There are two sources of inefficiency in monopolistic competition. These two sources of inefficiency can be seen in Figure 5. First, there is dead weight loss DWL due to market power: the price is higher than marginal cost in long run equilibrium. In the right hand panel of Figure 5. Total dead weight loss is the shaded area beneath the demand curve and above the MC curve in figure 5. The second source of inefficiency associated with monopolistic competition is excess capacity.
This can also be seen in the right hand panel of Figure 5. Therefore, the firm could produce at a lower cost by increasing output to the level where average costs are minimized. Given these two inefficiencies associated with monopolistic competition, some individuals and groups have called for government intervention. Regulation could be used to reduce or eliminate the inefficiencies by removing product differentiation. This would result in a single product instead of a large number of close substitutes.
Regulation is probably not a good solution to the inefficiencies of monopolistic competition, for two reasons. First, the market power of a typical firm in most monopolistically competitive industries is small. Each monopolistically competitive industry has many firms that produce sufficiently substitutable products to provide enough competition to result in relatively low levels of market power.
If the firms have small levels of market power, then the deadweight loss and excess capacity inefficiencies are likely to be small. Second, the benefit provided by monopolistic competition is product diversity. The gain from product diversity can be large, as consumers are willing to pay for different characteristics and qualities. Therefore, the gain from product diversity is likely to outweigh the costs of inefficiency. Evidence for this claim can be seen in market-based economies, where there is a huge amount of product diversity.
The next chapter will introduce and discuss oligopoly: strategic interactions between firms! An oligopoly is defined as a market structure with few firms and barriers to entry.
There is often a high level of competition between firms, as each firm makes decisions on prices, quantities, and advertising to maximize profits.
Thus, there is a continuous interplay between decisions and reactions to those decisions by all firms in the industry. Each oligopolist must take into account these strategic interactions when making decisions. Since all firms in an oligopoly have outcomes that depend on the other firms, these strategic interactions are the foundation of the study and understanding of oligopoly.
If Ford lowers prices relative to other car manufacturers, it will increase its market share at the expense of the other automobile companies. When making decisions that consider the possible reactions of other firms, firm managers usually assume that the managers of competing firms are rational and intelligent. These strategic interactions form the study of game theory, the topic of Chapter 6 below.
John Nash , an American mathematician, was a pioneer in game theory. Economists and mathematicians use the concept of a Nash Equilibrium NE to describe a common outcome in game theory that is frequently used in the study of oligopoly. In the study of oligopoly, the Nash Equilibrium assumes that each firm makes rational profit-maximizing decisions while holding the behavior of rival firms constant. This assumption is made to simplify oligopoly models, given the potential for enormous complexity of strategic interactions between firms.
The concept of Nash Equilibrium is also the foundation of the models of oligopoly presented in the next three sections: the Cournot, Bertrand, and Stackelberg models of oligopoly.
Augustin Cournot , a French mathematician, developed the first model of oligopoly explored here. This is the basis for strategic interaction in the Cournot model: if one firm increases output, it lowers the price facing both firms.
The inverse demand function and cost function are given in Equation 5. This will result in a Nash Equilibrium, since each firm is holding the behavior of the rival constant. Firm One maximizes profits as follows. This is as far as the mathematical solution can be simplified, and represents the Cournot solution for Firm One.
Oligopolists are interconnected in both behavior and outcomes. The two firms are assumed to be identical in this duopoly. The two reaction functions can be used to solve for the Cournot-Nash Equilibrium.
There are two equations and two unknowns Q 1 and Q 2 , so a numerical solution is found through substitution of one equation into the other.
This is the Cournot-Nash solution for oligopoly, found by each firm assuming that the other firm holds its output level constant. The Cournot model can be easily extended to more than two firms, but the math does get increasingly complex as more firms are added. Economists utilize the Cournot model because is based on intuitive and realistic assumptions, and the Cournot solution is intermediary between the outcomes of the two extreme market structures of perfect competition and monopoly.
This can be seen by solving the numerical example for competition, Cournot, and monopoly models, and comparing the solutions for each market structure. The competitive solution is given in Equation 5. The competitive, Cournot, and monopoly solutions can be compared on the same graph for the numerical example Figure 5.
The Cournot price and quantity are between perfect competition and monopoly, which is an expected result, since the number of firms in an oligopoly lies between the two market structure extremes. Assume two firms in an oligopoly a duopoly , where the two firms choose the price of their good simultaneously at the beginning of each period. Consumers purchase from the firm with the lowest price, since the products are homogeneous perfect substitutes.
If the two firms charge the same price, one-half of the consumers buy from each firm. The Bertrand model follows these three statements:. A numerical example demonstrates the outcome of the Bertrand model, which is a Nash Equilibrium. Firm Two has the lower price, so all customers purchase the good from Firm Two.
After period one, Firm One has a strong incentive to lower the price P 1 below P 2. Firm One has the lower price, so all customers purchase the good from Firm One. After period two, Firm Two has a strong incentive to lower price below P 1. The price cannot go lower than this, or the firms would go out of business due to negative economic profits. The Bertrand results are given in Equation 5.
The Bertrand model of oligopoly suggests that oligopolies are characterized by the competitive solution, due to competing over price.
There are many oligopolies that behave this way, such as gasoline stations at a given location. Other oligopolies may behave more like Cournot oligopolists, with an outcome somewhere in between perfect competition and monopoly. Heinrich Freiherr von Stackelberg was a German economist who contributed to game theory and the study of market structures with a model of firm leadership, or the Stackelberg model of oligopoly.
A numerical example is used to explore the Stackelberg model. Assume two firms, where Firm One is the leader and produces Q 1 units of a homogeneous good.
Firm Two is the follower, and produces Q 2 units of the good. This model is solved recursively, or backwards. Mathematically, the problem must be solved this way to find a solution. All of this is shown in the following example. This is the reaction function of the follower, Firm Two.
We have now covered three models of oligopoly: Cournot, Bertrand, and Stackelberg. These three models are alternative representations of oligopolistic behavior. The Bertand model is relatively easy to identify in the real world, since it results in a price war and competitive prices.
It may be more difficult to identify which of the quantity models to use to analyze a real-world industry: Cournot or Stackelberg? The model that is most appropriate depends on the industry under investigation.
Oligopoly has many different possible outcomes, and several economic models to better understand the diversity of industries. Notice that if the firms in an oligopoly colluded, or acted as a single firm, they could achieve the monopoly outcome.
If firms banded together to make united decisions, the firms could set the price or quantity as a monopolist would. This is illegal in many nations, including the United States, since the outcome is anti-competitive, and consumers would have to pay monopoly prices under collusion.
If firms were able to collude, they could divide the market into shares and jointly produce the monopoly quantity by restricting output.
This would result in the monopoly price, and the firms would earn monopoly profits. If the other firms in the industry restricted output, a firm could increase profits by increasing output, at the expense of the other firms in the collusive agreement.
We will discuss this possibility in the next section. These two models result in positive economic profits, at a level between perfect competition and monopoly. The most important characteristic of oligopoly is that firm decisions are based on strategic interactions.
Therefore, oligopolists are locked into a relationship with rivals that differs markedly from perfect competition and monopoly. Collusion occurs when oligopoly firms make joint decisions, and act as if they were a single firm. Collusion requires an agreement, either explicit or implicit, between cooperating firms to restrict output and achieve the monopoly price.
This strategic interdependence is the foundation of game theory. A game can be represented as a payoff matrix, which shows the payoffs for each possibility of the game, as will be shown below. A game has players who select strategies that lead to different outcomes, or payoffs.
This is shown in Figure 5. The police have some evidence that the two prisoners committed a crime, but not enough evidence to convict for a long jail sentence. The police seek a confession from each prisoner independently to convict the other accomplice. The outcomes, or payoffs, of this game are shown as years of jail sentences in the format A, B where A is the number of years Prisoner A is sentenced to jail, and B is the number of years Prisoner B is sentenced to jail.
However, if either prisoner decides to confess, the confessing prisoner would receive only a single year sentence for cooperating, and the partner in crime who did not confess would receive a long year sentence. If both prisoners confess, each receives a sentence of 8 years.
This story forms the plot line of a large number of television shows and movies. The outcome of this situation is uncertain. How should a prisoner proceed? One way is to work through all of the possible outcomes, given what the other prisoner chooses. This is called a Dominant Strategy , since it is the best choice given any of the strategies selected by the other player. This is an interesting outcome, since each prisoner receives eight-year sentences: 8, 8.
If they could only cooperate, they could both be better off with much lighter sentences of three years. A second example of a game is the decision of whether to produce natural beef or not. Natural beef is typically defined as beef produced without antibiotics or growth hormones. The definition is difficult, since it means different things to different people, and there is no common legal definition. This game is shown in Figure 5.
There are two players in the game: Cargill and Tyson. Each firm has two possible strategies: produce natural beef or not. In this game, profits are made from the premium associated with natural beef. If only one firm produced natural beef,. Both firms choose to produce natural beef, no matter what, so this is a Dominant Strategy for both firms. The outcome of this game demonstrates why all beef processors have moved quickly into the production of natural beef in the past few years, and are all earning higher levels of profits.
If all oligopolists in a market could agree to raise the price, they could all earn higher profits. Collusion, or the cooperative outcome, could result in monopoly profits. The roommates must each make a decision either to clean or not to clean the dorm room's common space. The payoff table for this situation is provided here, where the higher a roommates payoff number, the better off that roommate is. The payoffs in each cell are shown as payoff for Amy, payoff for Heather.
Amy has a cross dominant strategy, Clean and Do Not Clean, using the opposite choice that Heather makes. Heather has a cross dominant strategies, Clean and Do Not Clean, using the opposite choice that Amy makes.
Consider a small town that has two grocery stores from which residents can choose to buy a gallon of milk. The store owners each must make a decision to set a high milk price or a low milk price. The payoff table, showing profit per week, is provided here. The profit in each cell is shown as Store 1, Store 2. Refer to Table If grocery store 2 sets a high price, what price should grocery store 1 set? And what will grocery store 1's payoff equal?
If grocery store 1 sets a low price, what price should grocery store 2 set? And what will grocery store 2's payoff equal? If grocery store 1 sets a high price, what price should grocery store 2 set?
Grocery store 1 should set a low price when grocery store 2 sets a low price, and grocery store 1 should set a high price w. See Full Reader. DocumentM Download Report. View Download An equilibrium in which each firm in an oligopoly maximizes profit, given the actions of its rivals, is called a.
In an oligopoly, the total output produced in the market is a. Like monopolists, oligopolists are aware that an increase in the quantity of output always a.
Once a cartel is formed, the market is in effect served by a. In markets characterized by oligopoly, a. For the first player, Strategy X is called a a.
An equilibrium occurs in a game when a.
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