ANNOUNCEMENTS
Review class: Monday, December 13
4:15-5:15, LC6
Final Exam: Friday, December 17
10:30-12:30, LC1
80 multiple choice choice questions
Chapts. 1-11 & 13 -- 25 questions
Chapts. 14-17
-- 55 questions
DUOPOLY
Given the only the two
output
choices
of
the
10
10.5
duopolists, when they
2.5
10
7.5
Firm
both believe their
7.5
7
B 3.5
competitor will produce
10.5
7
2.5 units they both will
have an incentive to increase their output to 3.5 and
raise their profit to 10.5. However, when they both
increase output to 3.5, they both see their profits
Firm A
2.5
3.5
DUOPOLY
fall to 7. When they both
believe
that
their
10
10.5
competitor will produce
2.5
10
7.5
Firm
3.5 units, they each have
7.5
7
B 3.5
an incentive to decrease
10.5
7
their output to 2.5 to
increase their profit to 7.5. Therefore, neither both
producing 2.5 nor both producing 3.5 is an
equilibrium, since they both have an incentive to
Firm A
2.5
3.5
DUOPOLY
change their output
level.
In
many
situations,
10
10.5
there are combinations of
2.5
10
7.5
Firm
choices that agents can
7.5
7
B 3.5
make, that they will have
10.5
7
no incentive to change.
When economic agents have each chosen their best
strategy, given the strategies of the other agents, a
Nash equilibrium exists.
Firm A
2.5
3.5
DUOPOLY
change their output
level.
In
many
situations,
10
10.5
there are combinations of
2.5
10
7.5
Firm
choices that agents can
7.5
7
B 3.5
make, that they will have
10.5
7
no incentive to change.
When economic agents have each chosen their best
strategy, given the strategies of the other agents, a
Nash equilibrium exists. For example, when A
Firm A
2.5
3.5
DUOPOLY
believes that B will
produce 2.5, A’s best
10
10.5
strategy is to produce 3.5;
2.5
10
7.5
Firm
and when B believes that
7.5
7
B 3.5
A will produce 3.5, B’s
10.5
7
best strategy is to produce
2.5. Therefore when A produces 3.5 and B
produces 2.5, neither will have an incentive to
change. This is a Nash equilibrium. Similarly, A
Firm A
2.5
3.5
DUOPOLY
producing 2.5 and B
producing 3.5 is a Nash
10
10.5
equilibrium. Therefore
2.5
10
7.5
Firm
there can be more than
7.5
7
B 3.5
one Nash equilibrium.
10.5
7
For these duopolists, the
Nash equilibrium that maximizes their combined or
joint profits is when both produce 3 units of output.
Firm A
2.5
3.5
DUOPOLY
QB Q A
Q
P
TRA
3
3
3
3
3
3
3
3
3
4
5
6
7
8
9
10
7
6
5
4
3
2
1
0
0
6
10
12
12
10
6
0
0
1
2
3
4
5
6
7
TCA PROFIT
0
1
2
3
4
5
6
7
0
5
8
9
8
5
0
-7
When B
produces 3, A
will maximize
profits by
producing 3.
Similarly,
when A
produces 3,
DUOPOLY
B will
maximize
3
0
3
7
0
0
0
profits by
3
1
4
6
6
1
5
3
2
5
5
10
2
8
producing 3.
3
3
6
4
12
3
9
Then
each
3
4
7
3
12
4
8
producing 3
3
5
8
2
10
5
5
3
6
9
1
6
6
0
units of output
3
7 10
0
0
7
-7
is a Nash
equilibrium where each have profits of 9.
QA Q B
Q
P
TRB
TCB
PROFIT
DUOPOLY
The Nash equilibrium with each duopolist
producing 3 units of output and having profits of
9 gives industry output of 6, market price of 4,
industry profit of 18, and a deadweight loss of
(1/2)x(4-1)x(9-6) = 4.5.
DUOPOLY
Industry Market Industry Deadweight
output
price profit
loss
Monopoly
Duopoly (Nash equil 3,3)
Perfect Competition
5
6
9
5
4
1
20
18
0
8
4.5
0
The oligopoly result is between monopoly and
perfect competition. The greater the number of
firms, the closer the result is to perfect competition.
INDUSTRIAL
ORGANIZATION
Examining three possible ways to organize markets,
perfect competition, oligopoly, and monopoly,
perfect competition is the only market structure
that efficiently allocates resources (when there are
no externalities or natural monopolies). There is
another market structure which needs examination.
MONOPOLISTIC
COMPETITION
Monopolistic competition is a market structure that
is characterized by many sellers, product
differentiation and free entry and exit. It is like
perfect competition since there are many firms with
free entry and exit; and it is like monopoly since
each firm is the only producer and seller of its
product. However, unlike monopoly, each firm’s
product is similar to the product of its competitors’
products. Examples are tooth paste, shampoo,
MONOPOLISTIC
COMPETITION
$
MC
P
ATC
D
AVC
MR
Q
Q
breakfast cereal, and soft drinks.
Since each firm has a monopoly
selling its own product, it faces a
downward sloping demand curve
whose elasticity depends on the
number and closeness of good
substitutes. The firm chooses an
output Q where MR=MC, and
prices according to demand.
MONOPOLISTIC
COMPETITION
$
DEADWEIGHT
LOSS
ECONOMIC
PROFIT
MC
P
ATC
D
AVC
MR
Q
Q
It earns a profit equal to
(P-ATC)xQ. Since it produces
where P>MC, it produces less
than the socially efficient output
and, therefore, has a deadweight
loss.
MONOPOLISTIC
COMPETITION
$
ZERO
ECONOMIC
MC
PROFITS
ATC
P’
D
AVC
D’
MR’
Q’
Q
When economic profits are
being earned, this will be a
signal for new firms to enter this
industry. The new firms will
decrease demand for existing
firms, which will be forced to
lower price and output. New
firms will enter until economic
profits are zero. This is the long-
MONOPOLISTIC
COMPETITION
DEADWEIGHT
LOSS
$
Tangency of
demand and
ATC curves
MC
ATC
P’
AVC
D’
MR’
Q’
Q
run equilibrium. When
economic profits are zero,
the demand curve and the ATC
curve are tangent at the profit
maximizing price and output
combination (where MR=MC).
Even though there are zero
economic profits, there is still a
deadweight loss.
MONOPOLISTIC
COMPETITION
$
MC
ATC’
ATC
AVC
P
D
MR
Q
Q
Firms in monopolistically
competitive industries attempt
to protect themselves from
competition, by advertising
their product to maintain
consumer loyalty. However,
advertising raises costs. Since
the level of advertising is
MONOPOLISTIC
COMPETITION
$
Tangency of
demand and
ATC curves
MC
ATC’
ATC
AVC
P
D
MR
Q
Q
not determined by the level of
output, it is a fixed cost,
increasing ATC without
affecting MC or AVC. When
advertising expenditures
push ATC up to a tangency of
demand, economic profits are
zero and new firms will not
enter.
MONOPOLISTIC
COMPETITION
$
DEADWEIGHT
LOSS
MC
ATC’
ATC
AVC
P
D
MR
Q
Q
not determined by the level of
output, it is a fixed cost,
increasing ATC without
affecting MC or AVC. When
advertising expenditures
push ATC up to a tangency of
demand, economic profits are
zero and new firms will not
enter.
MONOPOLISTIC
COMPETITION
In the short run, monopolistic competitors can
earn economic profits. In the long run, economic
profits are driven down to zero by loss of market
share or increased advertising costs. When all firms
in the industry are earning zero economic profits,
the industry is in long-run equilibrium. However,
in long-run equilibrium the industry is producing
less than is socially optimal, causing a deadweight
loss, and not producing at minimum ATC.
MONOPOLISTIC
COMPETITION
Since regulation is too expensive and difficult to
do properly, monopolistically competitive markets
are generally unregulated except for advertising
claims and the monopolizing effect of potential
mergers.
MONOPOLISTIC
COMPETITION
Monopolistically competitive firms usually allocate
vast amounts of resources to advertising and
product differentiation. While consumers gain
by being given some choice among products and
from advertising that gives information about the
product, excessive differentiation may be wasteful,
as is advertising designed to psychologically
manipulate consumer tastes and preferences.
However, the fact that a firm is willing to spend on
MONOPOLISTIC
COMPETITION
advertising may be a signal that the firm believes
that it has a high quality product.
Brand names are important for monopolistic
competitors, since this is how consumers can
identify the product. Large amounts of resources
may be wasted on advertising designed to protect
and create “brand loyalty”. However, brand
name products are generally of known and uniform
MONOPOLISTIC
COMPETITION
quality, and as such brand names provide
information to the consumer. Firms that have an
investment in establishing a brand name have an
incentive to maintain the quality of its product.
In summary, monopolistic competition misallocates
resources by producing a less than socially optimal
output level in plants that are too large, and
potentially wastes resources on psychological
MONOPOLISTIC
COMPETITION
advertising designed to attract customers and
strengthen brand name recognition. While total
losses from monopolistic competition may be large
in absolute amount, they are relatively small
compared to the value of the total output of the U.S.
INDUSTRIAL
ORGANIZATION
In the absence of externalities and natural
monopolies, organizing markets as perfect
competition will efficiently allocate resources.
Monopoly, oligopoly and monopolistic competition
all misallocate resources and may require
government intervention to improve the allocation
of resources through regulation or enforcement of
the antitrust laws.