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10.0) Week 13 Agenda�10.1) Monopolistic Competition�10.2) Oligopoly�10.3) Game Theory and Applications�

Ch10. Monopolistic Competition, Oligopoly, and Game Theory

ECO 1002. Principles of Microeconomics

Week 13

Dr. Christopher Paik

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10.0) Week 13.1

Key Takeaway Questions:

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  • Q. What characteristics do monopolistic competition and oligopoly have?
    • Number of sellers
    • Availability of substitutes
    • Barriers to entry
    • Market power

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  • Q. Is monopolistic competition as equally efficient as perfect competition?

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  • Q. What are some examples of monopolistic competition and oligopoly?

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10.1) Monopolistic Competition

What is monopolistic competition?

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  • Number of sellers

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  • Availability of substitutes

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  • Barriers to entry

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  • Market power

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Perfect Competition

Monopolistic Competition

Monopoly

Image: freepik

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10.1) Monopolistic Competition

What is monopolistic competition?

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  • Number of sellers

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  • Availability of substitutes

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  • Barriers to entry

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  • Market power

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  • As consumerism and product variety expands, perfect competition and monopoly are inadequate in explaining these sudden, vast markets

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A market structure in which a large number of firms produce differentiated products

(e.g., fast food industry)

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Perfect Competition

Monopolistic Competition

Oligopoly

Monopoly

Large number of small firms; each firm has a small M/S

Easy entry and exit (no barriers to entry or exit)

Differentiated products

Substitutes

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10.1) Monopolistic Competition

Product differentiation and the demand curve

  1. Product differentiation
    • Superior product
    • Better location
    • Superior service
    • Clever packaging
    • Advertising

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  • Demand curve
    • The demand curve is similar to the monopolist’s �demand curve but is more elastic
    • Many substitutes

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10.1) Monopolistic Competition

Short-run and long-run equilibrium for monopolistic competition

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  • In the short run, MC = MR
  • Profit = TR – TC (shaded area)
  • In the long run, easy entry and exit
  • Positive profit increases supply and lowers the price
  • Negative profit decreases supply and raises the price

Q. As equally efficient as perfect competition?

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10.2) Oligopoly

Collusion

  • Collusion is illegal (antitrust law)
  • Price leadership

(e.g., baggage fees)

    • OPEC: international cartel

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10.2) Oligopoly

What is an oligopoly?

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  • Number of sellers

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  • Availability of substitutes

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  • Barriers to entry

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  • Market power

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Oligopoly markets are those in which a large market share is controlled by just a few firms:

      • Each firm considers its competitors’ reactions when making its own decisions
      • There are significant barriers to entry into the market
      • Cartels: joint profit maximization (e.g., OPEC - Organization of the Petroleum Exporting Countries)

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Perfect Competition

Monopolistic Competition

Oligopoly

Monopoly

Few firms

Significant barriers to entry

Mutual interdependence

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10.2) Oligopoly

The kinked demand curve and the stability of oligopolies

  • Oligopolies take their competitors into account when making pricing decisions (mutual interdependence):
    • If a firm raises their price, its competitors won’t react to capture more market share
    • If a firm lowers their price, its competitors will react to avoid losing market share

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Demand is more elastic, when a firm attempts to increase the price

Demand is more inelastic, when a firm attempts to decrease the price

  • The kinked demand curve shows why oligopoly prices are stable:
    • Each firm agrees to cut prices if another firm cuts prices

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10.3) Summary

Comparison of four different market structures:

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Perfect Competition

Monopolistic Competition

Oligopoly

Monopoly

# of Firms

Large #

Large #

Small #

One

(Pure monopolist)

Product Types

Homogeneous

Heterogeneous

(Differentiated)

Homogeneous or

Heterogeneous

Unique

(No substitutes)

Entry and Exit

Easy

Easy

Difficult

Almost impossible

Short-Run Profit

Positive,

Negative,

Normal

Positive,

Negative,

Normal

Positive,

Negative,

Normal

Positive,

Negative,

Normal

Long-Run Profit

Normal

Normal

Positive or Normal

Positive or Normal

Price

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Quantity

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10.0) Week 13.2

Please read the following questions before class.

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  • Q. What is game theory?
    • Sequential-move games
    • Simultaneous-move games

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  • Q. What is Nash equilibrium?

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  • Q. Why is it important to learn game theory?
    • What implications can we derive in support of current events?
    • How can we utilize game theory when making decisions?

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10.3) Game Theory

How do we set up a game theory?

  • Game theory framework:
    • Players: Sarah vs. Steve, firm vs. firm, plaintiff vs. defendant, two or more countries at war
    • Information: known information vs. private information
    • Strategies: players use strategies to improve the likelihood of achieving their best outcome
    • Outcomes: all possibilities, good or bad (e.g., win or lose)
    • Payoffs: the value that players get from each outcome; players try to maximize their payoffs

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  • Two types of game:
    • Sequential-move game: one player at a time makes a move
      • E.g., Chess, tic-tac-toe, golf, etc.
    • Simultaneous-move game: involve actions by players that occur at the same time
      • E.g., Sporting matches with offensive and defensive players, business pricing, etc.

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10.3) Game Theory

Sequential-move games (Virgin Galactic vs. SpaceX)

  • Sequential-move games are situations in which one player at a time makes a move
    • Game tree (extensive form analysis): e.g., Virgin Galactic vs. SpaceX, where Virgin makes the first move

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Solution (backward induction):

  • If Virgin Galactic chooses to pursue commercial space flight, SpaceX’s best response is to pull back (50 > 30)

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  • If Virgin Galactic pulls back, SpaceX’s best response is to pursue (90 > 10)

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  • The equilibrium: pursue, pull back

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  • Virgin Galactic has an advantage by moving first

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  • Not all games have a first-mover advantage (e.g., golf)

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10.3) Game Theory

Simultaneous-move game (Home Depot vs. Lowe’s)

  • Simultaneous-move games involve actions by players that occur at the same time
    • Two-player simultaneous-move games shown in a diagram are called game tables (payoff matrix)

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Framework:

  • If Lowe’s and Home Depot both advertise, each earns $100,000
  • If one advertises and the other doesn’t, the one that advertises earns $300,000 and other $50,000
  • If both firms don’t advertise, they each earn $200,000

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10.3) Game Theory

Simultaneous-move game (Home Depot vs. Lowe’s)

  • Simultaneous-move games involve actions by players that occur at the same time
    • Two-player simultaneous-move games shown in a diagram are called game tables (payoff matrix)

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Solution:

  • We look into both players’ best responses (BR)

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1. Home Depot’s perspectives

  • If Home Depot assumes that Lowe’s will advertise, Home Depot’s BR is advertise
  • If Home Depot assumes that Lowe’s will not advertise, Home Depot’s BR is advertise

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2. Lowe’s perspectives

  • If Lowe’s assumes that Home Depot will advertise, Lowe’s BR is advertise
  • If Lowe’s assumes that Home Depot will not advertise, Lowe’s BR is advertise

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Dominant Strategy

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10.3) Game Theory

Simultaneous-move game

  • Simultaneous-move games involve actions by players that occur at the same time
    • Two-player simultaneous-move games shown in a diagram are called game tables (payoff matrix)

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Solution:

  • A dominant strategy occurs when a player chooses the same strategy regardless of what his or her opponent chooses
  • Using the BR (best response) approach, the equilibrium is that both firms advertise (no deviation occurs) – Nash equilibrium
  • Nash equilibrium: A stable status where players will continue with their chosen strategy, having no incentive to deviate from it

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10.4) In-Class Activity

Practice question (Simultaneous-move game)

Q. What is the equilibrium of this game?

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10.4) In-Class Activity

Practice question (Simultaneous-move game)

Q. What is the equilibrium of this game?

Solution:

  • We look into both players’ best responses (BR) – here, the lower jail time is the better payoff

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1. Chris’s perspectives

  • If Chris assumes that Matthew will not confess, Chris’s BR is confess
  • If Chris assumes that Matthew will confess, Chris’s BR is confess

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2. Matthew’s perspectives

  • If Matthew assumes that Chris will not confess, Matthew’s BR is confess
  • If Matthew assumes that Chris will confess, Matthew’s BR is confess

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10.4) Applications of Game Theory

Prisoner’s dilemma

  • Nash equilibrium that results in an outcome that is inferior to another outcome that can be achieved via cooperation
    • A noncooperative game in which players cannot communicate or collaborate when making decisions, which results in inferior outcomes for both players
      • Even if people (or companies) rationally follow their own self-interests, the best outcome is hard to reach when they cannot or do not cooperate
    • Many oligopoly decisions can be framed as a prisoner's dilemma

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  • Other examples of prisoner’s dilemma outcomes: political campaigns, legal disputes, and trade disputes

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