Oligopolies and monopolistic competition In between the two competition benchmarks

Oligopolies and monopolistic competition Today we finish examining the competition continuum we introduced last week After today, you will know all four of the main models used to explain the different market structures The two extreme benchmarks (previous weeks) The two “middle ground” models

Oligopolies and monopolistic competition The “competition continuum” Market power of firms Monopolistic competition Many firms with differentiated products Oligopoly A few producers with high market power Perfect competition Many firms with a homogeneous product Monopoly A single producer

Oligopolies and monopolistic competition Importantly, the two cases we see today are in the middle of the competition continuum They are more realistic that the extreme benchmarks of perfect competition and pure monopoly More “powerful” models in that they correspond better to the real world Unfortunately, this means that they are also more complex These models have required the development of new tools

Oligopolies and monopolistic competition

Oligopolies The oligopoly corresponds to the following market structure : A few large producers Homogeneous products No entry of competing producers on the market Perfect information Perfect mobility of inputs Apart from the few producers instead of one, this is not much different from the monopoly

Oligopolies Oligopolies are usually caused by the presence of barriers to entry which deter potential competitors. Institutional or regulatory barriers (Example: defence industry or utilities) The nature of the technology, which determines the existence of returns to scale and the minimal efficient scale of the firm (Example : Aeronautical industry) Absolute cost differentials: Vertical integration, access to an efficient supply or distribution network (example: agribusiness)

Oligopolies This is a common situation in many industries : Car industry, aeronautical industry Agribusiness (Nestlé, Danone, Kraft foods, Coca-Cola Co) Electronics, computing Utilities, buildings, etc. Compared to the monopoly case, each firm has an extra element to consider: The behaviour of its competitors (introduced last week) Because a firm’s output influences market prices, competitors will react This will lead to strategic behaviour

Oligopolies A simple solution for the market price and quantity is possible if the firms decide to cooperate. This cooperative equilibrium is called a cartel. OPEC is a good example: an organisation of independent producers, producing the same goods, who decide to coordinate their strategies, so as to limit their output and increase prices. The good news: When firms do this (ie maximise collective profit), they practise monopoly pricing and get monopoly profits. This means the simple monopoly model is enough The “bad” news: This practise is illegal in most countries! Also, there is an incentive to cheat. So usually, firms will not cooperate, and a more complex model is needed...

Oligopolies mCA The cooperative equilibrium ACA p mRA q G Price ACA Inverse demand facing firm A mRA q p G Quantity

Oligopolies When firms in an oligopoly do not cooperate, there is a non-cooperative equilibrium Compared to the monopoly and the cooperative cartel case, it becomes difficult to characterise the market equilibrium (equilibrium price and quantity) If a firm changes its output (price), this changes the market price, and the profits of competitors. They will react to this change in profits by changing their output (price). The optimal strategy of a firm depends on the strategies of its competitors. There are as many types of equilibria as there are combinations of strategies.

Leader/Follower setting Oligopolies As a simplification, economic theory typically examines the duopoly: The case with two producers on a market with barriers to entry There are many possible models of duopoly: Quantity competition Price competition Simultaneous setting Cournot duopoly Bertrand Leader/Follower setting Stackelberg duopoly Price leadership

Oligopolies The Cournot duopoly (1838) : Is the first and simplest model of a duopoly: each firm considers the output of its competitor as given The 2 firms simultaneously choose their output, and consider that the current output of their competitor will not change (not very realistic...)

Oligopolies The profits of the two firms is given by: For simplicity, we re-write them as: The cost of production depends only on the firm’s output The market price however, depends on the aggregate output q1 + q2

Oligopolies As for all firms, the maximum profit condition is given by the first order condition These first order conditions can be rearranged to give a system of equations known as reaction functions A reaction function tells you the quantity q1 that maximises the profits of firm 1 given the quantity q2 produced by firm 2

Oligopolies Reaction functions and Cournot equilibrium q2 Reaction function of firm 1 Reaction function of firm 2 C1 C0 C2 C3 C q*1 q*2 q1

Oligopolies The existence and the stability of an equilibrium in an oligopoly depends on the expectations that firms form about the strategies of their competitors Several different equilibria are possible depending on the various combinations of strategies formulated. Most often, the tools of classical economics cannot find these different equilibria... ...unless strong simplifying assumptions are made. See the Cournot example: “treat output as given” Game theory was developed as a response to this problem. This will be seen next week

Oligopolies and monopolistic competition

Monopolistic competition Monopolistic competition corresponds to the following market structure : Large number of agents (Atomicity) Differentiated products Free entry and exit from the market Perfect information Perfect mobility of inputs The output of each producer is slightly different from the others ⇒ existence of varieties (brands)

Monopolistic competition Because each firm produces a slightly different good, consumers can have preferences over these different varieties. There will be an element of “brand loyalty” in consumer behaviour, where one variety of a good will be preferred over another one. Examples: Corner shops, restaurants, hair dressers, travel agents, etc. Unfortunately, the algebra necessary to generate such “preference for variety” models is a bit complicated ⇒ We will only look at the diagrams

Monopolistic competition Each firm has a small amount of market power Because of “brand loyalty”, it can increase its price a bit without loosing all its customers (as is the case in perfect competition) The price elasticity of demand is not infinite The demand curve facing the firm is downward-sloping (not flat as in perfect competition) There will be a (small) mark-up: Price is above mC However, because firms can enter the market freely, economic profits are equal to zero in the long run

Monopolistic competition How does this work ? At the firm level, the short run equilibrium diagram looks like the monopoly diagram It also solves like a monopoly ⇒ short run profits The adjustment to the long run behaves like perfect competition: Extra firms enter the market, attracted by the profits The demand facing each firm decreases until profits are competed away

Monopolistic competition Firm-market equilibrium Firm level Market level Price Price mC Positive profits in the short run S AC p d mR D q quantity Q Quantity

Monopolistic competition Firm-market equilibrium Firm level Market level Price Price Positive profits attract firms to the market (free entry + perfect information) mC zero profits in the long run S AC S d mR p p2 D q2 q quantity Q Q2 Quantity

Monopolistic competition Long run welfare implications Price mC AC In the long run, Total revenue is equal to Total cost ⇒ Profits are equal to zero Demand mR p = AC Similar to perfect competition. An improvement on monopolies/oligopolies p q Quantity

Monopolistic competition Long run welfare implications Price mC AC Even in the long run, there is a mark-up p > mC Consumer surplus Demand mR This implies some deadweight loss q p Producer surplus Quantity

Monopolistic competition Long run welfare implications Price mC AC Firms are not producing at the minimum AC. There is excess capacity (i.e. some production resources are wasted) Demand mR q* p q Quantity

Monopolistic competition This model has a competitive limit The weaker the preferences of consumer for variety (the “brand loyalty”), the less market power the firms have and the closer the model predictions are to perfect competition The demand curve becomes flatter The mark-up and deadweight loss are reduced The equilibrium tends to P = mC = AC

Monopolistic competition The competitive limit Case 1 Case 2 Price Price mC mC AC AC p q q p d d mR mR quantity Quantity