Monopolistic Competition and Basic Oligopoly Models - PowerPoint PPT Presentation

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Monopolistic Competition and Basic Oligopoly Models

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  1. Monopolistic Competition and Basic Oligopoly Models

  2. Monopolistic Competition (Chamberlin Model) Free entry, many firms sell (physically or perceivably) differentiated products. Firms ignore competitors. Each redefines market to a segment (consumers preferences) & estimates its own downward demand d. Other brands make firm’s demand d more elastic (for segment only) than market share curve M (for entire market). Firm’s market power limited, but still allows P > MC. In short run firm may move along d, but eventually similar conditions lead to similar P: each firm operates at d & M intersection. Equilibrium when firm’s re-estimatedd intersects M where SMC = MR.

  3. MC $ AC Monopolistic Competition in the Log-Run The Good(for Consumers): Product Variety The Bad(for Society): P > MC => Inefficiencies & Misallocations The Ugly(for Managers): Free Entry drives Long Run Profit to Normal = 0 Long Run Equilibrium (P = AC, so zero profits) P* P1 = AC1 AC* Entry D D1 MR Quantity of Brand X Q1 Q* MR1 Transitory Total Profit

  4. Strategies to Avoid (or Delay) the Zero Profit Outcome • Change; don’t let the long-run set in. • Be the first to introduce new brands or to improve existing products and services. • Seek out sustainable niches. • Create barriers to entry. • Increase the time it takes others to clone your brand with “trade secrets” and “strategic plans”.

  5. Oligopoly • Few sellers (< 10, 2 in duopoly) of homogeneous or differentiated product actively competing for market share. • Barriers to entry: • Entry limiting pricing P < P* and Market saturation: discourage entry • Fed Trade Commission antitrust against General Mills, General Foods & Kellogg for proliferation of brands (fill shelves & prevent entry) • Excess capacity (econ of scale) & reputed P retaliation: P cutting • In 1971 Proctor & Gamble (west cost) promoted (advertisement & P) its Folger in Pitt & Cleveland (General Foods’ Maxwell House turf). • GF lowered P & started promoting in midwest (shared turf). GF’s  30% in 1970, –30% in 1974. After PG retreated P &  recovered. • Capital requirements • Product differentiation, hard for entrant to attract customers • Strategic Interaction • What you do affects the profits of your rivals • What your rival does affects your profits

  6. Strategic Interdependence D2 (Rivals match your price change) P Firm is not in complete control of its own destiny. Change in firm’s quantity demanded depends on whether rivals match firm’s change in price! PH D (Rivals match your price Reductions but not price Increases) P0 PL D1 (Rivals hold their price constant) Q Q0

  7. P Sweezy (KinkedDemand) Model M = DMarket MCH MC MCL PK Few firms in the market (entry barriers) produce differentiated products.Each firm believes rivals match price reductions, but not price increases.Key feature: Price-Rigidity( cost firms operate at kink)With econ wide increase in production costs, firmmight profitable increaseprice, regardless of others.When others follow adjust d upward to new kink Q3,P2 MRM d = DFirm MRd D Q QK MR

  8. Sweezy Model: An Example • P = 10, TC = 1500 + 3Q + 0.0025Q2 • Consultant QM = 1500 - 50P and Qd = 3000 - 200P • At kink: Pk = 10 and Qk = 1000 QM = 1500 - 50P = 3000 - 200P = Qd • Vertical gap in MR (at Qk= 1000):MRM = 30 - 0.04*1000 = -10MRd = 15 - 0.005*1000 = 5 < MCMC = 3 + 0.005*1000 = 8 •  max: MRF -MC = 0 => QF = 800, PF = 11 •  Qk = 3000 < Q* = 3300

  9. Cournot Duopoly • Two firms produce homogenous product in an industry with barriers to entry • Firms maximize profit by setting output, as opposed to price • Each firm wrongly believes their rival will hold output constant if it changes its own output • Firm’s reaction (or best-response) function: profit maximizing amount of output for each quantity of output produced by rival

  10. Cournot’s Costless Duopoly 50

  11. Cournot Equilibrium • Each firm produces the profit maximizing output, given the output of rival firms • No firm gains by unilateral changes in its output • Assume: P = 950 - (Q1 + Q2) and MC = 50P = a - b(Q1 + Q2) and MCi = Ci max: MRi = 950 - 2Qi - Qj = 50 = MCMRi = a - 2bQi - bQj = Ci Qi = r(Qj) = 450 - 0.5Qj SimultaneouslyQi = r(Qj)= (a-Ci)/2b - Qj/2 solved: Q1 = Q2 = 300 • Perfect competition: P = MRT = 950 - QT = 50 = MC => QT = 900Duopoly: Q1 = Q2 = 300 & 300 unserved • Qn = Qpc[n/(1+n)], where n = # of firm in oligopoly

  12. Q2 r1 (Firm 1’s Reaction Function) Cournot Equilibrium Q2M Q2* r2 Q1M Q1* Q1 Cournot Equilibrium • Q1* maximizes firm 1’s profits, given that firm 2 produces Q2* • Q2* maximizes firm 2’s profits, given that firm 1 produces Q1* • No firm has an incentive to change output, given rival’s output • Beliefs are consistent: • In equilibrium, each firm “thinks” rival will stick to current output - and they do!

  13. Stackelberg Model • Few firms produce differentiated or homogeneous products in industry with barriers to entry • Firm leader commits to an output before followers • Remaining firms, followers, profit maximizing outputs, given the leader’s output. • Commitment and first-mover advantage can enhance profits in strategic environments • Leader produces more than in Cournot equilibrium (Larger market share, higher profits) • Follower produces less than in Cournot equilibrium (Smaller market share, lower profits)

  14. Stackelberg Equilibrium • Assume: P = a - b(Q1 + Q2) and MCi = Ci • Q1 chosen to maximize profitQ2 = r(Q1) = (a-C2)/2b - Q1/2 Cournot reaction to Q1 • 1 = PQ1 - TC1 = [a - b(Q1 + Q2)]Q1 - TC1= {a - b[Q1 + (a-C2)/2b - Q1/2]}Q1 - TC1 • max 1: d1/dQ1 = a - 2bQ1 - (a-C2)/2 + bQ1 - C1 = 0 Q1 = (a + C2 - 2C1) / 2b Q2 = (a-C2)/2b - Q1/2 • Q1Stackelberg> [QiCournot = (a-Ci)/2b - Qj/2] > Q2Stackelberg

  15. Bertrand and Edgeworth Duopoly • Two firms produce identical products at constant MC,in an industry with barriers to entry • Each firm independently sets its profit maximizing price • Consumers have perfect knowledge & no transaction costs • Suppose MC < P1 < P2 • Firm 1 earns (P1 - MC) per unit and firm 2 earns nothing • Firm 2 undercuts firm 1’s price to capture the entire market • Firm 1 then undercuts firm 2’s price • Undercutting continues until equilibrium: P1 = P2 = MC • Perfect competition profit maximizing solution P = MC possible with few firms and severe price competition • If duopolists have limited capacity relative to the Bertrand equilibrium, Edgeworth argued that price will not be stable

  16. Chamberlin Duopoly • Chamberlin applied results from his analysis of monopolistic competition on oligopoly • Cournot, Bertrand and Edgeworth models assume that competitors are extremely naïve • Chamberlin argued that oligopolists would recognize their mutual or strategic interdependence and engage in tacit or informal collusion: independently choose monopoly price and split profits • Managers signal to competitors their desire not to engage in destructive price war by setting price • Agreements are not necessary because firms realize any other strategy is less profitable • Formal Collusive agreements are illegal, although U. S. firms have been permitted to agree on export pricing

  17. Perfect Collusion: The Cartel • Monopoly against world. Max profit: Pcartel>MRcartel=MCmembers • Production allocated inside with MC rule: MRcartel=MCA=…=MCn(Ideal that lowest unit cost member has the highest Q & profit is sometimes modified in short run to maintain unity) • Assume Q=1660–200P. Set MR=8.3-.001Q=.305+.000508Q=MC(MCA=.15+.00015QA, MCB=.60+.0002QB & MCC=.25+.000125QC) and solve for QT=5300, P=5.65 and MR=3. Set MR=3=MCi and solve for allocations: QA=1900, QB=1200 & QA=2200

  18. Contestable Markets • Few sellers but free entry: Oligopoly will price at a perfect competition level & have only normal  = 0 • Key Assumptions • Producers have access to same technology • Consumers respond quickly to price changes • Existing firms cannot respond quickly to entry by lowering price • Absence of sunk costs • Key Implications • Threat of entry disciplines firms already in the market • Incumbents have no market power, even if there is only a single incumbent (a monopolist)

  19. Summary • Different oligopoly scenarios lead to different optimal strategies and different outcomes • Your optimal price and output depends on … • Beliefs about the reactions of rivals • Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products) • Your ability to commit