Introduction to Economics Test# 2 Monopolistic Competition and Oligopoly.

Is Oligopoly Efficient?

Generally, Oligopoly is not efficient. It suffers from the same source of inefficiency as monopoly. If firms in oligopoly play repeated prisoner's dilemma game, they can end up restricting output to the monopoly level and making the same economic profit as a monopoly would make. Even when the firms don't cooperate, they don't necessarily drive the price down to marginal cost.

The prisoner's dilemma

A game between two prisoners that shows why it is hard to cooperate even when it would be beneficial to both players to do so.

Duopoly

A market in which there are only two producers.

Oligopoly

A market structure in which: 1) A small number of firms compete. 2)Natural or legal barriers prevent the entry on new firms.

Playoff Matrix

A table that shows the playoffs for each player for every possible combination of actions by the players.

Strategies

All the possible actions of each player in a game.

Excess Capacity

An interesting feature of firms in monopolistic competition is that they always have excess capacity in long run equilibrium. Excess Capacity is the amount by which the efficient Scale exceeds the quantity that the firm produces.

Entry and Exit

In monopolistic competition, there are no barriers to entry or exiting the market.

The firm's profit-maximizing Decision

Firms maximize profit by producing the quantity at which marginal revenue equals marginal cost and by charging the highest price that buyers are willing to pay for this quantity.

Collusion impossible

Firms sometimes try to profit from illegal agreements- collusion- with other firms to fix prices and not undercut each other. Collusion is impossible when the market has a large number of firms, as it does in monopolistic competition.

Product Differentiation

Making a product that is slightly different from the products of competing firms. A differentiated product has close substitutes, but it does not have perfect substitutes.

Repeated game

Most real-world games get played repeatedly. This fact suggests that real-world duopolists might find some way of learning to cooperate so that they can enjoy a monopoly profit. If a game is played repeatedly, one player has the opportunity to penalize the other player for previous "bad" behavior.

1) A small number of firms compete

Oligopoly is a market with a small number of firms. Each firm has a large market share, the firms are interdependent and they face the temptation to collude. No one firm controls the price. But each firm is large, and the quantity produced by each firm influences the price. Firms in Oligopoly might produce identical or differentiated products. The problem for a firm in an Oligopoly is that its own profit-maximizing actions might decrease the profits of its competitors. But if each firm's actions decrease the profits of the other firms, all the firms end up with a lower profit.

Product Development and Marketing

To enjoy economic profit, firms in monopolistic competition must be continually developing new products. The reason is that wherever economic profits are earned, imitators emerge and set up business.

Long Run: Zero Economic profit

When new firms start to enter the market, the demand that used to be for the specific firm decreases because of the competition, quantity demanded decreases and price decrease. The firm start making zero economic profit with its ATC is the same as its Maximizing profit. If demand becomes relatively so low relative to cost, then the firms incur economic losses, exit will occur. As firms leave an industry, the demand for the products remaining firms increases and their demand curve shift rightward. The process ends when all the firms in the industry are making zero economic profit.

Competing on Price

Because of product differentiation, a firm in monopolistic competition faces a downward-sloping demand curve. The firm can set its price and output, but there's a tradeoff between quality and price. A firm that makes a high quality product can charge a higher price than a firm that makes a low quality product

Competing in Marketing

Because of product differentiation, a firm in monopolistic competition must market its product. Marketing takes two main forms: 1) Advertising 2) Packaging

No market dominance

Each firm must be sensitive to the average market price of the product, but it does not pay attention to any one individual competitor. Because all the firms are relatively small, no single firm can dictate market conditions, so no one firm directly affect the actions of the other firms.

small market share

Each firm supplies a small part of the market. Consequently, while each firm can influence the price of its own product, it has little power to influence the average market price.

Monopolistic Competition and Perfect Competion

Efficiency requires that the marginal benefit of the consumer equal the marginal cost of the producer. Price measures marginal benefit, so efficiency requires price to equal marginal cost. In Monopolistic Competition, price exceeds marginal revenue and marginal revenue equals marginal cost, so price exceeds marginal cost- a sign of inefficiency.

3) Marketing

Firms differentiate their products by designing and developing features that differ from those of their competitors' products. But firms also attempt to create a consumer perception of product differentiation even when actual differences are small. Advertising and packaging are the principle means firms use to achieve this end.

1) Cost vs. Benefit of product innovation.

The decision to innovate is based on the profit-maximizing calculation. Innovation and product development are costly activities, but they also bring in additional revenues. The firm must balance the cost and benefit at the margin.

The Four Firm Concentration Ratio

The percentage of the total revenue in an industry accounted for by the four largest firms in the industry. A ratio of less than 40% is regarded as a monopolistic competition A ratio of 40% and up is an Oligopoly zero for perfect competition 100% for Monopoly

Large number of firms

The presence of a large number of firms has three implications for the firms in the industry: 1) small market share. 2) no market dominance. 3) collusion impossible

Competing on Quality

The quality of a product is the physical attributes that make it different from the products of other firms.

Nash equilibrium

an equilibrium in which each player takes the best possible action given the action of the other player.

Monopolistic Competition

is a market structure in which: 1) A large number of firms compete. 2) Each firm produces a differentiated product. 3) Firms compete on price, product quantity, and marketing. 4) Firms are free to enter and exit.

Collusion

1) Cartel 2) Duopoly

Cartel

A group of firms acting together to limit output, raise price, and increase economic profit.

2) Efficiency and product innovation.

Because price exceeds marginal cost in monopolistic competition, product improvement is not pushed to its efficient level.

Efficient scale

The quantity at which average total cost is at minimum.

The Herfindahl-Hirshman Index

The square of the percentage market share of each firm summed over the 50 largest firms. (HHI= A^2 + B^2 + C^2 +....) A market in which HHI is less than 1,500, is regarded as being competitive-monopolistic competition A market in which HHI lies between 1,500 and 2,500 is regarded as being moderately competitive. Also a monopolistic competition. A market in which HHI exceeds 2,500 is regarded as being uncompetitive. In perfect compitition the HHI is small. In a monopoly, the HHI is 10,000

Game theory

The tool that economists use to analyze strategic behavior- behavior that recognizes mutual interdependence. All games share three features. 1) rules 2) strategies 3) payoffs.

Identifying monopolistic competition

To identify monopolistic competition, we need to measure the extent to which a market is dominated by a small number of firms. To measure this feature of markets, economists use two indexes called measures of concentration. 1) The four firm concentration ratio 2) The Herfindahl-Hirshman Index