CHAPTER 12 Imperfect Competition

The profit-maximizing output for the monopoly 2 If there are no other market entrants, the entrepreneur can earn monopoly profits that are equal to the area dcba. Quantity 0 Price, Cost AC MC D MR c a b d

Chapter Preview Most markets fall in between perfect competition and monopoly. An oligopoly is a market with only a few firms, and their behavior is interdependent. There is no one oligopoly model. In general we want to consider: Short run: pricing and output decision of the firms. Long run: advertising, product development. Very long run: entry and exit.

Pricing of Homogeneous Products: An Overview Price Quantity per week D MR MC = AC Q PC PMPM P PC QMQM Perfect competition and the Bertrand model (firms choose prices). Monopoly and the perfect cartel outcome. Cournot outcome (firms choose output).

Pricing of Homogeneous Products: An Overview So in an oligopoly there can be a variety of outcomes: If the firms act as a cartel, get the monopoly solution. If the firms choose prices simultaneously, get the competitive solution. If the firms choose output simultaneously get some outcome between perfect competition and monopoly.

Cournot Theory of Duopoly & Oligopoly Cournot model Two firms Choose quantity simultaneously Price - determined on the market Cournot equilibrium Nash equilibrium 6

The demand curve facing firm 1 7 Quantity 0 Price, Cost MC MR M D M (q 1 ) A D 1 (q 1,q 2 ) A-bq 2 q12q12 q11q11 D 2 (q 1,q 2 ’) A-bq 2 ’ MR 1 MR 2 q 1 declines as firm 2 enters the market and expands its output qMqM P=A-b(q1+q2)

Profit Maximization in a duopoly market Inverse demand function – linear P=A-b(q1+q2) Maximize profits π 1 = [A-b(q 1 +q 2 )]·q 1 - C(q 1 ) π 2 = [A-b(q 1 +q 2 )]·q 2 - C(q 2 ) 8

Reaction functions (best-response) Profit maximization: Set MR=MC MR now depends on the output of the competing firm Setting MR1=MC1 gives a reaction function for firm 1 Gives firm 1’s output as a function of firm 2’s output

Reaction functions (best-response) 10 Given firm 2’s choice of q 2, firm 1’s optimal response is q 1 =f 1 (q 2 ). Output of firm 1 (q 1 ) 0 Output of firm 2 (q 2 ) q 1 =f 1 (q 2 )

Reaction Functions Points on reaction function Optimal/profit-maximizing choice/output Of one firm To a possible output level – other firm Reaction functions q 1 = f 1 (q 2 ) q 2 = f 2 (q 1 ) 11

Reaction functions (best-response) 12 Given firm 1’s choice of q 1, firm 2’s optimal response is q 2 =f 2 (q 1 ). Output of firm 1 (q 1 ) 0 Output of firm 2 (q 2 ) q 2 =f 2 (q 1 )

Alternative Derivation -Reaction Functions Isoprofit curves Combination of q1 and q2 that yield same profit Reaction function (firm 1) Different output levels – firm 2 Tangency points – firm 1 13

Reaction Function 14 Output of firm 1 (q 1 ) 0 Output of firm 2 (q 2 ) x y q’ 2 q2q2 q1q1 q’ 1 Firm 1’s Reaction Function q1mq1m

Deriving a Cournot Equilibrium Cournot equilibrium Intersection of the two Reaction functions Same graph 15