Introductory Microeconomics (ES10001)

Introductory Microeconomics (ES10001) Topic 5: Imperfect Competition

I. Introduction • PC & Monopoly are useful benchmarks. • But, in more than half of the 800 major UK manufacturing product categories, 70% of market is shared by 5 largest firms in the market. • Real world markets are imperfectly competitive • Imperfectly competitive (IC) firms cannot sell as much as want at going market price; they face a downward sloping demand curve.

I. Introduction • Two models of imperfect competition Monopolistic Competition Oligopoly • And in terms of Oligopoly Non-Collusive Collusive

II. Monopolistic Competition • Theory originally developed by Chamberlain (USA) and Robinson (UK) in early 1930s • Many sellers producing similar, but not identical, products that are close substitutes for each other • Each firm has only a limited ability to affect the market price

II. Monopolistic Competition • Assumptions: • Large number of small firms; firms assume own behaviour has no influence on rivals actions; • Similar, but not identical, products; • Free entry and exit into industry

II. Monopolistic Competition • Implication • Each firm can, to some extent, influence its market share by changing its price relative to its competitors • Demand curve is downward sloping because different firms’ products are only limited substitutes for each other • Advertising; product differentiation

II. Monopolistic Competition • Short-run equilibrium of typical monopolistically competitive firm • Profit-maximising monopolist in its own brand • Thus MR = MC and (we assume) profit > 0

Figure 1: Monopolosit Competition (SR) π > 0 p SMC p0 SAC Profit LAC0 D = AR MR Q 0 Q0

II. Monopolistic Competition • Existence of supernormal profit induces other firms to enter industry with their own brands • This shifts down/left demand curve facing existing monopolistically competitive firms • Moreover, demand curve becomes more elastic since consumers now have a greater variety of choice • Process continues until no more firms enter industry (i.e. all firms are earning normal profit)

Figure 2: Impact on AR of entry of rival brands p AR0 AR1 Q 0

Figure 3: Monopolist LR Equilibrium π = 0 p LMC LAC p0 = LAC0 D = AR MR Q 0 Q0

II. Monopolistic Competition • Long-run tangency equilibrium where p = LAC • Monopolistically competitive firms are neither electively nor productively efficient • ‘... too many firms each producing too little output.’ (Chamberlain) • But … • ‘... excess capacity is the cost of differentness.’ (Chamberlain).

III. Oligopoly • ‘Competition among the few’ • Few producers, each of whom recognises that its own price depends on both its own output and the output of its rivals • Thus, firms are of a size and number that each must consider how its own actions affect the decisions of its relatively few competitors. • For example, firm must consider likely response of rivals before embarking on a price cutting strategy

III. Oligopoly • Collusion or competition? • Key element of all oligopolistic situations • Collusion; agreement between existing firms to avoid competition with one another • Can be explicit or implicit

III. Oligopoly • For example, existing firms might collude to maximise joint profits by behaving as if they were a multi-plant monopolist • i.e. restricting q to monopolist level, say q0, and then negotiating over the division of q and monopoly profits • Note, might not agree to divide up q equally; sensible for more efficient members of the cartel to produce q

Figure 4: Collusion or Competition p E0 p0 p1 MC MR D = AR q q0q1 0

III. Oligopoly • But, since cartel p > MC, each firm has an incentive to renege on the collusive agreement • ... temptation to reach the ‘first best’ renders the ‘second best’ unsustainable and drives firms to ‘third best’ First-Best: I renege, you collude Second-Best: Neither renege; we both collude Third-Best: We both renege • Cartels are inherently fragile!

Figure 4: Collusion or Competition p Cartel price is above cartel member’s marginal cost, thus incentive to renege (i.e. increase q) p0 Normal profit equilibrium p1 MC MR D = AR q q0q1 0

III. Oligopoly • Collusion is easiest when formal agreements between firms are legally permitted (e.g. OPEC). • More common in 19th century, but increasingly outlawed • Collusion is more difficult the more firms there are in the market, the less the product is standardised, and the more demand and cost conditions are changing in the absence of collusion

III. Oligopoly • In absence of collusion, each firm’s demand curve depends upon how competitors react, and firms have to make assumptions about this • A simple model of this was developed by Sweezy (1945) to explain that apparent fact that prices once set as a mark-up on average costs, tend not too change • ‘Kinked Demand Curve’ model

III. Oligopoly • Assume firm is at E0 selling q0 output at a unit price of p0 • Firm believes that if it raises price, its rivals will not raise their price (i.e. DA), but that if it lowers price, then its rivals will follow him (i.e. DB) • Thus demand curve is kinked at E0 being flatter for p > p0 and steeper for p < p0

Figure 5a: Kinked Demand Curve Model p E0 p0 DA DB q 0 q0

III. Oligopoly • Both the ‘no-follow’ demand curve (DA) and the ‘follow’ demand curve (DB) will have an associated MR curve (MRA, MRB) • Thus MR is discontinuous (i.e. vertical) at q0 since an increase in q beyond q0 will lead to a discontinuous fall in total revenue

Figure 5b: Kinked Demand Curve Model p E0 p0 DA DB q 0 q0 MRA MRB

Figure 5c: Kinked Demand Curve Model p E0 p0 D q 0 q0 MR

III. Oligopoly • Thus, fluctuations in marginal cost within the discontinuous part of the MR curve (i.e. within A-B) do not lead to a change in the firms profit-maximising level of output • Sweezy used the model to model the inflexibility of US agricultural prices in the face of cost changes

Figure 5a: Kinked Demand Curve Model p LMC E0 p0 A B D q 0 q0 MR

III. Oligopoly • But two key weaknesses: • Empirical Further evidence suggested that agriculture prices did not behave asymmetrically • Theoretical Model does not explain how we got to the initial equilibrium, or where we go if LMC moves outside of the discontinuity

III. Oligopoly • Cournot (1833) • Firms compete over quantities with ‘conjectural variation’ that other firm(s) will hold their output constant • Cournot originally envisaged two firms producing identical spring water at zero cost

III. Oligopoly • Two firms (a, b) costlessly produce identical spring water • Assume normal (inverse) demand curve for spring water is: qd = 100 – 5p <=> pd= 20 –0.2q • Assume that firm a believes that firm b will produce zero output (i.e. Ea{qb}=0); firm a’s optimal q is that which maximises firm a’s total revenue vis.

Figure 6a: Cournot Competition Firm a’s optimal output if Ea{qb}=0 p 20 Ea1 10 D = AR 50 q 100 0 MR

III. Oligopoly • However, if firm a were to produce 50 units, then firm b would presume that it (i.e. firm b) faces a (residual) demand curve of: • i.e. a residual demand given by the market demand for the good less firm a’s output • And firm b would make its optimal choice of output accordingly

Figure 6b: Cournot Competition p Firm a’s supply Firm b’s (residual) demand 20 Ea1 10 D´ = AR´ 50 q 0 100 MR MR´

Figure 6c: Cournot Competition Firm b’s residual demand p 10 Eb2 5 D = AR 25 q 0 50 MR

III. Oligopoly • Thus, if qa = 50, then firm b would maximise its profit (i.e. revenue) by setting qb = 25 • But this would imply that firm a would want to change its initial level of output; i.e. qa1 = 50 was optimal under the assumption that qb = 0 • But now that qb = 25, firm a will want to revise its choice of q accordingly

III. Oligopoly • Thus, firm a will choose the level of output that maximises total revenue given qb = 25 • Firm a’s residual demand curve is thus: • Such that

Figure 6d: Cournot Competition p Firm a’s supply Firm a’s (residual) demand 20 Eb2 15 D´ = AR´ MR´ q 25 0 100

Figure 6e: Cournot Competition Firm a’s residual demand p 15 Ea3 7.5 D = AR 37.5 q 0 75 MR

III. Oligopoly • This process will continue until neither firm ‘regrets’ its optimal choice of output • i.e. until its ‘conjectural variation’ regarding the other firm’s response is validated • The Cournot equilibrium is thus where:

Figure 6d: Cournot Competition Cournot Equilibrium p 20 Ea Eb D = AR q 0 33.3 33.3 100 MR MR´

III. Oligopoly • Cournot market shares

III. Oligopoly • It can be shown that total (i.e. market) equilibrium output under Cournot competition is given by: • where qc is the perfectly competitive level of output (i.e. where p = MC) • N.B. Usually termed ‘Nash-Cournot’ equilibrium, hence superscript ‘n’

III. Oligopoly • Monopoly n = 1 qn = (1/2)qc • Duopoly n = 2 qn = (2/3)qc • Perfect Competition n =qn = qc

III. Oligopoly • Cournot originally envisaged his model in term of sequential decision making on the part of firms • But it would irrational for each firm to persist with the conjectural variation that its rival will hold output constant when they only do so in equilibrium • Moreover, the model implies the existence of a future, in which case it can be shown that profitable collusion is sustainable

III. Oligopoly • Economists have re-interpreted Cournot’s model in terms of a one-shot game • i.e. only one amount of output actually put onto market vis. Cournot equilibrium level of output qn • But, it is assumed that each firm goes through a rational sequential decision making process before implementing its output choice

III. Oligopoly • The Cournot equilibrium may be re-interpreted in this sense as a Nash Equilibrium • That is, an equilibrium in which each party is maximising his utility given the behaviour of all the other parties • I am doing the best I can do, given what you are doing; and vice versa

III. Oligopoly • Stackelberg competition • Variation of Cournot in which firm a announces its output and, once that announcement is made, the output cannot be changed. • i.e. one-shot game or repeated game in which firm a produces the same level of output in each period.

III. Oligopoly • Assume: Firm 1 - market ‘leader’ Firm 2 - market ‘follower’ • N.B. firm 1 has to be able to make a credible, binding commitment to a particular output level

Figure 7: Stackelberg Competition p 20 E1 E2 Es 5 D´ = AR´ 50 25 75 q 0 100 MR MR´

III. Oligopoly • Bertrand Competition • Both Cournot and Stackelberg assume that firms chose outputs with prices determined by the inverse demand functions. • But in many oligopolistic markets firms appear to set prices and then sell whatever the market demands at those prices

Introductory Microeconomics (ES10001)