Week 12 · Chapter

Chapter 12 — Monopolistic Competition & Oligopoly

Principles of Microeconomics Free sample edition

The module's primary reading · ~40–50 minutes · Objective 7 (analyze monopolistic competition and oligopoly, including a two-player game, the prisoner's dilemma, and Nash equilibrium, and analyze labor markets as derived demand with the value-of-the-marginal-product hiring rule), building on Objective 6 (analyze perfect competition and monopoly with the profit-maximizing rules (P = MC for a price taker; MR = MC for a monopolist), the shutdown rule, long-run entry and exit, and the deadweight loss of market power) · Read it first this week; the lecture, the slide deck, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

Most stores you visit are not lonely monopolies and not anonymous stalls selling identical goods. They sit in between. This week you study two of those in-between markets. In monopolistic competition (many sellers whose products differ a little, with new sellers free to open), each shop has a small amount of pricing power, but newcomers keep its profit from lasting. In oligopoly (a market run by a few rivals who watch each other), each firm's best move depends on what the others do, and you will use a small table of payoffs to see why rivals so often cut prices they would rather keep high.

Why you already care about this

Picture a street corner with two coffee shops facing each other. Each one posts a price for a regular coffee each month. If one shop drops its price and the other does not, the cheaper shop pulls customers across the street. If both drop their prices, neither gains many customers, and both earn less on every cup. Each owner would love a world where both keep prices high. Yet month after month, both end up with the low price.

Now think about the phone-repair shops in a city. They all fix cracked screens, but they are not identical. One is two blocks from your home. One promises a repair in an hour. One gives a longer warranty. Each shop can charge a little more than the others without losing every customer, yet none of them seems to get rich. Both stories share a puzzle: firms with some power over price still end up earning less than you might expect.

By the end of this chapter you will be able to:

describe monopolistic competition and explain why each firm's demand curve slopes down;
apply the rule MR = MC to a monopolistic competitor and explain why its price is above marginal cost;
explain how entry and exit drive long-run economic profit to zero in monopolistic competition;
describe oligopoly, collusion, and cartels, and explain why collusion is unstable and illegal;
read a payoff matrix, find each player's dominant strategy, and find the Nash equilibrium;
explain the prisoner's dilemma with the two coffee shops' numbers;
compare the four market structures trait by trait.

Carry this sentence with you: compare within each column, not across the whole table.

Where we are

Already covered: Week 9 built the chair workshop's cost table, with average total cost lowest at 36 dollars. Week 10 put that workshop in a perfectly competitive market, where it took the price and produced where P = MC. Week 11 gave the town one ferry, which produced where MR = MC and read its price from demand.
This week: monopolistic competition and its long-run zero-profit result; oligopoly, collusion, and cartels; a first look at game theory, with the payoff matrix, dominant strategies, Nash equilibrium, and the prisoner's dilemma; and the four market structures side by side.
How they connect: the two market structures this week sit between Week 10's many price takers and Week 11's single seller, and the same MR = MC rule runs through all of them.
Where we're going next: Week 13 begins a new unit on factor markets, where the firm stops selling and starts hiring.

Two ideas from earlier weeks carry this chapter. First, from Week 11: a seller whose demand curve slopes down must lower its price on every unit to sell one more, so its marginal revenue sits below its price. The ferry sold 8 hundred tickets, where MR = MC = 4, and charged 12 dollars, well above its marginal cost. Second, from Week 10: when firms can enter and leave freely, profit draws newcomers in and losses push firms out, until economic profit is zero. This week those two ideas meet.

1. Meet monopolistic competition

Walk down the phone-repair street again. Every shop sells the same basic service, but each one has a twist. That twist is what makes a shop's customers stay when it charges a little more. It is also why no one shop owns the market: if it charges too much, its customers can walk to another shop that is almost as good.

Monopolistic competition is a market structure with many sellers offering products that differ a little, by location, style, quality, or service, and with free entry, so each firm faces a downward-sloping demand curve but entry drives economic profit to zero in the long run.
Product differentiation is the ways a seller makes its product different from its rivals' in buyers' eyes, such as location, style, speed, quality, service, or brand, which gives the seller a downward-sloping demand curve of its own.

The name sounds like a contradiction, and it is meant to. "Monopolistic" points at the small piece of pricing power each shop has, because no one else sells exactly its product. "Competition" points at the many rivals and the open door for new ones. Edward Chamberlin and Joan Robinson each set out this framework in 1933, working separately on the space between pure monopoly and perfect competition.

Picture one repair shop's demand on a graph, with repairs per week along the horizontal axis and the price of a repair up the vertical axis. Its demand curve slopes down, like the ferry's, but it is fairly flat. A small price rise loses some customers, not all of them, because the shop's closeness or speed holds the rest. Compare that with Week 10's chair workshop, whose demand was a perfectly flat line at the market price.

You meet this market structure every day: restaurants, hair salons, clothing shops, gyms, coffee shops on different streets, and repair shops. An honesty note: the model treats each firm as small and the door as open. Real markets fit that description more or less well, and the model is a classroom simplification that makes the logic visible.

Misconception check. Students often think a firm with a downward-sloping demand curve must be a monopoly. It is tempting, because Week 11's ferry was the first downward-sloping firm demand you met. The cure: a monopolist has no close substitutes, while a monopolistic competitor has many close substitutes that are not quite the same. The slope comes from differentiation, not from being the only seller.

2. Apply the output rule to a monopolistic competitor

A repair shop that wants to fix more screens each week has to lower its price a little to win customers from its rivals. That is the ferry's situation again, on a smaller scale. To sell one more repair, the shop lowers its price on every repair, so the extra revenue from that repair is less than its price.

So the shop's marginal revenue is below its price, as the ferry's was. The rule is the one every profit-maximizing firm uses:

The shop produces where MR = MC, the profit-maximizing rule for every firm.
It then reads its price from its own demand curve at that quantity.
Because marginal revenue is below the price at that quantity, the price is above marginal cost.

Write P for price, Q for the quantity sold, MR for marginal revenue, and MC for marginal cost. For the ferry the numbers made this plain: MR = MC = 4 at 8 hundred tickets, and the price read from demand was 12 dollars. A monopolistic competitor follows the same three steps. Its markup is usually smaller, because its demand curve is flatter: buyers have close substitutes a short walk away.

Product differentiation and advertising are how a firm in this market keeps its slice of pricing power. A shop can advertise its speed, its warranty, or its friendly service. Economists debate what advertising does. One side says it informs buyers about prices and choices, which can sharpen competition. The other side says it builds brand loyalty that lets a firm charge more for a product much like its rivals'. Which effect is larger is an empirical question, and the answer can differ from one market to another.

Misconception check. Students often apply P = MC to every firm that faces rivals. It is tempting because a repair shop has many competitors, like Week 10's chair workshop. The cure: P = MC is the price taker's form of the rule, and it holds only when marginal revenue equals the price. A repair shop's demand slopes down, so its marginal revenue is below its price. It produces where MR = MC and charges more than MC.

3. Follow the long run: entry and exit

Suppose the repair shops on one street are earning economic profit. Word gets around. A new shop opens, then another. Each newcomer takes a few customers who used to go elsewhere. Every existing shop now sells fewer repairs at each price than before.

On the graph, each existing shop's demand curve shifts left. The shifts continue as long as the shops still earn economic profit, because profit keeps drawing new entrants. They stop when the price each shop charges equals its average total cost (ATC), total cost divided by quantity. At that point economic profit is zero and no one else has a reason to enter.

The long-run zero-profit result is the prediction that in monopolistic competition entry and exit continue until each firm's price equals its average total cost, so economic profit is zero even though price stays above marginal cost.

Losses work in the opposite direction. If shops are losing money, some close. Their customers spread out to the shops that remain, and each survivor's demand curve shifts right until the losses disappear. Either way, the market settles where economic profit is zero.

Picture the long-run graph for one shop. Its downward-sloping demand curve falls until it barely touches the shop's bowl-shaped ATC curve at one point, the quantity the shop chooses. Because the demand curve slopes down, that touching point sits on the falling part of ATC, to the left of the lowest point. The shop produces a bit less than the quantity that would give it the lowest possible average cost. One way to describe this is as the price of variety: buyers get many slightly different shops, each a little smaller than the cheapest size.

Misconception check. Students often expect a well-run monopolistic competitor to keep its economic profit year after year, the way the ferry could. It is tempting because the shop has some pricing power. The cure: pricing power is not the same as protection. The ferry had barriers to entry; the repair street has an open door. With free entry, any economic profit draws newcomers who shift each shop's demand curve left until economic profit is zero.

4. Read the zero-profit result correctly

Zero economic profit sounds grim, but it is not. Recall Week 9 and Week 10: economic profit subtracts every cost, including the owner's own time and money. When a repair shop earns zero economic profit, its owner earns exactly what that time and money could earn in their next-best use. The books still show a positive accounting profit.

So in the long run a monopolistic competitor ends up like a perfectly competitive firm in one way and unlike it in another:

Like it: economic profit is zero.
Unlike it: price is still above marginal cost.

Compare the two long-run firms side by side. Week 10's chair workshop ended at a price equal to the lowest average total cost, 36 dollars, with P = MC. The repair shop ends at a price equal to its average total cost too, but at a quantity to the left of that cost curve's lowest point, and with its price above the cost of one more repair. The repair shop charges a little more than one more repair costs it, and in return buyers get choice: a shop near home, a fast shop, a shop with a long warranty.

Whether that trade is worth it is a normative question. A positive statement says what the model predicts: price above marginal cost, zero economic profit, more variety. A normative statement says whether the variety is worth the higher price, and people weigh that differently.

Misconception check. Students often read zero economic profit as "the owner earns nothing" or "the business is failing." The cure, carried from Week 10: zero economic profit means a normal return. The owner covers every cost, including the pay they gave up by not working elsewhere, and the business has no reason to close.

5. Meet oligopoly: a few rivals who watch each other

Go back to the two coffee shops on the corner. Unlike the repair street, this corner has room for only two shops; a third would need a lease nobody is offering. Each owner knows the other by name. When one changes its price, the other notices within a day.

An oligopoly is a market structure dominated by a few firms whose choices are interdependent, usually protected by barriers to entry, so each firm must think about how its rivals will respond.
Interdependence is the condition in which one firm's best choice of price or output depends on what its rivals choose, the defining trait of oligopoly.

Interdependence is what makes oligopoly different from every market structure you have met so far. The chair workshop never thought about any single rival; it took the market price. The ferry had no rival to think about. A repair shop on a busy street has so many rivals that no one of them matters much. In an oligopoly, each firm must ask: if I cut my price, what will they do?

The two coffee shops are the smallest possible oligopoly, a market with two sellers. They are a classroom model built for this course, not real companies, and their profits are illustrative numbers. Oligopolies in the wider economy tend to arise where barriers to entry are high: large up-front costs, scarce locations, or licenses keep the number of sellers small.

Misconception check. Students often mix up oligopoly and monopolistic competition, because both have more than one seller and both can have differentiated products. The cure: count the sellers and check the door. Monopolistic competition has many small sellers and free entry, so no single rival matters much. Oligopoly has a few large sellers behind barriers to entry, so every rival matters a great deal.

6. See why rivals are tempted to collude

If the two coffee shops could act as one, they could charge what a single seller would charge and split the profit. That is the logic of collusion.

Collusion is an agreement among rival firms to raise prices or restrict output instead of competing; price-fixing agreements of this kind are illegal under U.S. antitrust law.
A cartel is a group of firms that formally agrees to restrict output and raise prices so that its members act together like a single monopolist; it is unstable because each member gains by secretly selling more.

A cartel faces two problems. The first is the law: price-fixing agreements are illegal under U.S. antitrust law, the federal laws you met in Week 11. The second is temptation. Once every member is charging the high price, any one member can do better by quietly cutting its own price, or selling a little more, and stealing customers from the rest. Each member knows the others face the same temptation, so trust is hard to keep.

That second problem is a matter of numbers, and the next four sections put numbers on it. Keep this sentence in mind as you read them: a deal that pays everyone more can still fall apart if each member gains even more by breaking it.

Pause and reflect. Choose one of these and write two or three sentences.

(a) Think of a group agreement you have seen break down, such as a study group that agreed to split the work or friends who agreed to split a bill evenly. Describe what made one person tempted to break it.
(b) Think of a time two businesses near you seemed to watch each other's prices, such as two gas stations or two grocery stores on the same road. Describe what one did after the other changed its price.

Misconception check. Students often think a cartel lasts because its members all earn more under the agreement. They do earn more together. The cure: what matters to each member is whether it earns even more by cheating while the others keep their promise. If it does, the agreement is unstable even when everyone signed it.

7. Set up a payoff matrix

Economists study situations like the coffee corner with game theory, and its basic tool is a small table.

Game theory is the study of choices whose payoffs depend on what other decision makers choose, used in economics to analyze rivals such as the firms in an oligopoly.
A payoff matrix is a table listing each player's payoff for every combination of choices, with each cell written as (row player's payoff, column player's payoff).

Here each shop has two choices, a high price or a low price, so there are four possible outcomes. The payoff is each shop's monthly profit in thousands of dollars. The first shop picks a row; the second shop picks a column. Each cell holds two numbers: the first shop's profit, then the second shop's.

The table below shows Dataset O, the two coffee shops' pricing game, constructed for this course and not real data.

Monthly profit in thousands of dollars for each pair of pricing choices, written (first shop, second shop); illustrative
	Second shop prices high	Second shop prices low
First shop prices high	(10, 10)	(4, 14)
First shop prices low	(14, 4)	(6, 6)

Read the table in words, one cell at a time:

(high, high) = (10, 10): if both price high, each earns 10 thousand dollars a month.
First shop high, second shop low = (4, 14): the low-price shop pulls customers across the street and earns 14, while the high-price shop earns 4.
First shop low, second shop high = (14, 4): the same story with the roles reversed.
(low, low) = (6, 6): if both price low, neither steals customers, and each earns 6 on thinner margins.

This two-by-two table is a classroom model. Real pricing involves many prices and many months, but two choices and two players are enough to show the logic.

In practice (your tools). In Google Sheets, type the two column labels, "Second shop prices high" and "Second shop prices low", in cells B1 and C1, and the two row labels in cells A2 and A3. Then type each payoff pair into its cell as text, such as (10, 10) in B2. Shade nothing and color nothing: label each cell in words so the table reads aloud correctly. You will build a table like this with fresh numbers in the Model Workshop.

Misconception check. Students often read a cell's two numbers in the wrong order, as (second shop, first shop). The cure: the first number always belongs to the row player, the shop that picks the row, and the second to the column player. Say it aloud for each cell: "first shop, then second shop."

8. Find each shop's dominant strategy

Put yourself in the first shop's place. You do not know what the second shop will do, so check each possibility separately.

A dominant strategy is a choice that gives a player a higher payoff than any other choice whatever the other player does, found by comparing the player's payoffs within each of the other player's choices.

Worked example — the first shop's best reply. Look only at the first number in each cell, and compare within one column at a time.

If the second shop prices high (the left column): the first shop earns 10 by pricing high and 14 by pricing low. Since 14 > 10, the first shop prices low.
If the second shop prices low (the right column): the first shop earns 4 by pricing high and 6 by pricing low. Since 6 > 4, the first shop prices low.
The result. Low is better in both columns, so low is the first shop's dominant strategy.

In words: whatever its rival does, the first shop earns more by pricing low, so it never needs to guess the rival's move.

Worked example — the second shop's best reply. Now look only at the second number in each cell, and compare within one row at a time.

If the first shop prices high (the top row): the second shop earns 10 by pricing high and 14 by pricing low, and 14 > 10.
If the first shop prices low (the bottom row): the second shop earns 4 by pricing high and 6 by pricing low, and 6 > 4.
The result. Low is the second shop's dominant strategy too. Its payoffs are the mirror image of the first shop's.

In words: both shops have the same dominant strategy, the low price.

Misconception check. Students often pick the dominant strategy by finding the biggest number in the whole table. The biggest number here is 14, and it sits in a cell where the other shop prices high, which a player cannot choose. The cure: a dominant strategy is found by comparing within each column (or row), one possibility at a time. Compare within each column, not across the whole table.

9. Find the Nash equilibrium

Knowing each shop's best choice, you can predict where the game ends up. The test for a resting point is simple to state: would either player want to change its own choice, if the other kept its choice?

A Nash equilibrium is a set of choices, one for each player, in which no player can raise its own payoff by changing its own choice while the others keep theirs.

John Nash published the idea in 1950. It applies to any game, not only those with dominant strategies. When both players have a dominant strategy, as here, the Nash equilibrium is the outcome where each plays it.

Worked example — testing two outcomes. Check whether either shop would move on its own.

The prediction. Both shops play their dominant strategy, so the outcome is (low, low), with 6 thousand dollars a month each.
Testing (low, low). A shop that switches alone to high earns 4 instead of 6, a loss of 6 − 4 = 2. Neither shop moves, so (low, low) is a Nash equilibrium.
Testing (high, high). A shop that switches alone to low earns 14 instead of 10, a gain of 14 − 10 = 4. Either shop would move, so (high, high) is not a Nash equilibrium.

In words: once both shops price low, neither can do better alone, so the low prices stick; at the high prices, each shop is one decision away from grabbing 4 thousand dollars more.

Picture each shop as having arrows in the table. From any cell where a shop could do better by switching, draw an arrow toward the cell it would switch to. Every arrow in this game points toward the bottom-right cell, (low, low), and no arrow leaves it.

Misconception check. Students often think the Nash equilibrium is the best outcome for the players. It is tempting because "equilibrium" sounds like a happy balance. The cure: a Nash equilibrium is a prediction about where choices settle, not a judgment about whether they are good. Here the shops settle at 6 each, not at the 10 each they could earn together.

10. Name the prisoner's dilemma

Now set the two outcomes side by side. At the Nash equilibrium each shop earns 6. At (high, high), the cooperative outcome, each would earn 10, which is 10 − 6 = 4 more. Both shops would be better off at (high, high), yet each one's own best choice leads them to (low, low).

A prisoner's dilemma is a game in which each player has a dominant strategy, yet the outcome when both follow it leaves every player worse off than if all had cooperated.

Worked example — joint profit. Add the two payoffs in each kind of outcome.

Both high: 10 + 10 = 20 thousand dollars a month.
Both low: 6 + 6 = 12 thousand dollars a month.
One high, one low: 14 + 4 = 18 thousand dollars a month.

In words: the shops together earn 20 versus 12, so the price war costs them 8 thousand dollars a month between them, and yet neither can escape it alone.

The game gets its name from a story about two suspects questioned separately, each tempted to testify against the other. Merrill Flood and Melvin Dresher framed the game at the RAND Corporation in 1950, and Flood published a report of their experiments in 1958. The same structure shows up far from coffee: two neighbors deciding whether to keep up a shared fence, or two roommates deciding whether to clean a shared kitchen.

The dilemma also explains the cartel's instability from Section 6. Suppose the two shops agree to price high. Each one can gain 14 − 10 = 4 thousand dollars a month by cheating, so the agreement is unstable, and it is illegal as well.

Notice who the dilemma is bad for. The two shops lose; their customers pay the lower price and gain. Whether that is a good outcome depends on whose welfare you weigh, which is a normative question. The positive result is plain: in this model, the shops' own dominant strategies drive the price down.

Misconception check. Students often read the cooperative outcome, (high, high), as the Nash equilibrium because it pays both shops the most. The cure: test it. From (high, high), either shop gains 4 by switching to low, so it is not a resting point. The prisoner's dilemma is exactly the gap between the outcome that pays both the most and the outcome they reach.

11. Notice what changes when the game repeats

The coffee corner is not a single meeting. The two shops face each other every month. When the same rivals meet again and again, the threat of a future price cut can sometimes hold a high price in place: a shop that cheats this month may face a rival's low price for many months after. This course stops at that idea. How firms keep or break such patterns, and formal models of oligopoly, belong to later economics courses.

An honesty note on scope: one month's two-by-two game is a teaching model. It shows why cooperation is fragile, not how often it fails in any real market. Any claim about a real industry needs evidence about that industry, not this table.

Misconception check. Students often take the one-month game's result as a law: "rivals always end up in a price war." The cure: the model predicts (low, low) when the game is played once and each shop has a dominant strategy. Repetition can change what each shop expects, so the one-shot prediction is a starting point, not a forecast for every market.

12. Compare the four market structures

You have now met all four market structures this course covers.

A market structure is the type of market a firm sells in, described by the number of sellers, how alike their products are, and how easily new sellers can enter: perfect competition, monopolistic competition, oligopoly, or monopoly.

The table below lines them up trait by trait.

The four market structures compared on six traits, with each week's example
Trait	Perfect competition	Monopolistic competition	Oligopoly	Monopoly
Number of sellers	Many	Many	A few	One
Product	Identical	Differentiated	Identical or differentiated	No close substitutes
Entry	Free	Free	Barriers	Blocked
Price compared with marginal cost	Equal (P = MC)	Above	Usually above	Above
Long-run economic profit	Zero	Zero	Can last	Can last
This course's example	The chair workshop	The phone-repair shops	The two coffee shops	The town's only ferry

Read the table down its rows. Every one of these firms produces where MR = MC; only the price taker's rule reads P = MC, because only for a price taker does marginal revenue equal the price. Entry decides profit: where the door is open, as in the first two columns, long-run economic profit is zero; where barriers keep rivals out, as in the last two, profit can last. Interdependence belongs to oligopoly alone.

Two callbacks anchor the ends of the table. Week 10's chair workshop ended the long run at a price equal to the lowest average total cost, 36 dollars, with P = MC. Week 11's ferry sold 8 hundred tickets where MR = MC = 4 and charged 12 dollars, above marginal cost. The two structures this week fall between those cases.

Pause and reflect. Choose one of these and write two or three sentences.

(a) Pick a business you buy from often. Say which market structure fits it best and which two traits from the table convinced you.
(b) Pick a market you know from a job or a hobby. Say whether new sellers can enter it easily, and what that predicts about long-run profit there.

Misconception check. Students often think "many sellers" settles which structure a market is. The cure: check the product too. Many sellers with identical products is perfect competition, where each firm is a price taker; many sellers with differentiated products is monopolistic competition, where each firm's demand slopes down.

13. Check the classic wrong turns

Most mistakes this week are not deep confusions. They are a wrong comparison in a table or the wrong rule for a market structure. Here are the four to watch, each with its cure.

"The cooperative outcome is the Nash equilibrium." It is not. (high, high) pays both shops 10, but either one gains 14 − 10 = 4 by switching, so the game settles at (low, low).
"The dominant strategy is the one with the biggest number." It is not. The biggest number is 14, but a dominant strategy wins in every column, which you check one column at a time.
"A monopolistic competitor keeps its economic profit in the long run." It does not. Free entry shifts each firm's demand curve left until price equals average total cost.
"Oligopoly and monopolistic competition are the same thing." They are not. A few interdependent firms behind barriers differ from many small firms with an open door.

Misconception check. Students often think that because both shops "chose low," they must have agreed to it. The cure: no agreement is needed. Each shop chooses low on its own because low is its dominant strategy. An agreement would be needed to reach (high, high), and that agreement is the one that breaks down.

Key terms

Monopolistic competition — A market structure with many sellers offering products that differ a little, by location, style, quality, or service, and with free entry, so each firm faces a downward-sloping demand curve but entry drives economic profit to zero in the long run. (first used: 1. Meet monopolistic competition)
Product differentiation — The ways a seller makes its product different from its rivals' in buyers' eyes, such as location, style, speed, quality, service, or brand, which gives the seller a downward-sloping demand curve of its own. (first used: 1. Meet monopolistic competition)
Long-run zero-profit result — The prediction that in monopolistic competition entry and exit continue until each firm's price equals its average total cost, so economic profit is zero even though price stays above marginal cost. (first used: 3. Follow the long run: entry and exit)
Oligopoly — A market structure dominated by a few firms whose choices are interdependent, usually protected by barriers to entry, so each firm must think about how its rivals will respond. (first used: 5. Meet oligopoly: a few rivals who watch each other)
Interdependence — The condition in which one firm's best choice of price or output depends on what its rivals choose, the defining trait of oligopoly. (first used: 5. Meet oligopoly: a few rivals who watch each other)
Collusion — An agreement among rival firms to raise prices or restrict output instead of competing; price-fixing agreements of this kind are illegal under U.S. antitrust law. (first used: 6. See why rivals are tempted to collude)
Cartel — A group of firms that formally agrees to restrict output and raise prices so that its members act together like a single monopolist; it is unstable because each member gains by secretly selling more. (first used: 6. See why rivals are tempted to collude)
Game theory — The study of choices whose payoffs depend on what other decision makers choose, used in economics to analyze rivals such as the firms in an oligopoly. (first used: 7. Set up a payoff matrix)
Payoff matrix — A table listing each player's payoff for every combination of choices, with each cell written as (row player's payoff, column player's payoff). (first used: 7. Set up a payoff matrix)
Dominant strategy — A choice that gives a player a higher payoff than any other choice whatever the other player does, found by comparing the player's payoffs within each of the other player's choices. (first used: 8. Find each shop's dominant strategy)
Nash equilibrium — A set of choices, one for each player, in which no player can raise its own payoff by changing its own choice while the others keep theirs. (first used: 9. Find the Nash equilibrium)
Prisoner's dilemma — A game in which each player has a dominant strategy, yet the outcome when both follow it leaves every player worse off than if all had cooperated. (first used: 10. Name the prisoner's dilemma)
Market structure — The type of market a firm sells in, described by the number of sellers, how alike their products are, and how easily new sellers can enter: perfect competition, monopolistic competition, oligopoly, or monopoly. (first used: 12. Compare the four market structures)

Summary

Monopolistic competition: many sellers, differentiated products, free entry.
A monopolistic competitor produces where MR = MC and charges a price above MC.
Entry and exit drive its long-run economic profit to zero.
Oligopoly: a few interdependent firms behind barriers to entry.
Collusion is unstable because each member gains by cheating, and price fixing is illegal.
A dominant strategy wins in every column; compare within columns.
A Nash equilibrium is where no player gains by changing its own choice alone.
In a prisoner's dilemma, dominant strategies lead both players to a worse outcome.
Every firm uses MR = MC; only the price taker's rule reads P = MC.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

Two neighborhood gyms (an illustrative case) each decide whether to run a big ad campaign. Monthly profit in thousands of dollars, written (first gym, second gym), is (5, 5) if both advertise, (9, 2) if only the first gym advertises, (2, 9) if only the second gym advertises, and (7, 7) if neither advertises. Find each gym's dominant strategy and the Nash equilibrium.
For the same two gyms, say whether "neither advertises" is a Nash equilibrium, and explain whether this game is a prisoner's dilemma.
A city's food trucks each sell a different style of food, and new trucks can start up easily. This year each truck earns an economic profit. Predict what happens over the next few years to each truck's demand curve, to its price compared with its average total cost, and to its economic profit. Then say whether its price ends up equal to its marginal cost.
Name the market structure that fits each case, and say which output rule the firm uses: (a) the only water utility serving a town; (b) a wholesale wheat market with thousands of farms; (c) three cement plants that serve one region and watch each other's prices; (d) the many nail salons in a large city.

Answers (worked reasoning — read after attempting)

For the first gym, compare within each column. If the second gym advertises, the first earns 5 by advertising and 2 by not, and 5 > 2. If the second gym does not advertise, the first earns 9 by advertising and 7 by not, and 9 > 7. Advertising wins in both columns, so it is the first gym's dominant strategy. The second gym's payoffs are the mirror image, so advertising is its dominant strategy too. The Nash equilibrium is (advertise, advertise), with 5 thousand dollars a month each.
"Neither advertises" pays (7, 7), but either gym could switch alone to advertising and earn 9 instead of 7, a gain of 9 − 7 = 2. So it is not a Nash equilibrium. The game is a prisoner's dilemma: each gym has a dominant strategy, and when both follow it they earn 5 each instead of the 7 each they would earn if neither advertised.
Economic profit draws new trucks into the market. Each newcomer takes some customers, so each existing truck's demand curve shifts left. Entry continues until each truck's price equals its average total cost, where economic profit is zero. Its price stays above its marginal cost, because its demand curve still slopes down and it produces where MR = MC; expecting the profit to last would be the classic slip.
(a) Monopoly: it produces where MR = MC and reads its price from demand. (b) Perfect competition: each farm is a price taker, so MR = MC reads P = MC. (c) Oligopoly: a few interdependent firms, each producing where MR = MC while watching its rivals. (d) Monopolistic competition: many salons with differentiated services, each producing where MR = MC and charging a price above MC.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the course turns to factor markets, where the value of the marginal product sets how many workers a firm hires.

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