Microeconomics. Lecture Outline. Claudia Vogel. Winter Term 2009/2010. Part III Market Structure and Competitive Strategy

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1 Microeconomics Claudia Vogel EUV Winter Term 2009/2010 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Lecture Outline Part III Market Structure and Competitive Strategy 12 Monopolistic Competition Cartels Summary Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

2 Monopolistic Competition and monopolistic competition: Market in which rms can enter freely, each producing its own brand or version of a dierentiated product. oligopoly: Market in which only a few rms compete with ine another, and entry by new rms is impeded. cartel: Market in which some or all rms explicitly collude, coordinating prices and output levels to maximize joint prots. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Monopolistic Competition Monopolistic Competition A monopolistically competitive market has two key characteristics: 1 Firms compete by selling dierentiated products that are highly substitutable for one another but not perfect substitutes. In other words, the cross-price elasticities of demand are large but not innite. 2 There is free entry and exit: It is relatively easy for new rms to enter the market with their own brand and for existing rms to leave if their products become unprotable. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

3 Monopolistic Competition Equilibrium in Monopolistic Competition In the long run, these prots attract new rms with competing brands. Therefore in long-run equilibrium (b) price equals average cost, so the rm earns zero prot even though it has monopoly power. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Monopolistic Competition Monopolistic Competition and Economic Eciency In both types of markets, entry occurs until prots are driven to zero. In evaluating monopolistic competition, these ineciencies must be balanced against the gains to consumers from product diversity. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

4 Monopolistic Competition Example: Monopolistic Competition in the Markets for Colas and Coee Elasticities of Demand for Brands of Colas and Coee Brand Elasticity of Demand Colas Royal Crown -2.4 Coke -5.2 to -5.7 Ground coee Folgers -6.4 Maxwell House -8.2 Chock Full o'nuts -3.6 With the expection of Royal Crown and Chock Full o'nuts, all colas and coees are quite price elastic. With elasticities on the order of -4 to -8, each brand has only limited monopoly power. This is typical of monopolistic competition. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 In oligopolistic markets, the products may or may not be dierentiated. What matters is that only a few rms account for most or all of total production. In some oligopolistic markets, some or all rms earn substantial prots over the long run because barriers to entry make it dicult or impossible for new rms to enter. Nash equilibrium Equilibrium in oligopoly markets means that each rm will want to do the best it can given what its competitiors are doing, and these competitors will do the best they can given what rm is doing. When a market is in equilibrium, rms are doing the best they can and have no reason to change their price or output. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

5 The Firm's Output Decision duopoly: Market in which two rms compete with each other. Cournot model: model in which rms produce a homogeneous good, each rm treats the output of its competitors as xed, and all rms decide simultaneously how much to produce. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 The Cournot Model reaction curve: Relationship between a rm's prot-maximizing output and the amount it thinks its competitor will produce. Cournot equilibrium: Equilibrium in the Cournot model in which each rm correctly assumes how much its competitor will produce and sets its own production level accordingly. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

6 The Linear Demand Curve - An Example 1/3 Duopolists face the following market demand curve P = 30 Q (Q = Q 1 + Q 2 ) Also, MC 1 = MC 2 = 0 Total revenue for rm 1: R 1 = PQ 1 = (30 Q) Q 1 then MR 1 = R 1 Q1 = 30 2Q 1 Q 2 Setting MR 1 = 0 (the rm's marginal cost) and solving for Q 1, we nd Firm 1's reaction curve: Q 1 = 15 1 Q 2 2 By the same calculation, Firm 2's reaction curve: Q 2 = 15 1 Q 2 1 Cournot equilibrium: Q 1 = Q 2 = 10 Total quantity produced: Q = Q 1 + Q 2 = 20 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 The Linear Demand Curve - An Example 2/3 If the two rms collude, then the total prot-maximizing quantity can be obtained as follows: Total revenue for the two rms: R = PQ = (30 Q) Q = 30Q Q 2 then MR = R Q = 30 2Q Setting MR = 0 (the rm's marginal cost) we nd that total prot is maximized at Q=15. Then, Q 1 + Q 2 = 15 is the collusion curve. If the rms agree to share prots equally, each will produce half of the total output: Q 1 = Q 2 = 7.5 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

7 The Linear Demand Curve - An Example 3/3 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 First Mover Advantage - The Stackelberg Model Stackelberg model: model in which one rm sets its output before other rms do. Suppose Firm 1 sets its output rst and then Firm 2, after observing Firm 1's output, makes its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react. P = 30 Q (Q = Q 1 + Q 2 ) MC 1 = MC 2 = 0 Firm 2's reaction curve: Q 2 = Q 1 Firm 1's revenue: R 1 = PQ 1 = 30Q 1 Q 2 1 Q 1Q 2 = 15Q Q 2 1 And MR 1 = R 1 Q1 = 15 Q 1 Setting MR 1 = 0 gives Q 1 = 15, and Q 2 = 7.5 We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much prot. Going rst gives Firm 1 an advantage. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

8 Price Competition - The Bertrand Model Bertrand model: model in which rms produce a homogeneous good, each rm treats the price of its competitors as xed, and all rms decide simultaneously what price to charge. P = 30 Q (Q = Q 1 + Q 2 ) MC 1 = MC 2 = $3 Q 1 = Q 2 = 9, and in Cournot equilibrium, the market price is $12, so that each rm makes a prot of $81. Nash equilibrium in the Bertrand model results in both rms setting price equal to marginal cost: P 1 = P 2 = $3. Then industry output is 27 units, of which each rm produces 13.5 units, and both rms earn zero prot. In the Cournot model, because each rm produces only 9 units, the market price is $12. Now the market price is $3. In the Cournot model, each rm made a prot; in the Bertrand model, the rms price at marginal cost and make no prot. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Price Competition with Dierentiated Products 1/2 Suppose each of two duopolists has xed costs of $20 but zero variable costs, and that they face the same market demand curves: Firm 1's demand: Q = 12 2P 1 + P 2 Firm 2's demand: Q = 12 2P 2 + P 1 Choosing Prices Firm 1's prot: π 1 = P 1 Q 1 20 = 12P 1 2P P 1P 2 20 Firm 1's prot maximizing price: π 1 P1 = 12 4P 1 + P 2 = 0 Firm 1's reaction curve: P 1 = P 2 Firm 2's reaction curve: P 2 = P 1 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

9 Price Competition with Dierentiated Products 2/2 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Competition versus Collusion: The Prisoners' Dilemma In our example, there are two rms, each of which has xed cost of $20 and zero variable costs. They face the demand curves: Firm 1's demand: Q = 12 2P 1 + P 2 Firm 2's demand: Q = 12 2P 2 + P 1 We found that in Nash equilibrium each rm will charge a price of $4 and earn a prot of $12, whereas if the rms collude, they will charge a price of $6 and earn a prot of $16. But if Firm 1 charges $6 and Firm 2 charges $4, Firm 2's prot will increase to $20. And it will do so at the expense of Firm 1's prot, which will fall to $4. Firm 2 charge $4 charge $6 Firm 1 charge $4 $12, $12 $20, $4 charge $6 $4, $20 $16, $16 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

10 Cartels Analysis of Cartel Pricing Producers in a cartel explicitly agree to cooperate in setting prices and output levels. The OPEC Oil Cartel The CIPEC Copper Cartel Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Summary Summary 1/2 In a monopolistically competitive market, rms compete by selling dierentiated products, which are highly substituable. New rms can enter or exit easily. Firms have only a small amount of monopoly power. In the long run, entry will occur until prots are driven to zero. Firms then produce with excess capacity (i.e., at output levels below those that minimize average cost). In an oligopolistic market, only a few rms account for most or all production. Barriers to entry allow some rms to earn substantial prots, even over the long run. Economic decisions involve strategic considerations - each rm must consider how its actions will aect its rivals, and how they are likely to react. In the Cournot model of oligopoly, rms make their output decisions at the same time, each taking the other's output as xed. In equilibrium, each rm is maximizing its prot given the output of its competitor, so no rm has an incentive to change its output. The rms are therefore in a Nash equilibrium. Each rm's prot is higher than it would be under perfect competition but less than what it would earn by colluding. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

11 Summary Summary 2/2 In the Stackelberg model, one rm sets its output rst. That rm has a strategic advantage and earns higher prot. It knows it can choose a large output and that its competitors will have to choose small outputs if they want to maximize prots. Firms would earn higher prots by collusively agreeing to raise prices, but the antitrust laws usually prohibit this. They might all set a high price without colluding, each hoping its competitors will do the same, but they are in a prisoners' dilemma, which makes this unlikely. Each rm has an incentive to cheat by lowering its price and capturing sales from competitors. In a cartel, producers explicitely collude in setting prices and output levels. Successful cartelization requires that the total demand not be very price elastic, and that either the cartel control most supply or else the supply of noncartel producers be inelastic. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Problem 1 Exerxises 10 1 What are the characteristics of a monopolistically competitive market? What happens to the equilibrium price and quantity in such a market if one rm introduces a new, improved product? 2 Why is the Cournot equilibrium stable? (i.e. Why don't rms have any incentive to change their output levels once in equilibrium?) Even if they can't collude, why don't rms set their outputs at the joint prot-maximizing levels (i.e., the levels they would have chosen had they colluded)? 3 In the Stackelberg model, the rm that sets output rst has an advantage. Explain why. 4 What do the Cournot and Bertrand models have in common? What is dierent about the two models? 5 Why has the OPEC oil cartel succeeded in raising prices substantially while the CIPEC copper cartel has not? What conditions are necessary for successful cartelization? What organizational problems must a cartel overcome? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

12 Exerxises 10 Problem 2 A monopolist can produce at a constant average (and marginal) cost of AC=MC=$5. It faces a market demand curve given by Q = 53 P. 1 Calculate the prot-maximizing price and quantity for this monopolist. Also calculate its prots. 2 Suppose a second rm enters the market. Let Q 1 be the output of the rst rm and Q 2 be the output of the second. Market demand is now given by Q 1 + Q 2 = 53 P. Assuming that this second rm has the same costs as the rst, write the prots of each rm as functions of Q 1 and Q 2. 3 Suppose (as in the Cournot model) that each rm chooses its prot-maximizing level of output on the assumption that its competitor's output is xed. Find each rm's reaction curve. 4 Calculate the Cournot equilibrium. What are the resulting market price and prots of each rm? 5 Suppose Firm 1 is the Stackelberg leader (i.e., makes its output decisions before Firm 2). Find the reaction curves that tell each rm how much to produce in terms of the output of its competitor. 6 How much will each rm produce, and what will its prot be? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25 Problem 3 Exerxises 10 Suppose that two identical rms produce widgets and that the are the only rms in the market. Their costs are given by C 1 = 60Q 1 and C 2 = 60Q 2, where Q 1 is the output of Firm 1 and Q 2 the output of Firm 2. Price is determined by the following demand curve: P = 300 Q where Q = Q 1 + Q 2. 1 Find the Cournot equilibrium. Calculate the prot of each rm at this equilibrium. 2 Suppose the two rms form a cartel to maximize joint prots. How many widgets will be produced. Calculate each rm's prot. 3 Suppose Firm 1 were the only rm in the industry. How would market output and Firm 1's prot dier from that found in part (2) above? 4 Returning to the duopoly of part (2), suppose Firm 1 abides by the agreement, but Firm 2 cheats by increasing production. How many widgets will Firm 2 produce? What will be each rm's prots? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

13 Exerxises 10 Problem 4 Two rms compete by choosing price. Their demand functions are Q 1 = 20 P 1 + P 2 and Q 2 = 20 + P 1 P 2, where P 1 and P 2 are the prices charged by each rm, respectively, and Q 1 and Q 2 are the resulting demands. Note that the demand for each good depends only on the dierence in prices; if the two rms colluded and set the same price, they could make that price as high as they wanted, and, and earn innite prots. Marginal costs are zero. 1 Suppose the two rms set their prices at the same time. Find the resulting equilibrium. What price will each rm charge, how much will it sell, and what will its prot be? (Hint: Maximize the prot of each rm with respect to its price.) 2 Suppose Firm 1 sets its price rst and the Firm 2 sets its price. What price will each rm charge, how much will it sell, and what will its prot be? 3 Suppose you are one of these rms and that there are three ways you could play the game: (i) Both rms set price at the same time; (ii) You set price rst; or (iii) Your competitor sets price rst. If you could choose among these options, which would you prefer? Explain why. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 25

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