1. Models of Competition Part III: Imperfect Competition
Agenda:
Deviations from Conditions for Perfect Competition Revisited
2. Models of Imperfect Competition
A. Monopolistic Competition
B. Cournot Oligopoly
C. Stackelberg Oligopoly
D. Bertrand Oligopoly

2. Monopolistic Competition
A Continuum of Competition….
Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
Causes of monopoly:
Economies of scale (production technology – go back to gnomes), regulation (we don’t want everyone tearing up the roads to lay gas pipe, we want to know who to go to when something blows up)
Network externalities, Location (also a form of product differentiation)
Patents
Of the four assumptions underlying perfect competition, really only two are important: product differentiation and barriers to entry/exit. Pricing power comes from these (assumption #2) and we never have perfect information (transactions costs)
Key questions:
Is there meaningful product differentiation?
Are there significant barriers to entry or exit?
What is the elasticity of demand for the market and firm?

3. Monopolistic Competition: The Chamberlin Model
Key features:
Many firms
Free entry and exit
Symmetry – what’s good for one is good for the others equally
X Differentiated products make imperfect substitutes
Edward Chamberlin
Joan Robinson
Chamberlin, E.H. (1933) The Theory of Monopolistic Competition: A Re-orientation of the Theory of Value. Harvard University Press, Cambridge MA.
Robinson, J. (1933) The Economics of Imperfect Competition, MacMillian, London.
Poor Joan was British and a woman and the paper was written in 1933, so as Americans we only refer to the “Chamberlin” model
Friedman argued that Chamberlin model added nothing to the model of perfect competition (1953) “The methodology of positive economics,” in Essays in Positive Economics, Chicago: Chicago University Press.
Dixit and Stiglitz (1977) “Monopolisitc competition and optimum product diversity” American Economic Review, 67:297 – 308
Symmetry is necessary to make the math models work, not for the intuition, so we won’t focus on that.
A matter of degree….
Monopolistic Competition in the History of Economic Thought

4. Monopolistic Competition: The Short Run
Joan Robinson
Market demand curve
Which is more ELASTIC?
Firm demand curve P2
Firm demand is more elastic because customers can easily switch to competitors – but if you need (want) a shirt you ultimately get one so market demand is less elastic Q2
Entry of close substitutes
Is this firm making a producer surplus?
Is this firm making a profit?
What will happen in the long run?

5. Monopolistic Competition: Long-run Implications
REVIEW: What is Allocative Efficiency?
Is there any producer surplus in the long run?
Is there any economic profit in the long run?
Is there allocative efficiency in the long run?

6. What is Allocative Efficiency in a Perfectly Competitive Market?
REVIEW:
What is Allocative Efficiency in a Perfectly Competitive Market?
What can make the supply curve slope up in the long-run?
Is there producer surplus in the long run?
Is there consumer surplus in the long run?
See P&R p. 455 for a graphical comparison of long-run equilibrium in perfect and monopolistic competition

7. Monopolistic Competition
Perfect Competition
Monopolistic Competition
The value of
diversity!
Avinash Dixit
Joseph Stiglitz

8. Antoine Augustin Cournot
Oligopoly: The Cournot Model
Few firms (test yourself: why?)
Firms choose quantity at the same time and then the market sets price
Products must be relatively close substitutes. 5 75
Antoine Augustin Cournot
( )
KEY: Each firm takes the other’s quantity as GIVEN, which reduces the demand available to them!
See P&R p. 459

9. Antoine Augustin Cournot
Oligopoly: The Cournot Model
A firm’s RESPONSE FUNCTION expresses its Quantity in terms of the other firm’s Quantity
Antoine Augustin Cournot
( )
Recall the general linear demand function:
Response functions with MC = 0
Equilibrium is when
Q1 = Q2
See P&R p. 461 for a numerical derivation which requires some calculus to get the marginal revenue.

10. Example: Garden Gnomes…AGAIN!
Another firm manages to come up with different technology that also makes Garden Gnomes absorb CO2 and combat global warming. They have a patent too, and conveniently the same cost structure as you. So now the market is a duopoly. (Round Q to nearest whole #)
Market demand: QD = P or P = 65 – Q/100
FIRM #1 marginal revenue: 65-2Q1/100 –Q2/100
FIRM #2 marginal revenue: 65-2Q2/100 –Q1/100
FIRM total cost: C(q) = q2/200
FRIM marginal cost: MC(q) = 2q/200 = q/100
NOTE q = Q1 or Q2 depending on which firm you’re thinking about!
What is the response function for Q1 (an expression for Q1 in terms of Q2)?
HINT: remember, if in doubt try MR = MC!
Q1 = 2167 –Q2/3
How much does Q1 produce?
HINT: remember there is symmetry in the response
functions since both firms have the same cost structure.
Q1 = 2500 –(2500-Q1/3)/3
Q1 = 1,606
What is the equilibrium price and quantity for the market?
Q = 3,212 P = $32.88

11. TEST YOURSELF!
Compare the equilibrium price, quantity, profit, producer and consumer surplus for the perfectly competitive, monopoly and Cournot Duopoly markets!

12. Oligopoly: The Stackelberg Model
Firm #1 (leader) knows that firm #2 (follower) will take firm #1’s quantity as given following the Cournout model…
Demand Function
Heinrich Freiherr von Stackelberg
Substitute firm #2’s response function assuming MC = 0
What is Firm #1’s
Marginal Revenue Function?
Firm #1
Demand Function

13. How is Stackelberg different from Cournot? First Mover Advantage!!
Oligopoly: The Stackelberg Model Continued
What is on the X and Y axis?
What kind of functions are graphed?
First mover produces the same quantity as a pure monopolist
Cournot equilibrium
As long as second mover doesn’t respond and push the equilibrium to Cournot
How is Stackelberg different from Cournot?
First Mover Advantage!!

14. Joseph Louis François Bertrand
Oligopoly: The Bertrand Model
Firms choose price and the market sets quantity
Each firm takes the other’s price as given
Firm #1
Lower
Price
Same
Price
Higher
Price
Joseph Louis François Bertrand 
(1822 – 1900)
Firm #2
Lower
Price
all
half
nothing
all
all
all
all
half
nothing
Same
Price
Price set at MC
Same as
perfect competition!
half
half
half
Higher
Price
all
half
nothing
nothing
nothing
nothing
Collusion
Cartels
Dynamic games

15. Summary
1. Imperfect substitutes + free entry & exit = monopolistic competition
Producer surplus, but no economic profits
No allocative efficiency (P>MC)
The price of variety!
2. Perfect substitutes + barriers to entry and/or exit = ologopoly
Implications are all based on the assumptions!
Monopoly > Cornout > Stackelberg > Bertrand = perfect competition!
Game Theory!