoly is the tension between
cooperation and self-interest
Is best off cooperating
• Acting like a monopolist
– Produce a small quantity of output
– Charge P >MC

Each firm cares only about its own profit

• Powerful incentives not to cooperate

ECW1101 - Lecture Week 11 30

 Markets with Only a Few Sellers
Duopoly
Oligopoly with only two members
Example: Jack and Jill own the only water wells in
town
• Decide how much water to bring to town to sell
• Assume that the marginal cost of pumping each
gallon of water is zero
• Price is determined on the market by the
demand

ECW1101 - Lecture Week 11 31

The Demand Schedule for Water
 Markets with Only a Few Sellers
For a perfectly competitive firm
Price = marginal cost
• P=0
• 120 gallons of water would be sold
Quantity = efficient
For a monopoly
Price > marginal cost
• P>0
• profit maximized at a price of $60 and an output of
60 gallons
Quantity < efficient quantity
ECW1101 - Lecture Week 11 33
 Markets with Only a Few Sellers
A duopoly can
Collude and form a cartel - act as a monopoly
• to act together to set the price and quantity of
water
• agree on the monopoly outcome of 60 gallons
and a price of $60
• The cartel must also decide how to split the
production of water
• Each member will want a larger share because
that means more profit
ECW1101 - Lecture Week 11 34
 Markets with Only a Few Sellers
Collusion
Agreement among firms in a market
• Quantities to produce or
• Prices to charge

Cartel
Group of firms acting in unison

ECW1101 - Lecture Week 11 35

 Markets with Only a Few Sellers
Difficult to form cartels
Antitrust laws prohibit agreements among firms
• Squabbling among cartel members over their
shares is also likely to occur
• In the absence of a binding agreement, the
monopoly outcome is unlikely

ECW1101 - Lecture Week 11 36

 Markets with Only a Few Sellers
A duopoly can
Not to collude
• If duopolists pursue their own self-interest
when deciding how much to produce
– Produce a quantity greater than the
monopoly quantity
– Charge a price lower than the monopoly
price
– Earn total profit less than the monopoly
profit
ECW1101 - Lecture Week 11 37
 Markets with Only a Few Sellers
Assume that Jack expects Jill to produce 30 gallons of
water
Jack could also produce 30 gallons and earn a profit
of $1,800
However, he could produce 40 gallons and earn a
profit of $2,000
Jack will want to produce 40 gallons
Jill might reason the same way

ECW1101 - Lecture Week 11 38

 Equilibrium for an Oligopoly

Nash equilibrium
A situation in which economic actors interacting
with one another each
choose their best strategy
given the strategies that all the other actors have
chosen

ECW1101 - Lecture Week 11 39

 Equilibrium for an Oligopoly

Nash equilibrium occurs

when both Jack and Jill are producing 40 gallons
• Given that Jack expects Jill to produce 40
gallons, he will not be better off at any other
output level than 40 gallons
• Jill might reason the same way

Example: Nash Equilibrium -

https://www.youtube.com/watch?v=2d_dtTZQyU
M
ECW1101 - Lecture Week 11 40
 Equilibrium for an Oligopoly
Oligopolists
Better off cooperating and reaching the monopoly
outcome
They pursue their own self-interest
• Do not end up reaching the monopoly outcome
and maximizing their joint profit
• Each is tempted to raise production and
capture a larger share of the market
– Total production rises
– Price falls

ECW1101 - Lecture Week 11 41

 Equilibrium for an Oligopoly
When firms in an oligopoly individually choose
production to maximize profit
Produce a quantity of output
• Greater than the level produced by monopoly
• Less than the level produced by competition

The price is
• Less than the monopoly price
• Greater than the competitive price (MC)

ECW1101 - Lecture Week 11 42

 Equilibrium for an Oligopoly
If more sellers form a cartel
Maximize total profit
Produce monopoly quantity
Charge monopoly price
Difficult to reach & enforce an agreement as the
size of the group increases

ECW1101 - Lecture Week 11 43

 Equilibrium for an Oligopoly
If more sellers do not form a cartel
When an oligopolist decides to increase output,
two things occur
• The output effect
– Because P > MC, selling one more unit
increases profit
• The price effect
– Increasing production increases total
amount sold
– Decrease in price and lower the profit

ECW1101 - Lecture Week 11 44

 Equilibrium for an Oligopoly
The size of an oligopoly affects the market outcome
As the number of sellers in an oligopoly grows
larger
• Oligopolistic market - looks more like a
competitive market
• Price - approaches marginal cost
• Quantity produced – approaches socially
efficient level

ECW1101 - Lecture Week 11 45

 The Economics of Cooperation
The prisoners’ dilemma
Particular “game” between two captured prisoners
Illustrates why cooperation is difficult to maintain
even when it is mutually beneficial

Dominant strategy
Strategy that is best for a player in a game
• Regardless of the strategies chosen by the other
players

ECW1101 - Lecture Week 11 46

 The Prisoners’ Dilemma

Bonnie’s decision
Confess Remain silent
Bonnie gets 8 years Bonnie gets 20 years
Confess

Clyde’s Clyde gets 8 years Clyde goes free

Decision
Bonnie goes free Bonnie gets 1 year
Remain
silent

Clyde gets 20 years Clyde gets 1 year

In this game between two criminals suspected of committing a crime, the sentence
that each receives depends both on his or her decision whether to confess or remain
silent and on the decision made by the other
47
 Dominant Strategy

Bonnie’s dominant strategy is to confess

If Clyde remains silent, Bonnie can go free by
confessing
If Clyde confesses, Bonnie can lower her sentence by
confessing
Clyde’s dominant strategy is to confess
If Bonnie remains silent, Clyde can go free by
confessing
If Bonnie confesses, Clyde can lower his sentence by
confessing
If they had both remained silent, they would have been
better off collectively
with a sentence of only one year instead of eight
ECW1101 - Lecture Week 11 48
 The Economics of Cooperation
The prisoners’ dilemma
Because each pursues his or her own interests
• The two prisoners together reach an outcome
that is worse for each of them

Cooperation between the two prisoners is difficult

to maintain
• Because cooperation is individually irrational

ECW1101 - Lecture Week 11 49

 The Economics of Cooperation
Game oligopolists play
In trying to reach the monopoly outcome
Similar to the game that the two prisoners play in
the prisoners’ dilemma

Firms are self-interest

And do not cooperate
• Even though cooperation (cartel) would
increase profits
Each firm has incentive to cheat

ECW1101 - Lecture Week 11 50

 A Common-Resources Game

Exxon’s Decision
Drill Two Wells Drill One Well
Exxon gets $4 Exxon gets $3
Drill million profit million profit
Two
Wells Texaco gets $4 Texaco gets $6
Texaco’s million profit million profit
Decision
Exxon gets $6 Exxon gets $5
Drill million profit million profit
One
Well Texaco gets $3 Texaco gets $5
million profit million profit

In this game between firms pumping oil from a common pool, the profit that each
earns depends on both the number of wells it drills and the number of wells drilled
by the other firm.
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 The Economics of Cooperation
Common resources
Two companies – own a common pool of oil
Strategies
• Each company drills one well
• Each company drills a second well
– Get more oil
Dominant strategy
• Each company drills two wells
– Lower profit

ECW1101 - Lecture Week 11 52

 Why People Sometimes Cooperate
While cooperation is difficult to maintain, it is not
impossible
Cooperation is easier to enforce if the game is repeated
Firms that care about future profits will cooperate in
repeated games rather than cheating in a single game
to achieve a one-time gain
Cooperation among oligopolists is undesirable from the
standpoint of society as a whole because it leads to
production that is too low and prices that are too high

ECW1101 - Lecture Week 11 53

 Public Policy toward Oligopolies

Antitrust laws make it illegal to restrain trade or attempt

to monopolize a market.

ECW1101 - Lecture Week 11 54

FOR SELF-READING

ECW1101 - Lecture Week 11 55

ECW1101 - Lecture Week 11 56
ECW1101 - Lecture Week 11 57
ECW1101 - Lecture Week 11 58
ECW1101 - Lecture Week 11 59
 Conflict in Aircraft industry
 Airbus and Boeing trade blows -
http://www.economist.com/node/4030631
 Airbus versus Boeing: it’s war! -
https://eturbonews.com/61418/airbus-versus-boeing-it-s-war
 Airbus and Boeing Brace for a Crucial Phase in Their Subsidies
Dispute -
http://fortune.com/2016/08/16/airbus-boeing-subsidies-disput
e/

 The turbulent feud between Airbus and Boeing -

http://www.telegraph.co.uk/business/2017/09/17/turbulent-fe
ud-airbus-boeing/
ECW1101 - Lecture Week 11 60
 SUMMARY

ECW1101 - Lecture Week 11 61

Summary
A monopolistically competitive market is characterised
by three attributes:
many firms
differentiated products
free entry (or exit)

Monopolistic competition does not have all the

desirable properties of perfect competition
in equilibrium each firm has higher average costs
than firms in perfect competition
charges a price above marginal cost
this creates monopoly-like deadweight losses.

ECW1101 - Lecture Week 11 62

Summary
The number of firms can be too large or too small.
The product differentiation leads to the use of
advertising and brand names
Critics argue that advertising and brand names
take advantage of consumer irrationality and
reduce competition.
Defenders argue that advertising and brand
names inform consumers and create more
competition on price and product quality.

ECW1101 - Lecture Week 11 63

Summary
Oligopolists maximize their total profits by forming a
cartel and acting like a monopolist.
If oligopolists make decisions about production levels
individually, the result is a greater quantity and a lower
price than under the monopoly outcome.
The prisoners’ dilemma shows that self-interest can
prevent people from maintaining cooperation, even
when cooperation is in their mutual self-interest.
The logic of the prisoners’ dilemma applies in many
situations, including oligopolies.
Policymakers use the antitrust laws to prevent
oligopolies from engaging in behavior that reduces
competition.
ECW1101 - Lecture Week 11 64
 Next Week
Revision
Week 1 – week 11

ECW1101 - Lecture Week 4 65