When other firms see these potential profits they will enter the industry, causing a downward shift in the demand for a given firm s product.

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1 Characteristics of Monopolistic Competition large number of firms differentiated products (ie. substitutes) freedom of entry and exit Examples Upholstered furniture: firms; HHI* = 395 Jewelry and Silverware: 3 firms; HHI = 3 Metal oors and Windows: 7 firms; HHI = Women's Clothing: firms; HHI = 9 * Herfindahl-Hirschman Hirschman Index Herfindahl-Hirschman Index (HHI) Since 9, the U.S. epartment of Justice, the Federal Trade Commission, and state attorneys general have used the Herfindahl-Hirschman Index (HHI) to measure market concentration for purposes of antitrust enforcement. The HHI of a market is calculated by summing the squares of the market share percentages held by the top 5 firms. For example, an industry consisting of only two firms with market shares of 7% and 3% has an HHI of 7²+3², or 5. General frame of reference: < is considered perfectly competitive < is considered unconcentrated - is considered moderately concentrated - 99 is considered highly concentrated is considered an oligopoly is considered a monopoly Cost / Revenue (ollars) Maximizing Profits Within a Monopolistically Competitive Firm The demand curve is downward sloping because changes in price WILL effect the quantity demanded. Why? Well, if you raise your price then SOME of your customers will switch to your competition - but not all. Some will stay for your differential advantage. Profit Max: You guessed it! Profits are still maximized where marginal revenue is equal to marginal cost! Cost / Revenue (ollars) Cost / Revenue (ollars)

2 Cost / Revenue (ollars) Cost / Revenue (ollars) Remember, mono-comp s produce SUBSTITUES! Cost / Revenue (ollars) LOSS Loss: Eventually demand falls so low that the price ends up being lower than the average total cost! Cost / Revenue (ollars) Therefore, if the demand for your competitor s product increases Cost / Revenue (ollars) Competitor Remember, mono-comp s produce SUBSTITUES! Monopolistic Competition Long-Run Equilibrium Cost / Revenue (ollars) Oh no! Therefore, if the demand for your competitor s product increases then demand for your product will decrease! Cost / Revenue (ollars) Competitor Cost / Revenue (ollars) In the long-run, firms will leave if they are incurring losses. Thus, equilibrium is achieved when profit is maximized at the break-even even point (price = )

3 Oh my gosh Excess Capacity!!! Oh my gosh Excess Capacity!!! Cost / Revenue (ollars) Note that, in the long- run, a mono-comp produces an output where is NOT at its lowest point (as one would find in pure competition.) This is referred to as excess capacity. Cost / Revenue (ollars) Also note that, the more inelastic the demand, the greater the excess capacity! Characteristics of an Oligopoly few firms (typically to 5) HHI > 5 recognized interdependence barriers to entry identical OR differentiated products typically have high costs which tends to naturally limit the number of firms that can compete in the market examples: gas companies car manufacturers pharmaceuticals airlines Oligopoly Models Models used to explain the phenomenon observed in oligopolies fall under two general categories: a) traditional models b) game theory models Cost / Revenue (ollars) Traditional Models: Maximizing Profits Within an Oligopoly Oligopoly Output Levels The demand curve is downward sloping because changes in price WILL certainly effect the quantity demanded. If an oligopoly raises its price then SOME of its customers will switch to the competition; but some may stay for a differential advantage. Profit Max: Yup, profits are still maximized where marginal revenue is equal to marginal cost, but barriers to entry allow these profits to stay!!! Cost / Revenue (ollars) Kinked emand Model Oligopoly Kinked emand Model Prices within an oligopolistic market tend to be rather stable in other words, they are sticky. For this reason, many economists believe that an oligopoly faces a kinked demand curve. This is based on two assumptions: a) price increases will NOT be matched by competitors; b) price decreases WILL be matched by competitors. 3

4 Cost / Revenue (ollars) Kinked emand Model Oligopoly Kinked emand Model Therefore, if an oligopolist were to incur an increase in costs within a certain range, then it may NOT increase its prices, as it would risk losing too many sales to its competitors. Indeed, an oligopolist s marginal costs could shift anywhere within the vertical area of the marginal revenue curve, and they still would not increase their prices. Cost / Revenue (ollars) Kinked emand Model Oligopoly Kinked emand Model In fact, an oligopolist would have to incur a MAJOR increase in costs before it would increase prices. Other theories used to explain sticky prices: long-term contracts menu costs ominant Firm Model In the dominant-firm model, we see: One dominant firm that sets the price for the market (similar to a monopoly). At that price the market demands more than the dominant firm supplies. Remaining (non-dominant) firms sell an extra quantity of units that satisfies the unmet demand at the market price. Thus, the non-dominant firms accept the price determined by the dominant firm, and behave somewhat like firms within a purely competitive market. Cost / Revenue (ollars) ominant Oligopoly s demand at $. ominant Oligopoly Firm Cost / Revenue (ollars) Oligopoly Market Total Market emand at $ S Excess demand is satisfied by nondominant firms Supply is just for nondominant firms. emand is for entire market of consumers. Game Theory Models Game theory is a technique for analysing how people, firms and governments should behave in strategic situations (in which they must interact with each other). In deciding what to do, each party must take into account what the other party(s) are likely to do and how others might respond to what they do. In game theory, a dominant strategy is one that will deliver the best results for the player, regardless of what anybody else does. One finding of game theory is that there may be a large first-move advantage for companies that beat their rivals into a new market or come up with an innovation. One special case identified by the theory is the zero-sum game, where players see that the total winnings are fixed. In other words, for some to do well, others must lose. Far better is the positive-sum game, in which competitive interaction has the potential to make all the players richer. Another problem analysed by game theorists is the prisoner s dilemma. John F. Nash Jr. The Nash Equilibrium Named after John Nash, a mathematician and Nobel prize-winning economist, this is an important concept in game theory. John F. Nash, 9 - Russell Crow portrays John Nash in A Beautiful Mind John F. Nash, 9 - A Nash Equilibrium occurs when each player is pursuing their best possible strategy in the full knowledge of the other players strategies. A Nash equilibrium is reached when neither player has any incentive to change his strategy, because each player feels he has obtained the best possible outcome regardless of which strategy his opponent employs.

5 Bob s Strategies Confess eny Prisoner s ilemma An illustration of Nash Equilibrium Art and Bob are both suspects in a crime, and they are both offered the following deal if they confess Art s Strategies Confess 3 yrs. 3 yrs. yr. yrs. eny yrs. yr. yrs. yrs. Consider Art s options. If Bob denies and Art denies, then Art will get two years. Art is better off confessing and getting one year.. If Bob confesses and Art denies, then Art will get ten years, so Art is much better off confessing and taking three years. Consider Bob s options. If Art denies and Bob denies, then Bob will get two years. Bob is better off confessing and getting one year.. If Art confesses and Bob denies, then Bob will get ten years, so Bob is much better to confess and take three years. Thus, both parties will rationally choose to confess, and take three years even though they could have been better off denying. Each party does this because, considering the possible options of the other party, they always found the better option was to confess. When neither party has an incentive to change their strategy, they are in Nash Equilibrium. The Implications: The uopolist s ilemma Acme and Belco are the only firms operating within a given market. Thus, they are operating in a duopoly. Both firms could increase their profits if they were to collude with each other in an effort to restrict output. However, each firm could make even more money if they agreed to collude, but then cheated and secretly increased their output. Thus, each firm is faced with the following payoff matrix Belco s Strategies Cheat Comply Acme s Strategies Confess Cheat $ -.m $.5m Comply.5m.m -.m.m Consider Acme s options. If Belco complies and Acme complies, then Acme will earn million. Acme is better off cheating and earning.5 million.. If Belco cheats and Acme complies, then Acme will lose million, so Acme is again better off to cheat and earn zero profit. Consider Belco s options. If Acme complies and Belco complies, then Belco will earn million. Belco is better off cheating and earning.5 million.. If Acme cheats and Belco complies, then Belco will lose million. Belco is again better off to cheat and earn zero profit. Thus, both parties will rationally choose to cheat, and earn zero profits even though they could have been better off by complying with a collusive deal to restrict output. They will compete as fiercely as pure competitors - continually lowering their prices and increasing production until they reach a point where they are breaking even. This is where they will find themselves in Nash Equilibrium. They will have no motivation to move from this point. The trick is to compare across the firm s strategies! Airtouch has no dominant strategy because it s better off with a morning departure if Windward chooses a morning departure, but it s better off with an evening departure if Windward chooses an evening departure. No particular strategy proves to be consistently superior. Again, we compare across the firm s strategies! Windward OES have a dominant strategy because it s better off with a morning departure regardless of whether Airtouch chooses a morning or an evening departure. This one particular strategy proves to be consistently superior. If both firms know all of the information in the payoff matrix, then they will logically choose to leave in the morning. This is because Windward will leave in the morning no matter what (that s their dominant strategy). Knowing this, Airtouch will choose to leave in the morning in this case because that is the option that gives them the most profit in that scenario. Airtouch will earn $,., and Windward will earn $7.. Game Theory Model Although each oligopolist would be better off cooperating with each other, they decide not to cooperate in an act of self-preservation. Thus, each firm will end up competing as fervently as if they were operating within a purely competitive market. Thus, each firm will end up producing at the output associated with the lowest point on their curve. (The break-even point!) This determines the price for the market, while market demand at that price determines the quantity demanded. Quantity demanded at the market price sets the number of firms that can be supported. Output is for one firm. Cost / Revenue (ollars) Oligopoly Firm Cost / Revenue (ollars) Oligopoly Market Quantity for entire market. Thus, more than one firm can be supported! emand is for entire market of consumers. 5