Monopolistic Competition and Oligopoly: Non-Price Competition and Game Theory
Monopolistic competition is a market structure with many small firms, low barriers to entry and exit, and differentiated products, so each firm has a small amount of market power and faces a downward-sloping but relatively elastic demand curve.
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Method
- List the assumed characteristics of monopolistic competition: many firms, low barriers to entry/exit, and differentiated, not identical, products, giving each firm some, but limited, price-setting power.
- Draw the short-run and long-run monopolistic competition diagrams: in the short run a firm can earn supernormal profit where MR=MC; in the long run, low barriers mean new firms enter, shifting each incumbent's demand curve left until it is tangent to its average cost curve, leaving only normal profit.
- List the characteristics of oligopoly: a small number of large, interdependent firms, typically with a high concentration ratio, high barriers to entry, and both price and non-price competition.
- Explain interdependence: because there are few firms, each firm's price/output decision has a large enough impact on rivals that it can trigger a reaction, so firms must consider likely rival responses before acting.
- Explain the kinked demand curve model of oligopoly: firms assume rivals will match a price cut but not match a price rise, producing a demand curve that is relatively elastic above the current price and relatively inelastic below it, with a discontinuity in marginal revenue that can make prices sticky.
- Explain the basics of game theory applied to oligopoly using a simple payoff matrix, e.g. a prisoner's dilemma with two firms choosing high or low price, and identify a Nash equilibrium, the outcome where neither firm can improve its own payoff by changing strategy alone, given the other firm's chosen strategy.
- Learn named forms of non-price competition, advertising and branding, product development, loyalty schemes, quality of service, packaging, and explain why firms often prefer non-price competition to price competition, it is harder for rivals to copy quickly, and avoids the risk of a price war eroding industry profits.
Worked example
Two petrol stations, A and B, are the only two in a small town (a duopoly). Each can choose to keep its price high or cut its price low. The weekly profit payoffs (station A, station B), in thousands of pounds, are: both high = (10, 10); A high, B low = (2, 14); A low, B high = (14, 2); both low = (5, 5). Using this payoff matrix, explain what outcome game theory predicts and why.
- Consider station A's best response if B chooses high: A gets 10 from high, 14 from low, so A's best response to B choosing high is to choose low.
- Consider station A's best response if B chooses low: A gets 2 from high, 5 from low, so A's best response to B choosing low is also to choose low.
- Since A's best strategy is 'low' regardless of what B does, 'low' is a dominant strategy for A; by the matrix's symmetry, 'low' is also B's dominant strategy.
- Identify the outcome when both play their dominant strategy: both choose low, giving payoffs (5, 5).
- Explain the dilemma: both stations would earn more, (10, 10), if they both chose high, but neither can trust the other not to undercut them, so rational self-interested behaviour leads to the worse, mutual outcome of (5, 5), the prisoner's dilemma, and (low, low) is the Nash equilibrium since neither firm can improve its payoff by unilaterally changing strategy.
Practice questions
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Q1List two characteristics of monopolistic competition.Show answer
Answer: Any two of: many firms in the market, low barriers to entry and exit, or differentiated, non-identical, products.
Q2List two characteristics of oligopoly.Show answer
Answer: Any two of: a small number of large, dominant firms, high barriers to entry, firms are interdependent, or a high concentration ratio.
Q3What is meant by 'interdependence' between oligopoly firms?Show answer
Answer: Because there are only a few large firms, each firm's decisions have a large enough effect on the market that rivals are likely to react, so each firm must consider how competitors will respond before acting.
Q4In the kinked demand curve model, why might an oligopolist be reluctant to raise its price?Show answer
Answer: Because rivals are assumed not to match a price rise, hoping to gain market share, so the firm raising price would lose a large share of customers to competitors.
Q5Give two examples of non-price competition.Show answer
Answer: Any two of: advertising/branding, product development or innovation, loyalty schemes, or improvements to quality of service.
Q6What is a Nash equilibrium?Show answer
Answer: An outcome in a game where no player can improve their own payoff by changing their strategy alone, given the strategy chosen by the other player(s).
Q7Explain why oligopolists in a repeated game might be more likely to cooperate than firms playing a single, one-off game.Show answer
Answer: Because in a repeated game, a firm that undercuts a rival risks retaliation, e.g. a price war, in future periods, so the long-run cost of breaking cooperation can outweigh the short-run gain.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Using the concept of price rigidity and the kinked demand curve, explain why oligopolists often prefer to compete through advertising and branding rather than by changing price.
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Evaluate the extent to which oligopolistic markets operate in the best interests of consumers.
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