Oligopolies and monopolistic competition
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Oligopolies and monopolistic competition. In between the two competition benchmarks . Oligopolies and monopolistic competition. Today we finish examining the competition continuum we introduced last week

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Oligopolies and monopolistic competition

In between the two competition benchmarks


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Oligopolies and monopolistic competition

  • Today we finish examining the competition continuum we introduced last week

  • After today, you will know all four of the main models used to explain the different market structures

    • The two extreme benchmarks (previous weeks)

    • The two “middle ground” models


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Market power of firms

Perfect competition

Monopolistic competition

Monopoly

Oligopoly

Many firms with a homogeneous product

A few producers with high market power

A single producer

Many firms with differentiated products

Oligopolies and monopolistic competition

The “competition continuum”


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Oligopolies and monopolistic competition

  • Importantly, the two cases we see today are in the middle of the competition continuum

  • They are more realistic that the extreme benchmarks of perfect competition and pure monopoly

    • More “powerful” models in that they correspond better to the real world

    • Unfortunately, this means that they are also more complex

    • These models have required the development of new tools


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Oligopolies and monopolistic competition

Oligopolies

Monopolistic competition


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Oligopolies

  • The oligopoly corresponds to the following market structure :

  • A few large producers

  • Homogeneous products

  • No entry of competing producers on the market

  • Perfect information

  • Perfect mobility of inputs

  • Apart from the few producers instead of one, this is not much different from the monopoly


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Oligopolies

  • Oligopolies are usually caused by the presence of barriers to entry which deter potential competitors.

    • Institutional or regulatory barriers (Example: defence industry or utilities)

    • The nature of the technology, which determines the existence of returns to scale and the minimal efficient scale of the firm (Example : Aeronautical industry)

    • Absolute cost differentials: Vertical integration, access to an efficient supply or distribution network (example: agribusiness)


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Oligopolies

  • This is a common situation in many industries :

    • Car industry, aeronautical industry

    • Agribusiness (Nestlé, Danone, Kraft foods, Coca-Cola Co)

    • Electronics, computing

    • Utilities, buildings, etc.

  • Compared to the monopoly case, each firm has an extra element to consider: The behaviour of its competitors (introduced last week)

    • Because a firm’s output influences market prices, competitors will react

    • This will lead to strategic behaviour


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Oligopolies

  • A simple solution for the market price and quantity is possible if the firms decide to cooperate. This cooperative equilibrium is called a cartel.

  • OPEC is a good example: an organisation of independent producers, producing the same goods, who decide to coordinate their strategies, so as to limit their output and increase prices.

    • The good news: When firms do this (ie maximise collective profit), they practise monopoly pricing and get monopoly profits. This means the simple monopoly model is enough

    • The “bad” news: This practise is illegal in most countries! Also, there is an incentive to cheat. So usually, firms will not cooperate, and a more complex model is needed...


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G

p

Inverse demand facing firm A

mRA

q

Oligopolies

mCA

The cooperative equilibrium

Price

ACA

Quantity


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Oligopolies

  • When firms in an oligopoly do not cooperate, there is a non-cooperative equilibrium

  • Compared to the monopoly and the cooperative cartel case, it becomes difficult to characterise the market equilibrium (equilibrium price and quantity)

    • If a firm changes its output (price), this changes the market price, and the profits of competitors. They will react to this change in profits by changing their output (price).

  • The optimal strategy of a firm depends on the strategies of its competitors. There are as many types of equilibria as there are combinations of strategies.


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Oligopolies

  • As a simplification, economic theory typically examines the duopoly: The case with two producers on a market with barriers to entry

  • There are many possible models of duopoly:


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Oligopolies

  • The Cournot duopoly (1838) :

    • Is the first and simplest model of a duopoly: each firm considers the output of its competitor as given

    • The 2 firms simultaneously choose their output, and consider that the current output of their competitor will not change (not very realistic...)


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Oligopolies

  • The profits of the two firms is given by:

  • For simplicity, we re-write them as:

The cost of production depends only on the firm’s output

The market pricehowever, depends on the aggregate output q1 + q2


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Oligopolies

  • As for all firms, the maximum profit condition is given by the first order condition

  • These first order conditions can be rearranged to give a system of equations known as reaction functions

A reaction function tells you the quantity q1 that maximises the profits of firm 1 given the quantity q2 produced by firm 2


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C1

C0

C3

C2

q*2

q*1

Oligopolies

Reaction functions and Cournot equilibrium

q2

Reaction function of firm 1

Reaction function of firm 2

C

q1


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Oligopolies

  • The existence and the stability of an equilibrium in an oligopoly depends on the expectations that firms form about the strategies of their competitors

    • Several different equilibria are possible depending on the various combinations of strategies formulated.

  • Most often, the tools of classical economics cannot find these different equilibria...

    • ...unless strong simplifying assumptions are made. See the Cournot example: “treat output as given”

  • Game theory was developed as a response to this problem.

  • This will be seen next week


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Oligopolies and monopolistic competition

Oligopolies

Monopolistic competition


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Monopolistic competition

  • Monopolistic competition corresponds to the following market structure :

  • Large number of agents (Atomicity)

  • Differentiated products

  • Free entry and exit from the market

  • Perfect information

  • Perfect mobility of inputs

  • The output of each producer is slightly different from the others ⇒ existence of varieties (brands)


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Monopolistic competition

  • Because each firm produces a slightly different good, consumers can have preferences over these different varieties.

    • There will be an element of “brand loyalty” in consumer behaviour, where one variety of a good will be preferred over another one.

  • Examples: Corner shops, restaurants, hair dressers, travel agents, etc.

  • Unfortunately, the algebra necessary to generate such “preference for variety” models is a bit complicated ⇒ We will only look at the diagrams


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Monopolistic competition

  • Each firm has a smallamount of market power

    • Because of “brand loyalty”, it can increase its price a bit without loosing all its customers (as is the case in perfect competition)

    • The price elasticity of demand is not infinite

    • The demand curve facing the firm is downward-sloping (not flat as in perfect competition)

    • There will be a (small) mark-up: Price is above mC

  • However, because firms can enter the market freely, economic profits are equal to zero in the long run


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Monopolistic competition

  • How does this work ?

    • At the firm level, the short run equilibrium diagram looks like the monopoly diagram

      • It also solves like a monopoly ⇒ short run profits

    • The adjustment to the long run behaves like perfect competition:

      • Extra firms enter the market, attracted by the profits

      • The demand facing each firm decreases until profits are competed away


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Monopolistic competition

Firm-market equilibrium

Firm level

Market level

Price

Price

mC

Positive profits in the short run

S

AC

p

d

mR

D

quantity

Quantity

Q

q


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Monopolistic competition

Firm-market equilibrium

Firm level

Market level

Price

Price

Positive profits attract firms to the market (free entry + perfect information)

mC

zero profits in the long run

S

S

AC

p

p2

d

mR

D

quantity

Quantity

Q

Q2

q2

q


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Demand

mR

Monopolistic competition

Long run welfare implications

Price

mC

AC

In the long run, Total revenue is equal to Total cost ⇒ Profits are equal to zero

p = AC

Similar to perfect competition. An improvement on monopolies/oligopolies

p

q

Quantity


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Consumer surplus

Producer surplus

p

Demand

mR

q

Monopolistic competition

Long run welfare implications

Price

mC

AC

Even in the long run, there is a mark-up

p > mC

This implies some deadweight loss

Quantity


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Demand

mR

Monopolistic competition

Long run welfare implications

Price

mC

AC

Firms are not producing at the minimum AC. There is excess capacity (i.e. some production resources are wasted)

p

q

q*

Quantity


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Monopolistic competition

  • This model has a competitive limit

  • The weaker the preferences of consumer for variety (the “brand loyalty”), the less market power the firms have and the closer the model predictions are to perfect competition

    • The demand curve becomes flatter

    • The mark-up and deadweight loss are reduced

  • The equilibrium tends to P = mC = AC


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Monopolistic competition

The competitive limit

Case 1

Case 2

Price

Price

mC

mC

AC

AC

p

p

d

d

mR

mR

quantity

Quantity

q

q


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