Chapter 24 PPT - P - M For Mono - Oligo - Game Theory

Chapter Twenty-
Four
Monopolistic Competition,
Oligopoly, and Game Theory
Arnold, Economics, 14 Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part. 1
Icebreaker
1. The class will be broken up into pairs of students.

2. Each pair of students will discuss the question.
− Scenario: You and your partner were in business together and now you both
decide to go into business for yourselves in the same industry.
− Decide whether you should coordinate your prices or ignore each other.
− You and your now rival have 85% of the market for your product. What will
you do to keep other competitors out of your industry?
3. Then one person from each pair will share a one sentence answer to the
class.
Chapter Objectives
By the end of this chapter, you should be able to:

• Describe the characteristics of a monopolistically competitive market.
• Determine the profit-maximizing quantity and price for a monopolistically
competitive firm.
• Describe the characteristics of an oligopoly.
• Explain how collusion impacts production decisions in an oligopolistic market.
• Identify the dominant strategy, if present, for each player, given a payoff matrix.
The Theory of Monopolistic
Competition
Monopolistic Competition
• Monopolistic Competition: A theory of market structure based on three

assumptions:
1. Many sellers and many buyers
2. Each firms produces and sells a slightly differentiated product
3. Easy entry and exit
The Firm's Demand Curve
• The perfectly competitive firm has many rivals, all producing the same good, so
there are an endless number of substitutes for its product.
− The elasticity of demand is so high that it is horizontal demand curve.
• The monopoly firm has practically no rivals, and it produces a good that has no
substitutes.
− The elasticity of demand is low, so is a downward-sloping demand curve.
• The monpolistically competitive firm has many rivals, producing slightly
differentiated product, so there are some substitutes for its product.
− The elasticity of demand is not as high so that it faces a downward-sloping
demand curve.
Price and Output for the Firm
• For a monopolistic competitor, the

firm’s demand curve is not the same
as its MR curve.
▪ P > MR
• Profit maximization rule
▪ Produce Q at MR = MC
▪ Charge the highest price per
unit at which this quantity
of output can be sold.
Long-Run Profits
• If the firms in a monopolistically

competitive market are earning profits,
most likely they will not continue to earn
profits in the long run.
• Easy entry and exit will lead new firms to
enter the industry and reduce the
demand of each firm.
− Competition will reduce economic
profits
• Zero economic profit in long run
Excess Capacity and Efficiency
• Excess Capacity Theorem: A

monopolistic competitor in equilibrium
produces an output smaller than the
one that would minimize its costs of
production.
• Efficiency
− Not resource allocative efficient
▪ P > MC
− Not productive efficient
▪ Not lowest ATC
Knowledge Check 1a
The excess capacity theorem is associated with _____ and states that the firm in
equilibrium will produce a level of output that is _____ than the level of output that
minimizes its average total cost.
A. perfect competition; smaller

B. monopolistic competition; smaller
C. monopolistic competition; larger
D. perfect competition; larger
Answer 1a
• B. The excess capacity theorem is associated with monopolistic competition and

states that firms in equilibrium will produce a level of output that is smaller than
it would if it were minimizing its unit costs of production. The monopolistic
competitor does not experience productive efficiency as a result.
Knowledge Check 1b
In the long run, firms in a monopolistically competitive industry will
A. most likely earn zero economic profit.

B. definitely earn zero economic profit.
C. always earn an economic profit.
D. always earn an accounting profit.
Answer 1b
• A. Because of easy entry into a monopolistically competitive market, any

economic profits will likely be eliminated as firms enter the market and prices fall
in the long run. Similarly, easy exit from the market will likely be eliminated as
firms exit the market and prices rise in the long run. However, since
monopolistic competitive firms produce a product with close substitutes, it may
be able to differentiate its product sufficiently so that it does not have to lower its
price as new firms enter the market.
Knowledge Check 1c
Which of the following statements is false?
A. The monopolistic competitor and the perfectly competitive firm are both
resource-allocative efficient.
B. The monopolistic competitor and the perfectly competitive firm are both
productive efficient.
C. The monopolistic competitor produces a quantity of output at which price is
greater than marginal cost.
D. a and b
Answer 1c
• D. The perfectly competitive firm is resource-allocative efficient, but the

monopolistic competitor is not since price is greater than marginal cost for the
monopolistic competitor. The perfectly competitive firm is also productive
efficient, but the monopolistic competitor is not since the monopolistic
competitor does not produce at a level of output at which price is equal to its
lowest average total cost.
Oligopoly: Assumptions and
Real-World Behavior
Oligopoly
• Oligopoly: A theory of market structure based on three assumptions:

1. Few sellers and many buyers
2. Firms produce and sell either homogenous or differentiated products
3. Significant barriers to entry
Concentration Ratio
• Concentration Ratio: The percentage of industry sales (or assets, output, labor
force, or some other factor) accounted for by x number of firms in the industry
− x is usually 4 or 8
▪ CR4 = % of industry sales accounted for by four largest firms
▪ CR8 = % of industry sales accounted for by eight largest firms
• A high concentration ratio implies that few sellers make up the industry.
• A low concentration ratio implies that more than a few sellers make up the
industry.
Knowledge Check 2a
In which market structure is there a few sellers and many buyers?
A. Perfect competition
B. Monopolistic competition
C. Oligopoly
D. Monopoly
Answer 2a
• C. The only market structure that has few sellers and many buyers is oligopoly.
The assumption is generally that these few firms act interdependently; each firm
is aware of its competitors' actions and is aware that its actions affect its
competitors.
Knowledge Check 2b
In which market structure(s) can firms produce and sell either homogeneous or
differentiated products?
A. Perfect competition and monopolistic competition

B. Monopoly and oligopoly
C. Monopolistic competition
D. Oligopoly
Answer 2b
• D. The only market structure that has firms that sell either homogeneous or
differentiated products is oligopoly. In perfect competition firms only sell
homogeneous products and in monopolistic competition firms only sell
differentiated products. There are examples of both homogeneous oligopolies
and differentiated oligopolies in the real world.
Knowledge Check 2c
Suppose an industry is made up of twenty firms, all with equal sales. The four-firm
concentration ratio of that industry is _____.
A. 10%
B. 20%
C. 30%
D. 40%
Answer 2c
• B. The four-firm concentration ratio (CR4) of that industry is equal to the

percentage of industry sales accounted for by the four largest firms. Each firm in
an industry that is made up of twenty firms with equal sales would account for 5
percent of industry sales, thus CR4 = 5% + 5% + 5% + 5% = 20%.
Price and Output Under Cartel
Theory
Benefits of a Cartel
• Cartel Theory: A theory of oligopoly

in which oligopolistic firms act as if
there were only one firm in the
industry.
− Cartel: An organization of firms
that reduces output and increases
price in an effort to increase joint
profits.
Problems with a Cartel
• Several problems
− Forming the cartel
− Formulating cartel policy
− Entry into the industry
− Cheating
Knowledge Check 3a
A(n) _____ is an organization of firms that reduces output and increases price in
an effort to increase joint profits.
A. monopolistically competitive firm

B. oligopoly
C. excess capacity firm
D. cartel
Answer 3a
• D. A cartel is an organization of firms that reduces output and increases price in

an effort to increase joint profits.
Knowledge Check 3b
The key behavioral assumption of the cartel theory is that oligopolists in a cartel
act as if ___________.
A. there were many firms in the industry

B. there were only one firm in the industry
C. all firms in the industry are price takers
D. all firms in the industry are the same size
Answer 3b
• B. In a cartel, several firms band together in order to act as a

monopoly and capture the benefits that would accrue to a monopolist in that
market.
Knowledge Check 3c
The major economic objective of cartels is to __________.
A. develop new research methods

B. reduce costs
C. reduce output, push up price, and increase profits
D. experiment at finding new ways of producing high-quality products
Answer 3c
• C. In a cartel, several firms band together in order to act as a

monopoly and capture the benefits that would accrue to a monopolist in that
market.
Game Theory, Oligopoly, and
Contestable Markets
Game Theory
• Game Theory: A mathematical technique used to analyze the behavior of

decision makers.
− Who tries to reach an optimal position for themselves through game playing
or the use of strategic behavior?
− Who are fully aware of the interactive nature of the process at hand?
− Who anticipates the moves of other decision makers?
The Prisoner's Dilemma
• The Prisoner's Dilemma

− A well-known game in game
theory, the Prisoner’s Dilemma,
illustrates a case in which
individually rational behavior leads
to a jointly inefficient outcome.
• Lesson of the game
− “You do what is best for you, I’ll do
what is best for me, and somehow
we end up in a situation that is not
best for either of us.”
Cartels and the Prisoner's Dilemma
• Oligopoly firms enter into a cartel

agreement.
− This creates a prisoner’s dilemma
• The only way out is to have some
entity enforce the cartel agreement.
− To have firms not cheat
Contestable Markets
• Contestable Market: A market in which:

− Entry is easy and exit is costless
− New firms can produce the product at the same cost as current firms
− Existing firms can easily dispose of their fixed assets by selling them
• Perhaps the most important element of a contestable market is so-called hit-
and-run entry and exit.
− New entrants can enter (hit) and produce the product
− Take profits from current firms
− Then exit costlessly (run)
Knowledge Check 4a
A market is _____ if entry and exit are costless, new firms can produce the
product at the same cost as current firms, and exiting firms can easily dispose of
their fixed assets by selling them.
A. oligopolistic
B. monopolistic
C. contestable
D. monopolistically competitive
Answer 4a
• C. A market is contestable if entry and exit are costless, new firms can produce
the product at the same cost as current firms, and exiting firms can easily
dispose of their fixed assets by selling them.
Knowledge Check 4b
Two individuals, charged with jointly committing a crime, would be best off in a
prisoner's dilemma setting if _______.
A. both confess
B. neither confess
C. one confesses and the other one does not
D. one confesses, regardless of what the other one does
Answer 4b
• B. In a prisoner's dilemma setting, both individuals will be best off if neither of

them confess to the crime.
Knowledge Check 4c
Firms trying to form a cartel (enter into a cartel agreement) are likely to be in a
prisoner's dilemma setting because one aspect of a prisoner's dilemma setting is
that ____________.
A. each cartel member can make itself better off at the expense of others by
breaking the cartel agreement
B. no member of the cartel can make itself better off at the expense of others by
breaking the cartel agreement
C. each cartel member is productive efficient
D. each cartel member is resource allocative efficient
Answer 4c
• A. Firms trying to form a cartel (enter into a cartel agreement) are likely to be in
a prisoner's dilemma setting because one aspect of a prisoner's dilemma setting
is that each cartel member can make itself better off at the expense of others
by breaking the cartel agreement.
A Review of Market Structures
Characteristics
Number Barriers Long-Run Market Tendency of
Market Structure Type of Product
of Sellers to Entry Price and ATC
Perfect competition Many Homogeneous No P = ATC (zero economic profits)
Monopoly One Unique Yes P > ATC (positive economic profits)a,c
Monopolistic P = ATC (zero economic profits)b
Many Slightly differentiated No
competition
Homogeneous or P > ATC (positive economic profits)a,c
Oligopoly Few Yes
differentiated
Notes:
a. It is possible for positive profits to turn into zero profits through the capitalization of profits or rent-seeking activities.
b. It is possible for the firm to earn positive profits in the long run if it can differentiate its product sufficiently in the minds of the buying public.
c. It is possible for positive profits to turn into zero profits if the market if contestable.
Applications of Game Theory
Grades and Partying
• Suppose your letter grade in class

depends on how well you do
relative to others.
− You and your fellow students are
in a prisoner’s dilemma.
The Arms Race
• In the days of the Cold War, the U.S.

and Soviet Union engaged in an
arms race.
− Two countries were in a
prisoner’s dilemma
Speed Limit Laws
• In a world with no law against speeding, everyone speeds, and some accidents.
• In time, everyone agrees that something must be done.
− They propose speed limit signs on the road, and everyone promises to obey.
• As you know by now, once the agreement is made, it's a prisoner’s dilemma.
− Each person will be better off if they (alone) speed while everyone else
obeys the speed limit; by the end, everyone breaks it.
• To move the speeders out of the classic prisoner’s dilemma box, someone or
something must punish people who do not cooperate.
− A law against speeding, backed up by police and the court system, solves
the dilemma.
Chapter Summary
Now that the lesson has ended, you should have learned how to:
• Describe the characteristics of a monopolistically competitive market.
• Determine the profit-maximizing quantity and price for a
monopolistically competitive firm.
• Describe the characteristics of an oligopoly.
• Explain how collusion impacts production decisions in an oligopolistic market.
• Identify the dominant strategy, if present, for each player, given a payoff matrix.

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Chapter Twenty-

1. The class will be broken up into pairs of students.

By the end of this chapter, you should be able to:

• Monopolistic Competition: A theory of market structure based on three

• For a monopolistic competitor, the

• If the firms in a monopolistically

• Excess Capacity Theorem: A

A. perfect competition; smaller

• B. The excess capacity theorem is associated with monopolistic competition and

In the long run, firms in a monopolistically competitive industry will

A. most likely earn zero economic profit.

• A. Because of easy entry into a monopolistically competitive market, any

• D. The perfectly competitive firm is resource-allocative efficient, but the

• Oligopoly: A theory of market structure based on three assumptions:

In which market structure is there a few sellers and many buyers?

A. Perfect competition and monopolistic competition

• B. The four-firm concentration ratio (CR4) of that industry is equal to the

• Cartel Theory: A theory of oligopoly

A. monopolistically competitive firm

• D. A cartel is an organization of firms that reduces output and increases price in

A. there were many firms in the industry

• B. In a cartel, several firms band together in order to act as a

The major economic objective of cartels is to __________.

A. develop new research methods

• C. In a cartel, several firms band together in order to act as a

• Game Theory: A mathematical technique used to analyze the behavior of

• The Prisoner's Dilemma

• Oligopoly firms enter into a cartel

• Contestable Market: A market in which:

• B. In a prisoner's dilemma setting, both individuals will be best off if neither of

• Suppose your letter grade in class

• In the days of the Cold War, the U.S.

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