Monopolistic Competition and Oligopoly Chapter 12 Monopolistic Competition and Oligopoly

Topics to be Discussed Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners’ Dilemma Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Cartels Chapter 12 2

Monopolistic Competition Characteristics Many firms Free entry and exit Differentiated product Chapter 12 4

Monopolistic Competition The amount of monopoly power depends on the degree of differentiation. Examples of this very common market structure include: Toothpaste Soap Cold remedies Chapter 12 5

Monopolistic Competition Toothpaste Crest and monopoly power Procter & Gamble is the sole producer of Crest Consumers can have a preference for Crest – taste, reputation, decay preventing efficacy The greater the preference (differentiation) the higher the price. Chapter 12 6

Monopolistic Competition Two important characteristics Differentiated but highly substitutable products Free entry and exit Chapter 12 7

A Monopolistically Competitive Firm in the Short and Long Run $/Q Short Run $/Q Long Run MC AC MC AC DSR MRSR QSR PSR DLR MRLR QLR PLR Quantity Quantity 12

A Monopolistically Competitive Firm in the Short and Long Run Short-run Downward sloping demand – differentiated product Demand is relatively elastic – good substitutes MR < P Profits are maximized when MR = MC This firm is making economic profits Chapter 12 13

A Monopolistically Competitive Firm in the Short and Long Run Profits will attract new firms to the industry (no barriers to entry) The old firm’s demand will decrease to DLR Firm’s output and price will fall Industry output will rise No economic profit (P = AC) P > MC  some monopoly power Chapter 12 14

Monopolistically and Perfectly Competitive Equilibrium (LR) Perfect Competition Monopolistic Competition $/Q $/Q Deadweight loss MC AC MC AC DLR MRLR QMC P QC PC D = MR Quantity Quantity 17

Monopolistic Competition & Economic Efficiency The monopoly power yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle – deadweight loss. With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12 18

Monopolistic Competition and Economic Efficiency Firm faces downward sloping demand so zero profit point is to the left of minimum average cost Excess capacity is inefficient because average cost would be lower with fewer firms Inefficiencies would make consumers worse off Chapter 12

Monopolistic Competition If inefficiency bad for consumers, should monopolistic competition be regulated? Market power relatively small. Usually enough firms to compete with enough substitutability between firms – deadweight loss small Inefficiency is balance by benefit of increased product diversity – may easily outweigh deadweight loss Chapter 12 20

The Market for Colas and Coffee Each market has much differentiation in products and try to gain consumers through that differentiation Coke versus Pepsi Maxwell House versus Folgers How much monopoly power do each of these producers have? How elastic demand for each brand? Chapter 12 21

Elasticities of Demand for Brands of Colas and Coffee Chapter 12 22

The Market for Colas and Coffee The demand for Royal Crown more price inelastic than for Coke There is significant monopoly power in these two markets The greater the elasticity, the less monopoly power and vice versa. Chapter 12 23

Oligopoly – Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry Scale economies Patents Technology Name recognition Strategic action Chapter 12 24

Oligopoly Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment Chapter 12 25

Oligopoly Management Challenges Strategic actions to deter entry Threaten to decrease price against new competitors by keeping excess capacity Rival behavior Because only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react. Chapter 12 28

Oligopoly – Equilibrium If one firm decides to cut their price, they must consider what the other firms in the industry will do Could cut price some, the same amount, or more than firm Could lead to price war and drastic fall in profits for all Actions and reactions are dynamic, evolving over time Chapter 12 29

Oligopoly – Equilibrium Defining Equilibrium Firms are doing the best they can and have no incentive to change their output or price All firms assume competitors are taking rival decisions into account. Nash Equilibrium Each firm is doing the best it can given what its competitors are doing. We will focus on duopoly Markets in which two firms compete Chapter 12 30

Oligopoly The Cournot Model Oligopoly model in which firms produce a homogeneous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce Firm will adjust its output based on what it thinks the other firm will produce Chapter 12 32

Firm 1’s Output Decision MR1(0) Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing. D1(50) MR1(50) 25 If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. MR1(75) D1(75) 12.5 If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MC1 50 Q1 Chapter 12 38

Oligopoly The Reaction Curve The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce. A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2. Chapter 12 39

Reaction Curves and Cournot Equilibrium Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous model. 100 75 Firm 2’s Reaction Curve Q*2(Q2) 50 Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. x Firm 1’s Reaction Curve Q*1(Q2) x 25 x x Q2 25 50 75 100 Chapter 12 43

Reaction Curves and Cournot Equilibrium 100 In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. 75 Firm 2’s Reaction Curve Q*2(Q2) 50 x Cournot Equilibrium Firm 1’s Reaction Curve Q*1(Q2) x 25 x x Q2 25 50 75 100 Chapter 12 43

Cournot Equilibrium Each firms reaction curve tells it how much to produce given the output of its competitor. Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly. Chapter 12

Oligopoly Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium) The Cournot equilibrium says nothing about the dynamics of the adjustment process Since both firms adjust their output, neither output would be fixed Chapter 12 44

The Linear Demand Curve An Example of the Cournot Equilibrium Two firms face linear market demand curve We can compare competitive equilibrium and the equilibrium resulting from collusion Market demand is P = 30 - Q Q is total production of both firms: Q = Q1 + Q2 Both firms have MC1 = MC2 = 0 Chapter 12 4 45

Oligopoly Example Firm 1’s Reaction Curve  MR=MC Chapter 12 4 46

Oligopoly Example An Example of the Cournot Equilibrium Chapter 12 4 47

Oligopoly Example An Example of the Cournot Equilibrium Chapter 12 4 48

The demand curve is P = 30 - Q and both firms have 0 marginal cost. Duopoly Example Q1 The demand curve is P = 30 - Q and both firms have 0 marginal cost. Firm 2’s Reaction Curve 30 15 10 Cournot Equilibrium Firm 1’s Reaction Curve 15 30 Q2 Chapter 12 54

Oligopoly Example Profit Maximization with Collusion Chapter 12 4 55

Profit Maximization w/Collusion Contract Curve Q1 + Q2 = 15 Shows all pairs of output Q1 and Q2 that maximizes total profits Q1 = Q2 = 7.5 Less output and higher profits than the Cournot equilibrium Chapter 12 4 56

Duopoly Example Q1 30 15 10 7.5 For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium Firm 2’s Reaction Curve 15 Competitive Equilibrium (P = MC; Profit = 0) 10 Cournot Equilibrium Firm 1’s Reaction Curve Collusion Curve 7.5 Collusive Equilibrium 30 Q2 Chapter 12 54

First Mover Advantage – The Stackelberg Model Oligopoly model in which one firm sets its output before other firms do. Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q is total output Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1 output Chapter 12 58

First Mover Advantage – The Stackelberg Model Firm 1 Must consider the reaction of Firm 2 Firm 2 Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = 15 - ½(Q1) Chapter 12 59

First Mover Advantage – The Stackelberg Model Firm 1 Choose Q1 so that: Firm 1 knows firm 2 will choose output based on its reaction curve. WE can use firm 2’s reaction curve as Q2 Chapter 12 60

First Mover Advantage – The Stackelberg Model Using Firm 2’s Reaction Curve for Q2: Chapter 12 61

First Mover Advantage – The Stackelberg Model Conclusion Going first gives firm 1 the advantage Firm 1’s output is twice as large as firm 2’s Firm 1’s profit is twice as large as firm 2’s Going first allows firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless wants to reduce profits for everyone Chapter 12 62

Price Competition Competition in an oligopolistic industry may occur with price instead of output. The Bertrand Model is used Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge Chapter 12 63

Price Competition – Bertrand Model Assumptions Homogenous good Market demand is P = 30 - Q where Q = Q1 + Q2 MC1 = MC2 = $3 Can show the Cournot equilibrium if Q1 = Q2 = 9 and market price is $12 giving each firm a profits of $81. Chapter 12 64

Price Competition – Bertrand Model Assume here that the firms compete with price, not quantity. Since good is homogeneous, consumers will buy from lowest price seller If firms charge different prices, consumers buy from lowest priced firm only If firms charge same price, consumers are indifferent who they buy from Chapter 12 64

Price Competition – Bertrand Model Nash equilibrium is competitive output since have incentive to cut prices Both firms set price equal to MC P = MC; P1 = P2 = $3 Q = 27; Q1 & Q2 = 13.5 Both firms earn zero profit Chapter 12 65

Price Competition – Bertrand Model Why not charge a different price? If charge more, sell nothing If charge less, lose money on each unit sold The Bertrand model demonstrates the importance of the strategic variable Price versus output Chapter 12 66

Bertrand Model – Criticisms When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices. Even if the firms do set prices and choose the same price, what share of total sales will go to each one? It may not be equally divided. Chapter 12 69

Price Competition – Differentiated Products Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product. In these markets, more likely to compete using price instead of quantity Chapter 12 70

Price Competition – Differentiated Products Example Duopoly with fixed costs of $20 but zero variable costs Firms face the same demand curves Firm 1’s demand: Q1 = 12 - 2P1 + P2 Firm 2’s demand: Q2 = 12 - 2P1 + P1 Quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price Chapter 12 71

Price Competition – Differentiated Products Firms set prices at the same time Chapter 12 72

Price Competition – Differentiated Products If P2 is fixed: Chapter 12 73

Nash Equilibrium in Prices What if both firms collude They both decide to charge the same price that maximized both of their profits Firms will charge $6 and will be better off colluding since they will earn a profit of $16 Chapter 12 78

Nash Equilibrium in Prices Firm 2’s Reaction Curve $4 Nash Equilibrium Equilibrium at price of $4 and profits of $12 $6 Collusive Equilibrium Firm 1’s Reaction Curve P2 Chapter 12 77

Nash Equilibrium in Prices If Firm 1 sets price first and then firm 2 makes pricing decision Firm 1 would be at a distinct disadvantage by moving first The firm that moves second has an opportunity to undercut slightly and capture a larger market share Chapter 12

A Pricing Problem: Procter & Gamble Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd were entering the market for Gypsy Moth Tape. All three would be choosing their prices at the same time. Each firm was using same technology so had same production costs FC = $480,000/month & VC = $1/unit Chapter 12 79

A Pricing Problem: Procter & Gamble Procter & Gamble had to consider competitors prices when setting their price. P&G’s demand curve was: Q = 3,375P-3.5(PU).25(PK).25 Where P, PU, PK are P&G’s, Unilever’s, and Kao’s prices respectively Chapter 12 80

A Pricing Problem: Procter & Gamble What price should P&G choose and what is the expected profit? Can calculate profits by taking different possibilities of prices you and the other companies could charge. Nash equilibrium is at $1.40 – the point where competitors are doing the best they can as well Chapter 12 81

P&G’s Profit (in thousands of $ per month) Chapter 12

A Pricing Problem for Procter & Gamble Collusion with competitors will give larger profits. If all agree to charge $1.50, each earn profit of $20,000 Collusions agreement hard to enforce Chapter 12 83

Competition Versus Collusion: The Prisoners’ Dilemma Nash equilibrium is a noncooperative equilibrium: each firm makes decision that gives greatest profit, given actions of competitors Although collusion is illegal, why don’t firms cooperate without explicitly colluding? Why not set profit maximizing collusion price and hope others follow? Chapter 12 84

Competition Versus Collusion: The Prisoners’ Dilemma Competitor is not likely to follow Competitor can do better by choosing a lower price, even if they know you will set the collusive level price. We can use example from before to better understand the firms’ choices Chapter 12

Competition Versus Collusion: The Prisoners’ Dilemma Assume: Chapter 12 85

Competition Versus Collusion: The Prisoners’ Dilemma Possible Pricing Outcomes: Chapter 12 86

Payoff Matrix for Pricing Game Firm 2 Charge $4 Charge $6 Charge $4 $12, $12 $20, $4 $16, $16 $4, $20 Firm 1 Charge $6 Chapter 12 88

Competition Versus Collusion: The Prisoners’ Dilemma We can now answer the question of why firm does not choose cooperative price. Cooperating means both firms charging $6 instead of $4 and earning $16 instead of $12 Each firm always makes more money by charging $4, no matter what its competitor does Unless enforceable agreement to charge $6, will be better off charging $4 Chapter 12 89

Competition Versus Collusion: The Prisoners’ Dilemma An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face. Two prisoners have been accused of collaborating in a crime. They are in separate jail cells and cannot communicate. Each has been asked to confess to the crime. Chapter 12 90

Payoff Matrix for Prisoners’ Dilemma Prisoner B Confess Don’t confess Confess -5, -5 -1, -10 -2, -2 -10, -1 Prisoner A Would you choose to confess? Don’t confess Chapter 12 92

Oligopolistic Markets Conclusions Collusion will lead to greater profits Explicit and implicit collusion is possible Once collusion exists, the profit motive to break and lower price is significant Chapter 12 95

Payoff Matrix for the P&G Pricing Problem Unilever and Kao Charge $1.40 Charge $1.50 Charge $1.40 $12, $12 $29, $11 $3, $21 $20, $20 P&G What price should P & G choose? Charge $1.50 Chapter 12 97

Observations of Oligopoly Behavior In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur. In other oligopoly markets, the firms are very aggressive and collusion is not possible. Chapter 12 99

Observations of Oligopoly Behavior In other oligopoly markets, the firms are very aggressive and collusion is not possible. Firms are reluctant to change price because of the likely response of their competitors. In this case prices tend to be relatively rigid. Chapter 12 100

Price Rigidity Firms have strong desire for stability Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change Fear lower prices will send wrong message to competitors leading to price war Higher prices may cause competitors to raise theirs Chapter 12

Price Rigidity Basis of kinked demand curve model of oligopoly Each firm faces a demand curve kinked at the currently prevailing price, P* Above P*, demand is very elastic If P>P*, other firms will not follow Below P*, demand is very inelastic If P<P*, other firms will follow suit Chapter 12

Price Rigidity With a kinked demand curve, marginal revenue curve is discontinuous Firm’s costs can change without resulting in a change in price Kinked demand curve does not really explain oligopolistic pricing Description of price rigidity rather than an explanation of it Chapter 12

The Kinked Demand Curve $/Q If the producer raises price, the competitors will not and the demand will be elastic. MR D If the producer lowers price, the competitors will follow and the demand will be inelastic. Quantity Chapter 12 109

The Kinked Demand Curve $/Q MC MC’ So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. D P* Q* Quantity Chapter 12 MR 109

Price Signaling and Price Leadership Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Leadership Pattern of pricing in which one firm regularly announces price changes that other firms then match Chapter 12 110

Price Signaling and Price Leadership The Dominant Firm Model In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. The large firm might then act as the dominant firm, setting a price that maximizes its own profits. Chapter 12 110

The Dominant Firm Model Dominant firm must determine its demand curve, DD. Difference between market demand and supply of fringe firms To maximize profits, dominant firm produces QD where MRD and MCD cross. At P*, fringe firms sell QF and total quantity sold is QT = QD + QF Chapter 12

Price Setting by a Dominant Firm MCD MRD SF The dominant firm’s demand curve is the difference between market demand (D) and the supply of the fringe firms (SF). Price D DD At this price, fringe firms sell QF, so that total sales are QT. P1 QF QT P2 QD P* Quantity Chapter 12 115

Cartels Producers in a cartel explicitly agree to cooperate in setting prices and output. Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels Chapter 12 116

Cartels Examples of successful cartels OPEC International Bauxite Association Mercurio Europeo Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa Chapter 12 117

Cartels – Conditions for Success Stable cartel organization must be formed – price and quantity settled on and adhered to Members have different costs, assessments of demand and objectives Tempting to cheat by lowering price to capture larger market share Chapter 12 119

Cartels – Conditions for Success Potential for monopoly power Even if cartel can succeed, there might be little room to raise price if faces highly elastic demand If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work Chapter 12 120

Analysis of Cartel Pricing Members of cartel must take into account the actions of non-members when making pricing decisions Cartel pricing can be analyzed using the dominant firm model OPEC oil cartel – successful CIPEC copper cartel – unsuccessful Chapter 12

The OPEC Oil Cartel Price P* QOPEC TD SC MCOPEC MROPEC DOPEC Quantity TD is the total world demand curve for oil, and SC is the competitive supply. OPEC’s demand is the difference between the two. Price MROPEC DOPEC QOPEC P* OPEC’s profits maximizing quantity is found at the intersection of its MR and MC curves. At this quantity OPEC charges price P*. Quantity Chapter 12 124

Cartels About OPEC Very low MC TD is inelastic Non-OPEC supply is inelastic DOPEC is relatively inelastic Chapter 12 125

The OPEC Oil Cartel Price QC QT P* Pc QOPEC TD SC MCOPEC The price without the cartel: Competitive price (PC) where DOPEC = MCOPEC QC QT MROPEC DOPEC P* Pc QOPEC Quantity Chapter 12 124

The CIPEC Copper Cartel Price QCIPEC P* PC QC QT TD and SC are relatively elastic DCIPEC is elastic CIPEC has little monopoly power P* is closer to PC MRCIPEC TD DCIPEC SC MCCIPEC Quantity Chapter 12 130

Cartels To be successful: Total demand must not be very price elastic Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic Chapter 12 131

The Cartelization of Intercollegiate Athletics Large number of firms (colleges) Large number of consumers (fans) Very high profits Chapter 12 132

The Cartelization of Intercollegiate Athletics NCAA is the cartel Restricts competition Reduces bargaining power by athletes – enforces rules regarding eligibility and terms of compensation Reduces competition by universities – limits number of games played each season, number of teams per division, etc. Limits price competition – sole negotiator for all football television contracts Chapter 12 133

The Cartelization of Intercollegiate Athletics Although members have occasionally broken rules and regulations, has been a successful cartel In 1984, Supreme Court ruled that the NCAA’s monopolization of football TV contracts was illegal Competition led to drop in contract fees More college football on TV, but lower revenues to schools Chapter 12