Market Structures

Question 1:

Prisoner’s dilemma:

Given the two companies Exxon and Texaco that cooperate on maintaining one well each, the following table summarizes the results: (Mankiw, 2008)

From the above table the two firm’s can cooperate and drill only one well each, in this case they will earn 5 million in profits each, however the dominant strategy will be to drill an extra oil well and earn an extra 1million in profit, if Exxon drill two wells it earns 6 million in profits, both firms will choose the dominant strategy to drill two wells and the resulting outcome will be worse than if they had cooperated, when the two firms drill two wells each the resulting profit is 4 million compared to 5 million if they had both cooperated. (Mankiw, 2008)

At 4 million in profits the firms may decide to maintain the two wells each that they have drilled, however the one firm may decide to drill another well in order to increase its profits from 4 million to maybe 5 million, the two firms will choose the dominant strategy to drill an extra well and therefore further reduce profits lower than 4 million in the long run. The best strategy would be to cooperate and each firm earns 5 million in profits. (Mankiw, 2008)

Question 2:

Market Structures


The government can create a monopoly in a number of ways, when a firm discovers a new product in the market it attains a patent for the new product from the government, this patent allows the firm to be the only firm that produces that product in the market resulting into a monopoly. For example when a pharmaceutical firm discovers a new drug and acquires a patent, this patent creates a monopoly whereby there is only one firm that produces that particular product. (Hardwick, 2002)

The government will also create a monopoly if the product produced is a public good, this include services and products that cannot be produced by individual firm due to high maintenance costs, high initial investments and low returns. For this reason therefore a monopoly will emerge to produce public goods whose returns are unattractive to private firms. (Hardwick, 2002)

The government will also create a monopoly (natural monopoly) when the production and distribution of a product is more efficient and effective if only one firm exists in the market, this type of monopoly is called a natural monopoly, it is created given that the production and distribution of a product by more than one firm will result into inefficiency therefore a natural monopoly is created. (Hardwick, 2002)

Question 3:

Monopoly cost and revenue curves:

A monopoly has the power to set the prices of its products in the market unlike in a competitive

Market Structures

market, a firm in a competitive market structure will produce at the point where the marginal cost curve intersects the average revenue curve, however the monopolistic firm will not produce at this price level, the following diagram demonstrates the revenue and cost curves of a monopoly (Hardwick, 2002)

A firm in a competitive market will produce at Q2 and the price will be P2, however the monopoly firm will produce less at point Q1 and charges a higher price P1. This is because the monopoly has the power to set the prices. The shaded area B show the economic profit gained by the monopoly firm, the monopoly produces at point where MR = MC but charges at a higher price, this results into a dead weight loss (area D) due to the fact that it produces less than the efficient quantity, therefore the monopoly firm should not produce at the level which maximizes profit but produce at the point where it makes normal profits and therefore increase quantity produced. (Hardwick, 2002)

Question 4:


The output effect occurs when a firm in an oligopoly market structure is able to increase its profits by increasing output, the condition for increasing output is that the price must be greater than the marginal cost and therefore increasing the output level will increase profits. (Parkin, 2009)

The price effect on the other hand occurs due to increase of output by oligopolies, when output increases then the prices of their products declines, as the prices decline due to an increase in output then this also results into a decline in the profit levels of the oligopolies. (Parkin, 2009)

Market Structures

Oligopoly equilibrium occurs when these two effects are equal, if the price effect is greater than the output effect then the firm should lower their output level, if the output effect exceeds the price effect then the firm increases output. (Parkin, 2009)

Question 5:

In monopolistic competitive market structure entry of a new firms leads to two external effects, this include the product variety externality and the business stealing externality, the business stealing effect occurs when entry by a new firm results into a reduction in demand for goods from other firms by consumers and also a reduction in profits by other firms in the market. This is referred to as a negative externality to the existing firms in the monopolistic competition structure. (Parkin, 2009)

The entry of a new firm in the market also results into a positive externality, the new firm introduces new products in the market resulting into an increase in the consumer surplus, this is referred to as the product variety effect whereby more products are available in the market and therefore consumers experience a positive externality from the entry of the new firm. (Parkin, 2009)

Question 6:

Market Structures


Given tat there is only one firm in this structure advertising would not be necessary, brand name in this market structure will only be for identification purposes. (Parkin, 2009)

Monopolistic competition:

In monopolistic competition products are differentiated, this means that firms have an incentive to advertise in order to increase the demand for its products; firms will also have brand names that are aimed at differentiating products. (Parkin, 2009)


Given that there are only a few firms in this market structure, advertising will also help increase the number of buyers for a firm, advertising is aimed at informing the consumer about the quality of the product. (Parkin, 2009)

Perfect competition:

In perfect competition advertising is important given that it helps a firm to increase buyers for its

Market Structures

products, there are many firms in the industry and therefore the firms must advertise. Brand names are also related to advertising whereby the brands are aimed at indicating the quality of products produced. (Parkin, 2009)


Hardwick, P. (2002). Introduction to Modern Economics, New  Jersey; Prentice hall press

Mankiw, Gregory. (2008). Principles of Micro Economics. New  York: Dryden Press.

Michael Parkin (2009) Essential foundations of economics, New  York: McGraw Hill Press