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Week 12 · Lecture outline

Week 12 — Lecture Outline · Monopolistic Competition & Oligopoly

Principles of Microeconomics · ECON 1 Fall 2026 · Prof. Kessler Fictional sample

Course: Principles of Microeconomics (ECON 1) · Silver Oak University (fictional sample) · Prof. Kessler
Objective 7 — monopolistic competition, oligopoly & game theory · SLO A & B
Meeting pattern: two 75-min sessions (≈150 min). Segment minutes below total ~150 — scale to your room.

The deck (E), the tutorial (C), and the workshop (P) all teach from this outline. Every number here is pre-computed and independently verified (see the verified box in §4).

Week at a glance
Big question When a small number of firms compete strategically, why do they so often end up worse off than if they had cooperated — and what keeps them stuck there?
By week's end students can (1) identify monopolistic competition traits — differentiation, free entry, zero LR profit, excess capacity; (2) identify oligopoly traits — few firms, barriers, strategic interdependence; (3) read a payoff matrix and find dominant strategies; (4) identify a Nash equilibrium; (5) explain the prisoner's dilemma — why the Nash outcome is stable but jointly suboptimal.
Key vocabulary product differentiation, monopolistic competition, excess capacity, oligopoly, strategic interdependence, barriers to entry, cartel, dominant strategy, Nash equilibrium, prisoner's dilemma, cooperative outcome
Materials whiteboard; Week-12 readings/links; a spreadsheet or drawn matrix for the payoff table; an approved chatbot
Timing note 8 segments ≈ 150 min across two sessions. Segment 7 (interaction) can be trimmed if needed.

Segment 1 — HOOK: "Why doesn't OPEC just keep oil prices high?" (10 min)

Open with a puzzle: OPEC nations have, at various times, agreed to cut oil production to keep prices — and their profits — high. But the agreements keep unraveling. Why? Each country has a private incentive to pump a little more than its quota. If one country cheats while others hold the line, the cheater earns extra profit. But if everyone cheats, prices crash and everyone earns less. Students can feel the logic intuitively before we formalize it.

Promise: by the end of today, you'll have a model — the payoff matrix — that explains exactly why OPEC (and airline pricing, and advertising wars, and even nuclear arms races) keeps falling apart. The tool is game theory, and it's one of the most useful ideas in all of social science.

Segment 2 — MARKET STRUCTURE REVIEW & MONOPOLISTIC COMPETITION (25 min)

Brief review of the four-structure spectrum (PC → monopolistic competition → oligopoly → monopoly). Remind students that they now know the endpoints; today is the messy middle.

Monopolistic competition — the defining traits:
1. Many sellers (like PC), but each sells a differentiated product — not identical. Coffee shops, clothing brands, taco trucks, hair salons.
2. Free entry and exit (like PC). New firms can enter if existing ones are earning economic profit.
3. Some market power (like monopoly) — each firm faces a downward-sloping demand curve for its own product because it is a bit unique.

Short-run outcome: with differentiated products and some market power, a monopolistically competitive firm can earn short-run economic profit. It sets MR = MC and reads price off its demand curve (same rule as a monopolist). (Draw the standard downward-sloping demand / MR diagram with positive short-run profit.)

The long-run zero-profit result — walk through the mechanism carefully:

Free entry → short-run profit → new firms enter → demand for each existing firm shifts LEFT (rivals take some customers) → each firm's demand curve shifts in until it is tangent to the ATC curve → long-run P = ATC, economic profit = 0.

Name what this looks like on the diagram: the demand curve shifts left until it just touches (is tangent to) the ATC curve. At that tangency point, P = ATC, so profit = (P − ATC) × Q = 0.

Excess capacity — draw it and name it:

At the long-run tangency, the firm operates at a quantity to the left of the ATC minimum. It is NOT at minimum ATC. That gap between the firm's actual output and the output at minimum ATC is excess capacity. Monopolistic competition buys variety and differentiation at the cost of firms never fully using their capacity.

TRAP to address: students sometimes confuse "zero economic profit" with "zero accounting profit" — zero ECONOMIC profit still means the firm covers all its costs, including the opportunity cost of the owner's time and capital. The firm is viable; it's just not earning a surplus above the normal rate of return.

Segment 3 — OLIGOPOLY (15 min)

Oligopoly — the defining traits:
1. Few sellers — a small number of firms dominates the market. (Airline routes, wireless carriers, major streaming platforms.)
2. Significant barriers to entry — economies of scale, capital requirements, patents, network effects.
3. Strategic interdependence — each firm's best move depends on what the other firms do. This is the key distinction: in PC and monopolistic competition, firms are too small to worry about rivals; in oligopoly, rival reactions matter.

Why economic models get complicated here: there's no single "oligopoly equilibrium" the way there's a competitive equilibrium or an MR = MC monopoly output. The outcome depends on assumptions about how rivals behave. Rather than the full range of oligopoly models (Cournot, Bertrand, Stackelberg — out of scope at principles level), we use game theory to capture the core strategic insight.

Cartels: when oligopolists try to cooperate, they form a cartel — an agreement to restrict output and keep prices high (like the OPEC example from the hook). A cartel essentially tries to act like a monopoly. But as we'll see, cartels are inherently unstable: each member has a private incentive to defect.

Segment 4 — THE PAYOFF MATRIX: THE WEEK'S CENTERPIECE CALCULATION (30 min)

Now the week's key model. We'll use a clean, two-firm pricing game and work through it completely.

✅ VERIFIED PAYOFF MATRIX (pre-computed; use exactly)

Two firms (Firm 1 and Firm 2), each choosing High price or Low price.

Firm 2: High Firm 2: Low
Firm 1: High (10, 10) (3, 12)
Firm 1: Low (12, 3) (5, 5)

(Each cell shows Firm 1's profit, Firm 2's profit — in millions of dollars for concreteness.)

Verified checks:
- Firm 1's dominant strategy: if Firm 2 plays High, Firm 1 earns 12 (Low) > 10 (High) → Firm 1 prefers Low. If Firm 2 plays Low, Firm 1 earns 5 (Low) > 3 (High) → Firm 1 prefers Low. Low is dominant for Firm 1. ✓
- Firm 2's dominant strategy (symmetric): if Firm 1 plays High, Firm 2 earns 12 (Low) > 10 (High). If Firm 1 plays Low, Firm 2 earns 5 (Low) > 3 (High). Low is dominant for Firm 2. ✓
- Nash equilibrium: (Low, Low) = (5, 5). Neither firm wants to unilaterally switch — if Firm 2 plays Low and Firm 1 switches to High, Firm 1 earns 3 < 5. ✓
- (High, High) = (10, 10) is jointly better for both firms, but it is not a Nash equilibrium — each firm has an incentive to defect to Low (earning 12 > 10). ✓
- This is a prisoner's dilemma: the (dominant, dominant) outcome = (Low, Low) = (5, 5) is worse for both than the cooperative outcome (High, High) = (10, 10). ✓

Walk through the matrix with students step by step:

Step 1 — Find Firm 1's dominant strategy:
Fix Firm 2 on High (left column): Firm 1 earns 10 if High, 12 if Low → Firm 1 prefers Low (12 > 10).
Fix Firm 2 on Low (right column): Firm 1 earns 3 if High, 5 if Low → Firm 1 prefers Low (5 > 3).
In both cases Firm 1 prefers Low. Low is Firm 1's dominant strategy — best regardless of what Firm 2 does.

Step 2 — Find Firm 2's dominant strategy (by symmetry):
Same logic: Low is dominant for Firm 2 as well.

Step 3 — Find the Nash equilibrium:
Both firms play their dominant strategy → (Low, Low) = (5, 5). Verify it's an equilibrium: if both play Low, Firm 1 has no incentive to switch to High (3 < 5). Neither firm wants to deviate. It's stable.

Step 4 — Why cooperation breaks down:
At (High, High) = (10, 10), both firms earn more. Suppose they sign a cartel agreement to both charge High. Now ask: does Firm 1 want to stick to it? If Firm 2 holds to High, Firm 1 can defect to Low and earn 12 instead of 10 — pocketing an extra 2 at Firm 2's expense (whose profit drops to 3). Firm 1 breaks the agreement. Firm 2 faces the same temptation. Both defect → (Low, Low) = (5, 5). The cooperative outcome is jointly better but individually unstable. That is the prisoner's dilemma.

State it cleanly: the Nash equilibrium is (Low, Low) = (5, 5). It is stable (no unilateral deviation is profitable). The cooperative outcome (High, High) = (10, 10) is jointly better but not stable because each firm can earn 12 by defecting when the rival plays High. The individually rational strategy — always play Low — leads to a collectively bad outcome. This is why cartels break down, why arms races escalate, and why some environmental negotiations fail.

Segment 5 — NAMING THE KEY TRAP (10 min)

The key trap: confusing the Nash equilibrium with the cooperative outcome.

  • Nash equilibrium = the outcome where no one wants to deviate. It's stable. It's where a rational self-interested player ends up. In this game, (Low, Low) = (5, 5).
  • Cooperative outcome = what both firms would prefer if they could commit. (High, High) = (10, 10) here. But without a binding commitment mechanism, each has an incentive to defect — so the cooperative outcome is not a Nash equilibrium and is not stable.

Draw this on the board and make students say it: "The Nash equilibrium is not always the best outcome."

Students also mix up: when is there no dominant strategy? (When one player's best response changes depending on the rival's choice.) In this game there is a dominant strategy, which is a special and important case. Not all games have dominant strategies; this one does.

Segment 6 — TECHNOLOGY WORKFLOW + AI-CRITIQUE (15 min)

Live demo with a spreadsheet (Google Sheets / Excel): type the 2×2 payoff matrix into four cells. Have students highlight each row and column comparison to find the dominant strategy systematically. This is the Workshop approach — the Workshop has them fill in a matrix and underline each "best response" cell.

AI-critique moment: ask an approved chatbot to solve the payoff matrix and identify the Nash equilibrium. Then audit together:
- Did it correctly identify Low as the dominant strategy for both firms?
- Did it correctly state the Nash equilibrium as (Low, Low) = (5, 5)?
- Did it correctly explain why (High, High) is not stable — i.e., each firm can earn 12 by defecting?
- Common chatbot errors: stating the Nash as (High, High) because it looks "better"; confusing "jointly preferred" with "equilibrium"; forgetting to check both firms' incentives. The habit all term: the tool drafts, you judge.

Segment 7 — INTERACTION: think-pair-share (10 min)

Pose: "Airlines on a route frequently offer the same base fares. Is that evidence of cartel pricing — or is it just competitive equilibrium? How would you tell the difference?" Pairs discuss, then share. Target idea: if fares are low and near cost, it looks like competition; if fares are high and profits are consistently positive (with barriers to entry explaining why new entrants don't erode them), strategic pricing (oligopoly) is more plausible. This previews Discussion 12.

Segment 8 — CALLBACKS, TEASE & THE WEEK'S WORK (10 min)

  • Callback chain: from Week 10 (PC: P = MC, zero LR profit, no market power) → Week 11 (monopoly: MR = MC, market power, DWL) → this week (monopolistic competition: MR = MC, some market power, but free entry → zero LR profit; oligopoly: strategic, game theory).
  • Tease next week: "Next week we zoom into the factor side of markets — instead of asking what price a firm charges for its product, we ask: how many workers does it hire, and at what wage? The key: a firm's labor demand is derived from the demand for its output."
  • The week's work: Lecture Tutorial, Practice, Quiz 12, Discussion 12, Assignment 12, and Workshop 12 (the payoff matrix end-to-end).

Instructor FAQ — common stumbles

  • "Why is the Nash equilibrium 'worse' for both firms — isn't it just where they end up?" Yes, it's where they end up — that's what makes it a dilemma. The Nash equilibrium is stable but Pareto-inferior to the cooperative outcome. They end up there because each firm's individual incentive (earn 12 instead of 10) overrides the collective incentive to cooperate.
  • "Couldn't the firms just agree to both play High?" They can sign a cartel agreement — but without external enforcement, each member has an incentive to cheat (12 > 10). That private incentive is why antitrust law matters and why OPEC quotas frequently break down.
  • "Is there always a dominant strategy?" No — dominant strategies exist only when one choice is best regardless of the rival's move. This game has a dominant strategy (Low for both); many real strategic situations do not, which leads to the concept of mixed strategies (out of scope here).
  • "Excess capacity — I thought firms want to use all their capacity?" They do, but free entry erodes their demand curve until profit = 0 at a point left of minimum ATC. The variety of goods in monopolistic competition has a cost: each firm is chronically under-scale. Think of a strip of competing coffee shops: each is somewhat empty during slow hours.
  • "What distinguishes monopolistic competition from oligopoly in the real world?" Mainly the number of firms and the strategic interdependence. In a city of 50 independent restaurants, no single restaurant's price affects the others much — that's monopolistic competition. In a duopoly of airlines on a route (two carriers), each watches the other's prices closely — that's oligopoly.

~ Prof. Kessler's edition · Fall 2026 · built with thecoursemaker.com