Monopolistic Competition

• Large number of firms producing differentiated products

• By differentiating its product from its competitors’ products, the firm can reduce the extent of price competition

• With differentiated products, a price reduction attracts some customers from competing firms but not all customers

• A firm faces a downward sloping demand curve for its product with competitors’ products being demand substitutes.

• Since each firm faces a downward sloping demand curve for it’s product, it is as if the firm is a (small) monopolist in its product

• As a result, each firm chooses a price such that MR = MC, implying that P > MC, much as in a monopoly.

• Free entry of competitors implies that, in the long run, profits are zero

Advertising

• Persuasive:

-increases perceived product differentiation

-persuade customers to buy when they otherwise wouldn’t

-persuade customers to pay more than they otherwise would

• Informative:

-direct information on price/characteristics/existence (allows new firms to enter)

-indirect signal of product quality

High quality firms will have more repeat purchases and so they can afford to advertise more

Repeated Games and Collusion

• Can Bertrand paradox be resolved if firms interact repeatedly?

• Is it a Nash Equilibrium to set p>mc in the first period of a repeated interaction in an effort to ‘signal’ willingness to ‘cooperate’?

• Depends on what we mean by repeated?

-fixed number of times

-infinite number of times

• Fixed:

-last period is same as one-shot game

-no incentive to cooperate in any preceding period

-cooperation unravels

• Infinite:

-no last period so cooperation is possible

-influence behaviour through use of punishment strategies

• Cooperation more likely when:

-there is a high probability of future interaction

-actions of rivals can be monitored

-defectors can be easily punished

-interest rates are low

Cartels

• Firms work together to maximize their total profits

Example: OPEC

• Each firm/country has incentive to cheat and produce too much

• So joint profit maximization is not an equilibrium without enforcement

Multistage Games

• Many economic situations exist in which one agent acts before the other

• Decision makers must consider the manner in which their rival will respond to their decision

• Decision makers should only consider credible responses

Entry and Exit Decisions

• Potential entrant is trying to decide whether or not to enter a market in which there is an incumbent

• Incumbent’s threat to flood the market if the entrant enters is not credible

-once the entrant is in the market, the best the incumbent can do is accomodate

• The only subgame perfect equlibrium involves the entrant entering and the incumbent accommodating the entry

• Can the incumbent do anything to credibly deter entry?

-commit to larger output by investing in extra capacity

Increased capacity allows for greater levels of production if necessary

Pricing Strategies

• Attempt to discourage entry by charging a low price

-low price must somehow convey bad news to potential entrants about their post-entry profitability in the market

-potential entrants must believe that the low price will persist after entry

• Low price in second period is not credible—so the entrant should enter

• Is there any way to use price to deter entry?

-low price can be signal of low costs

• What about signaling aggressive pricing behaviour?

-would have to keep it up for ever—not profitable