Transcript Chapter 12

Chapter 12
Monopolistic Competition
and Oligopoly
Topics to be Discussed
 Monopolistic Competition
 Oligopoly
 Price Competition
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Monopolistic Competition
 Characteristics
1. Many firms
2. Free entry and exit
3. Differentiated product
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Monopolistic Competition
 The amount of monopoly power depends
on the degree of differentiation
 Examples of this very common market
structure include:
Toothpaste
Soap
Cold remedies
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Monopolistic Competition
 Toothpaste
 Crest and monopoly power
 Procter
& Gamble is the sole producer of Crest
 Consumers can have a preference for Crest –
taste, reputation, decay-preventing efficacy
 The greater the preference (differentiation) the
higher the price
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Monopolistic Competition
 Two important characteristics
Differentiated but highly substitutable
products
Free entry and exit
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A Monopolistically Competitive
Firm in the Short and Long Run
$/Q
Short Run
$/Q
MC
Long Run
MC
AC
AC
PSR
PLR
DSR
DLR
MRSR
QSR
Quantity
MRLR
QLR
Quantity
A Monopolistically Competitive
Firm in the Short and Long Run
 Short run
Downward sloping demand – differentiated
product
Demand is relatively elastic – good
substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits
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A Monopolistically Competitive
Firm in the Short and Long Run
 Long run
Profits will attract new firms to the industry
(no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC  some monopoly power
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Monopolistically and Perfectly
Competitive Equilibrium (LR)
$/Q
Monopolistic Competition
Perfect Competition
$/Q
MC
Deadweight
loss
AC
MC
AC
P
PC
D = MR
DLR
MRLR
QC
Quantity
QMC
Quantity
Monopolistic Competition and
Economic Efficiency
 The monopoly power yields a higher
price than perfect competition. If price
was lowered to the point where MC = D,
consumer surplus would increase by the
yellow triangle – deadweight loss.
 With no economic profits in the long run,
the firm is still not producing at minimum
AC and excess capacity exists.
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Monopolistic Competition and
Economic Efficiency
 Firm faces downward sloping demand so
zero profit point is to the left of minimum
average cost
 Excess capacity is inefficient because
average cost would be lower with fewer
firms
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Monopolistic Competition
 If inefficiency is bad for consumers,
should monopolistic competition be
regulated?
 Market power is relatively small. Usually
there are enough firms to compete with
enough substitutability between firms –
deadweight loss small.
 Inefficiency is balanced by benefit of
increased product diversity – may easily
outweigh deadweight loss.
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The Market for Colas and Coffee
 Each market has much differentiation in
products and tries to gain consumers
through that differentiation
Coke vs. Pepsi
Maxwell House vs. Folgers
 How much monopoly power do each of
these producers have?
How elastic is demand for each brand?
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Elasticities of Demand for
Brands of Colas and Coffee
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The Market for Colas and Coffee
 The demand for Royal Crown is more
price inelastic than for Coke
 There is significant monopoly power in
these two markets
 The greater the elasticity, the less
monopoly power and vice versa
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Oligopoly – Characteristics
 Small number of firms
 Product differentiation may or may not
exist
 Barriers to entry
Scale economies
Patents
Technology
Name recognition
Strategic action
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Oligopoly
 Examples
Automobiles
Steel
Aluminum
Petrochemicals
Electrical equipment
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Oligopoly
 Management Challenges
Strategic actions to deter entry
 Threaten
to decrease price against new
competitors by keeping excess capacity
Rival behavior
 Because
only a few firms, each must consider
how its actions will affect its rivals and in turn
how their rivals will react
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Oligopoly – Equilibrium
 If one firm decides to cut their price, they
must consider what the other firms in the
industry will do
Could cut price some, the same amount, or
more than firm
Could lead to price war and drastic fall in
profits for all
 Actions and reactions are dynamic,
evolving over time
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Oligopoly – Equilibrium
 Defining Equilibrium
 Firms are doing the best they can and have no
incentive to change their output or price
 All firms assume competitors are taking rival
decisions into account
 Nash Equilibrium
 Each firm is doing the best it can given what its
competitors are doing
 We will focus on duopoly
 Markets in which two firms compete
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Oligopoly
 The Cournot Model
Oligopoly model in which firms produce a
homogeneous good, each firm treats the
output of its competitors as fixed, and all
firms decide simultaneously how much to
produce
Firm will adjust its output based on what it
thinks the other firm will produce
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Firm 1’s Output Decision
P1
Firm 1 and market demand curve,
D1(0), if Firm 2 produces nothing.
D1(0)
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(0)
D1(75)
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MR1(75)
MC1
MR1(50)
12.5 25
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D1(50)
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Q1
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Oligopoly
 The Reaction Curve
The relationship between a firm’s profitmaximizing output and the amount it thinks
its competitor will produce
A firm’s profit-maximizing output is a
decreasing schedule of the expected output
of Firm 2
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Reaction Curves and Cournot
Equilibrium
Q1
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model.
100
75
Firm 2’s Reaction
Curve Q*2(Q1)
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce.
50 x
25
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
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x
75
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x
100
Q2
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Reaction Curves and Cournot
Equilibrium
Q1
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits.
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Firm 2’s Reaction
Curve Q*2(Q1)
50 x
25
Cournot
Equilibrium
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
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x
75
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100
Q2
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Cournot Equilibrium
 Each firm’s reaction curve tells it how
much to produce given the output of its
competitor
 Equilibrium in the Cournot model, in
which each firm correctly assumes how
much its competitor will produce and sets
its own production level accordingly
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Oligopoly
 Cournot equilibrium is an example of a
Nash equilibrium (Cournot-Nash
Equilibrium)
 The Cournot equilibrium says nothing
about the dynamics of the adjustment
process
 Since both firms adjust their output, neither
output would be fixed
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The Linear Demand Curve
 An Example of the Cournot Equilibrium
Two firms face linear market demand curve
We can compare competitive equilibrium and
the equilibrium resulting from collusion
Market demand is P = 30 - Q
Q is total production of both firms:
Q = Q1 + Q2
Both firms have MC1 = MC2 = 0
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Oligopoly Example
 Firm 1’s Reaction Curve  MR = MC
Total Revenue : R1  PQ1  (30  Q)Q1
 30Q1  (Q1  Q2 )Q1
 30Q1  Q12  Q2Q1
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Oligopoly Example
 An Example of the Cournot Equilibrium
MR1  R1 Q1  30  2Q1  Q2
MR1  0  MC1
Firm 1' s Reaction Curve
Q1  15  1 2 Q2
Firm 2' s Reaction Curve
Q2  15  1 2 Q1
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Oligopoly Example
 An Example of the Cournot Equilibrium
Cournot Equilibriu m : Q1  Q2
15  1 2(15  1 2Q1 )  10
Q  Q1  Q2  20
P  30  Q  10
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Duopoly Example
Q1
30
Firm 2’s
Reaction Curve
The demand curve is P = 30 - Q and
both firms have 0 marginal cost.
Cournot Equilibrium
15
10
Firm 1’s
Reaction Curve
10
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Q2
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Oligopoly Example
 Profit Maximization with Collusion
R  PQ  (30  Q)Q  30Q  Q
MR  R Q  30  2Q
MR  0 when Q  15 and MR  MC
2
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Profit Maximization w/ Collusion
 Collusion Curve
Q1 + Q2 = 15
 Shows
all pairs of output Q1 and Q2 that
maximize total profits
Q1 = Q2 = 7.5
 Less
output and higher profits than the Cournot
equilibrium
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Duopoly Example
Q1
30
Firm 2’s
Reaction Curve
For the firm, collusion is the best
outcome followed by the Cournot
Equilibrium and then the
competitive equilibrium
Competitive Equilibrium (P = MC; Profit = 0)
15
Cournot Equilibrium
Collusive Equilibrium
10
7.5
Firm 1’s
Reaction Curve
Collusion
Curve
7.5 10
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Q2
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First Mover Advantage – The
Stackelberg Model
 Oligopoly model in which one firm sets its
output before other firms do
 Assumptions
One firm can set output first
MC = 0
Market demand is P = 30 - Q where Q is total
output
Firm 1 sets output first and Firm 2 then
makes an output decision seeing Firm 1’s
output
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First Mover Advantage – The
Stackelberg Model
 Firm 1
Must consider the reaction of Firm 2
 Firm 2
Takes Firm 1’s output as fixed and therefore
determines output with the Cournot reaction
curve: Q2 = 15 - ½(Q1)
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First Mover Advantage – The
Stackelberg Model
 Firm 1
Choose Q1 so that:
MR  MC  0
R1  PQ1  30Q1 - Q - Q2Q1
2
1
Firm 1 knows Firm 2 will choose output
based on its reaction curve. We can use Firm
2’s reaction curve as Q2 .
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First Mover Advantage – The
Stackelberg Model
 Using Firm 2’s Reaction Curve for Q2:
R1  30Q1  Q12  Q1 (15  1 2Q1 )
 15Q1  1 2 Q12
MR1  R1 Q1  15  Q1
MR  0 : Q1  15 and Q2  7.5
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First Mover Advantage – The
Stackelberg Model
 Conclusion
Going first gives Firm 1 the advantage
Firm 1’s output is twice as large as Firm 2’s
Firm 1’s profit is twice as large as Firm 2’s
 Going first allows Firm 1 to produce a
large quantity. Firm 2 must take that into
account and produce less unless it wants
to reduce profits for everyone.
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Price Competition
 Competition in an oligopolistic industry
may occur with price instead of output
 The Bertrand Model is used
Oligopoly model in which firms produce a
homogeneous good, each firm treats the
price of its competitors as fixed, and all firms
decide simultaneously what price to charge
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Price Competition – Bertrand
Model
 Assumptions
Homogenous good
Market demand is P = 30 - Q where
Q = Q1 + Q2
MC1 = MC2 = $3
 Can show the Cournot equilibrium if Q1 =
Q2 = 9 and market price is $12, giving
each firm a profit of $81.
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Price Competition – Bertrand
Model
 Assume here that the firms compete with
price, not quantity
 Since good is homogeneous, consumers
will buy from lowest price seller
If firms charge different prices, consumers
buy from lowest priced firm only
If firms charge same price, consumers are
indifferent who they buy from
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Price Competition – Bertrand
Model
 Nash equilibrium is competitive output
since have incentive to cut prices
 Both firms set price equal to MC
P = MC; P1 = P2 = $3
Q = 27; Q1 & Q2 = 13.5
 Both firms earn zero profit
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Price Competition – Bertrand
Model
 Why not charge a different price?
If charge more, sell nothing
If charge less, lose money on each unit sold
 The Bertrand model demonstrates the
importance of the strategic variable
Price versus output
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Bertrand Model – Criticisms
 When firms produce a homogenous
good, it is more natural to compete by
setting quantities rather than prices
 Even if the firms do set prices and
choose the same price, what share of
total sales will go to each one?
It may not be equally divided
 Kreps and Scheinkman
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Price Competition –
Differentiated Products
 Market shares are now determined not
just by prices, but by differences in the
design, performance, and durability of
each firm’s product
 In these markets, more likely to compete
using price instead of quantity
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Price Competition –
Differentiated Products
 Example
Duopoly with fixed costs of $20 but zero
variable costs
Firms face the same demand curves
 Firm
1’s demand: Q1 = 12 - 2P1 + P2
 Firm 2’s demand: Q2 = 12 - 2P1 + P2
Quantity that each firm can sell decreases
when it raises its own price but increases
when its competitor charges a higher price
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Price Competition –
Differentiated Products
 Firms set prices at the same time
Firm 1 :  1  P1Q1  $20
 P1 (12  2 P1  P2 )  20
 12 P1 - 2 P  P1 P2  20
2
1
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Price Competition –
Differentiated Products
 If P2 is fixed:
Firm 1' s prof it maximizing price 
 1 P1  12  4 P1  P2  0
Firm 1' s reaction curve 
P1  3  1 4 P2
Firm 2' s reaction curve 
P2  3  1 4 P1
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