Chapter 6

Question 1

What are 3 assumptions of monopolistic competition?

Answer 1

1. There are quite a large number of firms. Each firm has a small share of the market, and its actions are unlikely to affect its rivals to any great extent. This is known as the assumption of interdependence.
2. There is freedom of entry of new firms into the industry.
3. Each firm produces a product or provides a service that is different from its rivals. Thus, it can raise its price without losing all its customers. Its demand curve will be downward sloping, albeit relatively elastic as there are a large number of competitors to which customers can turn. This is known as the assumption of product differentiation.

Question 2

In monopolistic competition what happens to the equilibrium of the firm in the short run?

Answer 2

Profits are maximised at the output where MC = MR. The AR and MR curves are more elastic than in a monopolist.
How much profit is made in the short run depends on the strength of demand: the position and elasticity of the demand curve. The further to the right the demand curve is relative to the average cost curve, and the less elastic the demand curve is, the greater will be the firm’s short-run profit. Thus, a firm whose product is considerably differentiated from those of its rivals may be able to earn considerable short-run profits.

Question 3

In monopolistic competition what happens to the equilibrium of the firm in the long run?

Answer 3

If supernormal profit is being earnt, new firms will enter. Demand for established firms will fall. Their demand curve (AR) will shift to the left and will continue doing so as long as supernormal profits remain and new firms are entering. Long-run equilibrium will be reached when only normal profits remain: where there is no further incentive for new firms to enter.

Question 4

What are the two main elements of non-price competition?

Answer 4

Non-price competition is competition in terms of product development or product promotion.
1. Product development: produce a product that will sell well (in high demand) and is different from rivals (inelastic demand due to lack of close substitutes).
2. Advertisitng: main aim is to sell the product. Successful advertising increases demand and makes the demand curve less elastic.

Question 5

How much should a firm advertise to maximise its profits?

Answer 5

The optimal amount is where the revenue from additional advertising (MRA) is equal to its cost (MCA).

Question 6

What are 3 problems with product development and promotion?

Answer 6

1. It is difficult to predict the effects of product development and advertising on demand.
2. Product development can affect a firms future costs. (e.g., after care/repair costs)
3. Product development and advertising will have different effects at different prices. Profit maximisation involves the more complex choice of the optimum combination of price, type of product, and level and variety of advertising.

Question 7

How does monopolistic competition compare to perfect competition?

Answer 7

Monopolistic competition has the following disadvantages:
1. Less will be sold and at a higher price
2. Firms will not be producing at the least-cost point
Monopolistic competition is typified by a large number of firms (e.g., petrol stations) all operating at less than optimum output and thus being forced to charge a higher price than they could charge if they had a bigger turnover.

Question 8

How does monopolistic competition affect the consumer?

Answer 8

Although there might be a higher price than under perfect competition, the difference is likely very small. Although the demand curve would be downward sloping, it is still likely to be highly elastic due to large number of substitutes. Consumers may benefit by having a greater variety of products to choose from.

Question 9

How does monopolistic competition compare with monopoly?

Answer 9

The freedom of entry and hence the lack of long-run supernormal profits may help to keep prices down for the consumer and encourage cost saving. However, monopolies are likely to achieve greater economies of scale and have more funds for investment/development.

Question 10

Define an oligopoly.

Answer 10

Occurs when just a few firms between them share a large proportion of the industry. Most oligopolists produce differentiated products (e.g., banking, supermarkets).

Question 11

What are 2 key features of an oligopoly?

Answer 11

1. Barriers to entry. The size of the barriers will vary from industry to industry.
2. Interdependence of the firms. As there are only a few firms, each firm has to take into account the others. They are mutually dependent (interdependent). Due to this, firms may react differently and unpredictably.

Question 12

How are oligopolists pulled in two different directions?

Answer 12

1. The interdependence of firms may make them wish to collude with each other.
2. They will be tempted to compete with their rivals to gain a bigger share of industry profit for themselves.
   The more firms compete the smaller industry profits will become. Ie., price competition will drive down the average industry price, while competition through advertising raises industry costs.

Question 13

What is collusive oligopoly?

Answer 13

Firms agree on prices, market share, advertising, etc. This reduces uncertainty and the fear of engaging in competitive price cutting or retaliatory advertising.
A cartel is a formal collusive agreement. The cartel will maximise profits if it acts like a monopoly. In many countries cartels are illegal.

Question 14

What is tacit collusion?

Answer 14

Dominant firm price leadership: firms keep to the price that is set by the firm that dominates the industry. The leader will set the price based on assumptions about its rivals reactions to price changes. If the leader increases price, followers may want to supply more at the new price. Alternatively, followers may just maintain their market share to avoid retaliation from the leader.
Barometric firm price leadership: the price leader is the firm that has proved to be the most reliable one to follow. In practice, the firm that is the barometer is likely to change. Any firm may take the initiative in increasing prices. If other firms are just waiting for someone to take the lead (e.g., because costs have risen) they will quickly follow suit.
Average cost pricing: rule of thumb. Add a certain percentage for profit on top of average costs. Thus, if average costs rise by 10%, prices will automatically be increased by 10%. This is useful in times of inflation.
Price benchmarks: e.g., clothes sell for $9.95 but not $12.31. If costs rise, firms raise their price to the next benchmark and other firms do the same.
Rules of thumb can also be applied to advertising (e.g., you do not criticise other firms products) or to the design of a product (e.g., everyone agrees not to bring out an everlasting light bulb).

Question 15

List 7 factors that favour collusion.

Answer 15

1. There are few firms and they are all well known to each other.
2. They are open with each other about costs and production methods.
3. They have similar production methods and average costs, and are thus likely to want to change prices at the same time and by the same percentage.
4. They produce similar products and can thus more easily reach agreements on price.
5. There is a dominant firm.
6. There are significant barriers to entry and thus there is little fear of disruption by new firms.
7. The market is stable.

Question 16

What contributes to the breakdown of collusion?

Answer 16

A firm will ask 2 questions:
1. How much can we get away with without inviting retaliation?
2. If a price war does result, will we be the winners?

Question 17

What is the kinked demand curve?

Answer 17

Even without collusion, prices under oligopoly can often remain stable, with little apparent compeition. This is a kinked demand curve, which is based on two assumptions:
1. If an oligopolist cuts its prices, its rivals will be forced to cut prices to prevent the loss of customers.
2. If an oligopolist raises its prices its rivals will not follow suit since, by keeping their prices the same, they will gain customers from the first firm.
Based on this, the demand curve is kinked at the current price and output. Demand is relatively elastic above the kink and relatively inelastic below the kink. Thus, oligopolists will be reluctant to change prices at all.

Question 18

How does oligopoly affect the consumer?

Answer 18

If colluding and acting as a monopoly, prices may be very high. Oligopoly may also be more disadvantageous than monopoly in two respects:
1. Depending on the size of the individual oligopolists, there may be less scope for economies of scale to mitigate the effects of market power
2. Oligopolists are likely to engage in more extensive advertising than a monopolist.
These problems are less severe if there is no collusion, some degree of price competition, and if barriers to entry are weak. The power of oligopolists in certain markets may to some extent be offset if they sell their product to other powerful firms (e.g., soap powder selling to a giant supermarket). This is known as countervailing power.

Question 19

What are two advantages of oligopoly?

Answer 19

1. Oligopolists can use part of their supernormal profits for research and development and will have considerable incentive to do so.
2. Non-price competition through product differentiation may result in greater choice for the consumer.

Question 20

What is game theory?

Answer 20

The study of alternative strategies that oligopolists may choose to adopt, depending on their assumptions about their rivals behaviour.

Question 21

Describe single move games.

Answer 21

Simplest type of game. Single move or single period game. This involves just one “move” by each firm involved.

Question 22

Describe simple dominant strategy games.

Answer 22

The simplest case is where there are just two firms with identical costs, products and demand. They are both considering which of two alternative prices to charge. Adopting the safer strategy is known as the maximin (choosing the policy whose worst possible outcome is the least bad). This will maximise the firms minimum possible profit.
An alternative strategy is to go for the optimistic approach and assume that your rivals react in the most favourable way to you. This is known as maximax; the strategy of choosing the policy that has the best possible outcome. ‘

Question 23

Define dominant strategy game.

Answer 23

This is where the same policy is suggested by different strategies (e.g., maximin and maximix, both lead to cutting price).

Question 24

What is the Nash equilibrium?

Answer 24

The position resulting from everyone making their optimal assumptions about their rivals decisions. Without collusion, there is no incentive for any firm to move from this position. E.g., collusion rather than a price war would have benefited both firms. However, even if they did collude, both would be tempted to cheat and cut prices. This is known as the prisoners dilemma.

Question 25

What is the prisoners’ dilemma?

Answer 25

Where 2 or more firms (or people), by attempting independently to choose the best strategy for whatever the other(s) are likely to do, end up in a worse position than if they had cooperated in the first place.

Question 26

Why are threats and promises important?

Answer 26

An oligopolist will often make a threat or promise that it will act in a certain way. As long as the threat or promise is credible (i.e., its competitors believe it), the firm can gain and it will influence its rivals’ behaviour.

Question 27

Elaborate on more complex games with no dominant strategy.

Answer 27

More complex games can be devised with more than two firms, many alternative prices, differentiated product and various forms of non-price competition (e.g., advertising). In such cases, the cautious (maximin) strategy may suggest a different policy (e.g., do nothing) from the high-risk (maximax) strategy (e.g., cut prices substantially). In complex and changing situations firms may alter their tactics. E.g., they compete hard for a time, then engage in tacit collusion, then compete again.

Question 28

Define repeated games.

Answer 28

Firms will often react to what their rivals do, and their rivals will react in turn. i.e., the game will move back and forth. These multiple-move games are known as repeated games or extensive-form games. E.g., “tit-for-tat” – a firm cuts prices or some other aggressive move only if the rival does so first.

Question 29

How does price discrimination work?

Answer 29

Price discrimination is where consumers are grouped into two or more independent markets and a separate price is charged in each market even though there is no difference in costs of production (e.g., seats on buses for adults and children).

Question 30

What is peak-period pricing?

Answer 30

Prices vary in line with daily or seasonal fluctuations in demand. It is intended to encourage people to purchase a service or produce when there is surplus capacity. This is different from price discrimination.

Question 31

What are the 3 necessary conditions for price discrimination to operate?

Answer 31

1. The firm must be able to set its price. This will be impossible under perfect competition, where firms are price takers.
2. The markets must be separate. Consumers in the low-priced market must not be able to resell the product in the high-priced market.
3. Demand elasticity must differ in each market. The firm will charge the higher price in the market where demand is less elastic and thus less sensitive to a price rise.

Question 32

How is price discrimination an advantage to the firm?

Answer 32

1. It will allow them to earn a higher revenue from any given level of sales.
2. It may be able to drive its competitors out of business. If a firm has a monopoly in one market (e.g., the home market) it may be able to charge a high price due to relatively inelastic demand and make high profit. It is under oligopoly in another market (e.g., the export market) it may use the high profits in the first market to subsidise a very low price in the oligopolistic market, thus forcing its competitiors out of business. This is known as predatory pricing.

Question 33

How does price discrimination affect the consumer?

Answer 33

No clear-cut decision can be made about the desirability of price discrimination from the point of view of the consumer. Some people will benefit from it; others will lose.