Chapter 7.1 Monopolistic Competition and Oligopoly Chapter 7.1 Monopolistic Competition and Oligopoly

The Continuum of the Market Structure Perfect Competition n=infinity n=1 Monopoly n large Monopolistic Competition n small Oligopoly No of firms, n

MONOPOLISTIC COMPETITION Assumptions of monopolistic competition Each firm sells a different variety or brand (think of coke or restaurants) There are many firms – –Act independently – ignore others’ reactions Freedom of Entry and Exit There is Symmetry – –New firms affect all old ones equally Assumptions of monopolistic competition Each firm sells a different variety or brand (think of coke or restaurants) There are many firms – –Act independently – ignore others’ reactions Freedom of Entry and Exit There is Symmetry – –New firms affect all old ones equally

MONOPOLISTIC COMPETITION Equilibrium: – –short run Equilibrium: – –short run

Suppose we consider the case of demand for eating out. £ Q O PsPs QsQs The ‘Industry’ Demand Curve looks like this

Suppose we consider the case of demand for eating out. £ Q O PsPs QsQs What about an individual restaurant? It is further in and flatter Why?

Suppose we consider the case of demand for eating out. £ Q O PsPs QsQs Each restaurant type has a share of the industry But knows that it can only vary its price a little

Suppose we consider the case of demand for eating out. £ Q O PsPs QsQs What if a new competitor appears? Demand line shifts in more and flattens more Getting closer and closer to Perfect Competition

£ Q O PsPs QsQs So now suppose we have a firm like the blue line … and this restaurant is doing well in the short-run

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

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

£ Q O AC MR AR  D PsPs QsQs MC AC s Short-run equilibrium of the firm under monopolistic competition

£ Q O AC MR AR  D PsPs QsQs MC AC s Short-run equilibrium

£ 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

£ 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

£ 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 (=D) curve still slopes downAR (=D) curve still slopes down So not in perfectly competitive caseSo not in perfectly competitive case Firms have market power (can choose price and quantity), but….Firms have market power (can choose price and quantity), but…. Competition is such that this power is illusory (in the long run)Competition is such that this power is illusory (in the long run)

MONOPOLISTIC COMPETITION Limitations of the model – –imperfect information about profits and demand – –difficulty in identifying industry demand curve – –indivisibilities/local monopolies – –importance of non-price competition   Variety   Advertising Limitations of the model – –imperfect information about profits and demand – –difficulty in identifying industry demand curve – –indivisibilities/local monopolies – –importance of non-price competition   Variety   Advertising

MONOPOLISTIC COMPETITION The public interest –comparison with perfect competition; PRODUCTION WILL NOT OCCUR WHERE LRAC IS AT ITS MINIMUM (unlike perfect competition which is efficient)

Long run equilibrium under perfect and monopolistic competition (with decreasing or constant returns to scale) £ Q O P1P1 LRAC D L under perfect competition Q1Q1

Long run equilibrium under perfect and monopolistic competition (with decreasing or constant returns to scale) £ Q O P2P2 P1P1 LRAC D L under perfect competition D L under monopolistic competition Q2Q2 Q1Q1

The Continuum of the Market Structure Perfect Competition n=infinity n=1 Monopoly n large Monopolistic Competition n small Oligopoly No of firms, n

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

Day 1: Suppose initially Monopoly firm in the Industry £ O Q D To make life simple suppose P=200-Q is the demand curve

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

Suppose initially Monopoly firm in the Industry £ O Q D P=200-Q TR= P*Q TR=[200-Q]*Q TR=200Q-Q 2 MR=200-2Q 200

Suppose initially Monopoly firm in the Industry £ O Q D P=200-Q TR= P*Q TR=[200-Q]*Q TR=200Q-Q 2 MR=200-2Q 200 MR 100 If MR = 0, 200=2Q MC

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

Suppose initially Monopoly firm in the Industry £ O Q D So monopolist supplies half the market in this case (Linear demand, MC=0) 200 MR 100 MC P=100

Day 2: Harmony is broken! Suppose now a new firm notices there are 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? MR 0 MC P=100 MC 2 It thinks it has demand P=100-Q MR=100-2Q It is just looking at this bit of the market Setting MC = MR =0 100=2Q Q=50

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=100 MC 2

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=

Day 3: The reckoning £ O Q D And MR is now MR=150-2Q So when MR=MC=0 Q= 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=

Day 4: The Mob Strikes BACK £ O Q D And MR is now MR=125-2Q So when MR=MC=0 Q= MR 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 MC P= If each firm sees that people are already being supplied, then it sees its market as P=200-Q –66.66 P= Q

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 EQUILIBRIUM (Cournot equilibrium)EQUILIBRIUM (Cournot equilibrium)

What do we learn from this story?What do we learn from this story? With a small number of firms, one firm’s actions directly affects the other.With a small number of firms, one firm’s actions directly affects the other. Where the number of firms are small, the firms will think strategically!!Where the number of firms are small, the firms will 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

Indeed:Indeed: Firms wouldn’t go through this tortuous process, they would figure out the situation pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium.Firms wouldn’t go through this tortuous process, they would figure out the situation pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium. Called Cournot Competition (competing over market share - Quantities)Called Cournot Competition (competing 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 =1/2 of 200=100Under Monopoly Firm 1 with a linear demand curve Zero MC supplied half the market, that is Q 1 =1/2 of 200=100 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 moves the economy closer to perfect competition as compared with monopolySo oligopoly moves the economy closer to perfect competition as compared with monopoly

Cournot: 1 firm supplies ½ of market1 firm supplies 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

£ O Q D 200 MR 1 = MR MC P= Profits Under Cournot P= 200-2(66.66)= = = Industry Profits=2(TR-TC) =2{66.66(66.66)}= But under Monopoly p=100; Q=100 and Profits = 100*100 =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: Collusion D 1 =D 2 Profits Under Cournot: 8,888 Profits under monopoly: 10,000

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 Factors favouring collusionFactors favouring collusion Collusive oligopoly: cartelsCollusive oligopoly: cartels –equilibrium of the industry

OLIGOPOLY Key features of oligopolyKey features of oligopoly –barriers to entry –interdependence of firms –incentives to compete versus incentives to collude Factors favouring collusionFactors favouring collusion Collusive oligopoly: cartelsCollusive oligopoly: cartels –Join forces and act collectively as a monopoly –allocating and enforcing quotas