1. UNIT III: MONOPOLY & OLIGOPOLY Monopoly Oligopoly Strategic Competition 7/8

2. Monopoly Market Structure Monopoly Multiplant Monopoly: 1 Firm – 2 Plants Price Discrimination: 1 Firm – 2 Markets Next Time: Review

3. Market Structure So far, we have looked at how consumers and firms make optimal decisions (maximize utility and profits) under constraint. Then we looked at how those individual decisions are coordinated via the market. Under Perfect Competition, we assume an infinite number of infinitely small price-takers, and we know that the competitive market equilibrium is Pareto-efficiency. Now want to consider other market structures (e.g., monopoly; duopoly) and characterize the corresponding equilibria; what are the welfare consequences of these market structures?

4. Market Structure Market structure is related to market concentration and competitiveness. Perfect Competition is a polar case (low conc; high comp), where rational decision-making at the individual level (consumer; firm) adds up to optimal outcomes at the social level – The Invisible Hand Theorem of Welfare Economics. Once we move away from the perfect case, firms can exploit market power: their behavior can influence prices (and profits). Monopoly is the case where a single firm has market power. Later we will consider what happens when several firms have power in the market (oligopoly). Here, competitive strategy comes to the fore.

5. Market Structure Perfect Comp Oligopoly Monopoly No. of Firms infinite (>)2 1 Optimality MR = MC = P ??? MR = MC < P ProfitNo ? Yes Efficiency Yes ? ???

6. Market Structure Firms are price-takers: can sell all the output they want at P*; can sell nothing at any price > P*. Homogenous product: e.g., wheat, t-shirts, long- distance phone minutes Perfect factor mobility: in the long run, factors can move costlessly to where they are most productive (highest w, r). Perfect Information: firms know everything about costs, consumer demand, other profitable opportunities, etc. Perfect Competition

7. Market Structure Firms are price-setters: one firm supplies entire market, faces downward-sloping demand curve. Homogenous product: necessarily so for a single firm. Barriers to entry: no perfect factor mobility. E.g., patents; licenses; franchises. Perfect Information: firms know everything about costs, consumer demand, other profitable opportunities, etc. Monopoly

8. Barriers to Entry: The number of firms is determined by entry conditions. As we have learned, profits are the incentive for entry. The only way a firm can remain profitable (and a monopoly) is if there are very strong barriers to entry, or if the market is too small for a second firm. Some of these barriers are natural (technology) Some are created by regulators (franchise, license) Some are created by the monopolist to deter entry by potential rivals (competitive strategy)

9. Monopoly Remember that a perfectly competitive firm can sell all it wants at the market price. This means that any time it wants to increase revenues, it needs only to produce more output. For this reason in perfect competition marginal revenue and price were equal, MC = MR = P. Since a monopolist necessarily faces the entire market demand, it faces a downward sloping demand curve. This means that, if the firm wishes to increase output it must lower price. If it wishes to raise its price, it must decrease its output. As it turns out this means that, for a monopolist marginal revenue is different from market price, MC = MR < P.

10. Monopoly Marginal Revenue the additional revenue from a unit increase in output. Remember, the firm must sell it’s entire output at the same price. Therefore, marginal revenue will be the price of that extra unit minus the change in revenue on all earlier (inframarginal) units MR = dTR/dQ = d(PQ)/dQ = P + Q(dP/dQ) = P + P(Q/P)(dP/dQ)= = P[1 + Q/P(dP/dQ)] = P(1 + 1/E) dP/dQ is neg, for downward sloping demand curve

11. Monopoly Marginal Revenue the additional revenue from a unit increase in output. Remember, the firm must sell it’s entire output at the same price. Therefore, marginal revenue will be the price of that extra unit minus the change in revenue on all earlier (inframarginal) units MR = dTR/dQ = d(PQ)/dQ = P + Q(dP/dQ) = P + P(Q/P)(dP/dQ)= = P[1 + Q/P(dP/dQ)] = P(1 + 1/E) E = P/Q(dQ/dP) price elasticity of demand

12. Monopoly Marginal Revenue the additional revenue from a unit increase in output. Remember, the firm must sell it’s entire output at the same price. Therefore, marginal revenue will be the price of that extra unit minus the change in revenue on all earlier (inframarginal) units MR = dTR/dQ = d(PQ)/dQ = P + Q(dP/dQ) = P + P(Q/P)(dP/dQ)= = P[1 + Q/P(dP/dQ)] = P(1 + 1/E) > -1; MR < 0 E = -1; MR = 0 0

13. $$$$ TR D: P = MR Q Q Monopoly Price-TakerPrice-Setter D: P = AR Q Q E > -1 (Elastic) E < -1 (Inelastic)

14. $$$$ D Q Q Monopoly TR = PQ Price-TakerPrice-Setter D: P = AR Q Q o Q 1 Q 2 Q P0P1P2P1Q1P2Q2P0Q0P0P1P2P1Q1P2Q2P0Q0 TR

15. $$$$ D: P = AR = MR Q Q Monopoly TR Price-TakerPrice-Setter D: P = AR Q Q MR MR > 0 (Elastic) MR < 0 (Inelastic)

16. $$$$ TR D: P = AR = MR Q Q AC Monopoly TR D: P = AR Q Q A monopolist will never produce at an inelastic portion of the demand curve MR > 0 (Elastic) MR < 0 (Inelastic)

17. Multiplant Monopolist Now consider a monopolist who operates several plants. Plant A Plant B Market q a q q b q Q $ mc a mc b Q = q a + q b D MR

18. Multiplant Monopolist Now consider a monopolist who operates several plants. Plant A Plant B Market q a q q b q Q Q $P$P mc a MC mc b MR D MC a = MC b = MR Not to scale

19. Perfect Competition Competitive equilibrium. Firms are producing at the efficient scale. P* = ac min ;  = 0. $ P* q* q Q* Q $ LRS mc ac D What would happen if a monopolist owned all the plants?

20. Multiplant Monopolist Monopoly equilibrium. Prices rise, total market quantity falls … $ P m P* q* q Q m Q* Q $ mc ac D MCsr Not to scale

21. Multiplant Monopolist Monopoly equilibrium. Plants are producing at less than efficient scale. P* > AC min ;  > 0. $ P m P* q m q* q Q m Q* Q $ mc ac D There is no supply curve (Q = f(P)) for a monopolist Not to scale MR

22. Multiplant Monopolist Monopply equilibrium. Plants are producing at less than efficient scale. P* > AC min ;  > 0. $ P m P* q m q* q Q m Q* Q $ mc ac D Not to scale Profit MCsr

23. Multiplant Monopolist Monopoly equilibrium. Plants are producing at less than efficient scale. P* > AC min ;  > 0. $ P m P* q m q* q Q m Q* Q $ mc ac D Not to scale Profit Dead Weight Loss Max SS – Actual SS DWL MCsr MR

24. Monopoly If the firm has access to many identical plants: Plants are producing at their efficient scale. P* > AC min ;  > 0. q* q Q m Q* Q $ mc ac D DWL Profit MClr $ P m P* MR

25. Monopoly Natural Monopoly. Sometimes, one large firm can produce more efficiently than many small ones. $ P* q* q Q* Q $ mc ac D tc = 100 + q 2 Q D = 1000 – 10P MR

26. Monopoly Natural Monopoly. Sometimes, one large firm can produce more efficiently than many small ones. $ P* q* q Q* Q $ mc ac D ac m Q D = 1000 – 10P tc m = 1000 + 2q MR

27. Monopoly Natural Monopoly. Sometimes, one large firm can produce more efficiently than many small ones. $ P m P* $ mc ac D ac m MC q m q* q Q m Q* Q MR tc m = 1000 + 2q mc m = 2 Q D = 1000 – 10P P = 100 -.1Q MR = 100 -.2Q = MC = 2 Q m = 490

28. Monopoly Natural Monopoly. Sometimes, one large firm can produce more efficiently than many small ones. $ P m P* $ mc ac D ac m MC q m q* q Q m Q* Q MR tc m = 1000 + 2q mc m = 2 What are the welfare implications?

29. Price Discrimination When a firm has market power, it will attempt to capture as much of the consumer surplus as it can. Goods susceptible to price discrimination: –Personal services (e.g., hair cuts) –Utilities (e.g., water; electricity)

30. Price Discrimination 3 rd Degree (Market Segmentation): Now consider a monopolist who sells in several markets. Market A Market BFirm q a q q b q Q Q $Pa$Pa dada MC MR b MR PbPb MR a MR a = MR b = MC dbdb Higher price in the less elastic market

31. Price Discrimination 2 nd Degree (Block Pricing): Firm charges different price for different units; all consumers face the same price schedule. $ 10 8 5 100 150Q 0-100$10 101-150 8 151- 5 CS PS CS PS D

32. Price Discrimination 1 st Degree (Perfect): Firm charges different price for to different consumers and different price for different units to the same consumer. $ Q D Entire area under demand curve capture by producer What are the welfare implications? MC

33. Market Structure POINT 1: The number of firms in the market is determined by entry conditions. Profits signal entry. For a firm to remain profitable, there must be barriers to entry (or the market is too small for a second firm). POINT 2: Under every market structure, all firms attempt to maximize profits, s.t., MR = MC. But under perfect competition P = MR and under monopoly P > MR. POINT 3: Thinking about market structure raises welfare questions. Perfect competition implies efficiency. What are the welfare implications of other market structures?

34. Market Structure Perfect Comp Oligopoly Monopoly No. of Firms infinite (>)2 1 Output MR = MC = P ??? MR = MC < P ProfitNo ? Yes Efficiency Yes ? ???

35. Oligopoly We have no general theory of oligopoly. Rather, there are a variety of models, differing in assumptions about strategic behavior and information conditions. All the models feature a tension between: –Collusion: maximize joint profits –Competition: capture a larger share of the pie

36. Duopoly Models Cournot Duopoly Nash Equilibrium Leader/Follower Model Price Competition

37. Duopoly Models Cournot Duopoly Nash Equilibrium Stackelberg Duopoly Bertrand Duopoly

38. Monopoly Cyberstax is the only supplier of Vidiot, a hot new computer game. The market for Vidiot is characterized by the following demand and cost conditions: P = 30 - 1/6QTC = 40 + 8Q

39. Monopoly P = 30 - 1/6QTC = 40 + 8Q MR = 30 - 1/3QMC = 8 => Q* = 66 P* = 19  = TR – TC = PQ – (40 + 8Q) = (19)(66) – 40 -(8)(66)  = 686 $ 30 P* = 19 Q* = 66 180 Q MC = 8 MR D

40. Duopoly Megacorp is thinking of moving into the Vidiot business with a clone which is indistinguishable from the original. It has access to the same production technology, reflected in the following total cost function: TC 2 = 40 + 8q 2 Will Megacorp enter the market? What is its profit maximizing level of output?

41. Duopoly If Megacorp (Firm 2) takes Cyberstax’s (Firm 1) output as given, its residual demand curve is P = 30 - 1/6Q Q = q 1 + q 2 ; q 1 = 66 P = 30 - 1/6(q 1 + q 2 ) P = 19 - 1/6q 2 $ 30 19 q 2 = 0 q 1 = 66 180 Q

42. Duopoly P = 19 - 1/6q 2 TC 2 = 40 + 8q 2 MR 2 = 19 - 1/3q 2 = MC 2 = 8 => q 2 * = 33 q 1 * = 66 P = 30 – 1/6(q 1 + q 2 ) P* = $13.50  2 = 141.5 Before entry, P* = 19;  1 = 686 Now,  1 ’ = 323 ow,  C ‘ = 297 q 1 *+q 2 * = 99 180 Q $ 30 19 13.5 q 2 = 0 MC 2 = 8

43. Duopoly What will happen now that Cyberstax knows there is a competitor? Will it change its level of output? How will Megacorp respond? Where will this process end?

44. Cournot Duopoly Reaction curves (or best response curves) show each firm’s profit maximizing level of output as a function of the other firm’s output. q1qm q1qm q 2 q 2 R 1 : q 1 * = f(q 2 )

45. Cournot Duopoly To find R 1, set MR = MC. Now, MR is a (-) function not only of q 1 but also of q 2 : q 1 66 132 q 2 P = 30 - 1/6(q 1 +q 2 ) TR 1 = Pq 1 = [30 - 1/6(q 1 +q 2 )]q 1 = 30q 1 - 1/6q 1 2 - 1/6q 2 q 1 MR 1 = 30 -1/3q 1 - 1/6q 2 = MC = 8 R 1 : q 1 * = 66 – 1/2q 2

46. Cournot Duopoly The outcome (q 1 *, q 2 *) is an equilibrium in the following sense: neither firm can increase its profits by changing its behavior unilaterally. q 1 q 1 * = 44 q 2 * = 44q 2 R 2 : q 2 * = 66 - 1/2q 1 R 1 : q 1 * = 66 - 1/2q 2 For the case of identical firms

47. Nash Equilibrium q 1 q 1 * = 44 q 2 * = 44q 2 R 2 : q 2 * = 66 - 1/2q 1 R 1 : q 1 * = 66 - 1/2q 2 For the case of identical firms A Nash Equilibrium is a pair of “best responses,” such that q 1 * is a best response to q 2 * and q 2 * is a best response to q 1 *.

48. Nash Equilibrium q1q1* q1q1* q 2 * q 2 Is this the best they can do? If Firm 1 reduces its output while Firm 2 continues to produce q 2 *, the price rises and Firm 2’s profits increase. A Nash Equilibrium is a pair of “best responses,” such that q 1 * is a best response to q 2 * and q 2 * is a best response to q 1 *.

49. Nash Equilibrium q1q1* q1q1* q 2 * q 2 Is this the best they can do? If Firm 2 reduces its output while Firm 1 continues to produce q 1 *, the price rises and Firm 1’s profits increase. A Nash Equilibrium is a pair of “best responses,” such that q 1 * is a best response to q 2 * and q 2 * is a best response to q 1 *.

50. Nash Equilibrium q1q1* q1q1* q 2 * q 2 Is this the best they can do? If they can agree to restrict output, there are a range of outcomes to the SW that make both firms better off. A Nash Equilibrium is a pair of “best responses,” such that q 1 * is a best response to q 2 * and q 2 * is a best response to q 1 *.

51. Stackelberg Duopoly Firm 1 is the dominant firm, or Leader, (e.g., GM) and moves first. Firm 2 is the subordinate firm, or Follower. q1 q1 q 2 R2R2 Firm 1 gets to search along Firm 2’s reaction curve to find the point that maximizes Firm 1’s profits.  1 = ?

52. Stackelberg Duopoly Firm 1 is the dominant firm, or Leader, (e.g., GM) and moves first. Firm 2 is the subordinate firm, or Follower. q 2 * = 33 q 2 R2R2 q 1 q 1 * = 66 MR 1 = MC 1 TR 1 = Pq 1 = [30-1/6(q 1 +q 2 *)]q 1 Find q 2 * from R 2 : q 2 * = 66 - 1/2q 1 = [30-1/6(q 1 +66-1/2q 1 )]q 1 = 30q 1 -1/6q 1 2 -11q 1 +1/12q 1 2 MR 1 =19 -1/6q 1 = MC 1 = 8 q 1 * = 66; q 2 * = 33

53. Stackelberg Duopoly Firm 1 is the dominant firm, or Leader, (e.g., GM) and moves first. Firm 2 is the subordinate firm, or Follower. q 2 * = 33 q 2 Firm 1 has a first mover advantage: by committing itself to produce q 1, it constraints Firm 2’s output decision. Firm 1 can employ excess capacity to deter entry by a potential rival. R2R2 q 1 q 1 * = 66

54. Bertrand Duopoly Under Bertrand duopoly, firms compete on the basis of price, not quantity (as in Cournot and Stackelberg). P q 1 If P 1 > P 2 => q 1 = 0 If P 1 = P 2 => q 1 = q 2 = ½ Q If P 1 q 2 = 0 Assumptions:

55. Bertrand Duopoly Under Bertrand duopoly, firms compete on the basis of price, not quantity (as in Cournot and Stackelberg). PP2 PP2 q 1 If P 1 > P 2 => q 1 = 0 If P 1 = P 2 => q 1 = q 2 = ½ Q If P 1 q 2 = 0 d1d1 Assumptions:

56. Bertrand Duopoly Under Bertrand duopoly, firms compete on the basis of price, not quantity (as in Cournot and Stackelberg). PP2 PP2 q 1 Eventually, price will be competed down to the perfect competition level. Not very interesting model (so far). d1d1

57. Duopoly Models If we compare these results, we see that qualitatively different outcomes arise out of the finer-grained assumptions of the models: P 15.3 13.5 8 c 88 99 132 Q Cournot Stackelberg Bertrand P = 30 - 1/6Q TC = 40 + 8q

58. Duopoly Models If we compare these results, we see that qualitatively different outcomes arise out of the finer-grained assumptions of the models: Cournot Stackelberg Bertrand Q c < Q s < Q b P c > P s > P b  1s >  1c >  1b  2c >  2s >  2b P P c P s P b =P pc c Q c Q s Q b = Q pc Q

59. Duopoly Models Summary Oligopolistic markets are underdetermined by theory. Outcomes depend upon specific assumptions about strategic behavior. Nash Equilibrium is strategically stable or self-enforcing, b/c no single firm can increase its profits by deviating. In general, we observe a tension between –Collusion: maximize joint profits –Competition: capture a larger share of the pie

60. Next Time 7/20Games & Strategic Competition Pindyck, Chs 12, 13. Besanko, Chs 13, 14.