Transcript Chapter 12
Chapter 12
Monopolistic Competition and Oligopoly
Monopolistic Competition
Characteristics 1.
2.
3.
Many firms Free entry and exit Differentiated product ©2005 Pearson Education, Inc.
Chapter 12 2
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 Retail ©2005 Pearson Education, Inc.
Chapter 12 3
Monopolistic Competition
Two important characteristics Differentiated but highly substitutable products (cross-price elasticity of demand large) Free entry and exit (keeps profits down) ©2005 Pearson Education, Inc.
Chapter 12 4
$/Q A Monopolistically Competitive Firm in the Short and Long Run Short Run MC AC $/Q Long Run MC AC P SR P LR D SR Q SR MR SR Quantity Q LR D LR MR LR Quantity
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 ©2005 Pearson Education, Inc.
Chapter 12 6
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 ©2005 Pearson Education, Inc.
Chapter 12 7
$/Q Monopolistically and Perfectly Competitive Equilibrium (LR) Perfect Competition MC AC $/Q Monopolistic Competition Deadweight loss MC AC P C D = MR P D LR MR LR Q C Quantity Q MC Quantity
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.
©2005 Pearson Education, Inc.
Chapter 12 9
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 ©2005 Pearson Education, Inc.
Chapter 12 10
Excess Capacity
The FIRM’s output is inefficiently low: less than minimum ATC Fewer total firms in the INDUSTRY would increase the FIRM’s demand and allow them to take advantage of economies of scale and increase output ©2005 Pearson Education, Inc.
Chapter 12 11
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.
©2005 Pearson Education, Inc.
Chapter 12 12
Oligopoly – Characteristics
Small number of firms Product differentiation may or may not exist Barriers to entry Scale economies Patents Technology access ($$) Name recognition ($$) Strategic action ©2005 Pearson Education, Inc.
Chapter 12 13
Oligopoly
Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment ©2005 Pearson Education, Inc.
Chapter 12 14
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 ©2005 Pearson Education, Inc.
Chapter 12 15
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 ©2005 Pearson Education, Inc.
Chapter 12 16
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 ©2005 Pearson Education, Inc.
Chapter 12 17
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 Market price depends on the total output of both firms Firm will adjust its output based on what it thinks the other firm will produce ©2005 Pearson Education, Inc.
Chapter 12 18
Firm 1’s Output Decision P 1 Firm 1 and market demand curve, D 1 (0), if Firm 2 produces nothing.
D 1 (0) If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. D 1 (75) MR 1 (0) MR 1 (75) MC 1 MR 1 (50) 12.5
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D 1 (50) Q 1
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Oligopoly
The Reaction Curve The relationship between a firm’s profit maximizing 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 Different MC = different reaction functions ©2005 Pearson Education, Inc.
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Reaction Curves and Cournot Equilibrium Q 1 100 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 50 25 x Firm 2’s Reaction Curve Q* 2 (Q 1 ) Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. x Firm 1’s Reaction Curve Q* 1 (Q 2 ) x
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25 50 75
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x 100 Q 2
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Reaction Curves and Cournot Equilibrium Q 1 100 In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits.
75 Firm 2’s Reaction Curve Q* 2 (Q 1 ) 50 x Cournot Equilibrium 25 x Firm 1’s Reaction Curve Q* 1 (Q 2 ) x
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x 100 Q 2
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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 ©2005 Pearson Education, Inc.
Chapter 12 23
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 ©2005 Pearson Education, Inc.
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The Linear Demand Curve
An Example of the Cournot Equilibrium Two firms face linear market demand curve We can compare competitive equilibrium, the equilibrium resulting from collusion, and Cournot Equilibrium Market demand is P = 30 - Q Q is total production of both firms: Q = Q 1 Both firms have MC 1 + Q 2 = MC 2 = 0 ©2005 Pearson Education, Inc.
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Oligopoly Example: Cournot
Firm 1’s Reaction Curve MR = MC Total Revenue :
R
1
PQ
1 ( 30
Q
)
Q
1 30
Q
1 (
Q
1
Q
2 )
Q
1 30
Q
1
Q
1 2
Q
2
Q
1 ©2005 Pearson Education, Inc.
Chapter 12 26
Oligopoly Example
An Example of the Cournot Equilibrium
MR
1
MR
1
R
1 0
Q MC
1 1 30 2
Q
1
Q
2 Firm 1' s Reaction Curve
Q
1 15 1 2
Q
2 Firm 2' s Reaction Curve
Q
2 15 1 2
Q
1 ©2005 Pearson Education, Inc.
Chapter 12 27
Oligopoly Example
An Example of the Cournot Equilibrium Cournot 15 1 2 ( Equilibriu m 15 1 2
Q
1 ) : 10
Q
1
Q P
Q
30 1
Q
2
Q
20 10
Q
2 ©2005 Pearson Education, Inc.
Chapter 12 28
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 10
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10 15 Cournot Equilibrium
Chapter 12
30 Firm 1’s Reaction Curve Q 2
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Oligopoly Example
Profit Maximization with Collusion Collusion implies industry profits maximized
R
PQ
( 30
Q
)
Q
30
Q
Q
2
MR
R
Q
30 2
Q MR
0 when Q 15 and
MR
MC
©2005 Pearson Education, Inc.
Chapter 12 30
Profit Maximization w/ Collusion
Contract Curve Q 1 + Q 2 = 15 Shows all pairs of output Q 1 maximize total profits and Q 2 that Q 1 = Q 2 = 7.5
Less output and higher profits than the Cournot equilibrium ©2005 Pearson Education, Inc.
Chapter 12 31
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 15 10 7.5
Collusion Curve
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7.5
10 Competitive Equilibrium (P = MC; Profit = 0) Cournot Equilibrium Collusive Equilibrium Firm 1’s Reaction Curve 15
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30 Q 2
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Review: How to solve Cournot
Begin with Total Revenue function Create by calculating P times Q1 and P is from the demand function in terms of Q total Must substitute Q1 + Q2 for Q Result: TR function in terms of Q1 and Q2 Identify Marginal Revenue and set equal to Marginal Cost Solve this equality in terms of Q1 = fn. Of Q2 ©2005 Pearson Education, Inc.
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First Mover Advantage – The Stackelberg Model
Oligopoly model in which one firm sets its output before other firms do Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q is total output Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1’s output ©2005 Pearson Education, Inc.
Chapter 12 34
First Mover Advantage – The Stackelberg Model
Firm 1 Must consider the reaction of Firm 2 Firm 2 Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q 2 = 15 ½(Q 1 ) ©2005 Pearson Education, Inc.
Chapter 12 35
First Mover Advantage – The Stackelberg Model
Firm 1 Choose Q 1 so that:
MR
MC
0
R
1
PQ
1 30
Q
1
- Q
1 2
- Q
2
Q
1 Firm 1 knows Firm 2 will choose output based on its reaction curve. We can use Firm 2’s reaction curve as Q 2 .
©2005 Pearson Education, Inc.
Chapter 12 36
First Mover Advantage – The Stackelberg Model
Using Firm 2’s Reaction Curve for Q 2 :
R
1 30
Q
1
Q
1 15
Q
1 1 2
Q
1 2
Q
1 2 ( 15 1 2
Q
1 )
MR
1
MR
R
1 0 :
Q
1
Q
1 15
Q
15 and
Q
2 1 7 .
5 ©2005 Pearson Education, Inc.
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First Mover Advantage – The Stackelberg Model
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.
©2005 Pearson Education, Inc.
Chapter 12 38
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 ©2005 Pearson Education, Inc.
Chapter 12 39
Price Competition – Bertrand Model
Assumptions Homogenous good Market demand is P = 30 - Q where Q = Q 1 MC 1 + Q = MC 2 2 = $3 Can show the Cournot equilibrium if Q 1 Q 2 = 9 and market price is $12, giving each firm a profit of $81.
= ©2005 Pearson Education, Inc.
Chapter 12 40
Price Competition – Bertrand Model
Assume here that the firms compete with price, not quantity Since good is homogeneous, consumers will buy from lowest price seller If firms charge different prices, consumers buy from lowest priced firm only If firms charge same price, consumers are indifferent who they buy from and each firm will supply half the market ©2005 Pearson Education, Inc.
Chapter 12 41
Price Competition – Bertrand Model
Nash equilibrium is competitive equilibrium output since have incentive to cut prices Both firms set price equal to MC P = MC; P 1 Q = 27; Q 1 = P & Q 2 2 = $3 = 13.5
Both firms earn zero profit ©2005 Pearson Education, Inc.
Chapter 12 42
Price Competition – Bertrand Model
Why not charge a different price? If charge more, sell nothing If charge less, lose money on each unit sold The Bertrand model demonstrates the importance of the strategic variable Price versus output ©2005 Pearson Education, Inc.
Chapter 12 43
Bertrand Model – Criticisms
When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices Even if the firms do choose the same price, what share of total sales will go to each one?
Probably not exactly half ©2005 Pearson Education, Inc.
Chapter 12 44
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?
©2005 Pearson Education, Inc.
Chapter 12 45
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 a payoff matrix to better understand the firms’ choices ©2005 Pearson Education, Inc.
Chapter 12 46
Payoff Matrix for Pricing Game
Firm 2
Charge $4 Charge $6 Charge $4
Firm 1
Charge $6 $12, $12 $4, $20 $20, $4 $16, $16
©2005 Pearson Education, Inc.
Chapter 12 47
Competition Versus Collusion: The Prisoners’ Dilemma
We can now answer the question of why firm does not choose cooperative price Cooperating means both firms charging $6 instead of $4 and earning $16 instead of $12 Each firm always makes more money by charging $4, no matter what its competitor does Unless enforceable agreement to charge $6, will be better off charging $4 ©2005 Pearson Education, Inc.
Chapter 12 48
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 ©2005 Pearson Education, Inc.
Chapter 12 49
Payoff Matrix for Prisoners’ Dilemma Confess
Prisoner B
Don’t confess Confess
Prisoner A
Don’t confess -5, -5 -1, -10 Would you choose to confess?
-10, -1 -2, -2
©2005 Pearson Education, Inc.
Chapter 12 50
Oligopolistic Markets
Conclusions 1.
Collusion will lead to greater profits 2.
Explicit and implicit collusion is possible: 1.
2.
3.
Reputations Short-lived gains from cheating Face retaliation 3.
Once collusion exists, the profit motive to break and lower price is significant ©2005 Pearson Education, Inc.
Chapter 12 51
Price Rigidity
Firms have strong desire for stability Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change Fear lower prices will send wrong message to competitors, leading to price war Higher prices may cause competitors to raise theirs ©2005 Pearson Education, Inc.
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Price Rigidity
Basis of
kinked demand curve model
of oligopoly Each firm faces a demand curve kinked at the current prevailing price, P* Above P*, demand is very elastic If P > P*, other firms will not follow Below P*, demand is very inelastic If P < P*, other firms will follow suit ©2005 Pearson Education, Inc.
Chapter 12 53
The Kinked Demand Curve $/Q So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MC
’
P* MC D
©2005 Pearson Education, Inc.
Q*
Chapter 12
MR Quantity
54
Price Rigidity
With a kinked demand curve, marginal revenue curve is discontinuous Firm’s costs can change without resulting in a change in price Kinked demand curve does not really explain oligopolistic pricing Description of price rigidity rather than an explanation of it How was price chosen to begin with?
©2005 Pearson Education, Inc.
Chapter 12 55
Price Signaling and Price Leadership
Price Signaling Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Leadership Pattern of pricing in which one firm regularly announces price changes that other firms then match ©2005 Pearson Education, Inc.
Chapter 12 56
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 Most fail to maintain high prices ©2005 Pearson Education, Inc.
Chapter 12 57
Cartels
Examples of successful cartels OPEC International Bauxite Association Mercurio Europeo Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa ©2005 Pearson Education, Inc.
Chapter 12 58
Cartels – Conditions for Success
1.
Stable cartel organization must be formed – price and quantity settled on and adhered to Members have different costs, assessments of demand and objectives Tempting to cheat by lowering price to capture larger market share ©2005 Pearson Education, Inc.
Chapter 12 59
Cartels – Conditions for Success
2.
Potential for monopoly power Even if cartel can succeed, there might be little room to raise prices if it faces highly elastic demand If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work Low potential = low incentive to work out organizational problems ©2005 Pearson Education, Inc.
Chapter 12 60
Cartels
To be successful: Total demand must be fairly inelastic Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must also be inelastic ©2005 Pearson Education, Inc.
Chapter 12 61
The Cartelization of Intercollegiate Athletics
1.
2.
3.
Large number of firms (colleges) Large number of consumers (fans) Very high profits ©2005 Pearson Education, Inc.
Chapter 12 62
The Cartelization of Intercollegiate Athletics
NCAA is the cartel Restricts competition Reduces bargaining power by athletes – enforces rules regarding eligibility and terms of compensation Reduces competition by universities – limits number of games played each season, number of teams per division, etc.
Limits price competition – sole negotiator for all football television contracts ©2005 Pearson Education, Inc.
Chapter 12 63
The Cartelization of Intercollegiate Athletics
Although members have occasionally broken rules and regulations, has been a successful cartel In 1984, Supreme Court ruled that the NCAA’s monopolization of football TV contracts was illegal Competition led to drop in contract fees More college football on TV, but lower revenues to schools ©2005 Pearson Education, Inc.
Chapter 12 64