Session 5 (Source: Sloman, J.

2006, Economics, FT
Pearson, Harlow) Chapter 7
Learning Objectives
At the end of the lesson, students will be able
to:
1. Describe the characteristics of
monopolistically competitive firms.
2. Describe the equilibrium position of the
monopolistic competitive firm in the short
run and the long run.
3. Describe the characteristics of an
oligopoly.
4. Describe the equilibrium position of the
kinked demand curve model of an oligopoly.
Imperfect Competition

Monopolistic
Competition
Characteristics of Monopolistic Competition

• Many small to medium-

medium-sized firms
– Small share of market
• Some monopolistic power
– Product differentiation
– The individual firm acts independently
and is not concerned about how their
competitors react to any change in its output
or price
Characteristics of Monopolistic Competition
Product differentiation can occur in
• Physical Differences
– appearance and quality
• Location
– number and variety of locations
• Services Provided
– differentiated based on the accompanying
services
• Product Image
– the image that the producer tries to create in the
minds of its consumers
Characteristics of Monopolistic Competition

• Ease of entry and exit leading to many firms in

industry. Competition is through non-
non-price factors.
The share of the market that each firm attracts
depends on the firm's ability to make the good or
service different and more desirable than those of its
competitors
• Demand curve of each firm is downward
downward--sloping and
highly elastic because of the presence of many
competitors and the availability of close substitutes.
– firm's demand curve will be more elastic the
greater the number of competing firms, and the
less differentiated the firm's product is.
Characteristics of Monopolistic Competition

– Firm cannot raise its price and expect sales

to be unaffected.
– because its product is differentiated, it has
some degree of market power
– can only choose either the price or the
output to be produced and to let the market
determine the other variable
• Imperfect knowledge of prices and technology
exist.
 MONOPOLISTIC COMPETITION

• Equilibrium of the firm

– short run
• MR = MC
• Diagram similar to monopoly except that the AR
and MR curves are more elastic.
• Can make supernormal, normal or subnormal
profits.
 Short-run equilibrium of the firm
under monopolistic competition: supernormal profits
£ MC

AC

Ps

ACs

AR = D

MR
O Qs Q
 Short-run equilibrium of the firm
under monopolistic competition: normal profits
£ MC

Ps = ACs

AR = D

MR
O Qs Q
 Short-run equilibrium of the firm
under monopolistic competition: subnormal profits
£ MC

ACs
Ps

AR = D

MR
O Qs Q
 MONOPOLISTIC COMPETITION

• Equilibrium of the firm

– long run
• New firms that are attracted to the market would
drive economic profits down to zero (i.e. normal
profits).
• Demand curve (ARL = DL) will shift left until it is
tangent to the LRAC curve.
• In the long run, equilibrium price = PL and
equilibrium output = QL where normal profits are
made only.
 Long-run equilibrium of the firm
under monopolistic competition
£ New firms entering Price falls to PL
the industry reduce
demand for each
individual firm.
LRMC

PS
LRAC

PL
ARS

MRS ARL = DL

QL QS MRL
O Q
Imperfect Competition

Oligopoly
 OLIGOPOLY
• Key features of oligopoly
– barriers to entry: similar to those of the monopoly
– interdependence of firms: each firm is affected by
its rivals’ actions
– incentives to compete or to collude:
interdependence make firms collude while small
number of firms forced them to compete.
• Factors favouring collusion
– few firms, open with each other
– similar production methods; similar products
– significant entry barriers
– stable market
– collusion is legal
 Oligopoly

• Duopoly: An oligopoly where there are

just two firms in the market.
Imperfect Competition

Game Theory
• Game Theory: A mathematical method of
decision making in which alternative strategies are
analyzed to determine the optimal course of
action for the interested party, depending on
assumptions about rivals’ behaviour
 Game Theory

• Single move or normal-form games

– alternative strategies: maximax and
maximin

– single dominant strategy games

 Profits for firms A and B at different prices

X’s price
£2.00 £1.80

A B
£2.00 £5m for Y
£10m each
£12m for X

Y’s price
C D
£1.80 £12m for Y
£8m each
£5m for X
 Game theory

• Single move or normal-form games

– alternative strategies: maximax and
maximin

– single dominant strategy games

• the prisoners’ dilemma
 The prisoners’ dilemma

Amanda's alternatives

Not confess Confess

A B Nigel gets
Not 10 years
Each gets
confess Amanda gets
1 year
Nigel's 3 months
alternatives
C Nigel gets D
3 months Each gets
Confess 3 years
Amanda gets
10 years
 Prisoner’s dilemma
• Prisoner’s dilemma: Where two or more parties, by
attempting independently to choose the best strategy for
whatever other(s) are likely to do end up in a worse
position than if they have cooperated in the first place.
• Dominant strategy: is the best possible choice of action
regardless of the choice of action chosen by rivals.
• Nash equilibrium: The position resulting from everyone
making from their optimal decision based on their
assumptions about their rivals’ decisions. Without
collusion, there is no incentive to move from this position.
 When is cooperation possible?

• When the game is repeated many times,

cooperation is possible
• These strategies may lead to
cooperation
– When your rival ‘cheats’ in one round, you
will also ‘cheat’ in subsequent rounds
– “Tit-for-Tat”: Whatever your rival does in
one round, you will do in the following
round.
Nash equilibrium
 Tutorial question 1
Sandy runs a web business where people can design and
buy a T-shirt. She pays $1,000 per week for web hosting
and internet connection. It costs Sarah $20 to produce a T-
shirt. The table below shows the demand schedule for the T
– shirts.
Price (dollars per T- Quantity demanded
shirt) (T-shirts per week)

0 100
20 80
40 60
60 40
80 20
100 0
Tutorial question 1(ct’d)
 Tutorial question 2

• Assume that a monopolistically

competitive industry is in long-run
equilibrium. Show the effect of a fall in
demand on a firm’s price and profit in (a)
the short-run and (b) the long run.
Tutorial question 3
Tutorial question 3 (ct’d)
Tutorial question 4
 Tutorial question 4

(a) What is Silky Inc’s dominant strategy?

(b) What is Smoothy Inc’s dominant strategy?
(c) Find the Nash equilibrium.
(d) If the game is played many times, find the
equilibrium for the game.
Tutorial question 5
Tutorial question 6
End of Unit 5