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Imperfect Competition

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Economics

Did it ever occur to you that the burgers at McDonald's are not exactly the same as the burgers at Burger King? Do you know why that is? And what does the market of fast-food chains have in common with the market of electricity or the global oil market? Do you want to know more about this and how most markets work in the real world? Then read on!

Imperfect competition definition

To define imperfect competition, we first need to understand what perfect competition is. In a perfectly competitive market, we have many firms that are selling the same undifferentiated products - think about produce: you can find the same vegetables sold at different grocery stores. In such a perfectly competitive market, firms or individual producers are price takers. They can only charge a price that is the market price; if they charge a higher price, they will lose their customers to all the other firms selling the same products at the market price. In the long-run equilibrium, firms in perfectly competitive markets don't make economic profits after we account for the opportunity costs of not being able to use the resources for other purposes.

For a refresher, read our explanation: Perfect Competition

You might be wondering: how is it possible that firms operate with no economic profits in the long run? That is not really how things work in the real world, right? Well, you are certainly not wrong - many firms in the real world do manage to make a handsome profit, even after accounting for opportunity costs. That's because most of the markets that we have in the real world are not perfectly competitive markets. In fact, we rarely have perfect competition in reality, save for the produce markets.

To learn more about how firms manage to maximize profits check our explanation - Profit Maximization!

Imperfect competition refers to the market structures that are less competitive than perfect competition. These include monopolistic competition, oligopoly, and monopoly.

Figure 1 below shows the different kinds of market structures on a spectrum. They range from the most competitive to the least competitive from left to right. In perfect competition, there are many firms selling the same product; in monopolistic competition, there are many firms competing with differentiated products; an oligopoly has only a couple or a few firms; and in a monopoly, there's only one firm serving the entire market.

Imperfect competition The spectrum of market structures StudySmarterFigure 1. The spectrum of market structures - StudySmarter

You bet we have an explanation on all these topics!

Check out:

Imperfect competition characteristics

Imperfect competition has some peculiar characteristics which make it different from perfect competition. Let's consider some of them!

Marginal Revenue Below Demand

A hallmark of an imperfectly competitive market is that the marginal revenue (MR) curve facing the firms lies below the demand curve, as Figure 2. shows below. There is a smaller number of competing firms under imperfect competition - in the case of monopolistic competition, there are many firms, but they are not perfect competitors due to product differentiation. Firms in these markets have some influence over the demand for their products, and they can charge a price that is higher than the marginal cost of production. In order to sell more units of the product, the firm must lower the price on all units - this is why the MR curve is below the demand curve.

Imperfect competition The marginal revenue curve lies below the demand curve StudySmarterFigure 2. Marginal revenue curve in imperfect competition - StudySmarter

On the other hand, there are many firms selling homogeneous products in a perfectly competitive market. These firms have no influence over the demand they face and have to take the market price as given. Any individual firm that operates in such a perfectly competitive market faces a flat demand curve because if it charges a higher price, it will lose all its demand to competitors. For an individual firm under perfect competition, its marginal revenue (MR) curve is the demand curve, as shown in Figure 3. The demand curve is also the firm's average revenue (AR) curve because it can only charge the same market price no matter the quantity.

Imperfect competition An individual firm in a perfectly competitive market StudySmarterFigure 3. An individual firm in a perfectly competitive market - StudySmarter

Market inefficiencies

Another main characteristic of imperfectly competitive markets is that they create market inefficiencies. Why is that? This actually has to do with the marginal revenue (MR) curve being below the demand curve. In order to maximize profit or minimize loss, all firms produce to the point where marginal cost equals marginal revenue. From a societal perspective, the optimal output is the point where marginal cost equals demand. Since the MR curve is always below the demand curve in imperfectly competitive markets, the output is always lower than the socially optimal level.

In Figure 4 below, we have an example of an imperfectly competitive market. The imperfect competitor faces a marginal revenue curve that is below the demand curve. It produces up to the point where marginal revenue equals marginal cost, at point A. This corresponds to point B on the demand curve, so the imperfect competitor charges consumers at a price of Pi. In this market, the consumer surplus is area 2, and area 1 is the profit that goes to the firm.

Contrast this situation to a perfectly competitive market. The market price is equal to the marginal cost at Pc. All the firms in this perfectly competitive market will take this price as given and jointly produce a quantity of Qc at point C, where the market demand curve for the entire industry intersects with the marginal cost curve. The consumer surplus under perfect competition would be the combination of areas 1, 2, and 3. So, the imperfectly competitive market leads to a deadweight loss of the size of area 3 - this is the inefficiency caused by imperfect competition.

Imperfect competition Imperfect competition with inefficiency StudySmarterFigure 4. Imperfect competition with inefficiency - StudySmarter

Imperfectly competitive market types

There are three types of imperfectly competitive market structures:

  • monopolistic competition
  • oligopoly
  • monopoly

Let's go through these, one by one.

Imperfect Competition Example: Monopolistic Competition

You may have noticed that the term "monopolistic competition" has both the words "monopoly" and "competition" in it. This is because this market structure has some characteristics of a perfectly competitive market and also some characteristics of a monopoly. Like in a perfectly competitive market, there are many firms because the barriers to entry are low. But unlike in perfect competition, the firms in monopolistic competition are not selling identical products. Instead, they sell somewhat differentiated products, which gives the firms some degree of monopoly power over the consumers.

Fast-food chains

Fast-food chain restaurants are a classic example of monopolistic competition. Think about it, you have many fast-food restaurants to choose from on the market: McDonald's, KFC, Burger King, Wendy's, Dairy Queen, and the list goes on even longer depending on what region you are in the US. Can you imagine a world with a fast-food monopoly where there's just McDonald's that sells burgers?

Imperfect competition Monopolistic competition a cheeseburger StudySmarterA cheeseburger, Source: Pixabay

All these fast-food restaurants sell essentially the same thing: sandwiches and other usual American fast-food items. But also not exactly the same. The burgers at McDonald's are not the same as the ones sold at Wendy's, and Dairy Queen has ice creams that you can't find from the other brands. Why? Because these businesses deliberately make their products a little bit different - that's product differentiation. It's certainly not a monopoly because you have way more than one choice, but when you are craving that specific kind of burger or ice cream, you have to go to that one specific brand. Because of this, the restaurant brand has the power to charge you a little more than in a perfectly competitive market.

We certainly invite you to learn more on this topic here: Monopolistic Competition

Imperfect Competition Example: Oligopoly

In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. When there are only two firms in the market, it's a special case of oligopoly called duopoly. In an oligopoly, firms do compete with one another, but the competition is different from the cases of perfect competition and monopolistic competition. Because there are only a small number of firms in the market, what one firm does affects the other firms. In other words, there is an interdependent relationship between the firms in an oligopoly.

Imagine that there are only two firms selling the same potato chips at the same price on the market. It's a duopoly of chips. Naturally, each firm would want to capture more of the market so that they can earn more profits. One firm can try to take customers from the other firm by lowering the price of its potato chips. Once the first firm does this, the second firm would have to lower its price further to try to take back the customers that it has lost. Then the first firm would have to lower its price again... all this back and forth until the price reaches the marginal cost. They can't lower the price further at this point without losing money.

You see, if oligopolists are to compete without cooperation, they might reach a point where they operate just like firms in perfect competition - selling with a price equal to the marginal cost and making zero profits. They don't want to make zero profits, so there is a strong incentive for oligopolists to cooperate with each other. But in the U.S. and many other countries, it is illegal for firms to cooperate with each other and fix prices. This is done to ensure that there's healthy competition and to protect consumers.

OPEC

It's illegal for firms to cooperate and fix prices, but when the oligopolists are countries, they can do just that. The Organization of Petroleum Exporting Countries (OPEC) is a group made up of oil-producing countries. The explicit aim of OPEC is for its member countries to agree on how much oil they produce so that they can keep the oil price at a level that they like.

To learn more, click here: Oligopoly

Imperfect Competition Example: Monopoly

On the very far end of the market competitiveness spectrum lies a monopoly.

A monopoly is a market structure where one firm serves the entire market. It is the polar opposite of perfect competition.

A monopoly exists because it's very difficult for other firms to enter such a market. In other words, high barriers to entry exist in this market. There are a number of reasons for a monopoly to exist in a market. It can be the case that a firm controls the resource that is required to make the product; governments in many countries often grant permission for only one state-owned firm to operate in a market; intellectual property protections give firms a monopoly right as a reward for their innovation. Besides these reasons, sometimes, it is "natural" that there's only one firm operating in the market.

A natural monopoly is when the economies of scale make sense for just one firm to serve the entire market. Industries where natural monopolies exist usually have a large fixed cost.

Utilities as natural monopolies

Utility companies are common examples of natural monopolies. Take the electric grid for example. It would be very expensive for another company to come in and build all the electric grid infrastructure. This large fixed cost essentially prohibits other firms from entering the market and becoming a grid operator.

Imperfect competition Natural monopoly Power grid infrastructure StudySmarterPower grid infrastructure, Source: Pixabay

What are you waiting for? To learn more, click on our explanation: Monopoly

Imperfect Competition and Game theory

The interaction between oligopolistic firms is like playing a game. When you are playing a game with other players, how well you do in that game depends not only on what you do but also on what the other players do. One of the uses of game theory for Economists is to help understand the interactions between firms in oligopolies.

Game theory is the study of how players act in situations where one player's course of action influences the other players and vice versa.

Economists often use a payoff matrix to show how players' actions lead to different outcomes. Let's use the example of the potato chips duopoly. There are two firms selling the same potato chips at the same price on the market. The firms face a decision of whether to keep their prices at the same level or to lower the price in order to try and take customers from the other firm. Table 1 below is the payoff matrix for these two firms.

Game theory payoff matrix
Firm 1
Keep price as before
Drop price
Firm 2
Keep price as before
Firm 1 makes the same profit
Firm 2 makes the same profit
Firm 1 makes more profit
Firm 2 loses its market share
Drop price
Firm 1 loses its market share
Firm 2 makes more profit
Firm 1 makes less profitFirm 2 makes less profit

Table 1. Game theory payoff matrix of the potato chips duopoly example - StudySmarter

If both firms decide to keep their prices as they are, the outcome is the top left quadrant: both firms make the same profits as before. If either firm drops the price, the other will follow suit to try to recapture the market share that they lose. This will continue until they reach a point where they can't drop the price any lower. The outcome is the bottom right quadrant: both firms still split the market but make less profit than before - in this case, zero profit.

In the potato chips duopoly example, there is a tendency for both firms to lower their prices in an attempt to capture the entire market in the absence of an enforceable agreement between the two duopolists. The likely outcome is the one shown in the bottom right quadrant of the payoff matrix. Both players are worse off than if they have just kept their prices as they were. This kind of situation where players tend to make a choice that leads to a worse outcome for all the players involved is called the prisoners' dilemma.

To learn more about this, read our explanations: Game Theory and Prisoners' Dilemma.

Imperfectly competitive factor markets: Monopsony

The markets that we usually talk about are product markets: the markets for goods and services that consumers buy. But let's not forget there's also imperfect competition in the factor markets as well. Factor markets are markets for the factors of production: land, labor, and capital.

There is one form of imperfectly competitive factor market: Monopsony.

Monopsony is a market where there's only one buyer.

A classic example of a monopsony is a large employer in a small town. Since people can't seek work elsewhere, the employer has market power over the local labor market. Similar to an imperfectly competitive product market where firms have to lower prices in order to sell more units, the employer in this case has to raise the wage to hire more workers. Since the employer has to raise the wage for every worker, it faces a marginal factor cost (MFC) curve that is above the labor supply curve, as shown in Figure 5. This results in the firm hiring a fewer number of workers Qm at a lower wage Wm than in a competitive labor market, where the number of workers hired would be Qc, and the wage would be Wc.

Imperfect competition Monopsonistic labor market StudySmarterFigure 5. A monopsony in a labor market - StudySmarter

To learn more, read our explanation: Monopsonistic Markets.

Imperfect Competition - Key takeaways

  • Imperfect competition is the market structures that are less competitive than perfect competition.
  • Different types of imperfectly competitive product markets include monopolistic competition, oligopoly, and monopoly.
  • In monopolistic competition, there are many firms selling differentiated products.
  • In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. A duopoly is a special case of oligopoly where there are two firms operating in the market.
  • In a monopoly, there is only one firm selling to the entire market because of high barriers to entry. There are different kinds of reasons for a monopoly to exist.
  • Economists use game theory to understand the interactions between the firms in an oligopoly.
  • An imperfectly competitive factor market takes the form of a monopsony, where there's a single buyer in the market.

Imperfect Competition

Imperfect competition describes any market structures that are less competitive than perfect competition. These include monopolistic competition, oligopoly, and monopoly. 

In a monopoly, there is only one firm serving the entire market. There is no competition.

The marginal revenue curve lies below the demand curve. The firms can charge a price higher than the marginal cost. The output is lower than the social optimum. There are market inefficiencies created by imperfect competition.

In perfect competition, there are many firms selling a homogeneous good. In reality, this rarely happens, and we have different types of imperfectly competitive markets.

Product markets: monopolistic competition, oligopoly, and monopoly. Factor markets: monopsony.

Final Imperfect Competition Quiz

Question

Which of the following is a characteristic of monopolistic competition?

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differentiated product

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Which of the following is possible in a monopolistic competition in the long run?

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positive economic profit

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If the existing firms are making a profit in the short term, the new firms will enter the market until the firms start making zero profit in the long run.

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True

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If the existing firms are making a profit, the new firms will enter the market and the demand curve of the existing firms shift rightwards.

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True


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If the existing firms are incurring a loss, then some firms will exit the market and the demand curve of existing firms shift rightwards. 

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True

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In Monopolistic Competition, all firms make positive profit in the long run.

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False

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In the long run and at the equilibrium output level, the demand curve is tangent to the average total cost curve.

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True

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What is the cause of the excess capacity?

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a firm’s profit-maximizing output is less than the output that the firm could potentially supply

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Which of the following is true for a firm'S demand curve in monopolistic competition?

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vertical

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If the existing firms are incurring a loss, then some firms will exit the market until when?

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Until the firms start making zero profit.

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When drawing a monopolistic competition graph in long-run equilibrium, what is the relationship between the demand curve is and the ATC? 

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ATC is above the demand curve

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Firms should produce a quantity where marginal revenue equals marginal cost to maximize the profit or minimize the losses.

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True

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If the demand curve shifts rightwards, how does the marginal revenue move?



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The marginal revenue shifts rightwards. 

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Why do the firms that are entering the market affect the existing firms in the market?

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Because of the change in demand

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 If the existing firms are profitable, new firms will enter the market. Accordingly, if the existing firms are losing money, some of the firms will exit the market.

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True

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The firms in monopolistic competition face competition since many firms are active in the market and there are low barriers to entry.

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True

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In the short run, why do firms produce a quantity where marginal revenue equals marginal cost?


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to maximize the profit or minimize the losses

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If the market price is above the average total cost at the equilibrium output level, then which of the following is true?

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 the firm will make a profit

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If the market price is below the average total cost at the equilibrium output level, then which of the following is true?

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the firm will incur loss

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How do we calculate a firm’s profit in the monopolistic competition in the short run?


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We take the difference in price and the average total cost and multiply the difference by the equilibrium quantity. 


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If the average total cost is above the market price, then the firm incurs losses.

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True

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Which of the following is true about  calculating a firm’s loss in monopolistic competition in the short run?

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Take the difference in the average total cost and the price, and multiply this value with the equilibrium quantity.

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Why the relationship between the demand curve and the average total cost curve is important?

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It defines whether the firm will make a profit or incur losses in the short run. 

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The loss is minimized at the point where marginal revenue equals marginal cost. 

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True

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Firms in monopolistic competition determine their price and output decisions in the short run, just like companies in a perfect competition.


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True


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Which of the following is the definition of the Marginal revenue (MR)?

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the marginal increase in revenue after the sale of one additional unit of output

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Marginal cost is the marginal cost of producing one additional unit of output.

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True

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The firms in monopolistic competition have some market power on their  differentiated products which makes it possible for them to determine their price.

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True

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What is game theory?

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Game theory is a field of economics that models decision making as a game in order to analyze firms and markets.

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What type of market structure among firms does game theory give insight to?

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Oligopolies. When there is a duopoly or larger oligopoly, there are very few firms that essentially monopolize the market, and the small number of firms lends itself to being analyzed as a simple game.

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What is a dominant strategy?

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A player has a dominant strategy in a game when the payoffs are such that one particular choice always gives the better outcome, regardless of what the other player chooses.

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Who is Nash Equilibrium named after, in game theory?

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Mathematician and Nobel Laureate John Nash

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What is the difference between dominant strategy and Nash Equilibrium in game theory?

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A player has a dominant strategy in a game when the payoff structure is such that one option is always the better choice, regardless of the opponent's choice. An outcome of the game is given by a pair of strategies, one for each player. An outcome is a Nash equilibrium if each player is maximizing their outcome taking as given the strategy of the other. A game may have a Nash equilibrium outcome without having any dominant strategy for any player, but if all players have a dominant strategy, then that combination of strategies is automatically a Nash equilibrium.

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What is a Nash equilibrium?

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When both players are playing a strategy that maximizes their outcome taking as given the actions of the other.

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What is the prisoner's dilemma?

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The prisoner's dilemma is a common game in Game Theory. The dilemma is whether to collude in order to get the best overall outcome, or testify against the co-conspirator to improve personal payoff. Because of the incentive to maximize personal payoff, the result is a fairly bad outcome.

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What is the economic man assumption?

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  1. Maximize personal profit and utility
  2. Make decisions using all available information
  3. Choose the most rational option in every situation

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Game theory shows cooperating gives the most equitable result, why don't firms cooperate?

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Cooperating may be equitable, but if players cannot communicate, then cooperating is not payoff maximizing. This creates an incentive to communicate about price fixing. However, communicating about setting prices is anti-competitive behavior that hurts consumers. In the U.S. it is against the law.

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If a player's best choice depends on what their opponent plays, can the player have a dominant strategy?

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No

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Can a game have multiple Nash equilibria?

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yes, there can be multiple Nash equilibria.

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If a player's best choice doesn't rely on another player's choice, do they have a dominant strategy?

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Yes

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What is it called when both players have a clear better choice regardless of the other player?

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Both have a dominant strategy and the game is in Nash equilibrium

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Would you choose to "win" or "win more"?

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Win more, and so would most firms, however, when playing game theory if both players pick to win more, it can result in a loss for both.

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What is an oligopoly?

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A market structure in which a very small number of firms essentially monopolize the market, such as Coke and Pepsi in the market for caffeinated beverages.

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Why does a monopoly exist?

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A monopoly exists because of barriers to entry.

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A firm in a perfectly competitive market is a ____

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price-taker

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What are some reasons that higher barriers to entry exist?

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1. control of resources;

2. government permission for only one firm to operate in the market;

3. intellectual property protection;

4. natural monopolies (economies of scale)

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A monopolist's marginal revenue (MR) curve is ___ the demand curve

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below

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Why is the monopolist's marginal revenue (MR) curve below the demand curve?

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because the monopolist has to lower the price in order to sell more units

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How does a monopolist maximize its profit?

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by setting quantity to where MR=MC

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The price that a monopolist charges is ___ than the marginal cost

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higher

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