Monopolistic Competition, Oligopoly, Game Theory

MONOPOLISTIC
COMPETITION, OLIGOPOLY, &

GAME THEORY
MONOPOLISTIC COMPETITION
• Firms in monopolistically competitive
industry share some of the
characteristics of perfect competition
market structure:
1. Presence of many firms.
2. Availability of complete information
3. Freedom of exit and entry
• But unlike Firms in perfect competition
industry, monopolistically competitive
industry firms share one unique
characteristic:
1. Products are not homogenous. Each firm
produces a product that differs in some
slight way from the products of its
competitors.
• But competitor’s products are close
substitutes, therefore in this market
structure, firms do have real monopoly
power.
• Example of monopolistic competition
firms: gas stations, dry-cleaning
services, etc.
MONOPOLISTIC COMPETITOR’S
DEMAND CURVE
• Due to the presence of substitutes for
monopolistic firm’s products, but not
perfect substitutes
• Demand curve is downward sloping.
REVENUE CURVES FOR
MONOPOLISTIC FIRM
• Monopolistic firms are assumed to
maximize their profits.
• So, the relationship between MC and MR
determines the optimal quantity of
output.
• Demand curve determines the price at
which output will be sold.
REVENUE CURVES FOR
MONOPOLISTIC FIRM
• Because product differentiation, a
monopolistic firm could alter the price of
its product to affect the quantity of output
sold.
• But the price alteration is limited by the
existence of close substitutes.
• So, monopolistic firm price P>MR
REVENUE CURVES FOR
MONOPOLISTIC FIRM
• A firm’s demand curve is equivalent to its
AR curve.
• Monopolistic firm’s demand curve is
downward-sloping, the MR curve lies
below it.
• Remember: When the average is falling,
the marginal is below the average.
PRICE AND MARGINAL COST
• As seen, monopolistic firm’s price,
P>MR.
• Monopolistic firm produces output at
which MR=MC
• Thus, monopolistic firm must produce at
a level of output at which P>MC.
• Monopolistic firm does not exhibit
resource allocative efficiency (P≠MC).
SHORT-RUN PROFIT
MAXIMIZATION
• Profit-Maximizing Output: Additions to
firm’s profit are positive as long as the
MR received from the sale of an
additional unit of output exceeds the MC
incurred in producing that unit.
SHORT-RUN PROFIT
MAXIMIZATION
• Profit-Maximization price: The MR curve
used to determine profit maximizing
output is based on the firm’s demand
curve. MR captures the firm’s revenues
of selling various levels of output at the
corresponding prices on the demand
curve. Thus, to find the equilibrium price,
find the point on the demand curve
directly above the profit-maximizing
output.
LONG-RUN PROFIT
MAXIMIZATION
• Effects of entry on the monopolistic firm:
as new firms enter, the demand curves
for existing firms shift inward
• Given the relationship between MR and
Demand, MR also shifts inward
• Thus, the inward shift in the Demand
results in lower levels of AR, which leads
to a profit declines.
LONG-RUN PROFIT
MAXIMIZATION
LONGT-RUN PROFIT
MAXIMIZATION
CHARACTERISTICS
• Excess Capacity Theorem: profit
maximizing output is at the point of
tangency between Demand curve and
AC. This level output is to the left of the
output level corresponding to minimum
AC. The difference between these two
output levels is known as excess
capacity.
EXCESS CAPACITY
OLIGOPOLY
• Few sellers and many buyers

• Firms produce either homogenous, or
differentiated products
• There are barriers to entry
• Concentration ratio: the percentage of
industry sales accounted for by x number
of firms in the industry. Note, high
concentration implies few sellers.
OLIGOPOLY
• Few sellers and many buyers

• Firms produce either homogenous, or
differentiated products
• There are barriers to entry
• Concentration ratio: the percentage of
industry sales accounted for by x number
of firms in the industry. Note, high
concentration implies few sellers.
PRICE AND OUTPUT UNDER
OLIGOPOLY
• Cartel Theory
• Kinked Demand Curve Theory
• Price Leadership Theory.
THE CARTEL THEORY
• A cartel exists when collusive behavior

between oligopolists takes the form of written
agreements or other formal arrangements
regarding output price and quantity.
• So doing, oligopolists act as if there were only
one firm in the industry.
• Thus, a cartel can reduce output and increase
price in an effort to increase joint profits.
THE CARTEL THEORY
The Benefits of Being Members
of a Cartel
We assume the
industry is in long-run
equilibrium, producing
Q1, and charging P1.
There are no profits. A
reduction in output to
QC through the
formation of a cartel
raises price to PC and
brings profits of CPCAB
THE CARTEL THEORY
• Problems with cartel:

1. Formation: each potential member has an
incentive to be a free rider.
2. Formulation of Cartel Policy: there may be as
many policy proposals as there cartel
members.
3. Entry: high profits provide incentives for new
suppliers to join the Cartel. The Cartel is likely
to break up if new members enter.
4. Cheating: Cartel members have incentive to
cheat on the agreement
THE CARTEL THEORY
THE KINKED DEMAND CURVE
THEORY
The key behavioral assumption is that if a
single firm lowers price, other firms will
do likewise, but if a single firm raises
price, other firms will not follow suit.
The Kinked Demand
Curve Theory
Observations About Kinked
Demand Theory
• Prices are “sticky” if oligopolistic firms face
kinked demand curves.
• The kinked demand curve posits that
prices in oligopoly will be less flexible than
in other market structures.
Price Leadership Theory
• One firm in the industry, called the dominant firm,
determines price and all other firms take this price
as given.
• The dominant firm sets the price that maximizes its
profits, and all other firms take this price as given.
• All other firms are seen as price takers. They will
equate price with their respective marginal costs.
THE PRICE LEADERSHIP
THEORY
Game Theory
• Is a mathematical technique used to analyze the
behavior of decision makers who:
1. Try to reach an optimal position through game
playing or the use of strategic behavior.
2. Are fully aware of the interactive nature of the
process at hand.
3. Anticipate the moves of other decision makers.
Prisoner’s Dilemma
Cartels and Prisoner’s
Dilemma
Theory of Contestable Markets
• There is easy entry into the market and
costless exit from the market.
• New firms entering the market can
produce the product at the same cost as
existing firms.
• Firms exiting the market can easily
dispose of their fixed assets by selling
them elsewhere.

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MONOPOLISTIC

COMPETITION, OLIGOPOLY, &

• Few sellers and many buyers

• Few sellers and many buyers

• A cartel exists when collusive behavior

• Problems with cartel:

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