Monopolistic Competition and Oligopoly Chapter 12 Monopolistic Competition and Oligopoly

Topics to be Discussed Monopolistic Competition Oligopoly Price Competition Chapter 12 2

Monopolistic Competition Characteristics Many firms Free entry and exit Differentiated product Chapter 12 4

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 Chapter 12 5

Monopolistic Competition 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 Chapter 12 6

Monopolistic Competition Two important characteristics Differentiated but highly substitutable products Free entry and exit Chapter 12 7

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 12

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 Chapter 12 13

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 Chapter 12 14

Monopolistically and Perfectly Competitive Equilibrium (LR) Perfect Competition Monopolistic Competition $/Q $/Q Deadweight loss MC AC MC AC DLR MRLR QMC P QC PC D = MR Quantity Quantity 17

Monopolistic Competition and Economic Efficiency The monopoly power yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle – deadweight loss. With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12 18

Monopolistic Competition and Economic Efficiency Firm faces downward sloping demand so zero profit point is to the left of minimum average cost Excess capacity is inefficient because average cost would be lower with fewer firms Chapter 12

Monopolistic Competition If inefficiency is bad for consumers, should monopolistic competition be regulated? Market power is relatively small. Usually there are enough firms to compete with enough substitutability between firms – deadweight loss small. Inefficiency is balanced by benefit of increased product diversity – may easily outweigh deadweight loss. Chapter 12 20

The Market for Colas and Coffee Each market has much differentiation in products and tries to gain consumers through that differentiation Coke vs. Pepsi Maxwell House vs. Folgers How much monopoly power do each of these producers have? How elastic is demand for each brand? Chapter 12 21

Elasticities of Demand for Brands of Colas and Coffee Chapter 12 22

The Market for Colas and Coffee The demand for Royal Crown is more price inelastic than for Coke There is significant monopoly power in these two markets The greater the elasticity, the less monopoly power and vice versa Chapter 12 23

Oligopoly – Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry Scale economies Patents Technology Name recognition Strategic action Chapter 12 24

Oligopoly Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment Chapter 12 25

Oligopoly Management Challenges Strategic actions to deter entry Threaten to decrease price against new competitors by keeping excess capacity Rival behavior Because only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react Chapter 12 28

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 Chapter 12 29

Oligopoly – Equilibrium 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 Chapter 12 30

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 Chapter 12 32

Firm 1’s Output Decision MR1(0) Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing. D1(50) MR1(50) 25 If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. MR1(75) D1(75) 12.5 If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MC1 50 Q1 Chapter 12 38

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 Chapter 12 39

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(Q1) 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 Chapter 12 43

Reaction Curves and Cournot Equilibrium 100 In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits. 75 Firm 2’s Reaction Curve Q*2(Q1) 50 x Cournot Equilibrium Firm 1’s Reaction Curve Q*1(Q2) x 25 x x Q2 25 50 75 100 Chapter 12 43

Cournot Equilibrium Each firm’s reaction curve tells it how much to produce given the output of its competitor Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly Chapter 12

Oligopoly Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium) The Cournot equilibrium says nothing about the dynamics of the adjustment process Since both firms adjust their output, neither output would be fixed Chapter 12 44

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 Chapter 12 4 45

Oligopoly Example Firm 1’s Reaction Curve  MR = MC Chapter 12 4 46

Oligopoly Example An Example of the Cournot Equilibrium 4 47 Chapter 12 4 47

Oligopoly Example An Example of the Cournot Equilibrium 4 48 Chapter 12 4 48

The demand curve is P = 30 - Q and both firms have 0 marginal cost. Duopoly Example Q1 The demand curve is P = 30 - Q and both firms have 0 marginal cost. Firm 2’s Reaction Curve 30 15 10 Cournot Equilibrium Firm 1’s Reaction Curve 15 30 Q2 Chapter 12 54

Oligopoly Example Profit Maximization with Collusion Chapter 12 4 55

Profit Maximization w/ Collusion Collusion Curve Q1 + Q2 = 15 Shows all pairs of output Q1 and Q2 that maximize total profits Q1 = Q2 = 7.5 Less output and higher profits than the Cournot equilibrium Chapter 12 4 56

Duopoly Example Q1 30 15 10 7.5 For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium Firm 2’s Reaction Curve 15 Competitive Equilibrium (P = MC; Profit = 0) 10 Cournot Equilibrium Firm 1’s Reaction Curve Collusion Curve 7.5 Collusive Equilibrium 30 Q2 Chapter 12 54

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’s output Chapter 12 58

First Mover Advantage – The Stackelberg Model 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) Chapter 12 59

First Mover Advantage – The Stackelberg Model Firm 1 Choose Q1 so that: Firm 1 knows Firm 2 will choose output based on its reaction curve. We can use Firm 2’s reaction curve as Q2 . Chapter 12 60

First Mover Advantage – The Stackelberg Model Using Firm 2’s Reaction Curve for Q2: Chapter 12 61

First Mover Advantage – The Stackelberg Model Conclusion Going first gives Firm 1 the advantage Firm 1’s output is twice as large as Firm 2’s Firm 1’s profit is twice as large as Firm 2’s Going first allows Firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless it wants to reduce profits for everyone. Chapter 12 62

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 Chapter 12 63

Price Competition – Bertrand Model 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 profit of $81. Chapter 12 64

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 Chapter 12 64

Price Competition – Bertrand Model 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 Chapter 12 65

Price Competition – Bertrand Model Why not charge a different price? If charge more, sell nothing If charge less, lose money on each unit sold The Bertrand model demonstrates the importance of the strategic variable Price versus output Chapter 12 66

Bertrand Model – Criticisms When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices Even if the firms do set prices and choose the same price, what share of total sales will go to each one? It may not be equally divided Kreps and Scheinkman Chapter 12 69

Price Competition – Differentiated Products Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product In these markets, more likely to compete using price instead of quantity Chapter 12 70

Price Competition – Differentiated Products Example Duopoly with fixed costs of $20 but zero variable costs Firms face the same demand curves Firm 1’s demand: Q1 = 12 - 2P1 + P2 Firm 2’s demand: Q2 = 12 - 2P1 + P2 Quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price Chapter 12 71

Price Competition – Differentiated Products Firms set prices at the same time Chapter 12 72

Price Competition – Differentiated Products If P2 is fixed: Chapter 12 73