Monopolistic Competition and

Oligopoly

ECON 0100

June 10, 2013

 Recall

Perfectly competitive markets must have the following

characteristics:
1 many buyers and sellers

2 all firms selling identical products

3 no barriers to new firms entering the market

This doesn’t faithfully describe many relevant markets,

where there is substantial competition but firms can still
increase prices without going out of business.
• Coffee shops
• Restaurants
 Monopolistically Competitive
Markets

Some markets feature monopolistic competition.

1 Many buyers and sellers

2 Low barriers to entry/exit

3 Firms sell similar, but not identical products

This product differentiation allows Starbucks to have

some control over its price.
Monopolistic competition
demand curve
Total revenues for Starbucks
Price Quantity TR
$6.00 0 0
$5.50 1 $5.50
$5.00 2 $10.00
$4.50 3 $13.50
$4.00 4 $16.00
$3.50 5 $17.50
$3.00 6 $18.00
$2.50 7 $17.50
$2.00 8 $16.00
$1.50 9 $13.50
$1.00 10 $10.00
$0.50 11 $5.50
$0.00 12 $0.00
Example: P=$4.00
Example: Cut price to $3.50
Example: Cut price to $3.00
 Marginal revenue

When lowering the price:

• The price effect is the lost revenue from previous
sales.
• The quantity (or output) effect is the increased
revenue from selling more units.
• The difference between the two is the marginal
revenue.
Marginal revenue is the change in total revenue divided by
the change in quantity OR the additional revenue per unit.
 Total revenues for Starbucks
Price Quantity TR MRLow MRHi
$6.00 0 0 $5.50 -
$5.50 1 $5.50 $4.50 $5.50
$5.00 2 $10.00 $3.50 $4.50
$4.50 3 $13.50 $2.50 $3.50
$4.00 4 $16.00 $1.50 $2.50
$3.50 5 $17.50 $0.50 $1.50
$3.00 6 $18.00 -$0.50 $0.50
$2.50 7 $17.50 -$1.50 -$0.50
$2.00 8 $16.00 -$2.50 -$1.50
$1.50 9 $13.50 -$3.50 -$2.50
$1.00 10 $10.00 -$4.50 -$3.50
$0.50 11 $5.50 -$5.50 -$4.50
$0.00 12 $0.00 - -$5.50
 Marginal Revenue

• Unlike for firms in perfect competition, MR is not

constant.
• MRLow and MRHi are approximations of the rate of
change in total revenues.
• MRLow is an underestimate.
• MRHi is an overestimate.
Total Revenue
This is incorrect...
This is incorrect...
This is correct...
 The Marginal Revenue Curve

• Intersects the price axis at the same point as the

demand curve.
• Is always steeper than the demand curve because of
the price and quantity effects.
• If the demand curve is linear, then the slope of the
marginal revenue curve is exactly twice that of the
demand curve.
TR(0) = 0

TR(2) = $5.00 ∗ 2
TR(2) = $10.00

MR(0) = ($10.00 − $0)/2

= $5.00
TR(0) = 0

TR(1) = $5.50
TR(1) = $5.50

MR(0) = ($5.50 − $0)/1

= $5.50
TR(0) = 0

TR(.5) = $5.75 ∗ 0.5

TR(.5) = $2.875

MR(0) = ($2.875 − $0)/0.5

= $5.75
Profit Maximization
 In the long run

Starbucks is earning economic profits

• This encourages new firms to enter the coffee
market.
• Although these new firms can not produce the exact
same product, they can produce a substitute.
Entry
 In the long run

• Neither perfectly nor monopolistically competitive

firms earn economic profits in the long run.
• Perfectly competitive firms charge P=MC while
monopolistically competitive firms charge P>MC.
• Perfectly competitive firms produce where ATC is
minimized while monopolistically competitive firms do
not.
 Efficiency

Monopolistic competition leads to neither allocative

efficiency nor productive efficiency.

Still, there are benefits to monopolistic competition in the

form of varieties of goods.
 Advertising

• Firms in monopolistic competition are still competing

for the same customers.
• Many turn to advertising and marketing to highlight
the differentiation between offerings.
• Advertising arms races could be seen as another
efficiency cost of monopolistic competition; however,
empirical research suggests that advertising drives
down the cost that consumers pay.
 Summary

• Monopolistically competitive firms have some

influence over the price of their output.
• Similar to competitive markets, i.e. profit maximized
where MR=MC and zero long-run economic profit.
• Neither productively nor allocatively efficient.
• Product differentiation may lead to consumer surplus
not measurable by traditional methods.
 Market Structures

Barriers to
No. of firms Type of Good
Entry
Perfect
Many Identical Low
Competition
Monopolistic
Many Differentiated Low
Competition
Similar/
Oligopoly Few High
Identical
 Barriers to Entry

Anything deterring the free entry of a firm into a market is

classified as a barrier to entry.
• Economies of scale
• Ownership of a key input
• Patents
• Government regulations (licensing, prohibition, taxes)
 Oligopolies

An industry is described as oligopolistic if the largest four

firms control more than 40% of the market.

e.g. Verizon, AT&T, Sprint, and T-Mobile control 89% of

the domestic wireless telephony market.
 Game Theory

Unlike firms in perfect competition or monopolistic

competition, oligopoly firms are relatively large and must
consider the response of their competitors when making
decisions.

Game theory analyzes strategic interactions and is

therefore the best tool for studying oligopoly markets.
 Games

A game is characterized by
• Players
• Strategies (or plans of action)
• Payoffs (or outcomes)
 Motivating Example

Suppose Jack and Jill are the only suppliers of water

because they are the only two owners of pails.

There are no costs associated with supplying water, but

the demand schedule is given as follows.
Quantity (Pails) Price (Dollars) Profit (Dollars)
0 120 0
10 110 1100
20 100 2000
30 90 2700
40 80 3200
50 70 3500
60 60 3600
70 50 3500
80 40 3200
90 30 2700
100 20 2000
110 10 1100
120 0 0
 One Potential Outcome

Profits are maximized at 60 pails for $60 a pail.

• Suppose Jack and Jill agree to produce 30 pails
each, earning each a profit of $1800.
• This is an example of collusion.
• Collusion occurs when two or more firms in the same
market agree not to compete.
• Cartels are formed for the purposes of collusion.
 The pitfalls of collusion
Suppose that Jack is considering increasing production
by 10 pails. Should he do it?
• This would bring total production to 70 pails and
lower the market price to $50.
• Jack’s profits would be 40 pails * $50 = $2000 >
$1800

Quantity (Pails) Price (Dollars) Profit (Dollars)

60 60 3600
70 50 3500
80 40 3200
90 30 2700
100 20 2000
110 10 1100
120 0 0
 Recap

• If Jack and Jill collude, they each produce 30 pails

and earn $1800 in profit.
• If Jack produces 10 more pails, he receives $2000
but Jill receives only $1500.

What if Jill were also to increase production to 40 pails?

• Total quantity = 80 pails so market price drops to $40.
• Jack’s profit = Jill’s profit = $1600.
 Jack and Jill game

Let’s structure this as a game:

• Players: Jack and Jill
• Strategies: 30 pails or 40 pails
• Outcomes: 4 combinations of outputs and profits
 Normal form

Jill
30 40

30 1800,1800 1500,2000
Jack
40 2000,1500 1600,1600
 Definitions

Dominant strategy a strategy that is best for one player

regardless of the strategy employed by the
other player.
Nash Equilibrium a situation in which each player
chooses the best strategy given the strategy
of the other player.

We can identify Nash equilibria and dominant strategies

by asking is a player will have an incentive to deviate.
 Equilibrium

• Jack and Jill each have a dominant strategy to

produce 40 pails.
• Therefore, the Nash equilibrium is where both
produce 40 pails and earn $1600 each.
• The payoffs are better for both is they were to
collude, but it is not an equilibrium because both
players have an incentive to “cheat”
 Definitions

Cooperative equilibrium an equilibrium in which players

cooperate to increase their mutual payoff.
Noncooperative equilibrium an equilibrium in which
players pursue their own self interest.
Prisoner’s Dilemma a game in which pursuing dominant
strategies results in noncooperation.
 One shot vs. repetition

• Nash equilibrium predicts that Jack and Jill will both

produce 40 pails of water.
• However, the underlying assumption is that the game
is played only once.
• If the game is repeated, then maybe they can
cooperate more effectively.
 Definition

Repeated game a game that is played more than once.

Suppose we interpret the demand for water as daily

demand, and Jack and Jill repeat the game each day.
• Wouldn’t $1800 each day be better than $1600 each
day?
• Need to remove the incentive to cheat by
incorporating punishments.
 Definition

Enforcement mechanisms are used to alter individual

incentives.

• “Carrots” are mechanisms that reward desired

behavior
• “Sticks” are mechanisms that punish undesired
behavior
 The largest stick

Grim Trigger strategy a punishment strategy that is

triggered if the other party deviates.

e.g. Jill announces “I will cooperate as long as you

cooperate, but if on any day you do not cooperate I will
produce 90 pails a day from that day forward.”
 Grim Trigger continued
• If Jack cooperates, he earns $1800 in each period.
• If Jack deviates, he earns an extra $200 in that
period; but in all future periods his maximum payoff is
$200!

Quantity (Pails) Price (Dollars) Profit (Dollars)

60 60 3600
70 50 3500
80 40 3200
90 30 2700
100 20 2000
110 10 1100
120 0 0
 Caveats

• Collusion and other forms of anti-competitive

behavior are illegal.
• Punishment strategies have to be credible. If a
player’s threat involves them suffering extreme
adverse consequences themselves, they will likely be
unwilling to follow through.
 Sequential games

Some games do not involve simultaneous decisions.

• Sometimes players get to move in sequence.
• These games are better represented with decision
trees, or in extensive form, rather than in normal
form.
Example
 Conclusion

• Monopolistic competition and oligopoly are not as

efficient as perfectly competitive markets.
• In the long run, monopolistically competitive firms do
not earn any economic profits, and customers benefit
from increased variety at the expense of allocative
and productive efficiency.
• Oligopolies are able to sustain economic profits
because of barriers to entry.
• If oligopolies strategically interact repeatedly over
time, they may be able collude.
• Collusion is detrimental to consumers and its practice
is illegal.