Chapter 12

1. Chapter 12 Monopolistic Competition and Oligopoly

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 • Many firms • Free entry and exit • Differentiated product Chapter 12

4. Monopolistic Competition • The amount of monopoly power depends on the degree of differentiation. • Examples of this very common market structure include: • Toothpaste • Soap • Detergent Chapter 12

5. Monopolistic Competition • Two important characteristics • Differentiated but highly substitutable products • Free entry and exit 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 • 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 • 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. MC AC MC AC P PC D = MR DLR MRLR QC QMC Monopolistically and Perfectly Competitive Equilibrium (LR) Monopolistic Competition Perfect Competition $/Q $/Q Quantity Quantity

10. Monopolistic Competition & Economic Efficiency • The monopoly power yields a higher price than perfect competition. • With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. Chapter 12

11. 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 • Inefficiencies would make consumers worse off Chapter 12

12. Monopolistic Competition • If inefficiency bad for consumers, should monopolistic competition be regulated? • Market power relatively small. Usually enough firms to compete with enough substitutability between firms • Inefficiency is balance by benefit of increased product diversity Chapter 12

13. The Market for Colas and Detergent • Each market has much differentiation in products and try to gain consumers through that differentiation • Coke versus Pepsi • Dynamo versus Top • How much monopoly power do each of these producers have? • How elastic demand for each brand? Chapter 12

14. The Market for Colas and Coffee • The greater the elasticity, the less monopoly power and vice versa. Chapter 12

15. 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

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

17. 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

18. 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

19. 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

20. 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

21. Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing. 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 Q1 Chapter 12

22. 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

23. Firm 2’s Reaction Curve Q*2(Q2) Firm 1’s Reaction Curve Q*1(Q2) Reaction Curves and Cournot Equilibrium Q1 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 shows how much it will produce as a function of how much it thinks Firm 1 will produce. 50 x x 25 x x Q2 25 50 75 100 Chapter 12

24. Firm 2’s Reaction Curve Q*2(Q2) Cournot Equilibrium Firm 1’s Reaction Curve Q*1(Q2) Reaction Curves and Cournot Equilibrium Q1 100 In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. 75 50 x x 25 x x Q2 25 50 75 100 Chapter 12

25. Cournot Equilibrium • Each firms 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. Observations of Oligopoly Behavior • In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur. • In other oligopoly markets, the firms are very aggressive and collusion is not possible. Chapter 12

32. Observations of Oligopoly Behavior • In other oligopoly markets, the firms are very aggressive and collusion is not possible. • Firms are reluctant to change price because of the likely response of their competitors. • In this case prices tend to be relatively rigid. Chapter 12

33. Price Rigidity • Firms have strong desire for stability • Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change • Fear lower prices will send wrong message to competitors leading to price war • Higher prices may cause competitors to raise theirs Chapter 12

34. Price Rigidity • Basis of kinked demand curve model of oligopoly • Each firm faces a demand curve kinked at the currently prevailing price, P* • Above P*, demand is very elastic • If P>P*, other firms will not follow • Below P*, demand is very inelastic • If P<P*, other firms will follow suit Chapter 12

35. Price Rigidity • With a kinked demand curve, marginal revenue curve is discontinuous • Firm’s costs can change without resulting in a change in price • Kinked demand curve does not really explain oligopolistic pricing • Description of price rigidity rather than an explanation of it Chapter 12

36. If the producer raises price, the competitors will not and the demand will be elastic. If the producer lowers price, the competitors will follow and the demand will be inelastic. D MR The Kinked Demand Curve $/Q Quantity Chapter 12

37. So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MC’ P* MC D Q* The Kinked Demand Curve $/Q Quantity Chapter 12 MR

38. Price Signaling and Price Leadership • Price Signaling • Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit • Price Leadership • Pattern of pricing in which one firm regularly announces price changes that other firms then match Chapter 12

39. Price Signaling and Price Leadership • The Dominant Firm Model • In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. • The large firm might then act as the dominant firm, setting a price that maximizes its own profits. Chapter 12

40. The Dominant Firm Model • Dominant firm must determine its demand curve, DD. • Difference between market demand and supply of fringe firms • To maximize profits, dominant firm produces QD where MRD and MCD cross. • At P*, fringe firms sell QF and total quantity sold is QT = QD + QF Chapter 12

41. SF D The dominant firm’s demand curve is the difference between market demand (D) and the supply of the fringe firms (SF). P1 MCD P* DD At this price, fringe firms sell QF, so that total sales are QT. P2 MRD QF QD QT Price Setting by a Dominant Firm Price Quantity Chapter 12

42. Cartels • Producers in a cartel explicitly agree to cooperate in setting prices and output. • Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel • If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels Chapter 12

43. Cartels – Conditions for Success • Stable cartel organization must be formed – price and quantity settled on and adhered to • Members have different costs, assessments of demand and objectives • Tempting to cheat by lowering price to capture larger market share Chapter 12

44. Cartels – Conditions for Success • Potential for monopoly power • Even if cartel can succeed, there might be little room to raise price if faces highly elastic demand • If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work Chapter 12

45. Analysis of Cartel Pricing • Members of cartel must take into account the actions of non-members when making pricing decisions • Cartel pricing can be analyzed using the dominant firm model • OPEC oil cartel – successful • CIPEC copper cartel – unsuccessful Chapter 12

46. Cartels • To be successful: • Total demand must not be very price elastic • Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic Chapter 12