Chapter 12 Monopolistic Competition and Oligopoly

Chapter 12Slide 2 Monopolistic Competition Characteristics 1)Many firms 2)Free entry and exit 3)Differentiated product

Chapter 12Slide 3 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

A Monopolistically Competitive Firm in the Short and Long Run Quantity $/Q Quantity $/Q MC AC MC AC D SR MR SR D LR MR LR Q SR P SR Q LR P LR Short RunLong Run

Deadweight loss MCAC Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium $/Q Quantity $/Q D = MR QCQC PCPC MCAC D LR MR LR Q MC P Quantity Perfect Competition Monopolistic Competition

Chapter 12Slide 6 Oligopoly Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry

Chapter 12Slide 7 Oligopoly The barriers to entry are: Natural  Scale economies  Patents  Technology  Name recognition

Chapter 12Slide 8 Oligopoly The barriers to entry are: Strategic action  Flooding the market  Controlling an essential input

Chapter 12Slide 9 Oligopoly Management Challenges Strategic actions Rival behavior Question What are the possible rival responses to a 10% price cut by Ford?

Chapter 12Slide 10 Oligopoly Equilibrium in an Oligopolistic Market In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price. In oligopoly the producers must consider the response of competitors when choosing output and price.

Chapter 12Slide 11 Oligopoly Equilibrium in an Oligopolistic Market Defining Equilibrium  Firms do the best they can and have no incentive to change their output or price  All firms assume competitors are taking rival decisions into account.

Chapter 12Slide 12 Oligopoly Nash Equilibrium Each firm is doing the best it can given what its competitors are doing.

Chapter 12Slide 13 Oligopoly The Cournot Model Duopoly  Two firms competing with each other  Homogenous good  The output of the other firm is assumed to be fixed  Firms decide simultaneously how much to produce

Chapter 12Slide 14 MC 1 50 MR 1 (75) D 1 (75) 12.5 If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. Firm 1’s Output Decision Q1Q1 P1P1 D 1 (0) MR 1 (0) If Firm 1 thinks Firm 2 will produce nothing, its demand curve, D 1 (0), is the market demand curve. D 1 (50)MR 1 (50) 25 If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount.

Chapter 12Slide 15 Firm 2’s Reaction Curve Q 2 *(Q 1 ) Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Reaction Curves and Cournot Equilibrium Q2Q2 Q1Q Firm 1’s Reaction Curve Q* 1 (Q 2 ) x x x x 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 example. In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits. Cournot Equilibrium

Chapter 12Slide 16 Oligopoly Questions 1)If the firms are not producing at the Cournot equilibrium, will they adjust until the Cournot equilibrium is reached? 2)When is it rational to assume that a competitor’s output is fixed?

Chapter 12Slide 17 Oligopoly An Example of the Cournot Equilibrium Duopoly  Market demand is P = 30 - Q where Q = Q 1 + Q 2  MC 1 = MC 2 = 0 The Linear Demand Curve

Chapter 12Slide 18 Oligopoly An Example of the Cournot Equilibrium Firm 1’s Reaction Curve The Linear Demand Curve

Chapter 12Slide 19 Oligopoly An Example of the Cournot Equilibrium The Linear Demand Curve

Chapter 12Slide 20 Oligopoly An Example of the Cournot Equilibrium The Linear Demand Curve

Chapter 12Slide 21 Duopoly Example Q1Q1 Q2Q2 Firm 2’s Reaction Curve Firm 1’s Reaction Curve Cournot Equilibrium The demand curve is P = 30 - Q and both firms have 0 marginal cost.

Chapter 12Slide 22 Oligopoly Profit Maximization with Collusion

Chapter 12Slide 23 Oligopoly Contract Curve Q 1 + Q 2 = 15  Shows all pairs of output Q 1 and Q 2 that maximizes total profits Q 1 = Q 2 = 7.5  Less output and higher profits than the Cournot equilibrium Profit Maximization with Collusion

Chapter 12Slide 24 Firm 1’s Reaction Curve Firm 2’s Reaction Curve Duopoly Example Q1Q1 Q2Q Cournot Equilibrium 15 Competitive Equilibrium (P = MC; Profit = 0) Collusion Curve 7.5 Collusive Equilibrium For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium

Chapter 12Slide 25 First Mover Advantage-- The Stackelberg Model Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q = total output Firm 1 sets output first and Firm 2 then makes an output decision

Chapter 12Slide 26 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: Q 2 = /2Q 1 First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 27 Firm 1 Choose Q 1 so that: First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 28 Substituting Firm 2’s Reaction Curve for Q 2 : First Mover Advantage-- The Stackelberg Model

Chapter 12Slide 29 Conclusion Firm 1’s output is twice as large as firm 2’s Firm 1’s profit is twice as large as firm 2’s Questions Why is it more profitable to be the first mover? Which model (Cournot or Stackelberg) is more appropriate? First Mover Advantage-- The Stackelberg Model