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 Implications of the Prisoners Dilemma for Oligopolistic Pricing Cartels Chapter 12 2
3 Monopolistic Competition Characteristics 1. Many firms 2. Free entry and exit 3. Differentiated, but highly substitutable 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 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
6 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 6
7 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 7
8 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
9 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 9
10 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 10
11 Oligopoly Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry Scale economies Patents Technology Name recognition Strategic action (interaction between firms) Chapter 12 11
12 Oligopoly Equilibrium Actions and reactions are dynamic, evolving over time 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 12
13 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 13
14 Oligopoly The Reaction Curve The relationship between a firm s profitmaximizing output and the amount it thinks its competitor will produce A firm s profitmaximizing output is a decreasing schedule of the expected output of Firm 2 Chapter 12 14
15 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. 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 15
16 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 25 x Firm 1 s Reaction Curve Q* 1 (Q 2 ) Cournot Equilibrium x x Q 2 Chapter 12 16
17 Oligopoly Cournot equilibrium is an example of a Nash equilibrium (CournotNash 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 17
18 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 18
19 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 19
20 Oligopoly Example Firm 1 s Reaction Curve MR = MC Total Revenue : R 1 = PQ1 = 30 Q) ( Q 1 = 30Q 1 ( Q 1 + Q 2 ) Q 1 = 30Q 1 Q 2 1 Q Q 2 1 Chapter 12 20
21 Oligopoly Example An Example of the Cournot Equilibrium MR MR Q Q = ΔR = 0 = = = 15 1 ΔQ MC 2Q 2 2Q = 30 2Q Firm 1' s Reaction Curve Firm 2' s Reaction Curve 1 Q 2 Chapter 12 21
22 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 22
23 Oligopoly Example Profit Maximization with Collusion R = MR MR PQ = (30 Q) Q = 30Q = ΔR ΔQ = 30 2Q = 0 when Q = 15 and MR Q 2 = MC Chapter 12 23
24 Duopoly Example Q 1 30 Firm 2 s Reaction Curve For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium Competitive Equilibrium (P = MC; Profit = 0) Cournot Equilibrium Collusive Equilibrium 7.5 Collusion Curve Firm 1 s Reaction Curve Q 2 Chapter 12 24
25 First Mover Advantage The Stackelberg Model Oligopoly model in which one firm sets its output before other firms do Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1 s output Conclusion Going first gives Firm 1 the advantage Firm 1 s output is twice as large as Firm 2 s Firm 1 s profit is twice as large as Firm 2 s Going first allows Firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless it wants to reduce profits for everyone. Chapter 12 25
26 Price Competition Competition in an oligopolistic industry may occur with price instead of output The Bertrand Model is used Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge Chapter 12 26
27 Competition Versus Collusion: The Prisoners Dilemma Nash equilibrium is a noncooperative equilibrium: each firm makes decision that gives greatest profit, given actions of competitors Although collusion is illegal, why don t firms cooperate without explicitly colluding? Why not set profit maximizing collusion price and hope others follow? Chapter 12 27
28 Competition Versus Collusion: The Prisoners Dilemma Competitor is not likely to follow Competitor can do better by choosing a lower price, even if they know you will set the collusive level price We can use example from before to better understand the firms choices Chapter 12 28
29 Competition Versus Collusion: The Prisoners Dilemma An example in game theory, called the Prisoners Dilemma, illustrates the problem oligopolistic firms face Two prisoners have been accused of collaborating in a crime They are in separate jail cells and cannot communicate Each has been asked to confess to the crime Chapter 12 29
30 Payoff Matrix for Prisoners Dilemma Prisoner B Confess Don t confess Confess 5, 51, 10 Prisoner A Would you choose to confess? Don t confess 10, 12, 2 Chapter 12 30
31 Oligopolistic Markets Conclusions 1. Collusion will lead to greater profits 2. Explicit and implicit collusion is possible 3. Once collusion exists, the profit motive to break and lower price is significant Chapter 12 31
32 Payoff Matrix for the P&G Pricing Problem Unilever and Kao Charge $1.40 Charge $1.50 Charge $1.40 $12, $12 $29, $11 P&G What price should P & G choose? Charge $1.50 $3, $21 $20, $20 Chapter 12 32
33 Observations of Oligopoly Behavior 1. In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur 2. In other oligopoly markets, the firms are very aggressive and collusion is not possible can lead to price rigidity. Chapter 12 33
34 Cartels Producers in a cartel explicitly agree to cooperate in setting prices and output Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels Chapter 12 34
35 Cartels Examples of successful cartels OPEC International Bauxite Association Mercurio Europeo Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa Chapter 12 35
36 Cartels To be successful: Total demand must not be very price elastic Either the cartel must control nearly all of the world s supply or the supply of noncartel producers must not be price elastic Chapter 12 36
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