Two broad cases are noteworthy: Monopolistic Competition

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1 Monopolistic Competition Until now, we have studied two extreme cases of competition: perfect competition and monopoly. Yet, reality is often in between: often, a firm s residual demand curve is downward sloping. This is the case when fixed costs in an industry are large compared to market demand, but not as big as to create a natural monopoly. Two broad cases are noteworthy: Oligopoly: The good in uestion is relatively homogenous, but entry is limited because of (uasi-)fixed costs (or possibly regulation). Monopolistic competition: The good of one supplier is uniue, but there exist close substitutes for the good. In practice, the distinction between these two market forms is sometimes difficult to draw precisely. Monopolistic competition is characterized by the following features:. A firm produces a specific variety of a good, which consumers perceive as different from that offered by competitors ( = product differentiation, e.g. geographic location, uality, taste, ) Monopolistically competitive firm has market power; firm s residual demand curve is downward sloping, because consumers only gradually shift away when firm raises its price.. The firm must pay high uasi-fixed costs to maintain its brand name (remember: uasifixed costs are paid independently of the uantity sold, if the uantity is positive). ACs decline over a large range, and the industry s minimum efficient scale is large. 3. Entry is possible in principle. firms in a monopolistically competitive industry make (approximately) zero profits. Firm s MR curve is downward sloping. 3 4

2 These features together imply that firm behaviour in monopolistic competition is given by two simple rules:. Marginal revenue euals marginal cost p, $ per unit p p = AC MC AC. Price euals average cost. In particular, the firm s residual demand curve and its average cost curve are tangent at the firm s optimal operating decision. MRr =MC MR r D r 5, Units per year 6 Three points to note: Monopolistically competitive euilibrium is inefficient: price is above marginal cost. In monopolistically competitive industries, there is excess capacity: if there were fewer firms, each firm could slide down its average cost curve by expanding output (but careful: less variety). Firms profits are driven to zero because of potential entry. But because uasi-fixed costs are large, not all profits need to be eroded. Hence, profits are only approximately zero. 7 p Example: The wiss coated cornflakes market (hypothetical numbers). firms with uasi-fixed cost of Fr..3 million: π = $.8 million 64 MR r for firms D r for firms AC MC , Thousand tons per year 8

3 p With 3 firms, the individual firm s residual demand curve shifts inward. All 3 firms make zero profits. Note: if fixed cost is larger than Fr..3 million, the third firm does not enter, and both firms make positive profits (smaller than Fr..8 million). AC MC An example of product differentiation: geographic location (Hotelling) Imagine the beach of a sea-side resort. uppose the beach is one kilometer long, and families are distributed eually along the beach. D r for 3 firms 0 48 MR r for 3 firms.5, Thousand tons per year 43 9 If there is one vendor who sells ice-cream, where should the vendor be located? 0 The average walking distance of all the people on the beach is minimized if the vendor sets up his shop at: Answer: At x = 0.5 and x = The vendors have a clientele of [0, 0.5) and (0.5, ], respectively. x = 0.5 (where x = 0 represents the left end-point and x = the right end-point of the beach). Now assume that there are two ice-cream vendors. Where should the two optimally But if the two vendors are acting competitively, where do they locate? (To simplify assume that they charge the same price.) The vendor at x = 0.5 has an incentive to move to the right: by doing this, she keeps all her old customers, but captures some new customers in the middle. locate? 3

4 imilarly, the vendor at Another application: Circular City (alop) x = 0.75 has an incentive to move to the left. Result: - Both vendors locate at x = The monopolistically competitive euilibrium is inefficient (too little variety). 3 4 Oligopoly We now turn to markets in which the good in uestion is relatively homogenous, but there are only few suppliers in the market because of high fixed costs or other entry barriers. In such markets (oligopolies), the production choice of each producer has a strategic impact on all other producers. Reminder: The distinction between oligopoly and monopolistic competition is not always clear cut. On the one hand, homogenous goods offered by different firms are rarely exactly identical, on the other hand, even if a producer sells a differentiated product that protects her somewhat from market pressure, the other producers strategic choices will matter for her

5 We study the simplest form of oligopoly: duopoly ( two sellers ) Assumptions: Market with one homogenous product, market demand D(p) Two firms in the market, no entry Firm i has cost function. C i () The strategic interaction in such a market can and does take many forms. In particular, one should ask: Is the relevant choice variable price or uantity? Is one firm dominant (leads in the decision making)? (Both these uestions are irrelevant in monopoly or in perfect competition) 7 8 The Cournot model In this model (Augustin Cournot, 838), neither firm is dominant (in the sense that it can directly influence the other s decision making), and both firms choose uantities. The important point: Each firm s optimal behaviour depends on what the other firm does. If, for example, firm chooses uantity, firm faces a residual demand curve of D r ( p) = D( p). Firm will, therefore, maximise its returns from pricing on this residual demand curve. If p( Q) = D ( Q) is the inverse market demand curve, this means that firm chooses to maximize p( + ) C ( ) 9 0 5

6 Assuming constant marginal cost: p This argument gives an optimal uantity = R ( ) for firm as a function of what firm produces. MC imilarly, we can derive the optimal uantity of firm as a function of what firm does: = R ( ). i The R are called best-response functions or reaction functions. MR r D r D 0 The Cournot euilibrium is defined as the pair (, ) such that = R ( ) and = R ( ). In words: firm s behaviour is the best response to firm s behaviour, and firm s behaviour is the best response to firm s behaviour. In other words: each firm chooses an output based on a belief about the other firm s choice, and no firm has an incentive to change its behaviour, once it learns the competitor s choice. 3 The Cournot euilibrium is the intersection point of the two best-response curves: Firm s best-response curve 0 M Cournot euilibrium Firm s best-response curve 4 6

7 Application: Competition in the airline market On many air-traffic routes, there are very few direct flights. In Europe these flights are often limited to the national carriers. Example: Geneva Berlin, where only wiss and ufthansa offer direct flights. The production function of air travel is characterized by constant and relatively low marginal costs high fixed costs We study competition between wiss and ufthansa on the Geneva - Berlin route by using a simple Cournot model, using rough estimates of cost and demand. Variables (expressed as one-way flight): price p (in Fr) uantity Q = + (000 passengers/year) Demand: D(p) = p Cost: VC() = 300 (identical for both carriers) and F = 3,000,000; F = 8,000,000) 5 6 The wiss perspective: maximize p 300 = ( ( + )) 300 The optimum is at = The ufthansa perspective: maximize ( ( + )) 300 which yields = The Cournot euilibrium is given by the intersection of these two reaction functions: = = ( ) = 70 By symmetry, also = 70. This gives a total uantity of Q = 40 and a price of p = At this price, each airline makes a profit of H: ( )70,000 8,000,000 = 8.33 million/year) WI: ( )70,000 3,000,000 = 3.33 million/year 8 7

8 Remark: The model is simplified in several respects. One is the lack of price discrimination: airlines charge at least two prices for the same flight in the same class, one discounted for weekend travels and one marked up for within-week travel. 9 Generalisation of Cournot model Consider n firms, all with identical cost structures, C() = c. inear market demand: p = a - bq (for Q < a/b). The individual firm maximizes profits: ( n a b( +... ) c) which gives the reaction function: i = ( a c b b j i j ) i 30 The n reaction functions form a system of n euations in n variables: a c b( M a c b( j umming all these euations, using = Q, yields j= which means n ) b ) b n n = 0 = 0 n ( a c) nbq = bq n Q = n + a c n This simple formula is very useful and reasonable: For n =, this is just the monopoly output (determined by a- bq = c). As n increases, Q increases. As n becomes large, Q tends to (a c)/b. But this is just the competitive output (given by c = a bq) b 3 3 8

9 Hence, the Cournot model provides a model that fits in between the monopoly outcome and the competitive outcome, and the number of firms indicates a degree of competitiveness. ummary Table

Managerial Economics & Business Strategy Chapter 9. Basic Oligopoly Models

Managerial Economics & Business Strategy Chapter 9 Basic Oligopoly Models Overview I. Conditions for Oligopoly? II. Role of Strategic Interdependence III. Profit Maximization in Four Oligopoly Settings