1. Monopolistic Competition and Basic Oligopoly Models

2. Monopolistic Competition (Chamberlin Model)
Free entry, many firms sell (physically or perceivably) differentiated products.
Firms ignore competitors. Each redefines market to a segment (consumers preferences) & estimates its own downward demand d.
Other brands make firm’s demand d more elastic (for segment only) than market share curve M (for entire market). Firm’s market power limited, but still allows P > MC.
In short run firm may move along d, but eventually similar conditions lead to similar P: each firm operates at d & M intersection.
Equilibrium when firm’s re-estimated d intersects M where SMC = MR.

3. Monopolistic Competition in the Log-Run
The Good (for Consumers):
Product Variety
The Bad (for Society):
P > MC => Inefficiencies & Misallocations
The Ugly (for Managers):
Free Entry drives Long Run Profit to Normal = 0
Long Run Equilibrium
(P = AC, so zero profits) $ AC MC P*
P1 = AC1
AC*
Entry D MR D1
Quantity of Brand X Q1 Q*
Transitory
Total Profit
MR1

4. Strategies to Avoid (or Delay) the Zero Profit Outcome
Change; don’t let the long-run set in.
Be the first to introduce new brands or to improve existing products and services.
Seek out sustainable niches.
Create barriers to entry.
Increase the time it takes others to clone your brand with “trade secrets” and “strategic plans”.

5. Oligopoly
Few sellers (< 10, 2 in duopoly) of homogeneous or differentiated product actively competing for market share.
Barriers to entry:
Entry limiting pricing P < P* and Market saturation: discourage entry
Fed Trade Commission antitrust against General Mills, General Foods & Kellogg for proliferation of brands (fill shelves & prevent entry)
Excess capacity (econ of scale) & reputed P retaliation: P cutting
In 1971 Proctor & Gamble (west cost) promoted (advertisement & P) its Folger in Pitt & Cleveland (General Foods’ Maxwell House turf).
GF lowered P & started promoting in midwest (shared turf). GF’s  30% in 1970, –30% in After PG retreated P &  recovered.
Capital requirements
Product differentiation, hard for entrant to attract customers
Strategic Interaction
What you do affects the profits of your rivals
What your rival does affects your profits

6. Strategic Interdependence
D2 (Rivals match your price change) P
Firm is not in complete control of its own destiny.
Change in firm’s quantity demanded depends on whether rivals match firm’s change in price! PH
D (Rivals match your price Reductions but not price Increases) P0 PL
D1 (Rivals hold their price constant) Q Q0

7. Sweezy (Kinked Demand) ModelP
M = DMarket
MCH MC
Few firms in the market (entry barriers) produce differentiated products. Each firm believes rivals match price reductions, but not price increases. Key feature: Price-Rigidity ( cost firms operate at kink) With econ wide increase in production costs, firm might profitable increase price, regardless of others. When others follow adjust d upward to new kink Q3,P2
MCL PK
MRM
d = DFirm
MRd D QK MR Q

8. Sweezy Model: An Example
P = 10, TC = Q Q2
Consultant QM = P and Qd = P
At kink: Pk = 10 and Qk = QM = P = P = Qd
Vertical gap in MR (at Qk= 1000): MRM = * = -10 MRd = *1000 = 5 < MC MC = *1000 = 8
 max: MRF -MC = 0 => QF = 800, PF = 11
 Qk = < Q* = 3300

9. Cournot Duopoly
Two firms produce homogenous product in an industry with barriers to entry
Firms maximize profit by setting output, as opposed to price
Each firm wrongly believes their rival will hold output constant if it changes its own output
Firm’s reaction (or best-response) function: profit maximizing amount of output for each quantity of output produced by rival

10. Cournot’s Costless Duopoly50

11. Cournot Equilibrium
Each firm produces the profit maximizing output, given the output of rival firms
No firm gains by unilateral changes in its output
Assume: P = (Q1 + Q2) and MC = P = a - b(Q1 + Q2) and MCi = Ci  max: MRi = Qi - Qj = 50 = MC MRi = a - 2bQi - bQj = Ci Qi = r(Qj) = Qj Simultaneously Qi = r(Qj)= (a-Ci)/2b - Qj/ solved: Q1 = Q2 = 300
Perfect competition: P = MRT = QT = 50 = MC => QT = 900 Duopoly: Q1 = Q2 = 300 & 300 unserved
Qn = Qpc[n/(1+n)], where n = # of firm in oligopoly

12. Cournot Equilibrium
Q1* maximizes firm 1’s profits, given that firm 2 produces Q2*
Q2* maximizes firm 2’s profits, given that firm 1 produces Q1*
No firm has an incentive to change output, given rival’s output
Beliefs are consistent:
In equilibrium, each firm “thinks” rival will stick to current output - and they do!
Q2*
Q1* Q2 Q1
Q1M r1 r2
Q2M
Cournot Equilibrium
(Firm 1’s Reaction Function)

13. Bertrand and Edgeworth Duopoly
Two firms produce identical products at constant MC, in an industry with barriers to entry
Each firm independently sets its profit maximizing price
Consumers have perfect knowledge & no transaction costs
Suppose MC < P1 < P2
Firm 1 earns (P1 - MC) per unit and firm 2 earns nothing
Firm 2 undercuts firm 1’s price to capture the entire market
Firm 1 then undercuts firm 2’s price
Undercutting continues until equilibrium: P1 = P2 = MC
Perfect competition profit maximizing solution P = MC possible with few firms and severe price competition
If duopolists have limited capacity relative to the Bertrand equilibrium, Edgeworth argued that price will not be stable

14. Chamberlin Duopoly
Chamberlin applied results from his analysis of monopolistic competition on oligopoly
Cournot, Bertrand and Edgeworth models assume that competitors are extremely naïve
Chamberlin argued that oligopolists would recognize their mutual or strategic interdependence and engage in tacit or informal collusion: independently choose monopoly price and split profits
Managers signal to competitors their desire not to engage in destructive price war by setting price
Agreements are not necessary because firms realize any other strategy is less profitable
Formal Collusive agreements are illegal, although U. S. firms have been permitted to agree on export pricing

15. Price Leadership by an Efficient Firm
If duopoliests split market demand D equally, each faces D’ and MR’.
Firm A with the lowest per unit costs sets Pa that firm B is forced to follow.
Firm B maximizes profit at Pb, but adjusts to Pa to preserve market share.

16. Price Leadership by a Large Firm (U.S. Steel)
Small competitors accept large firm’s profit maximizing P as in perfect competition and maximize profit where PL(=PS=MRS)=QS(=MCS). QL=QM-QS= P-(0.9P+150)= P. MRL=1253-7P=260=MCL => QL*=171.5 (QS=428.7) & PL=PM=309.

17. Perfect Collusion: The Cartel
Monopoly against world. Max profit: Pcartel>MRcartel=MCmembers
Production allocated inside with MC rule: MRcartel=MCA=…=MCn (Ideal that lowest unit cost member has the highest Q & profit is sometimes modified in short run to maintain unity)
Assume Q=1660–200P. Set MR= Q= Q=MC (MCA= QA, MCB= QB & MCC= QC) and solve for QT=5300, P=5.65 and MR=3. Set MR=3=MCi and solve for allocations: QA=1900, QB=1200 & QA=2200

18. Contestable Markets
Few sellers but free entry: Oligopoly will price at a perfect competition level & have only normal  = 0
Key Assumptions
Producers have access to same technology
Consumers respond quickly to price changes
Existing firms cannot respond quickly to entry by lowering price
Absence of sunk costs
Key Implications
Threat of entry disciplines firms already in the market
Incumbents have no market power, even if there is only a single incumbent (a monopolist)

19. Summary
Different oligopoly scenarios lead to different optimal strategies and different outcomes
Your optimal price and output depends on …
Beliefs about the reactions of rivals
Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products)
Your ability to commit