Transcript Chapter 12

Chapter 12
Monopolistic Competition and
Oligopoly
Topics to be Discussed
 Monopolistic Competition
 Oligopoly
 Price Competition
 Competition Versus Collusion: The
Prisoners’ Dilemma
 Implications of the Prisoners’ Dilemma for
Oligopolistic Pricing
 Cartels
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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 &
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
Inefficiencies would make consumers worse
off
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Monopolistic Competition
 If inefficiency bad for consumers, should
monopolistic competition be regulated?
 Market power relatively small. Usually
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 try to gain consumers
through that differentiation
Coke versus Pepsi
Maxwell House versus Folgers
 How much monopoly power do each of
these producers have?
How elastic 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 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)
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(Q2)
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
25
Reaction Curves and Cournot
Equilibrium
Q1
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximize its own profits.
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Firm 2’s Reaction
Curve Q*2(Q2)
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 firms 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  MC 1
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 Equilibrium : 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
 Contract Curve
Q1 + Q2 = 15
 Shows
all pairs of output Q1 and Q2 that
maximizes 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
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 Q
2
1
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 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 profits 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.
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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 + P1
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 profit 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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Nash Equilibrium in Prices
 What if both firms collude
They both decide to charge the same price
that maximized both of their profits
Firms will charge $6 and will be better off
colluding since they will earn a profit of $16
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Nash Equilibrium in Prices
P1
Firm 2’s Reaction Curve
Collusive Equilibrium
Equilibrium at price
of $4 and profits of
$12
$6
$4
Firm 1’s Reaction Curve
Nash Equilibrium
$4
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$6
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P2
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Nash Equilibrium in Prices
 If Firm 1 sets price first and then firm 2
makes pricing decision
Firm 1 would be at a distinct disadvantage by
moving first
The firm that moves second has an
opportunity to undercut slightly and capture a
larger market share
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A Pricing Problem: Procter &
Gamble
 Procter & Gamble, Kao Soap, Ltd., and
Unilever, Ltd were entering the market
for Gypsy Moth Tape.
 All three would be choosing their prices
at the same time.
 Each firm was using same technology so
had same production costs
FC = $480,000/month & VC = $1/unit
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A Pricing Problem: Procter &
Gamble
 Procter & Gamble had to consider
competitors prices when setting their
price.
 P&G’s demand curve was:
Q = 3,375P-3.5(PU).25(PK).25
Where P, PU, PK are P&G’s, Unilever’s, and
Kao’s prices respectively
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A Pricing Problem: Procter &
Gamble
 What price should P&G choose and what
is the expected profit?
 Can calculate profits by taking different
possibilities of prices you and the other
companies could charge.
 Nash equilibrium is at $1.40 – the point
where competitors are doing the best
they can as well
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P&G’s Profit (in thousands of $
per month)
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A Pricing Problem for Procter &
Gamble
 Collusion with competitors will give larger
profits.
If all agree to charge $1.50, each earn profit
of $20,000
Collusions agreement hard to enforce
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Competition Versus Collusion:
The Prisoners’ Dilemma
 Nash equilibrium is a noncooperative
equilibrium: each firm makes decision
that gives greatest profit, given actions of
competitors
 Although collusion is illegal, why don’t
firms cooperate without explicitly
colluding?
Why not set profit maximizing collusion price
and hope others follow?
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Competition Versus Collusion:
The Prisoners’ Dilemma
 Competitor is not likely to follow
 Competitor can do better by choosing a
lower price, even if they know you will set
the collusive level price.
 We can use example from before to
better understand the firms’ choices
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Competition Versus Collusion:
The Prisoners’ Dilemma
 Assume:
FC  $20 and VC  $0
Firm 1' s demand : Q  12  2 P1  P2
Firm 2' s demand : Q  12  2 P2  P1
Nash Equilibriu m : P  $4
Collusion :
P  $6
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  $12
  $16
62
Competition Versus Collusion:
The Prisoners’ Dilemma
 Possible Pricing Outcomes:
Firm 1 : P  $6
Firm 2 : P  $6
P  $6
P  $4
 2  P2Q2  20
  $16
 (4)12  (2)(4)  6  20  $20
 1  P1Q1  20
 (6)12  (2)(6)  4  20  $4
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Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $4
Charge $6
$12, $12
$20, $4
$4, $20
$16, $16
Firm 1
Charge $6
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Competition Versus Collusion:
The Prisoners’ Dilemma
 We can now answer the question of why firm
does not choose cooperative price.
 Cooperating means both firms charging $6
instead of $4 and earning $16 instead of $12
 Each firm always makes more money by
charging $4, no matter what its competitor does
 Unless enforceable agreement to charge $6,
will be better off charging $4
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Competition Versus Collusion:
The Prisoners’ Dilemma
 An example in game theory, called the
Prisoners’ Dilemma, illustrates the
problem oligopolistic firms face.
Two prisoners have been accused of
collaborating in a crime.
They are in separate jail cells and cannot
communicate.
Each has been asked to confess to the
crime.
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Payoff Matrix for Prisoners’
Dilemma
Prisoner B
Confess
Confess
Prisoner A
Don’t
confess
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-5, -5
Don’t confess
-1, -10
Would you choose to confess?
-10, -1
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Oligopolistic Markets

1.
2.
3.
Conclusions
Collusion will lead to greater profits
Explicit and implicit collusion is possible
Once collusion exists, the profit motive
to break and lower price is significant
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Payoff Matrix for the P&G
Pricing Problem
Unilever and Kao
Charge $1.40
Charge
$1.40
P&G
$12, $12
Charge $1.50
$29, $11
What price should P & G choose?
Charge
$1.50
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$3, $21
Chapter 12
$20, $20
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Observations of Oligopoly
Behavior
1. In some oligopoly markets, pricing
behavior in time can create a
predictable pricing environment and
implied collusion may occur.
2. In other oligopoly markets, the firms are
very aggressive and collusion is not
possible.
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Observations of Oligopoly
Behavior
2. In other oligopoly markets, the firms are
very aggressive and collusion is not
possible.
a. Firms are reluctant to change price because
of the likely response of their competitors.
b. In this case prices tend to be relatively rigid.
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Price Rigidity
 Firms have strong desire for stability
 Price rigidity – characteristic of
oligopolistic markets by which firms are
reluctant to change prices even if costs
or demands change
Fear lower prices will send wrong message
to competitors leading to price war
Higher prices may cause competitors to raise
theirs
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Price Rigidity
 Basis of kinked demand curve model of
oligopoly
Each firm faces a demand curve kinked at
the currently prevailing price, P*
Above P*, demand is very elastic
 If
P>P*, other firms will not follow
Below P*, demand is very inelastic
 If
P<P*, other firms will follow suit
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Price Rigidity
 With a kinked demand curve, marginal
revenue curve is discontinuous
 Firm’s costs can change without resulting
in a change in price
 Kinked demand curve does not really
explain oligopolistic pricing
Description of price rigidity rather than an
explanation of it
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The Kinked Demand Curve
$/Q
If the producer raises price, the
competitors will not and the
demand will be elastic.
If the producer lowers price, the
competitors will follow and the
demand will be inelastic.
D
Quantity
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The Kinked Demand Curve
$/Q
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.
MC’
P*
MC
D
Quantity
Q*
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Price Signaling and Price
Leadership
 Price Signaling
Implicit collusion in which a firm announces a
price increase in the hope that other firms will
follow suit
 Price Leadership
Pattern of pricing in which one firm regularly
announces price changes that other firms
then match
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Price Signaling and Price
Leadership
 The Dominant Firm Model
In some oligopolistic markets, one large firm
has a major share of total sales, and a group
of smaller firms supplies the remainder of the
market.
The large firm might then act as the
dominant firm, setting a price that maximizes
its own profits.
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The Dominant Firm Model
 Dominant firm must determine its
demand curve, DD.
Difference between market demand and
supply of fringe firms
 To maximize profits, dominant firm
produces QD where MRD and MCD cross.
 At P*, fringe firms sell QF and total
quantity sold is QT = QD + QF
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Price Setting by a Dominant
Firm
Price
SF
D
The dominant firm’s demand
curve is the difference between
market demand (D) and the supply
of the fringe firms (SF).
P1
MCD
P*
DD
P2
QF QD
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QT
MRD
Chapter 12
At this price, fringe firms
sell QF, so that total
sales are QT.
Quantity
80
Cartels
 Producers in a cartel explicitly agree to
cooperate in setting prices and output.
 Typically only a subset of producers are
part of the cartel and others benefit from
the choices of the cartel
 If demand is sufficiently inelastic and
cartel is enforceable, prices may be well
above competitive levels
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Cartels
 Examples of
successful cartels
 OPEC
 International Bauxite
Association
 Mercurio Europeo
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 Examples of
unsuccessful cartels
 Copper
 Tin
 Coffee
 Tea
 Cocoa
82
Cartels – Conditions for
Success
1. Stable cartel organization must be
formed – price and quantity settled on
and adhered to
 Members have different costs, assessments
of demand and objectives
 Tempting to cheat by lowering price to
capture larger market share
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Cartels – Conditions for
Success
2. Potential for monopoly power
 Even if cartel can succeed, there might be
little room to raise price if faces highly
elastic demand
 If potential gains from cooperation are
large, cartel members will have more
incentive to make the cartel work
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Analysis of Cartel Pricing
 Members of cartel must take into account
the actions of non-members when
making pricing decisions
 Cartel pricing can be analyzed using the
dominant firm model
OPEC oil cartel – successful
CIPEC copper cartel – unsuccessful
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The OPEC Oil Cartel
Price
TD
SC
TD is the total world demand
curve for oil, and SC is the
competitive supply. OPEC’s
demand is the difference
between the two.
OPEC’s profits maximizing
quantity is found at the
intersection of its MR and
MC curves. At this quantity
OPEC charges price P*.
P*
DOPEC
MCOPEC
MROPEC
QOPEC
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Quantity
86
Cartels
 About OPEC
Very low MC
TD is inelastic
Non-OPEC supply is inelastic
DOPEC is relatively inelastic
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The OPEC Oil Cartel
TD
Price
SC
The price without the cartel:
•Competitive price (PC) where
DOPEC = MCOPEC
P*
DOPEC
MCOPEC
Pc
MROPEC
QC
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QOPEC
QT
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Quantity
88
The CIPEC Copper Cartel
Price
TD
SC
MCCIPEC
•TD and SC are
relatively elastic
•DCIPEC is elastic
•CIPEC has little
monopoly power
•P* is closer to PC
DCIPEC
P*
PC
MRCIPEC
QCIPEC
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QC
QT
Quantity
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Cartels
 To be successful:
Total demand must not be very price elastic
Either the cartel must control nearly all of the
world’s supply or the supply of noncartel
producers must not be price elastic
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The Cartelization of
Intercollegiate Athletics
1. Large number of firms (colleges)
2. Large number of consumers (fans)
3. Very high profits
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The Cartelization of
Intercollegiate Athletics
 NCAA is the cartel
Restricts competition
Reduces bargaining power by athletes –
enforces rules regarding eligibility and terms
of compensation
Reduces competition by universities – limits
number of games played each season,
number of teams per division, etc.
Limits price competition – sole negotiator for
all football television contracts
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The Cartelization of
Intercollegiate Athletics
 Although members have occasionally
broken rules and regulations, has been a
successful cartel
 In 1984, Supreme Court ruled that the
NCAA’s monopolization of football TV
contracts was illegal
Competition led to drop in contract fees
More college football on TV, but lower
revenues to schools
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