Monopolistic Competition Oligopoly Duopoly Monopoly. The further right on the scale, the greater the degree of monopoly power exercised by the firm.

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1 Oligopoly

2 Monopolistic Competition Oligopoly Duopoly Monopoly The further right on the scale, the greater the degree of monopoly power exercised by the firm.

3 Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.

4

5 Types of Imperfectly Competitive Markets Oligopoly Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition Many firms selling products that are similar but not identical.

6 Copyright 2004 South-Western Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly (Chapter 15) Oligopoly (Chapter 16) Monopolistic Competition (Chapter 17) Perfect Competition (Chapter 14) Tap water Cable TV Tennis balls Crude oil Novels Movies Wheat Milk

7 Oligopoly is a market structure defined by Natural or legal barriers that prevent entry of new firms A small number of firms compete Oligopolies may be Natural, due to natural barriers to entry Legal, legal barriers to entry

8 The actions of each firm in the market simultaneously influence the nature of the market and the strategy of other firms This introduces a level of strategic interactions, which makes oligopoly complex, and unique

9 Example Car industry Airline industry Cigarettes Cleaning products Electrical appliance

10

11

12 Oligopoly arises, when there is a small number of firms Market concentration is measured via the Herfindalhl-Hirschman Index (HHI) Sum of the square of market share for the top 50 firms

13 Competitive market with 100 firms, each 1% share: Monopolist: Two firms, dividing the market equally: HHI above 1000 is considered oligopoly

14 HHI above 1000 is considered oligopoly Many oligopoly markets are dominated by a few firms (4 shown in red)

15 A natural barrier to entry, defined by the nature of the ATC curve In this case, the market is a natural duopoly, two firms are able to supply the entire market most efficiently

16 Costs and Revenue Average total cost Lowest possible Price=ATC Demand 0 Efficient scale of a single firm Two firms meet the demand Quantity Copyright 2004 South-Western

17 Pricing models Kinked demand curve Dominant firm oligopoly Cournot model Collusion

18 Kinked demand curve

19 From the perspective of one firm in an oligopoly If the firm charges more then the other firms, they will not follow the firm strategy If it charges less, other firm will follow the firm strategy From the perspective of the manager, the demand curve is not continuous, it breaks at the competitor price

20 Constant share demand curve: All firms in the market set the same price Market share doesn t depend on my price The demand for the firm s goods depends only on the total demand Variable share demand curve Other firms don t change their prices Market share depends on my price Demand curve is more elastic than before

21 Price Kinked demand curve Variable demand Constant share demand 0 Quantity

22 The MR curve associated with a kinkeddemand curve contains three distinct segments One is associated with the upper more elastic segment. One is connected to the lower less elastic segment. And one that arises from the kink that joins the two.

23 Copyright 2004 South-Western Costs and Revenue P Marginal cost Kinked demand curve 0 Q Marginal revenue Quantity

24 The firm perceives a break at the current market price (competitors price) keep in mind, the demand curve displayed here is the curve the firm faces The vertical segment is the key feature of this marginal revenue curve.

25 Copyright 2004 South-Western Costs and Revenue P MC2 MC1 Kinked demand curve Marginal revenue 0 Q Quantity

26 MC curve can increase or decrease without inducing a profit-maximizing oligopoly to change price or quantity This vertical segment is what helps to explain rigid prices for oligopoly

27 Dominant firm oligopoly

28 The kinked demand curve model occurs when a small number of firms have similar cost structures However, this is not always the case. Imagine, instead, that market concentration is high because it is dominated by a large firm, with many firms supplying small portions of the market Consider, Gas stations Electricity suppliers

29 The dominant firm acts almost like a monopolist If the dominant firm charges a single price, it faces a marginal revenue curve similar to a monopolist Other firms in the market are unable to price higher than the dominant firm The dominant firm will produce the quantity demanded net the amount supplied by smaller firms The output under the price leadership is between the production level under the monopoly and a perfect competition

30 Costs and Revenue Marginal cost P XD D MR 0 Q Quantity

31 Suppose, the dominant firm controls 80% of the market P = Q MC = Q 1. What is the quantity and the price set by the dominant firm? 2. What is the market price, if other firms are price takers? 3. What is the total quantity sold in the market?

32 The dominant firm has an incentive to push smaller firms out of the market: Merges: the dominant firm could just merge with the smaller firm Aggressive price setting: cut prices artificially low in order to drive smaller firms out of business. It can recoup its own losses by charging higher prices latter on (predatory pricing)

33 Cournot model

34 Suppose There are two firms (A and B) in the market and none of them dominant. They produce identical products and know each other cost curves. Firms can not collude (agree on the price this possibility will be discussed later)

35 Costs and Revenue Marginal cost P1 P2 Demand Marginal revenue Quantity

36 What is the Firm A optimal output if Firm B doesn t produce anything Firm A becomes a monopolist and produces 2000 units What is the Firm A optimal output if Firm B produces 4000 units (the perfectly competitive outcome) Firm A will not produce anything

37 The best response function shows the firm s optimal, profit maximizing output given the other firm production level The quantity, which the firm A will choose, depends on the quantity produced by the firm B. The decision of the firm A is based on XD (like in the dominant firm case) - the total demand minus the quantity supplied by the Firm B.

38 Quantity: B Best response A Best response B Quantity: A

39 The best response equilibrium: the point of intersection of the best response functions Both Firm A and Firm B will do best to produce units The duopoly total is (more than the monopoly outcome but less than the perfectly competitive production level) Will the market reach the best response equilibrium?

40 Small town has 90 residents The good cell phone service with unlimited anytime minutes and free phone Smalltown demand schedule Two firms: Cingular and Verizon Each firm s costs: FC=$0, MC=$3 P Q

41 P Q Revenue MR MC Monopoly outcome: P=$6 Q=40 Competitive outcome: P=MC=$3 Q=70

42 P Q Verizon Revenue MR MC Best response: Q=30 P=5

43 P Q $ QC 8 20-QC 7 30-QC 6 40-QC 5 50-QC 4 60-QC 3 70-QC 2 80-QC 1 90-QC

44 P QV Revenue MR MC $ QC 9 (10-QC) 70+QC QC 8 (20-QC) 50+QC QC 7 (30-QC) 30+QC QC 6 (40-QC) 10+QC QC 5 (50-QC) -10+QC QC 4 (60-QC) -30+QC QC 3 (70-QC) -50+QC QC 2 (80-QC) -70+QC QC 1 (90-QC) -90+QC 30

45 Verison will choose the quantity QV, which will maximize its profit MR=MC=30 The best response function is QC QV

46 Cingular faces analogous decision process. It maximized the profit, hence equalize MC=MR=100 Its best response function is QV QC

47 Verison Cingular QC QV QV QC If Cingular chooses 20, then Verison chooses 30. If Verison chooses 20, then Cingular chooses 30.

48 The best response equilibrium Q V = Q C = 25 The total supply and the market price (from a total demand curve) Q = Q V + Q C = 50 P = 5 Recall that: Competitive market: Q = 70, P = 3 Monopolistic market:q = 40, P = 6

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