Principles of Microeconomics L22 Lecture Notes PDF

Principles of Microeconomics Monopolistic Competition and Oligopolies Shuo Xu December 5, 2024 1/16 Characteristics of Monopolistic Competition A monopolistic competitive market (e.g. soft drinks) has the following chara...

Principles of Microeconomics Monopolistic Competition and Oligopolies Shuo Xu December 5, 2024 1/16 Characteristics of Monopolistic Competition A monopolistic competitive market (e.g. soft drinks) has the following characteristics: I Many sellers and many buyers. I Differentiated product. (imperfect substitutes, e.g. coke vs. pepsi) I Low barriers to entry. 2/16 A Monopolist within Product Market 3/16 A Perfectly Competitive Firm in the General Market Figure: Firms will enter Figure: Demand shifts to the left. I Low barriers to entry ⇒ zero profit in the long run. 4/16 Maintain Product Differentiation To maintain positive economic profit in the long run, a monopolistic competitive firm must main market power: I Innovation (Hard Evidence) I Advertisement (Costly Signal) 5/16 Characteristics of Oligopoly An oligopoly market has the following characteristics: I A small number of large firms. I The firms are interdependent. I Strategic price maker. I High barriers to entry. 6/16 Firms are Interdependent An oligopolist must consider how its rival will react to its decision. I A perfectly competitive firm is a price taker. I A monopolist has no rivals. I Within its own product market, a monopolistic competitive firm has no rivals. 7/16 Overt collusion The oligopolists jointly behave as a monopolist. (Pseudo-) Example: OPEC countries. 8/16 The Payoff Matrix To describe a game, you need to specify: I Players I Actions for each player. I Payoffs. Example (A’s Payoff, B’s Payoff) Confess Not Confess Confess (-2,-2) (0,-3) Not Confess (-3,0) (-1 , -1) 9/16 Strategy Strategy: A contingent plan that maps other players’ actions to your own action. Example (A’s Payoff, B’s Payoff) Confess Not Confess Confess (-2,-2) (0,-3) Not Confess (-3,0) (-1 , -1) Strategies: I Always confess. I Match the other player’s action. 10/16 Dominance Dominant Strategy: A strategy that gives the player the highest payoff, no matter how the other players do. Example (A’s Payoff, B’s Payoff) Confess Not Confess Confess (-2,-2) (0,-3) Not Confess (-3,0) (-1 , -1) Always confess is a strictly dominant strategy: I When B plays ”Confess”, ”Confess” is strictly better: −2 > −3. I When B plays ”Not Confess”, ”Confess” is strictly better: 0 > −1. 11/16 Nash Equilibrium Nash Equilibrium: No player can do better by unilaterally changing his or her strategy. Example (A’s Payoff, B’s Payoff) Confess Not Confess Confess (-2,-2) (0,-3) Not Confess (-3,0) (-1 , -1) I (Always Confess, Always Confess) is the equilibrium strategy. I (Confess, Confess) is the equilibrium outcome. I (-2,-2) is the equilibrium payoff. 12/16 How to Find Equilibrium How to find the equilibrium outcome? I Fixing the other player’s action, find the best action. I If both players are best-responding, then it is the equilibrium outcome. Example (A’s Payoff, B’s Payoff) P=3 P=2 P=3 (0.5,0.5) (0,0.8) P=2 (0.8,0) (0.4 , 0.4) 13/16 Second-Best Solution Example (A’s Payoff, B’s Payoff) Confess Not Confess Confess (-2,-2) (0,-3) Not Confess (-3,0) (-1 , -1) I In equilibrium, the sum of the payoffs is -4. (Second-best). I If both players choose ”Not Confess” then the sum of the payoffs is -2. (First-best). 14/16 Restoring First-Best through Repeated Plays I When a game is played repeatedly, the players can also base their strategies on the history of the play. 15/16 Restoring First-Best through Repeated Plays I When a game is played repeatedly, the players can also base their strategies on the history of the play. I Players can penalize each other if anyone is deviating from the first-best solution. 15/16 Restoring First-Best through Repeated Plays I When a game is played repeatedly, the players can also base their strategies on the history of the play. I Players can penalize each other if anyone is deviating from the first-best solution. I Intertemporal Trade-off: More profit in the current period vs. More profit in the future. 15/16 Restoring First-Best through Repeated Plays I When a game is played repeatedly, the players can also base their strategies on the history of the play. I Players can penalize each other if anyone is deviating from the first-best solution. I Intertemporal Trade-off: More profit in the current period vs. More profit in the future. I If both players are sufficiently patient, then monopoly profit is sustainable. 15/16 Restoring First-Best through Repeated Plays I When a game is played repeatedly, the players can also base their strategies on the history of the play. I Players can penalize each other if anyone is deviating from the first-best solution. I Intertemporal Trade-off: More profit in the current period vs. More profit in the future. I If both players are sufficiently patient, then monopoly profit is sustainable. I Within economics, there is a whole field called game theory that deals with these matters in detail. 15/16 Wrap-Up & Announcements 1. Any questions? 2. The SEI is now open. 16/16