Chapter 7

The Continuum of the Market Structure Perfect Competition n=infinity n=1 Monopoly n large Imperfect Competition n= small 2 ~ 8 firms OLIGOPOLY No of firms, n

MONOPOLISTIC COMPETITION Assumptions of monopolistic competition Each firm selling a different variety or brand There are many firms – –Act independently – ignore others REACTIONS Equilibrium of the firm Freedom of Entry and Exit There is Symmetry – –New firms affect all old ones equally Assumptions of monopolistic competition Each firm selling a different variety or brand There are many firms – –Act independently – ignore others REACTIONS Equilibrium of the firm Freedom of Entry and Exit There is Symmetry – –New firms affect all old ones equally

Suppose we consider the case of demand for eating out. £ Q O PsPs QsQs

Let’s make the Balti picture bigger £ Q O AC MR AR  D PsPs QsQs MC

£ Q O AC MR D QsQs MC AC s What happens now? New Firms enter What happens to D? So P and Q down P1P1 D1D1 MR 1

£ Q O AC MR D QsQs MC AC s What happens now? New Firms enter What happens to D? So P and Q down And Super- normal Profits down

What Happens Next? Still Super-Normal ProfitsStill Super-Normal Profits So firms keep enteringSo firms keep entering P keeps falling and Super-normal profits keep falling until….P keeps falling and Super-normal profits keep falling until…. In the LRIn the LR AR = AC and there are no supernormal profitsAR = AC and there are no supernormal profits

£ Q O LRAC MR L AR L  D L PLPL QLQL LRMC Long-run equilibrium of the firm under monopolistic competition

NOTICE: AR or D curve still slopes downAR or D curve still slopes down So not in perfect competition caseSo not in perfect competition case Still believe have some market power over price and quantityStill believe have some market power over price and quantity But….But…. Competition from new entrants is such that such power is short livedCompetition from new entrants is such that such power is short lived

MONOPOLISTIC COMPETITION Assumptions of monopolistic competition Equilibrium of the firm – –short run – –long run – –under-utilisation of capacity in long run Assumptions of monopolistic competition Equilibrium of the firm – –short run – –long run – –under-utilisation of capacity in long run

Under-utilisation of capacity in the long run £ Q O LRAC D L under monopolistic competition Q1Q1

MONOPOLISTIC COMPETITION Limitations of the model – –imperfect information about profits and demand – –difficulty in identifying industry demand curve – –entry may not be totally free – –Indivisibilities/local monopolies – –importance of non-price competition Limitations of the model – –imperfect information about profits and demand – –difficulty in identifying industry demand curve – –entry may not be totally free – –Indivisibilities/local monopolies – –importance of non-price competition The public interest –comparison with perfect competition –comparison with monopoly

Long run equilibrium of the firm under perfect and monopolistic competition £ Q O P1P1 LRAC D L under perfect competition Q1Q1

OLIGOPOLY Key features of oligopolyKey features of oligopoly –barriers to entry –interdependence of firms~What’s s/he up to? –incentives to compete versus incentives to collude

Suppose initially Monopoly firm in the Industry £ O Q D To make life simple suppose P=200-Q is the demand curve, And MC are zero What is the MR curve? 200

P=200-Q TR= P.Q TR= MR= Econ 106D exercise check result using chain rule with u=200-Q and v=Q

Suppose initially Monopoly firm in the Industry £ O Q D What quantity will this firm supply to the market? MR=MC at Q= P=200-Q P = 200 MR 100 MC P=100

Day 2: Harmony is broken! Suppose now a new firm notices there are 100 unfulfilled customers £ O Q D What will new firm do? 200 MR 100 MC P=100

Suppose now a new firm notices there are unfulfilled customers £ O Q D What will new firm do? 200 MR 100 MC P=100 MC 2 It thinks it has demand P=100-Q MR=100-2Q

Suppose now a new firm notices there are unfulfilled customers Q D What will new firm do? 100 MR 0 MC P=100 MC 2 It thinks it has demand P= MR=

So now firm 1 is supplying 100 unitsSo now firm 1 is supplying 100 units And firm 2 is supplying 50 UnitsAnd firm 2 is supplying 50 Units Will firm 1 accept that?Will firm 1 accept that? How will it react?How will it react?

Day 3: The reckoning £ O Q D Firm 1 sees that 50 people are already being supplied. So its market is P=200-Q –50 P=150-Q 200 MR 100 MC P=

Firm 1 was supplying 100 unitsFirm 1 was supplying 100 units Is Now Supply 75 unitsIs Now Supply 75 units Firm 2 is still producing 50 unitsFirm 2 is still producing 50 units How will firm 2 react to the cut in firm 1’s production?How will firm 2 react to the cut in firm 1’s production?

This is essentially the story now £ O Q Market D Firm 1 Supplies 75 Firm 2 Supplies 50 But now Firm 2 sees that there are 125 unsatisfied consumers 200 MR MC P=100 MC 2 MR 2 D1D1 D1D1 D2D2

Day 4: The Mob Strikes BACK £ O Q D Firm 2 sees that 75 people are already being supplied. So its market now is P=200-Q –75 P=125-Q 200 MR 100 MC P=

Firm 1 was supplying 100 unitsFirm 1 was supplying 100 units Firm 1 Is Now producing 75 unitsFirm 1 Is Now producing 75 units Firm 2 was producing 50 unitsFirm 2 was producing 50 units Firm 2 is now Producing 62.5 unitsFirm 2 is now Producing 62.5 units Firm 1’s Q is going down as Firm 2 goes UpFirm 1’s Q is going down as Firm 2 goes Up Firm 2’s Q is going Up as Firm 1 goes downFirm 2’s Q is going Up as Firm 1 goes down When will equilibrium occur?When will equilibrium occur?

Armageddon £ O Q D And MR is now MR= Q So when MR=MC=0 Q= MR 1 = MR MC P= If each firm sees that people are already being supplied, then P= Q D 1 =D 2

Firm 1 fall from supplying 100 units to unitsFirm 1 fall from supplying 100 units to units Firm 2 rises from supplying 0 units to unitsFirm 2 rises from supplying 0 units to units Given that firm 1 is supplying units firm 2’s best response is unitsGiven that firm 1 is supplying units firm 2’s best response is units Given that firm 2 is supplying units firm 1’s best response is unitsGiven that firm 2 is supplying units firm 1’s best response is units EQUILIBRIUMEQUILIBRIUM

What do we learn form this story?What do we learn form this story? Small number of firms, one firms actions affects the other.Small number of firms, one firms actions affects the other. Where the number of firsm are small we have to think strategically!!Where the number of firsm are small we have to think strategically!! What is the other guy (male or female) up to!What is the other guy (male or female) up to! How will they react to my actionsHow will they react to my actions Will see more stories later.Will see more stories later.

Note:Note: Firms wouldn’t go through this tortuous process, they would more likely figure out the situation pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium pretty quickly.Firms wouldn’t go through this tortuous process, they would more likely figure out the situation pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium pretty quickly. Called Cournot CompetitionCalled Cournot Competition Competing over market share – QuantitiesCompeting over market share – Quantities Can also model price competition- BertrandCan also model price competition- Bertrand

Comparison of Cournot with Perfect Compt. and Monopoly Under Monopoly Firm 1 with a linear demand curve Zero MC supplied half the market, that is Q 1 =100=1/2of 200.Under Monopoly Firm 1 with a linear demand curve Zero MC supplied half the market, that is Q 1 =100=1/2of 200. Here with 2 firms each supply 1/3 of 200, that is, and total output = Here with 2 firms each supply 1/3 of 200, that is, and total output = Under perfect competition MC = 0 would produce at Q = 200Under perfect competition MC = 0 would produce at Q = 200 So oligopoly moving you closer to Perfect competition compared with monopolySo oligopoly moving you closer to Perfect competition compared with monopoly

Cournot: 1 firm supply ½ of market1 firm supply ½ of market 2 firms supply 1/3 market each, 2/3 overall.2 firms supply 1/3 market each, 2/3 overall. What about 3 firms?What about 3 firms? 3 firms supply 1/4 market each, 3/4 overall.3 firms supply 1/4 market each, 3/4 overall...and 4 firms?..and 4 firms? 4 firms supply 1/5 market each, 4/5 overall.4 firms supply 1/5 market each, 4/5 overall. N firms, supply 1/(n+1) of market each, n/(n+1) overallN firms, supply 1/(n+1) of market each, n/(n+1) overall So more firms getting closer and closer to perfect competitionSo more firms getting closer and closer to perfect competition

Reading:Reading: Lipsey and Chrystal: Positive EconomicsLipsey and Chrystal: Positive Economics –Ch 14 Appendix p th Edition

£ O Q D 200 MR 1 = MR MC P= Profits Under Cournot P= 200-2(66.66)= P= = Industry Profits=2{TR-TC} = 2{66.66 (66.66)-0}= But under Monopoly p=100; Q=100 and Profits = 10,000 D 1 =D 2

£ O Q D 200 MR 1 = MR MC P= So two firms would be better off if they could get together and agree to limit market: So get Collusion or a CARTEL D 1 =D 2