Key Concepts and Summary

Key Terms

cartel a group of firms that collude to produce the monopoly output and sell at the monopoly price collusion when firms act together to reduce output and keep prices high differentiated product a product that consumers perceive as distinctive in some way duopoly an oligopoly with only two firms game theory a branch of mathematics that economists use to analyze situations in which players must make decisions and then receive payoffs based on what decisions the other players make imperfectly competitive firms and organizations that fall between the extremes of monopoly and perfect competition kinked demand curve a perceived demand curve that arises when competing oligopoly firms commit to match price cuts, but not price increases monopolistic competition many firms competing to sell similar but differentiated products oligopoly when a few large firms have all or most of the sales in an industry prisoner’s dilemma a game in which the gains from cooperation are larger than the rewards from pursuing self-interest product differentiation any action that firms do to make consumers think their products are different from their competitors'

Key Concepts and Summary

10.1 Monopolistic Competition

Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the firm sells the product, intangible aspects of the product, and perceptions of the product. The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist, because the monopolistic competitor has direct competition, unlike the pure monopolist. A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. The monopolistic competitor will produce that level of output and charge the price that the firm’s demand curve indicates. If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will experience exit of firms until economic losses are driven up to zero in the long run. A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC, but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm. Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.

10.2 Oligopoly

An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal. The prisoner’s dilemma is an example of the application of game theory to analysis of oligopoly. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.

Self-Check Questions

1 . Suppose that, due to a successful advertising campaign, a monopolistic competitor experiences an increase in demand for its product. How will that affect the price it charges and the quantity it supplies? 2 . Continuing with the scenario in question 1, in the long run, the positive economic profits that the monopolistic competitor earns will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm’s profit, what will happen to the original firm’s profit- maximizing price and output levels? 3 . Consider the curve in the figure below, which shows the market demand, marginal cost, and marginal revenue curve for firms in an oligopolistic industry. In this example, we assume firms have zero fixed costs.

FIGURE 10.6 a. Suppose the firms collude to form a cartel. What price will the cartel charge? What quantity will the cartel supply? How much profit will the cartel earn? b. Suppose now that the cartel breaks up and the oligopolistic firms compete as vigorously as possible by cutting the price and increasing sales. What will be the industry quantity and price? What will be the collective profits of all firms in the industry? c. Compare the equilibrium price, quantity, and profit for the cartel and cutthroat competition outcomes. 4 . Sometimes oligopolies in the same industry are very different in size. Suppose we have a duopoly where one firm (Firm A) is large and the other firm (Firm B) is small, as the prisoner’s dilemma box in Table 10.4 shows. Firm B colludes with Firm A Firm B cheats by selling more output Firm A colludes with Firm B A gets $1,000, B gets $100 A gets $800, B gets $200 Firm A cheats by selling more output A gets $1,050, B gets $50 A gets $500, B gets $20 TABLE 10.4 Assuming that both firms know the payoffs, what is the likely outcome in this case?