Question

• Recognize the key characteristics of monopolistic competition
• Describe the economic efficiency and other characteristics of monopolistic competition in the long run
• Explain the economic role of advertising
• Define price discrimination
• Compare and contrast perfect and imperfect price discrimination
• Identify an oligopoly as a market structure where firms are highly interdependent
• Describe collusion and strategic pricing decisions
• Describe game theory and why it is applied to oligopoly

Answer 1

1. The key characteristics of monopolistic competition are:

a. Large Number of Small Firms- A monopolistically competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that all firms are relatively competitive with very little market control over price or quantity.

b. Similar, But Not Identical Goods- Each firm in a monopolistically competitive market sells a similar product. Yet each product is slightly different from the others. The term used to describe this is product differentiation.

c. Resource Mobility- Monopolistically competitive firms, like perfectly competitive firms, are free to enter and exit an industry.

2. Monopolistic competitive markets are never efficient in any economic sense of the term. Because a good is always priced higher than its marginal cost, a monopolistically competitive market can never achieve productive or allocative efficiency. Suppliers in monopolistically competitive firms will produce below their capacity. Because monopolistic firms set prices higher than marginal costs, consumer surplus is significantly less than it would be in a perfectly competitive market. This leads to deadweight loss and an overall decrease in economic surplus.

3. Companies spend money on advertising because it increases sales of existing products, helps grow adoption of new products, builds brand loyalty, and takes sales away from competitors. Although the exact return on investment (ROI) varies tremendously across industries, companies, campaigns, and media channels, studies have found that a dollar spent on advertising returns $3–20 in additional sales. To compete and grow in today’s diverse, ever-changing marketplace, businesses must reach their target customers efficiently, quickly alerting them to new product introductions, improved product designs, and competitive price points. Advertising is by far the most efficient way to communicate such information.

4. Price Discrimination- Price discrimination is a selling strategy that charges customers different prices for the same product or service, based on what the seller thinks they can get the customer to agree to. In pure price discrimination, the seller charges each customer the maximum price he or she will pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price.

5. “Imperfect Price Discrimination” is a term used to describe markets that approach perfect price discrimination. Examples of imperfect price discrimination include car sales and college tuition rates for students in college. Car dealerships often post a “sticker price” and then lower the actual price depending on how much the consumer is willing to pay. Successful car sales persons are often those who have exceptional abilities to discern exactly how much each consumer is willing to pay, or their reservation price. Colleges and universities use imperfect price discrimination by offering scholarships and financial aid packages to students based on their willingness to enroll and attend an institution.Every dollar of consumer surplus has been transferred to the firm. First degree price discrimination is also called, “Perfect Price Discrimination.”

6. The distinctive feature of an oligopoly is interdependence. Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore, the competing firms will be aware of a firm's market actions and will respond appropriately. The Organisation of Petroleum Exporting Countries or OPEC is an oligopoly market which is dominated by the Arab oil producers as they hold the maximum amount of oil refineries which gives them an opportunity to dominate others and decide on prices. Cartel is another name for an oligopoly of producers of a commodity.

7. Strategic pricing sets a product's price based on the product's value to the customer, or on competitive strategy, rather than on the cost of production. This approach recognizes that people often make purchasing decisions based more on psychology than on logic, and that what's most valuable to the customer may not be what's most expensive to produce.When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide up the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion.

8. In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well. Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action. The prisoner’s dilemma is a type of game that illustrates why cooperation is difficult to maintain for oligopolists even when it is mutually beneficial. In this game, the dominant strategy of each actor is to defect. However, acting in self-interest leads to a sub-optimal collective outcome. The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy. Game theory is generally not needed to understand competitive or monopolized markets.