Monopolistic Competition and Oligopoly Chapter 10

Monopolistic Competition Characteristics Many firms Free entry and exit Differentiated product The amount of monopoly power depends on the degree of differentiation. Examples of this very common market structure include: Toothpaste Soap Cold remedies

Two important characteristics 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. Two important characteristics Differentiated but highly substitutable products Free entry and exit

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

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

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

Oligopoly – Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry Scale economies Patents Technology Name recognition Strategic action Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment

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 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

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 ● reaction curve Relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce. ● Cournot equilibrium Equilibrium in the Cournot model in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.

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.

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

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

Oligopoly Example Total revenue for firm 1: R1 = PQ1 = (30 –Q)Q1 then MR1 = ∆R1/∆Q1 = 30 – 2Q1 –Q2 Setting MR1 = 0 (the firm’s marginal cost) and solving for Q1, we find Firm 1’s reaction curve: By the same calculation, Firm 2’s reaction curve: Cournot equilibrium: Total quantity produced:

Oligopoly Example If the two firms collude, then the total profit-maximizing quantity can be obtained as follows: Total revenue for the two firms: R = PQ = (30 –Q)Q = 30Q – Q2, then MR = ∆R/∆Q = 30 – 2Q Setting MR = 0 (the firms’ marginal cost) we find that total profit is maximized at Q = 15. Then, Q1 + Q2 = 15 is the collusion curve. If the firms agree to share profits equally, each will produce half of the total output: Q1 = Q2 = 7.5

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 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)

Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react. P = 30 – Q Also, MC1 = MC2 = 0 Firm 2’s reaction curve: Firm 1’s revenue: And MR1 = ∆R1/∆Q1 = 15 – Q1 Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5 We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much profit. Going first gives Firm 1 an advantage.

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 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.

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 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

Price Competition – Differentiated Products Firms set prices at the same time If P2 is fixed:

In our example, there are two firms, each of which has fixed costs of $20 and zero variable costs. They face the demand curves: Firm 1’s demand: Firm 2’s demand: We found that in Nash equilibrium each firm will charge a price of $4 and earn a profit of $12, whereas if the firms collude, they will charge a price of $6 and earn a profit of $16. But if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2’s profit will increase to $20. And it will do so at the expense of Firm 1’s profit, which will fall to $4.

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

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. 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

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 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.

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

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