Microeconomics: Monopoly, Monopolistic Competition, and Oligopoly Lecture Notes

Overview of Market Structures: Monopoly, Monopolistic Competition, and Oligopoly

• Monopoly: A market structure with one supplier and no close substitutes, protected by barriers to entry.
• Monopolistic Competition: A market structure where a large number of firms compete with differentiated products.
• Oligopoly: A market structure characterized by a small number of firms and high barriers to entry.

Monopoly and How It Arises

• A monopoly is a market characterized by two key features:
  • No Close Substitutes: If a good has a close substitute, the firm faces competition from the producers of that substitute even if it is the sole producer of its own specific good. A true monopoly sells a good for which no close substitute exists.
  • Barriers to Entry: A constraint that protects a firm from potential competitors. There are three primary types of barriers to entry:
  • Natural Barriers to Entry: These create a natural monopoly. A natural monopoly exists when economies of scale enable one firm to supply the entire market at the lowest possible cost. In this scenario, the Long-Run Average Cost ($LRAC$) curve is still sloping downward when it meets the market demand curve ($D$).
    • Example: One firm can produce $4,000,000$ units of output at a cost of $5 \, \text{cents per unit}$. If two firms tried to supply the same market, producing $2,000,000$ units each, the cost would rise to $10 \, \text{cents per unit}$.
  • Ownership Barriers to Entry: Occurs when one firm owns a significant portion of a key resource. For example, during the last century, De Beers owned $90$ percent of the world’s diamonds.
  • Legal Barriers to Entry: These create a legal monopoly, where entry and competition are restricted by government actions, including:
    • Public Franchises: An exclusive right granted to a firm to supply a good or service (e.g., the U.S. Postal Service's franchise for first-class mail).
    • Government Licenses: Required for practicing certain professions like law or medicine.
    • Patents or Copyrights: Legal protections granted to inventors or creators.

Single-Price Monopoly Output and Price Decisions

• Monopoly Price-Setting Strategies:
  • Single-Price Monopoly: The firm must sell every unit of its output for the same price to all customers.
  • Price Discrimination: The practice of selling different units of a good or service for different prices. While many firms do this, not all are monopolies.
• Price and Marginal Revenue ($MR$):
  • A monopoly is a price setter because the demand for its output is the market demand.
  • To increase sales, a monopoly must lower its price. Therefore, for a single-price monopoly, marginal revenue is always less than price ($MR < P$).
• Marginal Revenue Calculation Example:
  • Suppose a monopoly sets a price of $\$16$ and sells $2 \, \text{units}$. Total Revenue ($TR$) is $\$32$.
  • To sell $3 \, \text{units}$, the firm cuts the price to $\$14$.
  • Revenue Loss: The firm loses $\$2$ on each of the $2 \, \text{units}$ it used to sell at $\$16$, totaling a $\$4$ loss.
  • Revenue Gain: The firm gains $\$14$ from selling the $3rd \, \text{unit}$.
  • Net Change in Total Revenue ($MR$): $\$14 - \$4 = \$10$. Thus, at $3 \, \text{units}$, the price is $\$14$ but the marginal revenue is $\$10$.
• Marginal Revenue and Elasticity:
  • Elastic Demand: If demand is elastic, a fall in price leads to an increase in total revenue ($MR > 0$). The revenue gain from increased quantity outweighs the revenue loss from the lower price.
  • Inelastic Demand: If demand is inelastic, a fall in price leads to a decrease in total revenue ($MR < 0$). The revenue loss from the lower price outweighs the gain from increased quantity.
  • Unit Elastic Demand: Total revenue is at its maximum, and $MR = 0$.

Monopolistic Competition

• Features of Monopolistic Competition:
  • Large Number of Firms: Results in each firm having a small market share and limited power to influence price. Firms are sensitive to the average market price but do not respond to the actions of specific individuals. Collusion is impossible.
  • Product Differentiation: Firms produce products that are slightly different from those of competitors.
  • Competing on Quality, Price, and Marketing:
  • Quality: Includes design, reliability, and service.
  • Price: Firms face a downward-sloping demand curve, creating a tradeoff between price and quality.
  • Marketing: Differentiated products require marketing in the form of advertising and packaging.
  • Free Entry and Exit: No barriers to entry exist, preventing firms from making an economic profit in the long run.
  • Examples: Producers of clothing, jewelry, computers, audio/video equipment, and sporting goods.
• Short-Run Decisions:
  • The firm maximizes profit by producing the quantity where $MR = MC$.
  • Price is determined by the highest price consumers are willing to pay for that quantity on the demand curve.
  • Economic profit occurs if $P > ATC$. Economic loss occurs if $P < ATC$.
• Long-Run Equilibrium:
  • Economic profits attract new entrants. As firms enter, the demand for existing firms' products decreases.
  • Demand and $MR$ curves shift leftward until the price equals Average Total Cost ($P = ATC$), resulting in zero economic profit.
• Comparison with Perfect Competition:
  • Excess Capacity: Firms in monopolistic competition produce less than the efficient scale (the quantity where $ATC$ is at a minimum).
  • Markup: The amount by which price exceeds marginal cost ($P > MC$). This is driven by the downward-sloping demand curve.

Oligopoly and Game Theory

• Features of Oligopoly:
  • Small number of firms compete, and barriers to entry (natural or legal) prevent new competitors.
  • Interdependence: Each firm’s profit depends on the actions of all other firms.
  • Temptation to Cooperate: Firms may try to form a cartel (a group acting together to limit output and raise prices). Cartels are illegal in many jurisdictions.
• Game Theory: A tool for studying strategic behavior, accounting for the mutual recognition of interdependence.
  • Common features of all games: Rules, Strategies, Payoffs, and Outcomes.
• The Prisoners’ Dilemma Case Study:
  • Players: Art and Bob.
  • Rules: Held in separate cells; suspected of a serious crime but only caught for a petty one.
  • Strategy Options: Confess or Deny.
  • Payoff Matrix:
  • If both confess: Each gets $3 \, \text{years}$.
  • If both deny: Each gets $2 \, \text{years}$.
  • If Art confesses and Bob denies: Art gets $1 \, \text{year}$, Bob gets $10 \, \text{years}$.
  • If Bob confesses and Art denies: Bob gets $1 \, \text{year}$, Art gets $10 \, \text{years}$.
  • Nash Equilibrium: The outcome where each player takes the best possible action given the action of the other player. In this game, both Art and Bob choose to confess because it is in their individual best interest regardless of the other's choice. This leads to a suboptimal outcome ($3 \, \text{years}$ each) compared to both denying ($2 \, \text{years}$ each).
• Oligopoly Price-Fixing Games:
  • Duopoly: A market with only two producers (e.g., Trick and Gear). A duopoly captures the essence of oligopoly strategies and the potential for price-fixing games similar to the prisoners' dilemma.