Market Structures: Imperfect Competition — Hard Practice Quiz
A Microeconomics cheat sheet for Market Structures: Imperfect Competition — every key formula with its symbols defined — plus a hard-level practice quiz to test recall.
Formulas & key concepts
In an oligopoly of just a few firms, each firm's profit depends noticeably on what its rivals do, creating strategic interdependence.
An oligopoly consisting of exactly two firms, each called a duopolist.
When firms cooperate to raise their combined profits, usually by restricting output to push prices up.
A group of producers that formally agrees to coordinate output and prices so as to behave like a single monopoly, such as OPEC.
When firms each act in their own individual interest instead of colluding, even though cooperating would raise their joint profits.
The study of behavior in situations of interdependence, where each participant's best move depends on what the others do.
The reward a player receives from a particular outcome of a game.
A table showing how each player's payoff depends on both its own action and the other player's action.
A game in which each player has an incentive to act in its own interest, producing an outcome that is worse for both than mutual cooperation would be.
An action that is a player's best choice no matter what the other player does.
An outcome, also called a noncooperative equilibrium, in which every player is doing the best it can given the others' actions, so no one wants to change unilaterally.
Actions a firm takes to shape the future behavior of its rivals, especially in games played repeatedly.
A repeated-game strategy of starting cooperatively and then copying whatever the rival did last round; it often sustains tacit collusion.
When firms keep output low and prices high without any explicit agreement, simply by anticipating one another's behavior.
Government efforts to keep firms from colluding and acting like monopolies.
A breakdown of tacit collusion in which firms repeatedly undercut each other, driving prices sharply down.
A pattern in which one firm sets a price and the others follow, coordinating behavior without an explicit agreement.
Competing for customers through means other than price, such as advertising or added features, so as to avoid setting off price wars.
Collusion is harder to sustain when there are many firms, products and prices are complex, firms' interests differ, or buyers have strong bargaining power.
A market structure with many firms selling differentiated products and free entry and exit in the long run.
Short-run profits draw in new firms, shifting each existing firm's demand curve left, while losses drive some firms out, shifting the remaining firms' demand curves right.
The long-run outcome of monopolistic competition, where each firm's demand curve is just tangent to its average total cost curve, so profits are zero and there is no entry or exit.
The tendency of monopolistically competitive firms to produce less than the minimum-cost output, leaving them with higher average costs than perfectly competitive firms.
In monopolistic competition, firms charge a price above marginal cost even in long-run equilibrium.
It leaves firms with excess capacity and prices above marginal cost, but whether this is truly inefficient is ambiguous because consumers value the product variety it provides.
Firms distinguish their products from rivals' by style or type, by location, or by quality.
Spending meant to raise demand for a product and strengthen a firm's market power; it helps society when it conveys useful information but can be wasteful when its only purpose is to create market power.
A name identifying a producer's goods; brand names can reassure buyers about quality but can also be used mainly to build market power.
The Organization of the Petroleum Exporting Countries is the best-known real-world cartel, coordinating oil output among member nations to influence world prices.
In the 1990s vitamin makers such as BASF and Roche ran an illegal price-fixing cartel, a real case of collusion later broken up by antitrust enforcement.
Practice quiz
If two duopolists face a Prisoners' Dilemma regarding output levels, and they cannot enforce a collusive agreement, what is the most likely long-run outcome, and why?
- They will achieve the collusive outcome, as it maximizes joint profits, despite the individual incentive to cheat.
- They will both choose the noncooperative strategy, leading to a Nash Equilibrium that is worse for both than mutual cooperation.
- One firm will collude, and the other will act noncooperatively, resulting in a dominant strategy for the non-colluding firm.
- They will engage in a price war until one firm exits the market, leading to a monopoly.
Answer: They will both choose the noncooperative strategy, leading to a Nash Equilibrium that is worse for both than mutual cooperation.
Which of the following scenarios would most likely lead to a breakdown of tacit collusion and initiate a price war among firms in an oligopoly?
- A significant increase in product differentiation, making it easier for firms to monitor each other's pricing.
- A decrease in the number of firms in the market, simplifying coordination.
- The introduction of highly complex pricing structures and frequent new product variations.
- Stronger bargaining power of buyers, forcing firms to compete more aggressively on price.
Answer: The introduction of highly complex pricing structures and frequent new product variations.
In the long-run zero-profit equilibrium of a monopolistically competitive market, which of the following statements is true regarding efficiency?
- Firms produce at the minimum of their average total cost curve, achieving productive efficiency, but charge a price equal to marginal cost.
- Firms exhibit excess capacity and charge a price above marginal cost, indicating allocative inefficiency, but this is offset by product variety.
- Firms achieve both productive and allocative efficiency because free entry and exit drive profits to zero.
- Firms operate with excess capacity and charge a price equal to marginal cost, leading to a socially optimal output level.
Answer: Firms exhibit excess capacity and charge a price above marginal cost, indicating allocative inefficiency, but this is offset by product variety.
Two airlines, Alpha and Beta, are deciding whether to offer a discount fare. If both offer discounts, both lose money. If neither offers discounts, both earn moderate profits. If one offers a discount and the other doesn't, the discounter gains significant market share and profit, while the other loses significantly. Assuming this is a one-shot game and both airlines act rationally to maximize their own profits, what is the most likely outcome?
- Both airlines will choose not to offer a discount, as this maximizes their combined profit.
- Both airlines will offer a discount, as offering a discount is a dominant strategy for each.
- One airline will offer a discount, and the other will not, leading to an unstable equilibrium.
- The outcome is indeterminate without knowing which airline moves first.
Answer: Both airlines will offer a discount, as offering a discount is a dominant strategy for each.
Despite the potential for high profits, cartels often struggle to maintain their agreements in the long run. Which of the following best explains this challenge, considering the concepts of noncooperative behavior and antitrust policy?
- Antitrust policies are typically ineffective against international cartels, allowing them to operate without consequence.
- Each member has an individual incentive to cheat on the agreement by increasing output, leading to a breakdown of collusion.
- The cartel's success depends on attracting new members, which dilutes the market power of existing members.
- Cartels are inherently unstable because they always lead to price wars, regardless of individual incentives.
Answer: Each member has an individual incentive to cheat on the agreement by increasing output, leading to a breakdown of collusion.
If one of two duopolistic soft drink companies suddenly decides to aggressively cut its prices, what would a rival employing a "Tit for Tat" strategy most likely do, and what is the intended long-term effect on tacit collusion?
- The rival would maintain its current price, hoping the first company will revert to the previous pricing, thereby reinforcing tacit collusion.
- The rival would also cut its prices in the next round, aiming to punish the first company and re-establish tacit collusion in the future.
- The rival would increase its prices, attempting to signal a desire for even higher profits, which would undermine tacit collusion.
- The rival would exit the market, as the price cut signals an unsustainable competitive environment, leading to a monopoly.
Answer: The rival would also cut its prices in the next round, aiming to punish the first company and re-establish tacit collusion in the future.
How does the entry of a new firm into a monopolistically competitive market, combined with its use of advertising to highlight product differentiation, affect the long-run equilibrium of existing firms in the market?
- It shifts the demand curve for existing firms to the right, increasing their profits and leading to further entry.
- It shifts the demand curve for existing firms to the left, reducing their profits and potentially leading to exit until zero-profit equilibrium is restored.
- It has no effect on existing firms' demand curves, as product differentiation creates entirely separate markets.
- It forces existing firms to lower their average total costs to compete, moving them closer to productive efficiency.
Answer: It shifts the demand curve for existing firms to the left, reducing their profits and potentially leading to exit until zero-profit equilibrium is restored.
Several large telecommunication companies operate in an oligopoly. They frequently introduce new features, bundles, and customer service improvements rather than engaging in direct price cuts. This behavior by the telecommunication companies is best explained as an attempt to achieve which of the following, given the nature of oligopoly?
- To initiate a price war by subtly attracting customers away from rivals without explicitly lowering prices.
- To avoid a price war and sustain tacit collusion by competing on non-price factors, acknowledging their interdependence.
- To differentiate their products so significantly that they effectively become monopolies in their respective niches.
- To reduce their average total costs by focusing on service improvements, which is a characteristic of perfect competition.
Answer: To avoid a price war and sustain tacit collusion by competing on non-price factors, acknowledging their interdependence.
Two pharmaceutical companies are caught by antitrust regulators for colluding to fix prices for a life-saving drug. They are offered a plea bargain: confess and implicate the other for a lighter sentence, or stay silent and risk a harsher penalty if the other confesses. This situation is a classic example of a Prisoners' Dilemma. If both companies act in their individual self-interest, what is the most likely outcome, and how does this relate to the effectiveness of antitrust policy?
- Both companies will remain silent, achieving the best collective outcome, which undermines antitrust efforts.
- Both companies will confess, leading to a worse outcome for both than if they had both remained silent, demonstrating how antitrust policy can break collusion.
- One company will confess, and the other will remain silent, leading to an unstable outcome that antitrust policy aims to prevent.
- The companies will continue to collude, as the threat of antitrust action is not strong enough to overcome their joint profit motive.
Answer: Both companies will confess, leading to a worse outcome for both than if they had both remained silent, demonstrating how antitrust policy can break collusion.
Consider a duopoly where two firms, A and B, are deciding whether to invest in a new, expensive advertising campaign. The payoff matrix (profits in millions of dollars) is as follows:\nFirm B Advertises: Firm A Advertises (A: $5$ million, B: $5$ million), Firm A Doesn't Advertise (A: $2$ million, B: $10$ million)\nFirm B Doesn't Advertise: Firm A Advertises (A: $10$ million, B: $2$ million), Firm A Doesn't Advertise (A: $7$ million, B: $7$ million)\nBased on the provided payoff matrix, what is the Nash Equilibrium for this game, and does either firm have a dominant strategy?
- The Nash Equilibrium is (Firm A Doesn't Advertise, Firm B Doesn't Advertise); neither firm has a dominant strategy.
- The Nash Equilibrium is (Firm A Advertises, Firm B Advertises); both firms have a dominant strategy to advertise.
- There are two Nash Equilibria: (Firm A Advertises, Firm B Doesn't Advertise) and (Firm A Doesn't Advertise, Firm B Advertises); neither firm has a dominant strategy.
- The Nash Equilibrium is (Firm A Advertises, Firm B Advertises); neither firm has a dominant strategy.
Answer: The Nash Equilibrium is (Firm A Advertises, Firm B Advertises); both firms have a dominant strategy to advertise.
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