Imperfect Competition Part III

1. Chapter 11 Imperfect Competition © 2004 Thomson Learning/South-Western

2. Cournot Equilibrium • In this Cournot equilibrium each firm produces 40 units of output. • Total industry profit is $3,200, $1600 for each firm). • Because the firms do not fully coordinate their actions, their profits are less than the cartel profit ($3,600) but much greater than the competitive solution where P = MC = 0.

3. Price Leadership Model • A model in which one dominant firm takes reactions of all other firms into account in its output and pricing decisions is the price leadership model. • A formal model assumes the industry is composed of a single price-setting leader and a competitive fringe which is a group of firms that act as price takers.

4. Price Leadership Model • This model is shown in Figure 11.4. • The demand curve D represents the total demand curve for the industry’s product. • The supply curve SC represents the supply decisions of all the firms in the competitive fringe.

5. FIGURE 11.4: Formal Model of Price Leadership Model Price SC D Quantity per week 0

6. Price Leadership Model • The demand curve (D’) for the dominant firm is derived as follows: • For a price of P1 or above the competitive fringe will supply the entire market. • For a price of P2 or below, the dominant firm will supply the entire market. • Between P2 and P1 the curve D’ is constructed by subtracting what the fringe will supply from the total market demand.

7. FIGURE 11.4: Formal Model of Price Leadership Model Price SC P 1 D’ P 2 D Quantity per week 0

8. Price Leadership Model • Given D’, the leader’s marginal revenue curve is MR’ which equals the leader’s marginal cost (MC) at the profit maximizing level QL. • Market price is PL and equilibrium output is QT (= QC + QL). • The model does not explain how the leader is chosen.

9. FIGURE 11.4: Formal Model of Price Leadership Model Price SC P 1 D’ P L P 2 MC MR’ D Quantity per week 0 Q Q Q C L T

10. APPLICATION 11.2: Cournot in California • Borenstein and Bushnell paper: Perhaps the most elaborate attempt at modeling the impact of electricity deregulation in California. • Authors focus on competition between the three major electricity-generating firms. • They argue that the smaller suppliers can be treated as competitive suppliers but that the major in-state producers behave in the way assumed in the Cournot model.

11. APPLICATION 11.2: Cournot in California • Borenstein and Bushnell show that under certain circumstances there is substantial market power in California wholesale electricity markets. • One way to measure that power is by the Lerner Index, the ratio (P – MC/P). • The authors showed with the Lerner Index that during peak periods, equilibrium in these markets is far from the competitive ideal. • They also show that market power can be significantly restrained by larger price elasticities of demand for electricity.

12. Product Differentiation: Market Definition and Firms Choices • A product group is a set of differentiated products that are highly substitutable for one another. • Assume few firms in each product group. • Firms will incur additional costs to differentiate their product up to the point where the additional revenue from this activity equals the marginal cost.

13. Product Differentiation: Market Equilibrium • The demand curve for each firm depends on the prices and product differentiation activities of its competitors. • The firm’s demand curve may shift frequently, and its position at any point in time may only be partially understood. • Each firm must make assumptions about its competitors’ actions, and whatever one firm decides may affect its competitor’s actions.