Chapter 12. Monopolistic Competition and Oligopoly

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1 Chapter 12 Monopolistic Competition and Oligopoly

2 Topics to be Discussed Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners Dilemma Chapter 12 2

3 Monopolistic Competition Characteristics 1. Many firms 2. Free entry and exit 3. Differentiated product Chapter 12 3

4 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 Chapter 12 4

5 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 Chapter 12 5

6 Monopolistic Competition Two important characteristics Differentiated but highly substitutable products Free entry and exit Chapter 12 6

7 A Monopolistically Competitive Firm in the Short and Long Run $/Q Short Run MC $/Q Long Run MC AC AC P SR P LR D SR D LR MR SR MR LR Q SR Quantity Q LR Quantity

8 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 Chapter 12 8

9 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 Chapter 12 9

10 Monopolistically and Perfectly Competitive Equilibrium (LR) $/Q Perfect Competition $/Q Monopolistic Competition MC AC Deadweight loss MC AC P P C D = MR D LR MR LR Q C Quantity Q MC Quantity

11 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. Chapter 12 11

12 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 Chapter 12 12

13 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. Chapter 12 13

14 The Market for Colas and Coffee (Ex 12-1) 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? Chapter 12 14

15 Elasticities of Demand for Brands of Colas and Coffee (Ex 12-1) Chapter 12 15

16 The Market for Colas and Coffee (Ex 12-1) 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 Chapter 12 16

17 Oligopoly Characteristics Small number of firms in a market Product differentiation may or may not exist Barriers to entry Scale economies Patents Technology Name recognition Strategic action Chapter 12 17

18 Oligopoly Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment Chapter 12 18

19 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 Chapter 12 19

20 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 Chapter 12 20

21 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 Chapter 12 21

22 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 Chapter 12 22

23 French philosopher, mathematician and economist, Augustin Cournot has been rightly hailed as one of the greatest of the Proto- Marginalists. The unique insights of his major economics work, é é (1838) were without parallel. Although neglected in his time, the impact of Cournot work on modern economics can hardly be overstated. Chapter 12 23

24 Firm 1 s Output Decision P 1 D 1 (0) Firm 1 and market demand curve, D 1 (0), if Firm 2 produces nothing. If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. D 1 (75) MR 1 (0) If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MR 1 (75) MC 1 MR 1 (50) D 1 (50) Q 1 Chapter 12 24

25 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 Chapter 12 25

26 Reaction Curves and Cournot Equilibrium Q 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. 75 Firm 2 s Reaction Curve Q* 2 (Q 1 ) 50 x Firm 2 s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. 25 x Firm 1 s Reaction Curve Q* 1 (Q 2 ) x x Q 2 Chapter 12 26

27 Reaction Curves and Cournot Equilibrium Q Firm 2 s Reaction Curve Q* 2 (Q 1 ) In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits. 50 x Cournot Equilibrium 25 x Firm 1 s Reaction Curve Q* 1 (Q 2 ) x x Q 2 Chapter 12 27

28 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 Chapter 12 28

29 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 Chapter 12 29

30 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 = Q 1 + Q 2 Both firms have MC 1 = MC 2 = 0 Chapter 12 30

31 Oligopoly Example Firm 1 s Reaction Curve MR = MC Total Revenue : R 1 = PQ1 = 30 Q) ( Q 1 = = 30Q 1 30Q 1 ( Q Q Q 2 2 ) Q Q Q 1 1 Chapter 12 31

32 Oligopoly Example An Example of the Cournot Equilibrium MR MR Q Q = ΔR = 0 = = = 15 1 ΔQ MC 2Q 2 2Q = 30 2Q Firm1' s Reaction Curve Firm 2' s Reaction Curve 1 Q 2 Chapter 12 32

33 Oligopoly Example An Example of the Cournot Equilibrium Cournot Equilibrium : (15 1 Q = Q1 P = 30 + Q Q 2 = 20 = 10 2Q 1 ) = 10 Q1 = Q2 Chapter 12 33

34 Duopoly Example Q 1 30 Firm 2 s Reaction Curve The demand curve is P = 30 - Q and both firms have 0 marginal cost. 15 Cournot Equilibrium 10 Firm 1 s Reaction Curve Q 2 Chapter 12 34

35 Chapter 12 35

36 Chapter 12 36

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