11.1 Graphing Exercise: Monopolistic Competition

Monopolistic competition is characterized by a large number of firms producing goods or services that are differentiated from one another. That is, the firms produce close, but not perfect, substitutes. Entry of new firms into the industry is relatively unrestricted. As a result, the typical firm will earn no economic profit in the long run.

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Exploration: What are the characteristics of short-run and long-run equilibrium in a monopolistically competitive industry?

The graph illustrates the demand and cost conditions for a typical firm in a monopolistically competitive industry. Its demand curve is downward sloping to reflect the monopoly power that arises from its product differentiation. The firm can raise its price without losing all its sales to rival firms. To use the graph, drag the demand curve with the mouse; the Show Profit/Loss button will illustrate any short-run profit available to the firm. Clicking on the Market Adjustment button will illustrate how the market and firm respond to restore long-run equilibrium.

1. Given the initial demand and cost conditions, what output level and price will maximize the firm's profit? What profit level can the firm attain?
   See answer here
2. Suppose demand for the products made by this industry increases. How will this firm respond in the short run? Will its profit increase in the short run?
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3. In response to an increase in industry demand and the resulting change in industry profits, what will happen to the number of firms in the industry? What impact will this have on this representative firm’s demand and marginal revenue curves? How will this firm respond to these changes? Will it make a positive economic profit in the long run?
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4. Experiment on your own. How would the firm and industry respond to a decline in demand in both the short and long run? What generalization can you make?
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11.2 Graphing Exercise: Game Theory

Game theory is the study of how people behave when placed in strategic situations—situations in which one's best action depends critically on the actions of one's rivals. In effect, game theory is a model of the effects of mutual interdependence. The theory has been used fruitfully to explore and explain the behavior of oligopolists in pricing, advertising, research and development, and a host of other decisions.

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Exploration: The applet shows the payoffs to each of two firms, Uptown and RareAir, from using either of two strategies—setting a high or low price. Uptown's payoff, expressed in millions of dollars, is shown in the lower left corner of each cell in the matrix, while RareAir's payoff is shown in the upper right corner. For example, if Uptown and RareAir both use the "high" strategy, each receives a payoff of $12 million.

To use the applet, hover the mouse over either one of the possible strategies for either firm. The possible outcomes of this choice are highlighted in dark gray. The other firm's best strategic response to this chosen strategy is highlighted in a lighter shade of gray. The cell containing the resulting payoffs is bordered in violet. All of this is summarized in the "Outcomes" box at the right.

1. Suppose Uptown chooses a high-price strategy. What are the resulting profit levels for each of RareAir's potential strategic responses? In response to Uptown's chosen strategy, what strategy would RareAir choose to maximize its profits? What is Uptown's profit level resulting from this combination of strategies?
   See answer here
2. Alternatively, suppose Uptown chooses a low-price strategy. What are the resulting profit levels for each of RareAir's potential strategic responses? In response to Uptown's chosen strategy, what strategy would RareAir choose to maximize its profits? What is Uptown's profit level resulting from this combination of strategies?
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3. Knowing how RareAir will respond to either of its two possible strategies and its own resulting payoffs, what strategy will Uptown likely select?
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4. Repeat questions 1 through 3 for RareAir's strategy set and Uptown's responses.
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5. Considering the choices that each firm sets independently, what are the resulting payoffs to each firm? How might the firms improve their profits by colluding with one another?
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6. Suppose the firms reach a collusive agreement to price high. How much might one firm profit by cheating on the collusive agreement, providing the other firm does not?
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7. Speculate: Since collusion is illegal, are there other means by which these firms may achieve the mutually beneficial outcome of high prices?
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