Market Structure Continuum

Chapter 10
Monopolistic Competition & Advertising
 What you should know by the end of this
week...
 How prices and profits are determined in monopolistic
competition in the short run and the long run
 Why monopolistic competition poses a trade-off between
lower prices and greater product diversity
 The economic significance of advertising and brand names
 How our understanding of oligopoly can be enhanced by

using game theory, especially the concept of the

prisoners’ dilemma
 How repeated interactions among oligopolists can help

them achieve tacit collusion

The Meaning of Monopolistic Competition

Monopolistic competition is a market structure in

which:
 there are many competing producers in an industry
 each producer sells a differentiated product
 there is free entry into and exit from the industry in
the long run
 Understanding Monopolistic Competition

 Because each firm is offering a distinct product, it is in a

way like a monopolist: it faces a downward-sloping
demand curve and has some market power—the ability
within limits to determine the price of its product.
 However, unlike a pure monopolist, a monopolistically
competitive firm does face competition: the amount of
its product it can sell depends on the prices and products
offered by other firms in the industry.
 The MC Firm in the Short Run
(a) A Profitable Firm (b) An Unprofitable Firm
Price, Price,
cost, cost,
MC
marginal marginal MC
revenue revenue

ATC ATC

P
P
Profit ATC
U
P Loss
ATC U
P

D D
P U
MR MR
P U
Q Quantity Q Quantity
P U
Profit-maximizing quantity Loss-minimizing quantity
Monopolistic Competition in the Long Run

 In the long run, equilibrium of a monopolistically

competitive industry is the zero-profit-equilibrium,
firms just break even. The typical firm’s demand curve
is just tangent to its average total cost curve at its
profit-maximizing output.
Entry and Exit Shift Existing Firm’s Demand Curve
and Marginal Revenue Curve
(a) Effects of Entry (b) Effects of Exit

Price,
Price,
marginal
marginal
revenue
revenue
Exit shifts the
Entry shifts the existing
existing firm’s
firm’s demand curve
demand curve and its
and its marginal
marginal revenue
revenue curve leftward.
curve rightward.

D
D 2
MR MR D 1 MR MR D1
2 1 2 1 2
Quantity Quantity
The Long-Run Zero-Profit Equilibrium
Price, cost,
marginal revenue

MC

Point of tangency

ATC

Z
P = ATC
MC MC

D
MR MC
MC
Q Quantity
MC
Product Differentiation

Product differentiation plays an even more crucial role

in monopolistically competitive industries.

Why?
 Tacit collusion is virtually impossible when there are
many producers.
Product Differentiation – How?
 How do firms in the same industry—such as fast-food
vendors, gas stations, or chocolate companies—
differentiate their products?

 Is the difference mainly in the minds of consumers or in

the products themselves?
 Three Forms of Product Differentiation

There are three important forms of product differentiation:

 Differentiation by style or type
 Differentiation by location
 Differentiation by quality
Product Differentiation – Competition & Diversity

There are two important features of industries with

differentiated products:

 Competition among sellers: Producers compete for

the same market, so entry by more producers reduces
the quantity each existing producer sells at any given
price.

 Value in diversity: In addition, consumers gain from

the increased diversity of products.
 Controversies About Product Differentiation

Advertising and Brand names play a big role in product

differentiation.
 The Role of Advertising

 Advertising is not a waste of resources when it gives

consumers useful information about products.

 Advertising that simply touts a product is harder to

explain.

 Either consumers are irrational, or expensive advertising

communicates that the firm's products are of high quality.
 Brand Names

 Some firms create brand names.

 A brand name is a name owned by a particular firm that

distinguishes its products from those of other firms.

 As with advertising, the social value of brand names can

be ambiguous.

 The names convey real information when they assure

consumers of the quality of a product.
Oligopoly &
Strategic
Behavior
 The Prevalence of Oligopoly
 Oligopoly arises from the same forces that lead to
monopoly, except in weaker form. It is an industry with
only a small number of producers.

 When no one firm has a monopoly, but producers

nonetheless realize that they can affect market prices, an
industry is characterized by imperfect competition.
 Some Oligopolistic Industries

http://www.investopedia.com/terms/h/hhi.asp

http://finance.fortune.cnn.com/2014/02/13/time-war
ner-cable-comcast-merger/
Understanding Oligopoly

 An oligopoly consisting of only two firms is a duopoly.

 With only two firms in the industry, each would realize

that by producing more, it would drive down the market
price. So each firm would, like a monopolist, realize that
profits would be higher if it limited its production.

 So how much will the two firms produce?

Understanding Oligopoly – Collusion & Non-Cooperative
 Sellers engage in collusion when they cooperate to raise
each others’ profits.

 The strongest form of collusion is a cartel, an agreement

by several producers to obey output restrictions in order
to increase their joint profits.

 They may also engage in non-cooperative behavior,

ignoring the effects of their actions on each others’
profits.
Competing in Prices vs. Competing in Quantities

 Firms may decide to engage in quantity or price

competition.

 Quantity competition
(or the Cournot model) is when firms are restricted in how
much they can produce, it is easier for them to avoid
excessive competition and to “divvy up” the market,
thereby pricing above marginal cost and earning profits.

 It is easier for them to achieve an outcome that looks like

collusion without a formal agreement.
 Competing in Prices

 Price competition (or the Bertrand model) is when firms

produce perfect substitutes and have sufficient capacity to
satisfy demand when price is equal to marginal cost

 Each firm will be compelled to engage in competition

by undercutting its rival’s price until the price reaches
marginal cost—that is, perfect competition.
The Prisoners’ Dilemma

 When the decisions of two or more firms

significantly affect each others’ profits, they are in a
situation of interdependence.
 The study of behavior in situations of
interdependence is known as game theory.
 The reward received by a player in a game—such as
the profit earned by an oligopolist—is that player’s
payoff.
 A payoff matrix shows how the payoff to each of the
participants in a two player game depends on the
actions of both. Such a matrix helps us analyze
interdependence.
The Prisoners’ Dilemma in Thelma & Louise
Louise

Don’t confess Confess

Louise gets 5-year Louise gets 2-year

sentence. sentence.

Don’t
confess

Thelma gets 5-year Thelma gets 20-year

sentence. sentence.
Thelma

Louise gets 20-year Louise gets 15-year

sentence. sentence.

Confess

Thelma gets 2-year Thelma gets 15-year

sentence. sentence.
 A Payoff Matrix – for Oligopolists
Ajinomoto

Produce 30 million Produce 40 million

pounds pounds

Ajinomoto makes $180 Ajinomoto makes $200

million profit. million profit.

Produce 30
million
pounds
ADM makes $180 ADM makes $150
million profit million profit
ADM

Ajinomoto makes $150 Ajinomoto makes $160

million profit. million profit.

Produce 40
million
pounds

ADM makes $200 ADM makes

million profit $160million profit
 The Prisoners’ Dilemma - Strategies

 An action is a dominant strategy when it is a player’s

best action regardless of the action taken by the other
player. Depending on the payoffs, a player may or may
not have a dominant strategy.

 A Nash equilibrium, also known as a non-cooperative

equilibrium, is the result when each player in a game
chooses the action that maximizes his or her payoff given
the actions of other players, ignoring the effects of his or
her action on the payoffs received by those other players.
 Overcoming the Prisoners’ Dilemma

Repeated Interaction and Tacit Collusion

 Players who don’t take their interdependence into account arrive
at a Nash, or non-cooperative, equilibrium. But if a game is
played repeatedly, players may engage in strategic behavior,
sacrificing short-run profit to influence future behavior. In
repeated prisoners’ dilemma games, tit for tat is often a good
strategy, leading to successful tacit collusion.

 Tit for tat involves playing cooperatively at first, then doing

whatever the other player did in the previous period.
Oligopoly in Practice

 Oligopolies operate under legal restrictions in the form of

antitrust policy. Antitrust policies are efforts undertaken
by the government to prevent oligopolistic industries
from becoming or behaving like monopolies. But many
succeed in achieving tacit collusion.

 Tacit collusion is limited by a number of factors,

including:
 large numbers of firms
 complex products and pricing scheme
 bargaining power of buyers
 conflicts of interest among firms
 Product Differentiation and Price Leadership

 When collusion breaks down, there is a price war.

 To limit competition, oligopolists often engage in

product differentiation which is an attempt by a firm to
convince buyers that its product is different from the
products of other firms in the industry.

 When products are differentiated, it is sometimes

possible for an industry to achieve tacit collusion through
price leadership.

 Oligopolists often avoid competing directly on price,

engaging in non-price competition through advertising