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Example of a simulation game in Monopolistic Competition

A monopolistic competition simulation can be used as an example in the standard economics classroom or for experimental economics. Economic experiments using monopolistic competition simulations can create real-world incentives that may be used in the teaching and learning of economics to help students better understand why markets and other exchange systems work the way they do. A detailed explanation of experimental economics is given by Roth (1995).

Through a simulation game, students may participate directly in a market by managing a simulated firm and making decisions on price and production to maximize profits. An excellent review of the use of a successful market simulation is given by Motahar (1994) in the Journal of Economics Education.

Assumptions of Monopolistic Competition

A simulation game in monopolistic competition needs to incorporate the standard theoretical assumptions of this market structure, including:

• Many buyers and sellers
• Easy entry and exit
• Product differentiation is possible but limited.
• Zero economic profits in the long-run

In a simulation of monopolistic competition, each firm must be small in size, and should not be able to influence the direction of the overall market. Yet each firm has some control over price owing to product differentiation. To be consistent with economic theory, the simulation model should allow entry of new to occur as long as profits are greater than normal, and economic profits exist. The entry of new firms will decrease the market price, and eventually cause economic profits to return to zero (see Baye, 2009).

Controllable Decisions in Monopolistic Competition

To simulate monopolistic competition, the controllable firm decisions of the participants (students) must include, at a minimum, those specified in the standard theoretical model, including (see Baye, 2009):

• Firm price
• Advertising
• Firm production
• Plant Size

Simulation Game Experience

From an educational point of view, students will have an “opportunity” to learn by their own observations and experience through participation in a simulation game (see Schmidt, 2003). Consistent with the theoretical model of monopolistic competition (see Baye, 2009), student participants would observe and experience that their pricing decisions are controlled by the market. They would “experience” that in the simulation they would have to lower their firm’s price to be competitive as new firms entered the market. In the long-run, they would see the impact of changing plant size. They would observe that the successful firms would take advantage of economies of scale, but would also be careful not to incur diseconomies of scale in the long-run. Students would experience that economic profits cannot be maintained in the long-run. They would see, first hand, that their accounting profits will inevitably decline and move closer to normal profits. This experience provides students an opportunity to learn (as a supplement to the lecture and readings) the economic messages of monopolistic competition.

EXAMPLES OF MONOPOLISTIC COMPETITION USING AN ECONOMICS SIMULATION GAME FOR TEACHING AND LEARNING

A monopolistic competition simulation can be used as an example in the standard economics classroom or for experimental economics. Economic experiments using monopolistic competition simulations can create real-world incentives that may be used in the teaching and learning of economics to help students better understand why markets and other exchange systems work the way they do. A detailed explanation of experimental economics is given by Roth (1995).

Listed on the American Economics Association AEA website is an online economic simulation game called “Beat the Market” that may be used to simulate several different examples of the monopolistic competition market. The success or failure of any simulation experiment depends on how it is designed and used. This simulation is designed to put students inside the theoretical world of monopolistic competition as described in the standard economics textbook. Through the simulation, students participate directly in the market by managing a simulated firm and making decisions on price and production to maximize profits.

Assumptions of Monopolistic Competition Simulation Example

A properly built simulation game used to teach or learn economics should closely follow the assumptions and rules of the theoretical models within this discipline.

All the example simulations follow the basic theoretical assumptions of the monopolistic competition market structure and include:

• A large number of firms (at least 25 in the simulation).
• Small firm size (starting market share of each firm in the simulation is about 4%.
• Easy entry and exit, based on economic versus normal profits.
• Product differentiation is possible and there is a degree of control over price.

In the example simulations, the instructor may select different environments within the context of monopolistic competition including the following:

• Short-run versus long-run.
• Degree of product differentiation
• Macroeconomic environment (stable, growth, cyclical)

Two simulation game examples will be illustrated, including one short-run and one long-run simulation. The example simulations illustrated here will hold the degree of product differentiation and the macroeconomic environment constant. (The software does allow these variables to be included at the discretion of the instructor.)

Short-run Example Simulation: Monopolistic Competition

The short-run simulations do not allow students to change the plant size of their firm, but firms will still enter or exit the market if accounting profits differ from normal profit levels in the simulated monopolistic competition market.

CONTROLLABLE STUDENT DECISIONS IN SHORT-RUN SIMULATION EXAMPLE

The firm decisions that the students can manipulate in this simulation example are:

• Firm price
• Firm production

SIMULATION PERFORMANCE IN SHORT-RUN EXAMPLE

At the start, the market is not in equilibrium and has the following characteristics.

TABLE 1: Starting point of Short-run Simulation (Normal Profits $100,000)

Quarter	Number Firms	Market Price	Market Demand	Market Supply	Avg. Accounting Profit
0	25	$75.11	127,125	102,500	$119,522

Students make decisions for their firms based on their own firm characteristics. Consistent with the market, firms start with an excess demand, and their accounting profits are initially $119, 522 which exceeds normal profits of $100,000. Students are given information on their firm costs and revenues, including marginal costs and marginal revenues. The knowledgeable students (and the numerous computer managed firms) begin by raising their prices and increasing the quantity supplied. No matter the decisions of any student managed firm, the overall behavior of the market is not influenced by any one student, since each firm is very small in size relative to the market. In quarter 1 in this example, average firm accounting profits increase, but through time the following expected results occur.

TABLE 2: Short-run Simulation Movement to Equilibrium (Normal Profits $100,000)

Quarter	Number Firms	Market Price	Market Demand	Market Supply	Avg. Accounting Profit
1	25	$78.56	110,480	110,400	$137,846
2	27	$76.96	118,271	118,508	$131,218
3	30	$74.71	129,167	131,224	$119,487
4	32	$73.02	137,328	139,484	$112,033
5	35	$70.89	147,551	150,227	$102,998
6	35	$70.04	151,632	152,417	$100,573

After quarter 1, new firms entered the market because accounting profits exceeded normal profit levels of $100,000 in this example. The number of firms increased from 25 in quarter 1 to 35 in quarter 5. No additional firms entered in quarter 6 because accounting profits were close to normal levels. The decrease in accounting profits occurred because the market price declined as new firms entered and the markets supply increased. The market stabilized after six quarters because economic profits were at, or close to, zero; and market demand was close to market supply.

Long-run Example Simulation: Monopolistic Competition

The long-run simulation example allows students to change the plant size of their firm and take advantage of economies of scale. Both economies and diseconomies of scale exist in the simulation. Students are given information on how the average variable costs change in the simulation with increases in plant size. But again, as required in the model, firms will enter or exit the monopolistic competition market until economic profits return to zero.

CONTROLLABLE STUDENT DECISIONS IN LONG-RUN SIMULATION EXAMPLE

In this example, plant size is added as a third controllable student decision, and now includes:

• Firm price
• Firm production
• Firm plant size

SIMULATION PERFORMANCE IN LONG-RUN EXAMPLE

At the start, the market is not in equilibrium and has the following characteristics.

TABLE 3: Starting Point of Long-run Simulation (Normal Profits $100,000)

Quarter	Number Firms	Avg Plant Size	Market Price	Market Demand	Market Supply	Avg. Accounting Profit
0	25	6	$75.11	127,125	102,500	$119,522

Note that the starting characteristics of the market are set to be the same as in the short-run example. In this way comparisons can be made more directly between the two simulation examples. The major difference in the long-run example is that plant size may now be changed. As in the previous simulation example, all firms start with an excess demand, and their accounting profits are initially $119, 522, which is greater than normal profits of $100,000. Given this starting scenario, students again begin by raising their prices and increasing the quantity supplied. But this time, plant size also increases as students take advantage of economies of scale that is built into this simulation example. Firm profits increase initially, but through time the following expected results occur.

TABLE 4: Long-run Simulation Movement to Equilibrium (Normal Profits $100,000)

Quarter	Number Firms	Avg Plant Size	Market Price	Market Demand	Market Supply	Avg. Accounting Profit
1	25	6.0	$78.64	111,621	110,347	$137,243
2	27	7.4	$75.01	130,283	129,595	$141,475
3	30	9.0	$69.75	156,602	157,854	$133,859
4	33	10.7	$63.86	185,217	192,432	$117,176
5	36	11.4	$58.98	208,652	220,541	$98,669
6	36	11.6	$56.86	219,731	221,730	$99,870

These results had a number of similarities to the short-run example, but also some major differences. As in the short-run example, firms entered the market after quarter 1 because accounting profits exceeded normal profit levels of $100,000. The number of firms increased and the market stabilized after six quarters because economic profits were at, or close to, zero; and market demand was close to market supply. But in the long-run simulation example there were several important differences.

• Plant size increased significantly since it was a controllable decision of the firm and there were economies of scale.
• Economies of scale meant firms were able to take advantage of lower average costs and initially earn higher profits (before entry of new firms).
• Market price was bid down much lower than in the short-run example because firms were able to lower their average costs of production, and firms continued to enter the market as long as economic profits existed.
• Even though firms were able to reduce costs through economies of scale, they were not able to maintain profits above normal levels in the long-run.

Concluding Remarks

From an educational point of view, the benefit of a simulation game example is that students will have an “opportunity” to learn by their own observations and experience. In these simulation examples, student participants would observe and experience that their pricing decisions are controlled by the market. They would “experience” that in the simulation they would have to lower their firm’s price to be competitive as new firms entered the market. In the long-run simulation example, they would see the impact of changing plant size. They would observe that the successful firms would take advantage of economies of scale, but would also be careful not to incur diseconomies of scale in the long-run. Students would see the benefits of economies of scale in reducing costs and increasing profits, but experience that economic profits cannot be maintained in the long-run. They would observe, first hand, that their accounting profits will inevitably decline and move closer to normal profits. While participating in the simulation, students would experience the same dilemmas and frustrations that firm owners face in the real world. This experience provides students another opportunity to learn (as a supplement to the lecture and readings) the economic messages of monopolistic competition.