sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part XVI

Monopolisti Competition

In the real world, the extreme ases of perfe t ompetition and monopoly are not observed frequently. Monopolisti

ompetition represents a market stru ture in between perfe t ompetition and monopoly. An ex ellent example of

monopolisti ompetition is the market for books. There are low barriers to entry and high levels of ompetition.

However, ea h book is unique and a publisher has a degree of pri e ontrol for ertain books. Thus, the pri e of

books almost always ex eeds marginal ost. What drives this pro ess?

The Chara teristi s of Monopolisti Competition:

� Monopolisti Competition: A market stru ture in whi h many �rms sell produ ts that are similar but not

identi al. To be more pre ise:

� Many Sellers: There are many �rms ompeting for the same group of ustomers

� Produ t Di�erentiation: Ea h �rm produ es a produ t that is at least slightly di�erent from those of

other �rms. Thus, rather than being a pri e taker, ea h �rm fa es a downward-sloping demand urve

� Free Entry and Exit: Firms an enter or exit the market without restri tion. Thus, the number of �rms

in the market adjusts until e onomi pro�ts are driven to zero.

� Monopolisti ompetition di�ers from perfe t ompetition be ause ea h seller o�ers a somewhat di�er-

ent produ t. There is a higher level of strategi intera tion and rigorous ompetition due to the produ t

di�erentiation. However, ea h �rm has a type of monopoly ontrol over their own unique version of the

produ t.

� The distin tion between market stru tures an be blurry. Often, e onomists use their own institution and

logi to lassify a system as one system (perfe t ompetition, monopoly, monopolisti ompetition, oligopoly,

et .) vs. another

Competition with Di�erentiated Produ ts:

� Ea h �rm in a monopolisti ompetitive market is, in many ways, like a monopoly (they have the �sole market�

for their unique good).

� One result of this is that ea h �rm fa es a downward-sloping demand urve for their spe i� good

� Thus, �rms will follow the pro�t-maximizing rule of hoosing to produ e at a quantity where marginal revenue

equals marginal ost:

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� Re all that pro�t maximizing is equivalent to ost minimizing. The �rm in panel (a) is maximizing pro�ts

while the �rm in panel (b) is minimizing losses. The position of the ATC relative to the pri e determined by

the demand urve determines the level of pro�ts

� Sin e there are no barriers to entry in the monopolisti ompetition market, the pro�ts in panel (a) en ourage

�rms to enter the market for that good while the losses in urred in panel (b) en ourages �rms to drop out �

demand will respond by de reasing or in reasing (for ea h individual �rm) � this stems from having more

hoi es in the market from the in�ux of �rms (or fewer options when less �rms are involved) �

� We will have a similar zero-pro�t long run ondition.

� Graphi ally, this ondition only o ur when the point of produ tion where MR = MC tou hes both the demand

urve and the ATC urve. There is only one point where this o urs:

Monopolisti vs. Perfe t Competition:

� Given the similar attributes that produ e perfe t ompetition vs. monopoly, ea h market stru ture mirrors

the other in ertain ways:

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� The pro ess of entry and exit leads to a level of produ tion that orresponds to zero e onomi pro�ts in the

long run for both monopolisti ompetition and perfe t ompetition. However, a monopolisti ally ompetitive

�rm does not produ e at the e� ient s ale (the point that orresponds to the minimum of ATC).

� Ex ess Capa ity: A monopolisti ally ompetitive �rm ould in rease produ tion and lower the average

total ost (ATC) of produ tion. The �rm forgoes this opportunity be ause it would need to ut its pri e

to sell the additional output. It is more pro�table for the �rm to stay at the lower level of produ tion.

� Markup Over Marginal Cost:

� In perfe t ompetition, every �rm operates at a point where pri e equals marginal ost. Sin e the pri e

is determined in the market (where all �rms and buyers intera t), ea h individual �rm takes this pri e

and sets output a ordingly.

� Produ tion is set at the downward sloping portion of ATC where ATC is tangent to the demand urve.

* For a monopolisti ompetitive �rm, on the downward-sloping portion of ATC, MC has to be below

ATC (due to the relationship between ATC and MC) � This means that the pri e level is also set

above MC.

* Every monopolisti ally ompetitive �rm has a degree of market power.

* A monopolisti ally ompetitive �rm will always want to attra t new ustomers whereas a �rm in

perfe t ompetition is indi�erent towards gaining new ustomers.

Monopolisti Competition and the Welfare of So iety:

� There is a orresponding deadweight loss of monopolisti ompetition to monopoly. Be ause P > MC �

there are ustomers who not make a mutually bene� ial trade.

� However, the administrative burden of �enfor ing� a law where every �rm harged a pri e orresponding to

their MC would be enormously large.

� There are many �rms and produ ts and it would be very ostly to determine what the MC of ea h

�rm is.

� Regulating pri e may also indu e a monopolisti ally ompetitive �rm to stop produ tion (sin e they are

already earning no e onomi pro�t). Thus, government subsidies or assistan e will be needed. The result may

be more e�ort than ne essary.

� Thus, the optimal solution may be no intervention at all.

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� There are two externalities asso iated with �rms de iding to enter or exit a market:

� The produ t-variety externality: Be ause onsumers get some onsumer surplus from the introdu tion of a

new produ t, entry of a new �rm onveys a positive externality on onsumers

� The business-stealing externality: Be ause other �rms lose ustomers and pro�ts from the entry of a new

ompetitor, entry of a new �rm imposes a negative externality on existing �rms.

� The externalities above are highly related (when a new produ t is introdu ed, there will be less business

for the urrent �rms; all �rms want to in rease produ tion as P > MC).

� It is extremely di� ult to orre t for the ine� ien ies asso iated with monopolisti ompetition. Thus, market

for es do not produ e the optimal out ome.

Advertising:

� Firms that sell highly di�erentiated onsumer produ ts (razor blades, ereal, perfume, et .) require large

spending on advertising. Firms that sell homogenous produ ts (peanuts, wheat, et ) spend almost nothing.

� The debate over advertising:

� Critiques of advertising: Firms rely on psy hologi al tri ks to onvin e onsumers that similar goods are

worth di�erent pri es.

� Defense of advertising: Firms use advertising to onvey valuable information to onsumers regarding new

produ ts, sales, lo ations and so forth

* Advertising an also foster ompetition by allowing more informed onsumers to make de isions on

pri e di�eren es. Advertising allows onsumers to fully take advantage of pri e di�eren es and for e

�rms to be ompetitive.

* Advertising may be a signal of quality and demonstrate di�erent grand quality

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part XVII

Oligopoly

Oligopoly: A market stru ture in whi h only a few sellers o�er similar or identi al produ ts.

� Oligopolisti �rms are interdependent in a way that ompetitive or monopolisti �rms are not. A �rm's a tions

and strategies have a large impa t on the other �rms in an oligopolisti stru ture.

Game Theory: The study of how people behave in strategi situations

� Tool to analyze how �rms make strategi de isions. Sin e ea h �rm knows that its pro�ts depend on what

other �rm's a tions are, there are extra layers of omplexity involved

� Strategy plays a key role (unlike ompetitive or monopolisti systems)

Markets with Only a Few Sellers:

� There is tension between ooperation and self-interest. Ea h �rm has a desire to maximize their own individual

pro�ts. However, this an ome at the expense of the other �rms and the onsumers in the marketpla e. How

is equilibrium rea hed?

� A Duopoly Example: The simplest example of an oligopoly: a duopoly has only two members. The problems

fa ed by a duopoly are the same as an oligopoly with 3 or more members.

� Consider a small town where two residents, Ja k and Jill, own the only wells that supply safe drinking water.

� To keep analysis simple, we assume that Ja k and Jill an pump as mu h water as they want at no ost

� marginal ost of water equals zero

� The following table demonstrates the town's demand s hedule. Ja k and Jill an sell 10 gallons of water for

$110, 20 gallons for $100 and so forth:

� Sin e the marginal ost/total ost of produ ing more water is 0, the total revenue is also total pro�t

� The demand urve based on this town has the standard downward-sloping shape. How will the organization

of the town's water industry a�e t the overall pi ture?

� Competition, Monopolies, and Cartels:

� We an ompare what situations would o ur in the ase of perfe t ompetition or monopoly:

� Perfe tly Competitive Out ome: Re all that in perfe t ompetition, �rms set marginal ost = to pri e.

Sin e we have assumed 0 marginal osts, the �rms would supply 120 gallons and not harge anything for

them (pri e = $0) � This is the so ially optimal out ome as the maximum amount of water is supplied.

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� Monopolist Out ome: Re all that a monopolist will maximize pro�ts. The table above demonstrates

that pro�ts are maximized at a quantity of 60 gallons and a pri e of $60 (Pro�t = $3,600) � This is an

ine� ient level sin e the quantity of gallons produ ed and onsumed falls short of the so ially optimal

level.

� If Ja k and Jill work together, the pro�t-maximizing level an be a hieved

� Collusion: An agreement among �rms in a market about quantities to produ e or pri es to harge

� Cartel: A group of �rms a ting in unison

* If Ja k and Jill a t in unison and harge $60 for 60 gallons, they an split the pro�ts of $3,600

equally.

* However, it is hard for �rms to oordinate and there are anti-trust laws to stop this type of a tion

� Strategy and Behavior:

* Ja k has an in entive to maximize individual pro�ts. Ja k has an expe tation that Jill will only

bring 30 gallons to the market � Pro�ts for resident #1 in rease if 40 gallons are brought to the

market ($1,800 to $2,000)

* However, resident #2 likely has the same expe tation: Overall result: 80 gallons produ ed with

$1,600 of pro�t for ea h resident.

* � Residents will not have a desire to produ e 50 gallons (pro�ts de rease from $1600 to $1500)

� Equilibrium: When both Ja k or Jill produ e 40 gallons, they have no in entive to adjust their behavior

given the others a tion of also produ ing 40 gallons

� Nash Equilibrium: An e onomi situation where a tors intera ting with ea h other hoose the best

strategy given the strategies that other a tors have hosen

� The result is through strategi intera tion, the oligopoly equilibrium moves loser to the so ially optimal

ompetitive level. However, sellers still have a desire to maximize their pro�ts. Thus, the so ially optimal

out ome is not a hieved.

* The oligopoly pri e is less than the monopoly pri e but greater than the ompetitive pri e.

How the Size of an Oligopoly A�e ts the Market Out ome:

� As the size of an oligopoly grows, it be omes in reasingly di� ult to oordinate and make de isions.

� It is more di� ult to form artels and ollude on pri es. Also, anti-trust laws would prohibit this type

of a tion

� How does an in rease in the number of sellers a�e t the out ome in the market. Ea h seller fa es de isions

based o� of the following two e�e ts:

� The Output E�e t: Be ause pri e is above marginal ost, selling one more gallon of water will raise pro�t

� The Pri e E�e t: Raising produ tion will in rease the total amount sold, whi h will lower the pri e of water

and lower the pro�t on all the other gallons sold

� If the output e�e t is larger than the pri e e�e t � the well owner will in rease produ tion

� If the pri e e�e t is larger than the output e�e t � the owner will not raise produ tion

� The larger the number of sellers, the less ea h seller is on erned about its own impa t on the market pri e.

� As the oligopoly grows in size, the magnitude of the pri e e�e t falls.

� If the oligopoly grows large enough, the pri e e�e t disappears altogether

� As the number of sellers in an oligopoly grows larger, an oligopolisti market looks more and more like

a ompetitive market. The pri e approa hes marginal ost, and the quantity produ ed approa hes the

so ially e� ient level.

The E onomi s of Cooperation:

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� The fundamental driving for e in oligopolies is �rm intera tion. Through the use of game theory, we an

develop a useful framework/theory regarding our expe tations of �rm behavior

� The Prisoner's Dilemma: A parti ular �game� between two aptures prisoners that illustrates why ooperation

is di� ult to maintain even when it is mutually bene� ial.

� Two riminals (Bonnie and Clyde) have been aptured by the poli y. Ea h is kept in a separate ell and

have no ommuni ation with one another. The poli e have enough eviden e to onvi t ea h riminal a

year ea h for minor rimes but believe the two ommitted a more serious rime together.

� The poli e have an in entive to onvi t the two riminals for as long as possible

� Ea h riminal has a desire to minimize their onvi tion length

� The poli e extend an o�er to ea h riminal: If they onfess and impli ate their partner, they will get go

go free and the partner will go to jail for 20 years. However, if both riminals onfess, the ost of a trial

an be avoided so ea h riminal will get intermediate senten es of 8 years ea h

� The payo�s for the two individuals given their de isions is summarized in the following table:

� Sin e ea h riminal makes self-interested de isions, ea h has a desire to minimize their individual senten e.

� The out ome for ea h riminal depends on what the other does. However, there is a lear strategy.

� For Bonnie, onfessing is the superior option. If Clyde onfesses, Bonnie will get 8 years instead of 20 and if

Clyde remains silent, Bonnie will go free instead of serving one year.

� The same is true for Clyde. Confessing is the best option regardless of what Bonnie does.

� Dominant Strategy: A strategy that is best for a player in a game regardless of the strategies hosen by the

other players

� There won't always be a dominant strategy asso iated with a payo� matrix.

� The result will be both riminals spending 8 years in prison ea h. This is a terrible out ome for both as they

ould have signi� antly shorter senten es if they had both agreed to be silent

� However, sin e there are in entives for ea h riminal to �rat out� the other, both make the self-interested

de ision to onfess instead

Oligopolies as a Prisoner's Dilemma:

� Consider again the dilemma fa ed by the two residents (Ja k and Jill) who supply water to the residents of

the town.

� The two hoose in between produ ing 30 gallons (and maximizing overall pro�ts) or produ ing 40 gallons (and

possible making higher pro�ts given the others de ision. However, this may result in lower pro�ts as well)

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� A payo� matrix summarizes these intera tions best:

� Both Ja k and Jill have a dominant strategy of high produ tion. Thus, they will rea h a Nash equilibrium

onsistent with our previous analysis.

� Though the superior option would be for the two to ooperate and produ e 30 gallons ea h, there are self-

interested in entives to produ e more.

This type of analysis an be applied to a variety of settings:

� Arms ra e example in text (page 358)

� Common resour e example (page 359)

Publi Poli ies Towards Oligopolies:

� Restraint of trade and Anti-trust laws: The Sherman A t of 1890 outlaws mergers between members of

oligopoly that disrupt the ompetitiveness of a market

Controversies over Antitrust Poli y:

� Resale Pri e Maintenan e

� Predatory Pri ing

� Typing

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