Microeconomic Analysis

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1 Microeconomic Analysis Oligopoly and Monopolistic Competition Ch. 13 Perloff

2 Topics Market Structures. Cartels. Noncooperative Oligopoly. Cournot Model. Stackelberg Model. Comparison of Collusive, Cournot, Stackelberg, and Competitive Equilibria. Bertrand Model. Monopolistic Competition.

3 Oligopoly Oligopoly - a small group of firms in a market with substantial barriers to entry. Cartel - a group of firms that explicitly agree to coordinate their activities. Monopolistic competition - a market structure in which firms have market power but no additional firm can enter and earn positive profits

4 Market Structures Markets differ according to: the number of firms in the market, the ease with which firms may enter and leave the market, and the ability of firms in a market to differentiate their products from those of their rivals.

5 Table 13.1 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Competition

6 Why Cartels Form A cartel forms if members of the cartel believe that they can raise their profits by coordinating their actions.

7 P r ic e, p, $ per unit Figure 13.1 Competition Versus Cartel (a) Fi r m (b) Ma r k et p m A C MC P r ic e, p, $ per unit p m e m S p c p c e c MC m MC m Ma r k et demand MR q m q c q * Quantit y, q, Units per y ear Q m Q c Quantit y, Q, Units per y ear

8 Laws Against Cartels Cartels persist despite these laws for three reasons: international cartels and cartels within certain countries operate legally. some illegal cartels operate believing that they can avoid detection or that the punishment will be insignificant. some firms are able to coordinate their activity without explicitly colluding and thereby running afoul of competition laws.

9 Laws Against Cartels (cont). In the late nineteenth century, cartels were legal and common in the United States. Examples: oil, railroad, sugar, and tobacco. Sherman Antitrust Act in 1890 and the Federal Trade Commission Act of 1914, Prohibit firms from explicitly agreeing to take actions that reduce competition.

10 Laws Against Cartels (cont). The Organization of Petroleum Exporting Countries (OPEC) - an international cartel that was formed in 1960 by five major oilexporting countries: Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. In 1971, OPEC members agreed to take an active role in setting oil prices.

11 Why Cartels Fail Cartels fail if noncartel members can supply consumers with large quantities of goods. Each member of a cartel has an incentive to cheat on the cartel agreement.

12 Maintaining Cartels To keep firms from violating the cartel agreement, the cartel must be able to detect cheating and punish violators. keep their illegal behavior hidden from customers and government agencies.

13 Mergers U.S. laws restrict the ability of firms to merge if the effect would be anticompetitive.

14 Non-cooperative Oligopoly Duopoly - an oligopoly with two firms. Three models: Cournot model Stackelberg model Bertrand model

15 Non-cooperative Oligopoly (cont). Three restrictive assumptions: All firms are identical in the sense that they have the same cost functions and produce identical, undifferentiated products. We initially illustrate each of these oligopoly models for a duopoly The market lasts for only one period.

16 Non-cooperative Oligopoly (cont). Duopoly equilibrium: A set of actions taken by the firms is a Nash equilibrium if, holding the actions of all other firms constant, no firm can obtain a higher profit by choosing a different action.

17 Cournot Model Our assumptions: (1) there are two firms and no other firms can enter the market, (2) the firms have identical costs, (3) they sell identical products, and (4) the firms set their quantities simultaneously.

18 Cournot Model of an Airlines Market Example: American Airlines and United Airlines compete for customers on flights between Chicago and Los Angeles. Cournot equilibrium (Nash-Cournot equilibrium) - a set of quantities sold by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity

19 Cournot Model of an Airlines Market (cont). residual demand curve - the market demand that is not met by other sellers at any given price

20 Figure 13.2 American Airlines Profit- Maximizing Output (a) Monopoly p, $ per passenger p, $ per passenger (b) Duopoly MC 147 q U = 64 MC MR q A, Thousand American Airlines passengers per quarter D MR r D r D q A, Thousand American Airlines passengers per quarter

21 Figure 13.3 American and United s Best-Response Curves

22 Cournot Model of an Airlines Market (cont). Market demand function is Q = 339 p p - dollar cost of a one-way flight Q total quantity of the two airlines (thousands of passengers flying one way per quarter). Each airline has a constant marginal cost, MC, and average cost, AC, of $147 per passenger per flight.

23 Cournot Model of an Airlines Market (cont). Residual demand American faces is: q A = Q(p) q U = (339 p) q U. rewriting p = 339 q A q U The marginal revenue function is: MR r = 339 2q A q U

24 Cournot Model of an Airlines Market (cont). American Airlines best response is the output that equates its marginal revenue, and its marginal cost: MR r = 339 2q A q U = 147 = MC and rearranging q A = 96 1/2 q U

25 Cournot Model of an Airlines Market (cont). United s best-response function is q U = 96 1/2 q A This statement is equivalent to saying that the Cournot equilibrium is a point at which the bestresponse curves cross.

26 Cournot Model of an Airlines Market (cont). To solve the model: and solve for q A. q A = 96 1/2 (96 1/2 q A ) Doing so, we find that q A = 64; q U = 64 Q = q A + q U = 128. Cournot equilibrium price is $211.

27 Table 13.2 Cournot Equilibrium Varies with the Number of Firms

28 The Cournot Equilibrium and the Number of Firms Cournot firm s Lerner Index depends on the elasticity the firm faces p MC 1 p n Thus, a Cournot firm s Lerner Index equals the monopoly level, 1/ε, if there is only one firm:

29 Application Air Ticket Prices and Rivalry

30 Solved Problem 13.2 Intel and Advanced Micro Devices (AMD) are the only two firms that produce central processing units (CPUs), which are the brains of personal computers. Both because the products differ physically and because Intel s advertising Intel Inside campaign has convinced some consumers of its superiority, consumers view the CPUs as imperfect substitutes. Consequently, the two firms inverse demand functions differ: p A = q A 0.3q I, p I = q I 6q A, where price is dollars per CPU, quantity is in millions of CPUs, the subscript I indicates Intel, and the subscript A represents AMD. Each firm faces a constant marginal cost of m = $40 per unit. (For simplicity, we will assume there are no fixed costs.) Solve for the Cournot equilibrium quantities and prices.

31 Stackelberg Model In the Cournot model, both firms make their output decisions at the same time. Suppose, however, that one of the firms, called the leader, can set its output before its rival, the follower, sets its output.

32 Figure 13.5 Stackelberg Equilibrium

33 Why Moving Sequentially Is Essential When the firms move simultaneously, United doesn t view American s warning that it will produce a large quantity as a credible threat. If United believed that threat, it would indeed produce the Stackelberg follower output level.

34 Comparison of Collusive, Cournot, Stackelberg, and Competitive Equilibria How would American and United behave if they colluded? They would maximize joint profits by producing the monopoly output, 96 units, at the monopoly price, $243 per passenger.

35 Table 13.4 Comparison of Airline Market Structures

36 Figure 13.6a Duopoly Equilibria

37 Bertrand Model Bertrand equilibrium (Nash-Bertrand equilibrium) - a Nash equilibrium in prices; a set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge these prices. Bertrand equilibrium depends on whether firms are producing identical or differentiated products.

38 Best-Response Curves. Suppose that each of the two price-setting oligopoly firms in a market produces an identical product and faces a constant marginal and average cost of $5 per unit. What is Firm 1 s best response if Firm 2 sets a price of p 2 = $10?

39 Figure 13.7 Bertrand Equilibrium with Identical Products

40 Bertrand Versus Cournot. Cournot equilibrium price for firms with constant marginal costs of $5 per unit by: p MC $ S 1 1/( n ) 1 1/( n ) where n is the number of firms and ε is the market demand elasticity. If the market demand elasticity is ε = 1 and n = 2, the Cournot equilibrium price is $5/(1 1 2) = $10 which is double the Bertrand equilibrium price.

41 Bertrand Equilibrium with Differentiated Products In markets with differentiated products such markets, the Bertrand equilibrium is plausible, and the two problems of the homogeneousgoods model disappear: Firms set prices above marginal cost, and prices are sensitive to demand conditions.

42 Figure 13.8 Bertrand Equilibrium with Differentiated Products

43 Monopolistic Competition Monopolistically competitive markets do not have barriers to entry, so firms enter the market until no new firm can enter profitably. monopolistically competitive firms face downward-sloping residual demand curves, so they charge prices above marginal cost.

44 Monopolistically Competitive Equilibrium Two conditions hold in a monopolistically competitive equilibrium: Marginal revenue equals marginal cost because firms set output to maximize profit, and price equals average cost because firms enter until no further profitable entry is possible

45 Figure 13.9 Monopolistically Competitive Equilibrium

46 Minimum efficient scale minimum efficient scale - (full capacity) the smallest quantity at which the average cost curve reaches its minimum

47 Fixed Costs and the Number of Firms The number of firms in a monopolistically competitive equilibrium depends on firms costs. The larger each firm s fixed cost, the smaller the number of monopolistically competitive firms in the market equilibrium.

48 Figure Monopolistic Competition Among Airlines

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