1. 1 Market Structure And Competition Chapter 13

2. 2 Chapter Thirteen Overview 1.Introduction: Cola Wars 2.A Taxonomy of Market Structures 3.Monopolistic Competition 4.Oligopoly – Interdependence of Strategic Decisions Bertrand with Homogeneous and Differentiated Products 5.The Effect of a Change in the Strategic Variable Theory vs. Observation Cournot Equilibrium (homogeneous) Comparison to Bertrand, Monopoly Reconciling Bertrand, and Cournot 6.The Effect of a Change in Timing: Stackelberg Equilibrium 1.Introduction: Cola Wars 2.A Taxonomy of Market Structures 3.Monopolistic Competition 4.Oligopoly – Interdependence of Strategic Decisions Bertrand with Homogeneous and Differentiated Products 5.The Effect of a Change in the Strategic Variable Theory vs. Observation Cournot Equilibrium (homogeneous) Comparison to Bertrand, Monopoly Reconciling Bertrand, and Cournot 6.The Effect of a Change in Timing: Stackelberg Equilibrium Chapter Thirteen

3. 3 Market Structures The number of sellers The number of buyers Entry conditions The degree of product differentiation The number of sellers The number of buyers Entry conditions The degree of product differentiation

4. 4 Chapter Thirteen Product Differentiation Definition: Product Differentiation between two or more products exists when the products possess attributes that, in the minds of consumers, set the products apart from one another and make them less than perfect substitutes. Examples: Pepsi is sweeter than Coke, Brand Name batteries last longer than "generic" batteries.

5. 5 Chapter Thirteen Product Differentiation "Superiority" (Vertical Product Differentiation) i.e. one product is viewed as unambiguously better than another so that, at the same price, all consumers would buy the better product "Substitutability" (Horizontal Product Differentiation) i.e. at the same price, some consumers would prefer the characteristics of product A while other consumers would prefer the characteristics of product B.

6. 6 Chapter Thirteen Types of Market Structures

7. 7 Chapter Thirteen Oligopoly Assumptions: Many Buyers and Few Sellers Each firm faces downward-sloping demand because each is a large producer compared to the total market size There is no one dominant model of oligopoly. We will review several. Assumptions: Many Buyers and Few Sellers Each firm faces downward-sloping demand because each is a large producer compared to the total market size There is no one dominant model of oligopoly. We will review several.

8. 8 Chapter Thirteen Cournot Oligopoly Assumptions Firms set outputs (quantities)* Homogeneous Products Simultaneous Non-cooperative *Definition: In a Cournot game, each firm sets its output (quantity) taking as given the output level of its competitor(s), so as to maximize profits. Price adjusts according to demand. Residual Demand: Firm i's guess about its rival's output determines its residual demand.

9. 9 Chapter Thirteen Simultaneously vs. Non-cooperatively Definition: Firms act simultaneously if each firm makes its strategic decision at the same time, without prior observation of the other firm's decision. Definition: Firms act non-cooperatively if they set strategy independently, without colluding with the other firm in any way

10. 10 Chapter Thirteen Definition: The relationship between the price charged by firm i and the demand firm i faces is firm is residual demand In other words, the residual demand of firm i is the market demand minus the amount of demand fulfilled by other firms in the market: Q 1 = Q - Q 2 Residual Demand

11. 11 Price Quantity 0 Demand Residual Demand when q 2 = 10 10 units Residual Marginal Revenue when q 2 = 10 MC q1*q1* Chapter Thirteen Residual Demand

12. 12 Chapter Thirteen Profit Maximization Profit Maximization: Each firm acts as a monopolist on its residual demand curve, equating MR r to MC. MR r = p + q 1 (  p/  q) = MC Profit Maximization: Each firm acts as a monopolist on its residual demand curve, equating MR r to MC. MR r = p + q 1 (  p/  q) = MC Best Response Function: The point where (residual) marginal revenue equals marginal cost gives the best response of firm i to its rival's (rivals') actions. For every possible output of the rival(s), we can determine firm i's best response. The sum of all these points makes up the best response (reaction) function of firm i.

13. 13 q1q1 Reaction Function of Firm 1 0 Reaction Function of Firm 2 q1*q1* q2*q2* Chapter Thirteen q2q2 Profit Maximization Example: Reaction Functions, Quantity Setting

14. 14 Chapter Thirteen P = 100 - Q 1 - Q 2 MC = AC = 10 What is firm 1's profit-maximizing output when firm 2 produces 50? Firm 1's residual demand: P = (100 - 50) - Q 1 MR 50 = 50 - 2Q 1 MR 50 = MC  50 - 2Q 1 = 10 Equilibrium Equilibrium: No firm has an incentive to deviate in equilibrium in the sense that each firm is maximizing profits given its rival's output What is the equation of firm 1's reaction function? Firm 1's residual demand: P = (100 - Q 2 ) - Q 1 MR r = 100 - Q 2 - 2Q 1 MR r = MC  100 - Q 2 - 2Q 1 = 10 Q 1r = 45 - Q 2 /2 firm 1's reaction function Similarly, one can compute that Q 2r = 45 - Q 1 /2

15. 15 Chapter Thirteen Profit Maximization Now, calculate the Cournot equilibrium. Q 1 = 45 - (45 - Q 1 /2)/2 Q 1 * = 30 Q 2 * = 30 P* = 40  1 * =  2 * = 30(30) = 900

16. 16 Chapter Thirteen Bertrand Oligopoly (homogeneous) Assumptions: Firms set price* Homogeneous product Simultaneous Non-cooperative *Definition: In a Bertrand oligopoly, each firm sets its price, taking as given the price(s) set by other firm(s), so as to maximize profits.

17. 17 Chapter Thirteen Homogeneity implies that consumers will buy from the low-price seller. Further, each firm realizes that the demand that it faces depends both on its own price and on the price set by other firms Specifically, any firm charging a higher price than its rivals will sell no output. Any firm charging a lower price than its rivals will obtain the entire market demand. Setting Price

18. 18 Quantity Price Market Demand Residual Demand Curve (thickened line segments) 0 Chapter Thirteen Residual Demand Curve – Price Setting

19. 19 Chapter Thirteen Residual Demand Curve – Price Setting Assume firm always meets its residual demand (no capacity constraints) Assume that marginal cost is constant at c per unit. Hence, any price at least equal to c ensures non- negative profits.

20. 20 Chapter Thirteen Best Response Function Each firm's profit maximizing response to the other firm's price is to undercut (as long as P > MC) Definition: The firm's profit maximizing action as a function of the action by the rival firm is the firm's best response (or reaction) function Example: 2 firms Bertrand competitors Firm 1's best response function is P 1 =P 2 - e Firm 2's best response function is P 2 =P 1 - e

21. 21 Chapter Thirteen Equilibrium If we assume no capacity constraints and that all firms have the same constant average and marginal cost of c then: For each firm's response to be a best response to the other's each firm must undercut the other as long as P> MC Where does this stop? P = MC (!) If we assume no capacity constraints and that all firms have the same constant average and marginal cost of c then: For each firm's response to be a best response to the other's each firm must undercut the other as long as P> MC Where does this stop? P = MC (!)

22. 22 Chapter Thirteen Equilibrium 1. Firms price at marginal cost 2. Firms make zero profits 3. The number of firms is irrelevant to the price level as long as more than one firm is present: two firms is enough to replicate the perfectly competitive outcome. Essentially, the assumption of no capacity constraints combined with a constant average and marginal cost takes the place of free entry.

23. 23 Chapter Thirteen Stackelberg model of oligopoly is a situation in which one firm acts as a quantity leader, choosing its quantity first, with all other firms acting as followers. Call the first mover the “leader” and the second mover the “follower”. The second firm is in the same situation as a Cournot firm: it takes the leader’s output as given and maximizes profits accordingly, using its residual demand. The second firm’s behavior can, then, be summarized by a Cournot reaction function. Stackelberg Oligopoly

24. 24 q1q1 q2q2 Follower’s Cournot Reaction Function Former Cournot Equilibrium A B (q 1 = 90) C Profit for firm 1 at A…0 at B…0 at C…1012.5 at Cournot Eq…900 Profit for firm 1 at A…0 at B…0 at C…1012.5 at Cournot Eq…900 Chapter Thirteen Stackelberg Equilibrium vs. Cournot

25. 25 Chapter Thirteen A single company with an overwhelming market share (a dominant firm) competes against many small producers (competitive fringe), each of whom has a small market share. Limit Pricing – a strategy whereby the dominant firm keeps its price below the level that maximizes its current profit in order to reduce the rate of expansion by the fringe. Dominant Firm Markets

26. 26 Chapter Thirteen Bertrand Competition – Differentiated Assumptions: Firms set price* Differentiated product Simultaneous Non-cooperative *Differentiation means that lowering price below your rivals' will not result in capturing the entire market, nor will raising price mean losing the entire market so that residual demand decreases smoothly

27. 27 Chapter Thirteen Q 1 = 100 - 2P 1 + P 2 "Coke's demand" Q 2 = 100 - 2P 2 + P 1 "Pepsi's demand" MC 1 = MC 2 = 5 What is firm 1's residual demand when Firm 2's price is $10? $0? Q 1 (10) = 100 - 2P 1 + 10 = 110 - 2P 1 Q 1 (0) = 100 - 2P 1 + 0 = 100 - 2P 1 Q 1 = 100 - 2P 1 + P 2 "Coke's demand" Q 2 = 100 - 2P 2 + P 1 "Pepsi's demand" MC 1 = MC 2 = 5 What is firm 1's residual demand when Firm 2's price is $10? $0? Q 1 (10) = 100 - 2P 1 + 10 = 110 - 2P 1 Q 1 (0) = 100 - 2P 1 + 0 = 100 - 2P 1 Bertrand Competition – Differentiated

28. 28 Coke’s Price MR 0 Pepsi’s price = $0 for D 0 and $10 for D 10 0 100 Chapter Thirteen Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Key Concepts Coke’s Quantity

29. 29 0 110 100 D0D0 D 10 Chapter Thirteen Key Concepts Pepsi’s price = $0 for D 0 and $10 for D 10 Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Coke’s Price Coke’s Quantity

30. 30 Coke’s Quantity MR 0 D0D0 0 MR 10 110 100 D 10 Chapter Thirteen Key Concepts Pepsi’s price = $0 for D 0 and $10 for D 10 Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Coke’s Price

31. 31 5 MR 0 D0D0 0 D 10 MR 10 110 100 Chapter Thirteen Key Concepts Pepsi’s price = $0 for D 0 and $10 for D 10 Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Coke’s Price Coke’s Quantity

32. 32 5 27.5 MR 0 D0D0 0 D 10 MR 10 30 45 50 110 100 Chapter Thirteen Key Concepts Pepsi’s price = $0 for D 0 and $10 for D 10 Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Coke’s Price Coke’s Quantity

33. 33 Chapter Thirteen Key Concepts Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Example: MR 1 (10) = 55 - Q 1 (10) = 5 Q 1 (10) = 50 P 1 (10) = 30 Therefore, firm 1's best response to a price of $10 by firm 2 is a price of $30

34. 34 Chapter Thirteen Key Concepts Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC Example: Solving for firm 1's reaction function for any arbitrary price by firm 2 P 1 = 50 - Q 1 /2 + P 2 /2 MR = 50 - Q 1 + P 2 /2 MR = MC => Q 1 = 45 + P 2 /2

35. 35 Chapter Thirteen And, using the demand curve, we have: P 1 = 50 + P 2 /2 - 45/2 - P 2 /4 or P 1 = 27.5 + P 2 /4 the reaction function And, using the demand curve, we have: P 1 = 50 + P 2 /2 - 45/2 - P 2 /4 or P 1 = 27.5 + P 2 /4 the reaction function Key Concepts Residual Demand, Price Setting, Differentiated Products Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC

36. 36 Pepsi’s Price (P 2 ) Coke’s Price (P 1 ) P 2 = 27.5 + P 1 /4 (Pepsi’s R.F.) 27.5 Chapter Thirteen Equilibrium and Reaction Functions Price Setting and Differentiated Products

37. 37 P 1 = 27.5 + P 2 /4 (Coke’s R.F.) P 2 = 27.5 + P 1 /4 (Pepsi’s R.F.) 27.5 Chapter Thirteen Pepsi’s Price (P 2 ) Coke’s Price (P 1 ) Equilibrium and Reaction Functions Price Setting and Differentiated Products P 1 = 110/3

38. 38 P 2 = 110/3 Bertrand Equilibrium 27.5 Chapter Thirteen Pepsi’s Price (P 2 ) Coke’s Price (P 1 ) P 2 = 27.5 + P 1 /4 (Pepsi’s R.F.) P 1 = 27.5 + P 2 /4 (Coke’s R.F.) Equilibrium and Reaction Functions Price Setting and Differentiated Products P 1 = 110/3 27.5

39. 39 Chapter Thirteen Equilibrium occurs when all firms simultaneously choose their best response to each others' actions. Graphically, this amounts to the point where the best response functions cross. Equilibrium occurs when all firms simultaneously choose their best response to each others' actions. Graphically, this amounts to the point where the best response functions cross. Equilibrium

40. 40 Chapter Thirteen Example: Firm 1 and Firm 2, continued P 1 = 27.5 + P 2 /4 P 2 = 27.5 + P 1 /4 Solving these two equations in two unknowns. P 1 * = P 2 * = 110/3 Plugging these prices into demand, we have: Q 1 * = Q 2 * = 190/3  1 * =  2 * = 2005.55  = 4011.10 Equilibrium

41. 41 Chapter Thirteen Profits are positive in equilibrium since both prices are above marginal cost! Even if we have no capacity constraints, and constant marginal cost, a firm cannot capture all demand by cutting price. This blunts price-cutting incentives and means that the firms' own behavior does not mimic free entry Profits are positive in equilibrium since both prices are above marginal cost! Even if we have no capacity constraints, and constant marginal cost, a firm cannot capture all demand by cutting price. This blunts price-cutting incentives and means that the firms' own behavior does not mimic free entry Equilibrium

42. 42 Chapter Thirteen Equilibrium Only if I were to let the number of firms approach infinity would price approach marginal cost. Prices need not be equal in equilibrium if firms not identical (e.g. Marginal costs differ implies that prices differ) The reaction functions slope upward: "aggression => aggression"

43. 43 Chapter Thirteen Cournot, Bertrand, and Monopoly Equilibriums P > MC for Cournot competitors, but P < PM: If the firms were to act as a monopolist (perfectly collude), they would set market MR equal to MC: P = 100 - Q MC = AC = 10 MR = MC => 100 - 2Q = 10 => QM = 45 PM = 55  M= 45(45) = 2025  c = 1800 P > MC for Cournot competitors, but P < PM: If the firms were to act as a monopolist (perfectly collude), they would set market MR equal to MC: P = 100 - Q MC = AC = 10 MR = MC => 100 - 2Q = 10 => QM = 45 PM = 55  M= 45(45) = 2025  c = 1800

44. 44 Chapter Thirteen A perfectly collusive industry takes into account that an increase in output by one firm depresses the profits of the other firm(s) in the industry. A Cournot competitor takes into account the effect of the increase in output on its own profits only. Therefore, Cournot competitors "overproduce" relative to the collusive (monopoly) point. Further, this problem gets "worse" as the number of competitors grows because the market share of each individual firm falls, increasing the difference between the private gain from increasing production and the profit destruction effect on rivals. Therefore, the more concentrated the industry in the Cournot case, the higher the price-cost margin. Cournot, Bertrand, and Monopoly Equilibriums

45. 45 Chapter Thirteen Homogeneous product Bertrand resulted in zero profits, whereas the Cournot case resulted in positive profits. Why? The best response functions in the Cournot model slope downward. In other words, the more aggressive a rival (in terms of output), the more passive the Cournot firm's response. The best response functions in the Bertrand model slope upward. In other words, the more aggressive a rival (in terms of price) the more aggressive the Bertrand firm's response. Cournot, Bertrand, and Monopoly Equilibriums

46. 46 Chapter Thirteen Cournot: Suppose firm j raises its output…the price at which firm i can sell output falls. This means that the incentive to increase output falls as the output of the competitor rises. Bertrand: Suppose firm j raises price the price at which firm i can sell output rises. As long as firm's price is less than firm's, the incentive to increase price will depend on the (market) marginal revenue. Cournot: Suppose firm j raises its output…the price at which firm i can sell output falls. This means that the incentive to increase output falls as the output of the competitor rises. Bertrand: Suppose firm j raises price the price at which firm i can sell output rises. As long as firm's price is less than firm's, the incentive to increase price will depend on the (market) marginal revenue. Cournot, Bertrand, and Monopoly Equilibriums

47. 47 Chapter Thirteen Chamberlinian Monopolistic Competition Market Structure Many Buyers Many Sellers Free entry and Exit (Horizontal) Product Differentiation When firms have horizontally differentiated products, they each face downward-sloping demand for their product because a small change in price will not cause ALL buyers to switch to another firm's product.

48. 48 Chapter Thirteen 1. Each firm is small each takes the observed "market price" as given in its production decisions. 2. Since market price may not stay given, the firm's perceived demand may differ from its actual demand. 3.If all firms' prices fall the same amount, no customers switch supplier but the total market consumption grows. 4. If only one firm's price falls, it steals customers from other firms as well as increases total market consumption Monopolistic Competition – Short Run

49. 49 Price Quantity d (P A =20) Chapter Thirteen Perceived vs. Actual Demand

50. 50 d (P A =50) d (P A =20) Demand assuming no price matching Chapter Thirteen Price Quantity Perceived vs. Actual Demand

51. 51 d (P A =50) d (P A =20) Demand (assuming price matching by all firms) 50 Chapter Thirteen Price Quantity Perceived vs. Actual Demand Demand assuming no price matching

52. 52 Chapter Thirteen Market Equilibrium The market is in equilibrium if: Each firm maximizes profit taking the average market price as given Each firm can sell the quantity it desires at the actual average market price that prevails The market is in equilibrium if: Each firm maximizes profit taking the average market price as given Each firm can sell the quantity it desires at the actual average market price that prevails

53. 53 Price Quantity d(P A =43) Chapter Thirteen Short Run Chamberlinian Equilibrium

54. 54 Quantity d (P A =50) Demand assuming no price matching d(P A =43) Chapter Thirteen Price Short Run Chamberlinian Equilibrium

55. 55 Quantity d (P A =50) Demand (assuming price matching by all firms P=P A ) Demand assuming no price matching d(P A =43) Chapter Thirteen Price Short Run Chamberlinian Equilibrium

56. 56 Quantity d (P A =50) Demand (assuming price matching by all firms P=P A ) Demand assuming no price matching 50 d(P A =43) 43 MR 43 mc 57 15 Chapter Thirteen Price Short Run Chamberlinian Equilibrium

57. 57 Chapter Thirteen Short Run Monopolistically Competitive Equilibrium Computing Short Run Monopolistically Competitive Equilibrium MC = $15 N = 100 Q = 100 - 2P + P A Where: P A is the average market price N is the number of firms MC = $15 N = 100 Q = 100 - 2P + P A Where: P A is the average market price N is the number of firms

58. 58 Chapter Thirteen Short Run Monopolistically Competitive Equilibrium A. What is the equation of d 40 ? What is the equation of D? d 40 : Q d = 100 - 2P + 40 = 140 - 2P D: Note that P = P A so that Q D = 100 - P B. Show that d 40 and D intersect at P = 40 P = 40 => Q d = 140 - 80 = 60 Q D = 100 - 40 = 60 C. For any given average price, P A, find a typical firm's profit maximizing quantity

59. 59 Chapter Thirteen Inverse Perceived Demand P = 50 - (1/2)Q + (1/2)P A MR = 50 - Q + (1/2)P A MR = MC => 50 - Q + (1/2)P A = 15 Q e = 35 + (1/2)P A P e = 50 - (1/2)Q e + (1/2)P A P e = 32.5 + (1/4)P A P = 50 - (1/2)Q + (1/2)P A MR = 50 - Q + (1/2)P A MR = MC => 50 - Q + (1/2)P A = 15 Q e = 35 + (1/2)P A P e = 50 - (1/2)Q e + (1/2)P A P e = 32.5 + (1/4)P A

60. 60 Chapter Thirteen Short Run Monopolistically Competitive Equilibrium D. What is the short run equilibrium price in this industry? In equilibrium, Q e = Q D at P A so that 100 - P A = 35 + (1/2)P A P A = 43.33 Q e = 56.66 Q D = 56.66

61. 61 Chapter Thirteen Monopolistic Competition in the Long Run At the short run equilibrium P > AC so that each firm may make positive profit. Entry shifts d and D left until average industry price equals average cost. At the short run equilibrium P > AC so that each firm may make positive profit. Entry shifts d and D left until average industry price equals average cost. This is long run equilibrium is represented graphically by: MR = MC for each firm D = d at the average market price d and AC are tangent at average market price

62. 62 Average Cost Quantity Price Residual Demand shifts in as entry occurs Marginal Cost q* P* q** P** MR Chapter Thirteen Long Run Chamberlinian Equilibrium

63. 63 Chapter Thirteen Summary 1. Market structures are characterized by the number of buyers, the number of sellers, the degree of product differentiation and the entry conditions. 2. Product differentiation alone or a small number of competitors alone is not enough to destroy the long run zero profit result of perfect competition. This was illustrated with the Chamberlinian and Bertrand models. 3. Chamberlinian) monopolistic competition assumes that there are many buyers, many sellers, differentiated products and free entry in the long run.

64. 64 Chapter Thirteen Summary 4. Chamberlinian sellers face downward-sloping demand but are price takers (i.e. they do not perceive that their change in price will affect the average price level). Profits may be positive in the short run but free entry drives profits to zero in the long run. 5. Bertrand and Cournot competition assume that there are many buyers, few sellers, and homogeneous or differentiated products. Firms compete in price in Bertrand oligopoly and in quantity in Cournot oligopoly. 6. Bertrand and Cournot competitors take into account their strategic interdependence by means of constructing a best response schedule: each firm maximizes profits given the rival's strategy.

65. 65 Chapter Thirteen Summary 7. Equilibrium in such a setting requires that all firms be on their best response functions. 8. If the products are homogeneous, the Bertrand equilibrium results in zero profits. By changing the strategic variable from price to quantity, we obtain much higher prices (and profits). Further, the results are sensitive to the assumption of simultaneous moves. 9. This result can be traced to the slope of the reaction functions: upwards in the case of Bertrand and downwards in the case of Cournot. These slopes imply that "aggressivity" results in a "passive" response in the Cournot case and an "aggressive" response in the Bertrand case.