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Chapter 12

Chapter 12. Monopolistic Competition and Oligopoly. DERYA GÜLTEKİN KARAKAŞ. Topics to be Discussed. Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners’ Dilemma Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Cartels.

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Chapter 12

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  1. Chapter 12 Monopolistic Competition and Oligopoly DERYA GÜLTEKİN KARAKAŞ

  2. Topics to be Discussed • Monopolistic Competition • Oligopoly • Price Competition • Competition Versus Collusion: The Prisoners’ Dilemma • Implications of the Prisoners’ Dilemma for Oligopolistic Pricing • Cartels Chapter 12

  3. Monopolistic Competition • Characteristics 1) Many firms 2) Differentiated but highly substitutable products 3) Free entry and exit Chapter 12

  4. Monopolistic Competition • Examples of this very common market structure include: • Toothpaste • Soap • Shampoo Chapter 12

  5. Monopolistic Competition • The amount of monopoly power depends on the degree of differentiation. • 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. • Question? Does Procter & Gamble have much monopoly power in the market for Crest? Chapter 12

  6. MC MC AC AC PSR PLR DSR DLR MRSR MRLR QSR QLR A Monopolistically CompetitiveFirm in the Short and Long Run $/Q $/Q Short Run Long Run Quantity Quantity

  7. A Monopolistically CompetitiveFirm in the Short and Long Run • Observations (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

  8. A Monopolistically CompetitiveFirm in the Short and Long Run • Observations (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

  9. Monopolistic Competition • Questions 1) If the market became competitive, what would happen to output and price? 2) Should monopolistic competition be regulated? 3) What is the degree of monopoly power? 4) What is the benefit of product diversity? Chapter 12

  10. Deadweight loss MC AC MC AC P PC D = MR DLR MRLR QC QMC Comparison of Monopolistically CompetitiveEquilibrium and Perfectly Competitive Equilibrium Monopolistic Competition Perfect Competition $/Q $/Q Quantity Quantity

  11. Monopolistic Competition • Monopolistic Competition and Economic Efficiency • The monopoly power (differentiation) 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. • With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12

  12. Oligopoly • Characteristics • Small number of firms • Product differentiation may or may not exist • Barriers to entry Chapter 12

  13. Oligopoly • Examples • Automobiles • Steel • Aluminum • Petrochemicals • Electrical equipment • Computers Chapter 12

  14. Oligopoly • The barriers to entry are: • Natural • Scale economies • Patents • Technology • Name recognition • Strategic action • Flooding the market • Controlling an essential input Chapter 12

  15. Oligopoly • Management Challenges • Strategic actions • Rival behavior • Question • What are the possible rival responses to a 10% price cut by Ford? Chapter 12

  16. Oligopoly • Defining Equilibrium: • Firms doing the best they can and have no incentive to change their output or price • Equilibrium in an Oligopolistic Market • In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price. • In oligopoly the producers must consider the response of competitors when choosing output and price. Chapter 12

  17. Oligopoly • Nash Equilibrium • Each firm is doing the best it can given what its competitors are doing. Chapter 12

  18. Oligopoly • The Cournot Model • Duopoly • Two firms competing with each other • Homogenous good • The output of the other firm is assumed to be fixed Chapter 12

  19. If Firm 1 thinks Firm 2 will produce nothing, its demand curve, D1(0), is the market demand curve. D1(0) If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MR1(0) D1(75) MR1(75) MC1 MR1(50) D1(50) 12.5 25 50 Firm 1’s Output Decision P1 What is the output of Firm 1 if Firm 2 produces 100 units? Q1 Chapter 12

  20. Oligopoly • The Reaction Curve • A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2. Chapter 12

  21. 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. Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Firm 2’s Reaction Curve Q*2(Q2) In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. x Cournot Equilibrium x Firm 1’s Reaction Curve Q*1(Q2) x x Reaction Curves and Cournot Equilibrium Q1 100 75 50 25 Q2 25 50 75 100 Chapter 12

  22. Oligopoly • Questions 1) If the firms are not producing at the Cournot equilibrium, will they adjust until the Cournot equilibrium is reached? 2) When is it rational to assume that its competitor’s output is fixed? Chapter 12

  23. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium • Duopoly • Market demand is P = 30 - Q where Q = Q1 + Q2 • MC1 = MC2 = 0 Chapter 12

  24. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium • Firm 1’s Reaction Curve Chapter 12

  25. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium Chapter 12

  26. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium Chapter 12

  27. 30 Firm 2’s Reaction Curve Cournot Equilibrium 15 10 Firm 1’s Reaction Curve 10 15 30 Duopoly Example Q1 The demand curve is P = 30 - Q and both firms have 0 marginal cost. Q2 Chapter 12

  28. Oligopoly Profit Maximization with Collusion Chapter 12

  29. Oligopoly Profit Maximization with Collusion • Collusion Curve • Q1 + Q2 = 15 • Shows all pairs of output Q1 and Q2 that maximizes total profits • Q1 = Q2 = 7.5 • Less output and higher profits than the Cournot equilibrium Chapter 12

  30. Firm 2’s Reaction Curve For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium Competitive Equilibrium (P = MC; Profit = 0) 15 Cournot Equilibrium Collusive Equilibrium 10 7.5 Firm 1’s Reaction Curve Collusion Curve 7.5 10 15 Duopoly Example Q1 30 Q2 30 Chapter 12

  31. First Mover Advantage--The Stackelberg Model • Assumptions • One firm can set output first • MC = 0 • Market demand is P = 30 - Q where Q = total output • Firm 1 sets output first and Firm 2 then makes an output decision Chapter 12

  32. 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 - 1/2Q1 Chapter 12

  33. First Mover Advantage--The Stackelberg Model • Firm 1 • Choose Q1so that: Chapter 12

  34. First Mover Advantage--The Stackelberg Model • Substituting Firm 2’s Reaction Curve for Q2: Chapter 12

  35. First Mover Advantage--The Stackelberg Model • Conclusion • Firm 1’s output is twice as large as firm 2’s • Firm 1’s profit is twice as large as firm 2’s • Questions • Why is it more profitable to be the first mover? • Which model (Cournot or Shackelberg) is more appropriate? Chapter 12

  36. Price Competition • Competition in an oligopolistic industry may occur with price instead of output. • The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods. Chapter 12

  37. Price Competition Bertrand Model • Assumptions • Homogenous good • Market demand is P = 30 - Q where Q = Q1 + Q2 • MC = $3 for both firms and MC1 = MC2 = $3 Chapter 12

  38. Price Competition Bertrand Model • Assumptions • The Cournot equilibrium: • Assume the firms compete with price, not quantity. Chapter 12

  39. Price Competition Bertrand Model • How will consumers respond to a price differential? (Hint: Consider homogeneity) • The Nash equilibrium: • P = MC; P1 = P2 = $3 • Q = 27; Q1 & Q2 = 13.5 Chapter 12

  40. Price Competition Bertrand Model • Why not charge a higher price to raise profits? • How does the Bertrand outcome compare to the Cournot outcome? • The Bertrand model demonstrates the importance of the strategic variable (price versus output). Chapter 12

  41. Price Competition 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. Chapter 12

  42. Competition Versus Collusion:The Prisoners’ Dilemma • Why wouldn’t each firm set the collusion price independently and earn the higher profits that occur with explicit collusion? Chapter 12

  43. Competition Versus Collusion:The Prisoners’ Dilemma • Assume: Chapter 12

  44. Competition Versus Collusion:The Prisoners’ Dilemma • Possible Pricing Outcomes: Chapter 12

  45. $12, $12 $20, $4 $4, $20 $16, $16 Payoff Matrix for Pricing Game Firm 2 Charge $4 Charge $6 Charge $4 Firm 1 Charge $6 Chapter 12

  46. Competition Versus Collusion:The Prisoners’ Dilemma • These two firms are playing a noncooperative game. • Each firm independently does the best it can taking its competitor into account. • Question • Why will both firms both choose $4 when $6 will yield higher profits? Chapter 12

  47. Competition Versus Collusion:The Prisoners’ Dilemma • An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face. Chapter 12

  48. Competition Versus Collusion:The Prisoners’ Dilemma • Scenario • Two prisoners have been accused of collaborating in a crime. • They are in separate jail cells and cannot communicate. • Each has been asked to confess to the crime. Chapter 12

  49. -5, -5 -1, -10 -10, -1 -2, -2 Payoff Matrix for Prisoners’ Dilemma Prisoner B Confess Don’t confess Confess Prisoner A Would you choose to confess? Don’t confess Chapter 12

  50. Payoff Matrix forthe P & G Prisoners’ Dilemma • Conclusions: Oligipolistic Markets 1) Collusion will lead to greater profits 2) Explicit and implicit collusion is possible 3) Once collusion exists, the profit motive to break and lower price is significant Chapter 12

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