Monopolistic Competition

1) Relatively large number of small producers

2) Similar but not identical products.

product differentiation may be due to:

the workmanship (Big Mac v Whopper)

service

location

promotion and packaging (Gap jeans v. Wal Mart Jeans)

3) Each firm has a small market share (limited control over price)

4) Easy entry and Exit

/ See OVERHEAD 25-1
The demand curve for a monopolistic Competitive firm is highly elastic but not perfectly elastic. (Not the same as perfect competition because few rivals and differentiated product)
The elasticity of the demand curve depends on the number of competitors.
Since the firm faces a downwardly sloping demand curve it will have profit maximization and loss minimization situations similar to a monopoly
/ However, since the firm has easy entry and exit the long run will be similar to a perfectly competitive market. This means that if they are earning economic profits other firms will enter.
To understand this change in the Demand curve we need to go back to two things we learned earlier.
List Determinants of Demand and relate price of Sub. to shift of Demand Curve
List Determinants of Elasticity and relate substitute products to elasticity.
Hence in theory the Demand curve shifts and rotates.

SEE OVERHEAD 25-2 / The Monopolistic Competitor does not reach allocative efficiency because the price is not equal to the Marginal Cost in the long run.
The Monopolistic Competitor does not reach productive efficiency because it does not produce where unit costs (average costs) are the lowest.

Oligopoly: Chpt 26

Prisoners Dilemma

Two students are arrested by the police. The police have enough evidence to put both in jail for one year. The police suspect both of being involved in a series of robberies. They put both students in separate rooms and present them with the following option.

If both of you remain silent they will both get 1 year jail on the gun charge.

If only you confess and implicate your partner we will cut a deal to allow you to go free and your partner will get 20 years.

If you do not confess and your partner does and implicates you then you will get 20 years.

If both of you confess and implicate your partner then you both will get 8 years.

Confess / Remain Silent
Confess / You get 8 years
I gets 8 years / You get 20 years
I go Free
Remain Silent / You go free
I get 20 years / You get 1 year
I get 1 year

What are both thinking?

That the other will rat them out and they will have to spend 20 years in jail. Because of this both will confess and rat the other one out.

What is the best thing for them to do?

Not confess and only get the one year in jail. The problem is that they both will think the other will cheat.

This is knows as the game theory.

The oligopoly operates on the Game Theory: There is much price strategy in deciding what price to charge.

High / Low
High / $12
$12 / $15
$6
Low / $6
$15 / $8
$8

Jumpers is in the lower left portion and Leapers is in the upper portion.

IF both price high they will both make a good profit. However if one decided it wants more profit it will lower the price. If this happens they make great profit and the other firm makes poor profit.

Each firms profits depends on both its pricing strategy and the pricing strategy of its rivals.

This often leads to collusion: a formal or informal pricing strategy.

There is because of the high payoff a strong incentive to cheat.

Kinked Demand: Non collusive Oligopoly:


(SEE OVERHEAD 26-2) / 1) If all firms in the industry match the price changes by the firm then the Demand curve could look like D1.
2) If the firms do not match the price changes of the firm then its demand curve will look like D2. The reason for this is that if they charge a price higher than everyone else they will not make as much as the other firms. If they lower the price they will then make more profit than the other firms.
3) The best alternative is that firms will match price drops but ignore raised prices. This allows them to keep their market share. This leads to a kinked demand curve.
This means that for the most part any change in price will be bad for the individual oligopolist.

The further lower the price the more inelastic the demand curve gets. This means that if they cut prices they will actually lose revenue.

The oligopoly will produce where MR = MC. However, they are actually working off of two different cost curve. If cost go up the profits will still remain the same because of the kinked demand curves.

As long as both parties will stick to it collusion is the best way to go for the manufacturer. It is through collusion that prices can remain the highest.


(SEE OVERHEAD 26-3) / If we assume that the firms in the industry have the same cost curves, and will match the others increase or decrease in price then we know that they will produce at the point where MR = MC.

Mutual Interdependence: Oligopolies are dependent on the other one. If one lowers prices the other one must lower prices. There is a mutual interdependence between them.

Some problems of collusion:

1) Demand and Cost differences: this makes it hard to agree on a price.

2) number of firms: the more firms the harder it is to agree.

3) Cheating: If any firm cheats the others must follow suit

4) Recession: This increases average prices.

5) Potential Entry:

6) Legal obstacles

Price Leadership: when the firms just follow the pricing of the largest firm in the oligopoly.

Cost- Plus Pricing: Firms just take their costs and add a percentage to it.