ECONOMICS Lecture –14

HSS 301
Monopolistic
Competition
 A market structure in which
many firms sell products that are
similar but not identical
 Many sellers
Features Product differentiation

Free entry and exit

 • Toothpaste/Soap/Shampoo
• Clothing Brands
• Restaurants/ Fast Food
Examples Chains/ Coffee Shops
• Earphones/Back-cover
• Computer Games/Software
• Novels/Movies
competitive market P=MR Profit
manimizing quantity at P MC
5 =
.
,

Profit maximizing quantity at MR

monopoly
Conditions
market 5 P MR . ,
=
MC

Monopolystic competition 5: Profit manimizing quantity at, MR =

MC and P> MR which is exactly like monopoly .

slopping ; they have unique

because demand curve of
,
monopolystic competitive market is downward
bayed their consumer on

unique product.
• Profit Maximizing Quantity at MR=MC (for monopoly ,
• P>MR=MC is similar to Monopoly due to product
differentiation
• In short run, when
• P>ATC, positive economic profit encourages entry.
• P<ATC, economic loss causes exit
• In long run equilibrium, when P=ATC, entry/exit stops &
firms earn 0 economic profit due to shift in demand.
Since monopolistic firms have monopoly on
their own differentiated product, demand
curve facing a monopolistic firm is downward
sloping just like a monopoly.
 A Monopolistic Competitor in the Short Run
Price

Price
MC MC
ATC ATC
𝑷𝟎 Short Run
ATC at 𝑸𝟏 Short Run
Profit Loss
ATC 𝑷𝟏
at 𝑸𝟎

D
D
MR MR

𝑸𝟎 𝑸𝟏
A Monopolistic Competitor in the Long Run

Price
MC
ATC ATC
at 𝑸𝟎 = 𝑷𝟎
Zero economic profit in
the long run

D
MR

𝑸𝟎
Oligopoly
A market structure in which only
a few sellers offer similar or
identical products
Features of an Oligopoly Market

A few sellers
Differentiated products
High barriers to entry
Price setting ability
Interdependence of firms
 • Car Brands
• Telecom Companies
• Tech Giants
Example
• OTT Platforms
• Airlines In The
International Market
• Key feature of any oligopoly market is the tension
between cooperation & self interest.
• Oligopolies are best off when they cooperate &
together act like a monopolist.
• But because each oligopolist care about own profit,
incentives are powerful against a cooperative outcome.

• Each firm in the oligopoly must consider how its

production decision affects the other firms.

• Our goal is to see how this interdependence shapes the

behavior of an oligopoly firm.
Collusion & Cartel

Collusion: An agreement among firms in a market,

about quantities to produce or prices to charge

Cartel: A group of firms acting in unison.

They behave like a monopoly. Charges a single price.
Decides who gets how much market share.
 Difficulties of Forming a Cartel

• Often cartel/collusion is not possible because self interest of

individual firms leads them to cheat the collusion. Because
Cheating the cartel & producing higher quantity could
generate more profit than the cartel quantity.

• When number of firms in the oligopoly market rises

(increasing market size), cartel formation becomes more
unlikely. As the market grows larger, it is driven towards
competitive outcome.

• Govt laws also prohibit agreements among oligopolists.

 • Duopoly: Simplest form of
oligopoly with only 2 members
or players.
A Duopoly
Example • Let’s consider a town with only
2 water well owners.
(For simplicity, we assume MC=0)
Market Quantity (gallons) Market Price ($) Profit = TR (since MC=0)
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
If the Market was Perfectly Competitive

• Then they would produce where P=MC=0.

• Total quantity would be 120 gallons of water while
each owner is producing 60 gallons.
• It would be the best quantity & the best price for
that society
• But the firms would earn 0 profit.
If they Could form a Cartel

• Then they would act like one (monopoly) firm

• They will produce where P>(MC=MR)
• Total quantity would be 60 gallons of water while
each firm is producing 30 gallons
• Which maximizes their joint profit = $3600 while
each firm is earning $1800
• Meanwhile, this would be less than desired quantity
& higher price for that society
 If they Produce Separately

• In absence of a binding agreement, monopoly outcome

is unlikely. Each firm predicts the other firm’s output &
decide to produce more.
• If one firm produce 40 gallons expecting the other firm
to produces 30 gallons, market quantity increases to 70
gallons which lowers the market price to $50.
• In that case, the first firm would earn $2000 while the
other firm would earn $1500 but their joint profit $3500
is now less than maximum.
• The 2nd firm can take the same strategy and produce 40 gallons
• In that case, market quantity becomes 80 gallons with each firm
producing 40 gallons & market price reduces to $40
• Each firm would earn $1600 reducing their joint profit to $3200
Now, will they produce more??
• If any one firm produces 50 gallons, it increases market quantity to 90
gallons & reduces market price to $30 which reduces this firm’s profit
to $1500.
• Since producing more reduces individual profit now, no firm would
want to produce more than 40 gallons.
• Therefore, the market reaches to an equilibrium of 80 gallons of
water with each firm producing 40 gallons & equilibrium price of $40
 Nature of Oligopoly Behavior

• We’ve seen that oligopolists would be better off cooperating

(forming a cartel) and reaching the monopoly outcome.
• Yet because they each pursue their own self-interest & tries to
cheat the cartel, they do not end up reaching the monopoly
outcome and, thus, fail to maximize their joint profit.
• When pursuing self-interest each firm tries to maximize own
profit, they produce a total quantity greater than the monopoly
quantity but less than competitive quantity, charge a price lower
than the monopoly price but higher than competitive price, and
earn total profit less than the monopoly profit.
 Nash Equilibrium
(The Equilibrium for an Oligopoly)

• Nash equilibrium, named after renowned

mathematician John Nash, is a situation in which
economic actors interacting with one another each
choose their best strategy given the strategies that all the
other actors have chosen.
• In our duopoly example,
• Nash equilibrium = (40 gallons, 40 gallons)

N.B. Nash equilibrium is not the optimum payoffs but the optimum strategies of the players
 • The study of how people
behave in strategic situations

Game Theory • It is useful for understanding

the economics of cooperation.
(John F. Nash) It is helpful to understand why
cooperation is desirable but
difficult among players (such
as oligopolies) in a strategic
situation.
 A particular “game” between
two captured prisoners that
Prisoner’s illustrates why cooperation is
Dilemma difficult to maintain even when
it is mutually beneficial
 • With the current evidence, we can
lock you up for 1 year.
Situation • If you confess to the bank robbery
Given to and implicate your partner, you’ll be
given immunity and can go free.
Each of the Your partner will get 20 years in jail.
Captured • But if you both confess to the crime,
Prisoners we won’t need your testimony and
we can avoid the cost of a trial, so
you will each get an intermediate
sentence of 8 years.
Payoff Matrix of Prisoner’s Dilemma

Babul’s Decision
Abul’s Decision Confess Silent

Confess (8 Y, 8 Y) (0 Y, 20 Y)

Silent (20 Y, 0 Y) (1 Y, 1 Y)
• The table shows the payoff matrix for their choices. Each
prisoner has two strategies: confess or remain silent.
• The sentence each prisoner gets depends on the strategy he
chooses and the strategy chosen by his partner in crime.
• Since they care only about their own individual prison
sentences, best strategy for each prisoners is to confess.
• Both of them end up confessing & getting 8-year sentences
• Nash equilibrium from this game : (confess, confess)

• Cooperation between the two prisoners is difficult to

maintain, because cooperation is individually irrational.
 Prisoner’s Dilemma in Arm’s Race
Decision of USA
Arm Disarm
Decision of Russia

(Safe & Powerful,

Arm (At Risk, At Risk)
At Risk & Weak)

(At Risk & Weak,

Disarm Safe & Powerful)
(Safe, Safe)
Prisoner’s Dilemma in a Water Duopoly

Kamal’s Decision
40 Gallons 30 Gallons
Jamal’s Decision

40
($ 1600, $ 1600) ($ 2000, $ 1500)
Gallons

30
($ 1500, $ 2000) ($ 1800, $ 1800)
Gallons
Prisoner’s Dilemma in an Oil Duopoly

Exxon Mobil’s Decision

Chevron’s Decision Drill 1 Well Drill 2 Wells

Drill 1
($ 5M, $ 5M) ($ 3M, $ 6M)
Well

Drill 2
($ 6M, $ 3M) ($ 4M, $ 4M)
Wells
 -> ge 30 Fe, 300522
Dominant Strategy (425 both case 5 same
strategy Tenne BET
dominant
strategy (

• A strategy that is best for a player in a game regardless of the

strategies chosen by the other players
• In the previous games, both players had dominant strategies
• Prisoner’s dilemma: confess
• Arm’s race: being armed
• Water duopoly: producing 40 gallons
• Oil duopoly: drilling 2 wells

• Can you determine the Nash equilibriums for those games?

• Let’s see games with absence of a dominant strategy
Advertising Game – No Dominant Strategy
Firm - B’s Decision
Advertise Doesn’t Advertise
Firm - A’s Decision

Advertise ($ 10000, $ 5000) ($ 15000, $ 0)

Doesn’t
($ 6000 , $ 8000) ($ 20000, $ 10000)
Advertise
Firm A :

Advertising Game – No Dominant Strategy

A will advertise
When firm B advertise : firm

When firm B doesn't advertise : firm A will doesn't advertise

Firm - B’s Decision
Finm B :

When firm A advertise : Advertise Doesn’t Advertise

firm B will advertise
Firm - A’s Decision

When firm B doesn't advertise : Firm B will doesn't advertise

Advertise ($ 10000, $ 5000) ($ 15000, $ 0)

from this
Nash
equilibrium game :
(Advertise Advertise) (doesn't advertise doesn't advertise
,

Doesn’t
, ,

Jes, preizOMET
Advertise
($ 6000 , $ 8000) ($ 20000, $ 10000)
dominent for both firm
No
strategy .
 Sample Game
Player 2
Choice A Choice B

Choice A (1 , 4) (2 , 3)
Player 1

Choice B (3 , 1) (4 , 2)
• In the case of advertising game, no firm has a
dominant strategy. Each firm chooses differently
when the other firm changes their decision.

• In case of the sample game, player-1 has a dominant

strategy (choice A) while player-2 has no dominant
strategy. His choice varies with the decision of
player-1.
Prisoner’s Dilemma & Welfare of the Society

Cooperation can Sometimes be better for the society’s

welfare
• In Arm’s race – Safety to the mass
• Oil production – Less waste/pollution

Lack of cooperation can sometimes be desirable for the

society as a whole
• In prisoner’s dilemma – convicting the criminals
• In Common resource (water) market – Meeting the necessity
Thank You