Monopolistic Competition and Oligopoly

Chapter 12
Monopolistic Competition and Oligopoly
Topics to be Discussed
Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners Dilemma Implications of the Prisoners Dilemma for Oligopolistic Pricing Cartels
2005 Pearson Education, Inc. Chapter 12 2
Monopolistic Competition
Characteristics
1. Many firms 2. Free entry and exit 3. Differentiated product
2005 Pearson Education, Inc.
Chapter 12
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
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
Two important characteristics
Differentiated but highly substitutable products Free entry and exit
Chapter 12
A Monopolistically Competitive Firm in the Short and Long Run

$/Q
Short Run
MC AC
$/Q
Long Run
MC AC
PSR PLR DSR DLR MRSR QSR

Quantity
MRLR QLR
Quantity

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

Long run
Profits will attract new firms to the industry (no barriers to entry) The old firms demand will decrease to DLR Firms output and price will fall Industry output will rise No economic profit (P = AC) P > MC some monopoly power
Chapter 12
Monopolistically and Perfectly Competitive Equilibrium (LR)

$/Q
Perfect Competition
MC AC
$/Q Deadweight loss
MC
AC
P PC D = MR DLR MRLR
QC
Quantity
QMC
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.
Chapter 12
11
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
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
The Market for Colas and Coffee

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
Elasticities of Demand for Brands of Colas and Coffee
Chapter 12
15
The Market for Colas and Coffee

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
Oligopoly Characteristics
Small number of firms Product differentiation may or may not exist Barriers to entry
Scale economies Patents Technology Name recognition Strategic action
Oligopoly
Examples
Automobiles Steel Aluminum Petrochemicals Electrical equipment
Chapter 12
18
Oligopoly
Management Challenges
Strategic actions to deter entry
Threaten
to decrease price against new competitors by keeping excess capacity only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react
Rival behavior
Because
Chapter 12
19
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

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
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
Firm 1s Output Decision

P1
D1(0)
Firm 1 and market demand curve, D1(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. If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount.
D1(75) MR1(75)
MR1(0)
MC1 MR1(50) 12.5 25 50

Chapter 12
D1(50)
Q1
23
Oligopoly
The Reaction Curve
The relationship between a firms profitmaximizing output and the amount it thinks its competitor will produce A firms profit-maximizing output is a decreasing schedule of the expected output of Firm 2
Chapter 12
24
Reaction Curves and Cournot Equilibrium

Q1 100
Firm 1s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The xs correspond to the previous model.
75
Firm 2s Reaction Curve Q*2(Q1)
50 x x
Firm 2s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce.
25
x
75
Chapter 12
25
50
100
Q2
25
Reaction Curves and Cournot Equilibrium

Q1 100
In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits. Firm 2s Reaction Curve Q*2(Q1)
75
50 x x
Cournot Equilibrium
25
x
75
Chapter 12
25
50
100
Q2
26
Cournot Equilibrium
Each firms 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
27
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
28
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 + Q2 Both firms have MC1 = MC2 = 0
Chapter 12
29
Oligopoly Example
Firm 1s Reaction Curve MR = MC
Total Revenue : R1 PQ1 (30 Q)Q1
30Q1 (Q1 Q2 )Q1 30Q1 Q Q2Q1

2 1
Chapter 12
30
Oligopoly Example
MR1 R1 Q1 30 2Q1 Q2 MR1 0 MC1 Firm1' s Reaction Curve Q1 15 1 2 Q2 Firm 2' s Reaction Curve Q2 15 1 2 Q1
Oligopoly Example
CournotEquilibrium : Q1 Q2 15 1 2(15 1 2Q1 ) 10 Q Q1 Q2 20 P 30 Q 10
Chapter 12
32
Duopoly Example
Q1 30
Firm 2s Reaction Curve The demand curve is P = 30 - Q and both firms have 0 marginal cost.
15
Cournot Equilibrium
10
Firm 1s Reaction Curve 10
15
Chapter 12
30
Q2
33
Oligopoly Example
Profit Maximization with Collusion
R PQ (30 Q)Q 30Q Q MR R Q 30 2Q MR 0 when Q 15 and MR MC

2
Chapter 12
34
Profit Maximization w/ Collusion

Contract Curve
Q1 + Q2 = 15
Shows
all pairs of output Q1 and Q2 that maximize total profits output and higher profits than the Cournot equilibrium
Q1 = Q2 = 7.5
Less
Chapter 12
35
Duopoly Example
Q1 30
Firm 2s 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)
15
Cournot Equilibrium
10
7.5
Collusion Curve
Collusive Equilibrium
Firm 1s Reaction Curve 7.5 10 15
Chapter 12
30
Q2
36
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 1s output

Firm 1
Must consider the reaction of Firm 2
Firm 2
Takes Firm 1s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = 15 - (Q1)
Chapter 12
38

Firm 1
Choose Q1 so that:
MR MC 0 R1 PQ1 30Q1 - Q - Q2Q1

2 1
Firm 1 knows Firm 2 will choose output based on its reaction curve. We can use Firm 2s reaction curve as Q2 .

Using Firm 2s Reaction Curve for Q2:
R1 30Q1 Q12 Q1 (15 1 2Q1 ) 15Q1 1 2 Q
2 1
MR1 R1 Q1 15 Q1 MR 0 : Q1 15 and Q2 7.5
Chapter 12
40

Conclusion
Going first gives Firm 1 the advantage Firm 1s output is twice as large as Firm 2s Firm 1s profit is twice as large as Firm 2s
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
41
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
42
Price Competition Bertrand Model

Assumptions
Homogenous good Market demand is P = 30 - Q where Q = Q 1 + Q2 MC1 = MC2 = $3
Can show the Cournot equilibrium if Q1 = Q2 = 9 and market price is $12, giving each firm a profit of $81.
Chapter 12
43

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
Chapter 12
44

Nash equilibrium is competitive output since have incentive to cut prices Both firms set price equal to MC
P = MC; P1 = P2 = $3 Q = 27; Q1 & Q2 = 13.5
Both firms earn zero profit
Chapter 12
45

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
Chapter 12
46
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 set prices and choose the same price, what share of total sales will go to each one?
It may not be equally divided
Chapter 12
47
Price Competition Differentiated Products

Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firms product In these markets, more likely to compete using price instead of quantity
Chapter 12
48

Example
Duopoly with fixed costs of $20 but zero variable costs Firms face the same demand curves
Firm
1s demand: Q1 = 12 - 2P1 + P2 Firm 2s demand: Q2 = 12 - 2P1 + P2
Quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price
Chapter 12
49

Firms set prices at the same time
Firm 1 : 1 P 1Q1 $20 P 1 (12 2 P 1P 2 ) 20 12 P 1 - 2P P 1P 2 20

2 1
Chapter 12
50

If P2 is fixed:
Firm1' s profit maximizing price 1 P1 12 4 P1 P2 0 Firm1' s reactioncurve P1 3 1 4 P2 Firm 2' s reactioncurve P2 3 1 4 P1
Chapter 12
51
Nash Equilibrium in Prices

What if both firms collude?
They both decide to charge the same price that maximizes both of their profits Firms will charge $6 and will be better off colluding since they will earn a profit of $16
Chapter 12
52

P1
Collusive Equilibrium
Equilibrium at price of $4 and profits of $12
$6
$4
Nash Equilibrium
$4
$6
Chapter 12
P2
53

If Firm 1 sets price first and then Firm 2 makes pricing decision:
Firm 1 would be at a distinct disadvantage by moving first The firm that moves second has an opportunity to undercut slightly and capture a larger market share
Chapter 12
54
A Pricing Problem: Procter & Gamble

Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd. were entering the market for Gypsy Moth Tape All three would be choosing their prices at the same time Each firm was using same technology so had same production costs
FC = $480,000/month & VC = $1/unit
Chapter 12
55

Procter & Gamble had to consider competitors prices when setting their price P&Gs demand curve was: Q = 3,375P-3.5(PU)0.25(PK)0.25 Where P, PU, PK are P&Gs, Unilevers, and Kaos prices respectively
Chapter 12
56

What price should P&G choose and what is the expected profit? Can calculate profits by taking different possibilities of prices you and the other companies could charge Nash equilibrium is at $1.40 the point where competitors are doing the best they can as well
P&Gs Profit (in thousands of $ per month)
Chapter 12
58
A Pricing Problem for Procter & Gamble

Collusion with competitors will give larger profits
If all agree to charge $1.50, each earn profit of $20,000 Collusion agreements are hard to enforce
Chapter 12
59
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 dont firms cooperate without explicitly colluding?
Why not set profit maximizing collusion price and hope others follow?

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
61

Assume:
FC $20 and VC $0 Firm 1' s demand : Q 12 2 P 1P 2 Firm 2' s demand : Q 12 2 P2 P 1 Nash Equilibrium : P $4 Collusion :
2005 Pearson Education, Inc. Chapter 12
P $6
$12 $16
62

Possible Pricing Outcomes:
Firm 1 : P $6 P $6
Firm 2 : P $6 P $4
$16
2 P2Q2 20 1 P1Q1 20
(4)12 (2)(4) 6 20 $20 (6)12 (2)(6) 4 20 $4

63
Payoff Matrix for Pricing Game

Firm 2 Charge $4 Charge $6
Charge $4
$12, $12
$20, $4
Firm 1 Charge $6
$4, $20
$16, $16
Chapter 12
64

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

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
66
Payoff Matrix for Prisoners Dilemma

Prisoner B Confess Dont confess
Confess
-5, -5
-1, -10
Prisoner A Dont confess
Would you choose to confess?
-10, -1
-2, -2
Chapter 12
67
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
68
Payoff Matrix for the P&G Pricing Problem

Unilever and Kao Charge $1.40 Charge $1.50
Charge $1.40
P&G
$12, $12
$29, $11
What price should P & G choose?
Charge $1.50
$3, $21
$20, $20
Chapter 12
69
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
Chapter 12
70
Observations of Oligopoly Behavior

2. In other oligopoly markets, the firms are very aggressive and collusion is not possible
a. Firms are reluctant to change price because of the likely response of their competitors b. In this case, prices tend to be relatively rigid
Chapter 12
71
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
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 P < P*, other firms will follow suit
Below P*, demand is very inelastic

If
Chapter 12
73
Price Rigidity
With a kinked demand curve, marginal revenue curve is discontinuous Firms 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
Chapter 12
74
The Kinked Demand Curve

$/Q
If the producer raises price, the competitors will not and the demand will be elastic. If the producer lowers price, the competitors will follow and the demand will be inelastic.
Quantity
MR
75
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
Q*
Quantity
MR
76
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
Chapter 12
77
Price Signaling and Price Leadership

The Dominant Firm Model
In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market The large firm might then act as the dominant firm, setting a price that maximizes its own profits
Chapter 12
78
The Dominant Firm Model

Dominant firm must determine its demand curve, DD
Difference between market demand and supply of fringe firms
To maximize profits, dominant firm produces QD where MRD and MCD cross At P*, fringe firms sell QF and total quantity sold is QT = QD + QF
Price Setting by a Dominant Firm

Price D SF
The dominant firms demand curve is the difference between market demand (D) and the supply of the fringe firms (SF).
P1 P* DD P2
MCD
At this price, fringe firms sell QF, so that total sales are QT.
QF QD
QT
MRD
Quantity
80
Chapter 12
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
Cartels
Examples of successful cartels
OPEC International Bauxite Association Mercurio Europeo
Examples of unsuccessful cartels

Copper Tin Coffee Tea Cocoa
Chapter 12
82
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
Chapter 12
83
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
Chapter 12
84
Analysis of Cartel Pricing

Members of cartel must take into account the actions of non-members when making pricing decisions Cartel pricing can be analyzed using the dominant firm model
OPEC oil cartel successful CIPEC copper cartel unsuccessful
Chapter 12
85
The OPEC Oil Cartel

Price
TD SC
TD is the total world demand curve for oil, and SC is the competitive supply. OPECs demand is the difference between the two.
P*
OPECs profit maximizing quantity is found at the intersection of its MR and MC curves. At this quantity OPEC charges price P*.
DOPEC MCOPEC
MROPEC
QOPEC
Quantity
86
Cartels
About OPEC
Very low MC TD is inelastic Non-OPEC supply is inelastic DOPEC is relatively inelastic
Chapter 12
87
The OPEC Oil Cartel

Price
TD SC
The price without the cartel: Competitive price (PC) where DOPEC = MCOPEC
P*
DOPEC
Pc
MROPEC
MCOPEC
QC
QOPEC
QT
Quantity
88
Chapter 12
The CIPEC Copper Cartel

Price
TD TD and SC are relatively elastic DCIPEC is elastic CIPEC has little monopoly power P* is closer to PC
SC
MCCIPEC P* PC DCIPEC
MRCIPEC
QCIPEC
QC
QT
Quantity
89
Chapter 12
Cartels
To be successful:
Total demand must not be very price elastic Either the cartel must control nearly all of the worlds supply or the supply of noncartel producers must not be price elastic
Chapter 12
90
The Cartelization of Intercollegiate Athletics

1. Large number of firms (colleges) 2. Large number of consumers (fans) 3. Very high profits
Chapter 12
91

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
Chapter 12
92

Although members have occasionally broken rules and regulations, has been a successful cartel In 1984, Supreme Court ruled that the NCAAs monopolization of football TV contracts was illegal
Competition led to drop in contract fees More college football on TV, but lower revenues to schools
Chapter 12
93

Monopolistic Competition and Oligopoly

Încărcat de

Informații document

Descriere originală:

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Monopolistic Competition and Oligopoly

Încărcat de

Drepturi de autor:

Formate disponibile

Chapter 12

Monopolistic Competition and Oligopoly

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

A Monopolistically Competitive Firm in the Short and Long Run

PSR PLR DSR DLR MRSR QSR

A Monopolistically Competitive Firm in the Short and Long Run

2005 Pearson Education, Inc.

A Monopolistically Competitive Firm in the Short and Long Run

2005 Pearson Education, Inc.

Monopolistically and Perfectly Competitive Equilibrium (LR)

Monopolistic Competition and Economic Efficiency

2005 Pearson Education, Inc.

Monopolistic Competition and Economic Efficiency

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The Market for Colas and Coffee

How much monopoly power do each of these producers have?

2005 Pearson Education, Inc.

Elasticities of Demand for Brands of Colas and Coffee

2005 Pearson Education, Inc.

The Market for Colas and Coffee

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Actions and reactions are dynamic, evolving over time

We will focus on duopoly

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Firm 1s Output Decision

MC1 MR1(50) 12.5 25 50

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Reaction Curves and Cournot Equilibrium

Firm 2s Reaction Curve Q*2(Q1)

Reaction Curves and Cournot Equilibrium

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The Linear Demand Curve

2005 Pearson Education, Inc.

Total Revenue : R1 PQ1 (30 Q)Q1

30Q1 (Q1 Q2 )Q1 30Q1 Q Q2Q1

2005 Pearson Education, Inc.

CournotEquilibrium : Q1 Q2 15 1 2(15 1 2Q1 ) 10 Q Q1 Q2 20 P 30 Q 10

2005 Pearson Education, Inc.

R PQ (30 Q)Q 30Q Q MR R Q 30 2Q MR 0 when Q 15 and MR MC

2005 Pearson Education, Inc.

Profit Maximization w/ Collusion

2005 Pearson Education, Inc.

Competitive Equilibrium (P = MC; Profit = 0)

2005 Pearson Education, Inc.

First Mover Advantage The Stackelberg Model

First Mover Advantage The Stackelberg Model

2005 Pearson Education, Inc.

First Mover Advantage The Stackelberg Model

MR MC 0 R1 PQ1 30Q1 - Q - Q2Q1

First Mover Advantage The Stackelberg Model

MR1 R1 Q1 15 Q1 MR 0 : Q1 15 and Q2 7.5

2005 Pearson Education, Inc.

First Mover Advantage The Stackelberg Model