1. Monopolistic Competition and Oligopoly
Chapter 12
Monopolistic Competition and Oligopoly

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

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

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

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

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

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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

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

16. 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

17. 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

18. Oligopoly Examples Automobiles Steel Aluminum Petrochemicals
Electrical equipment
Chapter 12 25

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

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

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

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

33. 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

34. Oligopoly Example
Profit Maximization with Collusion
Chapter 12 4 55

35. 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

36. 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

37. 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

38. 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

39. 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

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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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 = P1 + P2
Firm 2’s demand: Q2 = P1 + 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

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

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