Oligopoly and Monopolistic Competition Chapter Thirteen Oligopoly and Monopolistic Competition

Topics Market Structures. Cartels. Noncooperative Oligopoly. Cournot Model. Stackelberg Model. Comparison of Collusive, Cournot, Stackelberg, and Competitive Equilibria. Bertrand Model. Monopolistic Competition. © 2009 Pearson Addison-Wesley. All rights reserved.

Oligopoly Oligopoly - a small group of firms in a market with substantial barriers to entry. Cartel - a group of firms that explicitly agree to coordinate their activities. Monopolistic competition - a market structure in which firms have market power but no additional firm can enter and earn positive profits © 2009 Pearson Addison-Wesley. All rights reserved.

Market Structures Markets differ according to: the number of firms in the market, the ease with which firms may enter and leave the market, and the ability of firms in a market to differentiate their products from those of their rivals. © 2009 Pearson Addison-Wesley. All rights reserved.

Table 13.1 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Competition © 2009 Pearson Addison-Wesley. All rights reserved.

Why Cartels Form A cartel forms if members of the cartel believe that they can raise their profits by coordinating their actions. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.1 Competition Versus Cartel (a) Fi r m (b) Ma r k et , $ per unit , $ per unit MC p p S , , e e ic ic e m r p m r p m P P A C p c p c e c MC m MC m Ma r k et demand MR Q m q m q c q * Q c Quantit y , q , Units Quantit y , Q , Units per y ear per y ear © 2009 Pearson Addison-Wesley. All rights reserved.

Laws Against Cartels Cartels persist despite these laws for three reasons: international cartels and cartels within certain countries operate legally. some illegal cartels operate believing that they can avoid detection or that the punishment will be insignificant. some firms are able to coordinate their activity without explicitly colluding and thereby running afoul of competition laws. © 2009 Pearson Addison-Wesley. All rights reserved.

Laws Against Cartels (cont). In the late nineteenth century, cartels were legal and common in the United States. Examples: oil, railroad, sugar, and tobacco. Sherman Antitrust Act in 1890 and the Federal Trade Commission Act of 1914, Prohibit firms from explicitly agreeing to take actions that reduce competition. © 2009 Pearson Addison-Wesley. All rights reserved.

Laws Against Cartels (cont). The Organization of Petroleum Exporting Countries (OPEC) - an international cartel that was formed in 1960 by five major oil-exporting countries: Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. In 1971, OPEC members agreed to take an active role in setting oil prices. © 2009 Pearson Addison-Wesley. All rights reserved.

Why Cartels Fail Cartels fail if noncartel members can supply consumers with large quantities of goods. Each member of a cartel has an incentive to cheat on the cartel agreement. © 2009 Pearson Addison-Wesley. All rights reserved.

Maintaining Cartels To keep firms from violating the cartel agreement, the cartel must be able to detect cheating and punish violators. keep their illegal behavior hidden from customers and government agencies. © 2009 Pearson Addison-Wesley. All rights reserved.

Mergers U.S. laws restrict the ability of firms to merge if the effect would be anticompetitive. © 2009 Pearson Addison-Wesley. All rights reserved.

Noncooperative Oligopoly Duopoly - an oligopoly with two firms. Three models: Cournot model Stackelberg model Bertrand model © 2009 Pearson Addison-Wesley. All rights reserved.

Noncooperative Oligopoly (cont). Three restrictive assumptions: All firms are identical in the sense that they have the same cost functions and produce identical, undifferentiated products. We initially illustrate each of these oligopoly models for a duopoly The market lasts for only one period. © 2009 Pearson Addison-Wesley. All rights reserved.

Noncooperative Oligopoly (cont). Duopoly equilibrium: A set of actions taken by the firms is a Nash equilibrium if, holding the actions of all other firms constant, no firm can obtain a higher profit by choosing a different action. © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model Four assumptions: (1) there are two firms and no other firms can enter the market, (2) the firms have identical costs, (3) they sell identical products, and (4) the firms set their quantities simultaneously. © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market Example: American Airlines and United Airlines compete for customers on flights between Chicago and Los Angeles. Cournot equilibrium (Nash-Cournot equilibrium) - a set of quantities sold by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market (cont). residual demand curve - the market demand that is not met by other sellers at any given price © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.2 American Airlines’ Profit-Maximizing Output (a) Monopoly (b) Duopoly 339 339 , $ per passenger , $ per passenger 275 243 211 p p 147 MC 147 MC q U = 64 MR D MR r D r D 96 169.5 339 64 128 137.5 275 339 q , Thousand American Airlines q , Thousand American Airlines A A passengers per quarter passengers per quarter © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.3 American and United’s Best-Response Curves © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market (cont). Market demand function is Q = 339 − p p - dollar cost of a one-way flight Q total quantity of the two airlines (thousands of passengers flying one way per quarter). Each airline has a constant marginal cost, MC, and average cost, AC, of $147 per passenger per flight. © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market (cont). Residual demand American faces is: qA = Q(p) − qU = (339 − p) − qU. rewriting p = 339 − qA − qU The marginal revenue function is: MRr = 339 − 2qA − qU © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market (cont). American Airlines’ best response is the output that equates its marginal revenue, and its marginal cost: MRr = 339 − 2qA − qU = 147 = MC and rearranging qA = 96−1/2 qU © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market (cont). United’s best-response function is qU = 96−1/2 qA This statement is equivalent to saying that the Cournot equilibrium is a point at which the bestresponse curves cross. © 2009 Pearson Addison-Wesley. All rights reserved.

Cournot Model of an Airlines Market (cont). To solve the model: qA = 96−1/2 (96−1/2 qA) and solve for qA. Doing so, we find that qA = 64; qU = 64 Q = qA + qU = 128. Cournot equilibrium price is $211. © 2009 Pearson Addison-Wesley. All rights reserved.

The Cournot Equilibrium and the Number of Firms We can write a typical Cournot firm’s profit-maximizing condition as: If n = 1, the Cournot firm is a monopoly, The more firms there are, the larger the residual demand elasticity, nε, a single firm faces. As n grows very large, the residual demand elasticity approaches negative infinity , and the equation above becomes p = MC, which is the profit-maximizing condition of a price-taking competitive firm. © 2009 Pearson Addison-Wesley. All rights reserved.

Table 13.2 Cournot Equilibrium Varies with the Number of Firms © 2009 Pearson Addison-Wesley. All rights reserved.

The Cournot Equilibrium and the Number of Firms Cournot firm’s Lerner Index depends on the elasticity the firm faces Thus, a Cournot firm’s Lerner Index equals the monopoly level, −1/ε, if there is only one firm: © 2009 Pearson Addison-Wesley. All rights reserved.

Application Air Ticket Prices and Rivalry © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.4a Effect of a Government Subsidy on a Cournot Equilibrium © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.4b Effect of a Government Subsidy on a Cournot Equilibrium (cont’d) © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 13.1 Derive United Airlines’ best-response function if its marginal cost falls to $99 per unit. © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 13.2 Intel and Advanced Micro Devices (AMD) are the only two firms that produce central processing units (CPUs), which are the brains of personal computers. Both because the products differ physically and because Intel’s advertising “Intel Inside” campaign has convinced some consumers’ of its superiority, consumers view the CPUs as imperfect substitutes. Consequently, the two firms’ inverse demand functions differ: pA = 197 − 15.1qA − 0.3qI, pI = 490 − 10qI − 6qA, where price is dollars per CPU, quantity is in millions of CPUs, the subscript I indicates Intel, and the subscript A represents AMD. Each firm faces a constant marginal cost of m = $40 per unit. (For simplicity, we will assume there are no fixed costs.) Solve for the Cournot equilibrium quantities and prices. © 2009 Pearson Addison-Wesley. All rights reserved.

Stackelberg Model In the Cournot model, both firms make their output decisions at the same time. Suppose, however, that one of the firms, called the leader, can set its output before its rival, the follower, sets its output. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.5 Stackelberg Equilibrium © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 13.3 Use algebra to solve for the Stackelberg equilibrium quantities and market price if American Airlines were a Stackelberg leader and United Airlines were a follower. (Hint: As the graphical analysis shows,American Airlines, the Stackelberg leader, maximizes its profit as though it were a monopoly facing a residual demand function.) © 2009 Pearson Addison-Wesley. All rights reserved.

Why Moving Sequentially Is Essential When the firms move simultaneously, United doesn’t view American’s warning that it will produce a large quantity as a credible threat. If United believed that threat, it would indeed produce the Stackelberg follower output level. © 2009 Pearson Addison-Wesley. All rights reserved.

Strategic Trade Policy Suppose that two identical firms in two different countries compete in a world market. Both firms act simultaneously, so neither firm can make itself the Stackelberg leader. A government may be tempted to intervene to make its firm a Stackelberg leader. © 2009 Pearson Addison-Wesley. All rights reserved.

Problems with Intervention. For government subsidies to work five conditions must hold: government must be able to set its subsidy before the firms choose their output levels. other government must not retaliate. government’s actions must be credible. government must know enough about how firms behave to intervene appropriately. government must know which game the firms are playing. © 2009 Pearson Addison-Wesley. All rights reserved.

Table 13.3 Effects of a Subsidy Given to United Airlines © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 13.4 If governments subsidize identical Cournot duopolies with a specific subsidy of s per unit of output, what is the qualitative effect (direction of change) on the equilibrium quantities and price? Assume that the before-subsidy best-response functions are linear. © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 13.4 © 2009 Pearson Addison-Wesley. All rights reserved.

How would American and United behave if they colluded? Comparison of Collusive, Cournot, Stackelberg, and Competitive Equilibria How would American and United behave if they colluded? They would maximize joint profits by producing the monopoly output, 96 units, at the monopoly price, $243 per passenger. © 2009 Pearson Addison-Wesley. All rights reserved.

Table 13.4 Comparison of Airline Market Structures © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.6a Duopoly Equilibria © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.6b Duopoly Equilibria © 2009 Pearson Addison-Wesley. All rights reserved.

Application Deadweight Losses in the Food and Tobacco Industries © 2009 Pearson Addison-Wesley. All rights reserved.

Bertrand Model Bertrand equilibrium (Nash-Bertrand equilibrium) - a Nash equilibrium in prices; a set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge these prices. Bertrand equilibrium depends on whether firms are producing identical or differentiated products. © 2009 Pearson Addison-Wesley. All rights reserved.

Best-Response Curves. Suppose that each of the two price-setting oligopoly firms in a market produces an identical product and faces a constant marginal and average cost of $5 per unit. What is Firm 1’s best response if Firm 2 sets a price of p2 = $10? © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.7 Bertrand Equilibrium with Identical Products © 2009 Pearson Addison-Wesley. All rights reserved.

Bertrand Versus Cournot. Cournot equilibrium price for firms with constant marginal costs of $5 per unit by: where n is the number of firms and ε is the market demand elasticity. If the market demand elasticity is ε = −1 and n = 2, the Cournot equilibrium price is $5/(1− 1 2) = $10 which is double the Bertrand equilibrium price. © 2009 Pearson Addison-Wesley. All rights reserved.

Bertrand Equilibrium with Differentiated Products In markets with differentiated products such markets, the Bertrand equilibrium is plausible, and the two “problems” of the homogeneous-goods model disappear: Firms set prices above marginal cost, and prices are sensitive to demand conditions. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.8 Bertrand Equilibrium with Differentiated Products © 2009 Pearson Addison-Wesley. All rights reserved.

Monopolistic Competition Monopolistically competitive markets do not have barriers to entry, so firms enter the market until no new firm can enter profitably. monopolistically competitive firms face downward-sloping residual demand curves, so they charge prices above marginal cost. © 2009 Pearson Addison-Wesley. All rights reserved.

Monopolistically Competitive Equilibrium Two conditions hold in a monopolistically competitive equilibrium: Marginal revenue equals marginal cost because firms set output to maximize profit, and price equals average cost because firms enter until no further profitable entry is possible © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.9 Monopolistically Competitive Equilibrium © 2009 Pearson Addison-Wesley. All rights reserved.

Minimum efficient scale minimum efficient scale - (full capacity) the smallest quantity at which the average cost curve reaches its minimum © 2009 Pearson Addison-Wesley. All rights reserved.

Fixed Costs and the Number of Firms The number of firms in a monopolistically competitive equilibrium depends on firms’ costs. The larger each firm’s fixed cost, the smaller the number of monopolistically competitive firms in the market equilibrium. © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 13.10 Monopolistic Competition Among Airlines © 2009 Pearson Addison-Wesley. All rights reserved.

Solved Problem 13.5 What is the monopolistically competitive airline equilibrium if each firm has a fixed cost of $3 million? © 2009 Pearson Addison-Wesley. All rights reserved.