Question

Q1. Briefly explain why sometimes oligopolies may act like firms in a perfectly competitive market.

Q2. Briefly explain why in the long run we expect 0 economic profit in monopolistic markets.

Answer 1

1. The reason why at times oligopolies may act like a perfectly competitive firms is due to the hard competition and a lack of collusion/cartel among the oligopolists. To understand the intuition consider two firms A and B in a duopoly (simple form of oligopoly). Both firms can either cooperate and keep output down and earn monopoly profits or they may not cooperate - compete and produce higher output and earn zero long run profits.  

	Firm B
Keep Output Down (cooperate with other firm)	Increase Output (do not cooperate with other firm)
Firm A	Keep Down Output (cooperate with other firm)	A gets $10,000, B gets $10,000	A gets $2000, B gets $15,000
Increase Output (do not cooperate with other firm)	A gets $15,000, B gets $2000	A gets $4000, B gets $4000
Table - Prisoners Dilemma case in Duopoly

Observe the prisoner's dilemma case illustrated for the duopoly. If the firms at first decide to cooperate, then other firms has incentive to increase output and hence their profits. The dominant strategy here is to increase output for both firms which leads to a lower profit(sub optimal) than what could be earned when both firms would cooperate to produce lower output(optimal). A lack of trust and an incentive to earn more leads both firms to produce more and compete like a perfectly competitve firm.

2. Unlike a perfectly competitive firm, monopolistic competition firms, produce output at the level where MR=MC and P>MC. This leads them to eanr economic profits in short run. This denotes excess (unused) capacity of the monopolistically competitive firm. Due to economic profits, unused capacity and the free entry of firms in the market, new firms enter the market scene. as more firms enter, there is an increase in supply. As more is supplied, more of the demand gets fullfilled and demand keeps decreasing. This occurs till the point at which demand becomes tangent to the ATC curve at the profit maimizing level of output, At this point there no economic profits and no firms can enter any further.