Monopolistic Competition, Oligopoly, and Game Theory in Microeconomics

Monopolistic Competition and Other Market Structures

Market Concentration

Market concentration measures the extent to which a small number of firms dominate total sales in a market. It is a key indicator of market structure and competitiveness.

• Four-Firm Concentration Ratio: The percentage of total market revenue accounted for by the four largest firms.

• Herfindahl-Hirschman Index (HHI): The sum of the squares of the percentage market shares of all firms in the market.

Formula for HHI:

$HHI = s_1^2 + s_2^2 + ... + s_n^2$

where $s_i$ is the market share (in percentage) of firm $i$.

Example: If Firm 1 has 50% market share, Firm 2 has 25%, Firm 3 has 15%, and Firm 4 has 10%, then:

$HHI = 50^2 + 25^2 + 15^2 + 10^2 = 2500 + 625 + 225 + 100 = 3450$

Characteristics of Monopolistic Competition

Monopolistic competition is a market structure characterized by many firms selling similar but not identical products. Each firm has some market power due to product differentiation.

• Large number of firms

• Product differentiation

• Free entry and exit

• Some control over price

Comparison of Market Structures

The following table summarizes key differences among market structures:

Characteristic	Perfect Competition	Monopolistic Competition	Oligopoly	Monopoly
Number of firms	Many	Many	Few	One
Product type	Identical	Differentiated	Identical or differentiated	Unique
Barriers to entry	None	Low	High	Very high
Market power	None	Some	Significant	Complete

Limitations of Concentration Measures

• Do not account for product differentiation

• May not reflect competitive behavior

• Ignores potential competition

Price and Output in Monopolistic Competition

Short-Run Price and Output Decision

In the short run, a firm in monopolistic competition behaves similarly to a monopolist, choosing output where marginal revenue equals marginal cost.

• Can earn economic profit or incur losses

• Faces a downward-sloping demand curve

Long-Run Equilibrium

In the long run, entry and exit of firms drive economic profit to zero.

• Firms produce where average total cost is tangent to the demand curve

• Zero economic profit

Monopolistic Competition vs. Perfect Competition (Long Run)

• Markup: Price exceeds marginal cost in monopolistic competition

• Excess Capacity: Firms do not produce at minimum average total cost

Efficiency in Monopolistic Competition

Monopolistic competition may not achieve allocative or productive efficiency due to markup and excess capacity.

Product Development and Marketing

Product Development

Firms innovate to differentiate products and gain market power, but innovation is costly and may not always lead to efficiency.

• Incentive to innovate due to potential entry by other firms

• Brings extra revenue but incurs costs

• Weighing marginal benefits and costs

Advertising

• Increases demand for a firm's product

• All firms can advertise, which may offset individual gains

• Efficiency of advertising and brand names is debated

Example: Compare market outcomes when all firms advertise versus when no firms advertise. Advertising can shift demand curves and affect costs.

Oligopoly

Definition and Characteristics

An oligopoly is a market structure with a small number of firms, significant barriers to entry, and interdependent decision-making.

• Few firms dominate the market

• Products may be identical or differentiated

• High barriers to entry

• Firms' actions affect each other's outcomes

Oligopoly Games and Game Theory

Prisoner's Dilemma

The prisoner's dilemma illustrates how rational decision-makers may not cooperate, even when it is in their best interest.

	P2: Don't confess	P2: Confess
P1: Don't confess	(5,5)	(20,2)
P1: Confess	(2,20)	(15,15)

• Players choose strategies simultaneously

• Full information: payoffs are known

Dominant Strategy and Nash Equilibrium

• Dominant Strategy: A strategy that yields the highest payoff regardless of the other player's action

• Nash Equilibrium: Each player chooses the best strategy given the other player's choice

Example: Two firms choose low or high prices. Payoff matrix:

	Firm 2: Low Price	Firm 2: High Price
Firm 1: Low Price	(10,10)	(20,5)
Firm 1: High Price	(6,20)	(15,15)

Game of Chicken

Another strategic game where players choose between aggressive and passive strategies, with payoffs depending on mutual choices.

Repeated Games and Sequential Games

Repeated Games

In repeated games, players interact over multiple periods, allowing for strategies like Tit-for-Tat, which can sustain cooperation.

	Canada Brand: Tit for Tat	Canada Brand: Always Cheat
Website Bakeries: Tit for Tat	(100+100 each year)	(100+100 each year, 200+100 each year)
Website Bakeries: Always Cheat	(100+100 each year, 200+100 each year)	(400+100 each year, 400+100 each year)

Sequential Entry Games

Sequential games involve players making decisions one after another, with later players observing earlier actions. Backward induction is used to solve these games.

• First mover chooses market entry

• Second mover responds, affecting payoffs

Backward Induction: Solving the game by analyzing from the last move backward to the first.

Additional info:

• Anti-combine Law: Refers to legislation preventing anti-competitive practices (students are advised to read independently).