222 CHAPTER 13

If a monopoly is earning an economic profit, other Questions

firms would like to enter the monopoly’s industry,
but barriers to entry keep them out. Whether a
business can earn an economic profit in the long „ True/False and Explain
run revolves around the presence or absence of bar-
What Is Monopolistic Competition?
riers to entry. The presence makes a long-run eco-
nomic profit possible; the absence makes a long- T11. Product differentiation gives each monopolistically
run economic profit impossible. competitive firm a downward sloping demand
curve.
2. HOW TO DETERMINE THE EQUILIBRIUM IN A
PRISONERS’ DILEMMA GAME : Learning how to 12. Monopolistically competitive firms compete only
find the equilibrium of a prisoners’ dilemma-type on price.
game is important. Take the example of Chris and
Price and Output in Monopolistic Competition
Loren in a prisoner’s dilemma. Each player has to
choose between two strategies, confess or deny. 13. In the short run, to maximize its profit, a monopo-
First, set up the payoff matrix. Then look at the listically competitive firm produces the level of out-
payoff matrix from Chris’s point of view. Chris put that sets P = ATC.
does not know whether Loren is going to confess or 14. Monopolistically competitive firms can earn an
deny, so Chris asks two questions: (1) Assuming economic profit in the long run.
that Loren confesses, do I get a better payoff if I
confess or deny? (2) Assuming that Loren denies, 15. Free entry is the basic reason that monopolistically
do I get a better payoff if I confess or deny? Notice competitive firms have excess capacity.
that Chris asks “What if Loren does this or that?” 16. In monopolistic competition, price exceeds mar-
Chris’s “what if” questions concern Loren’s ginal cost.
choices. If Chris’s best strategy is to confess, regard-
less of whether Loren confesses or denies, confess- Product Development and Marketing
ing is Chris’s dominant strategy. 17. A monopolistically competitive firm can earn an
Next, look at the payoff matrix from Loren’s point economic profit if it develops new products.
of view. Let Loren ask the equivalent two ques- 18. Monopolistically competitive firms have large mar-
tions. That is, let Loren ask “What if Chris does keting and selling costs.
this or what if Chris does that?” Use Loren’s an-
swers to determine whether Loren has a dominant 19. Advertising can signal product quality.
strategy. The combination of Chris’s strategy and What Is Oligopoly?
Loren’s strategy comprises the equilibrium out-
10. There are no barriers to entry in oligopoly.
come of the game.
3. THE PRISONERS’ DILEMMA GAME AND THE 11. An oligopolist will consider the reactions of its
REAL WORLD : The key insight of the prisoners’ competitors before it decides to cut its price.
dilemma game is the tension between the equilib- Two Traditional Oligopoly Models
rium outcome (in which both players’ best strategy
12. The kinked demand curve model of oligopoly pre-
is to confess because they can’t trust each other)
dicts that the firm will change its price only infre-
and the fact that both players could make them-
quently.
selves better off if only they would cooperate. This
tension helps explain events in the real world. In 13. In a dominant firm oligopoly, the dominant firm
particular, it is not uncommon for cartels to break sets the market price.
apart, as individual producers cheat, and then re-
Oligopoly Games
form, when all producers realize that being in the
cartel is in their joint interest, only to break apart 14. In a one-time only prisoners’ dilemma game, the
once again as yet another producer cheats. A cartel best strategy for a prisoner is to confess only if the
that can persist for years is without defections and prisoner believes that the other player will confess.
failures is the exception not the rule!
MONOPOLISTIC COMPETITION AND OLIGOPOLY 223

15. If oligopolistic firms are able to sustain an output- Price and Output in Monopolistic Competition
restricting, price-increasing collusive agreement,
Figure 13.3 shows a monopolistically competitive firm in
they will produce the efficient level of output.
the short run. Use it for the next four questions.
16. If two firms’ decisions about whether to conduct
R&D can be characterized as a game of chicken,
the Nash equilibrium is for neither to conduct
R&D.

Repeated Games and Sequential Games

17. Repeated games are more likely to have a coopera-
tive equilibrium than one-time only games.
18. Price wars can break out when a small number of
new firms enter an industry.
19. A single firm in a contestable market might be un-
able to earn an economic profit.
20. Limit pricing refers to attempts by firms to set their
price at the highest possible limit.

„ Multiple Choice
What Is Monopolistic Competition?
14. How much output does the firm produce?
11. A monopolistically competitive firm is like a
monopoly firm insofar as a. Q1
b. Q2
a. both face perfectly elastic demand.
b. both earn an economic profit in the long run. c. Q3
c. both have MR curves that lie below their demand d. None of the above
curves. 15. What price does the firm charge?
d. neither is protected by high barriers to entry.
a. P1
12. A monopolistically competitive firm is like a perfectly b. P2
competitive firm insofar as c. P3
a. both face perfectly elastic demand. d. None of the above
b. both earn an economic profit in the long run. 16. What type of profit or loss is the firm earning?
c. both have MR curves that lie below their demand a. An economic profit
curves. b. A normal profit
d. neither is protected by high barriers to entry. c. An economic loss
d. An accounting loss
13. Product differentiation
a. means that monopolistically competitive firms 17. In the long run,
can compete on quality and marketing. a. new firms will enter, and each existing firm’s
b. occurs when a firm makes a product that is demand decreases.
slightly different from that of its competitors. b. new firms will enter, and each existing firm’s
c. makes the firm’s demand curve downward slop- demand increases.
ing. c. existing firms will leave, and each remaining
d. All of the above answers are correct. firm’s demand decreases.
d. existing firms will leave, and each remaining
firm’s demand increases.
224 CHAPTER 13

18. A monopolistically competitive firm has excess ca- 14. Because an oligopoly has a small number of firms,
pacity because in the a. each firm can act as a monopoly.
a. short run MR = MC. b. the firms are interdependent.
b. short run the firm does not produce at the mini- c. the firms may legally form a cartel.
mum marginal cost. d. the HHI for the industry is small
c. long run the firm does not produce at the mini-
mum average total cost. Two Traditional Oligopoly Models
d. long run the firm earns an economic profit. 15. A firm that has a kinked demand curve assumes that,
if it raises its price, ____ of its competitors will raise
19. In the long run, a monopolistically competitive their prices and that, if it lowers its price, ____ of its
firm’s economic profits are zero because of competitors will lower their prices.
a. product differentiation. a. all; all
b. the lack of barriers to entry. b. none; all
c. excess capacity. c. all; none
d. the downward-sloping demand curve of each d. none; none
firm.
16. In the dominant firm model of oligopoly, the large
Product Development and Marketing firm acts like
10. Monopolistically competitive firms constantly de- a. an oligopolist.
velop new products in an effort to b. a monopolist.
a. make the demand for their product more elastic. c. a monopolistic competitor.
b. increase the demand for their product. d. a perfect competitor.
c. increase the marginal cost of their product.
d. None of the above answers is correct. 17. In the dominant firm model of oligopoly, the
smaller firms act like
11. When deciding upon how much to spend on prod- a. oligopolists.
uct development, a firm will consider b. monopolists.
a. only the marginal revenue from product devel- c. monopolistic competitors.
opment. d. perfect competitors.
b. only the marginal cost of product development.
c. both the marginal revenue and marginal cost of Oligopoly Games
product development. 18. In the prisoners’ dilemma game with a Nash equilib-
d. the price and average total cost of product devel- rium,
opment. a. only one prisoner confesses.
b. neither prisoner confesses.
12. Which of the following statements about monopo- c. both prisoners confess.
listically competitive firms is correct? d. any confession is thrown out of court.
a. In the long run, they have deficient capacity.
b. They have high selling costs. 19. In a duopoly with a collusive agreement, when is the
c. They produce the efficient amount of output. industry-wide profit as large as possible?
d. They rarely advertise. a. When both firms comply with the collusive
agreement.
What Is Oligopoly? b. When one firm cheats on the cartel and the other
13. Suppose the efficient scale of production is such that firm does not.
a market has only three firms in it. This market is c. When both firms cheat on the collusive agree-
a. a three-firm monopoly ment.
b. an economies-of-scale oligopoly. d. The answer is indeterminate because it depends
c. a cost-based oligopoly. on the industry’s MR curve.
d. a natural oligopoly.
MONOPOLISTIC COMPETITION AND OLIGOPOLY 225

20. In a duopoly with a collusive agreement, when can 24. The equilibrium in the previous question is called a
one firm have the maximum possible profit? a. credible strategy equilibrium.
a. When both firms comply with the collusive b. Nash equilibrium.
agreement. c. duopoly equilibrium.
b. When one firm cheats on the agreement and the d. cooperative equilibrium.
other firm does not cheat.
c. When both firms cheat on the agreement. 25. If this game is played repeatedly and both firms
d. The answer is indeterminate because it depends adopt trigger strategies so that the cooperative equi-
on the firm’s MR curve. librium emerges,
a. both firms A and B will cheat.
Firms A and B are in a duopoly game, so they can either b. firm A will cheat and firm B will not cheat.
comply with a cartel agreement or cheat on the agree- c. firm A will not cheat and firm B will cheat.
ment. The cartel agreement calls for each firm to boost d. neither firm A nor firm B will cheat.
its price and restrict the amount it produces. For the next
5 questions, use the following payoff matrix that shows 26. If an R&D game between two firms is a game of
the firms’ economic profits. chicken, then the equilibrium has
a. both firms conducting the R&D.
A’s strategies
b. neither firm conducting the R&D.
Cheat Comply
c. one of the two firms conducting the R&D.
$0 –$1 million d. a flaw because R&D must be done but the
Cheat game’s equilibrium is that it might be done .

B’s $0 $3 million Repeated Games and Sequential Games

strategies 27. A strategy in which a firm takes the same action that
$3 million $2 million the other firm did in the last period is a
Comply a. dominant strategy.
b. trigger strategy.
–$1 million $2 million
c. tit-for-tat strategy.
d. wimp’s strategy.

21. If firm A cheats on the cartel and firm B complies 28. Price wars can be the result of
with the agreement, firm A’s profit is a. a cooperative equilibrium.
a. $3 million. b. a firm playing a tit-for-tat strategy in which last
b. $2 million. period the competitors complied with a collusive
c. zero. agreement.
d. –$1 million. c. new firms entering the industry and immediately
agreeing to abide by a collusive agreement.
22. If firm A cheats on the cartel and firm B complies d. new firms entering an industry and all firms then
with the agreement, firm B’s profit is finding themselves in a prisoners’ dilemma.
a. $3 million.
b. $2 million. 29. Limit pricing refers to
c. zero. a. the fact that a monopoly firm always sets the
d. –$1 million highest price possible.
b. a situation in which a firm might lower its price
23. If this game is played only once, to keep potential competitors from entering its
a. both firms A and B will cheat. market.
b. firm A will cheat and firm B will not cheat. c. how the price is determined in a kinked demand
c. firm A will not cheat and firm B will cheat. curve model of oligopoly.
d. neither firm A nor firm B will cheat. d. none of the above.
226 CHAPTER 13

„ Short Answer Problems

3. Suppose that a monopolistically competitive firm is

1. In Figure 13.4 draw a diagram illustrating a mono- initially in long-run equilibrium and it succeeds in
polistically competitive firm that is earning an eco- further differentiating its product. As a result, the
nomic profit in the short run. Identify the area that demand for its product increases. In Figure 13.6
equals the economic profit. show what happens to this firm in the short run.
Without drawing a diagram, describe what happens
in the long run.
4. Compare the advantages and disadvantages of per-
fect competition and monopolistic competition in
terms of how they benefit society.
5. Explain why firms in oligopoly are interdependent
while firms in perfect competition, monopolistic
competition, and monopoly are not.
6. How can a price war that eliminates profits be ex-
plained with game theory?
7. Two firms — Tom’s Taxis and Chet’s Cabs — are
the only two taxicab companies in a small college
town. These firms are engaged in a duopoly game.
If they both adhere to a collusive cartel agreement
to restrict the number of their cabs and raise their
price, each can earn an economic profit of $2 mil-
lion. However, if one company cheats on the
agreement — by shading its price a bit and perhaps
quietly acquiring some more taxis — and the other
2. In Figure 13.5 draw the long-run equilibrium for a complies with the agreement, the cheater earns an
monopolistically competitive firm. What condi- economic profit of $2.5 million and the compiler
tions must be satisfied for long-run equilibrium? suffers an economic loss of $1 million. If both
MONOPOLISTIC COMPETITION AND OLIGOPOLY 227

plying with the agreement earns an economic profit

Payoff Matrix for Short Answer Problem 7
of $0.5 million.
Tom’s strategies a. Complete the second payoff matrix above for
Cheat Comply the new taxi firm duopoly game.
b. Does Tom have a clear-cut best strategy? Does
Chet? Is there a clear equilibrium outcome in
Cheat
this game?
Chet’s
strategies Payoff Matrix for Short Answer Problem 9
Tom’s strategies
Comply Cheat Comply

$0 –$2 million
Cheat

Chet’s $0 $2.5 million

cheat, both earn $0 economic profit; that is, both
strategies
earn a normal profit. $2.5 million $2 million
a. Use the description of the situation to complete Comply
the payoff matrix above. Put Tom’s payoffs in
the darker triangles and Chet’s in the other tri- –$2 million $2 million
angles.
b. If this game is played only once, what is Tom’s
best strategy? What is Chet’s best strategy?
9. The taxi market changes again so that the payoff
What will be the equilibrium outcome?
matrix is as shown in the matrix for problem 9.
c. When is the joint total profit the largest? When Chet and Tom now see that they will be playing a
is Tom’s profit the largest? Chet’s profit? repeated game. Chet knows that Tom has adopted
a tit-for-tat strategy. Last period Chet did not cheat
Payoff Matrix for Short Answer Problem 8 on the cartel agreement.
Tom’s strategies a. If Chet cheats this period, what is his profit? If
he cheats this period, what is the maximum
Cheat Comply
profit he can earn next period? What is his
maximum two-period profit if he cheats?
Cheat b. If Chet complies with the agreement, what is
the maximum profit he earns this period? If he
Chet’s complies next period, what will be his profit? If
strategies he does not cheat in either period, what is the
two-period total profit he earns?
Comply c. Is Chet likely to cheat this period? Why?

„ You’re the Teacher

1. “You know, I’ve really been studying the book and
8. Suppose that the taxi firm duopoly game played in this study guide and now a lot of this stuff is mak-
problem 7 changes: The payoffs are the same as be- ing sense. I like the fact that firms in perfect com-
fore except when one player cheats and the other petition, monopolistic competition, and monopoly
does not. Now the cheating player earns an eco- actually have only one profit-maximization rule,
nomic profit of $2.5 million, and the player com-
228 CHAPTER 13

the MR = MC rule. It sure makes it easy if we don’t nopoly. There is another rule that is common; it
have to memorize different rules for different in- deals with when a firm earns an economic profit.
dustries! Can you think of any other rules that are With this hint, explain the other rule to the eager
the same across all industries?” This student is cor- student.
rect: Common rules ease your work. Perhaps more
importantly, common rules also show you that
there are factors in common to firms in perfect
competition, monopolistic competition, and mo-