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Economic Models of Conduct

Economic Models of Conduct. The Theoretical Effects of Structure Changes on Conduct in the Music Industry. Monopolistic Competition. Characteristics Many small firms Differentiated products Easy Entry Implications Downward sloping demand curves MR = MC to maximize profits

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Economic Models of Conduct

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  1. Economic Models of Conduct The Theoretical Effects of Structure Changes on Conduct in the Music Industry

  2. Monopolistic Competition • Characteristics • Many small firms • Differentiated products • Easy Entry • Implications • Downward sloping demand curves • MR = MC to maximize profits • Economic Profit attracts entry • Zero Economic Profit in the Long Run

  3. Monopolistic Competition • Reductions in cost (MC and AC) • Increase Q and reduce P • Profits increase • This attracts entry • Long Run Equilibrium • Economic Profit = 0 • Q falls • P falls • The number of firms (products) increases

  4. Bertrand: Homogeneous Good • Firms choose prices assuming rival does not react • Homogeneous good: perfect substitutes • Firm with lowest price takes entire market • Firms choosing the same price split market Q • Linear demand, constant MC • Nash Equilibrium: P = MC with only 2 firms • Graph

  5. Bertrand: Differentiated Products • Firms produce imperfect substitutes • Firms simultaneously choose prices • Q1 = 50 – 5P1 + P2, Q2 = 50 – 5P2 + P1 • Fixed Cost = 20, Marginal Cost = 1 • π1 = P1Q1- MC(Q1) - FC • = P1(50 - 5P1 + P2) - 1(50 - 5P1+ P2) - 20 • = 50P1 – 5P12 + P1P2 – 50 + 5P1 - P2 - 20 • ∆π1/∆P1 = 50 - 10P1 + P2 + 5 = 55 - 10P1+ P2 = 0 • Firm 1’s Reaction Curve: P1 = 5.5 + 0.1P2 • Firm 2’s Reaction Curve: P2 = 5.5 + 0.1P1

  6. Differentiated Bertrand (cont’d) • Firm 1’s Reaction Curve: P1 = 5.5 + 0.1P2 • Firm 2’s Reaction Curve: P2 = 5.5 + 0.1P1 • Substitute for P2 in firm 1’s reaction curve and solve for P1 • P1 = 5.5 + 0.1(5.5 + 0.1P1) = 6.05 + 0.01P1 • 0.99P1 = 6.05 • P1 = P2 = $6.11 • Q1 = Q2 = 50 – 5(6.11) + 6.11 = 25.56 • π1 = π2 = 6.11(25.56) – 1(25.56) – 20 = $110.61

  7. Bertrand: Differentiated Products • Now suppose costs fall: MC = 0, FC = 10 • π1 = P1Q1- MC(Q1) - FC • = P1(50 - 5P1 + P2) - 0(50 - 5P1+ P2) - 10 • = 50P1 – 5P12 + P1P2 - 20 • ∆π1/∆P1 = 50 - 10P1 + P2 = 0 • Firm 1’s Reaction Curve: P1 = 5 + 0.1P2 • Firm 2’s Reaction Curve: P2 = 5 + 0.1P1

  8. Differentiated Bertrand (cont’d) • Firm 1’s Reaction Curve: P1 = 5 + 0.1P2 • Firm 2’s Reaction Curve: P2 = 5 + 0.1P1 • Substitute for P2 in firm 1’s reaction curve and solve for P1 • P1 = 5 + 0.1(5 + 0.1P1) = 5.5 + 0.01P1 • 0.99P1 = 5.5 • P1 = P2 = $5.56 • Q1 = Q2 = 50 – 5(5.56) + 5.56 = 27.76 • π1 = π2 = 5.56(27.76) – 0(27.76) – 10 = $144.35

  9. Bertrand Conclusion • Falling MC reduces Price and increases Q • Changes in FC only affect profits, not Q • As costs fall • Price falls • Quantity increases • Profits increase • Does this attract entry? • Entry causes P to approach MC; • Market Q approaches Competitive Q • QM= [n/(n + 1)]Qc • n is the number of firms (products)

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