Monopolistic Competition and Oligopoly Chapter 10

1. Monopolistic Competition and Oligopoly Chapter 10

2. Monopolistic Competition • Characteristics • Many firms • Free entry and exit • Differentiated product • The amount of monopoly power depends on the degree of differentiation. • Examples of this very common market structure include: • Toothpaste • Soap • Cold remedies

3. 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. • Two important characteristics • Differentiated but highly substitutable products • Free entry and exit

4. 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

5. 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

6. 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

7. Oligopoly – Characteristics • Small number of firms • Product differentiation may or may not exist • Barriers to entry • Scale economies • Patents • Technology • Name recognition • Strategic action • Examples • Automobiles • Steel • Aluminum • Petrochemicals • Electrical equipment

8. 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 • 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

9. 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 ●reaction curve Relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce. ● Cournot equilibrium Equilibrium in the Cournot model in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.

10. 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.

11. Firm 2’s Reaction Curve Q*2(Q2) Firm 1’s Reaction Curve Q*1(Q2) 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 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

12. 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

13. Oligopoly Example • Total revenue for firm 1: R1 = PQ1 = (30 –Q)Q1 • then MR1 = ∆R1/∆Q1 = 30 – 2Q1 –Q2 • Setting MR1 = 0 (the firm’s marginal cost) and solving for Q1, we find • Firm 1’s reaction curve: • By the same calculation, Firm 2’s reaction curve: • Cournot equilibrium: • Total quantity produced:

14. Oligopoly Example If the two firms collude, then the total profit-maximizing quantity can be obtained as follows: Total revenue for the two firms: R = PQ = (30 –Q)Q = 30Q – Q2, then MR = ∆R/∆Q = 30 – 2Q Setting MR = 0 (the firms’ marginal cost) we find that total profit is maximized at Q = 15. Then, Q1 + Q2 = 15 is the collusion curve. If the firms agree to share profits equally, each will produce half of the total output:Q1 = Q2 = 7.5

15. 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 output • 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)

16. Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react. • P = 30 – Q • Also, MC1 = MC2 = 0 • Firm 2’s reaction curve: • Firm 1’s revenue: • And MR1 = ∆R1/∆Q1 = 15 – Q1 • Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5 • We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much profit. Going first gives Firm 1 an advantage.

17. 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 • 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 profits of $81.

18. 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 • 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

19. Price Competition – Differentiated Products • Firms set prices at the same time • If P2 is fixed:

20. In our example, there are two firms, each of which has fixed costs of $20 and zero variable costs. They face the demand curves: • Firm 1’s demand: • Firm 2’s demand: • We found that in Nash equilibrium each firm will charge a price of $4 and earn a profit of $12, whereas if the firms collude, they will charge a price of $6 and earn a profit of $16. • But if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2’s profit will increase to $20. And it will do so at the expense of Firm 1’s profit, which will fall to $4.

21. $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

22. -5, -5 -1, -10 -10, -1 -2, -2 • An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face. • 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. Prisoner B Confess Don’t confess Confess Prisoner A Would you choose to confess? Don’t confess

23. 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 • 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.

24. 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

25. 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 • Examples of successful cartels • OPEC • International Bauxite Association • Mercurio Europeo • Examples of unsuccessful cartels • Copper • Tin • Coffee • Tea • Cocoa