Monopolistic Competition, Oligopoly, and Game Theory in Microeconomics

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Monopolistic Competition and Other Market Structures

Market Concentration

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

Four-Firm Concentration Ratio: The percentage of total market revenue accounted for by the four largest firms in the industry.
Herfindahl-Hirschman Index (HHI): The sum of the squares of the market shares of each firm in the market, usually for the largest 50 firms.

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

Four-Firm Concentration Ratio = 50% + 25% + 15% + 10% = 100%
HHI =

Limitations: Concentration measures may not fully capture the competitive dynamics, especially in markets with many small firms or where market shares change rapidly.

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.

Many sellers
Product differentiation
Free entry and exit in the long run
Some control over price

Comparison of Market Structures

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

Price and Output in Monopolistic Competition

Short-Run Price and Output Decision

In the short run, a monopolistically competitive firm behaves similarly to a monopolist, choosing output where marginal revenue equals marginal cost () and setting price based on the demand curve.

Firms can earn economic profits or losses in the short run.

Long-Run Equilibrium

In the long run, entry and exit of firms drive economic profit to zero. Firms produce at a point where price equals average total cost (), but not at minimum ATC, resulting in excess capacity.

Zero Economic Profit:
Excess Capacity: Firms do not produce at the minimum point of their ATC curve.
Markup: Price exceeds marginal cost ().

Efficiency in Monopolistic Competition

Monopolistic competition is not allocatively or productively efficient. Firms charge a price above marginal cost and do not produce at minimum average total cost.

Allocative inefficiency:
Productive inefficiency:

Product Development and Marketing

Product Development

Firms in monopolistic competition have incentives to innovate and differentiate their products to attract customers and increase market share.

Innovation can bring extra revenue but is costly.
Firms weigh marginal benefits against marginal costs.
Product development may not always lead to efficiency.

Advertising

Advertising increases demand for a firm's product.
When all firms advertise, the effect may be offset, leading to higher costs without much gain in market share.
Advertising can inform consumers and create brand loyalty.

Efficiency of Advertising: Advertising can increase efficiency if it provides useful information, but excessive advertising may waste resources.

Oligopoly

Definition and Characteristics

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

Few firms dominate the market.
Products may be identical or differentiated.
Barriers to entry are high.
Firms are mutually interdependent.

Barriers to Entry

Economies of scale
Ownership of key resources
Government regulation

Oligopoly Games and Game Theory

Prisoner's Dilemma

The prisoner's dilemma is a standard example of a game that shows why two rational individuals might not cooperate, even if it appears that it is in their best interest to do so.

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

Each player chooses to confess or not, with payoffs depending on both players' choices.
Dominant Strategy: A strategy that is best for a player regardless of the strategies chosen by other players.
Nash Equilibrium: Each player chooses the action that maximizes their own payoff, given the action of the other player.

Oligopoly Pricing Game Example

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

Each firm chooses a price, and the payoffs depend on the combination of choices.

Game of Chicken

The game of Chicken is another strategic interaction where two players can either cooperate or compete, with the worst outcome occurring if both compete aggressively.

Repeated Games and Sequential Games

Repeated Games

In repeated games, firms interact with each other multiple times, allowing for strategies like Tit for Tat, where a firm mimics the previous action of its rival. This can sustain cooperation and deter cheating.

	Tit for Tat	Always Cheat
Tit for Tat	(100, 100 each year)	(100, 100 each year)
Always Cheat	(400, 100 each year)	(400, 100 each year)

Sequential Entry Games

In sequential games, one firm makes a move first, and the other firms respond. Backward induction is used to determine the optimal strategy by analyzing the game from the end and working backward.

Backward Induction: Solving a sequential game by analyzing the last mover's decision first and then determining the optimal strategy for the first mover.

Anti-Combine Law

Anti-combine laws (antitrust laws) are designed to prevent collusion and promote competition in markets. Additional info: Students are advised to read about anti-combine laws independently.